Banking at the Cross-Roads: Where Do We Go from Here?
Author:
Adair Turner
Location: London
Date: 2012-07-24
Two weeks ago the Economist front page headline was ‘Banksters’. When a respected magazine, read throughout the world, suggests that banking is riddled with malpractice, its ‘credibility shot’, trust evaporated, we have a major problem. A problem, because the banking system – and the wider financial system – plays a crucial role in a market economy. It connects savers and borrowers, investors and users of funds, it allocates capital, it provides payment services, it insures against risk. It performs complex and vital functions, functions whose effectiveness depends crucially on the integrity of those who operate within the system, integrity which in turn earns trust. And lack of trust in financial services is a problem for Britain in particular, because the City is a vital contributor to the UK economy. But the City’s overall reputation can be undermined by excesses and failures in particular areas of activity – excesses and failures to which competitors abroad are only too happy to draw attention. So we must consider where we go from here. In this speech I will do three things:
Collapsing trust Trust in banks and bankers has eroded. Three factors explain that collapse: people have come to doubt the economic benefits of financial liberalisation and of much banking activity; they doubt banks’ values; and they doubt whether banks have their interests at heart. Economic impact Ahead of the crisis, experts confidently asserted the great benefits of increasing financial intensity and innovation. Global financial flows were driving more efficient allocation of capital: ever more liquid markets were improving price discovery; the alchemy of securitisation was dispersing risks into the hands of investors best placed to bear it; derivatives were enabling better risk management; and, the rapid growth of UK-based banks, such as RBS, was seen as good for the UK economy. Huge bonuses may have amazed and bewildered the ordinary citizen, but the experts were on hand to explain that in some mysterious way ever more intense and complex financial activity was increasing the total size of the economic cake, with the prosperity of all enhanced, even if less richly than that of some bankers. And that proposition was essential to the social acceptability, or at least the tolerance, of huge individual rewards. But we now know that it wasn’t true. Some forms of financial innovation probably did have potential to deliver economic benefit, but much was of little true economic value; and far from making the financial system and overall economy more stable, it contributed to the financial crisis of 2008 and the Great Recession which has followed. The complexity and opaqueness of investment bank innovation contributed to that crisis: so too did excessive commercial bank lending, in particular to the commercial real estate sector. Central to the collapse of trust in banking is people’s feeling that they were sold a story about the benefits of increasing financial activity which turned out to be untrue. Part of the solution must therefore be policies which ensure that finance is in future focused on its valuable and essential functions, and that we more effectively offset its potential to create harmful instability – whether in investment bank activities or in plain old commercial bank lending. Values People are angry with banks and bankers – and with the policy makers who set the rules within which they operated – because of a Great Recession whose origins they believe, quite rightly, lay within the financial system itself. But the outrage which led directly to the headline ‘Banksters’ is also a fury about values, provoked by the quotes revealed in the Libor scandal: “come over …and I’m opening a bottle of Bollinger”, so we can celebrate fixing the Libor rate. Those quotes reveal a dealing room culture of cynical greed. So too do the attitudes revealed by Michael Lewis’s brilliant book The Big Short – securities salesmen knowingly selling securities whose value they doubted to customers whose judgement they disparaged – the “idiots in Dusseldorf”. And of course there is nothing new about dealing room culture, nor sharp practice. Anyone who thinks that there was no insider dealing before ‘big bang’ is looking at the past through rose-tinted spectacles; anyone who thinks that testosterone-driven dealing room culture is new didn’t visit an FX dealing room back in the early 1980s. But what is new, is that the sheer scale of financial activity has increased, its share within the economy is much larger, and that, as a result, the size of the potential corporate and personal benefits from malpractice have grown greatly. People are more concerned by poor values in finance, simply because finance got much bigger. Customers’ interests Malpractice in dealing room and in wholesale sales and derivatives matters. It is not a victimless activity even when, as is sometimes the case, it is not prosecutable as a crime. But shady practice in the esoteric arena of Libor fixing might still not have provoked quite as much public anger if it had not come on top of scandals which more directly affected the average citizen. In the UK, mis-selling of payment protection insurance to personal customers and of interest swaps to SMEs, and in the US, the activities of mortgage salesmen enticing borrowers into unsustainable credit commitments, have convinced many consumers that retail banks are out to serve their own interest, not the interest of their customers. So the collapse of trust in bankers which led to the ‘Banksters’ headline is the product of three factors.
The way forward to a more trusted banking system must address each of these three problems. And addressing the problem is important, not just for banking, but for all UK financial services, for the City, and for the UK economy. Yes, there have been severe faults in some parts of our financial system. But financial services – including complex wholesale financial services – play a crucial role in a vibrant market economy; and the UK is good at providing those services to the rest of Europe and to the world, and should continue to do so in future. Wholesale insurance services, equities research and trading and distribution; asset management; corporate finance advice: these are services which the City provides and has continued to provide well throughout the crisis. And while some investment bank product structuring and dealing activity appears to have added little to economic efficiency, the core functions of underwriting equity and bond issues and of providing liquidity via market making in key fixed income and foreign exchange markets, are valuable and essential ones. So let me be clear:
Financial services are essential to a complex modern economy, and Britain has a comparative advantage in their provision. But while recognising that, we also need to recognise that financial services in general – and banking in particular – are in some crucial respects different from other services and markets. And those differences help define what regulators and what industry leadership need to do to help restore trust. Distinctive features of financial services and banking Financial services in general, but banking in particular, are different from other sectors of the economy – retailing, manufacturing, leisure services, transportation – for four reasons: - First, financial markets and institutions, and in particular those involved in the process of credit and money creation, can introduce instability to the macroeconomy, fuelling booms and busts. If a retailer expands too rapidly, gets into trouble and goes bankrupt, that is a problem for the retailers’ shareholders and their workforce. But over-rapid bank expansion and subsequent bank failure can be fatal for the whole economy. That has implications for the responsibilities of bank management and boards. 1 Second, there is far greater potential in retail financial services than in other sectors for producers to rip off consumers. That’s because of the asymmetry of information and knowledge between the provider and the customer. The car buyer is well-equipped to test drive different cars and select the one he or she prefers; the unsatisfied supermarket customer can take his or her business elsewhere. But individuals cannot test drive complex investment and insurance products: they rely on trusted providers to give explicit or implicit advice. And many purchases are too infrequent and too large to make switching provider an effective market discipline. Either regulatory intervention, or producer responsibility and ethical values, have to compensate for the ineffectiveness of markets. 2 Third, and particularly in wholesale financial services markets, there is far greater potential for the proliferation of activities which are, in the economist Roger Bootle’s words, merely “distributive” rather than truly value “creative” – activities which simply redistribute money from one group of citizens to another, rather than increase the size of the economic cake. A significant share of what is described as innovative product structuring in the investment banking world is not innovative in a social value sense – but dedicated to either regulatory, accounting, or tax arbitrage – to seeking economic advantage from describing an unchanged set of risks in a more favourable regulatory or accounting form, or to redistributing an unchanged economic pie from the generality of tax payers to the bank’s customers or to the bank itself. And in the provision of complex financial services to end investors, there is much greater opportunity than in other sectors of the economy for purely rent extracting activity, for instance through unnecessary portfolio churn, which detracts rather than enhances investor return. 3 Fourth and finally, ethical risks are created by the immateriality of finance and by distance from end customers, particularly but not exclusively in the wholesale arena. One of the best books written on the origins of the financial crisis is Raghuram Rajan’s Fault Lines. Rajan is one of the few mainstream economists who identified the potential instability of the financial system ahead of the crisis – his warnings at Jackson Hole in 2005 were sadly not only ignored, but overtly rejected. In Fault Lines he gets behind the immediate causes of the crisis to some of the fundamentals – to global current account balances, and to over-rapid US credit extension deliberately encouraged for political reasons. But one of his chapters is about ethics, and entitled ‘When money is the measure of all worth’. And the point Rajan makes is as follows: - In all activities within a market economy, self-interested money-seeking motivation plays an important role. It was after all Adam Smith’s great insight that the interaction within competitive markets of self-interested individuals can lead to socially beneficial results. In many areas of economic activity, however, those self-interested pecuniary motivations are balanced and constrained by others – by pride in the service or product you are delivering, by desire to please customers as an end in itself, by enjoyment of the esteem in which you are held by customers or business counterparts with whom you have a sustained relationship. 1 But what is distinct to finance, and in particular to the areas of finance where savers and users of funds are connected via multiple steps in complex chains – is that many of the key participants have no direct contact with the end customers whose lives they are affecting, and only transient contractual relationships with their counterparties. And it is simply easier to make huge amounts of money out of a multi-step chain which connects ill-informed investors in one country to ill-informed sub-prime borrowers in another, and still go home believing that you are a fine upstanding member of society, than knowingly to sell a bad product or service to a customer with whom you have more direct contact. When money is the measure of all worth, constraints on the temptation to fix Libor or knowingly sell shoddy products, are greatly reduced. Where do we go from here? So where do we go from here? How will we rebuild trust in the banking system and rebuild recognition of the vital role which a well run banking system plays within our economy? I suggest five elements of the response.
Prudential rules and macro-prudential approach It may seem odd to start with prudential rules. After all we are talking about lack of trust, about mis-selling or market manipulation in retail and wholesale markets, about bankers perceived as ‘banksters’: where do capital and liquidity rules come into the story? Well, they are fundamental; because the biggest thing that has destroyed trust in the financial system, and in banking in particular, is that people were told that complex finance would make them more prosperous but that instead it caused a great recession. And the economic losses suffered as a result – the losses to wealth and income and employment, and the increased public debt burdens, are far far greater in value than any customer detriment resulting from malpractice. When the serious economic histories of this Great Recession are written, I am sure that they will concentrate on the policy mistakes which led to the crisis, with the role of individual miscreants or poorly run institutions likely to seem less significant over the years. Just as in the serious economic histories of the Great Depression public policy mistakes are to the fore, not the many examples of unscrupulous activity and bad individual business decisions which flourished ahead of the 1929 crash.
Putting all that right is crucial – and we have already made significant progress. Key elements of that progress are:
In all of this we face a very complex balancing act – how to make progress towards a sounder system in future, while not exacerbating the deflationary dangers created by deleveraging after past excesses. But at the end of the transition I am confident we will have a more stable system and that in itself will be central to the restoration of trust. And new prudential rules will also be central to reducing the potential for the proliferation of unnecessary activity of little social value. As already said, conduct problems in financial markets are not new – they were there in the much simpler financial markets of the 1960s and 1970s. But the scope of them exploded with the rapid growth in the scale and complexity of investment banking activities, the rapid increase in the size of bank balance sheets and of trading volumes relative to GDP which occurred between 1980s and the crisis. Part of that increase in financial activity was inevitable: the natural consequence of globalisation in the real economy, and of the move to floating exchange rates and open capital flows after the collapse of the Bretton Woods system. But part was unnecessary, and made possible by bad prudential rules which allowed investment banks to conduct trading activity on absurdly light capital bases, maximising the implicit put option onto the tax payer in the event of systemic crisis. Higher capital requirements overall, tighter leverage constraints and much higher capital against trading activities will reduce the scope for malpractice in complex wholesale finance, simply as a by-product of limiting the potential for unnecessary and risky activity overall. Structure: implementing the ICB’s ring-fencing proposals So better prudential rules and the macro-prudential role of the Financial Policy Committee are essential to a more stable system, which people can trust because it is less likely to generate financial and economic crisis. Structural reforms, such as those recommended in the UK by the Vickers Commission, or to be implemented in the US via the Volcker Rule, will also play an important role. They are not sufficient to ensure stability. Yes, complex investment bank trading activity played a role in the origins of the financial crisis – the failure of Lehman’s was a crucial event; but so too did over-rapid expansion of plain old lending to commercial real estate companies: HBOS also failed. And any idea that, having isolated retail and commercial banking within a ring-fence, we can then be indifferent to the development of risks outside it, is both wrong and dangerous. But structural reforms which create either entire banks or units within wider banking groups more exclusively focused on classic retail and commercial banking activity still have a vital role to play. In the UK the implementation of the Independent Commission on Banking’s recommendations will, I believe, deliver three important benefits.
More intense and robust conduct supervision, but recognising the limitations On the prudential side, more effective rules need to be supported by a new more effective supervisory approach; and the FSA has been putting that in place since 2008. On the conduct side the changes which the FSA has begun to make are equally important. In retail markets, the FSA has already described a major change in intended approach – seeking to identify emerging threats of customer detriment at an earlier stage, intervening to prevent or significantly limit a major mis-selling wave such as payment protection insurance, rather than simply ensuring customer redress after the event. In wholesale markets meanwhile, we are also considering whether our past traditional approach is still tenable. In the past, it’s fair to say that the FSA did tend to assume that relationships in wholesale markets, for instance the sale of products to apparently sophisticated institution investors such as pension funds, should be governed largely by a caveat emptor, market discipline approach. But increasingly we are aware that at the end of the chain of wholesale institutional relationships there will typically lie a retail consumer – the pension fund policyholder for instance. And that shoddy wholesale market conduct is certainly not a victimless activity. A somewhat more interventionist approach to wholesale conduct issues is therefore likely to be appropriate; and the FCA’s approach document –to be issued in the autumn – will discuss some of the options, and the implications for FSA resources and skills. But today I would like to stress not what more intense supervision, of either retail or wholesale conduct can achieve, but what it cannot. It cannot possibly prevent all malpractice in advance, without employing a hugely increased army of supervisors and probably not even then. And if we did deploy that army, we might well add more cost to the industry than the cost of customer detriment averted. The LIBOR scandal has thrown this challenge into relief: in that scandal there are two distinct phases and categories of manipulation – the low-balling of LIBOR submissions in the 2007 to 2008 for reputational reasons, and the earlier manipulation of rates, sometimes up and sometimes down, by a single or a few basis points, to benefit derivatives positions. There is a debate as to whether the authorities could have been more alert to the 2007 and 2008 manipulation – and I will not comment on that today. But in relation to the earlier period, to the manipulation of rates by a minute amount for a short period in either direction, I do not believe these problems could have been spotted from outside except via supervision so intensive as to be prohibitively expensive. Alongside more intense and better focused supervision, therefore, robust after-the-event enforcement action and sanction will have to remain a key regulatory tool. But alongside both, we also need strong management commitment to better culture and better values. Culture and values What do we actually mean by cultural change: what does it imply for bank leadership? At its core, I suggest, must be recognition of the distinctive features of finance and banking described above, and recognition that the top management and boards of banks have a responsibility to offset the dangers which those distinctive features create. Banks are different because their failure has consequences for the macroeconomy. There is therefore a social interest in bank boards and top management having a different attitude towards risk return trade-offs than would be acceptable in other sectors of the economy. We need them when assessing an organic growth plan, a funding strategy, or a major acquisition, to care more about the downside risks of failure than they would if running a retailer, a manufacturer, or a hotel company. They need to be custodians of institutions of great public interest, as well as custodians of shareholder value. There are therefore strong arguments for ensuring that bank directors face different personal risk return trade-offs than those faced in other companies. That is the logic behind the proposal set out in the government’s recently issued consultation document on Sanctions for the Directors of Failed Banks that, when banks fail, there should be some category of automatic sanction for directors which does not apply in other sectors of the economy. But banks, and other financial institutions, are also different because of the greater potential to engage in pure rent-seeking activity, the greater potential to exploit consumers, and the greater danger that ethics are undermined when money becomes the measure of all worth. So banks are only likely to earn the trust of customers and the respect of society at large, if from the very top there is a clear message that there are many things which may be profitable, which may be within the legal rules, and which neither the customer nor the supervisor will necessarily ever spot, but which go against firm values and which the bank therefore will not do. What does that mean concretely? Well, the only way to make it concrete is to give specific examples. So let me pose the following questions:
There is no value in beating about the bush. Unless management and boards themselves shift the tone from the top in such specific ways, and in addition make effective controls against dishonest behaviour the highest priority throughout the organisation, then we are not going to change the external perception of bankers which led to the Economist headline. Public recognition of constraints and trade-offs Much of the responsibility for restoring public trust in banking therefore lies not with the regulators but with the leadership of banks. But the challenge may prove an impossible one unless regulators, politicians, consumer groups and society at large are in turn willing to recognise the many good things that banks already do, recognise the constraints under which banks operate and honestly debate a crucial trade-off.
The last three weeks have been very bad for the reputation of British banking. Rebuilding trust will be a huge challenge. Some of that challenge falls to regulatory authorities – we made big mistakes before the crisis. Much falls to the leadership of banks themselves. But it is a challenge that must be met, given the vital role which the banking industry plays in our market economy. |