The Thatcherite legacy is receiving renewed scrutiny since the former UK prime minister’s death on Monday. One of its most important features was radical financial reform, along with a marked change in the way the financial sector was perceived.
When Margaret Thatcher came to power in 1979 the job of the financial system was thought to be about mobilising funds for investment and providing access to payment services – worthy but boring roles.
After the liberalisation of the City and the Big Bang reform of the stock exchange in 1986, politicians were pleasantly surprised to discover that the financial sector could contribute to economic growth while providing post-industrial jobs as British manufacturing ran down. Few foresaw the dangers in looking at an inherently fragile financial system as a motor of the economy.
As with so many policies at the time, this upheaval was not the product of ideology. (Never forget that the flagship privatisation of British Telecom took place because the Treasury’s rules on public sector investment were so restrictive that no one could work out how to finance the renewal of the disintegrating telephone network – hence the decision to outsource the headache to the private sector.)
Indeed the real architect of the historic deal struck between Cecil (later Lord) Parkinson, the secretary of state for trade, and Sir Nicholas Goodison, chairman of the stock exchange, to liberalise securities trading in London was not a politician. It was David Walker, then a director of the Bank of England, now Sir David and chairman of Barclays.
He and his colleagues at the Bank of England saw their role in relation to the City much like that of a sponsoring department in Whitehall. They worried about a lack of competitiveness in parts of the Square Mile. In particular they were concerned that a stock exchange club that excluded foreigners and operated a different dealing system from that of the US had become a backwater in a world of rapidly globalising capital flows.
In the aftermath of the Latin American debt crisis big companies could raise finance more cheaply in markets than from banks, which meant the City needed reinvigorated securities markets to keep up.
It was also behind New York in new risk management products such as interest rate and currency swaps, which had proliferated since the break-up of the Bretton Woods semi-fixed exhange rate system and banking deregulation.
With hindsight, one of the big regulatory shortcomings in the 1980s and 1990s was a failure to recognise the need for a bigger capital buffer as financial institutions took on more market risk and cross-border counterparty risk.
Indeed the opposite happened. The Basel capital adequacy regime of the late 1980s was a lowest common denominator exercise, driven by banks’ demands for a level playing field rather than concern about increased risk and growing concentration in the banking system that would cause the 'too big to fail' problem to escalate. In pursuit of high returns on equity, banks ran down their capital to absurdly low levels.
Another serious error was the downgrading of liquidity in the Basel regime when banks were becoming more dependent on volatile wholesale finance. Then there was the failure to grasp the extent to which the American dealing system, which allowed securities companies to make markets and deal on their own account as well as for clients, involved overwhelming conflicts of interest. The old ethical imperative of putting the client’s interest first was severely damaged. Combined with the introduction of ever-higher bonuses, this cultural change led ultimately to today’s Libor-related scandals and the rest.
The interesting question now, in the light of the banking catastrophes in Iceland, Ireland and Cyprus, is whether there is a case for putting limits on the size of banking systems in relation to economies to address incipient 'too big to save' problems.
An explicit limit may not, in fact, be necessary. The Swiss authorities are imposing a de facto constraint on size by demanding more draconian rules on bank capital than required by Basel III. The UK’s proposal for ringfencing retail banks may well end up having the same effect.
If markets believe the investment banking activities outside the ringfence will not be regarded by politicians as too big to fail, and if regulators respond to the non-ringfenced banks’ increased dependence on wholesale funds with tougher liquidity rules, funding costs in the non-ringfenced banks will be higher than in continental universal banks.
Does anyone believe that the Germans and French will allow the Liikanen review’s European ringfencing proposals to take effect? Surely not. They like to protect their big banks – in which case ringfenced UK investment banking may be a dead duck.
Copyright The Financial Times Limited 2013.