Get ready for a big fight over bank reform

The recent shenanigans over the government deal with the banks (project Merlin) now make more sense, following Anthony Hilton’s revelation in the Evening Standard (reported here in Lib Dem Voice).  The deal was weak on the banks because the banks did not get what they really wanted – which was to emasculate the Independent Commission on Banking Reform.  George Osborne was quite happy to oblige, it is reported, but the members of the Commission threatened to resign en masse.  This means that if the Commission does propose anything radical, an important part of the government will be against it.  This will (or should) provoke a major national debate.  Time to start marshalling the arguments, and to be all them more ready for the flood of obfuscation and irrelevant arguments that is bound to surround such a debate.  Let me offer some thoughts.

Even in a quick and selective overview, I have shot over 1,500 words.  I offer this below, but for those without the patience to read through this, my conclusions are these:  it is necessary to restrict the activities of wholesale banking so that the returns it makes are substantially lower in ordinary years, and the losses they make in bad years are also much lower; it is also important to make the banks less interconnected.  International reforms on bank capital are already doing some good, but we should not be afraid to do more since we are particularly exposed to a future crisis here in Britain. When it comes to the important business of improving finance to support small and medium sized businesses and innovation, we will need new institutions – the big banks will be of little use; the state must promote this type of financial innovation.

One thing is for certain: the established banks will not like any effective reform.  If Mr Osborne is taking their side, we can expect a battle royal.  It will take both determination and guile to face them down.  I will be reflecting on the latter in future posts.

What’s the problem?  First, there are two clear and legitimate issues for state policy.  We want to avoid the risk of another expensive state bailout of the banking system like that which was forced on us in 2008-2009.  Second we want the banks to lend more, at better rates, to small and medium sized businesses with decent prospects, in order to promote job-creation and the improved efficiency of our economy.  A third issue is politically toxic, and drawing most of the attention – that a lot of bankers seem to be grossly overpaid, with bonuses drawing particular anger.  It is less clear whether this is a legitimate issue for government interference, but we need to understand the issues here nevertheless.

Time to clear the decks a bit so that we can concentrate on what’s really important.  Here are some red herrings, to switch metaphors:

  • Bank bonuses are often blamed for promoting the crisis, on the basis that they distort incentives and incite reckless behaviour.  But why aren’t shareholders, whose stakes are at risk, managing this?  In fact the shareholders were as much a part of the problem in the banking crisis as bonus-crazed staff.  It is the incentives for shareholders that need real attention; sort this out, and the shareholders will sort the staff out.
  • Bankers’ pay is not comparable to that of film stars, sports stars or other entertainers who attract massive rewards.  Entertainment stars are a retail phenomenon which, with modern communications, works on a winner-takes-all basis in a mass market.  This is different on two counts from banking: the mega-profits are on the wholesale side of the industry; and it isn’t winner takes all either – a huge number of individuals and firms are able to attract oversized pay, not a lucky few in sea of wannabes.
  • In fact the issue isn’t really banker’s pay, but why the banks can afford to pay them so much.  Investment banking is hugely profitable in the good years.  This high level of profitability is a sign of wasteful economics, not a reward for value added to society.  A properly functioning industry is not particularly profitable because competition reduces profits.  A company at the frontier of technical innovation can deliver big profits and still be economically worthwhile – but this is not what is going on here.  There has been a lot of innovation in the banking industry, but not much of it has been to the overall benefit of society.
  • For the British, a defining moment of the crisis was the fate of Northern Rock, which had to be bailed out.  The reason why a bailout was forced on the state was that retail deposit insurance arrangements were inadequate, which caused a run, and put too many individuals’ savings at risk.  This problem has largely been fixed, and what happened to Northern Rock is pretty much irrelevant to the ongoing debate – it is simply a source of obfuscating arguments.
  • It is the banks that are the real problem, and not other players like hedge funds and private equity.  These institutions may be responsible for some egregious behaviour, but they also address a big weakness in our system of finance: an excessive aversion to risk in most investment institutions. They are not systemically dangerous. To the extent that they are dangerous, it is because of the ease with which they can get finance from the investment banks and over-leverage…which brings the problem back to the banks.
  • Finally dodgy lending by banks was at the bottom f the crisis, but it is not the main problem that needs to be fixed.  The question is why did so many lenders felt able to suspend the laws of proper management and common sense, and how were they allowed to carry on doing so for so long?  The answer is because it was too easy for them to pass buck to somebody else, in the form of securities put together by the investment banks. Securitization was justified at the time as a method of spreading risk – but this proved a fallacy.

Now, the real issues.  The first is that wholesale banking (services delivered largely within the finance industry, and not to retail customers – mainly investment banking) is much too profitable for too much of the time.  Why? This deserves more analysis, but one problem is clear from the bailouts.  Banks are making bets that pay off well most of the time, but deliver occasional disaster.  If you add up the bets that pay off with the costs of the disasters, then profitability may not look excessive.  But when disaster strikes the downside for bank employees – and shareholders – is limited, and others have to come in to bail them out.  In fact many bankers seem to think of the disasters as acts of God that really shouldn’t be their problem.  This leads to the risks being systemically underpriced.  What to do?  The critical thing is to look at how the bets are financed, and to limit the amount that is done through borrowed money rather than the shareholders’ own capital.  When things go bad, it the money banks (and various intermediaries they do business through) borrowed from elsewhere and can’t repay that cause the systemic problems, not the loss of their own capital.

The second problem is contagion.  If one institution fails then it can bring down others with it, forcing the government to bail the firm out, and creating a wider moral hazard problem referred to as “too big to fail”.  The essential problem is that too many financial institutions are lending too much money to each other.  Retail bank customers can be dragged into this mix, which tends to force governments’ hands.  This is a tough one to tackle, but the key points are to reduce the amount of lending between financial institutions (as in the previous paragraph) and to make sure that banks with retail deposits don’t lend them to other financial institutions, or severely restrict such lending.  While trading in securities by investment banks rightly attracts attention, the lending of money to other financial institutions that is used directly or indirectly to buy securities is just as much a problem.

The third problem is the lack of interest by banks (shareholders as much as managers) in lending to smaller businesses.  The problem is that to be successful this type of business requires information and relationships, and this requires good quality human input.  And that’s expensive.  We see big banks polarising into two types of business: wholesale services within the finance industry or mass retail services using computer algorithms and call centres.  Not much space in the middle.  I don’t think our big UK banks will ever be good at this; it is just too late.  We need innovative new institutions.  Two avenues are worth investigating: trying to improve venture capital facilities, and setting up publicly sponsored and locally focused institutions to lend to businesses, perhaps drawing inspiration from the German and Swiss systems (see this interesting paper from Civitas).

Basically this boils down to two things: cramping the style and reducing the profitability of investment banking.  And encouraging innovation in the supply of finance to small and medium sized businesses.  Forcing the current banks to lend more to businesses will not help; they simply won’t understand what is needed.  Making the big banks separate investment and retail banking would probably be a helpful reform, but it is not necessary and would not be sufficient.  Barclays have managed to insulate their retail from their investment banking businesses quite successfully.  Retail banks become exposed by lending money to investment banks or to the shady investment vehicles they create without them being part of the same organisation.

Some progress has been made on restricting investment banks internationally.  New international rules on capital are already putting investment banking profits under pressure, although not yet to the extent that they are having to cut pay (see this article in The Economist).  Is this enough?  Britain is uniquely exposed to financial crises, and we were lucky not to go the way of Ireland and Iceland, with mass bank failures on our hands. We can’t expect much solidarity from our European friends, given how stingy we have been to them.  An oil crisis is in the works; property prices could yet fall further; monetary policy and fiscal bailout have run out of road.  We shouldn’t shy away from extra measures to reduce our exposure.

Forcing the banks to cut pay is going to be tough going – but it is only then that we will know that reform is working.  High pay is rooted into the culture of these organisations.  Probably some banks will have to fail first.  We must hope that this will be the orderly winding down of some units, but we can’t rule out something worse.  And that leads us to a key paradox that will be at the heart of the argument.  Measures to make banks behave more safely may well cause some systemic instability.  The idea isn’t to abolish financial earthquakes, but to make them smaller and less threatening – even at the price of having more of them.

 

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Fontcrime: Comic Sans lives on

Readers who had seen my post on Public services are different may remember that somebody had been fraudulently buying up phone contracts under my name.  Last Friday I received this letter from the Carphone Warhouse UK Fraud Department.  Apart from the clumsy, evasive wording of the letter, what really hit me was its font.  Comic Sans should have died of ridicule years ago.  There’s even a website called bancomicsans.com.

Actually, Comic Sans has its place.  Its rather childlike appearance makes it quite appropriate for use in primary schools or nurseries, for example.  But what on earth is a fraud department of a major company doing using it?

If nothing else this shows that this department is disconnected from the rest of the company, which no doubt has strict house style rules. This is not a bad thing of itself.  The evasive and non-empathetic wording also shows that no communications professional has been anywhere near it.

As for the outcome, this letter says to me that my case has been filed in the closed category, with a bar being placed on anybody quoting my name an address buying anything from Carphone Warehouse.  I’m not complaining; I have no plans to buy anything from Carphone Warehouse after a couple of rather bad experience with them a few years ago, including another fraud.

But I’m still amazed how so many people are fontblind.

 

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The breaking wave: why I am an agnostic

Earlier this month BBC4 ran a documentary “The Secret Life of Waves”, by documentary-maker David Malone.  Apart from explaining the usual stuff about ocean waves, he went off into to a philosophical and spiritual dimension, comparing waves to life itself.  I found this very moving.  It was also nice to see that non-religious professionals are allowed to offer profound thoughts on spiritual matters.  Normally as soon as you mention “spiritual”, assorted religious types start to gather like vultures around a carcass, all too often offering no more than empty dogma.  Radio 4’s Thought for the Day doesn’t allow non-religious speakers.

When a wave breaks it disappears, but the water that carried it remains.  The wave has a life – a beginning, a middle and an end, but no substance of itself.  It is a manifestation of “energy”, although I find that an unhelpful word.  This is all we really need to know about our own lives.  The idea of an afterlife doesn’t really survive serious reflection.  Mr Malone shows this by pointing out that our concept of heaven – an essentially static place – isn’t at all attractive.

I was brought up a Christian, but the idea of heaven and hell never convinced me.  And I have found the idea of a God that intervenes in response to prayer, or sin or anything else, impossible too.  I accept the scientific view of the universe, of its vastness and of our own origins through evolution.  No heaven and hell; no divine intervention; no personal God.  Christianity was built on these ideas.  Without them the wave starts to break, just as an ocean wave breaks as it enters shallow water.

So why am I not an atheist?  I mainly think and act like one, long since having abandoned membership of a church.

Well in the first place I associate atheism with a hard, evidence-based view of the world.  This world has no room for mystery, as my brother Richard Green points out.    It is of the nature of scientific evidence that there can only be enough to cover a small fraction of what we experience; do we simply pretend not to see the world beyond evidence?  Atheists mock God as an “imaginary friend”, and yet their world requires quantities of a sort of negative imagination.

And the religious insights that attracted me to Christianity remain a powerful influence on me today.  I still cannot think of the Sermon on the Mount without excitement – it’s a flame that still burns bright – to invoke another transitory phenomenon.  It is a crazy, defiant creed that tells you to renounce worldly wealth, turn the other cheek, accept humiliation and not be bound by the letter of the law but by its spirit.  And there is so much more – it angers me that so many Christians seem to ignore what I see as the essence of Christian teaching.

And finally there is the wave of religious experience itself.  It is quite something to stand in an ancient Church and feel continuity with it – or to read ancient scriptures after so many generations before have done so.  It gives a sense of belonging.  The wave may be breaking, but I can’t quite renounce it.

 

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Reflections on the Isle of Wight

I’m just back from a few days break in the Isle of Wight.  It so happens that the Economist’s Bagehot has just blogged on the subject of the island, which was the lasting point of his print column last week.

The island has a bit of a charming, time-warp feel about it.  But Bagehot points out that its people are ahead of the game in one aspect – realising the implications of the coming parliamentary boundary changes.  Interesting to reflect that it has half the population of the borough of Wandsworth – and yet the latter can’t even support a decent local newspaper.

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