The UK banking sector and the lack of reform

Yesterday was yet another day of quite extraordinary volatility in world equity markets. Just look at how the day started with the  Japanese Nikkei index falling 1% and European equity markets falling 1.5% in morning trade, but then later on in the day markets recovered and in the end the American Dow Jones closed 2% up and overnight we saw the Nikkei rallying by 3% which is followed by European markets being up 1.5%! These markets are like a whirlwind at this moment in time and as I have said before they make life very difficult for the private investor. They are also becoming clearer indications of the amount of uncertainty in the market and its jumpiness.

The Banks and the paradox problem

As these institutions were a big factor in the lead up to the credit crunch you might think that since there we would have seen some fundamental reform since then. If you look at the UK banking sector I cannot really see any. The main change is that Royal Bank of Scotland is mostly public-sector owned and Lloyds Banking Group is mainly public-sector owned. There has been a less major change in that Santander a Spanish bank has purchased some smaller banks such as Alliance and Leicester and part of Bradford and Bingley to add to its existing ownership of what was Abbey National. But really these are just organisational changes with some mergers taking place as a type of crisis management. These organisational changes have in the case of RBS and Lloyds been topped up with taxpayer investments currently estimated by JP Morgan at £66 billion.

So we have no real reform but we have taken a step backwards in my view. You see the paradox is that before banks probably believed they would be backed by taxpayers whereas now they know they will. Indeed if you were a banker you must now think that if you are “too big to fail” or several of you get into trouble in a roughly similar manner at about the same time, there will be taxpayer-funded bailouts which are often quite generous. When politicians are forced to choose between global economic collapse and expensive financial system rescue, bankers must reckon that no politician will be strong enough to let them fail. And if you look at the evidence so far  bankers have every basis for this belief for the people who run our banks have, with very few exceptions, kept their jobs have they not? If you set a criteria for failure in charge of a bank surely Eric Daniels the Chief Executive of Lloyds Banking Group has to fail it but not only is he still in charge there was talk of a bonus for him this year. This is the man who presided over the most disastrous merger in UK banking history and then later admitted that proper due diligence was not done. But he is still there.

To my mind the paradox is going forward that bankers are even stronger than before. Not only are they the recipients of quite incredible in the circumstances job security but they also have the financial backing of the taxpayer. This includes the banks which were not actually bailed out such as Barclays and HSBC who to my mind benefitted from the implicit backing of the taxpayer even if they did not physically receive any funds, markets knew they had a back-stop. To my mind this is hardly likely to make them act in a more responsible way in the future. Indeed it is quite possible that the interventions made so far have made this situation worse and as we stand we have accelerated the next phase of problems.

What reforms have been suggested?

In essence so far it has been suggested that better regulation would have solved the problem and that this combined with a new revitalised supervisor would solve the problem. To my mind there are clear flaws in such a proposal. For example such a policy assumes  that the regulators will be able to identify the excess risks that banks are taking in the first place and if they do identify them then they will have to overcome the banks’ arguments that they have appropriate safety mechanisms in place. If they manage to do this then they will not only have to resist political pressure to leave the banks alone for the sake of the economy but they will need political support to impose what are likely to be controversial corrective measures that will be too complicated to be fully understood by either politicians or the public. At the same time the banks themselves (who can afford powerful lobbying organisations) will be arguing that none of the above is necessary.

The idea that we can simply regulate huge banks more effectively assumes that regulators will have the incentive and ability to do so which to my mind goes against everything that we know about regulators and what Americans call “regulatory capture”. There is a clear example of this going on in the Gulf of Mexico right now. The oil and gas industry and the leak from BP’s platform shows us clearly the limits of regulation as a solution to problems.

What else are we doing?

One other factor that people may not be aware of is the amount of money that is being poured into worldwide banking sectors. This again is hardly a recipe for reform as bankers must be thinking that any failure will be immediately followed by a free lunch.

1. A clear example is that central banks supplied as much cheap money as banks might want. If you were a proprietary trader at a commercial or investment bank you can take the cheap money and invest in something yielding much higher go to sleep for a year then wake up and count the profits and your bonus.Should this look like it is going wrong (Greek bonds) then a friendly central bank (the ECB) will then step in and buy any loss making bonds to limit your losses. I have argued many times in my articles that many of the euro zones “rescue packages” for Greece were in fact rescue packages for the euro zones banks with the side-effect of helping Greece. So plenty of easy profits for investment bankers.

2. There has been a clear decrease in competition in the private/public banking market. Not only have banks merged and numbers fallen but so have building societies. This has led to moves which are bad for competition but good for banks profits. In one of my first articles for this blog I discussed this point for the UK mortgage market.

To quote an example when the mortgage market was very competitive tracker mortgages were available at and often below the UK base rate. The best one that I can recall was offered by Cheltenham and Gloucester (which once was a building society and is now part of Lloyds Bank) which offered a rate 0.51% below the official base rate and hence is currently -0.01%.Now they are usually available at 2 or 2.5 % over the base rate. In other industries there would be an investigation into a change in pricing structure of this sort.

Now not only have we not seen any investigation but in the last week we have seen Lloyds Banking Group raise its standard variable rate for new mortgages from 2.5% to 3.99%. If you are looking for justification for this you will have a lot of trouble.The base rate is still 0.5%,savings rates are if anything falling and yields on UK government bonds have fallen too recently.Nice work or rather profits if you can get it. In addition Moneyfacts has recently published some research on overdraft rates showing that the average overdraft rate has reached its highest point in a decade.Despite the low-interest rate environment, the average authorised overdraft rate currently stands at 14.22% according to them. Rather revealingly the last time the average overdraft rate was as high as it is now was in May 2000, when the Bank of England’s base rate of interest was 6.00%.

I have written before about the apparent disconnection between official interest rates such as the base rate and the interest rates that individual and corporate borrowers actually face. It is not clear to me that our politicians have faced up to this or its consequences. It is an explanation of why the enormous monetary stimulus measures have disappointed but nobody in authority seems to be willing to come down from their ivory tower and consider the implications of the interest rates which exist in the real world.

Of course for politicians there is a clear moral hazard. The more money the banks make at this time the faster they will be able to privatise them and claim “victory”. To my mind such a victory would be Pyrrhic at best as the examples I have quoted above are a form of taxation for the banking sectors benefit. Also just to throw a question in where is the new super improved regulator? If it is not sorting out such issues now when there is public interest it surely will not when interest wanes.

Possible Solutions

Having suggested that we may be making things worse it is now time for me to make some suggestions as to how we can improve things. In another form it can be expressed as how do you get rid of the speculation and gambling in banking and encourage the investment and lending?

1. I am a fan of the Volcker Rules which have been proposed in the United States. In essence they would split investment and ordinary banking. This is a long way from a complete solution  but it is likely to help.
2. A way of dealing with banks becoming too large is to address this in capital requirements. As the size of a bank increases then it should be considered to be more risky and the amount of capital it is required to hold should be increased. This should help to reduce the “too big to fail issue”.
3. As banks have benefitted form the support of the taxpayer then they should be charged for it going forwards. This should be risk based so those who are very conservative should have the lowest payments and vice versa.

4. In the UK we have far too few banks and those that we have need to be broken up. The merger of Lloyds Bank and HBOS was a particular failure of policy as it created the biggest bank in the UK just when the problem was that banks had become too large! As taxpayers are big shareholders in both firm we have an opportunity to break it and RBS up.

5. I would institute a new directors code for banks around the issue of competence and would define and have clear penalties for gross negligence which if necessary would involve jail.


5 thoughts on “The UK banking sector and the lack of reform

  1. If the banks are broken up, how will this affect the ‘Global Economy’ i.e. will they tend to stick more to their home market rather than speculating overseas?

  2. Thank you for another fascinating and thought-provoking piece! I agree fully that regulation cannot be the answer to the problem of “too big to fail”. In fact, it risks making things worse since, when things go wrong, smart and ruthless bankers can say: “it’s not my fault, the regulator should have stopped me”. However, the logical alternatives seem to be only two:

    (i) structural rules that make sure no bank is too big to fail. This would allow market discipline to work since bankers would lose their jobs and shareholders/creditors their shirts when things go wrong) or

    (ii) full and permanent public ownership of banks that remain too big to fail (i.e., a socialist solution, in which all banking profits as well as losses are socialised).

    I have an instinctive dislike and distrust of (ii), but I fear that current politicians will never enact (i). Personally I would vote for a credible politician promising (ii) in preference to the current situation in which profits are private, losses are public and moral hazard increases with every new crisis.

  3. I agree with a lot of your comment and proposals save that I am not as dismissive as you on the role of regulation and regulators. The Treasury Select Committee were told by the FSA

    “The regulatory philosophy which we pursued in the past focused on ensuring that firms had the appropriate systems and controls in place and relied on the senior management of firms to make the right judgements. We did not see it as a function of the regulator to question the overall business strategy of the institution or more generally the possibility of risk crystallising in the future.”

    Just think about that. It is barely believable that those entrusted with responsibility to patrol against build-up of systemic risk could take such a laissez-faire approach and a “tick-box” light touch. Regulatory failure is deserving of a public inquiry and reforms should not bury that failure or excuse it.

    Another worry about the timing of reform is that around a half of UK banks’ aggregate wholesale funding is of less than six months’ maturity.
    The BoE say ” Over £1 trillion of UK banks’ term liabilities mature over the next five years…. Unguaranteed market funding,
    including maturing and callable securitisations, accounts for
    nearly £750 billion. In addition, banks face the withdrawal
    of extraordinary public sector support.” A need arises to synchronise reform with the re-gearing of the banks to avoid another crisis. I see no real debate on the juxtaposition of these mutually aggravating forces which are key to the UK.

    Finally, we should all be aware that the imposition of a banking levy will see its cost simply transferred to the bank’s customers through higher charges and arrangement fees. Banks will just lay it off. We might as well submit to higher taxes on ourselves.

    Good blog.


  4. if we’re not seeing anything like the Glass-Steagal Act or for that matter any regualtion or changes – then I ponder that ,really ,our politicians are in the pay of these banks ?

    biggest moral hazard as I note as you do that interests rate for mere pondlife like my self is divorced from the Bank of England rate

    I mean , if the BoE puts its rates up by 1% I can guess its not good for the public as the banks will double ,or more, the rrates to us!!

    Moral Hazard be dammed – I smell corruption !


  5. I think we really need to get something done with the banking sector! Anything ‘too big to fail’, for the well being of the country, in the private sector should be under public ownership. That would presuppose some sort of capability within the public sector of course! There must be a huge pent up demand for a half decent savings vehicle, as mentioned overdraft rates of 14+% and some credit cards carrying over 20% still, yet savers can get zilch, someone somewhere is coining it in! If only we had a publicly owned banking vehicle to deliver a decent return for savers and provide domestic as well as commercial lending…………….errrrr!
    I still think there should be a crime on the statute books, financial terrorism! Some of these people have done more to bring the country to its knees than any terrorist organisation has ever achieved!

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