Bank governor slams City errors

By Stephanie Flanders BBC economics editor

Mervyn King's reappointment will be discussed

Many senior bankers think the governor of the Bank of England should be the chief cheerleader for the city.

In his appearance before the Treasury Committee on Tuesday Mervyn King once again made it clear he disagrees.

King did not mince his words in discussing the reckless investments in complex financial products by leading financial institutions in the lead-up to last summer - and how these had contributed to the ongoing credit crunch in global markets.

"They [complex financial instruments] may have looked very clever, but actually they were based on some very poor assumptions," he told the committee of MPs.

"And the managers of those institutions, who probably knew far less about those instruments than they should have done, will know in future that if they want to keep their jobs they will have to have better control over the design of those instruments."

City dominance

Over the years, Labour ministers have taken every available opportunity to applaud and encourage the growth of Britain's financial sector.

Mr King said the City's financial institutions had make mistakes

But King said today that in some ways the City's economic dominance was regrettable.

"I do think it is rather unattractive that so many young people when contemplating careers look at the compensation packages available in the City and think that these dominate almost any other kind of career," he said.

"That is not an attractive position to be in when such a high proportion of our talented, young people naturally think of the City as the first place to work in. It shouldn't be. It should be one of the places, but not the only one."

This was not the first time the Bank Governor had highlighted the mistakes made by major financial institutions in the boom years leading up to the crunch. But he has not previously spelt out the negative consequences for the UK economy of an out-sized financial sector.

King's supporters would say these were the frustrated words of a central banker who has spent nine months being criticised for his handling of a financial mess, while the private sector roots of the mess are barely discussed.

But for many in the City it will confirm his reputation as an academic who lacks a hands-on understanding of how banking works.

No free lunch

King was a popular choice for Bank governor when he succeeded Eddie George in the post in 2003.

But even before last summer, senior bankers had complained about his failure to forge closer links with the London financial community, a failure which may have cost him crucial support in the dog days of last August.

At that time he was harshly criticised for his handling of the credit market strains which ultimately brought down Northern Rock.

He was said to have put too much emphasis on moral hazard- the risk that special support for banks now would reward banks who had made reckless decisions in the past, and not enough weight on the risks to the financial system as a whole.

But outside the City he won some support for trying to make sure that banks have an incentive to be more cautious in the future.

As financial conditions have worsened, the Bank's emphasis on moral hazard has receded somewhat. Its launch of a special £50bn lending programme on 21 April to ease the liquidity problems facing the banks seemed to confirm this change of emphasis.

King insisted today that he had not let up in his belief that banks should bear the consequences of their decisions.

The fact that the new liquidity scheme is designed to avoid transferring any risk from banks to the taxpayer underscores that he is still extremely resistant to offering the banks anything that resembles a free lunch.

If the logjam in money markets continues into the summer, the governor's tough stance is likely to be further tested.