Problems In British Banking System

Image: Kagan McLeod

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Americans are conditioned to think of Europe as a giant bureaucracy dotted with some old churches and nice restaurants. But in reality, London, as recently as two years ago, was a laissez-faire paradise. Banks and other financial firms could get by with even thinner capital cushions than their American counterparts. Rather than dole out punishments, regulators opted for negotiation­—friendly dialogues over tea.

This made London seem like a threat to New York’s reign as financial capital of the world. Egged on by the business and Wall Street lobbies, American politicians worried that New York was losing out, partly because of the oversight imposed by the Sarbanes-Oxley Act.

Now, however, the British capital is mired in as great a crisis as New York’s—and things are about to get worse, making a mockery of the insecurity complex regarding Britain that hit U.S. business leaders just months ago. Given that both countries are dealing with the same credit crisis, this should make us wonder why the two regulatory regimes, so different in structure, have each failed.

British bank stocks have plummeted in the wake of last year’s rescue attempt and subsequent failure of Northern Rock, a midsize bank whose customers were seen on the evening news lining up to withdraw their money. Britain’s surviving banks are scrambling to raise capital, with some having less success than others. The deflation of the British housing bubble has only just begun. Prices, which rose at roughly double the U.S. rate over the past decade, tumbled about 10 percent from their peak in August 2007 through the middle of this summer. Inflation and unemployment are rising, and Britain is in a bear market.

Things might become worse in Britain than in the U.S. Consumers are more indebted; financial services make up an even greater portion of the economy; inflation takes a much more significant bite because the British have to import so much.

What seemed like a prospering and unfettered free market has turned ugly. The two countries’ respective problems are related to financial excesses, but Britain seems further down the path of examining the faults and weaknesses in its financial regulatory structure.

We need to do the same. Then we can learn from London about what—and what not—to do.

In the U.S., problems started when home prices merely stopped rising, revealing the bad loans the financial sector had made. Subprime borrowers couldn’t refinance and began to default on their mortgages. Home prices dropped, and the credit problems spread beyond subprime. Britain’s troubles, in contrast, started not from credit problems but from banks’ reliance on short-term funding rather than deposits. The thin capital cushions suddenly became serious vulnerabilities. “It was presumed that the market simply wouldn’t deal with undercapitalized financial institutions. U.K. banks and insurance companies were allowed to run with much less capital than similar American institutions,” says John Hempton, an Australian financial analyst and expert on British markets.

Regulators allowed this skating on thin ice because they were weak. The British regulatory agency, the Financial Services Authority, has sweeping jurisdiction over the British financial world, yet it rules diffidently.

In the U.S., the Securities and Exchange Commission, and with it most of our financial regulatory framework, was created in the midst of a crisis, the Great Depression. The F.S.A. wasn’t formed until 1997, when the financial sector was politically and economically powerful. The British agency as we now know it was created following a decade of failed self-regulation.

Unfortunately, the political will didn’t exist to both create a regulator and have it actually do much. “The philosophy of the F.S.A. from when I set it up has been to say, ‘Consenting adults in private? That’s their problem, really,’” says Howard Davies, the agency’s first chairman, who is now the director of the London School of Economics and Political Science.

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