The evolution of the UK banking regulation until the 2007–2009 financial crisis

The Bank of England and HM treasury: the moral suasion tool

Most accounts of the history of banking regulation and supervision in the UK place its inception in the late 1970s and emphasise the fact that a formal licensing requirement and

1

See House of Lords» House of Commons, Parliamentary Commission on Banking Standards» ‘An Accident Waiting to Happen: The Failure of HBOS’ Fourth Report of Session 2012-2013 (4 April 2013) available at (accessed 26 July 2020).

supervisory regime for all banking institutions was only introduced by the Banking Act

1987.[1] However, if a broader notion of regulatory function is adopted, it is evident that the Bank of England had been exercising a proto-regulatory function since much earlier. Indeed, since the onset ofWorld War I, the Bank of England stopped competing against other banks and assumed effective leadership of the banking system. This took place despite the absence of any formal licensing, regulatory or supervisory powers of the Bank and is hence frequently described as ‘the moral suasion tool’. According to anecdotal evidence, it was common at the time for the Bank of England to invite the senior management of a bank for an informal conversation and to suggest them the need to change their business policy, for instance, by reducing lending to a particular economic sector or type of business.

The persuasive authority of the Bank of England was based on the fact that commercial banks relied on the Bank of England to restrict entry to the market thus insulating them from effective competition. This informal regulatory ecosystem was facilitated by the social and geographical proximity between the Bank and major UK banks, and by the strong interventionist role of the state in the economy between 1945 and the early 1970s. Ultimately, an omnipresent implicit threat of nationalisation, existing during the whole period from the 1930s until the 1970s, ensured compliance with the instructions and guidance provided by the Bank of England. By the 1930s, the Bank’s informal control over major banks encompassed crucial corporate decisions such as the payment of dividends and amalgamations. Thus, historically, the development of effective regulatory arrangements in the UK closely followed the full adoption of limited liability and the discontinuation of the practices of using reserve capital and uncalled capital in the early 20th century. This is unsurprising, as it is exactly the practice of limited liability banking that poses great risks of externalities and thus necessitates the establishment of effective regulatory and supervisory arrangements.

  • [1] See e.g. Mads Andenas and Iris HY Chiu, The Foundations and Future of Financial Regulation: Governance for Responsibility (Routledge 2014) 5-6 and Christopher Ryan, ‘Transfer of Banking Supervision to the Financial Services Authority’ in Michael Blair et al. (eds), Blackstone’s Guide to the Bank of England Act 1998 (Blackstone Press 1998) 39-40. 2 See Charles A.E. Goodhart, The Evolution of Central Banks (MIT Press 1988) 44-55. 3 A detailed account of the history of the UK financial industry in the 20th century can be found in David Kynaston, The City of London - Volume IV: A Club No More, 1945-2000 (Pimlico Publications 2002). 4 See Fred Hirsch, ‘The Bagehot Problem’ (1977) 45 The Manchester School of Economic & Social Studies 241, 248. 5 See John D Turner, Banking in Crisis: The Rise and Fall of British Banking Stability, 1800 to the Present (CUP 2014) 175. 6 Ibid., 176-177. 7 Such practices effectively made bank shareholders liable to some extent in the case of a bank’s insolvency and thus reduced incentives to take excessive risk. 8 For a concise discussion of the crisis, see Margaret Reid, The Secondary Banking Crisis, 1973-75: Its Causes and Course (Macmillan Publishers 1982).
 
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