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This article was written by Brian Quinn and originally published in Financial World magazine, September 2012 edition, www.financialworld.co.uk
Renew Respect for the Head
Reinstating the Prudential Authority of the Bank of England is a step in the right direction of putting it back on its pedestal, believes Brian Quinn
In my view, it all started in 1970 with the Competition and Credit Control statement, the first step in the liberalisation of the UK financial system. Before then, monetary policy took the form of a predetermined total amount of bank credit, with lending to individual sectors of the economy – shipbuilding, exports, etc – determined by government and the amounts loaned by each bank monitored by the Bank of England. Interest rates played a secondary, if not negligible role in the process. All recognised banks reported to the BoE and came into the discount office once a year for a discussion of their returns. There was no unambiguous legal definition of what constituted a bank. It was what the BoE said it was and any prospective new entrant had to be judged fit, usually after having operated with only its own capital for a period of a year or more.
The Discount Office received and monitored banks’ financial accounts and, more importantly, kept its fingers on the pulse of what was going on in the City of London generally. Informal information – including gossip – played an important part in this process. Talk of any unusual activity or questionable behaviour was passed on to the BoE, which, if the rumours had some foundation, would have a word with the relevant management, usually sufficiently early to anticipate problems. Much depended on confidence and trust, on pursuing real and not imagined problems, on not disclosing sources, and on how the action taken by the BoE, though not publicised, could adversely affect reputation. That mattered a great deal.
In this stable, clubby environment several features stood out. First, risk-taking was minimal, if not unnecessary. Interest and currency rates were generally stable. Market share had been decided by someone else and assessing credit risk was simple. Banks lent to the customers with which they had established relationships.
Actually, it went beyond that. I recall going round several banks in the City during the 1970s seeking a loan to help me buy a house. Despite having security in the form of German government bonds I was turned away – the banks claimed they had all met their allocation of credit already. I was made to feel slightly suspect for asking. It was instructive that, when I did find a lender, it was a US bank that looked first at the credit risk, not its ration book. The price of credit only varied within limited margins, hardly surprising in what was in effect an official oligopoly. In such conditions, profitability was pretty well assured, although return on capital was an, as yet, unknown concept.
Second, there was very little movement of staff around the City. A commercial banker who joined after leaving school remained with that bank until retirement. The same was true of investment bankers, insurers, brokers, jobbers (don’t ask) and members of discount houses. Switching from Barclays to Lloyds, for example, was unheard of, if not treasonable. There were some exceptions, such as foreign exchange dealers, who might move to join a fellow dealer who had found the pay more attractive in another bank, but even that was relatively rare.
Third, the BoE wielded enormous power throughout the City and especially in the banking sector. It exercised this carefully and shrewdly on the whole and, as a result, its judgment was trusted. A career could be blighted and an institution’s reputation seriously damaged by a summons to the Principal of the Discount Office.
If a bank avoided this risk, banking was a comfortable, prestigious and financially rewarding profession. Standards of behaviour were recognised by all and monitored and enforced by unwritten consent, with the BoE unquestionably the financial arbiter. There was a strong ethical or normative element and movements in the governor’s eyebrows were usually all that was necessary to bring an institution into line. Of course there were occasional transgressions, and the BoE’s views were not always accepted without protest, but challenging its role as headmaster of the City carried its own risks.
Interestingly, this state of affairs co-existed with a very sizeable presence of foreign banks in London, which tended to complain less to the BoE regarding its informal regulation of the system than many locals. They not only saw that as a condition of being accepted in the UK market, but also as a better way to do it. I can recall several conversations with managers of foreign banks in which they contrasted the open way they were treated in London with a more legally binding approach at home. They accepted the system and liked the culture. Forty years on, it all feels very different. Financial scandals at both the individual bank and systemic level are no longer the shock they would have been in the 1960s and 1970s. With remuneration and, in particular, large bonuses based on short-term performance, sailing close to the wind is not only compelling but also accepted.
Ernest Bevin, a Labour MP and former mining union leader, reacting to the removal of incomes policy, said: "If it is to be a free for all, we want to be part of the all." In recent years, it has sometimes seemed that his is the motto of financial professionals. Banks appear to follow a strategy of going to the very edge and trying to redefine the edge to their advantage. Any idea of providing a public good seems to have gone out of the window. If this is true how did it come about and what, if anything, can be done about it?
To answer the first of these questions, it is necessary to go back to Competition and Credit Control. It was not just a change in the operating framework of monetary policy but the beginning of the change in how banks and bankers think of their roles. Market share and a steady flow of profits could no longer be counted on. Capital had to be competed for, not only with peers but with other companies outside the financial sector, and return on capital became a driver in a bank management’s thinking and business plans. Efficiency and cost control increasingly jostled with customer care in conducting business. New ways of doing things were explored and welcomed by investors – and by customers, if the whole picture is to be acknowledged.
In the early 1970s, the process of changing the structure of the financial sector in the UK, and indeed in many countries, picked up pace and scope. Financial products and services became much less easy to label as exclusively banking, insurance or investment activities. This was formally and legally recognised in the UK in 1986 by Big Bang, which allowed the bringing together of commercial banks and investment banks, and, subsequently, insurance and asset management companies within a single group.
Perhaps paradoxically, at around the same time, there was an increase in specialisation of function – such as risk management, product development, strategic planning and compliance. Inevitably people began to move around within the financial sector as they identified more with their specialist colleagues and less with a particular institution. With this constant change, the values and standards of conduct regarded as acceptable also altered. What was legally permitted by contract, rather than what seemed the right thing to do, occupied an increasingly important role, partly because what was right was no longer clear.
The formation of the Single European Market in the 1970s and 1980s widened the competitive arena and indirectly contributed to changes in London. Conformity with the law, which was always a stronger factor in European countries, reinforced other changes taking place in the UK. The Banking Acts of 1974 and 1987 were a direct result of the UK’s accession to the European Community. Certainly the supervisory staff of the Bank of England had it drummed into them that observance of the new laws must play a central role in their work. Positive judgments for the BoE in the courts reinforced the shift in emphasis from the informal to the legally binding because, despite the endorsement of the BoE’s judgment, it was clear where the ultimate authority now rested.
Similar changes were taking place in the US, particularly the repeal of the Glass-Steagall Act, which had required the legal separation of commercial and investment banking. However, it is arguable that in a country in which observance of the law had always played a much greater part, the culture of banking changed less than in London over the past 40 years.
The common theme in these and other countries was liberalisation: intended to raise the productivity of the sector and to increase the choice for users. Liberalisation cleared the way for new ways of thinking about how things could be done. Structural change, with consequences for behaviour, had gone well beyond the expectations of those who embraced it.
Other powerful factors took the financial sector in the same direction, notably technological advance, an enormous enabling factor permitting greater efficiency in the running of banks’ operations, the management of risk and the creation of new products.
Technology has greatly reduced the personal contact in financial business, at both the institutional and individual level. Replacing the trading floor of the Stock Exchange with computers was welcomed as a sign of progress but it also removed the personal contacts that created and reinforced trust among the traders. At the individual customer level, every automated phone call or internet exchange that has replaced speaking directly to an actual bank employee has depersonalised an important part of business life.
While greater efficiency may be the chosen prize, trust is the casualty. Sir Jeremy Morse, one of the outstanding figures in UK banking over the past 40 years, was asked a little while ago what were the most important differences in banking in recent years. He replied, without hesitation, that it was the erosion of the principle that bankers’ primary duty was to look after their customers’ interests – not greater efficiency or higher return on investment, or personal remuneration. Anyone who knows Sir Jeremy will understand that these are not casual remarks.
I now have a strong feeling that the integration of deposit-taking banking with trading activities was a profound mistake, at least in terms of culture and behaviour. Recorded conversations between dealing desks tell you that their view of what constitutes acceptable behaviour differs from that of conventional commercial bankers. In a fiercely competitive world, with remuneration tied to short-term performance, traders take more chances, operate at a greater distance from their employers’ ultimate clients and behave more as tribal groups than as employees of the firm they happen to work for. The faith placed in so-called Chinese walls has been shown, time and again, to have been misplaced, if not naïve.
Liberalisation has led financial services companies to reorganise themselves. Compliance with laws and regulations has ousted respect for a central authority as the primary disciplinary characteristic of London. There have been clear benefits in terms of the choice of financial goods and services and their price. But the later stages of a boom expose behaviour that goes well beyond what is regarded as acceptable.
What form should the response take? Can you "manage" or "engineer" cultural change in any meaningful sense? Is it possible for City institutions and individuals to recover their reputation for honest and honourable dealing, or at least to the extent that the users of financial services no longer routinely suspect the suppliers of those services of "ripping them off" at every opportunity? In 1970, to describe yourself as a banker brought a degree of respect. Today, I have heard bankers duck the question.
None of this is to argue for a return to old ways of doing things, or to suggest that further changes in the structure of markets or the companies operating them should not be permitted. That would be both silly and impossible to accomplish. However, newer, tougher laws and more muscular regulation do not have a great track record in changing behaviour in any lasting way. Have fines already become more of a cost of doing business than a means of changing behaviour? The real penalty in criminal sanctions or professional disqualification arises from the social odium that attaches. That is why some bankers currently dodge the question about where they work. The UK media are fond of pointing to the tougher measures taken in the US on financial crime or misdemeanour. Odd, is it not, how it nevertheless keeps happening in the US, at both the institutional and personal level?
Here are some pointers from the recent past that might help show the way. First, the discovery that there has been misbehaviour, or worse, during a financial boom is hardly new. So, should not the boards of financial institutions spend more time thinking through the possible effects on behaviour of any proposed changes in, say, business strategy, remuneration or company organisation before they are introduced? Do governments and regulatory authorities consider sufficiently the possible effects on culture and behaviour of new laws and regulations?
Second, I believe it was mistaken to discard what had become the natural authority of the Bank of England when the regulatory system was reformed in 1997. You might expect me to say this, and there had been imperfections in the BoE’s performance as regulator in chief, but the tripartite arrangement that succeeded the BoE’s oversight of the City was a more grievous failure, judged by the consequences. Reinstating the BoE as the prudential authority is an important step in the right direction. Further, regulation of market conduct needs to be integrated into the new regulatory system, once again drawing fully upon the direct involvement of the BoE markets day to day.
Third, changes in the culture and behaviour of firms cannot be imposed from outside. Boards of directors and senior management are best placed to set and enforce standards of behaviour. Acting promptly to discipline someone who has ignored company standards of behaviour, and making this known within the firm, would be a start.
The regulator has a crucial part to play in spelling out how the laws and regulations will be interpreted and enforced and, indeed, trying to anticipate transgressions rather than always waiting until a breach has occurred. Informal warnings can be a powerful supervisory weapon, particularly if they are seen subsequently to have been ignored. The action taken by the governor of the BoE and chairman of the FSA to make their feelings plain to the chairman of Barclays regarding the position of its CEO demonstrates that informal sanction still has force.
In recent years, I have felt that the regulator and the financial sector have been pointing in quite different, if not opposite, directions. This is a crucial change in what London offered as a global financial centre. Times are, of course, different now and competitive conditions make the interests of the regulator, the shareholder and management much less easy to reconcile. But would it not be worthwhile trying to recapture some of what distinguished London from other financial centres?
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