The debate over the future organisation and operation of the banking industry seems to have spluttered back into life.
Just before Christmas the first report of the Parliamentary Commission on Banking Standards made its appearance. The report focused on structures. Its most eye-catching and newsworthy recommendation was that the ring-fence between retail and investment banking, proposed by the Vickers Review, should be “electrified”. The aim is “that banks be given a disincentive to test the limits of the ring-fence”. That relatively simple statement is perhaps more revealing of the ethics and operation of the banking industry, and hence the regulatory challenge, than it first appears.
The continuing focus on the Vickers proposals is troubling. Even more troubling is the working assumption that if the Government holds its nerve – or there is sufficient pressure from outside to make sure it doesn’t backslide – so that the Vickers proposals are implemented in full then that would be an ambitious policy triumph that would tame the banks and deal with the problem. It is nothing of the sort.
There are straightforward arguments against this focus. Banks operating very different business models got into serious, and in some cases terminal, difficulty during the financial crisis. Some of the worst casualties – for example, Northern Rock, Bradford and Bingley – had no investment banking component. Their failure had everything to do with bad decision-making, poor risk management and weak regulatory oversight. As Frances Coppola has recently pointed out, this is not untypical. Looking back at previous banking crises problems of risk management and management oversight are much more frequently the source of banks getting into difficulty. But we seem incapable of learning this lesson.
The Parliamentary Commission proposes further reports later in the year covering a broader range of issues including organisation culture in banking. It will be intriguing to find out the shape that those reports will take.
The latest – and perhaps slightly belated – contribution to this debate is the publication of the IPPR’s Don’t bank on it: the financialisation of the UK economy.
This report works on a much broader canvas. It argues that, on balance, the financial industry acts as a drag on the UK economy. The profits and high incomes going to finance do not represent the reward for socially valued activities so much as rent-extraction. In order to address this, and rebalance the UK economy, the IPPR argue that more wide-ranging reform is required. Their recommendations are (p4):
- Retail and investment banking activities should be split into separate organisations.
- Competition in retail banking should be increased, for example by reducing barriers to entry.
- Risk-taking in investment banking should be reduced, for example by making senior directors and managers liable for financial loss when things go wrong.
- A British Investment Bank should be set up to fill the financing gaps left by commercial banks.
- Investors should stop paying extremely high fees for what can only – on average – be investment performance in line with the market.
- More should be done to make the case for wide-ranging financial transaction taxes and to explore ways to minimise avoidance of them.
- The overall level of credit in the economy – in particular speculative credit – should be controlled.
There is perhaps nothing starkly novel about this set of recommendations. In some respects they are just strengthening proposals already on the table. Or reasserting the value of proposals that have already been rejected. For me the most interesting recommendation is number 3. We know that regulation in this field is bedevilled by information asymmetries. We also know that there is nothing like equality of arms between global banking organisations and regulators. The bankers have the resources – including resources that they’ve extracted from the public sector in the form of bailouts –to win the argument most of the time. As far as I can see the only mechanism likely to genuinely make the banks’ senior management sit up and take notice is greater liability located at the top.
The last of the IPPR’s recommendations – on regulating the amount of speculative credit – hints as the issue of whether much of what goes on in the financial markets is actually of any value. There is already a line of economic argument that while the financial sector plays a vital role in allowing market economies to function, beyond some level of development it becomes a drag on the rest of the economy. This is an argument that needs to be given a much wider airing because it runs against the prevailing understanding of the role of finance, in the UK in particular.
The most interesting discussion I’ve read recently on this topic is Engelen et al’s After the great complacence: Financial crisis and the politics of reform. They provide a sociologically-inflected discussion of the mythologisation of finance as the saviour of the UK economy, in the context of broader economic decline. When the claims for the broader benefit of the finance industry – in terms of overall contribution to the economy, contribution to tax revenues, direct and indirect employment and spillovers into the real economy – are set against the realities the claims become hard to sustain. The broader benefit of the financial industries – rather than the material benefit to financial industry players directly involved – is rather modest. This is a line of argument that the IPPR report develops further.
Engelen and colleagues, writing in 2011, are also sceptical of the reform agenda. If finance is genuinely to be tamed then reform needs to be more ambitious. For example, nothing in the contemporary reform agenda challenges the notion that maximising short term shareholder value is the appropriate metric by which to judge organisational performance. Yet, it can be argued that the shareholder value model lies at the heart of the practices that led to the financial crisis because it creates the temptation to over-leverage.
Engelen et al also provide an important discussion of policy development over the 2008-2010 period. It shows how relatively ambitious proposals for supranational changes in the parameters of the system, such as increased capital adequacy, were progressively watered down after consultation. What was left was something the banks could relatively easily satisfy. They document who was consulted on the various proposals and find that the vast majority of those expressing views were bankers who, perhaps understandably, were not very keen on having their freedom to make money constrained.
There is a structural challenge in policy development here. These processes tend to take place within relatively closed policy communities among policy elites. The process can easily become captured by industry interests. The outcome is therefore modest incremental adjustment, rather than the transformational structural change that many of those excluded from the policy community feel is required. If anything in the banking context this problem has got worse over time – the complexity of financial practice, which is part of the problem, can also be used as a justification for denying “outsiders” any standing in the debate.
But there is also an economic challenge for the UK specifically. Much of the discussion has been directed at curbing the damaging excesses of the financial industry, while preserving the useful but less exciting components. The net result of this will be a less risky but less profitable financial industry. If that outcome is achieved it leaves the question of what, if anything, is going to fill the gap. If finance has to some extent been propping up the economy and disguising the scale of economic decline elsewhere then we need a much more urgent conversation about what can be done to revive other sectors. This is something that the Coalition government has touched upon by, for example, increasing the number of apprenticeships or funding to start up companies. But these initiatives are probably an order of magnitude too small, if the rebalancing agenda is serious.
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The more I think about bank reform the more convinced I am that we are going in entirely the wrong direction. IPPR’s latest contribution simply takes us even further down the wrong road. I know I’m a lonely voice on this, but the fundamental issues that no-one is addressing are that the real problems lie in retail banking, not investment banking, and they arise from the fact that ordinary boring deposit-taking, payments and vanilla lending are not sufficiently profitable. You hinted at that with your comment about shareholder value, but I would take it much further. All of the mis-selling scandals (going back 20 years now), and the overgrowth of higher-risk lending and trading, arise from the same thing – the desperate lack of profitability in core retail banking. Regulating them out of existence would leave retail banks more in need of taxpayer support, not less.
People have unreasonable expectations in regard to retail banking. Maintaining an expensive branch network is increasingly unjustifiable from a commercial point of view as branch use declines – but socially there is a case for maintaining small branches, just as there is with post offices. And the cost of deposit insurance and payment services is unsupportable unless banks can use deposit balances to fund higher-return (and therefore higher-risk) activities, which would be curtailed by full separation and by the end of cross-selling higher value products such as insurance. This road leads to a far more expensive banking system for ordinary users. Free banking would have to end: there would have to be a charge for safe deposits and people would have to start paying for payment services and cash withdrawals. And there would have to be wider spreads between rates to depositors and interest rates on lending, especially mortgages.
If people don’t want to pay more for retail banking services, then the government would have to support them. In effect, retail banks would have to become public utilities. That to my mind would be the inevitable consequence of full separation. Pity the IPPR hasn’t thought this through.
Frances, sorry for not responding sooner – my access to broadband has been a little intermittent over the last couple of days. Thanks for your comment, which certainly offers a distinctive perspective on the issue. I think your point about the profitability – or otherwise – of retail banking in isolation is an exceleent one. It isn’t one that I’ve thought about in detail before and I am not aware of how extensively the absolutely basic question of the viability of these operations was examined in the run up to the Vickers proposals. Will need to think about this some more.
The proposal to ‘electrify’ the ring fence between retail and investment banking smacks of a fudge. The idea is to give the regulator the ‘reserve power’ to force the separation, to require bank directors to maintain a firewall and to allow their prosecution for serious breaches of that firewall.
Regulators always work to two sets of rules – the formal and explicit ones contained in the governing legislation and a second informal set dictated by their reading of what those they answer to want – and often also what those they hope to answer to in the future want. The formal rules necessarily leave lots of scope for interpretation and this provides all the wriggle room needed.
So, if the politicians can’t agree on a clear course of action now because it’s too contentious don’t expect the regulators will take firm action at some future date however egregious the breaches of the rules may be. One only has to look at the recent performance of the FSA to understand the limits.
On Frances Coppola’s point I agree to a point but not entirely. The financial sector has become an inverted pyramid resting on a tiny base; any industry as bloated as this is bound to suffer from low returns eventually. That point was deferred for many years by running a (temporarily) successful property Ponzi but that is now out of steam and retail banking must soon downsize dramatically. The end result may well be higher charges for banking services but strictly on the understanding that it’s in return for adopting a fiduciary appoach to their customers. I do, however, think retail should be split from investment, not least because banks should be much smaller (i.e. not TBTF) and this is a convenient way to cleave them that reflects a cultural divide the government should enforce with the retail banks operating more like utilities and the investment banks necessarily more freewheeling but speculating only with their own money.
Where I do disagree with the IPPR (and indeed almost everyone else) is in believing that more competition is a part of the answer. Neoliberal fundamentalists who see the market as a secular equivalent of a god that delivers all Good Things and disciplines the ungodly also see competition as the secular equivalent of the Holy Spirit – the power by which their god operates. Meanwhile, back in the real world, full-throated competition is too effective; firms experiencing it are driven to desperate measures – typically including cheating their customers and eating the seedcorn that should be invested for the future. Hence both the banking scams and lack of investment that characterise our neoliberal utopia. In the longer term, a hadfull of winners emerge in each sector and form an oligopoly that is tight enough that competitive forces are neutered.
The alternative is for constrained competition where firms operate within a framework of regulations that mute competition so it still provides incentives to improve but which don’t permit a handful of winners to hoover up whole sectors and then – once big enough – set the rules to suit themselves.
Gordon – thanks for your detailed comment. I like your theological analogy. I’d not thought of it in those terms before. But I think you’re right in the sense that in a world of strongly asymmetric information – where quality (ie risk) is difficult to observe and performance is judged on short term profitability – then competition that is too fierce could drive banks in the direction you suggest.
There is a Matt Taibbi article in this month’s Rolling Stone magazine that, right at the end, argues that the US government bailout, by giving an almost openended guarantee to underwrite the banks, however stupid their behaviour, has created the most enormous moral hazard problem and made lending even riskier – as banks go for the return, expecting the state to mop up the mess when the risks crystallise. Well worth a read: