The financial crisis has brought forth a sense of nostalgia for the 1950s and 1960s, when the financial industry may have been smaller and less dynamic, but at least it was stable. Linda Arch’s new book on the regulation of the London clearing banks between 1946 and 1971 is therefore timely. It provides a careful and thorough account of how ‘banks’ were defined (complicated) and of the various ways in which they, and especially the London clearing banks, were regulated (also complicated).

It cannot be stressed too strongly that the main reason why the monetary authorities regulated the banks after 1945 was macro-economic, rather than what would now be called macro-prudential. The post-war public finances were in a dire state. The government debt/GDP ratio was astronomic in the 1950s, and, because there was a lot of short-term government debt, increasing interest rates would have made it bigger. As to fiscal policy, the democratic process did not attach a high priority to debt repayment by means of budget surpluses. If you wanted to restrain domestic demand, financial repression was the only thing left. Some of the financial repression was general in application – exchange controls, for example, but much of it was applied to banks, and the London clearing banks in particular: ratio requirements, compulsory deposit schemes, official ‘requests’ to restrain lending, etc.

Arch rightly points out that most of the bank-directed devices were introduced without legislation, after negotiation between the Bank of England and the clearing banks (though Treasury Deposit Receipts, invented in 1940, were a statutory imposition, as were foreign exchange and capital issues controls). The Bank of England greatly preferred to avoid legislation where possible, and for example stoutly resisted the Treasury’s initial assumption that the Special Deposits scheme, introduced in 1958, should be based on statute. However, all the negotiations, such as they were, were overshadowed by the certainty that, should they end without a conclusion, legislation would follow. This procedure of course offended against the principle that the power of the state should be exercised as directed by Parliament and not at the discretion of appointed officials. The Bank’s ostensible reason, and perhaps its real reason, for preferring non-statutory regulation was that an agreed imposition could be more easily adapted to changing circumstances than a statutory one; but of course the procedure also ensured that the Bank had a prominent role in the design and implementation of this and other schemes.

Arch swallows a bit too easily the Bank of England’s assertion that the minimum liquid asset ratio, which required banks to retain the equivalent of 30% of their deposits in liquid assets of precisely defined types, was based on bankers’ long standing practice, and therefore, in a sense, not an official imposition. The Bank put its assertion in writing in an article published in its Quarterly Bulletin in 1962, which Arch quotes; however, as  the economists E.T. Nevin and J.E. Wadsworth pointed out, the assertion has little historical merit; it must be regarded as a distortion of the truth used as propaganda by the Bank. In practice, the liquid asset ratio was not a very effective weapon of credit control.

Arch gives the impression of being a bit nostalgic herself, when she concludes with two ‘points of reflection’ (pp 118-119). One is that:
 ‘In considering how best to manage the risk of banking crises, and manage the adverse consequences when they do occur, it is essential to reflect critically upon the efficacy of the approach to regulation adopted since the 1970s – one which relies heavily upon regulation in a highly codified form, and upon detailed and often highly codified rules.’
The other is ‘how can this perception – that banks are not trustworthy – be reversed.’ Both are important questions.
In the reviewer’s opinion, we have in fact wound up with a kind of bank regulation which has a great deal in common with the 1946-71 model, except that it is more stringent and much more complicated.  There is a new version of the mandatory liquidity ratio – the Basel 3 Liquidity Coverage Ratio – which seems likely to have a far larger effect on bank behaviour than the old one did. There are minimum capital ratios – first introduced in 1988 – but, unlike liquid asset ratios, they are always vulnerable to the possibility that assets can be overvalued so as to make the ratios look much stronger than they really are.

And, as in 1946 –71, there is a border between the regulated and the unregulated, though the range of banks inside the border is now much wider. Arch contends that modern regulation relies heavily on codified rules. The FSA, when initially set up, set out codified rules, so that banks, if they complied with them, need not be over-burdened by regulatory intrusion; ‘light-touch’ regulation was embraced by British politicians of all parties. The FSA’s motives were entirely respectable:  legitimate regulation should in principle be a matter of rules, not the regulator’s discretion. Basel 2 took the codification process further by refining the risk weights of Basel 1. However, it didn’t work; banks gamed the rules and the rest is history. Post-crisis, there are now far more codified rules; it is hard for an outsider to know whether there is more regulatory discretion or not.

The 1946–71 model broke down because it was routinely abused by the government. Controls on the London clearing banks – statutory or otherwise – were used in order to try to contain the inflationary consequences of the government’s other macro-economic policies. Eventually, in 1968-69, the banks had to choose between disappointing the government by violating the ceilings on lending that they had been asked to observe, and refusing credit to creditworthy customers, and thereby putting some of them out of business. Wisely, they chose to disappoint the government.

Current regulation, unless it is redirected towards macro-economic objectives (as has been recommended to the Labour party) is not vulnerable to the same fate. It is vulnerable to ‘disorder at the border’: unregulated intermediaries could get into distress, and if they were big enough, they could cause a systemic problem.
Current regulation was assembled very hastily, and it almost certainly will have some undesirable and unintended effects. It may well prevent banks from performing socially desirable functions – e.g. transmission of immigrants’ remittances to family members in dangerous countries where the regulators see a risk that it might get into the hands of terrorists; provision of guaranteed credit facilities to corporate customers; market-making in bonds and other securities. It would be wise to review the new structure of regulation thoroughly to identify and remove such unintended consequences.

In reflecting on public trust in banks, nostalgia can be misleading. The public of the 1950s was probably not very enamoured of the banks’ practice of levying charges without providing any explanation of how they were calculated; now at least there are schedules of charges, even if they are pretty hard to understand. Probably the best way for banks to rebuild public trust would be for bank charges to bear some recognisable relation to the costs and risks of the services provided: no more rip-off charges for retail foreign exchange transactions; no more ‘back book’ interest rates for long-standing deposits. In other words, no more cross-subsidisation. That’s fine, but it will entail closing more unprofitable branches and not serving unprofitable customers.

Such changes are inevitable. Competition in banking is happening and the technological backwardness of the large incumbents gives a big advantage to the new challengers. The results, however, might not please the government or the regulators.

Linda Arch has made a valuable contribution, not just to history but also to current debate, by setting out, carefully and thoroughly, the facts about bank regulation after 1945, and raising important questions about the future. It remains to be seen whether Basel 3 has put the genie of bank instability back in the bottle.