Evidence heard in Public

Questions 355 - 448



This is a corrected transcript of evidence taken in public and reported to the House. The transcript has been placed on the internet on the authority of the Committee, and copies have been made available by the Vote Office for the use of Members and others.


The transcript is an approved formal record of these proceedings. It will be printed in due course.

Oral Evidence

Taken before the Joint Committee

on Wednesday 31 October 2012

Members present:

Mr Andrew Tyrie (Chair)

The Lord Bishop of Durham

Mark Garnier

Baroness Kramer

Lord Lawson of Blaby

Mr Andrew Love

Mr Pat McFadden

John Thurso

Lord Turnbull

Examination of Witness

Witness: Martin Taylor, Chairman of Syngenta and former member of the Independent Commission on Banking, gave evidence.

Q355 Chair: What you lack in numbers behind you is made up for in quality; I note that the head of the Treasury Bill team is sitting behind you. I hope that no notes get passed. Thank you very much for coming. You have thought about these issues very deeply-as deeply as almost anybody-and you did so on the basis of very extensive personal experience in a major bank. May I begin by asking you what contribution, if any, you think that structural reform-whether a ring fence or full separation-can make to improving standards in banking, which is at the heart of this Commission’s work?

Martin Taylor: I will start with the ring fence, since it forms the basis of our recommendations and also the Bill.

Chair: One or two Members are asking if you could speak up.

Martin Taylor: Yes, of course. There are two principal points about the ring fence. One of them is that it would help in resolution, in a crisis, allowing the authorities to protect the ring-fenced bank and let the rest go, theoretically at least. I do not think that would help with banking standards, but the second point certainly would, which is that the ring fence is intended to undermine the extension of the implicit Government guarantee to the whole banking organisation-that is, to allow the investment bank, as has been the case in the past, to raise money on the faith and credit, effectively, of the retail organisation. It is our belief that installing the ring fence will prevent this from happening. If that is successful-and I believe it would be-you will prevent the investment bank from doing certain kinds of business that it was able to do in the pre-crisis years. I regard that as a big contribution to standards.

Q356 Chair: How will that alter the way banks sell products to retail customers?

Martin Taylor: The way that banks sell products to retail customers is an issue that the Vickers Commission did not really consider, except in trying to make sure that there was enough competition in the market. It is a very troublesome issue. We have got ourselves in the wrong place, in the way banks sell products to retail customers. A lot of people in the industry recognise that. I was thinking this morning, coming in, how difficult it is for retail customers-including, by the way, what the industry calls high-net-worth retail customers-to get genuinely disinterested advice. It is astonishing really, because one would suppose that there is an enormous demand for it. The purchases of major investment products, insurance products and mortgages-the big things that people do in their financial lives-are enormously important to them. They are not products that should be pushed, and certainly not products that should be sold against the interests of the customer.

Q357 Chair: Are they going to be better protected if we have a ring fence? In particular, do you set any store by the view that traditional banking, as it is often described, was infected by investment banking at a certain point, thereby changing the culture of retail banks for the worse by moving towards a more transaction-based approach?

Martin Taylor: I have just been reading the paper that Alan Budd submitted to this Commission describing the ecosystem as it was at the end of the 1980s, and I certainly recognise the world that he describes; the cultures of the old clearing banks and investment banks were indeed very different. Has there been contamination?

Q358 Chair: That is more or less what he is saying.

Martin Taylor: I am not sure that he is. He is saying that these things are very different, and this was 20 years ago. He says, "Things have changed since then." One of the big changes that have taken place in the past 10 years is that these organisations are now-or were until very recently, in the case of Barclays-all run by investment bankers. That is a big change; it was not the case in the 1980s or 1990s. I suppose that was done because boards had so much risk on the table in the investment bank, which they imperfectly understood, that they put someone in place who they knew could manage it, or at least understand what was going on.

The pushing of the sales culture in retail banks has obviously been growing. I do not know whether you can blame the investment bank co-location for that. It seems to me to have at least as much to do with the free-in-credit current account. Because the banks are, under the present interest rate circumstances, forced to make a loss on their bread-and-butter products, they get the money back somewhere else.

Q359 Chair: We are not asking whether it was the only factor-we are already confident that there were many factors-but we are asking whether it made a contribution.

Martin Taylor: Maybe.

Q360 Chair: If so, and if you put a ring fence in, is it going to contribute to dealing with the problem?

Martin Taylor: If you put a ring fence in, or if you did a complete split, you would have a board that was responsible for the retail operations, and one could suppose that there might be an attempt to build a distinctive retail culture, which has been rather obliterated in some places.

Q361 Chair: Banks appear to have somewhat grudgingly accepted that a ring fence is going to be imposed. Do you think the right incentives are in place for them to ensure that this works in the long term? Do you think there is a case for putting on the statute book, on a contingency basis, at least implicit scope for full separation, and putting that in the hands of the regulators, perhaps with some political checks and oversight before it could be triggered, to ensure that banks do not engage in a war of attrition?

Martin Taylor: For me, there are a number of disadvantages in having a full split rather than a ring fence. The main reason why I would support a full split was if I thought a ring fence was unworkable. I do not think that-I think a ring fence is a superior solution-but if a ring fence were put in place and proved to be unworkable because of attrition, as you call it, there would be a case for going further, but I do not start from that.

Distinguished people who have given evidence to this Commission have pointed out to you that a ring fence could be permeable. It is certainly true that there might be an awful lot of people out there who have an interest in making a ring fence permeable. Equally, if you give the regulators the powers that, as I understand it, the draft Bill foresees that they should have, and if you give the board of the ring-fenced body the duties that it is foreseen they should have, I think you have some pretty strong defences in place. Fences need keeping up; whether it is a garden fence or a ring fence, they need work.

Q362 Chair: Are you confident that we have this fence at the right height?

Martin Taylor: A lot of thought went into the Commission’s1 work. I was looking at the book this morning. There is a list of detailed stipulations on page 73 of the final report, which I draw to the Commission’s2 attention. They are, in particular, intended to prevent the investment bank-the non-ring-fenced organisation-from improperly leveraging itself on the back of the ring-fenced bank’s assets. Let us remember, too, of course, that we are not recommending a ring-fenced bank in isolation. The whole world is moving towards much tighter capital standards, thank goodness, so they will also be in place-both inside and outside the fence.

Q363 The Lord Bishop of Durham: It was not in the remit of the independent Commission-the Vickers Commission-to look at banking standards or conduct, but if it had been in your remit, do you think that it would have altered any of your conclusions, particularly around the ring fence, but also more generally?

Martin Taylor: We should have wanted at least another year if we had looked at banking standards.

Q364 The Lord Bishop of Durham: That does not encourage us.

Martin Taylor: We asked questions about culture. It was in the back of our minds, rather than at the front. We certainly did not put anything in place that we thought would worsen the prevailing standards in the industry. We were conscious of the potential benefits-I didn’t exaggerate them-that I mentioned in answer to Andrew Tyrie’s question.

Q365 The Lord Bishop of Durham: Following on from that, most of the comments about culture have been about avoiding contamination, about trying to limit damage. They have been negatives, in a sense. From your very, very wide experience- particularly at Barclays, which I remember dealing with in a previous life as a very, very good bank indeed-where would you see ways in which structure would help culture improve? What do you see as the positives? Everyone whom we have heard and most of our submissions have said that there is a very serious problem with culture.

Martin Taylor: It is a mistake to suppose that all the problems in culture come from the investment banking industry. We have got ourselves in a strange state on the regulation of retail banking products. I don’t know about you, but I get letters from various banks almost on a monthly basis enclosing the new rule book that applies to the product that I have bought. My credit card note has 64 pages of tiny, tiny print, which I do not believe anyone in the country reads. It is a complete waste of time to do it this way.

The regulators are saying that banks are evil and rapacious institutions, "so we will tie them up in as much legal red tape as we can, and then we will let them out and say, ‘Buyer, beware’." The model is that we have dangerous dogs walking around with muzzles. I would like an ecology with some family pets as well. The way that we regulate has pushed the bankers away from the natural place where retail banking ought to be, which is the duty of care to clients.

We must remember that retail banking is quite a new industry. Until the ’70s, most people in the country did not have bank accounts. They had very small amounts of money. Their financial requirements were very primitive. In the clearing banks that Alan Budd describes in his submission, the retail bankers were quite a low form of life. Anybody who was ambitious at Barclays wanted to go to the Savoy Grill and lend a billion to a property company, not sell life insurance in north Wales, although we would probably have made much more money on the latter activity than on the former. It is an adolescent industry. It was seen for a long time as a by-product of commercial banking.

Deposits were collected to lend to companies, and then it was realised that individuals themselves had gigantic borrowing capacity, which they have enthusiastically used in the last 25 years. We then began to sell to people all sorts of investment products, which are also quite new, and the sales culture has been pushed down from other industries.

We have gigantic information asymmetry in retail banking. The customer knows a fiftieth as much about the product as the person selling it to them does. When you go into Sainsbury’s and buy a chicken, you may not know as much about chickens as the Sainsbury poultry buyer, but you know nearly enough. That is not the case when you buy a complex insurance bond or something like that. What the customers need-by the way, I think that some of the banks under new leadership are at last perceiving this-is someone they can genuinely trust, rather than someone who says, "Please tick all these boxes to make sure that you’ve read the small print and that you’ve understood the risks that you are running, and here’s my commission". We have just got ourselves in the wrong place. The point I am making is that the current model of regulation reinforces the system that we have. It is much easier to diagnose this ill than to suggest a cure.

Q366 The Lord Bishop of Durham: You just took the words out of my mouth. What cure are you suggesting?

Martin Taylor: You would have to give me an extra year, remember. The best cure, of course, is competition. I rather hoped this would happen when the building societies demutualised in the 1990s. The banks were a little worried that an organisation like the Halifax could, for a while at least, genuinely present itself as a friendlier business to deal with and more on the customer’s side. Then that turned out to be propaganda as well. At some stage, one of the banks will get this right and do a huge amount of business.

I was a victim of this as well3, of the cross-selling model, which has been tried without notable success in retail banking for about 30 years. You say, "We sell our average customer 1.7 products. If we could get it up to 2.5, we would be the most profitable organisation in the world," but they don’t. The reason for this is that customers are not buying supermarket products when they make major financial purchases. When they buy a mortgage or an insurance policy, they do something that is not quite life-threatening if it goes wrong, but could be very costly for them, so they are quite careful about it. They make a lot of mistakes, still, because they do not understand what they are doing, but they are not just going to buy from the bank that holds their current account through sheer inertia. I think we have learned that lesson, but people are still playing the game.

The Lord Bishop of Durham: Thank you. That is instructive, if not terribly definitive.

Q367 Lord Lawson of Blaby: You were in the Vickers Commission, and I have congratulated you before on an extremely useful report. I am glad that the Government have taken it up. As you say, to over-simplify slightly, you looked at the question of how you prevent the taxpayer being liable, in the way he has been, if there is some major banking error in the future. You were not charged, as we are, with looking at standards and culture in banking. So my first question is: would you agree that there is a real problem of standards and culture in banking at the present time?

Martin Taylor: Yes.

Q368 Lord Lawson of Blaby: Paul Volcker, who knows a little bit about banking, gave evidence to us. I do not know if you read his evidence.

Martin Taylor: I have.

Q369 Lord Lawson of Blaby: He said that his idea of separation is a complete separation. Admittedly it is in a different place from where you made your ring fence, but let’s leave aside the question of precisely where you draw the line for a moment. He said that the reason why he wanted this was pre-eminently because of the problem of the cultural infection. Indeed, Alan Budd’s evidence, which you referred to, in a sense reinforces this particular cultural problem with different traders and those serving the customers in a retail bank. I absolutely agree that this is not the only problem, but it is a major problem. Paul Volcker said-you may have read his evidence-that he thinks that nothing short of full separation will be impermeable over time. It might be to begin with, but ways will be found around it. You, however, have just told us that full separation would be a disadvantage. Are the disadvantages of full separation so great that they outweigh the huge risks, bearing in mind the cultural dimension and behavioural element, of a ring fence being permeable over time and having holes in it? What are the huge disadvantages that you see?

Martin Taylor: I was certainly struck by one particular thing in Paul Volcker’s evidence, which was his description of the erosion of Glass–Steagall before it was eventually abolished. Perhaps later in this session we should come to some of the detailed changes that the Government have made to the Vickers proposals, particularly the question of derivatives in the ring fence. It seems to me that many proponents of a full split make two mistakes-not you, Nigel, I am sure. They start with two fundamental ideas that I think are wrong. One is that retail banking is safe and investment banking is dangerous-the utility/casino thing.

Retail banks go bust as frequently as investment banks. The recent Irish events were not an investment banking problem, nor was Northern Rock; I don’t need to labour the point. If you have a full split, you remove the possibility, which may seem comical to the Commission, but to me is a real possibility, that in a combined group where the retail business, the ring-fenced bank, got into trouble, it would be bailed out by the other side-by a megabank, so to speak. If they are sharing a brand, that is certainly what would happen.

One sees banks going to enormous lengths to protect subsidiaries or commitments they have made with their brand on. If you look at this with the object that the investment bank is the only dangerous thing, you can make a bad mistake. I don’t terribly like the idea. If we enforced a split in the UK, you would have a rather strange ecosystem with very large, very highly correlated retail banks with no earnings diversification from elsewhere, and I don’t think that is a particularly good idea.

The second error that people are prone to make is that somehow splitting is simple, and a ring fence is complicated. In fact, if you are going to split, you have to go through all the complexity that we have gone through with ring-fencing and decide exactly where the split should come. You would have just as much regulatory complexity, and of course you would also risk putting it in the wrong place. If the industry is unreformable-I hope for its redemption-it is possible that in the end a full split will be necessary, but having a ring fence in place to start with would be a jolly good place to begin.

We were also aware of the deep difficulties under European law of mandating full separation. One would have to get European banking law changed, and if one couldn’t do that, one would have to change it in one country. The constant threats to us from some banks throughout our work-I think they demeaned themselves in making those threats-was that they would leave the country if they didn’t like what we came up with. Had we mandated a fully split, one or two banks could reasonably have asked themselves whether they would want to move. We put forward a solution, and you said in opening, Mr Chairman, that the banks seem resigned to the ring fence. That suggests that we have got to a place of balance.

Q370 Lord Lawson of Blaby: I shall put to one side the question of whether the banks, if they did not like what was happening, would go away. That is something that this Commission will no doubt look at, but it is not for today’s session. Also, the question of European law that you raise is an interesting one, and we will no doubt wish to take advice on that, but it is not for this session.

I do not see why it is any more difficult to decide where a split should be than to decide where a ring fence should be. It seems to me it is exactly the same question.

Martin Taylor: It is the same question.

Q371 Lord Lawson of Blaby: It is neither easier nor more difficult; it is the same question.

Martin Taylor: But harder to correct if you get it wrong.

Q372 Lord Lawson of Blaby: As for the cultural thing, I think some of us find it difficult to conceive how there can be two diametrically opposed cultures within one and the same institution, with, incidentally, one and the same group of shareholders, but what concerns me, if I may say so, Martin, is the slight lack of historical perspective. In this country, we used to have a complete separation, not through legislation, but through custom and practice. The clearing banks, joint stock banks, were completely separate, with a separate culture, from the merchant banks as they used to be called in those days, as you well recall.

Martin Taylor: Indeed.

Q373 Lord Lawson of Blaby: It worked pretty well, and not only did it work pretty well in the sense that London was a great financial centre and British industry and British customers were well served, but, contrary to what is often implied, we never had a serious banking failure during the whole of that time. This is the first one we have had, unlike other countries. We had none during the 1930s. America and continental Europe had a whole lot. The system actually worked pretty well, so with the exception of the point that if they don’t like it, they may up sticks and go elsewhere, I do not think you have really answered my question about what the overriding disadvantages are of a full separation.

Martin Taylor: The question was not whether full separation might not be desirable for some banking groups. Indeed, that is a question that frequently crossed my mind when I was a chief executive. It is a question of whether it should be mandated by law, it seems to me. At the moment, it is open to organisations to split themselves up if they decide that the ring fence undermines the principal reason for their being together. It certainly undermines a principal reason for their being together. Should we force them to do it when we have what we believe is a completely workable solution? I do not know.

On your point about the absence of any banking failures in the past, we had a very different kind of regulation in the past, too, didn’t we? One of the things that Alan Budd discusses in his paper is the enormous power of the Bank of England over the banking system and its deep knowledge of what was going on day by day, in a system that was still largely national. This was a national system. There was international financing going on out of London, but these were British banks.

We live in a different world now, and of course a lot of the major players in the markets are not even under the local regulator’s purview. We clearly have not got this right, but I do not think that it is necessarily the case that going back to the old structures would make this problem go away, because I think there is more to it. I think there are more contributing factors than structure.

Q374 Lord Lawson of Blaby: You have put your finger on something, because it is the case that the investment banking sector is much more international than the utility banking sector, isn’t it?

Martin Taylor: Indeed.

Q375 Lord Lawson of Blaby: And you say that the national banks, as it were, are easier for the authorities and the Bank of England to supervise effectively.

Martin Taylor: Yes.

Q376 Lord Lawson of Blaby: They are also slightly less complex organisations in other ways. So if you have a full separation, you are then likely to get a much more effective form of supervision of the section of the banking industry which is most important, because of the payment system, the depositors, the small and medium-sized enterprises, and so on. In fact, your analysis would, it seems to me, reinforce the case for separation because it would ease the supervisory problem to which you correctly allude.

Martin Taylor: I believe that the ring fence will do that job well enough. The ring-fenced bank will give you the benefits of simpler supervision without going all the way to a full split. My opposition to a full split is that I believe it makes the financial ecology slightly less stable and I think it is unnecessary because the ring fence can be made to work. Let me be clear: if I did not believe that the ring fence could be made to work, I would be voting for a full split too, but I do.

Q377 Chair: To clarify, are you saying that you think a full separation would be as difficult to police as a ring fence?

Martin Taylor: No, I am saying that a ring-fenced bank will be as easy to supervise as a separated retail and commercial bank. I do not see a further benefit in supervisory simplicity and transparency.

Q378 Chair: It is very nearly the same point, you are just wording my question slightly differently.

Martin Taylor: It is just looked at in a different way.

Q379 Chair: On another point that you raised, that there might be some risk that banks might up sticks and leave under full separation-the regulatory arbitrage point-do you think we should be influenced by that?

Martin Taylor: Any legislator-

Q380 Chair: Let me put it like this: given the huge damage that has been done as a result not only of the banks’ mistakes but also the mistakes of politicians and regulators in this field, do you think that we should be taking into account some loss of business were we to go for a separation?

Martin Taylor: If we believed that only a full separation would make the system safe, presumably we would be prepared to take the consequences of that and I would see no objection to doing so. I do not believe it is necessary to go as far as that. From the point of view of the banks-and I have no sympathy with all this wittering about not liking it and going off; I think they made fools of themselves-one has to recognise that it is possible for Governments to make the competitive environment for an industry in their jurisdiction so difficult relative to other jurisdictions that a board of directors ought to ask itself whether it should move. I saw no real reason to push them that way gratuitously.

Q381 Mark Garnier: Mr Taylor, turning to the draft banking reform Bill which is coming in as a result of your recommendations, the Treasury proposes in the Bill to give itself quite a broad power to direct how the regulator sets capital requirements. Do you think it is necessary to give the Treasury quite so much power to tell the regulator what to do in this respect?

Martin Taylor: I do not pretend to be on very strong ground when discussing precisely how the governance of all this should work. I understand that this is an overarching piece of primary legislation which basically gives the Treasury and the regulators the power to do what they want as circumstances change. I think it is very desirable that there should be a good deal of flexibility in the powers that the regulators have. We expressed a lot of our views in terms of principles. What we did not say, as far as we could help, was that this particular product should not be allowed in the ring fence, because we know that the banks can immediately invent a new product that would get round it. That is the sort of game that we felt we could not play, taking a 20 or 30-year view of the industry. What we want the regulators to have in mind are principles of operation for the ring fence, which I hope the legislation will enshrine so that they can respond to changing practices in financial services. I have no doubt that several products will be invented before that comes into force that are not covered in our recommendation.

Q382 Mark Garnier: I am certainly very interested in the role of the Bill in terms of ring fence, but I am dealing with capital requirements, which are a very important part of this. There is a lot of influence from Basel, and so on. The key question here is to what extent should the regulator maintain its independence? That is quite a fundamental shift from the principle of the FSMA 2000, the whole point of which, as I understand it, is that the regulator is absolutely independent, so that they cannot succumb to political pressure. Yet here is something in this Bill which is now suggesting that the Treasury can tell the regulator where to set capital requirements. Of course you have the other confusion in this, which is the FPC. The FPC will also be in a position, under the Financial Services Bill when it is enacted, to do that kind of thing as well. Is not this the thin end of the wedge of the regulator losing their independence?

Martin Taylor: I have always concentrated rather more on the independence of the Monetary Policy Committee of the Bank of England-the interest rate setting-which is something that is well worth taking care of. I know that the Treasury Committee has spent a lot of time thinking about the governance of the Bank with its enlarged powers, and this is an important question. To whom should the regulators be answerable? Should they be answerable to the Treasury or directly to Parliament? That goes way beyond the Vickers remit, I am afraid. I believe that it is important-

Q383 Mark Garnier: I cannot tempt you to take a personal view on that?

Martin Taylor: I am not sure that I am competent to give a personal view. What is extremely important is that supervision should be dynamic and that the authorities should have the powers to respond very rapidly in an emergency. If I were a member of the Select Committee, I would be interested in making sure that any recommendations that I put forward would cover those contingencies. What does not make sense-we saw some of the bad side of this in ’07 and’08 after the Northern Rock crisis-is to have a confused regulatory framework where no one is quite sure where the responsibility begins and ends. Almost unprecedented decisions have to be taken over weekends. Somehow or other someone has to be in charge of this. I do not know quite who; that is for Parliament to decide. What you cannot do is tie the whole thing up in red tape; it just will not work and we shall have a crisis the next time that we have a difficulty.

Q384 Mark Garnier: Is it not the case that the contrary argument of that is that if you are going to try and run a big financial institution, or even a small financial institution, the one thing that you need to have some confidence about is the regulatory framework that you have on a month-by-month basis. While I completely accept that if there is a major event that requires a quick reaction-it is right to be able to have that-does the way that this Bill has been proposed not leave an awful lot of doubt as to what may happen? My final point on this is that there are avenues where the Treasury can direct the regulator on the capital requirements, and you can have secondary legislation on the Banking Reform Bill as to where the ring fence goes-again I can accept your argument on that-but given that you have so much flexibility on this does it not potentially leave the Government open to accusations that they have been manipulated by banks who are coming along and doing exactly what we discussed a bit earlier? They come along and say, "Unless you move the ring fence in our favour, we are going to up sticks and go back to Hong Kong," or something.

Martin Taylor: To take an example at random. One of the things that went wrong of course was that the regulators stopped having a view on capital requirements. They outsourced it all to the Basel rules. When I became CEO of Barclays at the end of 1993, the bank had just been through a crisis, had cut its dividend, and had taken big losses for bad debts but probably, with hindsight, not as much as it could have done. As most banks are after a recession, it was probably technically insolvent, but the accounts did not say that. The Bank of England called me on the first day that I was there and said, "We want you to hold 1.5% more capital than anyone else until you have sorted this out." I was not very pleased with the call, but it was the right sort of thing for the Bank of England to be doing. I think that what happened after the changes in 1997 is that the Bank of England-or the FSA-stopped doing that sort of thing, and everything went to the automaticity of Basel I and then Basel II, where people were free, if they wanted to, to game the system. It was very easy to hold less regulatory capital than you perhaps really needed to hold-you were following the rules, but you were not being especially sensible.

By the way, if I may say so now, one of the things that I regret very much that the Government are not taking forward from our report is the introduction of an unweighted leverage ratio of 4%, which I saw that Paul Volcker was also advising us to put in. It is very important to do that. I understand why the Government are not keen to do so. There is an international argument going on at the moment in which people are struggling to hold the Basel line at 3%, which means that the organisation can be 33 times geared. I think we are making a big mistake here.

Q385 Mark Garnier: You talk about the call from the Governor of the Bank of England about your capital, but now this Bill and the Financial Services Bill mean that you have the Bank of England, the FPC and either separately or as part of that the MPC, and now the Treasury and the regulator, all with an influence on the ratio of capital that the bank has to hold. Is that too confusing? Will there be too many tensions between those organisations about what is right and what is wrong?

Martin Taylor: I reply with great timidity because I do not know enough about it, but I would say that that they should all have an influence does not seem to me to be unreasonable. The line of final decision, however, has to be absolutely clear. In the end, someone has to decide such things.

Q386 Mr Love: May I come on to derivatives within the ring fences that you mentioned earlier? This is the one area that we have been specifically asked to advise the Chancellor on. Your Commission took a fairly sceptical view. The industry felt that with appropriate safeguards you could have simple derivative products. What is your view today?

Martin Taylor: The industry always takes the view that with appropriate safeguards things are all right. The argument has been put to me by people who have studied this more closely than I have that there are some theoretical advantages in resolution to have some simple derivatives in the ring fence, but I think that the big problem is defining what a simple derivative is. This seems to be absolutely the sort of area that will go the slippery slope way, as Paul Volcker described on Glass-Steagall. You can define your simple derivatives this year, but a coupe of years from now the banks will come and say, "Well, this product is now completely plain vanilla; it ought to be held in the ring-fenced bank," and before you know where you are you have lost it.

Q387 Mr Love: So this is the thin end of the wedge.

Martin Taylor: I think it is the thin edge of the wedge. I prefer the prohibition, although it does mean that there are certain operational infelicities. The banks have to act as agent of an investment bank either within or without their own group, but they can easily do that. The thing about a prohibition is that it is very simple, and since, like you, I am very anxious that the ring fence should be impermeable, the simpler we keep the rules, the better.

Q388 Mr Love: I noticed this morning that Barclays in their announcement of their accounts have made a further provision for interest rate swap products. That is certainly something that we have been looking at. Is it something that has influenced you? The likelihood, put to us by several witnesses, is that it is the next big mis-selling scandal.

Martin Taylor: Without wishing to identify it, I would not be surprised if there was another mis-selling scandal coming along. For me, this is not about this or next year’s scandal, but about how you keep the ring fence at the right degree of thickness and height. I just prefer a blanket prohibition. I think it has a lot to be said for it.

Q389 Mr Love: As I understand it, your Commission’s report suggested some form of agency agreement. Do you think that will stop the mis-selling? It was put to us that, in terms of interest rates, it was very much driven by the incentive structures in the investment part of the organisation.

Martin Taylor: I do not think that the ring fence would in and of itself prevent mis-selling, I’m afraid. I do not think that it is all-powerful. I am more concerned that the ring-fenced organisation should not get itself into trouble on its own balance sheet.

Q390 Mr Love: We have interviewed Mr Volcker, who wants to exclude proprietary trading, Mr Liikanen, who has a different ring fence, and, of course, there are your own proposals. They seem very similar in some ways but very different in others. Can we get the best of all three?

Martin Taylor: We obviously looked at the Volcker rule, because it was pre-existent. We-the Commission-took evidence from Paul Volcker. We did not see that it would solve the problem we were trying to solve. If you wanted belt and braces, there is nothing to stop you putting a Volcker rule on top of the ring fence. You could say, for example, "No organisation which contains a ring-fenced bank may indulge in proprietary trading within or without the ring fence." By doing that, you might make it more likely that the banks would choose to divide themselves, although strangely, the banks all say they do not do it anyway. It is one of those funny things-the invisible sin. A Volcker rule is of course a lot less radical from the banks’ point of view than a ring fence. When the banks realised that we were going in the ring-fence direction, they all came to see us and said, "Why don’t you do the Volcker rule instead", because it is much less inconvenient for them.

Q391 Mr Love: Were you influenced by the complexity of differentiating between proprietary trading and market making? Trying to define what proprietary trading is has caused a furore across the pond. Was that an influence on you?

Martin Taylor: It was not the critical influence. The critical influence, on me personally, was that I just did not think that it would do the job. I believe that there are quite serious difficulties in defining a prohibition based on intention rather than on an actual hard product. When you say this to Paul Volcker, and I am sure you did, he has some magnificently disingenuous lines, like, "If a CEO says to me he can’t tell the difference between proprietary trading and market making, he is in the wrong job." It’s a good line, but it doesn’t solve the problem.

The US experience has been different from ours. Liikanen is interesting because, of course, that came after us. It is very similar, but the fence goes in a different place. In a sense, we are trying to put a fence round the deer park and Liikanen is trying to cage the wild animals. It comes to the same thing in the end. I thought the Liikanen report very interesting and highly compatible in many ways with Vickers. The only thing that disappointed me about Liikanen was that the de minimis threshold, which I quite understand they needed, given that they were dealing with a much more complicated set of banking systems than we are in the United Kingdom, was put at far too high a level. Far too many banks escaped. It was put on the 15th floor rather than on the mezzanine. Presumably that was a political issue, as so often in Europe.

Q392 Mr Love: Yes, and I think they suggested there might be some flexibility in that.

Martin Taylor: Downwards, I hope.

Q393 Mr Love: It now goes forward to the European Commission, which will no doubt look critically on that.

Let me ask you one final question about regulatory arbitrage. If all three different authorities go ahead, broadly speaking, with their proposals-you mentioned that the banks said, "We’d rather have a Volcker"-do you think there are any opportunities for regulatory arbitrage with the three different systems?

Martin Taylor: There are always micro-possibilities for regulatory arbitrage, in that products can be booked in certain jurisdictions rather than others. I do not believe that we will have wholesale moving of banks’ head offices, which is what we were worried about two or three years ago, simply because pretty much the entire world is going in the same direction. I work in Switzerland and spend half my time there. I remember in 2009-10, all the people in the City were saying they wanted to move to Switzerland, and all the Swiss banks wanted to move to London. Each of them was ignorant about the changes taking place on the other side. The Swiss put in stiff capital standards, even stiffer than ours.

Q394 Lord Lawson of Blaby: In answer to Andy Love’s question, you said that you can see having both Vickers and Volcker.

Martin Taylor: You could put Volcker on top of Vickers, yes.

Q395 Lord Lawson of Blaby: Do you see any great disadvantage in that?

Martin Taylor: Piling Pelion upon Ossa? No, I think the question is whether it is necessary. It is odd, really. The banks’ response to us all the way through our work was as though we were going out of our way to make their lives inconvenient. We were actually going out of our way to make the system safer. Where we had a choice, we tended to take the line that would not put extra cost or inconvenience on the banks. For example, we allowed the ring-fenced bank and the non-ring-fenced bank to share treasury functions and IT functions. This saves these banks a lot of money.

On the question of Volcker on top of Vickers, I am simply making the point that they are not incompatible. My question would be, is it necessary to have Volcker on top of Vickers? We concluded that it was not necessary. Parliament may think differently.

Q396 Lord Turnbull: Can I come to the question of governance within the banking group, the plc? Banking groups are perfectly familiar with having subsidiaries, but you have a particular requirement that the ring-fenced subsidiary should have independent directors. A number of banks and Paul Volcker himself asked whether this is really plausible. Who are these independent directors, and how can it actually be made to work?

Martin Taylor: Their independence would not, of course, apply to all matters. There would be many areas in which the group board was sovereign-capital allocation, for example. If the ring-fenced bank wanted to grow very rapidly and the group as a whole did not want to grow the ring-fenced bank very rapidly, the group could simply say, "We won’t give you the capital to grow."

The point of having independent directors in the ring-fenced bank is to make it harder for it to be put under pressure to break the rules. The overriding fiduciary duty of the ring-fenced bank directors would be to maintain the integrity of the ring fence. One way of keeping the ring fence impermeable is to have respectable people who can say to the top board, if improper suggestions are made, "I’m sorry, we aren’t allowed to do that." One would hope that by putting that in place the improper suggestions would evaporate. But that does seem to be important.

On the question of dividend payments, there is nothing, provided the regulators approve, to stop dividends from being paid up from the ring-fenced bank to the rest of the business, but the question of what the dividends should be is something that the ring-fenced bank board would also have a say on.

Q397 Lord Turnbull: You say that there are many things where the group is sovereign: strategy, capital raising, risk management for the group as a whole, dividends and returns to investors. But they, presumably, also appoint these directors.

Martin Taylor: They would also appoint them?

Q398 Lord Turnbull: Yes.

Martin Taylor: The directors could be appointed by the outside shareholders.

Q399 Lord Turnbull: But the shareholders are working through the group. So it is the group that is appointing them. The group has to get approval from the shareholders. So they are not people who are appointed by someone else. It is difficult to see how these people are really independent.

Martin Taylor: The question of directors’ independence is very vexed. As a company chairman and someone who has been on public company boards for a quarter of a century, I struggle with this. The institutional investors will tell you that you stop being independent the longer you have been on a board. That is not necessarily so: some people are independent after 12 years; some people are never independent. Independence of mind is a quality that one looks for in a director and does not always find.

The important thing simply is that they should not be people who gain their living from other jobs in the main banking group. If Barclays has a subsidiary in Spain or a subsidiary in Italy, the people who are on the boards-the legal entity boards of those banks-will, give or take the odd independent chairman who is largely decorative, on the whole be people who earn their living working full-time at Barclays. This is true for all the banks. In the ring-fenced bank this should not be the case. These should be people who are outsiders and who don’t rely on the bank for any living apart from their director’s fee.

Q400 Lord Turnbull: Are there executives on this board of the ring-fenced bank?

Martin Taylor: I don’t see why there shouldn’t be. We make some suggestions as to the potential composition of the board.

Q401 Lord Turnbull: The other question is whether it is really necessary to insist on this because the regulator has a relationship directly with this ring-fenced bank to stop them doing the wrong things. But you list two major advantages there: helping and resolution; and reducing the implicit guarantee. Is this question of independent directors really necessary to achieve those two things?

Martin Taylor: It is not necessary if everybody else behaves well all the time and if the regulators are all-seeing. The problem with regulators is that they often don’t notice what is going wrong in organisations. How should they when boards of directors often don’t notice what is going wrong in organisations?

We were influenced by what had happened in ring-fenced subsidiaries in some of the utility industries when we made this proposal. We simply felt that it would be helpful to have a group of people whose job it was, in a sense, to be whistleblowers and to say, "You can’t do this."

If the non-ring-fenced bank is coming under financial pressure, there are going to be all sorts of ways in which it can try to bend the rules and leverage off the ring-fenced balance sheet. They are all forbidden by the regulator. But who is going to know that that is happening? The board of the ring-fenced bank will know that that is happening. I think they are an important precautionary measure. I am not one of those people who believe that non-executive directors are the answer to all problems, but having someone there with their reputation on the line is just going to make it harder for people to cheat.

Q402 Chair: And the very enthralling prospect of being employed as a whistleblower, as opposed to also working on the development and success of that bank? How are executives going to work in a collaborative way with this group if they think they are just whistleblowers?

Martin Taylor: I don’t think they would just be whistleblowers. You asked why they were necessary. I think it would also be very desirable that they should work towards the other development of the retail bank-that they should work on the standards and culture of the retail bank. I think if any outsiders in the system are going to help with something that this Commission is wanting to foster, in a sense they are the obvious ones.

The tension between collaborative strategy forming and policing and governance is inherent in all boards of directors, because the relationship between non-executives, as you must have noticed in your own career, and the executive members of management, is partly collaborative and partly adversarial. It has a strange tension in it. I am speaking entirely personally here, because we did not discuss this at very great length in the Commission, but I don’t see why the board of a ring-fenced bank should not be the same.

Q403 Chair: One quirk of the Government’s proposals is that the ring-fenced bank cannot own the non-ring-fenced bank, but a non-ring-fenced bank can own a ring-fenced bank.

Martin Taylor: Yes.

Q404 Chair: Don’t you think it would be better if both of them were owned directly by the group and neither could own the other? I am thinking of the Liikanen proposal.

Martin Taylor: The Liikanen proposal is certainly that they should be separate subsidiaries under the same holding company. That is clearly something which we look kindly on-recommend-but don’t mandate. I would have no difficulty in mandating it. Again, we were trying to mandate only what we found absolutely necessary, and clearly the non-ring-fenced bank couldn’t belong to the ring-fenced bank, but we have no objection to the other way about. Liikanen does. I think for European harmonisation it would be easier to go that way.

Q405 Chair: On a different subject-bailing: it was an amazing anomaly, really, that the only bondholders throughout this whole economic and financial crisis who were protected were bank holders.

Martin Taylor: Yes.

Q406 Chair: Correcting that, I think, is important. These proposals seem welcome, but they have been criticised as being things that work well when they are not really needed, and don’t work well when they really are; that people will run a mile from these kinds of instruments. Is this something that can really deliver the goods?

Martin Taylor: Bailable bonds: at the time we were working on it there was a Liliputian type of debate going on between the CoCos and the bail-in bonds. We didn’t really take sides. It is for the industry to sort out.

What I am very keen on is that the capital should be bail-in-able by the time the new system comes in; that therefore the owners of bonds should know the risk they are taking when they buy them. I think it would be very interesting to see how this works in practice. It would make it much more difficult. A bank that is getting into difficulties will find it very hard to roll over its bonds. There is no doubt about that. Bank debt tends to be rather short in duration, with an average life of about five years, so banks have big refinancing issues. One of the conveniences of setting the beginning of 2019 as the start date that we recommended was that it would enable this to be put in place and the bail-in work to be done before the bank debt rolled over. It is very important that that is done.

You can imagine that a bank that is getting into difficulty with its capital will not be able to raise bond funds on any comfortable terms and will be forced to raise new equity. Since what we really want is for them to raise new equity anyway, as much as possible, I do not personally worry about that, but it is certainly going to be interesting to see.

I think the banks will end up paying quite different coupons on their bonds. There will be much more differentiation between the price a good bank has to pay for money and the price a weaker bank has to pay for money than there was in the pre-crash days, when all bonds were treated-correctly, as it turned out-as being semi-Government guaranteed, or indeed, wholly Government guaranteed, when push came to shove.

Q407 Chair: On the bail-in bonds, it is quite likely that a firm is going to face a cliff edge, where everyone will make a rush for the door at once. It will not be a linear decline in the value of these bonds and the need for an increase in yield. Therefore, one wonders how effective as a tool they will be.

Martin Taylor: The bank will not have its bonds maturing simultaneously. Maturity management is a crucial skill of a bank’s treasury, so they will be rolling off regularly. You will get early warning of this. The first six-month slice that you find difficult to repay will cause the bank to reduce its dividend, take the cost down, or something like that-fire the CEO, or whatever they usually do. I do not think it will be exactly a cliff, because you will not have all the bonds maturing simultaneously.

Q408 Chair: On boards and non-executives, I think you would agree that the non-executives of the key institutions all failed spectacularly, even though they were very high-quality people.

You seem to be asking rather a lot of these non-executives you are now proposing for the ring-fenced bank. Why should they do any better than the collective dead-loss of a group that we had in charge of the existing banks that got into trouble? If you think there is a risk that they don’t do any better, should they be given some additional statutory or regulatory duty that may make them somewhat more independent?

Martin Taylor: They should be given a statutory duty. The maintenance of the integrity of the ring fence should be a statutory duty for those directors, precisely to stiffen their sinews. Compared with the directors of the larger banking groups, they have a much more simple job-very much more simple. It is a job that cannot quite be reduced to box-ticking, but it is something about which you can clearly say, "I am going to do this properly", and be sure that you can do it properly.

On the boards of banks, I have seen bank boards get more professional in the sense that more people on the bank boards have industry experience, and seven or eight years ago, it was felt that that would make them more effective. It hasn’t done, or it didn’t do. I think it is very difficult to sit on the board of one of these banks as an outsider. You know so little.

Q409 Chair: You are talking about the existing banks.

Martin Taylor: I am talking about the big banks, the big boards, the top boards. You know so little compared with the executives. You can suspect and you can sniff, but identifying what is going on in these enormous machines is very tricky.

Q410 Chair: If you have proposals on how we can encourage them to sniff more-

We have just talked about a stick-some kind of statutory duty-but maybe there are carrots as well. Maybe you could consider it and come back to us, given your experience.

Martin Taylor: I will think about that.

Q411 Baroness Kramer: I was going to say get some stroppy women on boards. That might do the trick.

Martin Taylor: That is not at all a foolish idea.

Q412 Baroness Kramer: If I could go back, Mr Taylor, you were very interesting when you talked about competition. You suggested-I’m trying to put words in your mouth-a mechanism that could get us to the point where the retail bank offered that customer-centred service that everybody wants to see. Is that a competition that you feel can be delivered through the current range of banking institutions? Or is there a need to get much more diversity into the sector, whether it is mutuals, community banks, peer-to-peer, small banks or business-based banks? Is there a requirement that we get much more diversity into the field, if we are to achieve the kind of competition that you envisage?

Martin Taylor: That was very much on our minds when we worked on the competition section of the book, as you can imagine. Certainly, encouraging diversity of provision is almost always a good thing. We were faced with the hard facts that diversity had been declining in the sector for a very long time, if you look at the decline in the building society movement, the decline of mutual businesses in general and the decline in the number of institutions, because the big building societies that had turned into banks in the 1990s almost all failed. Clearly, the environment into which we were trying to introduce diversity or coax diversity to come about was a very tricky one. It is not easy to suppose it is going to be an easy wand to wave.

I am encouraged by the outcome of the Lloyds branch sale. It does not really give that much more diversity, but it does give another medium-sized player in the market. There are some small people out there trying new and interesting things, and all power to their elbow. My personal suspicion is that the most promising place for a very big change is that one of the large institutions begins to get it right because that would have a very substantial effect on the market.

We all wondered for a while. When I was at Barclays, the internet banking boom was beginning and it was possible to believe that the internet would change the dynamics of branch banking in a way that would introduce lots of new competition into the industry. A lot of new entrants came in-retailers came in, foreign banks came in-but most of them have gone. Anything you can do to stimulate a standards-based competitor would be admirable.

Q413 Baroness Kramer: What do you think the role of the regulator might be, or is there a role for the regulator? I think the bishop talked in one of our previous meetings about regulatory comfort. The regulator in a sense has every incentive just to fall back on mirroring what is already in the market-hopefully, the better end of that-when they set up the framework and look at possible new entrants. Are we in a circumstance of regulatory comfort? Is there a role the regulator could take to try to open up the market to much greater diversity?

Martin Taylor: We try to encourage that by getting a pro-competitive charge into the remit of the FCA, and I think if that is taken seriously it could make a big difference. At the moment, the only way that uncompetitive behaviour is addressed in the banking market is by a full-scale inquiry by the Competition Commission, which is a terrifying thing that takes a very long time and does not always come up with a constructive result. One would like to see the industry re-inventing itself a bit.

I was writing a piece for a newspaper yesterday, and I think there are signs-I do not know whether this is an unfashionable or pre-fashionable thing to say-that the deep changes that the crash and the regulatory response to it will cause in the investment banking market will produce a rather more interesting and diverse industry than we have had in the past. I would like to believe that that will happen in retail banking, too. It is obviously going to happen more easily against a friendlier economic background where people are more willing to take risks and try things out.

Q414 Baroness Kramer: On a different tack, I was very fascinated by comments that you made in one of your statements, which I will probably paraphrase wrongly. You talked about bankers in a traditional retail setting working for their institution and investment bankers working in their institution-in a sense, therefore, ready to be mobile at any time.

The "for" sounds very desirable, but is that not a two-way situation? In other words, the sort of loyalty and commitment to the long-term life of the institution has to come from an institution’s commitment to its employees as well, and I think we could probably all agree that that has largely gone out of the window in many institutions over recent decades. Is it ever possible to recapture that, or are we trying to deal with a sort of nostalgia and we will have to go a very different way about looking at standards?

Martin Taylor: I must disclaim responsibility for the idea about bankers working for or at an institution, because it was Alan Budd’s phrase, although I completely agree with him and it was extremely felicitous. That was the case at the time at which he was talking. I am so out of touch with what is actually happening in retail banks now and what it feels like to be in a retail bank that I cannot tell you how things are.

As far as nostalgia is concerned, there were an awful lot of people in the retail banking industry-I am not just talking about the institution I worked at-who worked for the institution but were not terribly happy doing so. They did not much like their jobs, they were plodding towards a pension and they were rather afraid of the world outside. They had convinced themselves that the only thing to do was to go straight into a bank and stay there. A lot of people who chose to work in the banking industry in the ’70s and ’80s had a very high desire for personal security. There was a personality type. I remember a psychologist coming from London university who had done some work at Barclays, and she said to me, "I cannot understand it. You have a brilliant HR department because you manage to win over the population and you get this personality type, which presumably is what you want in the organisation." I remember saying to her, "No, that’s quite wrong. They choose us."

The great problem we had in the 1990s is that we were taking people who had come in to be administrators. The work in banking was clerical in the old-fashioned sense; in the 1970s, people were still entering things in ledgers. You may remember that bank branches opened for about four hours a day and the entry of the customers was an inconvenience to the staff, because it stopped them doing their work. People are not nostalgic for that. The employees had an awful lot of trouble, because we asked them to become customer-facing. We asked them to start to sell things or just to interact with the customers, and many of them did not like it. I remember a woman-she spoke for many-once saying to me on a branch visit, "I have to do all this stuff with customers now. I joined the bank to get away from all that." That is one sample of the anecdotes, but that is really what it was like, so turning that into a selling organisation, much of whose work is electronic nowadays, is a gigantic transformation in the culture of the enterprise. Please do not imagine that the retail banking cultures and behaviours of the 1970s are intact today. They just cannot be. They cannot be.

Q415 Baroness Kramer: If, basically, a performance-driven staff is going to be necessary in retail banking today, do you think there will be any significant impact from the proposals that we have had from the British Bankers Association and others that we need a sort of independent professional board, equivalent to the BMA, where people join a professional association and can be struck off if they behave badly? Is that a red herring or is it something that you can see playing a significant role?

Martin Taylor: I-

Chair: Tell us what you think, Martin.

Martin Taylor: I was going to say that I was very touched when I went to Barclays to be made an honorary member of the Institute of Bankers, because the institute was horrified by the idea that the CEO of Barclays should not be a member of their guild. I did not even have to pass the exam.

Q416 Chair: They have a code of conduct, which I have read.

Martin Taylor: They do have a code of conduct. Simply introducing a code of conduct and making everybody sign it would be the wrong way round. Doing that would be to start at the end. If the industry or a single institution decided what professional standards really ought to be and worked with its staff to get towards that, at the end you can have a proper professional body, but you do not make a medical profession by calling all the quacks "doctors", if you see what I mean. You have to go through the proper process.

I do think there is some merit in these ideas, because clearly the industry has lost what trust it had among a very large proportion of its customers. Thoughtful people in the banking industry are desperately worried about this. It cannot be done, however, by propaganda and PR. It must be deeply grounded and deeply grounded in behaviours. You cannot tell people to operate to professional standards on Monday and then, on Tuesday, give them the kind of sales target that requires them not to operate to such standards.

Q417 Chair: Is a code of conduct such as the one for the institute that you have just joined-albeit in an honorary capacity-a piece of propaganda and PR?

Martin Taylor: No. Most people in the British banking sector 30 or 40 years ago joined the bank straight from school, usually with no qualifications beyond O-level, although some had a bit more than that, and they needed to learn the business of banking and sat examinations and qualified themselves.

Q418 Chair: Susan’s question is not whether we are going to solve it with this single shot. She is asking whether it will make a contribution or whether it is not worth bothering with until we have sorted everything else out, which seems to be the implication of your penultimate reply.

Martin Taylor: It is not worth bothering with if it is done as a PR exercise. We have seen bankers addressing such issues. We heard Bob Diamond talking about citizenship a year ago, and he was right that citizenship is what the banks should be aiming to do. The problem was that people did not believe it. It has to be credible.

Chair: He did not believe it anyway.

Q419 John Thurso: I want to ask you about remuneration, but first, could I quickly ask you a follow-up question to the points that Andy Love and Lord Lawson were putting to you about Volcker-Liikanen-Vickers? Is it not the case that at one end in the retail bank we have deposit-taking, which we wish to see properly protected, and at the other end we have trading, be it proprietary or market-making, which we do not wish to contaminate the other end? Therefore, would not the simple rule be: if you take deposits you cannot trade and if you trade you cannot take deposits? But actually, the line could be anywhere between the two, provided one or the other is excluded.

Martin Taylor: That is pretty close to what our ring-fence rules say. When we started off trying to make rules for the ring fence, the natural instinct of the civil servants and the secretariat was to have two lists-things in and things out-and sort of micro-manage it. We ended up saying, "This goes here; that goes there; everything else can go anywhere.".

Q420 John Thurso: If one wanted to reduce it to a fundamental, easily-put-forward principle, "You can have deposits or you can have trading but you can’t have both" would be a pretty good place to start.

Martin Taylor: It is a very good way of explaining it.

Q421 John Thurso: Thank you. Now, can I go on to the question of pay? You wrote your fascinating article in the FT on 8 May, in which you make it pretty clear that you believe that shareholder interests have been poorly served by the compensation culture within the banks.

Martin Taylor: That is an understatement, I would say.

Q422 John Thurso: Yes, I was trying to be generous. You wrote:

"Pay levels are in absolute terms too high…Shareholders seem at last to realise that the banks can indeed not make profits under the new rules if they persist in paying the sort of remuneration that was already way too high under the old, lax rules.".

So my question is: Is there a role for variable pay within banks, and if there is, who should get it?

Martin Taylor: I think there is a place for variable pay. Going back to the old City, which Lord Lawson invoked earlier, the point of variable pay in places like broking and jobbing firms was that in some years you would make no money at all, and in some you would make an awful lot, depending on financial circumstances. If the partnership had a high fixed-cost base, it would go out of business in the first bad year. I think it is true to say that in 1994, which is not that long ago, the Goldman Sachs partners around the world took home no money at all in a year when the firm was under an enormous amount of pressure. There is some concern in the industry-which I think is well justified-that some of the rules that are coming out to try to tame the bonus culture are going to lead to a large increase in base salaries. But I do not think the problem is fixed and variable; I think the problem is that people just got out of control. It got completely out of control and the whole system went haywire. The question people never asked about in relation to bonuses-which is, in a sense, a child’s question-is: where is all this money coming from? They talked about whether it was immoral or not, which is indeed an interesting question. But a more interesting question is, was the money really there in the first place? It was certainly there when it got into the hands of the employees, but we had a machinery for turning funny money into real money in the banking system.

John Thurso: That is an incredibly important point, and I know that one of my colleagues would particularly like to ask you a question about that, so I am going to stop you there.

Martin Taylor: Right.

Q423 John Thurso: I am particularly interested in two things, the first of which is that we should accept the read-across from the old partnership model. For people who are working in transactional areas or trading, the most appropriate form of compensation, provided that the rules and quantum are right, may well be relatively low base and payment on results, providing that the results relate to a reality of money. Do you agree that for the transactional-based operative-the trader or whatever-that is a reasonable way for them to be remunerated?

Martin Taylor: Yes.

Q424 John Thurso: Is the opposite true for executives at board level and in management? In other words, if the traders have been rewarded by variable pay, the only way in which you can control, monitor and guard that is for management, chief executives and financial officers, to be paid to do a job and have either very little or no variable pay.

Martin Taylor: I had not thought of it quite that way, but I certainly see no reason why senior executives at banks should be paid in a violently different way from senior executives at other large businesses where there used to be quite a large degree of bonus compensation-variable pay-but nothing like what was seen in the financial services industry. I am talking not in terms of absolute quantum, but in terms of the relation of variable to fixed. For quite a lot of senior executives today it would be 2:1 or 3:1; in the banking world it could be 10:1 or even 20:1.

We must remember that there has been a feedback loop. Pay in large industrial companies, from which many people have benefited, including myself, has been influenced about what has been happening in the financial services industry. People have said, "Why are these people being paid so much, and we are being paid so relatively little?" Although they are not being paid as much as people in the financial services industry, they have been paid a lot more than they used to be. The remuneration problem is a problem not just for the banking industry, but for business in general.

Q425 John Thurso: Absolutely. Indeed, if you go down to the FTSE 350 as opposed to the FTSE 100, you get a completely different set of answers. The likelihood is that you will be looking at half a million for a CEO as a base salary with a maximum of 40% or 50% of variable pay earnable and not always paid, whereas if you go up to the FTSE 100, you are looking at multiples of base pay as a potential to be earned.

Martin Taylor: That was exactly the compensation of the chief executive of Barclays in 1994.

Q426 John Thurso: The point behind this is to look at culture. A large body of evidence that we have, from Kay right through to Volcker, is about two distinct cultures. One is paid on transactions and getting the result today-high five and out in the evening; the other is about much more stewardship, joint stock, nursing a business and so on. Both cultures have their place, but either culture in the wrong place leads to a poor result. I am driving at whether we should be looking much harder at compensation to reinforce the right culture in the right place.

Martin Taylor: I am not saying this just to split hairs: I think that there are far more than two cultures. In the pure investment banks, there was always-there is still-a huge cultural divide between the traders and the advisory people. The people advising clients are completely different from the traders. There is usually profound mutual contempt between the two parties.

In the retail bank, too, there is a big difference between administrative payments, IT people and the sales teams. But as for the broad conclusion that compensation is a powerful driver of culture or reinforcer of culture, if you get the compensation system wrong-and, boy, have we got it wrong in this industry-you drive the car right off the road.

Q427 John Thurso: You were talking earlier about the difficulties that non-execs have on the board.

Martin Taylor: In banking in particular.

Q428 John Thurso: Yes, I think it’s true in any largish company, but particularly in banking. The default model of most boards is to be collegiate. The job of the chairman is to bring everybody together and if there is a little bit of pressure outside, "We think the CEO is doing quite a good job; we can back him on this one"-all that sort of stuff. Particularly in financial institutions, is it important to stop that and create a structure which has a much more challenging and-if you like-opposition role for somebody, whether it is as chair of risk or whatever? So actually there is a much greater test, and being collegiate is probably a very bad sign for a bank board, rather than a good sign.

Martin Taylor: As a company chairman rather than a banker, I think that it is an extremely important subject in governance. It is almost the most important subject and it is not properly discussed because you have to be actually on a board to see it and feel it.

The culture you want on a board is a bracing culture, but the problem is that the default culture of collegiality-which you correctly referred to-comes from our social habits. Man is a social animal. You have dinner with people the night before and one of them says, "Do you want to borrow my house in Tuscany and the rest of it?" It doesn’t happen to me, but you know what it mean. Then the next day at the board meeting, do you say to them, "Look, I have three questions for you and I’m not going to stop until you’ve answered all three of them properly"? People don’t do that.

It varies from culture to culture. I’ve been and worked in a number of countries and the British, or at least the English, culture of embarrassment in going a bit too far is very much present. I know this doesn’t apply in the Houses of Parliament, but you can ask one awkward question, maybe one and a half, then you’re going to stop and everyone looks at you and thinks, "He’s gone far enough for today". This can be a complete disaster.

Q429 John Thurso: Was that at the heart of the board failures in the banking crisis-RBS, HBOS and all the rest of them?

Martin Taylor: I suspect that it must have played a role. Three directors of RBS pre-crash have said to me individually that they had thought of resigning and wish they had done, but decided that it would have made no difference. Do you know? If all three of them had resigned, it would have made a colossal difference.

Q430 Chair: Given what you said about the statutory duties for non-executives in ring-fenced banks and what we discussed earlier about the need for holding companies, are we on the road to two-tier boards? You have some continental experience.

Martin Taylor: We’ve got two-tier boards in the UK. We always have had. The board of directors doesn’t run the company. Even if you have executive directors on the board, the company is run by an executive committee. All companies are. We have effectively a two-tier board system, but it just isn’t enshrined in law.

Q431 Chair: So your answer to Andrew Turnbull’s point that these non-execs aren’t engaging in the business is that they never did?

Martin Taylor: They don’t run the business. It would be a strange company where the non-execs ran the business because they wouldn’t be non-executive.

Q432 Lord Turnbull: There is a massive deleveraging going on-

Martin Taylor: Yes.

Q433 Lord Turnbull: That will reduce bank profits. A billion pounds of bank capital will support much less earning activity than it used to. The bonus pots ought to be coming down. How far is that movement going to take us to where we want to be, or do we have to reinforce that in some way?

Martin Taylor: I think that the bank profitability conundrum is easy to solve: across the industry, you just take the pay down. Take the pay back to where it was 10 or 12 years ago and you have solved it. The only difficulty in all this is that individual institutions are terrified of being the first to do it. Although we saw UBS yesterday.

Q434 Chair: They are all subject to the same deleveraging and all frightened that these surplus profits that they are able to make by leveraging out are disappearing. Does that not help in getting them to work in concert?

Martin Taylor: I think that things are falling back to earth, but not at the same speed, oddly enough. Some things come down before others, but the shoes are dropping.

Q435 Chair: Some of it is the rates people are paid at and the number of people who are entitled to draw on the pool. For UBS yesterday it was 10,000 people. The number of people also drops.

Martin Taylor: Yes-10,000 people is a colossal issue by UBS, colossal.

Q436 Mr Love: On a completely different subject, public service obligation was something you raised some time ago. It did not appear anywhere in the Commission report. Do you still support the idea of a public service obligation for the larger banks and what shape would it take?

Martin Taylor: It is an interesting idea and it is certainly debatable. The banks would all say that in some cases they were performing public service obligations-they do a lot of things at the margin of their business that are not, strictly speaking, commercially sensible.

I am open minded about how formalised it ought to be, but it is certainly there for all of them. They are huge players in the economy and big citizens. Oddly enough, I think that they all want to get this right. The bankers have moved on a lot in the past two years. There has been a big advance. They have gone from saying that they are misunderstood, that everyone got this wrong and that it was not their fault to actually recognising the role that the financial industry played in this disaster. The more thoughtful people are really thinking about this and wondering how they can get it right. So in a sense we are pushing on an open door.

Q437 Mr Love: Let me pose something to you. A bank account is a gateway to all sorts of financial services. The way the state is moving, people have to have a bank account or something equivalent. Is there a role there for the banks? We keep hearing reports that some banks are more reluctant to open bank accounts for the very reasons you gave-they are a loss leader. Is there a role for a public service obligation there?

Martin Taylor: There may be-it is like the Royal Mail delivering letters to the Hebrides for the same price as in London. The huge expansion of bank accounts took place in the 1970s.

I cannot remember when the Truck Acts were repealed and an employee could no longer demand to be paid in cash. There was a deal there between Government and the financial services industry-you bank the unbanked and you will get a hell of a lot more business. The number of accounts that the big banks were handling multiplied by three or four; it was an enormous expansion in banking. Of course, the business model changed with it. That was when the high-touch relationship banking which people are nostalgic for went out of the window, very largely. I think there is room for all that; all these things should be on the table.

Q438 Mr McFadden: Reflecting on the culture change, I think there is an important lesson for the banks. I draw the political parallel. "Clause 4 moments", as we call them in politics, have to be genuine and come from within and they often have to involve some pain for the organisation involved. If they are PR exercises, or superficial change in order to get on with business as usual, that will quickly be found out. That has been a problem for some of the claims the banks have made since the beginning of the crisis.

Martin Taylor: I agree with that.

Q439 Mr McFadden: I want to ask about one or two other things. Going back to the question that John Thurso asked you about pay, do you believe that we have been asking the wrong question about pay? We have been framing this in terms of fairness and people’s understandable and legitimate anger about the size of bonuses and so on, rather than coming at it from the other end of the telescope, which you began talking about-the relationship between pay and the economic health of these organisations. I will just quote an article that you wrote a couple of years ago about this, in which you said:

"What were the sources of this imaginary wealth? First, spreads on credit that took no account of default probabilities…Second, unrealised mark-to-market profits on the trading book…Third, profits conjured up by taking the net present value of streams of income stretching into the future".

And then you talked about:

"This non-existent wealth"

that was being paid out

"in cash to their employees…Because they had no measure of cash flow to tell them they were idiots".

You then talked about

"accounts that have become misleading to the point of treachery."

Can we deal with the problem of pay without dealing with this problem of how the current accounting system creates fictional money?

Martin Taylor: The problem that I was really referring to in that article, which was written quite a long time ago now, was that bankers do not think about cash in the same way as other businesses. Businesses know that even if they are unprofitable for a while, they are okay as long as they can get some cash in, but if they run out of cash they are bust. Bankers live in a huge pool of liquidity and can always get money from other banks.

So, effectively what was happening was that if you wanted to pay out a very large bonus pool for whatever reason, the bankers may have asked themselves what their shareholders would think about it and whether it would look good in the accounts. They might even have thought, for a nanosecond, about the fairness issue-probably not for long. But they didn’t ask about where they get the money, because they can get it in the market. And you just go out there and there it is. It is flowing around and we will give some to you, some to you and some to you.

Now, this is going to be harder. If the bankers were fooled by their own accounts, and I think that to some extent they were-one of the things that particularly got my goat was this thing on very, very long-term derivatives.

One reason for the explosion of the derivative business was that it was so profitable for bankers to sell derivatives, but if you have sold a derivative to a client-a pension fund, for example-and it lasted, say, for 20 years or even 50 years, the client would be paying a small fee every year to service that derivative. What the bankers do is to roll up those 50 years of fees unpaid into the first year and they take half of it, and then the derivative goes into a drawer. This is where part of the fictional money came from.

Q440 Mr McFadden: I want to pursue this. For a Commission such as ours, which is concerned with culture and standards, what I am really asking is this-should it be an important concern of ours that if we want to change culture, we ought to look at the accounting standards or think about exactly what you just described? I say that because, for example, we took evidence in part of the Commission on these interest rate swaps that are being sold to businesses. Precisely the same phenomenon was taking place there-future profits are all booked on day one for a product that may have a very long time scale. And that creates this capacity to pay yourself huge bonuses out of money that may never come about to the organisation. In fairness, can you really change pay just by thinking about it, or do you have to take on this other end of the telescope, too?

Martin Taylor: The accounting profession now requires all sorts of things to be present valued and put in the books as a charge or as a profit on day one. If the stream of income is held to be certain, and the stream of income on a derivatives transaction over a long time with a solvent pension fund is held to be certain-the bank will get the money in and all the people who have been paid today will be dead by the time the last instalment comes-there is hope for some accounting standards to change.

One of the most ludicrous standards that came from the US has recently been changed. It was one of the things that threw the banks’ accounts during the crisis-it threw up huge profits. I am just trying to think of a way of explaining it simply; it is so crazy. The idea was that if a good bank has a large exposure to a bad bank, bad bank’s credit rating is cut, so bad bank now becomes worse bank. Good bank takes the loss on its exposure to bad bank-now worse bank-to show that there has been some deterioration in the credit. There is more risk of not getting repaid, which is perfectly fair.

The American accountant said, "Yes, but this is unbalanced because we have only one entry here", so if there is a loss for good bank there must be a profit for worse bank because otherwise the books do not balance. So banks that were having their debt downgraded were showing accounting profits-of course, there was no cash involved. I wonder whether the boards understood that.

It was completely insane. The truth of the matter is that if you have a world where there are just two agents and one is creditworthy and the other one is not, and the less creditworthy one gets even less creditworthy, there has been a real loss of value in the system. It is not a transfer of wealth from one to the other. I do not know how that ever came about, but it was put in place in about 2004 and has just been removed. It is a piece of insanity. So there is hope. They do sometimes see sense.

Q441 Mr McFadden: The point that I am driving at is that we must not allow the complexity of accounting to disguise what in the end is a very simple point-unless the money is real, all that you have is a licence for people to loot the company rather than operate on the basis on which a non-financial company would operate, such as the black country engineering companies that I represent. You might get a bonus if you are doing really well that year, but if you are not, you should not, and each business has to live according to its means.

Martin Taylor: I completely agree. One of the difficulties is that the board of directors of the bank may not have understood that the money was not really there.

Q442 Mr McFadden: That is a pretty fundamental point.

Martin Taylor: It is a pretty fundamental point, and it is shaming to have to say it in Portcullis House.

Q443 Mr McFadden: I want to explore that, because this issue about pay is about not just fairness but the economic health of the companies. I just want to ask you something else that goes back to the Vickers report and to get your reflections on the version of Vickers which is now going to be legislated for-as far as we know the details; there is some detail that we do not know.

Andy Love earlier asked you about the supposedly simple derivatives. Lord Turnbull asked you about bail-in debt, which was an important recommendation of yours as well as of Liikanen’s. The third area is the amount of capital that banks are supposed to hold. The Vickers report suggested a higher ratio than the Basel III standards, but the Government have said that they will not pursue that and will go with the Basel III standards rather than the level of capital recommended in your report.

Thinking about these things, is it your view, as someone who served on the Commission, that these departures are small and unimportant, or that your report is being watered down in a material way that should concern Parliament? Are there other areas that perhaps I have not mentioned that you are worried about in that regard?

Martin Taylor: Thank you for asking that question; it is a very important one and I am happy to answer. Bail-in debt is crucially important. I don’t believe that is absent from the Bill because the Government are not interested in it. It is because it is being handled at European level at the moment.

I would certainly recommend to Parliament that, if for any reason the European supervisors lose their nerve on bail-in debt, Britain itself does something. There ought to be an international standard there. A common international standard is also very desirable. If we can do that through the European work, that would be the best answer for that.

With regard to capital, we said 17% to 20%, and I think it has come out at 17%. As long as the regulator has the right, under these ferocious powers that Mark Garnier talked about earlier in the Treasury, to vary this number up if they believe the bank is doing something especially risky, I think that’s fine. I was a little worried that our 17% to 20% was being taken in the wrong way by the industry, because when we put out 17% to 20%, a lot of people in the banking industry said, "Well, 17% to 20% means 20%. We had better have two on top of that to be safe, so that means 22%." In fact, it didn’t mean 22%; it meant 17% for a sensible bank.

There is an issue of counter-cyclicality, not making the banks go completely crazy, to push the capital ratio right up at a time like the present. I am not worried about that provided the regulator is sensible about it. I do think, as I said earlier, that removing the 4% gross leverage number that we prescribed for the ring-fenced bank is simply a mistake. If any friendly Member of Parliament wanted to raise that again, certainly in the light of what has happened since and eloquent comments by Paul Volcker last week, that would be very good.

Derivatives and the fence, we have covered. The only other thing that strikes me as a potential problem is what I think of as the HSBC work-around on loss-absorbing capital. How much has to be available for the UK taxpayer, given the structure of the HSBC group in particular? I know they objected forcefully to having to keep a lot more capital here when they had a lot of capital in other places in the world. The work-around that the Commission agreed with the Treasury was that that would be fine provided they could demonstrate that capital outside the UK would be available to the UK taxpayer in an emergency here. We wait to see whether that is done properly. I would hold feet to the fire on that one, if I were in Parliament.

Mr McFadden: Thank you. That is a very helpful list for us to keep an eye on.

Q444 Chair: May I clarify? Did you say that the work-around, as you put it, on HSBC was negotiated directly between the Commission and the Treasury, with the Treasury acting on behalf of HSBC?

Martin Taylor: No. The Treasury, with exemplary courtesy and friendliness-instead of just taking our paper and saying, "Thank you very much-goodbye"-has kept us in touch with the consultation work it has been doing and asked us for our views on things. I take that very kindly. They did raise the subject with us as a Commission. If John Vickers were here, he would say they couldn’t do that because the Commission no longer exists.

Q445 Chair: I am grateful for that reassurance. You don’t concern yourself unduly about the complexity for the regulator of trying to keep an eye on a subsidiary of HSBC abroad, which is what we are talking about here.

Martin Taylor: My concern is that HSBC, like Barclays and RBS, has been running its global investment bank off its UK retail bank balance sheet. Personally-here I go way beyond the remit of the Commission or the place of the commissioner-I think that is just bad practice. It is almost a health and safety issue, and the ring fence will handle it to a large degree.

Then the question came up of how much capital should be available for this UK-registered global investment bank in an emergency. HSBC is an admirable bank and they have got a point, because their business is extremely international. One reason why they did well relatively well in the crisis is that they were well managed. Another reason why they did well is that a lot of their business was in Asia. If there were a crisis in Asia, things would be different.

Chair: That is very helpful.

Q446 Lord Lawson of Blaby: In answer to a question from Pat McFadden earlier, you said that there is some hope for improvement in accounting standards. You gave as an example a particular bêtise that is being stopped. Do you think there need to be further changes in accounting standards, and, if so, what?

Martin Taylor: I think the most important thing is that users of accounts should understand what the accounts mean. The accounting standards seem to me to have gone to a particular kind of intellectual purity that, personally, I disagree with because I think it is based on a fallacy. That certainly has made it more difficult for boards of directors to know how much money is there now. Either the accounting standards need to change or the boards of directors need to be educated. The second is probably easier.

Q447 Lord Lawson of Blaby: The first is probably more important.

Martin Taylor: Perhaps.

Chair: We may want further advice and help in that area, which we may move to outside this meeting.

Q448 Baroness Kramer: This follows up on that point. Once I had got over the shock of any suggestion that a banker who has gone through any training at all cannot tell the difference between cash and accrual-it has to be wilful blindness-I wondered where the auditors were in all this.

It seems to me that the auditors surely must have had responsibility for bringing this to the attention of the board of directors, and making it clear how exactly they were structuring their pay and on what degree of rock or sand. Is there a real question here about the role that auditors played, and do we need to act on it?

Martin Taylor: I do not believe that the bankers did not understand the difference between cash and accrual. I do believe that they thought that the availability of cash for their business would not become a problem, so paying out accrual earnings, although to you and me a disgraceful practice, was something they thought would not put the business in danger. I know that banks’ audit committees are even more serious bodies than they used to be. They meet more frequently, and they have more papers than they ever had. The difficulty, of course, is to see the big picture.

Chair: Your evidence has been extremely lucid and very valuable to the Commission, and we are very grateful to you for coming in this morning.

Martin Taylor: Thank you, Chairman. It has been a pleasure.

[1] Note by witness: Independent Commission on Banking

[2] Note by witness: Parliamentary Commission on Banking Standards

[3] Witness correction: meant to say “I was an intellectual victim of this idea” instead of “I was a victim as well”

Prepared 9th November 2012