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John Redwood: A catalogue of banking errors led to the current crisis

Guardian Economics 14th March 2009

If I could see from the sidelines that easy credit and good times could lead to disaster, why couldn't the then chancellor?

I have always been careful to go along with the conventional wisdom and with the government spin that there are banks that are too large to be allowed to fail. I have done so knowing how powerful the spin against me would be if I ever suggested otherwise.

To concede that does not mean, however, that I have to support the huge sums of money the government has made available to bail out bad banks, and certainly does not mean I agree with buying shares in them, which delays sorting them out. If the authorities are stupid enough to get themselves into the position where some banks are too big to fail, it is even more important they take prompt action to break them up so they cease to be too big to fail.

The correct strategy with an unwieldy conglomerate such as RBS is to break it up into its constituent parts and find answers for each of them. Some could be sold immediately. Some will need managing to health and some, such as the investment bank, can be closed down after the bits of value have been sold. You should also keep RBS short of capital and cash to force it to raise more of its own, and to prevent it from paying the absurdly high salaries and bonuses it is still paying when it is no longer making profits and raising private money to do so.

This is a good policy for the taxpayer, cutting risk and getting some cash back. It is a good policy for the banks' customers, leading to more banks and therefore more choice in the marketplace. It is good policy for the regulators, making it easier to see what is going on, with each business having its own balance sheet and its own, more visible and accountable, management team.

The competition authorities were asleep on the watch in recent years. They should not have allowed the Lloyds/HBOS merger, nor some of the constituent mergers that created RBS. Allowing banks to become that big does damage the market, putting too much banking under common decision-making and ownership.

I read yesterday that the FSA is now going to hire 280 extra staff and is going to make life frightening for banks. I don't think that is the right response. The regulatory failure in the UK occurred thanks to the former chancellor. He was the man who split responsibility for banks' capital and solvency by making the Bank of England responsible for the banking system and making the FSA responsible for individual banks. He became the chief regulator himself, as the head of the tripartite system. He must take the ultimate responsibility for what went wrong.

What he failed to see was obvious. Banks were allowed to expand their balance sheets far too much. It does not take 280 people to work that out. Just one person who knew what they were doing could have seen that the top four banks were expanding too quickly and had too little capital in relation to the amount of business they were writing. If I could see that from the sidelines, surely the chancellor could see it, aided by all the advisers he enjoys at the Treasury, Bank and FSA. They had the powers to make them have more capital for any given volume of business – and should have used them.

When I wrote the Conservative Economic Policy review foreword, I read the banks' balance sheets and described how the fast growth of the previous few years rested upon the weird and wonderful expansion of financial instruments in the banking and shadow banking system. I explained how this would now come to a stop and how times would get tougher. This has been selectively quoted by commenters on this website to suggest I thought the expansion was a good idea! They refused to quote the crucial following passages and the recommendation that the Bank of England needed to be given back its powers to control banks cash and capital.

For those who have read the quote about how the easy credit created good times, here is the following quote about what could happen next, written in June 2007, well before the run on Northern Rock and the events that followed:

As we write, there is considerable uncertainty about how far the Fed, the ECB and the Bank of England may go in raising rates to squeeze inflation out of the system. They must know there are huge pyramids of debt throughout the system, and inflation will not be killed unless the appetite for more debt is blunted. They also know [perhaps they didn't!] that if they push interest rates too high for too long they could bring the debt structures crashing down, as we have seen with the sub prime mortgage collapse in the USA, leading to falling asset prices, rising unemployment and even recession.

I rest my case.

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