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Banking StandardsWritten evidence from Neil Jeffares


Banking is not a profession. The illusion that it can be leads to misplaced regulation.

Banking is nowhere near as profitable as people think. Until we work out how much of the industry is sustainable, policy will continue to fail.

Unbridled market forces have resulted in the selection for survival of banks and bankers whose appetites caused the present crisis.

Myths persist about remuneration; mere deferral of bonuses will do nothing to change excessive risk.

Staff compensation swallows an unsustainable proportion of profits, and probably exceeds true value added at industry level.

Stiffer compliance and more fines for misdemeanours will not change behaviour given the deep-rooted cultural issues. Neither will ring-fencing alone. In any case there are serious failings in the regulatory system.

Focusing only on the illegal or unethical misses the real threat posed by banking: its model of socially useless rent-seeking can extract far too much out of the economy without needing to break laws.

What is needed is complete separation at the level of equity capital, unbundling utility and different types of investment banking activities, so that market forces can be brought into alignment with the public interest and determine which of these activities should grow or decline.

Investment managers will need to do a better job of looking after shareholders’ interests.

About the Author

1. I commenced work in the City in 1982. After initial credit training in a major American commercial bank, I worked for a number of institutions, spending nearly 12 years at a British merchant bank which I joined when it was still a private partnership; it subsequently became the investment banking arm of a major European bank, and when I left I was global head of a structured finance business. I have also held a senior position in the financial services arm of a major industrial group, as well as running an advisory boutique. I am now an art historian and am no longer active in banking. This submission is made in my personal capacity; my observations below are not directed at any previous employer.

Is banking a profession?

2. No. Banking is a strictly profit-making business, and is not, and never has been, a profession in the sense that, say, medicine or the law is. Many in the City, including myself, have been confused about this, and have attached undue attention to the protection of reputation and sought to impose what we saw as professional standards on staff in the mistaken belief that such values would attract business. We adhered to the “relationship” model of banking which was inexorably supplanted by the “transactional” model in the 1990s. By the mid-1990s clever bankers understood that more money could be made by increasing risk, even if this meant downgrading their bank’s credit rating or reputation.

3. There may be tiny parts of the industry which could be set up as professional activities, for example M&A advice, but these are activities which involve the sale of labour alone and cannot generate the level of income required to be part of a large banking business. That was why, following Big Bang, not only were these businesses taken over but they were incorporated into other activities that required, and deployed, capital (eg underwriting securities as part of the M&A transaction) for which vastly higher returns could be demanded.

4. A good many confusions follow from this error, notably the idea that professional standards could be relied upon to protect customers with (until very recently) only light touch regulation or (subsequently) more onerous regulation. Where there is a powerful profit drive, neither type of regulation will be effective; the Canute-like delusion that it can be in the face of market forces reveals dangerous naïvety which persists among some regulators. The LIBOR fixing scandal alone demonstrates that regulators simply aren’t able to identify or stop such practices over many years, and Lord Turner has recently accepted that the costs of attempting to handle this through more intensive compliance would be unacceptable. What is needed, as I argue below, is major structural change to the industry so that market forces are aligned with the public interest, rather than relying on compliance sitting orthogonal to the market.

Rent-seeking and the profitability of banking

5. An aspect of the present crisis which, astonishingly, has been overlooked in almost all public debate is the issue of sustainable profitability in the sector. The Vickers commission’s remit was too narrow to look at this. Politicians of neither party are likely to want to confess how, without challenge, they allowed this apparent success story to take hold of the entire economy. And figures from individual banks don’t easily reveal the story. But looking at the overall picture, it is clear that the scale of the industry and its reported profits have grown over the last 25 years at an impossible rate. The bulk of this growth has come from zero-sum activities such as trading. While some genuine earnings can come from providing the real economy with liquidity (levels of which were already more than adequate 25 years ago), the growth in derivatives has outstripped that in GDP by several orders of magnitude. This is just not credible.

6. When politicians say that the City is a major contributor to the UK economy, they may be thinking of several different things. One is the fees and income earned by UK banks from overseas customers. This is no doubt real, even if those customers are being sold products they haven’t evaluated correctly (see the further discussion below). But fewer and fewer of our banks are UK owned. Politicians may also be referring to the national insurance and income tax contribution of foreign bank employees located in London: but this is just a percentage of the total value extracted by those banks, often at the expense of UK customers or taxpayers. These geographical ambiguities foster confusion about where the national interest lies.

7. What no one has done is analyse properly the real contribution the City makes to the UK economy, taking full account of the public interest as well as the complicated way in which the City has induced the state into providing unlimited taxpayers’ support: bail-outs each time there is a crash (and Vickers, even if implemented in full, will not prevent these), as well as by siphoning off significant parts of state support mechanisms. Nor has there been any systematic analysis of the way in which derivatives and similar instruments can be and have been used to roll forward liabilities until the next crash. Until this is done Government and its various commissions will be working in the dark, and policies will remain ineffective.

8. My suspicion is that when this exercise is carried out, we will see that a sustainable banking sector will be far smaller than the current scale of activity in London. The bloated state of the industry is the result of astronomical leverage (direct as well as concealed through derivatives and similar instruments) designed to multiply unnecessary components and permit the repeated extraction of rents from the same underlying assets. The burden of this ultimately falls on the investors, depositors and underwriting taxpayers generally. Social uselessness or Emperor’s clothes, it is unacceptable to carry on any longer with our eyes shut.

Culture and Natural Selection

9. When over twenty years unfettered market forces are allowed to shape an industry—and particularly where that industry employs clever people with every incentive to obtain results quickly—it can hardly be surprising if the resulting animal is as efficient as possible in achieving its goal. If you don’t have testing, athletes on drugs will take the prizes. Banks who cut corners achieve better results than those who do not; the winners take over the losers, and their culture dominates. (It should surprise no one, but it did, that Barclays, whose culture the FSA has criticised far more severely than any other bank’s, should nevertheless post outstanding first half earnings figures in August 2012.) Worse than this: banks which break rules also succeed and pass on their genes, even where the breach is likely to come to light: it is only necessary for discovery of the breach to be delayed until after the acquisition.

10. The same law of the jungle applies to individual bankers, a fortiori, since they can be dismissed even more readily than a bank can be taken over. Bankers who object to unethical practices, or simply to excessive risk, will be labelled as trouble-makers or just treated as “not a team player”. Their departure from the bank may be covered under a variety of headings and protected through rigorous compromise agreements. Since it is unlikely that the practices they object to will result in criminal convictions, they are rarely in a position safely to communicate their experiences in public. Whistleblowers cannot be adequately protected by public interest disclosure legislation.

11. You do not have to believe that individual bankers are dishonest to accept this narrative. Rather, through this process has emerged a generation of bankers who have willingly adopted doctrines such as the efficient market hypothesis as an excuse for not considering the broader implications of their conduct. In most cases this is no more than bad faith—in failing to ask the difficult questions—if that, and in many cases bankers may genuinely believe that they are doing nothing wrong if neither statute nor regulation prohibits a profitable practice. While there may be cases of dishonesty which merit a more robust approach to criminal prosecution, it would be imprudent to imagine that all malpractice can be dealt with in this way. The courts are unlikely to convict bankers who have complied with inadequate rules. The industry nevertheless epitomises a trahison des clercs on an extraordinary scale, and requires a different response.

12. Government and other constituencies (investors, journalists, accountants) are not immune from blame: they have failed, and mostly still fail, to ask the questions that would have forced bankers to confront these issues. The bankers their policies have allowed to survive are merely behaving as their selection profile requires. In fairness to the regulators I criticise it may reasonably be argued that had they spoken up to oppose Government policies before the crash, they too would simply have been sacked or sidelined.

13. There is also a broader debate to be had concerning the matters I highlight in paragraphs 5–8 above. There is a core of activity in the City which now makes a substantial, if not the major, contribution to reported earnings, and which is neither illegal nor contrary to regulation nor dishonest in any way. But it is socially useless. From the perspective of the bank employee there can be no objection to entering into such a transaction, even if from the perspective of the shareholder who also invests in the unfortunate counterparty the net result is the cost of the staff bonuses. This is the major problem confronting the City: it arises not from occasional illegality, but from systemic, lawful predation. Banking crashes, which all now recognise offer an unacceptable threat to society, can arise from behaviour which will not be controlled by any acceptable statutory or regulatory framework.

14. It may help to illustrate this discussion with some examples.

(a)British bank sells a complex derivative to a German Landesbank, a professional counterparty whose staff nevertheless lack the skill to price the instrument correctly, and consequently makes a loss; no actionable misrepresentation is made.

(b)Same transaction, where the counterparty is another UK bank: considered from the perspective of a shareholder of the selling bank only, and from that of a shareholder in both counterparties.

(c)As a, where the vendor is an American investment bank and the purchaser is a British bank.

15. My personal view is that none of these is attractive. It is not socialism, but personal self-interest, that makes me wish to prevent activity c occurring. But we cannot expect to have profits from activity a without tolerating c. What has changed since the 1980s is that now c dominates a. In that respect politicians’ complacency about the City’s contribution and the national interest (paragraph 6) needs to be examined more carefully.

16. Consider now two further variants of transaction a above:

(d)In the same transaction, an unrecorded conversation takes place in which the British trader misleads the German trader as to the risks.

(e)Ditto, where the misrepresentation is in a discoverable document.

(f)As a, where the counterparty is a UK small company or retail customer.

What these illustrate is how tempting it is for bankers to step into illegal territory. It is of course much easier for the Committee to identify the issues raised by these ethical and legal transgressions. But it would be a mistake to imagine that by improving regulatory responses to such transgressions, we are tackling in any significant way the fundamental threat to the economy offered by the rent-seeking model of today’s banking confined to lawful activities a–c, and as set out in paragraphs 5–8 above.

17. It will be said that there is more to City business than the a, b or c model transactions I have outlined. Only a detailed analysis of every line of business will provide a full response; that is the enquiry I demand in paragraph 7 above. Numerous activities come to mind which are wholly legal and perfectly sensible from the bank’s sole perspective but which simply drain resources from the economy as a whole (examples range from PFI to the promotion of tax planning schemes). Anyone who has worked in the City will recognise the model in which money flows more freely where someone has mispriced a transaction than in those deals where everyone benefits. The latter opportunities are scarce and cannot be scaled up to meet the returns demanded.

Culture and Remuneration

18. Many of the myths about remuneration practices have recently been exploded in the press, although some of us were always sceptical. One of the more ludicrous was the idea that paying bankers large bonuses would improve their decision making (that sat oddly with the misconception that they were professionals). Rather more insidious (because still prevalent in some quarters, including in government and among regulators) is the idea that deferring bonuses or paying them in restricted shares can create alignment and bridle the pursuit of personal greed. This misconception ignores the cognitive error shared by most surviving bankers, in which the risks they take are simply not objectively assessed. There was full alignment but no shareholder protection in the remuneration structure at Lehmans. This will always be the case where (see paragraph 10 above) bankers who do not take risks lose their jobs: that sanction, with its immediacy and devastating personal consequences, will always trump the concern that a risk might reduce part of one’s remuneration. Moreover, even if rationally assessed, it ignores the optionality of the banker’s compensation, and its positive expectation even where the shareholder’s odds are disastrous.

19. Proposals to combat short-termism such as those recently made by John Kay are unlikely either to be adopted or to be effective at changing this pattern of behaviour without far more radical steps (see below).

20. Those who have followed the public debate with an open mind will probably now accept that an excessive proportion of bank earnings is taken by employees and that this is a continuing fraud on the shareholders (albeit one in which investment managers who control most of the shares have been complicit). What matters from this perspective is total employee compensation rather than the structure of fixed salary/variable bonus or immediate/deferred compensation. On the other hand it is argued that banks depend on key staff who will defect if measures are brought in to restrict remuneration; alternatively entire banks threaten to emigrate to softer regimes.

21. Several aspects of this debate have not been fully explored, and they are relevant to the cultural inquiry.

22. The first is that shareholders are disadvantaged by proposals to defer bonuses, for the simple reason that employees will discount such compensation more heavily than shareholders. If retention is the object, one should pay only the minimum required by the employee: that will be least for cash than for elaborate packages. The growth of such packages (in industry as well as in banking) is really only a cover for increasing the total transfer of wealth away from the providers of capital to its managers.

23. A corollary of this which will assist in the development of a culture of professionalism is that shareholders and society are best served when employees receive nothing more than a fixed cash salary. The incentive to achieve comes down to a sense of personal commitment. That is found in all professions.

24. Secondly, although the proportion of declared operating profit going to staff is already outrageous (often in the range of 67–80% or higher in investment banks, considerably more than a generation ago), the position in relation to true value added is far worse from the point of view of shareholders and other stakeholders. This is because accounts do not consolidate the results of counterparties to zero-sum trading, in both of which shareholders may have an interest. In such cases staff compensation can amount to far more than 100% of aggregate profits. (This is another example of the failure of the public debate to grasp the whole picture.)

25. As noted above (paragraph 7) the international dimension allows the position to be further obscured while the basic logic remains. The lack of clarity about where the benefits flow also permits banks to persuade Government that the threat to emigrate is real, and the losses to the UK economy will be catastrophic. Successive governments in no position to assess these consequences have been paralysed by this fear. They have failed to see that tax havens will not offer the implicit government support on which the whole investment banking machine depends. Of course concerted action among developed Western economies will be more effective than unilateral action on compensation, but Britain is the least willing to join such initiatives because of politicians’ illusions about the City.

Retail Consumer Protection

26. I do not need to comment in detail upon the plight of retail customers of banks, cheated by a growing number of bad products designed solely to boost banks’ profits. Enough of these have been exposed in the press, and the figures of complaints to the Financial Services Ombudsmen tell the story eloquently. What is clear is that banks are now completely unconcerned about their reputation (which has no further to fall), and it is in their best commercial interests to continue to offer unsuitable products despite the risks of fines and compensation.

27. Two reasons explain this. One is that a bank which does not engage in this will generate lower profits than one that does: this is the logic of paragraph 9 above.

28. The second is more worrying. It is the breathtaking incompetence which rules at the Financial Ombudsman Service. I should be happy to provide full details of specific cases where in my view FOS staff have demonstrated a systematic inability to understand the basic principles of consumer protection. The costs of this service fall across the industry and are probably passed onto consumers; if not they are borne by shareholders, but never by the managers who benefited from the activities. As with FSA sanctions for serious wholesale misconduct, fining banks is an ineffective deterrent. This is because shareholders, many of whom are ultimately also the consumers, are not in a position to influence specific behaviour, particularly where the whole industry indulges in a sharp practice.

What is to be done?

29. In my view it is unacceptable to ignore these issues: that will simply lead to further banking crashes. And Vickers, even if not watered down and even if its provisions are in place before the next crash, will be ineffective in protecting stakeholders from those consequences.

30. I favour an approach based on specific legislation that will enable market forces to come into alignment with the public interest, in a way which will reduce our dependence on regulation and compliance which cannot provide an answer.

31. To do this it is vital to go back to Vickers and insist on a full break-up of the banks. Ring-fencing alone, which I (as an experienced structured financier) have always argued will be easily subverted, will not only be ineffective, but will do nothing to align the interests of shareholders and regulators. Shareholders will remain unable to exert real influence over the industry when they are faced only with a handful of universal banks all running broadly similar businesses. We need to break up these institutions at the voting equity capital level. In other words, the component entities that will emerge will have shareholders associated with each business stream, in a position (through voting at AGMs or sale of shares) to influence the behaviour of individual activities.

32. The simplest paradigm for this would be the separation of utility and casino operations. This may be all that is required in legislation, although I think there would be merit (and perhaps sufficient market logic to see emerge with its own momentum) in a further separation between say pure advisory and capital-intensive investment banking activities, and for further subdivisions, or “unbundling”, of different parts of these. The key point is that the market would decide, through the value of shares, which activities would receive the capital needed. The utility entities would effectively enjoy full state support, in exchange for severe restrictions on staff compensation, activities and leverage; while the Government would explicitly be prevented from supporting casino operations. Shareholders would be on notice that these businesses are extremely risky. I suspect many will conclude that their capital is unlikely to receive an adequate return for the risks involved, and the withholding of further capital will have the effect of shrinking the size of this sector to manageable proportions. It will also be more conducive to shareholder intervention (as well as addressing the “too big to fail” issue) if the businesses they own are individually smaller and more homogeneous. Accounts should be required to reveal more about the sources of profits—eg from zero sum trading—in a manner that permits investors to obtain a full picture of the aggregate results from all their shareholdings. More complete disclosure of underlying exposures from derivatives and other products should also be required.

33. One area will require continued attention. Shareholders are largely represented by managers in pension or other collective funds, and their lemming-like behaviour, propensity for group-think and general passivity has allowed the present situation to take hold. My recommendations above put them into a position where they can have a real influence of the structure and performance of this industry. But they must exercise that power with far greater vigour than hitherto. It would be disappointing if they continued to invest my money in casino businesses offering only a tiny premium over the utility returns because they have failed to understand the risks. This is a group where we have every right to insist on professional standards of care and attention, and the exercise of independent thought. Politicians will need to look after the public interest by holding these managers to account.

28 July 2012

Prepared 19th June 2013