Banking StandardsWritten evidence from James Featherby

Summary of this Submission

1. The characteristics of modern banking are such that banks have a strong tendency to create poor internal cultures.

2. The structure of banking has not evolved to ameliorate the resultant risks to the economy or society.

3. Structural reform of banks is necessary to realign banking with more economically and socially purposeful activities and to remove a variety of structural opportunities and incentives for poor behaviour.

4. Increased regulation is unlikely to be either sufficient or effective.

5. Structural reform may need to encompass:

(a)banks adopting an appropriate degree of public purpose to sit alongside their private purpose;

(b)the full separation of investment banking from retail and commercial banking;

(c)full reserve rather than fractional reserve banking;

(d)limits on the creation of excessive debt; and

(e)a reduction in speculative trading, hedging and derivatives unconnected to the needs of the real economy.

6. The culture of banking in the UK is, however, as much a human issue as a structural or technical issue. As a society we need to change the way we analyse problems and construct solutions. It is unrealistic to expect banking to change unless we do.

7. The choice between economic growth and structural reform of banking in the UK is a false dichotomy.

The Particular Cultural Challenges Of Banking

8. Banks have a strong tendency to create cultures that show insufficient concern for the welfare of their customers, for the welfare of the economy and society in which they operate, and for regulatory compliance.

9. There are various reasons as to why this tendency is stronger in the banking sector than in other sectors:

(a)Debt has a tendency to centralise wealth on the person to whom debt is owed, and wealth has a tendency to centralise power (see “The dangers of excessive debt” on pages 30 -31 of OMM). The balance sheets of banks have grown significantly in recent years, and the effect has been to centralise power on banks. Power without adequate checks and balances trends to corrupt and desensitise, particularly when it is unconstrained by any responsibility for the public good;

(b)The contractual nature of the returns available to banks under debt contracts (see “The disinterest of debt” on page 32 of OMM). Unlike the risk sharing nature of equity, debt contracts do not incentivise banks to be interested in the economic success of borrowers or of the economy or society that supports them because the returns available to banks under debt contracts are not so obviously dependent on such factors;

(c)The contractual nature of debt also leads to over-confidence because it enables reliance (whether justified or not) on contracted future cash flows and hedged and secured risks (see “The effect on cultures and behaviours” on pages 50—52 of OMM). In other industries investors and managers accept that their businesses will inevitably be affected by unpredictable events. That leads to a less over-confident approach;

(d)The instability of both bank funding under the fractional reserve model (see “Too big to live” on page 36 of OMM) and the value of bank assets due to mark-to-market valuation. This leads to a desire to maximise the externalisation of risk, and that risk can only be externalised to the rest of the economy;

(e)The pressure put on senior management by the equity markets because of the asymmetric returns available to shareholders through making investments in banks. Within banks short term profits can be quickly magnified, through increased bank leverage, and if necessary at the expense of good behaviour which tends to pay off only over a longer time frame. From the shareholders’ perspective, significant losses that might otherwise have been incurred by them as a result of such activities can be externalised to others through the combination of limited liability and government support for banks too big to fail. This moral hazard has not been resolved by, and will not be resolved by, even full adoption of the Vickers Commission recommendations or Basle III;

(f)Difficulty in distinguishing between activities that are net contributors to real economic growth and those that are merely a zero sum game (where the gain of another must come as a result of a loss to the bank). This leads to a tendency to assume in practice that all banking activities are a zero sum game, and this leads to a tendency in practice to seek to minimise contributions towards the prosperity of others, beyond the minimum needed to make a trade, because of the assumed cost to the bank of doing so;

(g)A significant growth in profits in recent years from proprietary trading, which has no identifiable human customer or counter-party and therefore no apparent moral consequences;

(h)The nature of investment banking, where banks are often in effective competition with their own customers. This gives rise to an increased occurrence of conflicts of interest between banks and, in particular, their financial services sector customers. In turn, this gives rise to increased opportunities for banks to abuse those conflicts of interest and to act contrary to the interests of their customers;

(i)The motivation of large numbers of staff through:

(i)high pay rather than job satisfaction obtained through factors such as social contribution, autonomy or physical creativity;

(ii)high pay structured by reference to short-term, inward facing financial criteria rather than longer-term, external facing stakeholder criteria;

(iii)high pay that is in large measure discretionary, partly to incentivise constant over-achievement and partly to facilitate cost control on downsizing by avoiding the normal employee protection rules on termination pay; and

(iv) high pay that is asymmetric in risk as between employer and employee.

This can readily lead to individualistic priorities, a lack of loyalty between employer and employee, and therefore a lack of loyalty between employees and the bank’s other stakeholders, aggressive rather than co-operative relationships between staff and others, increased risk taking, and the encouragement of an over-confident, even narcissistic, view of self in a society that increasingly attributes worth to wealth.

(j)A combination for large numbers of staff of over-work (demanded by banks in return for high pay) and a lifestyle enabled by high pay that is removed from the demands placed on others. This can readily lead to a lack of connectivity with reality, and therefore to a lack of appreciation of the broader social and economic consequences of decisions.

Structural And Cultural Reform

10. The evidence is clear from the last few years that the culture of banking in the UK can produce significant financial pollution for the rest of the economy, and result in serious regulatory breaches. It is my view that the combination of challenges listed above may well put banking beyond adequate cultural change absent material structural reform. The objectives of such structural reform would be to:

(a)increase the rationale and incentives for positive behaviour; and

(b)reduce the opportunities and incentives for poor behaviour.

Structural Reform

11. An appropriate degree of social purpose for banks, to sit alongside their private purpose, would provide the senior management of banks with:

(a)the rationale and energy for creating and maintaining more positive cultures. It has been recognised since Aristotle that virtue loses its power if it is not seeking the achievement of a positive destination. A social purpose would provide banks with that destination;

(b)greater clarity on the responsibility of banks to:

(i)manage their own and systemic risk;

(ii)protect and maintain the payment system;

(iii)provide only appropriate products to retail customers;

(iv)assist retail customers to save and budget as well as borrow;

(v)contribute to the growth of the UK economy by supporting SMEs rather than their currently increasing focus on mainly large corporate borrowers; and

(c)a degree of protection against short-term equity market pressures, particularly from investors with a short-term perspective.

12. “Private purpose” on pages 18—19 of OMM describes why “enlightened shareholder value” is currently failing to produce more long-term and stakeholder aware decision-making within large companies, including banks. Pages 20—24 of OMM provide suggestions as to how to introduce an appropriate degree of social purpose.

13. A social purpose may or may not affect the profitability of banks. It is not inevitable that it would, and it may even increase their profitability since it is generally the case that businesses that serve the interests of stakeholders prosper more over the longer term. In any event, a social purpose may be seen as a fair price for on-going government support and the privilege of continued limited liability.

14. The Commission may wish to consider whether some or all of the following are also necessary in order to reverse the structural problems within UK banking:

(a)the full separation of investment banking from retail and commercial banking;

(b)the full separation within investment banking of proprietary activities from agency and advisory activities; and

(c)full reserve rather than fractional reserve banking.

Further details are given in OMM (see from “Debt Engines” to “Kicking the habit” on pages 32–39).

15. Full reserve banking has various advantages, including improved bank safety. Professor Kay, in his Review of Long-Term Decision Making, recommends that fiduciary standards should apply to all relationships in the investment chain that involve discretion over the investments of others. The savings accounts of depositors under full reserve banking could similarly be made subject to fiduciary standards. This would accord more with the understandable (if currently technically incorrect) assumption made by many retail depositors under our current fractional reserve system that money deposited with banks remains “theirs” and does not belong to the bank.

16. Further rationale for reducing excessive debt, including suggestions for how to do so, is given in “Reducing excessive debt” on pages 25—39 of OMM. Further rationale for leaning against speculative trading, hedging and derivatives unconnected to the needs of the real economy is given in “Taming speculative and claims-based trading” on pages 41—53 of OMM, including suggestions for how to do so on page 49.

Other Reforms

17. Increased regulation aimed at controlling behaviour may not be an effective option. Where people are, or feel themselves to be, under pressure to behave poorly it is generally intrusive, expensive and ineffective to attempt to stop them from doing so through regulation. Indeed, increased regulation often incentivises more perverse behaviour. I therefore suggest that structural reform should be favoured over increased regulation.

18. I would, however, suggest an exception in relation to the sale of loans and other credit facilities to retail borrowers. In this area the principle of “buyer beware” constrained only by rules on misleading advertising appears inadequate. Given that borrowing can affect a person’s financial health as much as saving, it would seem appropriate to apply the same standard of customer appropriateness to the sale of credit as applies to the sale of investments.

19. The banking sector is not short of corporate governance procedures. I see no reason for thinking that increased corporate governance would improve the culture of banking.

20. Requiring bankers to join a professional body may result in some cultural improvements, particularly in retail and commercial banking. Professional bodies, combined with appropriate training and peer-led disciplinary procedures, can be effective tools. Such a process is, however, in my view less likely to be effective in investment banking where the cultural challenges are greater.

21. It is not clear that increased competition would improve the culture of banks. As the Kay Review points out, the financial services sector differs from other sectors in that the quality of its products and services is not readily apparent, either for borrowers or savers. With many banks it is also the case that a significant proportion of their profit comes from proprietary trading where there is effectively no customer for whom competition issues are relevant.

22. I would, however, welcome a significant increase in the number of banks offering services to retail and commercial customers in the UK for other reasons, including the resultant:

(a)decrease in power of the current major UK banks;

(b)decrease in reliance of the UK economy on so few a number of UK banks;

(c)increase in diversity of likely business models; and

(d)increase in systemic strength of the UK banking sector.

23. The FSA has stated its desire to regulate the culture of banks. I understand, however, that the FSA is finding it difficult to formulate a basis for doing so. In particular, I understand that the FSA feels reluctant to specify what a “good” culture looks like in the absence of guidance from government. This may also be an issue the Commission wishes to address.

Cultural Reform

24. Material though the structural problems facing banks are, the cultural problems within banks are not primarily technical. They are instead human issues, resulting from intellectual and philosophical mistakes. Some would call them moral mistakes, particularly if by moral one means those motivations and behaviours that are most likely to help an individual, and the society of which he or she forms part and upon which he or she depends, to flourish.

25. Banks are not alone in appearing to have lost their appreciation, familiarity, and dexterity with the concepts and language of morality in the public arena. Many of us have been making the false assumption that the public arena, including business, can and should be a “values free” zone, where the positive side of human nature is assumed, with the negative side of human nature is ignored, where following the rules or the market provides sufficient morality, where financial incentives substitute for common purpose, and where the fear of judgementalism prevents leaders from exercising discernment over those motivations and behaviours most likely to produce desired outcomes.

26. Many of us are analysing issues and constructing solutions on a basis that is individualistic, reductionist, utilitarian, fearful, disparate, arrogant and pragmatic. “Pruning the vine” on pages 5- 12 of OMM describes this in more detail. In part this is because we have come to believe that that is the best way to analyse issues and construct solutions. As a result, many of us are undervaluing the social and economic value of making decisions on a basis that is relational, holistic, neighbourly, adventurous, purposeful, humble and principled.

27. However, the leaders of UK banks do in particular appear to have lost their ability to inspire and embed positive motivations and behaviours within their organisations. The leaders of banks in the UK will need to develop a new skill set; one that permits them to identify, name, communicate and embed positive values throughout their organisations. This is not just a worthy aim. It is the bedrock of creating and maintaining long-term value for their organisations and all of their stakeholders. To do so, the leaders of banks in the UK will need to provide not just mission statements but fully formed, formal and informal, intellectual, social and economic support for positive behaviour.

28. Some have questioned how it has happened that UK banks have developed such poor cultures whilst in general being led by men and women of personal integrity. I believe the issues raised by this submission go some way to answering that question. Personal integrity is no longer enough. The task now is to transpose that integrity into the public arena. If necessary it must lead to changes in the priorities, objectives, products, services, processes, and incentives of banks. It must change the way in which issues are analysed and solutions are found, and it must change the nature of public discourse. Some of this can be achieved through structural reform. Much of it, however, can only be achieved through a fresh understanding of the kind of positive business objectives and practices that lead to the creation of sustainable value.

29. It may be unrealistic to expect the culture of banks operating in the UK to be significantly more positive than the general culture operating within the rest of the UK. Nevertheless, it is incumbent on the leaders of all public and private institutions to take responsibility for attempting to inspire and embed a more positive culture.

30. It will be for the members of the Commission to determine the extent and means by which government is able to bring about broader cultural change. It may, however, be helpful for the Commission to express the challenge that exists within banking within this broader and challenging UK cultural context.

Growth Versus Culture

31. Some see the challenge of reforming the culture of banking as a choice between, on the one hand, structural reform and better cultures and, on the other hand, the growth and jobs that arise from an internationally competitive City. That choice is a false dichotomy, not least because those are not the only two policy choices available. In any event, a City that cannot be trusted will not flourish to produce the hoped for growth or jobs.

12 August 2012

Prepared 19th June 2013