Banking: Parliamentary Commission on Banking Standards

Lord Turnbull Excerpts

Thursday 5th December 2013 Lords Chamber

[Lord Turnbull (CB)]

My Lords, I join noble Lords in welcoming the noble Lord, Lord Carrington, to this House. I suspect that the smaller, innovative banks like Gatehouse are going to make a disproportionate contribution to the improvement of banking services in this country, so his knowledge and wisdom in that area will be valuable to us.

The final report of the PCBS opened with the following summary:

“Banks in the UK have failed in many respects. They have failed taxpayers, who have had to bail out a number of banks including some major institutions with a cash outlay peaking at £133 billion. They have failed many retail customers with widespread product mis-selling … They have failed their own shareholders, by delivering poor long-term returns and destroying shareholder value. They have failed in their basic function to finance economic growth, with businesses unable to obtain the loans that they need at an acceptable price”.

That is a harsh verdict that poses a number of questions. Is it a fair verdict or is it just banker-bashing, providing politicians with a smokescreen for their own failures? Were other players also to blame? Are the remedies appropriate? Has something gone wrong with bank culture and can something be done about it? Lastly, will we kill the golden goose and drive away banks and/or bankers?

On the first question, it is certainly the case that the banks were not uniquely to blame for the financial crash. Top of my list of contributors is a major intellectual failure. The model of the financial world that was taught in our universities and business schools, and championed by Alan Greenspan among others, presumed that capital markets functioned efficiently. In fact, almost all of those assumptions proved to be wrong. Financial markets were riddled with serious flaws, such as major externalities, misaligned incentives, irrational herd instincts and asymmetry of information.

Secondly, there was the connivance of western Governments, particularly in the US and the UK, who actively promoted access to credit for their citizens as a way of promoting the appearance of rising living standards. Thirdly, there was the widespread use of inflation targeting of price indices based on a narrow basket of consumer goods while ignoring asset prices and underlying credit conditions. The list goes on—there were all the players that should have provided checks and balances but did not, such as regulators, auditors and rating agencies—but it is clear that the banks played a powerful role as an accelerator and transmitter of these forces, taking greater and greater risks.

Initially, the response to the financial crisis was largely a structural one. The first phase was to restructure the regulators. A twin-peak structure was put in place in the first Financial Services Act 2012. In my view this is not necessarily the only, or perhaps not even the best, model, but it has been done and we should get on with it and make it work, rather than continuing to debate the alternatives.

The other part of the structural response was through the Independent Commission on Banking led by Sir John Vickers, set up in June 2010, which reported its conclusions in September 2011. The ICB set itself four objectives. The first was to make banks more resilient and better able to absorb losses, through higher capital and lower leverage. The second was to make it easier and less costly to sort out banks that get into trouble by dividing them into ring-fenced entities carrying out the core functions of taking deposits, supplying overdrafts and operating the payments system, with other, riskier investment banking activities being kept in a different entity, though still within a banking group.

The third objective was to curtail incentives for excessive risk-taking. In particular, the ICB wanted to cut back the implicit guarantee that arises if banks, and those investing in them, come to believe that banks are too big to fail or too complex to be allowed to fail. Finally, it wanted to strengthen competition and consumer choice by creating a more diverse, less concentrated banking market and by making switching easier.

By mid-2012 the debate was still dominated by these structural issues. Some people argued that if incentives and structures were improved, if the implicit guarantee was curtailed and if the banks were properly capitalised, behaviours would improve. If that view was ever true, though, it was blown away by a series of revelations about conduct in the summer of 2012. The straw that broke the camel’s back was LIBOR fixing. At this point the patience of politicians snapped and we moved on to a different agenda, one concerned not just with structure but with behaviour, standards and culture. The PCBS was created to investigate this.

I should at this point record my thanks to my colleagues on the commission and to the clerks and advisers who supported us. Not only did we pioneer some new approaches to committee evidence-gathering, such as the use of counsel, but we demonstrated how much can be achieved within the discipline of unanimity. Even as the commission began its work, reports of misconduct multiplied. They came more or less weekly.

There was widespread mis-selling to consumers and SMEs of retail products such as PPI and interest rate swaps, there was mis-selling of complex mortgage securities in the wholesale market and there were poorly supervised rogue trading, aggressive tax planning, money laundering and sanctions busting. This time even the survivors of the crash, such as JP Morgan, HSBC and Standard Chartered, were implicated. The list of abuses grows even to this day, with rumours that there may have been fixing in foreign exchange markets and claims that RBS has exploited some of its SME customers.

The PCBS has produced five reports but its findings on conduct can be summarized briefly. First, there was a lack of personal accountability. The approved persons regime was found wanting, as it served only to control entry into senior posts—although, as the Reverend Flowers’s case indicates, at times it did not even achieve that. It was ineffective in influencing conduct and in enforcing standards. In this crisis only one senior banker has been fined, and no action has been taken against any CEO.

Secondly, there was remuneration that was widely perceived as excessive and incentivising poor behaviour. Thirdly, there was an erosion of professional standards and a decline in the status of chartered bankers. Fourthly, there was a loss of customer focus.

Anthony Salz, once of Freshfields and then of Rothschild, was asked by Barclays to review its business practices. He found a,

“culture that tended to favour transactions over relationships, the short term over sustainability, and financial over other business purposes … remuneration systems that tended to reward revenue generation rather than serving the interests of customers and clients”,

and a bank acting,

“within the letter of the law but not within its spirit”.

In a few words, he pretty much captures it, and the same could be said of most other banks.

The commission’s recommendations provide an extensive agenda to rectify this, including a senior managers regime to replace the APR, which will define responsibilities and hence create a chain of accountability. That will make it easier to identify who is responsible and therefore to sanction or disqualify poorly performing executives. It seeks to eliminate the Macavity defence of “I didn’t know” or “I wasn’t there”. Below senior management, banks will be required to identify all staff whose actions are capable of damaging the bank, its shareholders or customers and to attest that they will operate to proper standards.

A new body has been created by the banks, led by Sir Richard Lambert, to promote codes of professional standards. A new criminal offence of reckless conduct is to be applied where a bank has failed and required state assistance. There would be a tougher remuneration code requiring a larger proportion of pay to be deferred and for longer, plus a power for the regulator to claw back remuneration that has already vested where a bank fails and requires state support.

I return to some of the questions I posed at the start. Is this unfair targeting of banks and bankers? I would argue that it is not. Even now, banks accept that their conduct was not acceptable and that they have forfeited the trust of their customers. Banks are also exceptional in a number of other ways. They provide a public service through the payments system, which cannot be allowed to be interrupted. They are highly interconnected: a failure of one bank can damage other banks either directly or by undermining the trust on which the whole system is based. They can fail with astonishing speed. Even after the structural changes have been made, they will still enjoy some degree of implicit guarantee. In addition, their funding structure is different. Compared with most industrial and commercial companies, equity forms a tiny part of their balance sheet. Almost of necessity, they are highly geared organisations.

Will banks, and hence London as a financial centre, be forced by tighter regulation and higher capital requirements to contract or divest themselves of certain lines of business? To a degree, yes they will, and we should accept that. Our largest banks became too big to manage. Cutting RBS down to size so that it concentrates on serving UK firms and households is to be welcomed. It is essential that leverage is brought down. The UK is a middle-sized economy with a global-sized banking sector. In 1990 the combined balance sheet of UK clearing banks was 75% of GDP. In 2010 that had risen to 450%. Even by 2012, it was still at 350%. That exposes us as a nation to certain risks that we have to be prepared to face.

A lot of proprietary trading is better conducted in the hedge fund sector where the proprietors have more at stake and the implicit guarantee does not operate. Will banks or bankers move out of London, as many around the dining tables of the City tell us? Where would they go—into the hands of the US Department of Justice, the land of the orange jumpsuit and the perp walk, or into the bureaucratic clutches of the European Commission and the European Parliament? We should have the confidence to see a better regulated London as a source of strength, not weakness.

Finally, we must ask whether it is all going to work. In our debates, some noble Lords have described the ring-fence structure, even as strengthened by the commission, as an experiment. To a degree, it is, but so, too, would be fuller structural separation. The option of staying with the status quo simply is not available. Will the report achieve the objective of its title, Changing Banking for Good? We need a regime that works not just now, when banks have been chastened, but when animal spirits have revived and memories of the crash have dimmed. If it is to succeed we need to address both parts of the agenda, structure and culture, as they are closely linked.

The Government said they strongly endorsed,

“the principal findings of the report”—

and intended—

“to implement its main recommendations”.

The initial proposals in the Financial Services (Banking Reform) Bill fell short of that claim. Some recommendations were accepted but only weakly implemented, while others were ignored altogether. However, I can report that through the process of Committee and Report, a number of important amendments have been agreed, and significant assurances have been secured on the nature of reviews and on how the regulators will operate the new regimes. I hope that by Third Reading next week we can resolve the remaining issues.

Ultimately, however, the question of behaviour is for the banks themselves. Will they get back to a greater emphasis on relationships rather than transactions, and to serving their customers rather than seeing customers as the people from whom they make money? Opinion is clearly shifting for the good, but will this be temporary or will it be a change that lasts? Only they can answer this.