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Cleaning the cesspit

6 August 2012 By Hugo Dixon

Five years after the credit crunch erupted in August 2007, banking still looks like an industry running amok. Scandals keep tumbling out of the closet: an alleged ring of banks including Barclays that attempted to rig interest rates; money laundering by HSBC; insider tips passed by Nomura to its clients; and terrible risk management by JPMorgan, where traders have so far lost $5.8 billion.

True, some of these scandals date from the rip-roaring days of the bubble. And the industry is now being reformed. But the public is growing impatient with the slow pace of change, especially as recession bites in large parts of the industrialised world. Some observers therefore want to clear out the entire old guard. The idea is that only new teams can clean the cesspit. There are also increasing calls to break up banks into supposedly low-risk retail banks and casino-style investment banks. Even Sandy Weill, the man who created Citigroup, now advocates splitting up financial conglomerates.

Something must be done. The financial industry has made a mockery of capitalism. Despite endless bailouts, bankers are still paid far too much. Profits are privatised, while losses get socialised.

The regulatory noose around the industry is tightening. After the credit crunch, there was a global push to jack up capital and liquidity buffers, while reining in risk-taking. If lenders get into trouble in future, the idea is that they will be wound down safely rather than bailed out. Bankers’ compensation is also being modified – for example, allowing pay to be clawed back in future years if there are losses.

This battery of new regulations is putting pressure on the industry’s profitability – and its pay. Banks are reviewing their business models. They are cutting back on proprietary risk-taking, slashing jobs, and even pulling out of some business lines.

The snag is that it will take until the end of the decade for all these changes to be implemented. That’s partly because the technicalities are complex; and partly because policymakers fear that, if they come down too hard on such a crucial industry, their economies will be driven even deeper into recession.

In the circumstances, proposals for wholesale management change and breakups have strong popular appeal. But they are not the best options.

Last month, both Bob Diamond, Barclays’ chief executive, and Kenichi Watanabe, Nomura’s chief executive, rightly fell on their swords. But if everybody with a senior position in a troubled firm departed, novices would be in charge. That’s just too dangerous.

If managers are tainted by scandal, however remotely, they clearly need to go. They must also quit if they are unable to shift their mindset from the money-grabbing culture of the past to the more service-orientated culture of the future or can’t apologise sincerely for the excesses of the past.

These yardsticks should be used to determine whether the managers currently in the firing line – such as JPMorgan’s Jamie Dimon and Deutsche Bank’s co-chief executive Anshu Jain, whose chairman has just cleared him of involvement in the Libor scandal – should walk the plank.

Meanwhile, it is naive to think that breaking up banks would be a quick fix to the sector’s problems. It’s just not true that a combination of investment and retail banking caused the crisis. Plenty of retail-only banks – the UK’s Northern Rock and America’s Washington Mutual, not to mention Spain’s savings banks – got into trouble. And remember: the biggest failure of all was a pure investment bank, Lehman Brothers.

What’s more, breakups can’t happen fast. Given the continued euro crisis, a standalone investment bank such as Barclays Capital would struggle to finance itself in the market. The only way it could survive would be through liquidity injections from the public sector. It might even need to be nationalised. Once these investment banks are shrunk, de-risked and recapitalised, breakups may be possible. But that’s at least a five-year job.

So what should be done in the meantime? Further action is possible on at least three fronts.

First, pay. Capping bonuses, as the European Parliament is proposing, is not sensible as it merely encourages banks to boost salaries. A better idea is to require lenders to pay a big chunk of their managers’ compensation in the form of the bank’s own subordinated debt. If the bank then got into trouble, executives would lose a lot of money. That should concentrate their minds on better risk management.

Second, the industry is under-taxed. The best solution here is not the financial transaction or “Robin Hood” tax proposed by the European Commission. That wouldn’t make the industry safer. Better options are to impose VAT on financial services and require banks to pay a levy to the extent that they finance themselves with hot money – a tax that has so far only been adopted in some countries.

Third, boards have too often failed to hold powerful executives to account. That was a big weakness at Barclays and other banks such as Britain’s RBS. Both regulators and shareholders need to insist that bank boards have more clout.

If the existing regulatory package was supplemented along these lines, some of the public’s indignation would be sated. There would also be less chance of the industry running amok in the future.

 

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