Until the drama over MPs’ expenses, workers in the financial services had been reeling from a succession of blows: collapsing banks, nationalisations, frozen bonuses, job losses and contemptuous, withering condemnation by the public and by opinion-formers in the media, church pulpits and parliament. An optimistic scenario was one of slow rehabilitation under a less permissive regime involving tougher regulation, partial public ownership of banks and a diminished, chastened City.
Now the bankers can’t believe their luck. A couple of days after the first revelations in the Daily Telegraph, the headline in the City’s free newspaper City AM was a shout of orgasmic release: “Now THEY can’t lecture US.” It said it all. Collapse of moral authority and politicians’ will. Back to business as usual.
The dangers of drift were highlighted in the speech given at Mansion House on 17 June by Mervyn King, governor of the Bank of England. He publicly expressed discomfort at the idea of banks that are “too big to fail”: he has concluded that such banks are simply too big. But the government is reluctant to tackle these banks, as the conduct of Lord Myners and the institutionalised passivity of UK Financial Investments Ltd (UKFI) – the Treasury-backed bank shareholder body – indicates. Instead, there seems to be a yearning to disengage government from the financial sector as quickly as possible. Political developments have made that disengagement easier to achieve, now that parliamentarians, including members of the Treasury select committee, have been collectively discredited, and power within the Labour government has shifted from a wounded Prime Minister to a revitalised Chancellor articulating the Treasury line.
It is deeply worrying that some of the most important policy questions for a generation are now being decided by default and in a political vacuum. How can a semi-nationalised banking system best serve the different but overlapping interests of UK bank borrowers, depositors and taxpayers, as well as private shareholders and bank executives? How should the systemic risks of banking – and the City generally – be managed through regulation, in order to safeguard the wider UK economy? Most important, is it actually possible for the UK to play host to a major financial service sector?
The response to all these questions is a lazy, uncritical, self-serving one: that, bar a few regulatory tweaks that will need to be made, the previous regime was essentially fine. The bankers’ view is that UK politicians need to get off their backs as quickly as possible and get the banks back into the private sector; to reverse “penal” (ie, 50 per cent) marginal tax rates; and to stop the European Commission, or more self-confident UK regulators, from “undermining the City’s competitiveness”. These arguments are winning.
Indeed, there is a danger that the counter-revolution could soon become a rout.
Yet it is only a matter of months since half of the British banking system collapsed and had to be rescued by the state through total or partial nationalisation. Thanks to that intervention, the banks have stabilised (if nothing more). Several small banks are now fully nationalised; RBS and the Lloyds Banking Group are partly nationalised; the two remaining global banks (HSBC and Barclays), along with the remainder of the sector, depend on a variety of implicit or explicit guarantees.
How we got to that point has been discussed elsewhere (including in my book The Storm): I am now concerned with the future. There is a bifurcation of paths opening up. One route builds on the experience of recent bank crises in Scandinavia, Israel, Korea and elsewhere, including the US, whose so-called Resolution Trust model helped to limit the savings and loans crisis of the late 1980s and early 1990s. Following this route, the state leads and manages a clean-up and restructuring of banks, usually within a decade or so. Approaches have varied, but there are some common elements: the wiping clean of the slate, in respect of losses incurred by existing private shareholders and the removal of failed management; fresh, taxpayer equity capital; structures to ensure that lending can continue unhindered to good, solvent borrowers; the valuation and active management of “bad” assets, in order to retrieve whatever value is left; then, in due course, the selling off of some or all publicly owned banks to achieve maximum return to the taxpayer and leave a varied ecology of properly regulated national banking institutions.
Some of us thought that was where the government was originally heading. After the October rescue, there were some tough-sounding conditions on new lending and curbing bonuses and, for a while, as it basked in the glow of international approval, the government seemed to be on the right track.
But it has gradually become apparent that we are being taken down a different route, where government money and guarantees are used to facilitate a quick return to “business as usual”. UKFI has been populated by financiers rather than business people with experience as bank customers. The public-sector shareholders seem to have had no quarrel with bank management’s efforts to build profitability and deleverage as quickly as possible.
The Asset Protection Scheme introduced in January also provides insurance cover for “toxic assets”, which means the government has taken on an open-ended risk without a corresponding “upside” for the taxpayer. This route was chosen in preference to fresh government equity capital precisely because it makes a quick return to private-sector ownership easier. There is now a danger of premature reprivatisation, which would leave the taxpayer with a vast toxic dump of losses and a poor price for the share sale. There are already rumours that Northern Rock is being lined up for a rapid sale.
If banks are to return to “normal” commercial operation under private ownership, the issue arises of how they should be regulated. The Cruickshank report on banking, commissioned by Gordon Brown a decade ago, posed the central question: why should banks be allowed to pursue the maximisation of shareholder value – and management bonuses – when they are underwritten by the taxpayer? This question has never been answered properly. Banks should either surrender their protection and compete like other firms, or be protected and have their profit regulated like utilities. In the wake of a banking crisis, the logic is even starker. In the past few weeks we have seen leading executives at Barclays awarding themselves millions while the bank ultimately remains dependent on government guarantees, despite its precarious independence. It is not surprising that executives of the semi-nationalised banks want to follow suit.
What has brought the issue to a head is the judgement that the major UK-based banks are “too big to fail” and have to be rescued in a financial emergency. This concept is an economic and democratic outrage. Either they must be subject to tight state control or they should be broken up so that they are not “too big to fail”. The point has been grasped, improbably, by ministers in banker-friendly countries such as Switzerland, and by our own central bank’s governor. Yet ministers today seem no less terrified of confronting the banks than when Brown initially fled the battlefield a decade ago.
One solution would be to restrict protection, including deposit protection, to “narrow banks”, confined to lending out no more than they receive in deposits. Other banks would operate competitively but be stripped of any protection. I, for one, am attracted to the concept; but it would involve a revolutionary change, a discontinuation of fractional banking altogether, and in the short run it is unlikely to be adopted.
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Who said what about
the banking crisis
The financial services sector in Britain, and the City of London at the centre of it, is a great example of a highly skilled, high-value-added, talent-driven industry that shows how we can win in a world of global competition.
Gordon Brown, June 2007
When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.
Chuck Prince, Citigroup CEO, July 2007
We cannot have a situation where the banks are able to privatise their profits and nationalise their losses.
Vince Cable, April 2008
We can’t tell every bank what to do.
Alistair Darling, April 2008
Where there is excessive and irresponsible risk-taking, that has got to be punished. The day of big bonuses is over.
Gordon Brown, October 2008
We had ten years of record growth when I was prime minister. I have, unfortunately, come to the conclusion that it was luck.
Tony Blair, January 2009
The government is clearly playing for time in order to avoid doing anything to upset the bankers.
Vince Cable, February 2009
Royal Bank of Scotland has the largest balance sheet in world banking so it is critical that Stephen succeeds.
Sir Philip Hampton, RBS chairman, defends the pay deal for the new RBS CEO, Stephen Hester, worth up to £9.6m, June 2009
A less drastic way of dealing with overgrown banks would be to split off the investment banking arms of the main global banks – what Mervyn King calls the “casinos” – and to confine government protection to the remaining “traditional” banking wings. These would then operate as regulated utilities: the model that broadly prevailed in the United States before the repeal of the Glass-Steagall Act a decade ago. The urgent need to change our system is highlighted by the ambition of Barclays Capital to become “the premier global investment bank”: it is madness for the British taxpayer to be a last-resort guarantor for this kind of business. To be sure, the demarcation is not clear-cut: there is high-risk “traditional” banking and low-risk investment banking, and the separation of roles would not be straightforward. The big banks – HSBC and Barclays – argue that they would be stopped from tapping into the securitisation markets (which may, after recent disasters, not be quite the loss they believe it to be). There is also the implied threat that global banking operations will be withdrawn from the UK.
The government must face down this kind of blackmail. The British taxpayer simply should not be made responsible for the risks that global banks take outside our regulatory jurisdiction. There are undoubtedly technical difficulties in separating out those aspects of global banks that the government can guarantee and those it cannot, but these problems cannot be an excuse for bottling out completely.
One lesson of the financial crisis is that the “light-touch” regulatory approach was a failure. It may have failed in part because of the poor quality of bank supervision rather than the absence of regulation. And the rapid innovation of capital markets undoubtedly ran ahead of regulators’ capacity to monitor activity effectively. But the vast cost to the British taxpayer – and the wider economy – of the banks’ failure and the consequent bailout make it imperative that regulation be strengthened.
We are now at a crunch point. The need to strengthen and update the regulatory regime has collided with the financial institutions’ growing confidence that they can keep the state off their backs. Self-serving arguments are being employed, notably that regulation will suppress “innovation”. It will. It should. We need more financial “innovation” like a hole in the head.
The other argument is that regulation (and 50 per cent tax rates) will undermine the City’s “competitiveness” and “drive away” banking and non-bank financial institutions. This argument has to be met head-on; the idea of a regulatory race to the bottom does not square with political and economic reality. Co-operation rather than regulatory arbitrage between the main jurisdictions will always be best, but if that co-operation does not materialise, the UK should not chase business by offering low standards that create wider risks for the UK economy. The arguments about City “competitiveness” are bogus, self-serving and dangerous. It is profoundly to be hoped that Brown, Alistair Darling, Ed Balls and others who fell for them so haplessly in the past have now learned their lesson.
The new regulatory agenda espoused by Lord Turner, chairman of the Financial Services Authority, is sensible and not especially controversial. Indeed, many in the City see it as a minor irritation, followed by a green light to get back to business as “normal”. It contains sensible elements – such as “macro prudential regulation” that would focus on systemic risks, rather than regulation of individual banks – and more controversial but basically prudent ideas, such as limiting loan-to-value ratios and/or multiples of income for mortgage lending.
Lord Turner has also supported the argument that the most dangerous forms of risk-taking in banking institutions can be limited by paying bonuses not in cash but in stock, redeemable after a period of years. As stock prices are depressed and the capital gains tax payable is only 18 per cent, any half-sober City trader will have worked out he should be doing this in any event. But it is not a silver bullet – the bosses at both Lehman Brothers and Bear Stearns had huge equity-related incentives, and look where they are today. These issues require pause for thought: there are bigger regulatory battles shaping up.
One concerns the proposal to establish a clearing house for complex financial derivatives so that they can be traded, netted and regulated. Properly regulated, these activities can spread risk and, in a general sense, add to stability. What is much more dangerous, as the recent financial crisis has illustrated, is to have a vast pyramid of paper claims – as in the CDS/CDO (credit default swap/collateralised debt obligation) “markets” – which cannot be settled in an orderly way through a clearing house. Important lessons can be learned from the recent collapse of General Motors. CDS contracts with a value in excess of $35bn were netted down to $2.2bn, causing little more than a ripple in the overall CDS market. The danger is that nothing will be done, setting up a huge systemic risk – and the next big crash.
One practical remedy would be to establish a clearing-house system as soon as possible. Big banks that make a lot of money from OTC (“over-the-counter”) trading are not happy: if they were forced to use a regulated exchange they would lose this business. In practice, complex, structured derivatives would therefore be prevented. A second issue is whether the London Stock Exchange – and the Bank of England as the lender of last resort – are big and strong enough to support a clearing house dealing with transactions valued at many times the size of the world economy. Co-operation with the US is potentially important. And perhaps a European approach is required, in order to draw on the bigger firepower of the European Central Bank, but that may unleash some dangerous political demons.
Meanwhile, the European Union has precipitated another major regulatory battle by putting forward proposals, both for strengthening European co-operation over bank supervision – reluctantly conceded to by the UK – and for toughening the regulation of hedge funds and private equity. Britain’s financial community has a collective paranoia about Europe, and there is envy of London’s currently predominant role and a distaste for the freewheeling “Anglo-Saxon” model (not that German, Dutch or even French banks behaved very differently in the crisis).
However, it is surely eminently sensible to ask, as the European Commission is doing, whether these new forms of financial intermediation are healthy and adequately regulated. There are some critics who question the value of hedge funds altogether and would be happy to see them regulated out of existence. But a more relaxed view is that there is a role for specialist financiers who pursue high yield via high risk – provided they do not depend on taxpayers’ guarantees or indirectly contribute to the systemic risk that taxpayers underwrite. The former has not been a problem in the recent crisis (no hedge fund has asked for government help), but the latter undoubtedly is. There is a proper debate to be had as to how hedge funds should be regulated: to treat the tentative proposals of the European Commission as akin to a Napoleonic invasion threat is simply idiotic.
There is a more fundamental argument about the scale of Britain’s financial services industry in relation to the UK economy. I wouldn’t expect the City to vote for contraction, or for curbs on its freedom to operate, any more than I would expect turkeys to vote for Christmas. But the poultry farmer – the Labour government – cannot just ask the turkeys what they want. He has to be willing to wield a knife and cut some throats. A combination of national, European and global regulation is necessary to ensure that the vast negative externalities associated with the City do not exceed the (genuine) benefits that the UK economy derives from a successful, internationally traded, financial services sector. In addition, there will have to be a major structural adjustment out of traded financial services into other services and manufacturing.
Unfortunately a weak, demoralised, delegitimised Labour government is in no shape to face this challenge, and a Tory government pumped up by City donations would have no need or inclination to take it on. The opportunity for reform and renewal is passing us by and, if it does, financial crises will return with even greater ferocity in years to come.
Vince Cable, economic spokesman for the Liberal Democrats, is the author of “The Storm: the World Economic Crisis and What It Means”, published by Atlantic Books (£14.99)