Structural Power and the Politics of Bank Capital Regulation in the United Kingdom

Abstract

This article describes and explains a significant tightening in bank capital regulation in the United Kingdom since the 2008 financial crisis. The banks fiercely resisted the new capital regulations but in a novel theoretical contribution we argue that the structural power of business was reduced due to the changing ideas of state leaders, by changing institutional arrangements within the state and by wider open politicisation of banking reform.

Keywords

banking structural power ideas institutions

Introduction

This article analyses the battle over bank capital regulation in the aftermath of the 2008 banking crisis in a core financial market, the United Kingdom. Bank capital is shareholder’s equity, a bank’s own reserves, as well as retained earnings. Banks with higher ratios of capital to total assets are more likely to be able to withstand significant losses. The banking industry has nevertheless traditionally opposed higher capital requirements, arguing that higher capital levels increase costs, depress lending and weaken profits. Capital regulation has, however, increasingly been tightened in the post-crisis era. We argue that this substantially reflects changes in the structural power of banks and financial institutions as well as increased state capacity. Three factors matter here: the changing ideas of policy makers and their perception of structural power threats; enhanced state capacity, including bureaucratic capacity and insulation in key regulatory agencies, especially the Bank of England; and the wider ‘noisy’ politicisation (Culpepper, 2011) of banking reform.

We identify three phases of capital regulation in the United Kingdom. Prior to 2008 and over a long period there was a significant winding down in capital levels in a major risk shift from the banks to the state (Haldane and Alessandri, 2009). Post-crisis, amidst intense bank lobbying, capital levels were increased, although in the view of some commentators, only moderately, through the Basel III negotiations and the subsequent implementation of these rules via the European Union’s Capital Requirements Directive (CRD) IV. Subsequently, the Bank of England’s Financial Policy Committee (FPC, 2013b) working alongside the Prudential Regulatory Authority (PRA) has, in its own words, taken a ‘conservative and comprehensive view of capital adequacy’ (p. 5) and significantly tightened regulatory constraints to produce one of the world’s toughest standards on capital adequacy, despite very substantial opposition from the UK financial industry. This article seeks to highlight how and why such policy tightening has occurred, especially in terms of arguments about the structural power of business, and associated arguments about ideational change, state capacity and wider political change.

Our theoretical starting point in explaining these policy changes is Charles Lindblom’s (1977) classic argument that ‘privileged’ business interests wield structural power by virtue of their control over key economic resources and the investment and credit processes on which governments and the wider society depend. Structural power can help explain the government’s caution about capital regulation in the immediate aftermath of the 2008 crisis. The banks, at that time, had some success in arguing that increasing capital levels would inevitably result in lower lending and that this would jeopardise the recovery. But how, in this case, can we account for the subsequent tightening in regulation? Our answer is found in rejecting the assumption that structural power is a material reality which arises automatically in capitalist societies. Against this, Stephen Bell (2012) has argued that ideas, particularly the ideas held by state leaders, condition and mediate structural power. We argue that structural power has been mediated and policy change facilitated through the way in which expert state elites developed and deployed ideas in key political contests, especially in challenging the banks’ arguments about capital and lending.

Our article also develops new theoretical insights about how structural power is shaped and mediated by first arguing that the changing institutional context of state policy makers strengthened the banks’ hand and second by arguing that the noisy politicisation of banking reform in the wake of the 2008 crisis also helped embolden policy makers.

The (Variable) Structural Power of Business

Lindblom (1977) argued that governments and the wider society depend on a strong economy and hence in a capitalist economy on the willingness of business to invest and produce. Governments are therefore dependent upon business and financiers and typically have strong incentives to cater to their needs and demands.

This form of structural power is not automatic, however. As we argue, agents, especially within the state, mediate the relationship. For example, not all sectors of business are necessarily privileged. Some sectors may lack resources or be economically weak, or governments might perceive their growth as non-essential or even detrimental to overall economic growth. In the case at hand, however, we argue that there is a strong prima facie case for arguing that the banking industry possesses a strong measure of structural power in the sense employed by Lindblom. First, banking and finance are a critical sector within the UK economy. On one estimate, banking and finance comprised 8.3% of gross domestic product (GDP) prior to the 2008 crisis, employed 303,000 people in London, generated a £44 billion trade surplus, attracted £40 billion in foreign direct investment and accounted for 25% of Corporation Tax revenue (TheCityUK, 2008). Second, banks and other financial institutions provide vital credit supplies to households and businesses. The varieties of capitalism literature (Hall and Soskice, 2001: 28; Zysman, 1983: 63) argues that businesses in liberal market economies rely primarily on equity markets for finance, yet this is no longer true of the United Kingdom. In the early 2000s, the bond and capital markets together provided around 80% of funds for new business investment, but by 2006/2007 bank lending had become far more central, providing 80% of these funds: a remarkable shift (Pattani and Vera, 2011: 319). Between 1997 and 2007, UK bank lending to non-financial companies grew at a rate of between 10% and 20% a year (Hardie and Maxfield, 2013: 59).

There have been a range of additions to and critiques of Lindblom’s original arguments about structural power. Some have argued that structural power can be shaped and mediated by the economic cycle (Vogel, 1989), while others argue it can be shaped by institutional dynamics (Hacker and Pierson, 2002), divisions within the business sector between financial and coalitions of other business interests (Helleiner and Thistlewaite, 2013; Pagliari and Young, 2014), collective action problems (Woll, 2014), and the structural parameters of economies and exit options for capital (Culpepper and Reinke, 2014). On this reasoning, simple structural power accounts are often too mechanical and deterministic and cannot account for temporal and/or (as above) for sectoral variations in such power. There is a further key problem with Lindblom’s account: it leaves too little room for agency. Bell (2012) argues that structural power arguments have largely overlooked the importance of the agency of government policy makers and their ideas and how they appraise and respond to structural power threats. In contrast to Lindblom (1977), and to Hacker and Pierson (2002) and others, who argue that the structural power of business is generated ‘independently and automatically’ (p. 277) because of micro-decisions about lending or investment taken by business leaders,¹ we argue that power is not an objective condition but is shaped subjectively and inter-subjectively amidst changing relations between business and government which can be mediated by institutional factors and by wider political factors, as we show here.

Although Lindblom is well aware of business agency and lobbying power, his account tends to downplay interactions between agency and structure. Lindblom argues either that ‘privileged business controls are largely independent of the electoral controls of polyarchy’, or that business interests can ‘bend polyarchy to accommodate business controls’ (Lindblom, 1977: 190). Neither account is fully satisfactory. We argue for stronger connections between agency and structure. In our view, structural power is in part ideationally constructed (Bell, 2012), an approach which recognises that ideas, language and discourse provide crucial building blocks for establishing meaning and understanding and thus for purposeful action in politics and institutional life. What counts in the power equation is not just whether business lending or investment is essential for growth in particular cases, but also whether state actors believe this to be the case. One reason why the structural power of business varies is because government actors’ normative and causal ideas about the value and determinants of business investment and credit flows vary.

Bell (2012) and Bell and Hindmoor (2014b) thus argue that the ideas held by state leaders and, in particular, the way in which they appraise and react to business investment or credit threats, can be important in shaping or mediating the structural power of business. Power then does not simply shape or dominate ideas, as Steven Lukes (1974), John Gaventa (1980) and Michel Foucault (1979) all argue. It is also the case that ideas shape power. In this view, structural power must be ‘actualised’ through efforts by business leaders to convince policy makers and perhaps the public more generally about the veracity of such power. In a democratic system, business leaders’ arguments about the consequences of state regulation can be contested by interest groups, rival business interests, the media or, as happened in this case of capital regulation, by academic and professional economists. Policy debates take place against the backdrop of constantly evolving arguments about the likely consequences of acting in particular ways and these arguments shape the structural power of business.

Because structural power is mediated by ideas, it follows that structural forms of power might be supported by instrumental forms of business power. As Claus Offe and Helmut Wiesenthal (1980) have argued, business policy preferences and structural power might be ‘exploited and fine-tuned’ (p. 86) through overt business lobbying and communication directed at government. In this view, business power is thus a product of a relationship between business and government operating through structural and instrumental channels. This is not to suggest that we collapse the analytical distinction between the two forms of power but only to suggest that the two forms of power can often work together. We are therefore not, as Pepper D. Culpepper (2015) charges, challenging ‘the very utility of the distinction between structural power and instrumental power’ (p. 396), but instead simply pointing out how the two can run together in the real world.

There are two further theoretical innovations in this article. First, we draw upon the state capacity literature and join this to structural power arguments by arguing that the institutional location and capacities of state policy makers are also important. The Bank of England’s institutional resurgence is especially important, specifically the clarity of the FPC’s mandate, its relative autonomy, and its administrative resources and knowledge capacities. Hence, ideas and state capacities are not separate explanatory factors: the Bank of England’s institutional empowerment is reflective of post-crisis ideational change and lesson-learning that shaped and promoted institutional change. In this manner, we show below how changing ideas and the changing institutional contexts of policy makers helped empower them in the face of structural power threats.

Second, Bell and Hindmoor (2014a) have recently explored how the role of voters and wider political contestation can impact on structural power dynamics, and this is also the case here. The 2008 crisis turned the previously insular world of bank regulation into a far more high-profile and contested arena. This shift from quiet to noisy politics in the world of banking regulation enhanced state capacity and helped empower the Bank of England. Indeed, the political legitimacy and clout of the banking industry was weakened by the way in which public debate about the role and value of banks was ignited by the 2008 crisis and then further inflamed by a succession of subsequent banking scandals. It is difficult to untangle the relative influences stemming from the ideational, institutional and structural power dynamics we explore from the wider impact of politicisation. We simply argue that changing ideas and structural power dynamics are highly salient, and that the impetus for reform was further supported by the noisy politicisation surrounding the banks, all of which helped further embolden and support policy makers. It is possible, however, to distinguish analytically between ideas which helped animate and embolden such actors on the one hand, and growing incentives for action on the other, which stemmed not only from ideas but also from the wider context of contestation, one which increasingly proved unfavourable to the banks. Ideas and incentives therefore ran together in this case. Ideas that proved enlightening and empowering for policy makers were spurred and supported by the changing political context. This suggests that Lindblom’s argument that ‘privileged business controls are largely independent of the electoral controls of polyarchy’, or that business interests can ‘bend polyarchy to accommodate business controls’, first, unrealistically segregates structural power dynamics from the wider context political context and, second, wrongly assumes that such contexts can simply be ‘bent’ (Lindblom, 1977: 190) to suit structural power imperatives.

The Dynamics of Capital Regulation

In the nineteenth century, banks in Britain routinely held capital equivalent to around 30% of total assets (Haldane, 2011a). Market investors required banks to hold this level of capital to support confidence and to ensure liquidity and solvency. Subsequently, average capital levels declined dramatically. The Independent Commission on Banking (ICB, 2011: 128) reports that average capital levels of UK banks had fallen to 5.5% of total assets by the late 1970s and that prior to the 2008 crisis they had fallen to just 2.5% of total assets. This capital wind-down was facilitated by the state and by the Basel accords. The Basel Committee on Banking Supervision (BCBS) finalised Basel I in 1988 in order to prevent an international regulatory race-to-the bottom and to guarantee minimal capital standards in an increasingly internationalised banking system. Yet in practice, Basel I and its successor, Basel II, resulted in a reduction in average capital levels by setting minimal capital levels relative to ‘risk-weighted’ rather than total assets and by creating an additional regulatory category of tier 2 capital which included undisclosed reserves, revaluation reserves, hybrid (debt/capital) instruments and subordinated debt.

Bank executives also had a bonus-based incentive to wind down capital levels in order to improve their return on equity by boosting returns and reducing equity. Investors accepted the winding down of capital due to the introduction of state-supported deposit insurance and lender of last resort functions and because they underestimated the extent of bank balance sheet exposures and dependence upon short-term wholesale funding prior to the 2008 crisis (Hindmoor and McConnell, 2013).

The crisis, which originated in the US subprime mortgage market, exposed the limitations of the Basel regulations. In 2008, the International Monetary Fund (IMF) estimated subprime loses at US $500 billion (Admati and Hellwig, 2013: 60), only a small fraction of overall bank balance sheets (Bernanke, 2012). Yet these losses triggered a general financial crisis for two reasons: the losses led investors to question the value of other banking assets, and raised questions about the solvency of the largest banks. Suddenly, capital buffers mattered: investors knew that low capital levels meant small balance sheet losses could prove fatal. Panicked wholesale funding markets began to demand more collateral or higher interest payments to roll over their loans. With costs suddenly rising and profits falling, banks had to repair their balance sheets by either raising additional capital or selling existing assets. This logic was played out over several years as first Northern Rock and then Bear Stearns and, finally, Lehman Brothers failed. By the time the crisis had been contained in the United Kingdom through a Treasury-led recapitalisation, the Financial Services Authority (FSA) calculated total losses experienced by UK-based investment banks to be the equivalent of 160% of their capital (Barwell, 2013: 23).

Global capital account imbalances, the re-engineering of balance sheets away from lending towards financial trading, insufficient liquidity and the fragilities of wholesale funding markets, inadequate risk management, the frenetic search for yield in a low interest-rate environment, and a myriad of other factors also contributed to the onset of the crisis (see Bell and Hindmoor, 2015; Davies, 2010; Financial Crisis Inquiry Commission, 2011; Friedman, 2009). Yet in its immediate aftermath, low capital ratios were also cited by a number of regulators and politicians as a key cause. The Financial Stability Forum (FSF, 2008) criticised the ‘significant weaknesses’ (p. 12) in pre-crisis capital regulation. The UK Chancellor, Alistair Darling, said, ‘it would have been better if the banks were holding more capital … when the crisis hit’ (Darling, 2009). The influential Turner Review (Turner, 2009b: 7) concluded that ‘the quantity and quality of overall capital in the global banking system should be increased’. The US Treasury Secretary, Timothy Geithner, concluded that ‘the top three things to get done are capital, capital, capital’ (quoted in Howarth and Quaglia, 2013: 333).

The banking industry did not directly challenge such views. Instead, it argued that higher capital levels in the wake of the crisis would have the effect of reducing lending and prolonging the post-crisis recession. The Institute of International Finance (IIF, 2010), an international bank lobby group, published a report purporting to show that a 2% increase in capital levels would reduce cumulative economic output by 3.1% in the Eurozone, the United States and Japan by 2015 and destroy 9 million jobs (Lall, 2012: 628). Similarly, the British Bankers Association (BBA) commissioned PwC to produce a report assessing the likely impact of any additional capital regulations on the supply of credit (James, 2016: 15). The Chief Executive of the BBA, Angela Knight, maintained that higher capital levels would ‘reduce the ability to use new capital to support lending and that will be very important as we start to come out of recession’ (Knight, 2009). A year later, Knight argued that ‘it is very easy to call for quick timetables’ (to raise minimal capital levels) but that higher capital would ‘dramatically impede’ the ‘ability of the industry to finance economic recovery’ (Knight, 2010b). Also that year, she held that ‘in crude terms, it is not possible both to hold more capital and to lend the same amount of money’ (Knight, 2010a).

Post-crisis debates about capital regulation were initially played out in the context of international negotiations over Basel III. In September 2010, a draft agreement suggested raising core capital equity requirements from 2% of risk-weighted assets to 4.5% of such assets and tier 1 capital from 4% of risk-weighted assets to 6%, while also introducing a new mandatory capital conservation buffer of 2.5%, a discretionary countercyclical capital buffer of up to 2.5% and an overall leverage ratio of 3% of tier 1 capital relative to overall assets. There is a rich literature on the politics and regulatory significance of Basel III. Andrew Baker (2013) presents Basel III as one part of a more general and ambitious turn towards macroprudential financial regulation. Kevin Young (2012) points to the limited influence of financial interests upon the initial drafts of the Basel III agreement. The Financial Times columnist Martin Wolf (2010), on the other hand, described Basel III as the ‘mouse that did not roar’ (but see Wolf, 2014: 225–227 for a more nuanced account). Ranjit Lall (2012) shares Wolf’s scepticism, arguing that Basel III ‘falls far short of its creator’s aims’ (p. 609). David Howarth and Lucia Quaglia (2013: 335) argue that the initial drafts of the Basel III agreement constituted a significant step change in regulatory standards but also point to the way in which implementation of Basel III was delayed until 2019 after intense lobbying by the financial industry.

The Bank of England, for its part, viewed Basel III as an improvement upon Basel II but nevertheless as inadequate. In October 2010, the Bank of England’s then Governor, Mervyn King (2010), publicly identified a number of deficiencies in the draft agreement and warned that ‘Basel III on its own will not prevent another crisis’. The Executive Director of Financial Stability at the Bank of England, Andy Haldane, subsequently told us that ‘it was a pretty open secret that [in relation to minimal capital ratios] we’d have preferred a number that was well North of where we came in’ (interview, 9 May 2013). This argument about capital regulation intensified in 2011 when the European Commission released a draft of the CRD IV giving effect to Basel III. Attention in the United Kingdom focused upon provisions within CRD IV which significantly weakened the terms of Basel III by allowing banks to count the capital assets of insurance firm subsidiaries towards their overall capital requirements, by rolling back the commitment within Basel III to introduce an overall (that is non-risk-weighted) leverage ratio, and, above all, by introducing ‘maximum’ capital buffers to sit alongside Basel III’s minimal capital buffers (Howarth and Quaglia, 2013: 336–337). This final measure was defended as being necessary to ensure the effective maintenance of the single European market. The European Commission’s position was driven primarily by the German and French governments whose banks would have been most adversely affected by the full implementation of Basel III. The BBA (2012) had, however, also sought to exert pressure particularly in relation to the introduction of maximum harmonisation provisions.

Garnering public support from the European Central Bank, the IMF and a plurality of European Finance Ministers, Bank of England officials publicly criticised the draft CRD IV agreement (Howarth and Quaglia, 2013: 340). On 2 May 2012, the United Kingdom rejected a compromise agreement which would have allowed member states to increase their capital buffers up to a specified threshold level. A deal was, however, eventually struck. The United Kingdom agreed to accept the provisions within CRD IV in relation to the counting of capital assets and the rolling back of the commitment to introduce a European leverage ratio in return for an explicit agreement that no other country would challenge its decisions to raise the capital buffers of UK banks. In effect, the United Kingdom secured an opt-out from maximum harmonisation.

The Bank of England was prepared to fight hard on the issue of maximum harmonisation because, by this time, plans to overhaul the United Kingdom’s own regulatory framework and strengthen the authority of the Bank of England were already well advanced. The key moment here came in 2011 with the publication of the White Paper A New Approach to Financial Regulation: Building a Stronger System in which the then Coalition Government confirmed that the FSA was to be abolished and replaced by two new bodies, the FPC and the PRA, both to be located within the Bank of England. The FPC has broad oversight of financial stability and systemic risk (HM Treasury, 2011: 7). The PRA is the ‘coal-face’ regulator responsible for the supervision of over 1700 financial firms. The FPC was established in a shadow form in February 2011 prior to its formal statutory establishment in April 2013 and now holds the legal authority to set the countercyclical capital buffer introduced through Basel III, to set sectoral capital requirements, make ‘comply or explain’ recommendations to the PRA, and make recommendations to the Treasury on the setting of the boundary between regulated and non-regulated financial activities (Tucker et al., 2013: 195).

The FPC and PRA have used their authority to further tighten regulatory standards in relation to capital. In his 2015 Mansion House speech, the current Governor of the Bank of England, Mark Carney, told his audience that the ‘age of irresponsibility is over’ and pointed, among other things, to the way in which capital requirements have, in his words, been raised ‘ten-fold’ since the financial crisis (Carney, 2015). The FPC has pursued a regulatory agenda initially developed within the Financial Stability Board to require ‘systemically important’ global banks to hold an additional 3%–5% of tier 1 capital relative to risk-weighted assets. Second, the FPC has used stress testing to assess the adequacy of capital buffers. Significantly, these tests have been much more demanding than those employed by the European Banking Authority (Bank of England, 2014c: 60–64). Third, the FPC has directed the PRA to scrutinise the risk weights used by the banks in calculating their overall capital buffers. In March 2013, UK banks were required to raise an additional £27 billion in capital to compensate for deficiencies in risk weights (FPC, 2013b: 3). Fourth, the FPC has introduced a leverage ratio for UK banks initially set at 3% of total non-risk-weighted assets (Bank of England, 2014d: 24). Finally, and in relation to concerns about consumer debt, the FPC has sought and been granted additional powers to directly limit mortgage lending (Bank of England, 2014c: 44–45).

As a result of these moves, the overall ratio of core tier 1 equity to risk-weighted assets has risen from 7% at the end of 2011 to over 11%. This is 2% higher than the internationally agreed benchmark for tier 1 capital within the Basel III agreement schedule to be fully implemented by 2019. The overall leverage ratio – measuring equity capital as a percentage of banks’ reported assets on an unweighted basis – is double the level it was in 2007 prior to the start of the financial crisis (Bank of England, 2015: 34–35). Between 2008 and 2015, UK banks have raised nearly £100 billion in additional capital and disposed of £1.4 trillion in non-core assets – most notably trading assets – which has also had the effect of raising capital as a proportion of total assets (Bank of England, 2014c: 17).

In late 2014, the banking industry renewed its campaign against bank regulation. The former Chairman of Barclays, Sir David Walker, argued that there is a ‘compelling and urgent’ need to review rules relating to the ringfencing of investment and retail banking (Quinn, 2015). Standard Charter and HSBC have criticised the scope and scale of the bank levy on wholesale borrowing and, in doing so, have repeated their earlier threats to move abroad (Wright, 2015). The banks have had some successes. In his 2015 Mansion House address, Chancellor George Osborne (2015) signalled an end to ‘bank bashing’. Since then, the Chancellor has cut the size of the bank levy (balancing this with an additional tax on bank profits) and effectively sacked the Chair of a third regulatory body, the Financial Conduct Authority (Fortado and Arnold, 2015). Significantly, however, the United Kingdom’s comparatively stringent regulations on capital, leverage and risk weighting have not been challenged and now appear to be a fixed part of the regulatory landscape.

How Ideas Mattered

The literature on state capacity focuses on the ability of a state to implement its policy agendas and emphasises bureaucratic expertise and state authority, as well as the nature of the state’s relationship with key social or economic interlocutors (Bell and Hindmoor, 2009: 59–66; Cingolani, 2013; Evans, 1995; Savoia and Kunal, 2012). However, the literature does not focus on the role of ideas in shaping state capacity, and in this section we argue that state capacity and the ability of state elites to withstand structural power threats can be enhanced by the very ideas and basic conceptions that state elites formulate and utilise (Bell, 2012).

In the pre-crisis period, banks lobbied for and were awarded lower capital requirements. Since then, capital standards have been significantly tightened despite sustained opposition from the banks. We cannot easily explain this in terms of shifts in the banking sector’s size or economic significance. Jobs have been lost in the City since 2008, but TheCityUK (2015) estimates that banking and finance and related professional services still employ 7% of the UK workforce and account for 12% of total output. Ministers remain unambiguously committed to the City as a global financial centre (Bell and Hindmoor, 2014c: 351). It is true that, in the immediate aftermath of the crisis, bond and equity markets became a more important source of finance for business investment relative to bank loans (Pattani and Vera, 2011: 319). Yet a clear majority of business investment is still funded through bank loans (Farrant et al., 2013). It is not the bank’s changing role in the economy but the ideational and institutional environment in which banks operate that has weakened their structural power.

In the aftermath of the crisis, the banks argued that raising capital would increase costs, cut lending and harm the economy. This argument acquired political traction because bank lending was viewed as being vital to economic recovery. The then Business Secretary, Lord Mandelson (2010), warned that ‘as the recovery strengthens, we must avoid banks shrinking their balance sheets to meet regulatory requirements at the expense of lending to the viable businesses that we need to drive the recovery’. Prior to the 2010 general election, George Osborne warned that regulators were showing ‘too little consideration of the impact of higher capital and liquidity requirements on overall financial conditions and the pace of recovery’ (Osborne, 2010). Once in office, Osborne continued to express concern that excessive bank regulation could result in the ‘stability of the graveyard’ (Armistead, 2011). In a review of business lending, the Confederation of British Industry (CBI, 2012: 12) – which has generally been critical of the supply of lending to small and medium-sized businesses – nevertheless endorsed the banking sector’s arguments: maintaining that ‘increases [in] the level of capital banks are required to hold, increase the costs to banks of lending to businesses’.

Since around 2011, however, the banks’ arguments about the relationship between capital and lending have been successfully challenged by officials within the Bank of England and by academic economists. Significantly, the banks describe capital as a reserve which must be set aside to cover potential future losses. Higher capital requirements, they argue, mean that more money must be set aside which means less money for loans. However, in November 2011 the FPC’s Robert Jenkins (2011) described such arguments as being ‘intellectually dishonest’ and intended to exploit common ‘misunderstanding and fear’. In contrast to the banks’ arguments, Bank of England officials argue that capital is not a reserve but a source of funding, just like deposits or other forms of bank borrowing. In order to lend to business, banks must first raise money. They can do so by collecting deposits, raising funds on capital markets or borrowing on wholesale funding markets. Banks can, all else being equal, actually increase the amount of funds they have available to lend by raising additional capital. Hence capital is not a ‘reserve’. Its key importance is that it serves as a buffer if and when losses are incurred on the asset side of the balance sheet. As the PRA’s Chief Executive, Andrew Bailey argues:

Equity capital is not money that has to be stashed away for a rainy day and thus put to no good use. It is the shareholders’ stake in the company. … Equity finances the provision of loans to households and companies, and those loans are the bank’s assets (Bailey, 2013).

However, the banks argue that equity is more expensive than debt. To raise capital, banks must pay dividends and offer a return on equity. To get wholesale loans, banks must pay interest and reassure lenders they will not default. Banks argue that interest on wholesale funds is less than the cost of new capital and that – therefore – raising minimal capital requirements raises their overall costs: requiring them to charge higher interest rates on loans and so depressing lending.

Bank of England officials have responded by arguing that equity is only more expensive than debt because banks are perceived as being ‘too big to fail’. When deciding what interest to charge on a loan, lenders factor in default or insolvency risk and demand an interest-rate premium if risk is high. The more likely a company is thought to default, the higher this premium. Yet banks partly escape this logic because lenders believe that banks will be bailed out by the authorities in a crisis. Hence banks have to pay a lower interest rate in order to borrow money than do non-financial companies. Capital is not inherently more expensive than debt (all else being equal), but the cost of debt in a ‘too big to fail’ world has been artificially deflated by a hidden subsidy in the form of state support (Haldane, 2012). Nevertheless, using the Modigliani–Miller theorem (Modigliani and Miller, 1958), Bank of England economists and officials suggest that, in so far as equity is indeed relatively more expensive than debt, this is also because banks currently hold so little loss-absorbing capital. Low capital encourages equity investors to assume that relatively small losses will threaten their investment, leading to demands for higher returns for their investment (Haldane, 2010; Tucker, 2013). This reverses the causal logic of the banks’ arguments about the relationship between capital and lending. It is low capital levels which jeopardise bank lending by weakening investor confidence, thus making it more expensive for banks to raise additional funds through either equity or wholesale funding markets. According to Mervyn King:

[T]hose who argue that requiring higher levels of capital will necessarily restrict lending are wrong. The reverse is true. It is insufficient capital that restricts lending. That is why some of our weaker banks are shrinking their balance sheets. Capital supports lending and provides resilience. And, without a resilient banking system, it will be difficult to sustain a recovery (King, 2013).

The Bank of England’s arguments about the relationship between capital and lending have proven highly influential. They have been echoed and extended in a widely reviewed book on bank regulation by the economists Anat Admati and Martin Hellwig (2013; also see Admati, 2013; The Economist, 2013; Wolf, 2013 for reviews). Since 2012, they have also been taken up by Government Ministers, most notably the Conservative MP and Financial Secretary to the Treasury Mark Hoban (2012) and by the Parliamentary Commission on Banking Standards (2013b: 191). On the other hand, in 2013 the Liberal Democrat Business Secretary Vince Cable publicly decried the ‘capital Taliban’ within the Bank of England (Parker et al., 2013) while the media reaction to the introduction of the FPC’s leverage ratio emphasised the possible knock-on effects on mortgage rates (Boyce, 2014; Titcomb, 2014). It is nevertheless the case that the balance of the debate about the relationship between capital and lending has significantly changed as a result of the Bank of England’s intervention. Perhaps more tellingly, the banks themselves – in their evidence to the Parliamentary Commission on Banking (Barclays, 2012; BBA, 2012; Lloyds Banking Group, 2012), in response to the requirement to raise an additional £27 billion in capital in 2013 (BBA, 2013) and in response to the introduction of a leverage ratio (BBA, 2014) – have stopped arguing that raising capital requirements will reduce lending. The banks continue to argue that regulation must be calibrated in such a way as to ensure that lending remains profitable. They have stopped arguing, however, that lending is constrained by capital regulations.

The often highly technical debate about the relationship between capital and lending should also be seen within a broader ideational context. As historians of political thought (Skinner, 2002) and discursive institutionalists (Schmidt, 2008) have emphasised, ideas are connected: changes in one idea can lead to changes in other ideas. Prior to 2008, regulators’ views about capital were complemented and reinforced by the conviction that financial markets were efficient, that rising asset prices reflected economic fundamentals, that banks could effectively manage risk, that credit rating agencies knew what they were doing, that securitisation and credit default swaps had distributed risk, and that banks would always be able to maintain solvency by selling assets and borrowing money in liquid funding markets (see Bell and Hindmoor, 2015).

The crisis repudiated all of these ideas. It produced a ‘fairly complete train wreck of [the] predominant theory of economics and finance’ (Turner, 2009a) and demanded a ‘fundamental reconsideration of financial regulation’ (Goodhart, 2010: 73). The Bank of England has, in this context, embraced not only much higher capital levels but also a new macroprudential regulatory agenda which recognises the possibility of irrational exuberance, asset bubbles, systemic risk, poorly aligned incentive structures and unpredictable cascades of defaults and market failures (Baker, 2013; FPC, 2014; Kohn, 2013; Tucker, 2013; Tucker et al., 2013). Officials now operate explicitly on an assumption that it is neither possible nor desirable to eliminate entirely the possibility of a bank failing and that higher minimal capital requirements are needed to ensure that the costs of any subsequent failure do not fall on the taxpayer (Carney, 2013). This revised ideational context has been central in helping guide and empower policy makers and has provided incentives to face down the banks’ opposition to higher capital requirements. Policy makers have arrived at a more critical reappraisal of the stability of financial markets and the competence of banks and asserted their own policy agenda. The initial attempts by the banks to exert structural power by threatening to reduce credit were weakened as policy makers revised their ideas.

The Institutional Mediation of Structural Power

In this section, we continue our analysis of state capacity. In cases where cooperative relations with external or societal interests cannot easily be established or maintained, a degree of state insulation from such interests may be required in order to enhance state capacity. In other cases of conflict, overt confrontation with external interests may well reflect and enhance state capacity. Indeed, Patrick Emmenegger (2015) has shown how certain forms of state authority may be used to exert structural power over business interests by threatening their economic position. In this case, however, we argue that bureaucratic insulation was important in enhancing state capacity and the ability of state elites to face down structural power threats.

In a classic expression of structural power, banks threatened that higher capital levels would jeopardise lending and harm the economy. This argument, as we have seen, was subsequently and effectively challenged by the Bank of England. Ideas alone, however, cannot fully explain this change. Institutions in the shape of rules and resources which both constrain and enable behaviour also matter (Bell, 2011). If power is ideationally mediated then the marketplace of ideas is also institutionally mediated. Certain institutional venues privilege certain interests and, with those interests, certain ideas. As Hugh Ward (1987) observed some time ago in relation to the City of London’s then traditionally close relationship with the Bank of England, ‘structural power may result from organisational structures within the state which are partially sustained through links with a certain industry’ (p. 595). But this can also work the other way. Structural power can also be challenged by organisational structures within the state due to the latter’s institutional capacities. In the case of hostile relations with key social interlocutors, bureaucratic insulation can enhance state capacity.

As we have argued, a key moment in the development of post-crisis capital regulations came with the establishment of the FPC within the Bank of England in shadow form in 2011. In the immediate post-crisis period, the Bank of England was constrained by the need to negotiate agreements with other central banks (in relation to the Basel III negotiations) and with members of the European Union (in relation to CRD IV) and draft proposals relating to maximum harmonisation. As we have seen, the Bank of England also had to contend with politicians who were, at least initially, persuaded by the banks’ arguments that increasing capital requirements would result in less lending. Scott James (2016: 13; and references therein) argues that the Bank of England, during this period, also encountered opposition from the UK Treasury which sympathised with arguments about maximum harmonisation. Yet the Bank of England was far from powerless in these struggles. Bank officials occupied influential international positions during the Basel III negotiations. Paul Tucker, a Deputy Governor, chaired the Basel Committee on Payment and Settlement Systems, while Lord Turner, the Chairman of the FSA, chaired the Financial Stability Board’s Standing Committee on Supervisory and Regulatory Cooperation. During the dispute over CRD IV, Scott James (2016: 19) argues that the Bank of England was able to hold the ‘Treasury’s feet to the fire’ by publicly and steadfastly underlining its opposition to maximum harmonisation.

The Bank of England has also been helped by public interest in and hostility towards the banks. Prior to 2008, discussions about bank regulation were confined to a ‘quiet’ (Culpepper, 2011) world in which regulatory debates took place well beyond the public gaze in an environment in which the supposedly expert judgements, technical acumen and market efficiency of bankers were largely accepted by the authorities (Bell and Hindmoor, 2014b). During this period, the British banking system was lauded by politicians – most notably Gordon Brown in his 2007 Mansion House Speech (Brown, 2007) – as the engine of Britain’s economic renaissance. The 2008 crisis changed everything. As The Economist (2009) observed, ‘whilst economists continue to debate the ultimate causes of the collapse of the financial crisis … the public and most politicians, however, are clear: the blame lies with bankers, venal and incompetent in equal measure’. Once the Coalition was elected in 2010, the key question of whether to break up the largest banks was handed to the technocratic ICB (Bell and Hindmoor, 2014b). Over the next few years, the banks, including Barclays’ Chief Executive, Bob Diamond, made periodic efforts to persuade the public that the ‘time for banker remorse is over’ (Wilson and Armistead, 2011). These efforts were compromised by the fact that, at this stage, bank lending was still contracting, by the ongoing reputational costs of inquiries into and compensation for the banks’ miss-selling of Payment Protection Insurance, by HSBC’s involvement in the laundering of drug money in Mexico and, above all, by the LIBOR (London Interbank Offered Rate) scandal which broke in May 2012 and shattered the banks’ efforts to persuade the public and politicians that they had changed. One immediate result of the LIBOR scandal was the establishment of the Parliamentary Commission on Banking Standards which, through a series of reports, public hearings and interventions into policy debates (most notably regarding the ‘electrification’ of the ringfence proposed by the ICB), kept the banking industry in the headlines and on the defensive.

One consequence of the continued politicisation of banking was that technical debates about capital buffers and risk weighting took place in a noisy environment in which the media and the public were predisposed to question the banks’ honesty and competence. In Australia, in 2010 the mining industry was able to derail proposals for a new profit tax by publicly arguing that new taxes would cut investment and employment. The mining industry was certainly helped by the fact that it could afford to saturate the airwaves with its advertisements. But it was also successful because the public had a generally favourable image of the industry as the guardians of Australia’s prosperity and so believed their arguments (Bell and Hindmoor, 2014a). Following the financial crisis, the banks in Britain were not operating in nearly as favourable a political environment.

The establishment of the FPC was nevertheless an important moment because it enhanced the institutional authority of the very officials who were challenging the banks’ arguments about the relationship between capital and lending. Three specific institutional attributes of the FPC have strengthened its position. First, the FPC has a relatively clear mandate: identifying, monitoring, reducing and removing sources of systemic risk arising from ‘structural features of financial markets’, the ‘distribution of risk within the financial sector’ and ‘unsustainable levels of leverage, debt or credit’ (Tucker et al., 2013: 193). This remit has been somewhat complicated by the Treasury’s insistence that the FPC not act in ways that would ‘have a significant adverse effect on the capacity of the financial sector to contribute to the growth of the UK economy’ (Barwell, 2013: 87). This reflects Chancellor Osborne’s above-noted concern about the financial ‘stability of the graveyard’. Yet there is no evidence that the FPC views this requirement as an impediment, largely because it sees financial stability as an essential prerequisite for growth (FPC, 2014: 6; Haldane, 2011b). In a demonstration of the importance not only of institutional rules but also of ideas, the FPC has concluded that its mandate is an unambiguously simple one which provides it with a clear responsibility to challenge the interests of the banks if needed.

Second, The FPC has been granted a great deal of autonomy not only from the European Commission, but also from both the UK government and the banks. The government has confirmed that the FPC’s ‘members need to be, and be seen to be, independent of government and other influences’ (FPC, 2013a: 3). As Andy Haldane described it, the FPC is a

technocratic [body] put at arm’s length from the political process, which is a lesson we sort of learnt from monetary policy … it helps a lot if you can be at arm’s length from the electorate, or from the political process more generally (Interview, 9 May 2013).

The FPC is thus only obliged to explain to the Chancellor how its decisions promote medium and long-term economic growth (HM Treasury, 2011: 20). The Government has no institutional authority to question these explanations or veto policy proposals. Given the historically close relationship between the major parties and the City, this political autonomy is an important new source of institutional capacity. The FPC’s autonomy is also reflected in the fact that it is not required to consult with the banking sector. The FPC includes a voting minority of four outside members: currently (as of September 2015) Clara Furse, the former Chief Executive of the London Stock Exchange; Donald Kohn, a Former Vice Chairman of the US Federal Reserve and Member of the Bank of England Board of Governors; Richard Sharp, a former Chairman of Goldman Sachs’ European Principal Investments; and Martin Taylor, a former Chairman of the agro-chemical firm Syngenta AG and an advisor to Goldman Sachs. There is no evidence, however, that those external members have articulated the interests of UK banks in lobbying for lower capital. Indeed, one of the former external members of the Committee, Robert Jenkins, who, in his own words, was a ‘former lobbyist for the investment industry’ (Jenkins, 2011), has, as we have seen, publicly denounced the banks’ arguments about the impact of raising capital buffers on lending.

Finally, the Bank of England and its coal-face regulator, the PRA, have been given sufficient staff and resources to develop their own research capacity. Although senior regulators in the United States have complained about a lack of resources and staff (Walter, 2013), in the United Kingdom, by contrast, the Bank of England has benefited from significant investment, reflecting a new view that prior to the crisis the FSA and regulators had been starved of resources (Parliamentary Commission on Banking Standards, 2013a: 25–28). The total number of staff increased from 1900 in 2009 to 3600 in 2014 (Bank of England, 2014a: 1). Prior to the crisis, the Bank of England focussed on inflation (Irwin, 2013: 122), but it now employs 7 economists who specialise in banking crises, 9 who work on asset pricing, 20 on banking and financial investment, 24 on financial markets, 6 on financial stability policy and 6 who work on risk management (Bank of England, 2014b).

On this basis, the Bank of England has challenged the structural power of the banks, both through an ideational shift and through an enhancement of institutional authority and capacity. These are linked: the extension of the institutional authority of the Bank of England should be explained as the result of post-crisis lesson-learning by its officials, by ministers and by advisory bodies like the Turner Report (2009b), the ICB (2011), and the Parliamentary Commission on Banking Standards (2013b). First, the location of the FPC within the Bank of England has been informed by arguments that the pre-crisis ‘tripartite’ arrangements – in which responsibility for financial regulation was shared between the FSA, The Treasury and the Bank of England – were inadequate and resulted in a delayed and confused response to the Northern Rock Crisis (see Treasury Select Committee, 2010 for a summary). Second, the granting of a clear mandate to the FPC has been informed by arguments that the pre-crisis FSA was hamstrung by a requirement imposed upon it within the 2000 Financial Services and Markets Act to seek financial stability while also ‘maintaining market confidence’ and the ‘competitive position of the United Kingdom’ in relation to finance (Financial Services and Markets Act, 2000). Finally, the FPC’s institutional autonomy from government and industry lobbyists reflects a widespread view that the FSA had been too close to the industry it was regulating and that Downing Street and the Treasury had been too ready to intervene when the banks had complained about over-regulation (Engelen et al., 2011: 10; FSA, 2011: 29).

Conclusion

Scholars are slowly gaining a clearer understanding of the variables that shape the structural power of business interests. We have moved a large distance from early, purely structural accounts featuring the automatic nature of the power of business. A number of intervening structural and institutional variables have been added to accounts which now show how structural power might vary or change. More recently there have been accounts which explicitly highlight agency, especially the role of political leaders and how they use ideas to appraise and even re-assess structural power threats (Bell, 2012; Bell and Hindmoor, 2014b). There have also been accounts which bring in the electorate, showing how electoral perceptions about structural power and disinvestment threats can alter the calculations of political leaders and how they respond to business threats (Bell and Hindmoor, 2014a). This article has extended this focus on agency, showing how the ideas of policy officials played a key role in defusing structural power threats made by banks in the United Kingdom about the costs and economic implications of higher bank capital levels. The article also shows that arguments regarding state capacity and the institutional resources and insulation of key officials can be important in aiding officials in advancing and sustaining their ideas in confrontations with business interests.

Empirically this article illustrates the significance of national policy arenas in financial regulation and the step change in UK capital buffers following the establishment of the FPC. A number of commentators have argued that the post-crisis politics of bank reform has essentially failed (Mirowski, 2013; Wolf, 2014), with Eric Helleiner (2014) referring to a ‘status quo crisis’. Similarly, Johal et al. (2012) argue ‘the financial elite [in the UK] has been able to use its lobbying and financial muscle to shape [post-crisis] institutional arrangements and to elaborate a dominant regulatory ideology’ (see Johal et al., 2014 for a more detailed elaboration). It is true that Basel III and CRD IV regulations have been widely criticised. Nonetheless, in the United Kingdom, we have argued that significant reform has occurred and that the regulatory landscape now looks very different. This is not to suggest that the banking system is now safe or that regulatory reform has been sufficient. Indeed we have previously expressed concerns that regulators are in danger of ‘winning battles but losing the war over bank reform’ in as much as banks retain the incentive and capacity to try to evade regulatory rules through financial innovation and by transferring risk to the shadow banking sector (Bell and Hindmoor, 2014c). Yet it is clear that, as a result of changes in the ideational and institutional environment, significant changes in capital regulation have occurred since the 2008 crisis and that, within this arena, the structural power of the banks has been challenged. As Andy Haldane (2014) suggests, since 2008, the Bank of England’s thinking in relation to regulation in general and on capital in particular has gone through an ‘elegant 180 degree shift’.

Footnotes

Funding

The author(s) received no financial support for the research, authorship and/or publication of this article.

Notes

Author Biographies

Stephen Bell is Professor of Politics at the University of Queensland. His co-authored book with Andrew Hindmoor on the 2008 banking crisis, Masters of the Universe but Slaves of the Market, was published by Harvard University Press in 2015.

Andrew Hindmoor is Professor of Politics at the University of Sheffield and Honorary Professor of Politics at the University of Queensland. His co-authored book with Stephen Bell on the 2008 banking crisis, Masters of the Universe but Slaves of the Market, was published by Harvard University Press in 2015.

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