The Structure of the Banking System Between the 1960s and the 1980s
This chapter can be really defined as 'historic', because of the great changes that have affected the British banking system after the 1980s. Even if no gap can be found in the evolution -- institutional, structural, operational -- of the system ('historic non facitsaltus'), it's undeniable that the present configuration bears only a thin resemblance to the previous morphology, legislation, functions. At the same time, this retrospective view of the banking and financial industry, also in its interactions with public policy issues and cultural frameworks then prevailing, is useful in order to put in focus the situation of today, and to understand better the most recent turmoil and its possible (not necessary) outcomes. To be sure, we cannot take the whole period from the 1960s through the 1980s as a single bloc.
In order to strengthen the protection of competition, two laws were passed completely revising the relevant legislation: the Competition Act 1998 and the Enterprise Act 2002. However, to understand the various aspects of the reform and grasp its scope, it is necessary to make a brief examination of the evolution of the law in this field. In the period from immediately after the Second World War to today, competition law in the UK has developed in a haphazard way. The system grew more and more complex because, since 1948, there have been several statutes extending the scope and adding new layers of legislation. Part of the law was judge-made in the form of common law doctrine. In the most recent period, moreover, Community law has exercised a powerful influence, in the same way as in the banking and financial sector, both through the adoption of new legislation and through judgments of the European Court of Justice.
The most important regulatory reform affecting banks and, in general, financial institutions occurred only during 1997 -- 2000, after few grave, but not systemic, banking crises, when the whole structure of financial regulation and supervision was changed, and the monetary policy decision-making process was also revised.
One might wonder why this chapter ends with the 1980s, and not, for example, with the creation of the Financial Services Authority (FSA) and the approval of the Financial Services and Markets Act (FSMA) of 2000, that will be dealt with in a subsequent chapter. The periodization is always a matter of discretion, if not an arbitrary choice; but fter the Big Bang and during the 1990s a series of developments occurred that shaped the banking and financial system in a way not far from today's environment, for example in terms of internationalization, use of 'exotic' financial instruments, diversification of household assets in a broad range of financial products, blurring of distinctions between different types of financial intermediaries. The legislation of 1997 -- 2000 systemized this whole matter, and we live now within that framework, and with the features just mentioned. In addition, our main database, that covers the period 1990 -- 2005, appeared the best suited to give a fairly comprehensive and deep perspective of the economic and financial trends underway.
Despite the considerable differences in the way they operated, discount houses are included in this segment because they served to meet the requirements of deposit banks. Discount houses were money market institutions, whose liabilities consisted of 'sight' loans, primarily obtained from the clearing banks as part of their treasury management, and whose assets consisted of short to medium-term securities issued by the British government and commercial bills; securities that were given as collateral to the financing banks. If banks were to need liquidity and withdraw their 'sight' funds, the discount houses could turn to the Bank of England as lender of last resort. The reasons for this 'cushion' between the deposit banks and the central bank are essentially of a historical and traditional nature: in short, the reluctance of banks to seek finance in cases of necessity from a sister bank, even a special one like the central bank. This explains why the development of an active and liquid inter-bank market gradually squeezed out the discount houses.
The secondary banks segment, primarily comprising accepting houses, overseas banks and foreign banks, appears considerably more heterogeneous. As mentioned earlier, the common factor distinguishing them from the first segment was their lack of direct access to the payment mechanism and the clearing arrangements. Moreover, unlike deposit banks, secondary banks took the bulk of their deposits on the wholesalemarket rather than the retail market.
1.2 The 1970s: more competition, secondary banks' crisis, the Banking Act 1979 One of the system's most distinctive traits, the deposit banks' interestrate cartel, was abolished in 1971 with a series of measures following on from the Bank of England's consultation paper 'Competition and Credit Controls' (CCC), aimed at increasing competition in the banking system and reviewing the modus operandi of monetary policy. As a matter of fact in the same year the Bank of England decided to replace the quantitative limits imposed on all banks and the liquidity ratio imposed on clearing banks with a new system requiring all banks to hold minimum reserve assets equal to 12.5 per cent of their eligible liabilities.
The 1971 measures removed the partition separating the two market segments of deposit banks and secondary banks and permitted the full entry of deposit banks into wholesale banking (previously they had had only indirect access to the wholesale market through subsidiaries). This had an impact on the functioning of the money market. In fact, prior to the CCC, one area (the discount market) fell within the operational scope of the deposit banks, which through the discount houses 'made' the money market and had access to central bank discounting; the second area (the parallel money market) fell within the scope of the secondary banks, was not covered by the central bank's 'safety net' and was primarily concerned with the Euromarket. The two areas had been kept separate to prevent the foreign sector from interfering with the domestic money market, in accordance with a structure which was deemed to meet the needs of monetary policy.
The absence of supervision by the Bank of England allowed the secondary banks to collect large amounts of unsecured funds on the secondary market and to use them to provide finance, including long-term loans, for the construction of non-residential property, a market that was booming in those years. The removal of quantitative limits for banks in 1971, together with the expansionary stance of monetary policy despite the high point of he cycle, fuelled a speculative bubble in the building sector. The decision, taken towards the end of 1973, to raise the discount rate led to a problem of maturity mismatching for many secondary banks. In just a few months both house prices and the share market fell. 25 secondary banks paid the price, but were subsequently saved thanks to the intervention of the Bank of England and the support of the clearing banks, which bought 16 of the banks involved in the crisis. The Bank of England bore approximately 10 per cent of the cost of the bailout. According to an estimate, although the Bank of England didn't provide figures, it had to put aside 'a remarkable total of about GBP100m for the possible cost to itself of the whole rescue strategy'.The crisis of the secondary banks is significant because, after decades of stability, it marked the central bank's debut in a systemic bailout. 'The fact that the central bank, a state-owned body, accepted responsibility for potential losses of such a scale, with a resultant drop in its payments to the Nation's Exchequer, alone makes the measures taken to deal with the secondary bank crisis a matter of major public interest'.
1 The Structure of the Banking System Between the 1960s and the 1980s
This chapter can be really defined as'historic', because of the great changes that have affected the British banking system after the 1980s. Even if no gap can be found in the evolution -- institutional, structural, operational -- of the system ('historia non facit saltus'), it's undeniable that the present configuration bears only a thin resemblance to the previous morphology, legislation, functions. At the same time, this retrospective view of the banking and financial industry, also in its interactions with public policy issues and cultural frameworks then prevailing, is useful in order to put in focus the situation of today, and to understand better the most recent turmoil and its possible (not necessary) outcomes.
To be sure, we cannot take the whole period from the 1960s through the 1980s as a single bloc. After a long and relatively undisturbed post-war phase, an evolution occurred that, broadly speaking, meant the passage from an oligopolistic banking structure, an interest rate cartel, a rather protective environment, where banks could almost be considered as public utilities, and from a mostly informal supervision by the central bank, to a more dynamic environment, where the seeds of competition were sowed, and regulation and supervision became more articulate and statutory-oriented. The driving forces of the change can be found in some sectors of the banking system, less bound by the 'constraints'of the central bank, still very focused on the narrow group of the clearing banks, and in the openness of London as a financial centre, that increasingly attracted international banks (particularly American, but also branches of European banks).
8 The New Regulatory Framework: The Financial Services Authority
It is difficult to find a single, major cause for the creation of the new regulatory framework in the UK, but several factors have contributed to the reform, that have spanned a period of approximately four-years. The creation of complex financial intermediaries had caused the distinc-tions that had previously characterized the financial sector to become blurred. Banks did not appear to be 'special' anymore or at least not as special, as before, now being in competition, both on the provision and on the gathering of funds, with other financial institutions, and entering themselves into other fields of financial intermediation, while the regulatory structure remained fragmented, and still very much reliant on self-regulation.
The availability of financial products, which is sometimes difficult to understand for the retail customer, raised a problem of customer awareness and protection. This problem was compounded by the misselling of some products, particularly pension products, where inadequate supervision was found. The stability of the banking system had remained largely intact, but some big failures: the cases of BCCI and Barings, raised questions aboutthe effectiveness of the supervision of the central bank. The idea of a conflict of interest between the regulatory and supervisory function, and the monetary policy function, was strongly supported and pointed to a separation of the two functions, and the need for them to be allocated to different bodies.
The models of supervision available are numerous, as the experience of diverse countries demonstrates, but can be summarized under three headings: the single regulator; the twin peaks regulation, where supervision is split according to the purpose: prudential/stability on one side, transparency/conduct of business on the other; and regulation by sector (banks, securities firms, insurance, etc.). Variations may exist for each model, and their distinction is, in fact, not so clear-cut as theoretically possible. The role of the central bank may range in its extension, but it is never totally out of the supervision perimeter.
Britain's choice has been the single regulator, the FSA, and a role on macro-systemic oversight attributed to the Bank of England, that keeps anyway the lender-of-last resort responsibility. This choice is based on consideration of cost-effectiveness, economies of scale and scope, on the opportunity of a uniform approach to regulation, and on consumer protection and financial crime prevention. The stability issue is not damaged, in the legislator's view, by the division of responsibilities between the regulator and the central bank that is between the micro-supervisor and the macro-oversighter: the linkage between the FSA and the Bank rests on a Memorandum of Understanding (that includes the Treasury) and is assured by a continuous contact between the two.