Banking StandardsWritten evidence from Donald R Clarke


This paper addresses certain limited but fundamental issues raised by the Commission, notably culture and separation of functions, and argues:

that the root cause of the recent banking crisis was the repeal of Glass-Steagall;

that investment and retail banking are totally different businesses and should never have been allowed to merge;

that cultural differences are at least as important as differences in business practice;

that the total separation of the two kinds of business is essential;

that everybody needs a clearing bank but not everybody needs an investment bank; and

that customers of the clearing banks should be free to buy suitable products from the investment bank of their choice.

1. I worked for 27 years for what is now called 3i but started life in 1945 as The Industrial and Commercial Finance Corporation, formed by the Clearers and the Bank of England as a commercial institution to provide loan and share capital to small and medium-sized businesses. Until its flotation in 1994 it remained in the same ownership, with the Bank of England owning 15% and holding the ring between the clearers; by then their original investment of £115 million had become worth some £3 billion. The post-war Government had wanted a financial mechanism to stimulate reconstruction of the economy: there is a strong argument for such an institution today.

2. I joined in 1964 and from 1968 until I retired as Finance Director in 1991 I was responsible for all its fund-raising. During most of my tenure, until the mid-80s, the clearing banks were essentially short-term institutions, taking deposits from the general public through a widespread branch network and providing short-term facilities, mainly by way of overdraft, to individuals and businesses.

3. With the Bank of England as lender of last resort they were able to lend many times the amount of their capital—on the reasonable assumption that the millions of depositors would not all want to take all their money out at once—and if any one bank got into trouble the Bank of England could apply its last resort facilities in protecting the depositors.

4. That was a very satisfactory arrangement which allowed the banks to make comfortable returns for their shareholders—through their ability to lend many times their share capital—without taking unnecessary risks. This was also good for the economy in general because it provided huge amounts of credit which would otherwise not have been available.

5. In this respect the clearing banks enjoyed a very privileged position. By having the support of the Bank of England they were able to borrow much more than any other commercial organisation which had a similar share capital. In return for this privilege the banks were subjected to close monitoring by the Bank of England and the amount they could borrow was determined by the Bank as part of its control mechanism.

6. In my time this monitoring was informal and friendly—but the Bank of England kept its ear to the ground, maintaining close contact with the City institutions, including us. By this means it was able to control the banks without formal regulation—of the kind The Financial Services Authority employed, with singular lack of success, from its formation until the crisis exploded in 2008.

7. A most important element in this informal control was that there were no rules for the banks to get round—just a nod and a wink from the Bank of England from time to time. I was present at a number of these meetings and can vouch for the effectiveness of its method. It was a satisfactory system for everyone and when one or two secondary banks, like Slater Walker, got into trouble in the 1970’s the Bank of England was able to take control of them without a general collapse of confidence in the system as a whole.

8. The proximate cause of the 2008 crisis was that the banks had been taking much greater risks than their privileged capital structure justified. Desperate to improve their profits by earning better margins than they could get by borrowing from you and me, and lending back to me and you, they started borrowing in large quantities from each other and from large non-banks—in effect moving from being retailers to wholesalers.

9. This change was reflected in their lending policies—tired of lending at small margins directly to you and me—or more likely our children—they tried to improve their margins by buying packages made up of small loans made by other banks—generally to people you and I wouldn’t lend a penny to. For the banks selling these packages it was a convenient way of offloading their riskiest loans, which, for some reason I can’t understand, were rated as being very low risk.

10. Rating definitely needs investigation. It is normally a process of assessing the quality of governments, large companies and banks which is done by a small number of mainly American rating agencies. For a fee they will allocate a rating which can range from triple B at the bottom end—meaning a very bad risk—to triple A meaning the best possible risk. Triple A is normally reserved for major governments and the biggest companies, but for some reason these packages of “toxic debt”—comprising mortgages taken out by people who often had no means of repaying—were rated very highly, often as high as triple A, which allowed the banks to justify buying them as though they were high quality assets.

11. It was not the actual businesses which were being rated but the loan packages themselves, separately from the banks which were buying and selling them, and that is very odd. When I had 3i rated AA in the 80s we were subjected to the most rigorous scrutiny of our whole business, its policies, its investment methods and its assets. Unlike the banks in their recent behaviour, we never bought other people’s assets—we always made our own investment decisions, after detailed examination of the underlying businesses.

12. The Financial Services Authority, which was formed in 1997, took over banking supervision from The Bank of England but it didn’t seem to investigate very thoroughly the kind of risks the banks were taking on. This was probably because it was operating on Treasury instructions to supervise the banks “with a light rein”, but also because its staff did not have the Bank of England’s in-depth knowledge of the banking sector.

13. It seems to me particularly unfortunate that the supervisory role of the Bank of England was removed in 1997 because there had, not long previously, been a major change in the banking system, which in my view contained the seeds of the current disastrous situation.

14. It was in 1933, when the world was in the grip of the last global banking crisis, that the United States Government brought in legislation to compel the retail banks to stick to their basic activity and forbade them to take on investment business—like the sort of thing we did in 3i, but more particularly the kind of business carried on by merchant banks, or investment banks as they are known in the States. At that time the US Government thought the banking free-for-all was responsible for the crisis: does this sound familiar?

15. The reason they gave for the new legal separation of functions was the inherent conflict of interest between investment and retail banking. This piece of legislation—known as the Glass Steagall Act—remained in effect until 1991 when it was repealed by the Clinton administration—under intense pressure from the banks. The decision was influenced by a similar relaxation which had taken place previously in London and had given the City a big advantage over New York as a financial centre.

16. In my time the UK merchant banks were relatively small, independent institutions, under the Bank of England’s control but with a quite different function from that of the clearing banks. Essentially they existed to help governments and major companies to raise capital in the stock market and in the international bond markets. I used merchant banks, particularly the egregious S.G.Warburg, to help me raise capital for 3i and there is no question that they had a critical role in oiling the wheels of the capital markets.

17. The blurring of the demarcation line between these two quite different kinds of banks, following the repeal of Glass Steagall and the similar relaxation in the UK, had a dramatic effect on the clearing banks. It allowed them to set up their own merchant banking arms by poaching the highly specialised and highly paid staff of the merchant banks—or sometimes simply buying them. But not only did the two kinds of bank have different functions—they had totally different cultures.

18. The clearing banks were relatively staid and risk-averse, with staff—like our old friend from Dad’s Army, Captain Mainwaring—who typically worked their way up through the ranks and retired with a comfortable pension. All the chief executives of the banks who I met in my career had risen from the ranks. None had come in from outside. Bonuses were then unheard-of, as was profit-sharing.

19. The merchant banks, on the other hand, had a tradition—going back beyond the clearing banks—of buccaneering risk-taking on an international scale. They financed railways in Patagonia, issued bonds for the Imperial Chinese Government and, more recently, raised funds for 3i from the Central Bank of Saudi Arabia. They made their money from fees and commissions and from trading in their clients’ stock, using their own capital.They were staffed with bright, young, ambitious Oxbridge graduates, who were paid very well, with bonuses, profit sharing and generous share option schemes. You can see how different were the two cultures and how important it had seemed in 1933 to keep these radically different bodies apart.

20. In my opinion it was the repeal of the Glass Steagall Act, combined with the relaxation of the equivalent British separation of functions, that opened the floodgates. It allowed the banks to trade in securities on top of their normal short-term lending and at the same time to adopt both the risk-taking cultures of the merchant banks and their remuneration packages, while retaining their own privileged capital structures. It allowed greedy merchant banking practices into the sleepy but safe old clearing banks—typified by Captain Mainwaring—and the introduction of investment bankers into positions from which they could bet the whole bank—and destroy it—yet walk away with footballers’ pay packages

21. Any proposal to keep retail banking alongside wholesale and investment banking within an overarching banking group, even though ring-fenced in capital terms, would create huge conflicts of interest within the parent company. Allocation of resources, both financial and human, would inevitably be weighted towards the subsidiary producing the better returns, and accordingly able to offer the more attractive pay packages, resulting inevitably in internecine warfare between the subsidiaries, with their wholly different cultures, and envy among the less well paid staff.

22. The banks should be forced to float off their UK retail arms into new, separately owned and managed banks, doing what they used to do, their depositors protected by The Bank of England’s last resort facility, their capital ratios set much more generously than those of the investment banks, and subject to close supervision by the central bank. Pay structures should be appropriate to the low risk business they would take on but with profit share and generous pensions. By virtue of their capital ratios returns would, as before, be acceptable to investors looking for safety rather than high returns.

23. The remaining wholesale/investment banks would be subject to quite different international regulation on which I am not qualified to comment. Justification for their pay packages would be of no concern to staff, shareholders and depositors in the clearing banks.

Everyone needs a clearing bank to run current and deposit accounts, but not everyone needs an investment bank. It should be open to businesses to shop around for the exotic products of the investment banks without affecting their day-to-day clearing bank relationships.

17 August 2012

Prepared 19th June 2013