Submission from Ian Fraser, 24 August 2012[Update: January 12, 2013. This is my submission to the Parliamentary Commission on Banking Standards, which is being chaired by Andrew Tyrie MP. Written in August 2012, it was published on the Parliamentary website [pdf 28mb] on December 19th, 2012 — it can be found on pages 192-195. The initial batch of written evidence to the commission is also available on the Parliament website [PDF 4.2mb]. [The version below contains minor edits]
The lack of effective regulation or oversight of the UK banking sector, especially in 2001-08, played a key role in precipitating the current banking crisis, which has in turn played the major part in tipping the UK economy into recession.
In a regulatory and judicial environment in which senior bankers could be relatively confident that excessive leverage, reckless negligence, other forms of wrongdoing, and indeed crimes, would go unpunished, and in which “growing shareholder value” was deemed to be the sole objective of corporations from the late 1970s onwards, it was perhaps unsurprising that banks and bankers behaved badly.
The insuperable conflicts of interests ushered in by ‘Big Bang’ in 1986, the deregulatory instincts of successive UK governments, the mispricing of risk promoted by securitization and the “shadow banking” sector and the financial regulator’s post 2006 faith in unrealistic models clearly made matters worse.
The changes introduced since the banking and financial crisis of 2007-08, including the “ringfencing” proposals of Sir John Vickers’ Independent Commission on Banking, are a wholly inadequate response to the problems that bedevil the UK’s banking sector. Much more radical action is required if it is going to be reformed. This could include:-
- More of those who were responsible for malfeasance and criminality in the banking sector need to be held to account (where appropriate through criminal prosecution/enforcement but at the very least through losing their jobs).
- The incentive structures that drive banks’ and bankers’ behaviour, including share options, need to be totally overhauled.
- “Too big to fail” banks need to be broken up.
- The separation between retail and investment banking must be enforced structurally, through different ownership, rather than through potentially porous “ringfences”.
- It must be made easier for new market entrants.
- Account switching must be made easier.
- Diversity of ownership of financial institutions should be actively encouraged (I believe the UK has the highest weighting of publicly listed banks of any nation in the world)
- The incestuous “revolving door” between the professions, politics, government, regulators and banks should be closed, or at least slowed down.
- Politicians, civil servants and regulators, who have in recent times bent over backwards to accommodate the wishes of bankers (as a result of what former Bank of England monetary policy committee member Adam Posen has called the UK’s “festish-isation of finance”) must become much more sceptical towards the special pleading of lobbyists for the sector. They should pay greater heed to the views of organisations representing the interests of ‘end investors’ and consumers of financial products and services including Brussels-based Finance Watch and the New Economics Foundation
- The fiduciary duties of directors of publicly-quoted companies, including banks, should be extended to encompass duties other than the maximisation of short-term shareholder value, including social/public duties.
A summary of what went wrong with British banking
- Banks became “too big to fail” owing to a failure of anti-trust regulation from the 1890s onwards, and the regulator’s apathy especially since 1997 as some banks vastly extended their reach both geographically and functionally, often into areas that their managements poorly understood.
- Driven by analysts’ and investors’ obsession with short-term share price performance, bank chief executives and their management teams were driven to the boundaries of risk-taking, morality and legality in pursuit of short-term financial goals.
- According to Professor William K Black, associate professor of economics and law at the University of Missouri–Kansas City, the combination of investor pressure for short-term returns and the absence of effective regulation created a “Gresham’s dynamic” in the UK banking sector.
- Under this “Gresham’s dynamic” (named after the 16th century Elizabethan notion that “bad money drives out good”) banks and other financial firms discovered they were able to gain a competitive advantage by cheating. Banks that “cheated big and cheated early”, as Black puts it, reaped the biggest P&L rewards. Other players in the market felt obliged to follow suit. If they didn’t, they risked being left standing in the profitability stakes.
- This “Gresham’s dynamic” fuelled the series of scandals that have blighted the British banking sector since the 1980s. These have included personal pensions misselling, endowment mortgages misselling, PPI misselling and interest-rate swaps misspelling to SMEs. Others include the “rip off” charges on pension and investment products and the abuse and asset-stripping of SME and mid-corporate customers by some UK banks.
- The scandals suggest that, despite their often plausible exteriors, the executive directors of British banks have few qualms about swindling or ripping off their customers. In an interview with the Daily Telegraph March 2011, Sir Mervyn King, the governor of the Bank of England, decried banks for their cynical exploitation of “gullible or unsuspecting customers”. Oliver Morgans of Consumer Focus said: “PPI is a clear example of everything that is wrong with the banking sector. It shouldn’t need the intervention of a High Court to ensure that bank customers are treated fairly.”
- The sums misappropriated from customers by banks stretch into the tens of billions of pounds.
- The flawed incentive structures within the banking industry mean that executives responsible for promoting and executing such activity go unpunished; in fact they actually enjoy enhanced financial rewards.
- Regulators including the Financial Services Authority became largely “captured” by the industry they were supposed to be regulating, especially in 2003-08 (the capture is considered by some to have become complete when HBOS chief executive Sir James Crosby was on the FSA board from January 2004 to February 2009).
- It did not help that the government of Prime Minister John Major allegedly extended an immunity from criminal prosecution to large UK financial institutions and their senior executives in the wake of the Blue Arrow appeal court hearing of July 16th, 1992.*
- The accounting standards known as International Financial Reporting Standards, introduced in the UK and Ireland in 2005, were a major contributor to the financial crisis in both countries. As Tim Bush of Pensions Investment Research Consultants has pointed out IFRS:- (a) is incompatible with UK company law and (b) enabled UK banks to live in a “fool’s paradise” in the three years prior to the crisis.
- The bank bail-outs of 2007-08 came with insufficient strings attached. There was talk of quid pro quos relating to lending targets and bankers’ pay, but these were unrealistic and never properly enforced. The “Gresham’s dynamic” continued. For example, some banks continued to manipulate their London Inter-Bank Offered Rate (LIBOR) numbers even after the bailouts.
What is happening now?
- The FSA was jolted into reconsidering its approach, and giving less credence to bank managements and more to the victims of their malfeasance, especially after the bailouts of October 2008. The regulator has since shown a greater inclination to properly regulate the banking sector, as we saw with the recent interventions at Barclays, but it takes a long time for the internal culture of an organisation such as the FSA to change.
- In some of the cases that predate its change of heart, the FSA continues to be obstructive. This is usually because, were the regulator to properly probe cases of past bank misbehaviour and alleged criminality, it would risk showing up its past collusion with the banks and its former propensity to whitewash such things.
- Every UK bank is a greater or lesser degree still attempting to bury and cover up some of the malfeasance and alleged criminal behaviour that occurred prior to the crisis. For example, it seems that Lloyds Banking Group is still trying to downplay multiple alleged crimes and misdemeanours committed by HBOS in 2002-08, including the behaviour of its “mid-market, high-risk” corporate team based in offices in Bishopsgate and Reading.
- In a session with the Treasury Select Committee in November 2011, the four top executives in the FSA – Lord Turner, Hector Sants, Margaret Cole and Martin Wheatley – unanimously expressed a strong preference for cosy backroom deals, in which miscreant bankers are coerced into agreeing to lifetime bans from working in the financial sector, in exchange for agreements from the FSA to call a halt to investigations.
- The FSA has already struck deals along these lines with former head of investment banking at RBS, Johnny Cameron, and unsuccessfully sought to strike such a deal Peter Cummings, the former head of corporate lending at HBOS. In my view such deals, together with the out-of-court settlements with banks and financial institutions favoured by financial regulators in many jurisdictions are a travesty of regulation/justice.
- Such deals are favoured by regulators because they are much easier and cheaper to pull off than criminal investigations and prosecutions, and there is less chance they will go wrong. They also give regulators the chance to sweep much high-level ‘white collar’ crime, as well as evidence of their own past failures, under the rug. But such deals are ineffective at the best of times and do nothing to alter behaviour.
- Some of the most egregious activities in the UK banking sector today are taking place in the “distressed assets” divisions of major banks. The commission should conduct a proper forensic analysis of the activities and behaviour of the Global Restructuring Group/West Register arm of Royal Bank of Scotland, together with that of its retained external consultants and advisers, especially in the period 2006 to date. This should include seeking testimony from affected parties, including directors of customer firms.
- Often, even today, the United Kingdom seems to have to rely on US regulators, or US law suits, to get to the bottom of malfeasance and alleged criminal behaviour of UK banks and UK bankers. This is clearly disastrous for Britain’s reputation in the world.
- The Parliamentary Commission on Banking Standards must not look at banks and banking in isolation. It must also explore the role of suppliers and professional advisers, including investment bankers, accountancy firms, auditors, insolvency practitioners, law firms, actuarial advisers, credit rating agencies etc. It is clear that the multifarious failures of the UK banking sector would have been averted, or would at least have been less severe, if the advisory community had retained its professional scepticism and been less willing to rubber stamp some of the bankers’ wilder schemes.
- The ethical antennae of the “Big Four” audit firms were dulled by the prospect of cross-selling and consultancy fees. The House of Lords Economics Affairs Committee’s March 2011 report into the audit profession concluded that the “complacency” and “dereliction of duty” of auditors was a major contributor to the banking and financial crisis. The government needs to make clear what action it will take in response to the House of Lords Economics Affairs Committee report.
- I would be more than happy to expand on any of these points and themes either via a supplementary memorandum or by appearing in person in front of the Banking Commission.
- I have covered almost all these points in greater detail on my website, www.ianfraser.org.
In the wake of scandals that plagued the Lloyd’s of London insurance market in 1986, Lord Roskill’s Fraud Trials Committee concluded:-
“The public no longer believes that the legal system … is capable of bringing the perpetrators of serious frauds expeditiously and effectively to book. The overwhelming weight of the evidence laid before [my committee] suggests that the public is right. While petty frauds, clumsily committed, are likely to be detected and punished, it is all too likely that the largest and most cleverly executed crimes escape unpunished.”
Twenty five years later, very little has changed. In the wake of the Libor-rigging scandal – which has confirmed how corrupt UK and international banking has become and is almost certainly the tip of the iceberg where market manipulation in the global financial markets is concerned – we have an unprecedented opportunity to rectify that.
*I am able to provide further evidence of the immunity from criminal prosecution that appears to have been extended by the UK government to financial institutions and their senior executives post-‘Blue Arrow’ on request.