The Politics and Markets of U.K. Financial Services, from The Political Economy of Financial Integration in Europe: The Battle of the Systems, ith Ingo Walter, MIT Press, 1997.

In the present debate about what happened in the 1980s, there is a widespread view that the Conservative government of the time “de-regulated”. As  argued below, the story is much more complex. One thing that can definitely not be maintained with any credibilityis that the Thatcher/Lawson government “de-regulated”. Rather, they were arch-regulators. It may be worth adding that there was a lot of discussion at the time of the Too-Big-To-Fail problem. Lawson’s memory in the WSJ article is playing him a trick.

Here is an example of the “de-regulatory” argument by the Wall Street Journal. As  argued below, the story is much more complex.

‘Few events embody the free-market thinking that shaped modern finance better than Big Bang. Under former Prime Minister Margaret Thatcher, a small group of officials, including Treasury chief Nigel Lawson and Secretary of State for Trade and Industry Cecil Parkinson, scrapped decades-old rules at the stock exchange and other institutions that they feared could leave London trailing behind rapidly globalizing markets.

‘The reforms helped trigger an economic boom and boosted the status of London’s banking district……Looking back two decades later, Messrs. Lawson and Parkinson say at least one thing went wrong: Banks were allowed to grow too big for anyone, including their own managers, to oversee.

‘”The notion that banks would get as big and as bloated as they did get — that was totally unexpected,” says Mr. Lawson…’

Full article:

The Politics and Markets of U.K. Financial Services

            With the Conservative victory in the 1983 elections, Prime Minister Thatcher’s government embarked on a policy of far-reaching changes to accentuate the dominance of the capital markets in the United Kingdom through a determined exertion of state authority.1 One outcome was to bind the U.K. deeper into the EU than ever before, and move the debate on financial policy close to matters of constitutional reform.

In retrospect, a number of political and market considerations had been pointing in the direction of “the City revolution.”2 Successive governments after World War II had given priority to re-establishing London as a prime centre for international finance under the aegis of the Bank of England, which had been nationalised in 1946. Partly as a consequence, the various cartels composing the British financial system,3 came under pressure from the development of parallel markets, which escaped the Bank of England’s control. The most important of these was the growth in the Eurodollar market, which brought London into close relationship to New York. This interdependence posed a challenge in the longer run to the Bank’s inherited style of regulation, predicated on an informal code relayed by the frown on the Governor’s brow, and the “nods and winks” he dispensed to the varied quarters of his financial universe. The fiction held that, assuming that politics and economics were separate, so politicians left the Bank to run the nation’s financial capital in its own discrete way. This mask fell away as financial markets¾combined with political parties, the press and parliament¾brought financial policy into the heart of U.K. politics.

                                             The Postwar U.K. Financial System

Until the late 1960s, the main features of the U.K. financial system were much the same as in 1945. The City’s style of self-regulation, often derived from statutory law, prospered as long as the cartel structure of the financial system remained in place. Decisions could take effect rapidly because they were relayed through the City élite, which dominated the Bank of England’s court of part-time directors. The Bank was responsible for the non-statutory supervision of the clearing banks, and the Registrar of Friendly Societies looked after the mutual sector. Other banks and deposit-takers, as well as insurance, were either subject to minimal regulation by the Department of Trade and Industry (DTI) or escaped regulation altogether. The Stock Exchange and Lloyds were both self-regulated with their own distinct constitutions.

Two measures had laid the foundations for this U.K. aura of financial permanence¾a set of informal agreements in 1934 concluded among the discount houses, clearing banks and the Bank of England in the wake of the global depression. This arrangement was further strengthened during the war, when the Treasury controlled capital market issues and provided instructions to the clearers to guide their lending according to public-interest criteria.

The Labour government nationalised the Bank of England in 1946. Founded in 1694 under Royal charter, the Bank acted as the government’s banker, managed the public debt, and operated as lender of last resort to other banks. Its post-war status derived from the Bank of England Act of 1946. Its court of directors, including the Governor and Deputy Governor, are appointed by the government. The Bank has all the main functions of a central bank: (1) The exclusive right of currency issue in England and Wales; (2) The operation of the government bond market (gilts) on the Treasury’s behalf; (3) Responsibility, as the government’s adviser, for control of the monetary system; and (4) Supervision of financial institutions. The 1946 Act stipulated the Bank’s formal subordination to the Treasury. In practice, Bank and Treasury have consulted each other and the Prime Minister on key decisions.

At the heart of the financial structure was the clearing bank cartel,whose share of total U.K. deposits fell from over two thirds in the 1920s to under one-third by the late 1960s, when the mergers of 1968 reduced their number to six.The mergers left the United Kingdom with four major banks: Barclays, National Westminster, Midlands and Lloyds. These London-based banks operated as instruments of government monetary and credit policies, in return for which their cartel arrangements curtailed competition for deposits, and set charges on loans and services provided. The cartel extended to abstaining from entry to new markets or services, such as offering higher- rate deposit accounts, access to Eurocurrency markets, or medium- and long-term loans. The banks stayed out of the burgeoning short-term money markets, and stuck to lending to or to drawing on the discount houses in the national money market, operated under the aegis of the Bank of England. Loan rates for borrowers were pegged, in essence, to the rate set by the Bank of England in its capacity as a source of funds to the discount houses. Not least, the London-based clearing banks controlled the interbank clearing mechanism for the settlement of loans and deposits in the system. Other financial institutions were granted access to the London Clearing House on negotiated terms, providing the clearing banks with a major advantage in the market for current and checking accounts.

A notably different category of institutions were the building societies and trustee savings banks, founded in the eighteenth and early nineteenth centuries with the express purpose of providing housing finance and a secure outlet for the savings of working-class people. They were concerned primarily with longer-term savings and investments.

The building societies4 enjoyed a special status as non-profit organisations, and offered attractive rates on deposit, opened at convenient hours, and provided up to three-quarters of funds necessary for home purchases. They, too, operated a cartel under the authority of the Chief Registrar of Friendly Societies¾an official responsible to Treasury and parliament¾to ensure that they met their legal commitments to place 95% of their assets in mortgages.

The trustee savings banks were also non-profit organisations¾or “mutuals” organised for the benefit of staff and depositors¾that spanned the whole country, assembled by the 1970s into nineteen regional groupings. With six million customers, the trustee savings banks could lay claim to being the popular banks of the country, with strong representation in the traditional manufacturing regions of the north.

In addition, the state owned the National Savings banks, and in 1968 set up the National Girobank, using the services of the Post Office to attract savings.

Finally, retail savings in the decades following the end of World War II poured into the life insurance companies, pension funds and unit trusts.

Another group of institutions dealt primarily in the money and short-term credit markets. These were the institutions which the Bank of England sought to influence in implementing monetary and credit policy. The discount house syndicate,formed in 1934,operated at the heart of the system, acting as a warehouse for liquidity and as an intermediary between the Bank of England and the clearing banks. The Bank supplied or withdrew reserves from the banks by buying and selling bills from the discount houses. These manipulations in turn set the rate of interest for the banks in need of funds on the short-term, money markets. Prior to 1914, the discount houses had served to discount bills on London, issued by merchant banks in the Accepting Houses Committee to finance international trade. With the collapse of trade in the 1930s, the accepting houses turned to financing sterling business in the markets of the British Commonwealth, and voluntarily excluded themselves from the deposit and loan business of the clearing banks. They had no major deposit base of their own, and had limited capital at their disposal. Their business in the post-war years therefore developed in the direction of corporate financing, the management of institutional funds and dealing in the international interbank market that developed after 1958 in London. In similar fashion, the overseas banks established to finance trade mainly across the British Empire were absorbed by merger into the clearing banks, diversified into the Eurocurrency markets or redeployed into the principal markets of western Europe, the United States and Asia. Standard Chartered, Hong-Kong and Shanghai and Grindlays remained well represented in their traditional markets of Asia, Africa and the Indian subcontinent.

The Stock Exchange of the United Kingdom and Ireland was formed in 1973 out of the U.K. regional and Irish stock exchanges. Regional exchanges had provided external funds for industrial enterprises in the nineteenth century, but the bulk of business in the main London markets was in the quotation of international securities. The link between industrial companies and banks, promoted by the state in Germany from 1871 on, was largely absent in Britain, where the stock market developed in a unique manner. The sources of funds to the markets came not from the banks, as in Germany, but from private shareholders. Rules governing the market, introduced in the early 20th century, complemented these conditions. Brokers represented their private clients for a commission and recommended the purchase of bonds or equities. Jobbers kept an inventory of stock, for which they held a monopoly on trading. This privilege derived from the 1920 Finance Act, whereby jobbers paid stamp duty on purchases of stock. Separation of function between brokers and jobbers provided an incentive for the broker to serve the client’s interest rather than to unload stock, which was in the hands of the jobber. The stamp duty underpinned the jobber’s monopoly. A compensation fund existed to protect the investor from the failure of a firm, and fixed commissions were charged on services rendered in order to preserve this single-capacity grouping of functions and to feed the compensation fund. The price of the cartel reflected in higher transaction costs of gilts and equities. But the arrangement proved relatively free of scandals, and served to protect the shareholders from fraud.

Historically, uses of funds on the London Stock Exchange went into government debt and railway bonds, with about 20% going to meet corporate needs for finance beyond those supplied by commercial bank loans and retained earnings. The market was transformed by the expansion of government debt during the second world war. In the immediate post-war years, the Treasury’s authority was ensured through the Capital Issues Committee and strict foreign exchange controls. Both were phased out in 1959, following the general move to currency convertibility. This left the Bank of England with the task of managing the maturity structure of gilts in a more open financial environment.

A primary objective of successive governments was  to ensure the marketability of long-dated bonds with maturities of 15 to 30 years. Policy therefore aimed to limit speculation on gilts in order to preserve confidence of gilt holders. This prompted the extension of quantitative controls over ever-wider swathes of the financial system. Simultaneously, however, governments provided for exemptions for particular categories of loans, continued the upward drive in public expenditure, sought to keep interest rates low through interventions in the short-term money markets and the markets for foreign exchange, and¾as inflation rates crept up¾moved to control commodity prices and wages. The brunt of restrictions on loans was borne by commercial banks, even as inflation spurred speculation between financial assets.

Finally, the market for insurance at Lloyds was ruled under the constitution set by Acts of Parliament of 1871 and 1911. The first Act vested the powers of Lloyds committee in the general meeting of members and made it a criminal offense for non-members to sign a Lloyds policy. Only wealthy individuals were eligible. The second Act extended the scope of business to “insurance of every description.” By the late 1960s, no more than 6,000 people were members of Lloyds. Membership was then opened to non-British Commonwealth members. Market rules were designed to protect the interests of members, called “Names”¾individuals who pledged their personal wealth on conditions of unlimited liability in the event that claims had to be paid. The “single capacity” rule prevailed here as well. Brokers acted as middlemen between the names and the underwriters, organised into syndicates by managing agents. Syndicates and agents were regulated by Lloyds. The market’s revival after World War II was encouraged by heavy income tax¾up to 98% for the wealthy¾and tax rebates provided by the Treasury in the event of losses incurred. Successive government’s thereby acted as reinsurance to the names. Even so, a series of major losses incurred in 1965-1967 frightened away existing and prospecting members, and prompted Lloyds to reduce minimum wealth limits in order to attract new names.

                                     Decartelisation of the U.K. Financial System

Market forces and liberal economic policies were the two factors that led to dismantling the various cartel practices that restrained competition. The climate of opinion in the U.K. in the late 1960s became more favourable to  greater competition in the financial sector.5 The Treasury was won-over gradually to ideas circulating in the IMF and elsewhere in favour of a looser exchange rate regime.6 Competition and credit control, launched under the Conservatives in September 1971 to free-up financial markets as a vehicle for re-establishing regulatory control, was withdrawn by the same government.7 Two strands of policy fought for the allegiance of the Labour party in the governments of 1974-1979. One emphasised the desirability of introducing more competition through stricter regulation of restrictive practices. The other favoured nationalisation of the clearing banks, and the creation of a National Investment Bank to channel savings into manufacturing.8 More competition through stricter regulation of market practices was implemented, but not until the radical conservative government of 1983-87.

The clearing bank cartel dissolved slowly. To reverse their long-term decline in the share of total deposits, the clearers first entered the market for wholesale funds and then began to compete more aggressively to win back market-share on the retail side. With the easing of restraints on competition in 1971-1973, the commercial banks rushed into bidding for deposits and loans. The explosion of credit, and the series of bank failures which ensued, prompted the government to impose quantitative restrictions on lending again. In the mid-1970s the banks entered the fray to extend loans to developing countries. With the election of the Conservatives in 1979, the cartel restrictions were eased, and  the banks again expanded into the domestic retail markets.9 In this they were encouraged by the heavy losses incurred on their loans to Latin America in the early 1980s.

Domestic competition was further promoted by government policy to equalise tax treatment across the various types of financial institutions, and to end the Stock Exchange cartel, prompting clearing banks to form their own merchant banks. By the 1990s, clearing banks had expanded the scope of business from retail to corporate services, with National Westminster and Barclays recording assets twice that of their nearest rivals, Lloyds and Midlands.

This more competitive environment also helped to break up the building societies’ cartel, which had facilitated regulation of the mortgage markets, and taken the societies to a market share of over 50% of U.K. savings. Alongside this, institutional investors came to control over two thirds of U.K. equities by the early 1980s, compared to 58% in private shareholders hands in 1963.10 Private investors were net sellers of equities, while pension funds and life insurance companies bought up financial assets as household wealth expanded, and as hedges against inflation.

The Conservative government further stimulated the pace of change by turning the Trustee Savings Bank, traditionally close to the Labour movement, into a limited liability company in 1986, and privatised the much smaller Girobank in 1988. Both building societies and clearing banks in the 1980s converged onto the housing market,11 beating-down loan conditions and fuelling the bubble which burst in 1989-1990 as interest rates edged up in response to the rise in inflationary pressures. The institutions were poorly prepared for the conditions of the late 1980s, and the threat of competition on domestic markets from the continent as market access to Britain was eased in the light of legislation on the EU’s internal single-market. Continental institutions faced lower tax rates than those prevailing in the United Kingdom. Competition pared profits, as compared to the major competitors in France and Germany. The institutions were hurt by the October 1987 crash, and the reduction in the value of their assets.

Merchant banks in the U.K. circumvented the clearing bank cartel¾and their exclusion from the Stock Exchange monopoly¾by developing a range of corporate services in the burgeoning Euromarkets. They also earned income from institutional management of the flow of savings.12 With the agreement between the government and Stock Exchange to end single-capacity brokerage and jobbing in 1986, the merchant banks moved,with Bank of England support, to create financial conglomerates. There were three main motivations: (1) To compete with the U.S. and Japanese securities houses in world markets by building up a larger capital base; (2) To develop a presence in North America, Asia and the principal continental European markets; and (3) To keep as much central market control as possible of British equities. But, following the October 1987 stock market crash, financial conglomerates came into disfavour as commission rates fell in highly competitive securities markets, and managerial problems of creating all-purpose universal banks became more evident. A number of U.S. houses withdrew from the British market as it became clearer that established relations between U.K. banks and corporations counted as much, if not more, than capital. By the early 1990s, the shape of British merchant banking had polarised between a handful of large securities houses, such as S.G. Warburg, Kleinwort Benson, Barclays de Zoete Wedd and County NatWest, and specialist houses with more narrow focus like Shroders, Rothschilds, Hoare Govett and Flemings. Global ambitions were scaled own, with British and London-based merchant banks concentrating more on cross-border alliances in Europe, only to be re-ignited by a new focus on “emerging markets” and “transition economies” following the collapse of the communist state system.

The biggest changes came in the structure of the U.K. Stock Exchange. Trading in gilts and equities came to be dominated by institutions which lobbied the government successfully to end the single-capacity rule. Brokers and jobbers were swept into the rush to form financial conglomerates. Bouyant equity markets were fed by the growth in corporate profits, by the government policy to sell-off nationalised industries, and the takeover wave of the 1980s. Meanwhile, both government and the London Stock Exchange promoted separate markets with less strict listing requirements. The Unlisted Securities Market, launched in 1978, paved the way for the Third Market, both dealing in the shares of small and medium-size businesses. Licensed securities dealers developed the over-the-counter markets, and formed the National Association of Securities Dealers and Investment Managers (Nasdim). The net effect of these series of market- and policy-driven changes was to extend share ownership in the United Kingdom, provide a highly liquid market for corporate finance, and make London the prime financial capital in the European time-zone.

                                         Internalisation of U.K. Financial Markets

Decartelisation of British financial markets was also driven by the determination of successive British governments, Conservative and Labour, to preserve the City of London as a world financial centre. In the immediate post-war years, this took the form of promoting the use of sterling as an international currency in the role of junior partner to the United States dollar. In retrospect, devaluation of the pound sterling in November 1967 marked the end of that road. The new orientation evolved slowly along two not readily compatible tracks. One was to convert the City of London into a world financial centre turning on the dollar. The other was U.K. entry to the EU, along with Ireland and Denmark in 1973. As public support was either hostile or cool on the EU, domestic divisions on “Europe” came back regularly to haunt British public policy. These developments parallelled the collapse in 1971 of the Bretton Woods system. Private financial markets generated in large part by the expansion of government securities growth in oil money, took over from central bankers the crucial task of setting currency relationships. The process towards privatisation of world money markets created much greater instability and unpredictability, prompting a surge in new financial products designed to hedge against as many risks as possible.

The internalisation of financial markets hinging on the dollar turned London into an offshore financial centre. There was nothing ineluctable about this choice. Despite arguments by British “declinists” that the sacrifice of the industrial base on the altar of financial gains began sometime in the 1880s, Britain emerged from the second world war as the United States’ junior partner, but one with considerable means. Paul Kennedy writes that Britain’s rapid growth of new industries already in 1940 had a fifty per cent greater output than Germany in aircraft as well as in tanks.13 Only with the boost in German arms production in 1943 did Festland Europa overtake Britain in arms output. This massive German industrial machine was shorn of one quarter of its productive capacity by war or dismantlement, leaving the remainder to fuel the Federal Republic’s trade-based economic revival in the 1950s. The central point of Britain’s position was not economic decline, but a conscious act of policy to merge Britain’s future security in alliance with the United States.

During the war, new industries had been adopted on a grand scale. The new Keynesian economics provided a theoretical framework for expansionary fiscal policy, while the banking cartel provided the institutional structure for state manipulation of interest rates. All parties were committed to social reforms. Financial aid was forthcoming from the United States. Lend-lease enabled Britain to be supplied without immediate payment. Many dominions had achieved self-government and India was well on the way there prior to the war. Following the war successive British governments had overstretched the country’s resources by opting for extensive overseas military commitments, trade liberalisation, active promotion of capital exports, a reserve currency status for sterling and the restoration of London as an international financial centre. Both main parties sought to maintain the wartime consensus on welfare and full employment. Above all, they failed to establish effective labour market laws and institutions. And they alternated between periodic doses of deflation and reflation until they abandoned attempts to defend sterling’s parity with the dollar and the role of sterling as a reserve currency. Britain entered the EU on terms that de Gaulle had insisted should involve the sacrifice of the Commonwealth agricultural system to the EU’s common agricultural programme.

Anxieties about Britain’s future had come to a head in the late 1950s, with the formation of the EU’s custom’s union and the tightening of exchange controls in 1957 after a run on sterling. Banks began to substitute dollars for sterling in their international transactions. This laid the foundations for the growth of the Euro-dollar markets in the subsequent decade, and for London’s restoration as a financial centre dealing in dollars rather than in sterling. The number of foreign banks in London rose from 113 in 1967 to 280 in 1973, and 349 in 1974.14 American banks entered the U.K. domestic loan business, and helped to fund North Sea oil and gas exploration and development. London financial markets became integrated more closely with those of the U.S., increasing the British economy’s vulnerability to the twists and turns of U.S. monetary and exchange rate policy.

Britain entered the EU on an inflationary boom, more than ever integrated into the dollar area and with a widening trade deficit, two-thirds of which was continental Europe. Stagnant investment and falling profits in the subsequent years discouraged any major renewal of plant and equipment. One estimate suggested that the average life of total U.K. plant and machinery was 35 years, or twice the level of France or Germany.15

While the domestic economy stagnated, corporate Britain expanded overseas. If there was one consistent thread in British economic policy since 1945, it lay in the strategy of British corporations and financial institutions to recover as much as possible the losses incurred by the prosecution of the war. Profits, too, were higher abroad.16 By 1973, a United Nations study suggested that the value of British production abroad was twice that of visible export trade.17 Furthermore, the City of London’s earnings on “invisibles” rose three-fold between 1973 and 1979, as financial and bank operations abroad expanded alongside a booming re-insurance market. By the end of the decade, there were 400 foreign banks in London, while the British big four clearing banks expanded their international business on the back of the Eurocurrency boom. Meanwhile, the rise in popular savings had stimulated the growth of  units trusts, pension funds and insurance companies, and invigorated the London Stock Exchange. The ending of foreign exchange controls in 1979, forty years after the opening of the second world war, led to a surge of outward investment into the equity markets of South-East Asia and North America.

The years between 1974 and 1979 witnessed a sea-change in U.K. economic policy. Initially, the Labour government had responded to the inheritance of the conservatives’ inflationary boom and the rise in oil prices by promoting the development of the world’s recycling of OPEC funds in London, and public-sector borrowing to sustain demand. This placed it in the awkward position of borrowing  on the  world’s capital markets at a time that the Labour left was most vociferous in calling for bank nationalisations, price controls and dividend controls, a state-led “industrial strategy” and withdrawal from the EU. The corporate sector faced a severe liquidity squeeze. When, on March 4, 1976, the markets suspected the government of trying to engineer sterling’s devaluation in order to promote exports, OPEC withdrawals of sterling balances and short-term capital outflows turned into an avalanche. Over the coming months, the government edged towards a stabilisation policy, following further runs on sterling and massive sales of government securities by investors.18 A Letter of Intent was signed with the IMF in December, announcing budgetary restrictions, monetary targets set by the Bank of England, and an “incomes policy” comprising price and wage controls.

The fall of the dollar against the DM in the course of 1977 enabled the Bank of England to intervene on the exchange markets and to keep sterling down. But that led to an expansion of external reserves and the domestic money supply. On October 31, 1977, the Bank of England announced that sterling would be allowed to float free, since any further attempt to hold down the exchange rate would have inflationary consequences. The flood of dollars then turned on the DM, driving it upwards and prompting Chancellor Schmidt to propose a “zone of currency stability” with France in the EU. This move to exchange rate stability on the continent left the Labour government with little option other than to follow the priorities laid down in the IMF Letter of Intent. Any expansionary policy would trigger a renewed run to sterling. So the onus of policy fell on incomes restraint. That crumbled in the winter of 1978. A wave of strikes ensued, causing widespread disruptions to public services, the calling of general elections, and nearly two decades of Tory government following their sweeping victory in May 1979.

Conservative economic policy, presented in the June 1979 budget, represented an “experiment akin to those always available in the natural sciences,” the BIS commented laconically.19 The central decision was the freeing of foreign exchange controls. British corporations were free to invest abroad, while North Sea oil income irrigated the London financial markets. Tight control was exerted over monetary aggregates, and the currency was allowed to soar. Manufacturing output plummeted. The economy began to turn up again in 1981, and the subsequent GDP expansion at 3-4% over the decade was accompanied by a decline in government debt and a major drive to privatise state-owned assets. Government finances moved to surplus from 1985 on. Equity ownership became much more widely diffused. Labour market legislation was liberalised. Corporate profits improved, and non-residential investment took off. Expansion was facilitated by the high oil prices, disguising the shift to deficit in manufacturing trade. Mrs. Thatcher’s impact on the U.K. economy, in short, had been astounding.

When oil prices fell in 1986, the trade accounts plummeted into deficit. Inflation was at 2-3%. Why did Britain’s inflation rates rise again, leading to the drama of sterling  in the ERM in the years 1990-92? As mentioned, the Tory government eased fiscal policy and encouraged home ownership on the back of a credit boom. Following the Louvre Accords of February 1987, U.K. monetary policy was relaxed, as the Bank of England’s reserves rose by £20 billion to sustain the dollar. Financial market deregulation restricted the government’s ability to control monetary aggregates. As the former Chancellor, Nigel Lawson, pointed out, “Today, when financial deregulation (which is particularly advanced in the U.K.) and the globalisation of financial markets have made the domestic monetary aggregates an especially unreliable guide, an external discipline, should there be one readily available, is clearly preferable.”20 In other words, the financial market reforms in the U.K., to which we shall now turn, raised the question of whether to join the ERM and accept the Bundesbank as central bank, or establish its own independent central bank. The Treasury and Foreign Office wanted sterling in the ERM, as “an anchor against inflation.”21 The Prime Minister was opposed, on the grounds that “the DM is slightly deflationary.”22

Britain’s experience invited comparison with the Federal Republic. The notable feature by the early 1990s was how divergent their structures had become. Germany was the continent’s dominant economy, with tightly-knit insider business and policy-networks. All political parties supported the high-cost and corporatist institutions of the social market economy. British manufacturing productivity had nearly caught up to Germany’s. But manufacturing in Germany made up 31% GDP, against only 20% for Britain. The DM’s undervaluation in the ERM had swollen German surpluses, whereas sterling moved up or down outside it. London was an international, unlike Frankfurt as a national financial centre. London had an open market for equities, and the U.K. was a champion of open equities markets in the EU. As the Bundesbank stated with uncharacteristic forthrightness, Germany’s universal banks must not be forced “by virtue of the EU regulations to switch over to a system of functional operation in the financial services sector, such as predominates in the Anglo-Saxon countries.”23 The British stock of foreign direct investment was 22% of GDP in 1987, probably rising to 50% by 1995, compared to Germany’s 8% and 15% respectively.24 Britain was also the EU’s prime recipient of inward foreign direct investment, accounting for 38% of U.S. and Japanese cumulative foreign direct investment in the EU.25 The promise included an emerging Japanese-British industrial alliance that would help to  regenerate British-based manufacturing through the expansion of Japanese-owned plants.26

                                             Regulation and the Bank of England

The manner and tempo at which U.K. financial markets were transformed was driven by the Bank’s preference for an informal style of regulation over banks. But as stated by the so-called Wilson Committee, convened under Prime Minister Callaghan to head off a Labour Party proposal for nationalisation of the banks, “the secondary banking crisis showed that the larger a market becomes and the less homogeneous those operating within it, the more difficult it is to rely on informal non-statutory methods of regulation.”27 Yet a constant fear of the Bank of England was that more formality would weaken the ability of the authorities to match the inventiveness of markets. And there was the concern that the laws governing depositor protection, particularly popular among politicians of all parties, might take the risk out of banking and allow depositors to contemplate compensation by the state rather than face the discipline of the market. Much intellectual effort was spent on defining the right balance between law and markets. Too much law raised costs for market participants, and inhibited regulators in adapting to market conditions. Too much emphasis on market efficiency overlooked matters of elementary justice, and systemic risk.

Statutory amendments to the Bank’s supervisory powers were preceded by a series of major regulatory failures. The first was occasioned by the introduction of Competition and Credit Controls in September 1971, intended “to permit the price mechanism to function efficiently in the allocation of credit and to free the banks from the rigidities and restraints which have for too long inhibited them.”28

The unexpected result of this measure to end the cartelisation of financial markets, and simultaneously to strengthen the Bank’s control over the financial system, was an explosion of credit. So-called “fringe” banks sought deposits on the wholesale money markets in London to lend to the real estate sector. In the dramatic climate of late 1973, the wholesale markets called in their funds from the fringe banks, who suffered a dramatic loss of confidence by depositors. The Bank of England responded by setting up a Control Committee, composed of the clearing banks who were persuaded to extend emergency facilities to the troubled banks.29 Its supervisory powers thereby were strengthened, but the Bank continued to rely on outside auditors, responsible to their clients, rather than on its own inspectorate.

Ten years later, in 1984, Johnson Matthey Bankers (JMB), dealing on the gold bullion market, were bailed out by a syndicate of  200 U.K. and foreign financial institutions, under the aegis of the Bank of England, which was accused of procrastination since it was well aware of JMB’s risky loan portfolio. Its supervisory powers were again altered. Then in 1991, the Bank of England led a multinational action to seize the assets of Bank of Credit and Commerce International (BCCI)¾based in Luxembourg¾ with business in over 66 countries. The Bank had known of the BCCI’s dubious practices as early as the 1970s, but had failed to take action. In both the JMB and BCCI cases, information about the true state of the banks’ books was divulged too little and too late.

New statutory powers were grafted on to the Bank’s older habits of informality,30 and with equal regularity proved inadequate to the task. In the aftermath of the secondary banking crisis, City institutions were confirmed in their belief that their interests could only be secured under the aegis of the Bank of England, as the champion to the government of continued self-regulation.31 This was reflected in the 1979 Banking Act, which established a two-tier definition of banks that rested, in effect, on the Bank’s view of their reputation in the markets. A special compensation fund was set up to support depositors in the event of a bank failure.

The Bank assumed that it was the second-tier banks which needed close supervision, rather than the first tier of banks, defined as those “with a high reputation and standing in the financial community.” But JMB was in the first tier. The Bank’s supervisory failure was not appreciated in Whitehall32 or in the City. Not least of the government’s embarrassments was the gulf between its free-market approach to the non-banking sector and the Bank’s rescue of JMB, at City institutions’ expense. The 1987 Act, steered by a firm Treasury hand,33 established a special supervisory board in the Bank, including non-Bank appointments, and provided for closer links between bank auditors and Bank supervisors. After the BCCI affair, the Bank was given positive powers of intervention to close a bank on the suspicion of difficulties and to set up a special investigative unit in the Bank itself.34

The 1987 Act also sought to tidy-up government thinking about foreign takeovers of financial institutions. The Bank of England’s strategy to make London the “third leg” of world financial markets along with New York and Tokyo required, as the Governor indicated, that London must be a place where “people other than the home team can play.”35 But Whitehall preferred domestic ownership of banks, with the Bank exercising a watchful eye. In a 1972 memorandum, the Bank of England had “understood” that banks would consult with it on all proposals for participations in U.K. banks exceeding 15% of equity. This was ignored by the Hong Kong and Shanghai Bank in its 1981 bid for the Royal Bank of Scotland (in competition with Standard Chartered). The bid was turned down on grounds of nationality of HSBC, that the Royal Bank was judged vital to Edinburgh’s future, and that the acquired bank in the hands of an overseas owner would have to respond to the policy requirements of the home government.36

This latter point only underlined Whitehall’s strong preference for host country control. It was the nationality issue which needed clarification. This came in two forms. First, the Banking Act of 1987 stipulated that the Bank of England was to have control over mergers and acquisition in the banking sector. All bids were to be preceded by a notification to the Bank. Secondly, a tough reciprocity clause was inserted into the Financial Services Act of 1986, whereby the government had the power to block a foreign takeover if equivalent opportunities were not available to British firms in the acquiring bank’s home country. It was this clause which the European Commission transposed directly into its draft for the Second Banking Directive, presented in January 1988.

If there was one area where the Bank asserted its powers, it was in reform of the gilts market. Difficulties in funding the government deficits of the 1970s¾in the face of institutions ready to hold more government paper only at a high price¾ convinced officials in the Bank of England of the need for greater liquidity in the markets for gilts. Two discount houses accounted for up to 90% of the short-term money market, and the level of commissions charged by Stock Exchange member firms in gilt-edged transactions was regarded as excessive.

Bank officials’ prime concern was to meet the Bank’s statutory obligation to raise money for the government as cheaply as possible. The Treasury was brought around to the view that more competitive and liquid markets in government securities would reduce funding costs, and spill-over onto equities to help absorb the size of flotations required in the government privatisation campaign. The Treasury and Bank therefore leaned on the Stock Exchange to relax rules restricting the stakes of non-members and encouraged City institutions to form conglomerates, merging commercial and investment banking.37 In 1984-85, the Bank organised a new primary dealer network, much along the lines followed by the New York Federal Reserve.38 Equity markets were also organised on dual-capacity broker-dealer lines.The main criteria for the selection of participating institutions was that they be well capitalised and that they be members of the Stock Exchange. By October 27 1986¾the date widely labelled “Big Bang”-27 market-makers, 10 of which were linked to U.S. groups, had replaced the two discount houses.

Development of the interbank market in London and the new significance of wholesale banking in world markets made the Bank of England particularly sensitive to the need to foster a greater degree of international cooperation among central banks and supervisory authorities. The Bank of International Settlements in Basle provided the main multilateral forum, both for discussions in the EU and with the United States or Japan. Initial steps were taken on the initiative of the Governor of the Bank of England in July 1974, at a regular meeting of the central bankers at Basle in the BIS.39 The Herstatt Bank in Germany had closed the month previously after heavy losses incurred on the foreign exchange markets. The central bankers nodded in the direction of home country responsibility for subsidiaries of banks operating in other countries. In September, the central bankers agreed to establish a Committee on Banking Regulation and Supervisory Practices, headed by the supervisor recently appointed to the position in the Bank. British and foreign banks in London  then rushed into the business of borrowing Eurodollars at very low interest rates on the London interbank market and re-lending to developing countries. Once the bubble burst in 1982, an EU directive on consolidated accounting was rushed through Brussels procedures. The Bank of England then became involved with the clearing banks in the 1980s negotiations on developing country debt restructuring, led by the U.S. Treasury. Meanwhile,the Eurobond market had taken off.

Under the 1987 Banking Act, the Bank of England took over as lead regulator for securities firms involved in both securities and banking. This affirmation of the Bank’s authority was helped by its success in establishing a settlements system for the gilt market and the money markets, and stood in strong contrast to the failure of the London Stock Exchange to update its own settlements system. Indeed, after “Big Bang,” the Exchange found its varied functions either moving up to the Bank, down to the self-regulatory organisations, or being lost to competitors. Its monopoly on market information services was ended as a restraint on trade. And the Exchange had to close its floor within months of “Big Bang.” The screen-based, SEAQ International, operated along the lines of Nasdaq, the U.S. over-the-counter market, and provided a quote-driven system where shares are fixed by competition between market-makers.  That left the Exchange in charge of the settlements system, run on 1970s technology. Institutional investors backed a new design, TAURUS, in 1982 but voted to abandon it in 1993. One reason was technological complexity of meeting the requirement under U.K. law that shareholder names appear on companies’ share registry. The other was that smaller share registrars and companies were opposed to any modification in the law. The Bank therefore moved to squeeze the smaller registrars out of the market by speeding up the settlement cycle.40 The clearers, with their large registrars, could offer a shorter settlement cycle under more centralised control and economies of scale. The new system, CREST, was scheduled for introduction in 1996.

                                              Regulation and Investor Protection

From the viewpoint of City practitioners, there were two features of the U.S. regulatory scene that were anathema: (1) The concentration of investigative, policing and legal powers in the hands of the SEC; and (2) the U.S. method of plea-bargaining, offering discounts from sentences if the accused pleaded guilty in cases such as insider trading. Yet the U.S. experience was the one to which British administrators, politicians and market operators turned for inspiration. The process of introducing U.S. policy experience into the U.K. market context proved slow, with the City aware that its de facto status as a private club hampered effective policing of the markets.

The process started with concern over insider dealings associated with the takeover spree in the 1960s, and the 1965-67 market losses at Lloyd’s. There were then a string of corporate failures in insurance, and the 1973-75 secondary banking crisis. A bill was introduced in 1973 to make insider dealing a criminal offense, and the Fair Trading  Act of 1973 made a provision for the registration of restrictive practices in services, which the Labour government expressly extended to the financial sector. The Policyholder’s Protection Act of 1974 required that the insurance sector set up a board in order to administer a levy to guard against future collapses. A more stringent monitoring system was introduced under the DTI, which strengthened the British Insurance Brokers Association, formed in 1976, as the sector’s umbrella organisation. It was to administer the Insurance Brokers Act of 1977, which provided for registration, a code of conduct, and an indemnity fund.

The Labour government was prepared to challenge the self regulatory traditions of Stock Exchange and Lloyd’s on a platform of statutory powers in a competitive market framework. In 1978, the insider trading bill was revived, with the Conservatives in opposition less keen on introducing the criminal law and the Stock Exchange expressing reservations. The Office of Fair Trade (OFT) insisted that the Stock Exchange register its rule book so that, under the Act, the Exchange became guilty until proven innocent. The OFT listed seventeen restrictive practices.41

Meanwhile, the Bank of England had the Exchange create a Council for the Securities Industries, as a pre-emptive measure against the threat of statutory law. A similar step was taken by the Lloyd committee. In response to concerns expressed in the House of Commons and the press about its procedures, The committee in 1978 appointed a working party, led by Sir Henry Fisher, a High Court judge. Lloyd’s had become dependent for two-thirds of its income and reinsurance business on the United States, and over two-thirds of its business had come to be controlled by eight publicly quoted brokers which owned underwriters. This undermined the “single capacity” rule. As noted earlier, membership had been opened to people of more modest wealth, growing from 6,000 in 1969 to about 17,000 names in 1978. As insurance rates were bid down, competition sharpened, with the market plagued by a series of scandals. Names organised to sue Lloyd’s, challenging the principle of unlimited liability.

Much the same prevarication between statutory law and non-intervention in City affairs was evident in the Conservative government of 1979-1983. Taxes were cut in May and then all foreign exchange controls abolished in October 1979. As the currency rose on foreign exchange markets, and interest rates remained high to squeeze-out inflation, and the clearing banks were helpless to prevent the government imposing a profits tax. The OFT continued its investigations into restrictive practices on the Stock Exchange. Insider dealing, defined as the abuse of specific information likely to have a “material effect” on the price of shares, became a criminal offense in the 1980 Companies Act. In July 1981, the DTI commissioned a study of statutory regulation of the securities markets, the initial proposal of which was to set up four large self-regulatory authorities. Yet City preferences demanded accommodation. The 1980 Companies Act was policed by the Stock Exchange and the Takeover Panel-another self-regulatory organisation composed of the City’s great and good. Only three convictions had been recorded by 1985,42 despite substantial evidence of a surge in securities fraud.43 The proposals were duly modified. The Bank of England was to supervise commodity and financial markets, while the DTI was to be vested with powers to ensure investors rights, with responsibility for fraud, registration, drawing- up of rules of conduct, confirming its role as the main regulatory agency. Alongside this was to be a network of statutorily-based self-regulating bodies, coordinated through the voluntary Council for the Securities Industry (CSI), supervised by the DTI.44

The Conservatives made two notable concessions to their City supporters. Conservative members of Lloyd’s steered a private member’s bill through parliament, with only modest opposition from Labour.45 Sir Henry Fisher had declared the powers of Lloyd’s committee “inadequate for self-regulation in modern conditions.” He suggested the creation of a new Council, to be elected by working members and to abolish the direct democracy which had prevailed hitherto in Lloyd’s governance, whereby authority was vested in the General Meeting of members. The 1982 Lloyd’s Act confirmed the working members’ position as privileged insiders: The new Council was formed with a chairman drawn from Lloyd’s and a chief executive appointed by the Bank of England. An immunity clause made it impossible for any member to sue the Council. Insurance brokers were to divest underwriters, which helped consolidate the position of the underwriters.46

After the 1983 Conservative election victory, the Trade Secretary, Cecil Parkinson, struck a deal with the chairman of the Stock Exchange, Sir Nicholas Goodison, to drop the restrictive practices case in return for reforms. A deadline was set for October 27,1986, the date familiarly associated with the City’s “Big Bang.” The Stock Exchange argued that the adversarial proceedings of the court made any alteration in its rule-book a sign of weakness. There were also the members’ fears that a Court ban on Stock Exchange rules could have led to the establishment of a statutory body such as the U.S. SEC to regulate securities activities.47

                                                     The Financial Services Act

In a speech of March 1984, the Governor of the Bank of England announced that reform of the financial markets was to be his prime objective. If the goal was to secure London as the “third leg,” of world financial markets alongside New York and Tokyo, the method was to be along lines combining statutory law with “practitioner based regulation.”48 The government then announced in October 1984, the setting up of a Securities Investment Board (SIB) to register firms, draw up rules of conduct and to enforce them. These suggestions found their way into the White Paper, presented in January 1985,49 and then in December 1984 into the Financial Services Bill. The bill passed through parliament, at one time facing up to 400 amendments, and received the Royal Assent in November 1986.

The principle feature in the Financial Services Act was for investment services to be subject to regulation under statutory supervision. All persons engaged in the securities business had to be registered as “fit and proper.” The DTI was to hold statutory powers, and devolve them upon the SIB. The SIB was the key to the system. It received its delegated authority from the state, but operated as a private institution. Senior SIB appointments were to be made by the Bank of England and the DTI. All organisations offering financial services were to receive its authorisation before opening procedures for membership in one or more of the self-regulatory organisations (SROs). These were originally to seven in number, and be structured along familiar demarcation lines. In effect, they segmented into two broad groups, dealing in wholesale or retail markets. The SROs were to have their own rule books, equivalent in content to the SIB’s Conduct of Rules Book. They were to have their own staff for the process of authorisation and implementation. The SIB was to serve as a court of appeal, with the DTI as ultimate arbiter. The Bank of England, subject to the Treasury, was a de facto partner for the DTI in its capacity as supervisor of the banks and hence the securities markets. Complexity across the 212 articles of the Act was in part due to this hierarchy of cross-cutting competences. The Act came into effect in April 1988, providing the U.K. with a statutory regulatory structure, which arguably imposed stricter standards than any in the EU.50

                                       Supervision of Retail Investment Services

Inserting the SIB into the U.K. context was bound to be controversial in view of the City’s aversion to statutory law. That did not discourage the SIB’s first chairman, Sir Kenneth Berrill¾a Whitehall mandarin¾from adopting the position, similar to that of the SEC, that strong regulation was good for markets. The SIB’s Rules of Conduct reflected this concern to establish the best, rather than minimal, standards. Chancellor of the Exchequer Nigel Lawson had hinted that he was not averse to a more centralised and uniform regulation of financial markets,51 and the Bank had been weakened by his criticism of its competence, notably in the JMB affair. With the DTI in support, there was little resistance from government departments to the SIB’s testing how far to extend its statutory domain.

Nor was there anything to fear from Labour. The call from the left of the party for nationalisation of the clearing banks, and the creation of a National Investment Bank to channel savings into manufacturing, had failed to win electoral support. And the conservative victory in the 1983 general elections left the way clear for the government to stage the flotation of the Trustee Savings Bank and the building societies, both traditionally allied to the Labour Party. It was noticeable that Labour’s policy document for the 1987 election-“Making the City Safe”-concentrated on the weaknesses in the FSA. The new Labour line clearly favoured a SEC-type approach.

Reform of retail investment services on the domestic market proved arduous. In October 1984, the government set up a Marketing Investments Board (MIB), to supervise this disparate sector. But the initiative was dropped in favour of a single authority in the form of the SIB. A galaxy of acronymic organisations emerged to represent retailers¾NASDIM, FIMBRA, IMRO, LAUTRO, LUTIRO. None was predominant enough to act as a federator and bring them into one umbrella retail self-regulatory organisation. The most organised group were the insurers, which had associated under pressure from the 1970s Acts. They stacked the SIB committee charged with drawing-up regulations for the sector.52 The main effect of the new rules was to end the independence of intermediaries in life insurance and to encourage them to become tied agents, while banks, insurance houses and building societies entered the insurance field. In 1990, the SIB launched a full review of the rules and organisation of this sprawling sector. Its records showed that one in four life policies lapsed in the first two years.53 SIB’s new policy package for the sector carried two key components: (1) Retail salesmen would have to reveal much more about the pricing of commissions; and (2) a Personal Investment Authority (PIA) was set up to incorporate the warring factions. The PIA was told to slim-down its board, stuffed with the warring factions, and to increase representatives of the public interest.54

                                       Supervision of Wholesale Capital Markets

As long as the City remained solidly pro-Tory out of fear of Labour in the 1979, 1983 and 1987 general elections, the government had the upper hand over its City supporters. With nowhere else to go, they could do little other than fight rearguard actions as radical reforms were thrust upon them. The government’s attention went to the large institutional investors and security houses, rather than to the smaller stockbrokers and jobbers. Simply, the “third leg” wholesale market strategy meant incorporating foreign institutions in the SROs.

Financial futures was the first market to organise as a SRO. Membership of LIFFE was opened to foreign participation, both U.S. and continental European. The Association of Future Brokers and Dealers (AFBD) was incorporated in 1984.

Next to form a SRO were the international bond traders. A Committee of International Securities Regulatory Organisation (ISRO) was set up with a view to forming a Recognised Investment Exchange (RIE), together with the Association of International Bond Dealers (AIBD) to supervise the vast Eurobond market. Merger with the London Stock Exchange was announced in September 1986. The merged exchange became the International Stock Exchange (ISE) of the United Kingdom and the Republic of Ireland. Its Council was restricted to 31 members, drawn equally from ISRO and the Exchange. The main Securities Association had a governing body of 25, drawn from either exchange and including six independent members, and the Securities and Futures Securities Association Authority (SFA) took over as the central regulatory authority to police the markets.

As a fractious body of competing members, the Securities Association found a degree of unity in opposition to the SIB, which had won government agreement to impose its own rules on SROs. ISRO then lobbied successfully for legal immunity of SROs for damage claims arising from action “taken in good faith.”55 The SIB furthermore insisted that SROs seeking recognition had to submit rule books to provide equivalent protection to that offered investors by the SIB. The Securities Association drew the lesson that its rule book be spelled out in arcane legal detail. Its publication in July 1987 occasioned a summer of discontent in the City, leading to a new version in December. Acrimonious haggling ensued, resulting in delay in the process of registration and authorisation for investment houses beyond the deadline of April 1988. There was talk of the Bank reasserting its traditional authority over financial markets, and hopes expressed of a more sympathetic ear at the SIB to heed City concerns that complex rule books for wholesale markets might compromise London’s competitive position. SIB duly introduced a Bank distinction pointing to different regulatory approaches for wholesale and retail markets, and defined ten core principles guiding policy, insisting that these be “entrenched” in SRO rule books, along with 40 basic rules governing market practices.56

The period from February 1988 to June 1992 spanned negotiations in the EU on financial services. The 1987 Banking Securities Act provided the statutory basis for the reassertion over the DTI of the Bank’s traditional role as ultimate arbiter in financial markets. In July 1987, the Securities Association published its capital adequacy requirements for members, after discussions with the Bank. These were predicated on “base capital,” counted as 25% of annual operating costs, and “position capital,” to ensure against on market risks. The downturn came with a vengeance on October 19, 1987, unleashing a price war between market-makers. The Bank slapped on a third category of capital adequacy, termed “counterparty” funds, to cover credit risks. This was followed by central bank agreement in June 1988 at Basle on capital adequacy ratios for banks.

In late 1988, negotiations on financial services in the EU picked up momentum. This was the moment chosen by an ISE committee, dominated by the “home team,” to push for a change in market rules whereby details of a trade were to be revealed the day after. U.S. investment houses voted against this rule on the grounds that only British firms had the contacts to unwind the deals.57 In March 1990, four major U.S. securities houses lobbied the EU Commission independently on proposals for capital adequacy in the draft directive on investment services.58 British firms, though, registered similar complaints through the Bank of England.

This period also spanned negotiations in the BIS on capital adequacy for banks and investment houses. The Securities Association’s fractious members needed Treasury, Bank, SIB and DTI support in international negotiations. The SEC had concluded a series of bilateral accords with Switzerland, Japan and the Cayman Islands on securities practices. A “memorandum of understanding” was signed in September 1986 between the DTI and the two main regulatory authorities covering securities and futures markets, the SEC and the Commodity Futures Trading Commission (CFTC). The agreement set out the conditions for a confidential exchange of information  between the U.S. and U.K. authorities to serve as the basis for world-wide policing of markets.59  With the launch of the EU internal market programme in early 1988, the picture was complicated further. The supervisors meeting in the Basle Committee urged securities houses to hold additional capital against market risks. ISRO members complained that the central bankers had failed to appreciate the difference between bank loans, requiring capital reserves to cover credit risks, and the securities business, where risk was spread across a diversity of assets. The struggle between securities firms and regulators was then projected into the negotiations between the Basle Committee and IOSCO, the international organisation o securities regulators. The investment houses’ two foes proved to be the SEC in alliance with the Bundesbank, lined up against the Bank of England and the French authorities. It was a Franco-British alliance in June 1992 which put through the light capital adequacy requirements for security houses in the EU.

Unsurprisingly, neither Justice Bingham, in his report on the Bank’s handling of the BCCI collapse, nor the SIB called for any major change of the U.K.’s regulatory framework, despite rumours of forthcoming radical revisions. Bingham suggested the Bank strengthen its supervisory methods.60 The SIB described itself as a regulator of regulators in a two-tier system with the SROs.61

A more open question remained the Bank’s own status. The Treasury wanted Bank and the SIB to be answerable to it.62 The Bank looked forward to greater autonomy in the conduct of monetary policy, but favoured retaining control over bank supervision.63 In the end, London’s mixture of statutory control and self-regulation provided a friendly environment for securities business. Improvements were required in implementation of the 1986 legislation and were undertaken. Overhaul of the 1986 legislation along the lines of a SEC with a clear regulatory mandate could have reduced London’s comparative advantage in wholesale trading relative to competing financial centres.64

                                                             Learning by Doing

Here lay the paradox at the heart of the U.K.’s incremental move to statutory regulation of financial markets. The SIB’s main weakness lay in implementation. But SEC-like powers, to be effective, had to have the support of the City. Whether conceived as a strategy or discovered as part of the prolonged policy process, successive governments in effect allowed market participants to discover the limits of self-regulation before taking the next step. There was no confrontation comparable to that between government and coal miners in 1984-85. The government’s emphasis was first to create the two-tier structure of SIB and SROs, then to establish rules, and finally to address the central matter of implementation. The procedure adopted over the longer term was to introduce measures, which symbolised intent, but had inadequate means to achieve stated objectives. The benefit was to ensure that the learning process was widely shared as the markets stumbled from one scandal to another. The cost was recorded in the various disasters which may have been avoided had supervisory authority been asserted earlier.

The demise of Lloyd’s served as one painful lesson of the limits to the Bank’s preference for “practitioner based regulation.” Lloyd’s was not included in the Financial Services Act of 1986, on the grounds that the Lloyd’s 1982 Securities Act sufficed. The DTI ordered an inquiry instead,65 rather than burden the FSA with another sensitive issue.66 But all was not well. The mid-1980s were years of frenetic boom at the market, despite the Tory government’s lowering of top tax rates, providing Lloyd’s names with an incentive to place their personal wealth in less risky undertakings. Agents recruited names with modest means in a scramble to expand its capital. Cheap reinsurance meant primary insurers took on poor risks in the rush for market share, while catastrophe risks were shuffled around the syndicates. The DTI set up its own inquiry into the market, and suggested reducing the power of insiders, but fell short of proposing statutory control. Even the U.S. Internal Revenue Service held a joint review with the U.K.’s Inland Revenue about the goings-on in Lloyd’s. Membership reached its peak at 32,000 in 1988. That  year the bills began to roll in with a series of natural disasters, huge court claims for damages awarded in the United States and the onset of recession. By 1991, Lloyd’s losses amounted to $7 billion.

Another lesson hard learned was the cost of leaving the task of policing the market to private agents, who also participated in it. As a general statement, it was no doubt true that all agents in the market would benefit by high standards, jointly kept. But the incentives in competitive markets are on individual organisations to prosper and perhaps cut corners, involving a calculus of the costs and benefits. Evidently, many individuals or firms felt that the cost of providing evidence against competitors engaged in insider trading outweighed any benefits, in view of the difficulties experienced by the DTI in providing sufficient evidence to meet the rigorous standards of criminal justice required to bring cases of insider trading under the 1980 Act. The Company Securities (Insider Trading) Act of 1985 failed to modify this weakness, despite the fact that government support at the time to create financial conglomerates made insider dealing more rather than less likely.67 In part, this was remedied under the 1987 Criminal Justice Act, which gave new powers to a strengthened Serious Fraud Office to compel witnesses to give evidence. But the measure was controversial since it infringed an ancient right to silence in criminal proceedings. Powers to investigate and police were in any case dispersed across a variety of bodies, including the DTI, the SFA, the Director of Public Prosecutions and the Serious Fraud Office. Not least, the Bank of England relied, as did financial markets, on evidence from the auditors about the state of their clients’ accounts. The 1987 Banking Securities Act, following the failure of auditors to alert the Bank about the true condition of JMB’s finances, suggested that the auditor keep an open line of communication to the Bank. But there was no obligation to do so. The figurative chickens soon came home to roost, with the demise of the Lloyd’s market, the Polly Peck and Guiness scandals, the Maxwell affair and the BCCI mess.

It was only when disaster struck in the form of the massive losses of 1988-1991 that deep changes began to be implemented in Lloyd’s. Revelations on shoddy standards and sharp practices undermined the trust of the names on which self-regulation relied. The only way to attract back capital was to open the doors to corporate money. But that spelled formal abandonment of the principle of unlimited liability and submitting to the rigorous requirements of corporations, themselves subject to the discipline of the equity markets. It also meant a fundamental revision of Lloyd’s rule book, and a new Act.

In retail investment services, the SIB’s more assertive posture came after FIMBRA had gone bust and Robert Maxwell¾in the summer of 1991, months before his death¾had  walked away with £400 million from his group pension fund to ward off the banks.

In wholesale markets, the Bank’s handling of the BCCI case justified Justice Bingham’s critique that its responsibilities to police markets could not be delegated to auditors. Revision in 1992 of the law on insider trading saw a new emphasis placed on the option for civil action to be taken before a special court.68 The City, in short, was edging towards acceptance of statutory law, involving the clear allocation of responsibilities between accountable authorities.


Transformation, absorption, autonomy and reform are the four characteristics of the British financial system of the 1990s.

•           The system has been transformed from a figurative archipelago of cartelised islands to a competitive market for wholesale and retail investment or banking services.

•           It has absorbed policies and initiatives emanating from the United States, with whose markets interdependence is close, and has become at the same time¾and in its own specific way¾Europe’s prime financial centre. What has emerged is a particular form of British capitalism, derived from inherited institutions and attitudes, from the U.S. example and (with the creation of multi-purpose banks) comparable but still distinct from German universal banks. The system has been shaped by a state which has sought to sustain its autonomy over markets through a dual process of liberal economic policies and the slow, but accretive concentration of powers in a two-tier regulatory framework.

           Autonomy has been maintained despite the massive presence of foreign institutions in the U.K., through the medium of international negotiations with other regulators and by the de facto preferential alliance between the Bank of England and the banks, evident in the privileges of the clearing banks and the position of the British merchant banks in securities markets (now mainly subsidiaries of British and continental commercial banks).

•           Reforms have been implemented by serendipity in a costly process of learning by doing as accretive changes became open to further modifications through experience. This process won the City to accept some new and as yet undefined balance between authority, informality, law and markets, where powers are more clearly allocated between Treasury and Bank, and between the Bank, the DTI and the Securities Association and the PIA.

With clearer allocation of tasks comes the matter of accountability to parliament, and the broader constitutional issue of reform in the inherited constitution of the United Kingdom.

At the same time, the rhythm of reforms in the United Kingdom has been driven by domestic politics and markets, and the context of the world political economy. Membership in the EU played a marginal role in this process, although the U.K. representation in Brussels spent much time and energy from 1973 to 1986¾and the launch of the internal market package¾to pressing for greater liberalisation of financial services. By the time that negotiations on financial services were underway, in 1986-92, the broad design of U.K. regulation was already in place. Given the centrality of investment services for London, and the convergence of institutions from banking, insurance or units trusts and pension funds on the markets, the central battles for the United Kingdom in the EU were fought over the content and timing of the investment services directives.

The Treasury, the Bank of England, the DTI and the SIB shared responsibility for U.K. policy towards the EU, supported by a City advisory committee. British negotiators were confronted by two major challenges relating to capital markets. One was the concern among security houses in ISRO that EU legislation would be less rigorous than the new regulatory framework in the U.K.69 There was also concern that the central banks would impose capital ratios on securities firms that would benefit capital-rich banks. The other was the Commission’s inclusion¾with French support¾of the reciprocity clause in the Second Banking Directive. But it was not this internal market legislation or procedures which split the City and the Conservative party so much as French, German and Commission support¾with the backing of most other member states¾for the project of the Social Chapter, and  of monetary and political union. It was not over style so much as over substance, that British differences with the other member states waxed, rather than waned.


1.         For a different slant, arguing from the perspective of 1983 that British governments had limited discretion in the face of Britain’s dominant capital markets, see John Zysman, Governments, Markets and Growth: Financial Systems and the Politics of Industrial Change,Oxford, Martin Robertson, 1983.

2.         Maximilan Hall, The City Revolution: Causes and Consequences  (London: MacMillan Press, 1987). W. A. Thomas, The Securities Market (London: Philip Allan, 1989).

3.         Jack Revell, The British Financial System (London: MacMillan, 1973).

4.         J. S. Fforde, “Competition, Innovation and Regulation in British Banking,” Bank of England Quarterly Bulletin, September 1983, Volume 23. No. 3.

5.         Ibid., and Michael Moran, The Politics of Banking (London: MacMillan, 1984), and K. K.Zawadzki, Competition and Credit Control, (Oxford: Basil Blackwell, 1981).

6.         Samuel Brittan, Steering the Economy: The Role of the Treasury (London: Penguins, 1971).

7.         On the secondary banking crisis, see Moran; Margaret Reid, The Secondary Banking Crisis, 1973-75 (London: MacMillan, 1982) and K. K. Zawadzki, Competition and Credit Control (Oxford: Basil Blackwell, 1981).

8.         See The Trade Unions Congress submission, “The Institutions and the Industrial Challenge of the Eighties: The Need for a New Investment Strategy,” to the “Wilson Committee,” Committee to Review the Functioning of Financial Institutions (London: HMSO, Cmnd. 7937).

9.         See John Grady and Martin Weale, British Banking, 1960-85 (New York: St. Martin’s Press, 1986), J. S. Fforde, op.cit.

10.      The Economist, July 14, 1988.

11.      J. S. Fforde, op.cit. p.371.

12.      Financial Times 29.06.1985.

13.      Paul Kennedy, The Rise and Decline of the Great Powers: Economic Change and Conflict from 1500 to 2000 (London: Fonta, 1989).

14.      William Clarke, Inside the City (London: George Allen and Unwin, 1979).

15.      OECD Economic Survey, United Kingdom, March 1979.

16.      W. B. Reddaway, S. J. Potter and C. T. Taylor, Effects of UK Direct Investment Overseas (Cambridge: Cambridge University Press, 1968).

17.      United Nations, Multinational Corporations in World Development (New York: U.N., 1973).

18.      Barry Riley, “Gilt Edged: A System Under Strain,” Financial Times, October 30, 1976.

19.      BIS, Cinquantième Rapport Annuel, Bâle, 9 June 1980.

20.      Nigel Lawson, “No quick-fix solutions to economic problems.” Financial Times, October 8,1990.

21.      Chancellor Lawson’s words, quoted in the Financial Times, January 4,1988.

22.      Interview with the Prime Minister, The Independent, November 23, 1987.

23.      As the Bundesbank stated with uncharacteristic forthrightness, Germany’s universal banks must not be forced “by virtue of the EC regulations to switch over to a system of functional operation in the financial services sector, such as predominates in the Anglo-Saxon countries.” Report of the Deutche Bundesbank for the Year 1989.

24.      See DeAnne Julius, Global Companies and Public Policy, Table 2.4, p. 38. If these relations are converted into purchasing power parity GDP the global German and British stock of capital are about equal.

25.      Ibid, Table 3.3, p. 51. By comparison, in 1987, Britain attracted only 10% of German outward FDI, Financial Times, April 20,1989.

26.      Chris Dillow, A Return to Trade Surplus? The Impact of Japanese Investment on the UK, (London: Nomura Research Institute, August, 1989).

27.      Committee to Review the Functioning of Financial Institutions (London: HMSO, Cmnd 7937). para 1102.

28.      Quoted by Moran, p.30.

29.      The Bank of England’s submission to the Wilson Committee, “The Secondary Banking Crisis and the Bank of England’s Support Operations,” Bank of England Quarterly Bulletin, Volume 18. No. 2, June 1978. pp. 230-236.

30.      Michael Moran, The Politics of Banking (London: MacMillan, 1984).

31.      Frank Welsh, Uneasy City: An Insider’s View of the City of London (London: Weidenfeld and Nicholson, 1986).

32.      Nigel Lawson, The View From No.11, Memoirs of a Tory Radical (London: Bantam Press, 1992).

33.      Report of the Committee Set up to Consider the System of Banking Supervision (London: HMSO, Cmnd 9550).

34.      Financial Times, 23.10.1992.

35.      Robin Leigh-Pemberton, quoted in the Financial Times, 02.03.1984.

36.      Financial Times, 16.01.1982.

37.      Financial Times, 28.12.1983.

38.      “The Future Structure of the Gilt-Edged Market,” Bank of England Quarterly Bulletin, November 1987.

39.      “Developments in Cooperation Among Banking Supervisory Authorities.” Bank of England Quarterly Bulleting, July 1981. Volume 21. No. 2.

40.      Financial Times, 27.11.1993.

41.      Financial Times, 9.10.1978.

42.      The Economist, 15.06.1985.

43.      Financial Times, 19.01.1983.

44.      Review of Investor Protection Report, Part I by L.C.B. Gower (London: HMSO, Cmnd 9125).

45.      Labour members in the House of Commons Committee voted for legal immunities in the hope of blocking government legislation to deprive the trade unions of their legal immunities.

46.      Godfrey Hodgson, Lloyd’s of London (Hardmondsworth: Penguin, 1986). pp.307-324.

47.      Maximilan Hall, The City Revolution (London: MacMillan, 1987).

48.      Bank of England Quarterly Bulletin, December 1984.

49.      Financial Services in the United Kingdom: A New Framework for Investor Protection (London: HMSO, Cmnd 9432).

50.      The Economist, 25.06.1988.

51.      “As the institutions in the market,” Nigel Lawson was quoted as saying in the House of Commons, “see themselves as providers of financial services across the board, compartmentalised regulation of their separate activities makes less sense,” quoted in Financial Times, 04.07.1984.

52.      Financial Times, 26.09.1986.

53.      Financial Times, 14.03.1992.

54.      Financial Times, 14.01.1993.

55.      Financial Times, 07.02.1986; 25.02.1986.

56.      Financial Times, 29.03.1989.

57.      Financial Times, 20.03.1989; Wall Street Journal, 09.03.1989.

58.      Wall Street Journal, 05.03.1990.

59.      Financial Times, 11.10.1986.

60.      Financial Times, 23.10.1992.

61.      Financial Times, 29.05.1993.

62.      Financial Times, 12.10.1992.

63.      Interview with Robin Leigh Pemberton, Financial Times, 23.06.1993.

64.      International Herald Tribune, 19.09.1984. The attraction for members of the AFBD was a market for professionals where truants, it was argued, would be punished “in the privacy of the City”

65.      Report of the Committee of Inquiry, Regulatory Arrangements at Lloyd’s (London: HMSO, Cm.59, January 1987).

66.      Financial Times, 11.01.1986.

67.      Maximilan Hall, “Reform of the London Stock Exchange: The Prudential Issues”, Banca Nazionale del Lavoro Quarterly Review, No.161. June 1987.

68.      Lord Alexander, Chairman of NatWest, quoted in Financial Times, 27.11.1992.

69.      The Chairman of Hambros, “Chips” Keswick, at the IMF/IBRD meetings in Berlin in 1988, talked of the SIB’s “stifling and excessive bureaucracy.” The Banker, November 1988.

About Jonathan Story, Professor Emeritus, INSEAD

Jonathan Story is Emeritus Professor of International Political Economy at INSEAD. Prior to joining INSEAD in 1974, he worked in Brussels and Washington, where he obtained his PhD from Johns Hopkins School of Advanced International Studies. He has held the Marusi Chair of Global Business at Rensselaer Polytechnic Institute, and is currently Distinguished Visiting Professor at the Graduate Schoold of Business, Fordham University, New York. He is preparing a monograph on China’s impact on the world political economy, and another on a proposal for a contextual approach to business studies. He has a chapter forthcoming on the Euro crisis. His latest book is China UnCovered: What you need to know to do business in China, (FT/ Pearson’s, 2010) ( His previous books include “China: The Race to Market” (FT/Pearsons, 2003), The Frontiers of Fortune, (Pitman’s, 1999); and The Political Economy of Financial Integration in Europe : The Battle of the Systems,(MIT Press, 1998) on monetary union and financial markets in the EU, and co-authored with Ingo Walter of NYU. His books have been translated into French, Italian, German, Spanish, Chinese, Korean and Arabic. He is also a co-author in the Oxford Handbook on Business and Government(2010), and has contributed numerous chapters in books and articles in professional journals. He is a regular contributor to newspapers, and has been four times winner of the European Case Clearing House “Best Case of the Year” award. His latest cases detail hotel investments in Egypt and Argentina, as well as a women’s garment manufacturer in Sri Lanka and a Chinese auto parts producer. He teaches courses on international business and the global political economy. At the INSEAD campus, in Fontainebleau and Singapore, he has taught European and world politics, markets, and business in the MBA, and PhD programs. He has taught on INSEAD’s flagship Advanced Management Programme for the last three decades, as well as on other Executive Development and Company Specific courses. Jonathan Story works with governments, international organisations and multinational corporations. He is married with four children, and, now, thirteen grandchildren. Besides English, he is fluent in French, German, Spanish, Italian, reads Portuguese and is learning Russian. He has a bass voice, and gives concerts, including Afro-American spirituals, Russian folk, classical opera and oratorio.
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