Banking StandardsWritten evidence from Sir Alan Budd

1. The comments in this memorandum are mainly partly based on my experience as Group Economic Adviser to Barclays Bank from 1988 to 1991. This was after Big Bang and some of the challenges of amalgamating two different sorts of financial institution were still evident.

2. I set out my thoughts under three headings. The first is the conduct of what were then known as the clearing banks before Big Bang. The second, which is related to the first, concerns the culture of those who worked for the clearing banks. The third concerns the culture of those who worked in investment banking and the ways in which it differed from those in the clearing bank. I end with some conclusions.

The Clearing Banks—“a Cosy Cartel”.

3. The clearing bank system in the UK, prior to Big Bang, was commonly described as a “cosy cartel”. The phrase was not used in a technical (or even necessarily pejorative) sense but applied to arrangements under which a small number of banks shared the retail and commercial banking business between them. It was slightly odd that economic conditions in the UK, which were not greatly different from those in other industrial countries, resulted in a market with such a small number of institutions and others have offered explanations. It may be worth recalling that in my lifetime, and before Big Bang, clearing banks had continued to merge—the National Provincial, Martins and Williams and Glyn’s, for example, had disappeared as separate entities. Whatever the explanation, it can be said that mergers were permitted because the authorities believed that the surviving banks would not take undue advantage of their market position. In fact an implicit gentleman’s agreement operated between the banks themselves and between the banks and the Bank of England.

4. The implicit agreement between banks limited the intensity of competition between them in terms of lending and deposit rates. (They also operated an informal no-poaching agreement under which they would not attempt to recruit staff from their competitors.) I can describe three aspects of the implicit agreement between the clearing banks as a whole and the Bank of England. The first, as I have already mentioned, is that the clearing banks would not seek fully to exploit their oligopoly position and to make excessive profits. There were also gains to be made from the considerable inertia in relation to the normal business of banks for households and businesses. In the days before credit-scoring, detailed knowledge and long experience of clients’ financial affairs were key to decisions about lending. The acquisition of this knowledge was time-consuming and costly but it could be seen as an investment by both parties. Clients were reluctant to move because they were unwilling to go through the whole process again, and banks did not have a strong incentive to attract customers from other banks because they would have to pay the costs of acquiring the information. It can be said that the extent of competition between the banks was a matter for the competition authorities rather than for the Bank of England but it is reasonable to conclude that the Bank of England’s attitude to the clearing banks was coloured by the extent to which they were believed to be exploiting their favoured market position. The second aspect of the implicit agreement concerned banking regulation. To over-simplify, rules were regarded as a boundary to be kept well clear of rather than limits to be tested. “Light-touch regulation” was appropriate because the banks themselves kept a margin of safety around themselves. They had no wish to disturb their comfortable relationship with the Bank of England and were also quick to recognise informal signals about their actions—the Governor’s mythical eyebrows.

5. The third aspect of the agreement concerned the use of controls on banks as an instrument of economic policy. They could be formal, as in the case of limits on the growth of bank advances, or informal –the eyebrows again. Such formal and informal controls are more powerful when good relations with the Bank of England are important.

6. What were the banks getting in exchange? They will have been confident that, in extremis, they would be helped out if they got into difficulties. But they also got a quiet life in which they could make comfortable profits without too much competition. We hear a great deal about “regulatory capture” in which regulators attach too much importance to the interests of those whom they are supposed to be regulating. But it works both ways. The regulators can learn to live comfortably with regulation, particularly if it raises the costs of entry to the industry.

Clearing Bank Culture

7. A bridge between the previous section and this one can be provided by the following story. De-regulation of the clearing banks, before Big Bang, allowed them to enter the housing loan market which had previously been limited to the building societies. By the early 1990s, problems were emerging as borrowers found themselves with negative equity and repossessions were rising. A senior colleague at Barclays said to me, “They never should have let us do this”.

8. The culture at the clearing banks reflected the environment in which they were operating. Loyalty and long experience were the essential qualities. The bankers were responding to familiar, repetitive problems. The organisation was hierarchical with a careful and detailed grading system to establish status. Two members of a bank meeting each other would soon discover (by asking questions about cars etc) what their relative status was. At Barclays and, I assume, the other clearing banks, operations were run by the general managers, most of whom would have left school at 16 and worked their way to the top. At the higher levels, bankers would be respected members of their local community. At the highest level they were part of a club playing a role, through their links to the Bank of England, in the management of the economy. They were part of the Establishment. All employees could see how loyalty and experience were rewarded. The ethos was at least as important as regulations in controlling behaviour. Risk-taking was not a significant part of the culture.

9. I am not suggesting that this was some kind of paradise lost. It was not obvious, for example, that the careful and rather comfortable way of doing business was in the best interests of the customers. The lack of competition made it fairly easy for customers, to be exploited. I can still recall an excellent paper given by a visiting academic at the London Business School, explaining how UK banks could profit from the funds that were, in effect, locked in to their deposits at close to zero interest rates (he also explained why you had to queue in UK banks but not American ones). The exploitation could extend to the terms on which overdrafts were granted.

10. Nor did the cosy cartel prevent the clearing banks from making major lending errors.

Investment Bank Culture

11. The culture of the clearing banks fitted the tasks that they faced. Investment banking, which is concerned with transactions rather than relationships, needed different skills and a different organisation (there are obvious analogies with the organisation of military units). Transactions required an immense concentration of time and effort over a relatively short term. The relevant unit was a team, able to operate flexibly and intensively, often for very long hours. The leaders of the teams would choose the members on the basis of their relevant skills. Each transaction could involve unique challenges and precedents were not necessarily relevant.

12. In my time at Barclays most of my dealings were with the “old” bank rather than the investment banking side and I was aware of the tensions between them. A crude and slightly unfair way of distinguishing between the two cultures is to say that those at the old bank thought of themselves as working for Barclays whereas those on the investment banking side thought of themselves as working at Barclays. The investment bankers needed the infrastructure and the capital. The question was how the profits from a transaction were to be shared between those who had worked on it and the bank. If the investment bankers did not like the split they could move elsewhere and would not hesitate to do so. (This characterisation is crude and unfair, since it certainly did not apply to all those who worked on the investment banking side, but it does, I think, describe the difference between the average behaviour in the two parts of the bank.) I heard complaints from both sides. The clearing bankers regarded the investment bankers as overpaid, reckless and not loyal to the bank. The investment bankers regarded the clearing bankers (who provided the capital) as timid, unimaginative and slow.

13. In such an environment it is difficult to see how a corporate ethos could have prevailed and it certainly could not have mirrored the ethos of the clearing banks. It is also worth noting that constraints that would have applied before the big bang mergers had been weakened or removed. The first refers to the financial risks. Stockbroking and jobbing firms, for example, were partnerships and the partners had their own capital at risk. In fact the main motive for the mergers following Big Bang was to increase the capital available to them so that they could operate on a global scale. Partners as providers of capital were replaced by shareholders (and eventually by taxpayers). The second constraint was the opportunity to become a partner, a position granting recognition and respect within the City community. After Big Bang the rewards and the measurement of success were provided by money. It should also be noted that the weakness of employee loyalty was matched by the terms and practices of employment. People could lose their jobs at a moment’s notice if market conditions were believed to require it. Loyalty works both ways.

14. I have described the cultures of clearing banking and investment banking separately and commented on the difficulty of combining the two. It is reasonable to ask whether the culture of clearing banking was already changing and, if so, whether this was due to “contamination” from investment banking or whether there were other factors. I believe that changes were already in process; the story does not begin in 1986. The de-regulation of the financial sector from the early 1980s (with some changes dating from the early 1970s) was changing opportunities and incentives. I have already quoted the comment on the effect of allowing banks to provide mortgages. Prior to that, building societies were often operating what was in effect a rationing system, just as banks had at times been operating a rationing system for overdrafts. That is a very different world from one in which institutions are competing with each other for deposits and borrowers. Barclays itself was engaged in a campaign to regain the leading place as a commercial bank that it had lost to the National Westminster Bank. I can remember bank managers saying how odd they found it to be trying to increase loans rather than deposits.

15. I have also mentioned the move to credit-scoring, which was replacing the knowledge gained through a long-term relationship with a personal or business customer. Branch closures were another aspect of the same development.

16. Banks were also increasing the recruitment of graduates in response to the changes in banking and the greatly increased supply of graduates.

17. I have always assumed that the main motive for the changes in regulation which permitted Big Bang was the wish to allow London to maintain or expand its role as a major centre for international financial transactions. There was no attempt to keep this as a domestic activity. Overseas banks were welcome. The result was never going to be cosy and the Governor’s eyebrows could not be seen in all the bustle. It is true that retail banking has remained largely a domestically owned business but it operates in a much more open environment and the culture that suited the old style of clearing bank was bound to change, though I believe that it can still be distinguished from the culture that suits investment banking.

Concluding Comments

18. The comments in this note are anecdotal rather than scientific, and my direct experience of Barclays ended over 20 years ago. At the time I thought that the clash of cultures meant that the attempt to create a universal bank could not succeed. I may have been too pessimistic. I did not anticipate any of the kinds of action that have given rise to the current inquiry but my experiences may help to explain why they have occurred.

19. All this is by way of diagnosis rather than cure and I am conscious that it is difficult for me to say what could be done to alleviate the sorts of problems that have led to the establishment of the Independent Commission. I have considered how much overlap there is between the work of the Vickers Commission and this Commission. The former was concerned with the questions of financial stability and competitiveness. The latter is concerned with the extent to which professional standards in UK banking are absent or defective. The Vickers Commission believes that a change in structure can reduce the risk of financial structure while other changes, including the divestiture of branches from Lloyds, the introduction of a switching system for current accounts and the actions of the Financial Conduct Authority can enhance competition. This Commission is considering the extent to which professional standards, or their absence, contributed to the actions which caused the financial crisis, but members will be aware that the inappropriate selling of payment protection insurance, on the retail side, or the misreporting of LIBOR, on the wholesale side, for example, can hardly themselves be thought of as contributory factors. They are both symptoms of the same sort of forces which also produced the crisis. My pessimism about Barclays in 1988 arose from what I saw as the great difficulty of combining two cultures, particularly when the constraints on conduct in the investment banking side were already being weakened, for the reasons I have given.

20. I do not know to what extent the universal banks distinguish in their recruitment between the different parts of the organisation. I assume that they do, and those that apply for jobs will be aware both of differences of culture, and of financial rewards, so it continues to be the case that banks combine different cultures and that people will apply for the side that best suits their temperament, though no doubt there has been some convergence. I can argue the case for or against breaking up the universal banks. The clearing bank side may exercise constraints on the investment banking side or the investment bank may contaminate the clearing bank side. Breaking up the universal banks may make the clearing/retail side better (and increase the confidence of its customers) but make the investment banking side worse. If problems are more likely to arise on the investment banking side, that is where the solutions have to be found.

21. Finally, I am sure that the Commission recognises the distinction, between culture and ethos on the one hand and regulations on the other. I have mentioned that the culture of the clearing banks was to operate comfortably within the regulations (and not to chafe at their presence). The Treasury Committee’s Report on Fixing LIBOR shows that there can also be a culture, in some parts of a universal bank, of breaking regulations. Severity of penalties and success in enforcement can help discourage such a culture but both the regulations and the culture may need to change.

8 October 2012

Prepared 19th June 2013