When I started my career at Rothschilds in 1970, the City had long lost its pre-World War I, international eminence and was doing little more than serving the UK economy. I remember an older employee advising me against a City career as he saw it as in long term decline.
I have been proud of, and often spoken in support of, the City’s amazing resurgence over the last 40 years, interestingly, unleashed by the Wilson Government, permitting the payment of gross interest on wholesale deposits in the late 1960s, when the US had imposed the Interest Equalisation Tax. This gave birth to the Euro Dollar and Eurobond markets, operating from London, followed by the related FX business and other international banking services; the investment management industry “took off” globally later in the 1990s, with London also becoming the main base for managing international Hedge Funds. Around the same time the derivatives businesses and private equity sector also took off. In the early 1990s Lloyds suffered a crisis, and London’s international insurance and re-insurance business has faced international competition, but has also performed surprisingly well with the development of new areas such as the insurance of warranties relating to private equity and takeover deals. On the back of the growth in financial businesses, the legal profession and management consultancy have also increased hugely.
What I have welcomed is the City achieving approaching £100bn p.a. of invisible earnings, helping to finance our manufactured imports from Asia, and the huge and well remunerated employment it has provided, delivering rising living standards and large tax revenues. It is a material loss that tax revenues from City firms have fallen from £70bn p.a. to £40bn p.a. over the last 5 years.
In this context, I view it as wholly mistaken to attack the City, collectively, amounting to “shooting ourselves in the feet”. It is, however, undeniable that much of the banking sector has been a disaster since 2007/08, with the banking crisis, followed by PPI mis-selling, the Libor-rigging scandal, and in turn the money laundering offences. The point should be made, however, that most of the rest of the activities of the City have not attracted disasters and scandals, with the investment management industry, in particular, faring surprisingly well during a period of very difficult financial markets. Beyond over-lax monetary policies and wrong regulation leading to the 2007/09 Banking crisis, the question poses itself as to why much of the banking sector has been such a disaster. A central answer is that the principle of acting with integrity seems to have been overridden by “if it makes money, do it”. The City in which I started in 1970 had broad principles and integrity and a clear understanding of what was OK and what was not – albeit that some of things that were OK then have subsequently become not OK. The first period and structure of Financial Regulation promulgated by Professor Gower worked well. It was based more on principles than rules; its specialist industry units, overseen by the SIB, knew their territories well and, above all, there was constructive dialogue between the industry and the regulators to try to get things right. This is not to say that everything worked well. The change from a period of higher to lower inflation and interest rates, with underperforming equity markets, led to the “mortgage mis-selling” problems, but this had more to do with the changed economic environment than wanton greed or deliberate mis-selling.
I suggest there are 3 important issues on which to focus:
- The FSMA and the FSA look to have been a disaster as regards regulating or supervising the banking sector. It becomes increasingly apparent that the FSA did not know what was going on. This covers both the “pedalling” to banks of toxic CDO s from the US; ignorance of the development of a $60 trillion Credit Default Swops (CDS) market; permitting inadequate banking capital and failure to pick up on the rigging of Libor rates. This raises the question as to what the nature of banking regulation/supervision should be. Hopefully, returning responsibility to the Central Bank (Bank of England) with the objective of effective supervision and oversight, rather than useless (and evadable) rule-box ticking, will do better. Although not perfect, the Bank of England has overseen the banking industry, relatively successfully, without costing the tax payer anything, from 1870 to 2000.
- Secondly, is the point that banking in the UK became an oligopoly with the inevitable tendency to cartelised behaviour. Economic history shows that such has always led to problems, in whatever sector. I suggest there should have been both a much greater “anti-trust” focus on the banking sector over the last 20 years and that a healthy, competitive market in banking services should be a cardinal objective in reforming financial regulation. By and large, this has been achieved by the amendments to the Financial Services Bill in the Lords. I am not suggesting that greater competition is the automatic cure of all problems, but it should improve customer service and transparency. One of the key problems of an oligopolistic banking sector has been that banks have become too large to manage; non-executive Board members cannot possibly know what is going on and too much power can fall into the hands of head-strong Chief Executives, as happened in the case of RBS and HBOS.
- The third, and more difficult issue to address, is to bring back a culture of integrity. Here, it is observable that the banking sector broadly lost its integrity post “Big Bang”, and imported unprincipled behaviour from other jurisdictions.
In the past, for stockbrokers and merchants banks, whose capital was significantly provided and owned by the executives, the “bonus culture” worked. In bad years, partners often had to put in money; in good years, bumper profits were shared. Its migration to the mainstream banking sector was inappropriate and incentivised unprincipled behaviour. Part of the problem was that those receiving huge bonuses were not also owners/shareholders and were “playing with” other people’s money. During the period in which my father worked for one of the main banks between 1929 and 1970, latterly in a senior capacity, no one received bonuses and executive pay was more in line with the Civil Service – appropriate to the work content. It is interesting to note that one of the most successful banks in the UK – Handelsbanken – does not pay bonuses but, where profits are in excess of budget, the excess is shared on an equal amount basis by all staff. This does not seem to have prevented Handelsbanken from hiring first class executives. Here, I believe it unfortunate that the new Governor of the Bank of England will receive a pay and benefits package so significantly more than that of Sir Mervyn King and that Barclays is providing Hector Sants with a pay package, reportedly worth as much as £3m p.a. These send the wrong message where the Regulator is endeavouring to cut back excessive remuneration.
I am, in principle, against State intervention in pay, which, as occurred in the 1970s, can lead to major economic distortions. I would like to think that the banks themselves will come to see that a culture of excessive remuneration and bonuses is damaging to their businesses. Where generous bonuses are paid, these should be for doing an outstanding job in managing a particular area of the bank’s business, rather than happening to make large amounts of money trading in a particular year (where, inevitably, other businesses have the offsetting losses). I can see, however, that changing the culture of banks needs to be addressed internationally, or there is the risk that London will lose out on business to other financial centres. Here, it is to be hoped there might be scope for better international co-operation, particularly via Central Banks?
We now have the new US culture of massive, random fines. There is clearly an urgent need for inter-Government and Financial Regulator co-operation to achieve common and appropriate policies and regimes with regard to fines. It is the shareholders – largely Pension Funds and other collective saving entities – who suffer the losses resulting from enormous fines, rather than the wrong-doing executives. When banks are still under capitalised, such excessive “plundering” of their capital makes little sense. I suggest this territory needs an agreed international approach, urgently, or it could lead to political, as well as banking, problems.
The key challenges are to restore a culture of integrity to the banking sector, to achieve more manageable banking units and a much more competitive banking industry. Next year the Banking Reform Bill will be passing through its Parliamentary stages. The case has strengthened for a full “Glass-Steagall” separation of investment (and trading) activities from straightforward commercial and retail banking. If nothing else, this would help address remuneration/culture problems, where there would, again, be no place for huge bonuses in the commercial and retail banking industries. It would not solve all the problems; I doubt a “Goldman Sachs” could be allowed to fail without causing substantial damage to, if not bringing down, the commercial banking sector. It is also important to note that it was bad lending – particularly by allowing themselves to be “stuffed” with toxic CDO paper from the USA – which was the direct cause of the 2007/09 banking crisis. I cannot help feeling that with London’s banking business thus damaged, there are arguments for taking the risks of more radical reform than the Vickers’ proposals?