Banking Standards

Submission from Hermes Equity Ownership Services (S018)

1. To what extent are professional standards in UK banking absent or defective? How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets?

We are not aware of significant and actively pursued professional standards in banking, whether in the UK or globally. It appears to us that currently banking is not a profession in the sense that it does not seek to assert and impose formal professional standards and related training, and nor does it seek to exclude from its ranks those individuals who have failed to live up to the expectations of others in the trade. These are to us the minimum requirements of a profession (they are features of, for example, the legal, medical and accounting professions). We thus do not believe that at present banking should be dignified with the name ‘profession’.

We are aware of debate over recent years about the possibility of introducing a Hippocratic Oath for the financial sector (not just banking). While recognising that the standards for the medical profession clearly go significantly beyond this one expectation, we did understand the desire for a ‘first do no harm’ standard for finance. Our view was, however, that this was not the right framing of the basic standard for the finance industry: instead, we proposed that the equivalent for finance ought to be ‘first – or always – serve your client’. It is the failure to focus on client interests and the failure to deliver on genuine client needs which go to the core of the failure in recent years of the banking sector, and of the finance sector more generally.

The corporate culture of every financial services firm must above all be to serve the interests of its clients. By delivering value to clients, the firm will prosper for the long run. It is also the nature of much of the financial services industry that it acts in a fiduciary capacity, stewarding assets on behalf of their beneficial owners.

It concerns us the extent to which much of the financial services industry fails to consider fully the implications of the fiduciary duties which apply to it – too few firms state that they put clients’ interests first, and fewer still have the culture, structures and practices in place to deliver on such assertions. We believe that there would be considerable value in reassessing and perhaps reasserting the understanding of fiduciary duty such that it is more fully at the forefront of the minds of every individual within banking and the financial services industry more generally.

2. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole?

It is clear that the failure to focus first and closely on client needs and client interests have damaged the interests of those clients, both retail and wholesale. The impact on the economy as a whole is a damning indictment of the finance industry’s failings.

3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector?

Given the repeated mis-selling of products and services and the introduction of additional frictional costs of business, it is unsurprising that public trust in banking, and the financial sector as a whole, is at its lowest ebb. The public seem to expect next to nothing from the banking sector – indeed most seem to expect the sector to abuse its position – and it is hard to be confident that this is a mistaken position given recent experience.

4. What caused any problems in banking standards identified in question 1?

Culture and compensation ratios

The professional standards for the banking sector, such as they were, were never akin to those developed, imposed and enforced by the genuine professions. The question is therefore why has the culture of the finance industry shifted from the tradition of "my word is my bond" and a genuine focus on the needs of clients to the current situation where neither consideration seems significantly high on individuals’ agendas. This is clearly a cultural failure. It is a cultural failure that arises from a number of areas, among them: individual greed, a misalignment of remuneration and incentives, a failure to apply appropriate capital charges to risky activities, and a desire to generate greater returns on capital to compensate for too much of the revenue earned by banks being swallowed by their staff.

One of the most significant drivers of the shift in culture occurred when investment banks changed from being partnerships to being limited companies. This removed the risk to partners’ capital from any failure and so dramatically increased the risk appetite as well as created a more sanguine approach to leverage because its risks are faced by the shareholders rather than the executives. Ironically, this shift was not accompanied by a change which ought to have followed automatically: a dramatic reduction in compensation ratios, the proportion of overall banking revenues which are paid to staff. While banks were partnerships with individuals’ own capital at risk the compensation was in effect a return on their capital investment; once the structure of the industry changed there should have been a dramatic reassessment of how the returns on the business are allocated between those operating within it and those who provide the capital. The failure of compensation ratios to fall in recent times goes a long way to explaining why there is currently very limited appetite among investors for bank equity: put simply, the compensation paid to the staff means that little (if anything at all when looked at over a lengthy time-horizon) is left over for shareholders.

The role of shareholders

At present the greatest threat to increased and increasingly effective shareholder involvement in the governance of financial institutions is that they are crowded out by the close involvement of the FSA and other regulators. The approval process for directors limits the scope for shareholders to impose themselves in the nominations process and makes it harder for investors to seek the removal of individuals that they see as failing to perform in their roles. The FSA seems indifferent to investor views on director quality, preferring its own judgements to those of others – its response to attempts at communication have in our experience been decidedly unwelcoming. The situation is even more extreme with regards to remuneration, where the detailed prescription on pay structures and levels set by the FSA and other regulators mean that the role for investors risks being extremely limited. Where we disagree with the approach of the regulators, our voice is inevitably ignored.

We do not think that shareholders should be required to exercise a stronger role, but we do think that they should do so, and further we fundamentally believe that it is in their interests for them to do so – certainly it is in the interests of their underlying beneficiaries that they should do so. Perhaps the most radical and welcome element of the Walker recommendations was in this area, requiring the establishment of a Stewardship Code in the UK and its oversight and regular review by the Financial Reporting Council. The introduction of the Code has had some impact, and many fund managers have asserted their compliance with it; however, the extent to which this is genuinely delivered in practice is open to question. The unwillingness of the industry to encompass the Stewardship Code in fund management mandates is perhaps the strongest indicator that there may be less delivery in practice than is asserted in theory. An industry delivering fully on its fiduciary duties to customers would be more active in taking forward stewardship responsibilities.

Accounting issues

The allegation is sometimes raised by various parties that fair value accounting played a role in the crisis, and this question will no doubt be raised once again to you. We are not convinced that this is the case and so feel it is appropriate to discuss this complex issue briefly.

It is worth stepping back to consider what the purpose of the reported accounts is. Under English law, this is to communicate corporate performance and the current position to the current shareholders. The communication enables shareholders to understand the performance of their company, and just as importantly it forms a basis for shareholders to hold management and the board to account for their stewardship of the company's assets. So our test for whether accounting for banks is appropriate is whether it best serves this underlying purpose – providing the information that shareholders need to assess performance and where necessary to call management and boards to account.

We see no practical alternative to fair value accounting for financial instruments; while this offers no more than a snapshot which will not remain representative of values even a short time after the snapshot is taken, it is necessary to have a basis on which to call management to account. It provides a better insight into performance than the alternative valuation measures.

A key area criticised under the headline of fair value accounting is with regards to the impairment of debt. IFRS was clearly wrong about this, and we welcome the IASB’s agreement to move to an expected loss approach rather than a incurred loss model. It is unfortunate that this change to the far more appropriate expected loss approach is being delayed and we are encouraging the IASB to accelerate this key change. We have also in recent times been encouraging banks to make more disclosures around impairments such that it is possible for investors to understand what the expected losses might be even though the new standard is not yet in place. But we are not convinced that the incurred loss model is correctly called fair value accounting – at least one academic points out that the expected loss approach can much more accurately be considered to be the fair value of the debt.

Having highlighted these two specific areas, there is a more general issue. One major allegation with regard to fair value accounting is its procyclicality – boosting performance in the upswing of markets and making the downswing much more painful. Procyclicality is clearly unhelpful but we are not sure that fair value accounting was the biggest driver of procyclical behaviour in the run-up to the crisis. Rather, money was too cheap (in the form of consistently low interest rates, lowered every time there was a chance the long boom – laughably then considered the ‘great moderation’ – showed signs that the bubble might have sprung a leak); regulators acted in a procyclical manner, rather than countercyclically, by relaxing supervision and regulations and basing capital requirements on banks’ flawed internal models; and all of us were sucked into beginning to believe that the prices in markets were reflections of reality rather than leveraged gambles that prices would continue to rise. There were large numbers of real transactions in those unreal markets, particularly in terms of property and securitisation. In many ways, securitisation is simply a way for banks to turn illiquid assets into realised profits. There is no question of whether an asset should be valued at mark-to-market or mark-to-model, or held on the books at historic cost, when it has been sold in an open market transaction. Thus procyclicality was a function of inflated prices in the market – real transactions in unreal markets, perhaps they might be called – as much as any accounting assessment.

Accounting can never be a substitute for common sense, whether on the part of investors, directors, auditors or regulators. It can never be a substitute for effective regulation and supervision. All parties need to think and to act in a countercyclical manner. The irony is that in the aftermath of the crisis almost all of these parties are continuing to act in a procyclical manner by tightening standards and their approaches in the downswing. This is perhaps no more than human nature.

Auditor dialogue with regulators

We share the disappointment felt by the House of Lords Select Committee on Economic Affairs that the practice of active dialogue between auditors and regulators fell into disuse. We welcome the fact that these discussions appear to be happening again, though we are clear that this needs to be a two-way dialogue in order for it to be most effective in limiting systemic risks and safeguarding value for shareholders.

5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally?

We believe that it is necessary to carry through in full the ring-fencing of retail banking from investment banking as proposed by the Independent Commission on Banking. We believe that one of the fundamental reasons why banks have tended to take on inappropriate risk is because capital is fungible between investment banking and other risky activities and the banks’ less risky operations. We believe that unless and until different banking activities face specifically appropriate costs of capital there is in effect a cross-subsidy to the high risk businesses from less risky activities. Without the appropriate costs of capital being applied the risks of activities are not appropriately priced in, and banks may continue to make mistaken assessments as to the risk/reward trade off of certain activities. This need for appropriate costs of capital goes beyond what ring-fencing can ever deliver (for example much of the riskiest lending in the credit bubble was on commercial property, an activity which seems likely to be on the retail side of the ring-fence), so the capital discipline needs to be applied by boards, with appropriate influence from regulators and shareholders; the ring-fence is not a panacea.

The introduction of the ring-fence will ensure that there is no cross-subsidy of capital costs from the retail side of the business to investment banking – including ensuring that the implicit government guarantee of the retail bank does not subsidise the broader activities of banking firms. This is necessary in terms of ensuring that the implicit government guarantee is not overstretched but perhaps more importantly it will ensure that the separate parts of the business must apply a properly segregated cost of capital to relevant operations. Ensuring that risky activities face a heightened cost of capital such that performance is understood in a fully risk-adjusted way is necessary for any understanding of performance of both the bank and of the individuals. We suspect that significantly less risk will be taken once a proper cost of capital is applied to the most risky activities.

We hope that ring-fencing will be taken up internationally such that this same capital discipline applies to all banking activities wherever in the world they occur. This may over time facilitate a return to investment banks operating as partnerships and so subject to the risk management disciplines which are inherent in that structure.

We have also been struck in our dialogue with bank executives and non-executives just how significant the challenges are in managing such big businesses; we hope that over time their scale can be reduced such that not only are banks not too big to fail but they are also no longer too big to manage effectively.

6. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government's proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice.

If the Independent Commission on Banking proposals are delivered in full without any watering down we believe that this would go a significant way to delivering what is required – though noting the caveats in our response to Question 5.

We are concerned that the FSA may be stepping beyond an appropriate level of supervision to excessive intrusion. One bank director recently commented to us that the level of direction (the example given was asserting the appropriate level of pay for a relatively junior compliance officer) risked exposing the FSA to charges of being a shadow director. This disquiet reflects our concern that the regulator’s actions may be overstepping the mark. We are also concerned by the FSA’s requests to attend board meetings of regulated entities, and have supported those banks which have declined requests to welcome FSA staff into their boardrooms; we do not believe that this sort of activity will provide a benefit. The level of supervision of financial institutions prior to the crisis is widely accepted to have been inappropriately low but we fear that the swing of the pendulum may have gone too far and there may now be excessive intrusion. It risks disempowering boards and making them less effective rather than more so.

The risk is that rules will inevitably lead to formal, legal compliance with the letter rather than the spirit of the law or regulation. In turn this leads to behaviour that is focused on formal, defensive compliance (which easily drifts into a gaming of the system) rather than the sort of culture and approach that we should all be seeking, which is a dynamic of seeking improvement within appropriate risk parameters rather than mere compliance. We believe that it is this culture which is more likely to secure the successful future of the banking industry and limit the risks of future failures. Regulation which bolsters the principle of fiduciary duty – both in terms of the duties of directors and in terms of the duty to clients – is more likely to be effective than detailed and prescriptive rule-based regulation.

7. What other matters should the Commission take into account?

We attach some documents outlining possible next steps in the areas of remuneration and banking regulation. Our Banking Remuneration Principles lay out our expectation of banks in which we invest, both in terms of pay itself and in terms of the governance structures which frame it. In our discussion paper Rewriting the Rules of the Banking Sector we highlight ways in which the regulatory regime can be further enhanced.

We also attach a discussion paper that we produced regarding pay more generally – the discussion paper being our commentary compiled ahead of a seminar we held which brought together the remuneration committee chairs or their representatives from 44 FTSE 100 companies with their underlying owners in the firm of trustees and executives from leading pension schemes. We believe that our ideas on pay provide the basis for a better long-term model than the regulators’ reliance on at-best medium term deferral of bonuses which does not get to the heart of the short-termism which is currently too prevalent in banking and financial services more generally.

We believe that each of these three documents is relevant to the Commission’s inquiry and may be helpful in your deliberations.

The following 3 attachments have also been submitted and are available upon request:

- HEOS Rewriting Bank Rules

- HEOS Banking Remuneration Principles

- HEOS Proposed Reforms to UK Executive Remuneration

24 August 2012

Prepared 22nd September 2012