Friday 23 October 2009

Bogey Banks

People don’t like banks or bankers much at the moment. For good reason:
- They over-extended themselves badly, requiring massive taxpayer support;
- Their failures last year, and the resulting drying up of credit, have been a major factor in the current recession;
- Despite receiving massive taxpayer support, UK banks have not met their side of the bargain in renewing credit to UK businesses; and
- UK and global banks are making a lot of money again, partly because market volatility allows them to and partly because there are fewer banks able to compete. And they are paying out as big a percentage of their profits to employees as they used to. Taxpayers do not like their money effectively being routed to pay substantial sums to bankers.

It’s not all the banks’ fault, though, and developing public policy to deal with these issues can’t simply be based on bashing bankers and taxing bonuses because they are complex. Hence some of the disagreements between the UK Government, the Bank of England Governor and the FSA (although the last two have more in common than the media imply) over what to do. And hence the lack of agreement on real action internationally*.

There are lots of reasons for banks becoming over extended; Bad management is certainly one: George Bush’s comment “Wall St got drunk” is as good an explanation as any. But lax regulation and encouragement from Governments was another very important factor, as was the willingness of most of us to spend future income immediately and as a result borrow too much. I’d split the blame 25:25:50 between the banks, the public and Governments.

Having got in a mess, Governments have had split views on the ideal outcome. Yes, they want banks to lend more but more importantly they want them to rebuild their capital. They also do not want to see them make too much money because of the public impact. But profitable banks have three major benefits for Governments: they can reduce the level of support they are giving; they can eventually sell the stakes they have for a profit; and both the banks and their employees will pay tax and spend money to help kick start the economy. Hence you’ve seen the Governments talk about restricting bank profits and bonuses, while doing nothing. Evidenced by the fact that in the UK some of the bigger pay packets are going to be at RBS, which we as taxpayers own and where the Government could take direct action if it wished.

What should happen?

I wrote some time ago about why banks paid such big bonuses: a lot of that is still valid. Essentially, it’s because their margins are too high for two main reasons:
- the correct price of what they sell (or buy) is only known with hindsight, often after many years. They have better information than their customers and they charge too much. As the end eventual buyer of most financial services is the ordinary person’s savings, this extra profit is a real cost to the rest of us.
- Much of the advisory and financing work banks do for companies and Governments is really important to the individual company and the Government. The impact of a failed transaction is very high – so what matters is the quality of the service and the chance of success. The fee is unimportant: it’s like the price of a drug to an addict.

But overall financial services have been good for the economy, powering increases in wealth, especially in the UK. So any changes must not damage the long term health of the sector.

There are four ways of reducing bank margins:
Capital: insisting banks should have more capital, particularly for certain types of trading activity where customer involvement is limited. This discourages banks from doing this sort of business, the sort of business which caused many of the losses.
Transparency: letting customers understand charges is the easiest way of reducing them. Financial services are traditionally opaque: regulators need to force banks to disclose what they really charge.
Competition authorities: high margins usually mean there is a market structure failure, which should be subject to a competition review. Remedies might include price controls or breaking up banks which are too large.
Government contracts: Banks want and need Government contracts; Governments are one of the main buyers of banking services. They should insist on lower fees.

In addition, I think this and next year are special cases. Governments have not insisted on a proper reward for taxpayers for the support we gave. All banks, even those who did not receive a direct injection of capital, benefited from the support given to the system. There is a case for an override on all banks to prevent excessive bonus payments either by forcing increased capital retentions or special tax payments.

And lastly, the Bank of England Governor’s concern that moral hazard has increased is valid. Banks now know they are important to fail: they have an implicit Government guarantee. This has to be reduced over time and a way found to protect retail deposits while allowing shareholders, bond holders, some creditors and employees to suffer. I think a separation of investment banking from basic banking is too extreme but the head of the FSA's idea of making banks define how they should be wound up and having higher capital for investment banking is a good start. Much more constructive than the Chancellor’s and PM’s refusal to admit the merit of The Governor’s concern.

None of these things are easy. Many are however on the agenda, and not all require co-ordinated international action. They could be done here if there was a strong Government. Which recognised that its flawed regulatory system magnified the problem in the UK.

* Brown did try to take the credit at various international summits for bringing the world together, but as you’d expect there was much talk and no action.


Hadriana's Treasures said...

Sorry it has taken me an age to get to your blog. Thank you for your comments over at mine.

I need to come back and re-read your words to absorb it all.

Interestingly XXXX Bank want to renew our business loan for one year only (originally it was for another 14 years). Arrangement fee for that is £3045. (So it looks as if they want to charge us £3000 per year to make the loan available to us.) They want to put up the interest rate by 3%. They also want to charge us £100 per month for "management time". We are a tiny B&B and they are effectively crucifying us. We have put in an official we shall see what they come up with.

I've talked to the Finanical Ombudsman, sent all details of it to the Northumberland Standards Trading Office and taken advice from the FSA.

Banks...yes...we need them but not if they act in this irresponsible manner...then they turn round to small businesses and demand money with menaces!

BTW (sorry about the rant)...

Happy Christmas and a stress free 2010!

John Woodman said...

I'd love to know which one XXXX is...

Couldn't agree more with you about banks' behaviour. This is one of the areas where Government should be helping business in the recession by creating a simple credit guarantee scheme.

(Forgive me for saying - as the Tories proposed in Winter 2008, when they were being accused of being the do-nothing party).