Banking StandardsWritten evidence from Theos
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Nick Spencer is Theos’ Research Director. He has previously worked as Research Director at the London Institute for Contemporary Christianity, researcher for the Jubilee Centre, and, before then, as a researcher and consultant for Research International and The Henley Centre. He is a Visiting Research Fellow, at the Faiths & Civil Society Unit, Goldsmiths, University of London and is author of Rebuilding Trust in Business: Enron and Beyond.
Summary
A false distinction is made between regulatory, structural and cultural change of the banking system. Cultural change will result when the interests of shareholders, employees and the general public are appropriately aligned. The public interest needs to be structurally recognised.
The duty of bank directors to act in the interest of their shareholders is part of common law, and now statute law (Section 172, Companies Act 2006). The public utility function of the banking sector has been assumed, rather than recognised in statute. Where these roles conflict, directors have failed to recognise the public interest.
The shareholder/director relationship in a bank is unlike other limited companies. Shareholders suffer a massive informational disadvantage—capital allocation decisions are too frequent and rapid for shareholders to track and value and major banks are far too large and complex shareholders and non executive directors to exert any strategic traction.
Employees are insufficiently exposed to the risk of their own capital allocations. In order to avoid short-termism, action needs to be taken to ensure that rewards have a horizon which matches the considered interests of shareholders.
We are concerned that competition will be seen as a panacea. Competition can have negative outcomes when it seeks ends other than the common good. Competition is not only too narrow but also too monochrome—we don’t need more entrants offering the same kind of services, but more diverse entrants offer more relational and local services.
We submit that banks are probably too large to govern prudentially, and that scale results not in economies but in greater complexity, uncertainty and regulatory convolution.
Introduction—The Cultural Problem
The ongoing discussion around values and culture is beset by uncertainly about the ways in which change might be achieved. Compared to applying leverage ratios, capital requirements, and stronger regulation, corporate culture seems indefinite. We want people to behave better, but how does that happen?
Most attempts to address the challenge of distorted banking cultures offer a persuasive diagnosis of what went wrong, followed by a restatement of the need for ethical behaviour. Such critiques don’t take account of the plethora of influences present in the ecology of any business, all the more so with large and complex institutions like multi-national banks. Too often, “values” have been seen in the abstract—purely a matter of what people think and believe to be good or acceptable, rather than the habitual practices, cues, incentives and accretion of decisions over a that over time shape, re-shape and potentially distort, culture. The debate is at risk of making a false dichotomy between hard changes (structure, governance, incentives on the one hand) and soft changes (around culture and values on the other).
This is not to say that deliberation and thinking about culture and ethics is not necessary. It is to suggest that tangible changes should be made to change how employees and managers view risk, agency and accountability within the financial services. We propose adjustment under three headings—addressing the issue of banking purpose, questioning the role of competitive pressure, and changing culture in the context of size and complexity.
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1. Addressing the issues of ownership and purpose
a.As has been widely observed, the gradual change from banks being privately owned to publicly trade companies has created misaligned interests in the banking sector. Under Section 172 of the Companies Act the primary legal duty of any company director has been to “act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole” (while having “regard” to other factors). The benefit of members was understood at time of the Act’s passage to refer mainly to the financial interests of shareholders, albeit those interests considered over time. In short, bank directors are tasked with ensuring a return on equity for investors. Whether in the medium term they have been successful in doing this is, of course, now in doubt.
b.Meanwhile, the public utility function of banks has been assumed, rather than recognised in law. Section 172 (2) of the Companies Act provides for the existence of companies that have a purposes other than the benefit of members. Ironically, this describes banks precisely, but both culturally and legally they have been assumed to be a company like any other.
c.We have assumed that this dual role (providing profit for investors and financial plumbing for the economy) could be reconciled. In fact, they have not. The services that banks provide to the broader economy (safeguarding deposits, operating payment systems, channelling savings to productive investment) have been damaged by attempts to maintain or increase profitability (and thus value of equity and size of the bonus pool) by over-leveraging, entering more esoteric markets, or indeed by engaging in profitable and legal but socially questionable activity (eg, advising corporation on reducing their tax burden). At times they have acted against the public interest.
d.In terms of behaviour which led both to the banking failures since 2008, as well as further malpractice, responsible shareholding (as well as responsible management) should have acted as a brake on the changing culture of the sector. Why did shareholders exert so little influence in this period?
e.Although treated as limited liability companies, there are a number of ways in which banks are unlike other corporations. As well as being essential to the wider economy in operating payment systems, and extending credit through the wider economy through fractional reserves, the relationship between shareholders and senior managers in a bank is almost completely different to that of other corporations. In the latter, major capital allocation decisions are made by a small team of senior managers on a (relatively) infrequent basis, and can be (relatively) easily understood and their value judged by shareholders over time. That investment is then usually illiquid, and any returns are measured over a reasonable period of time.
f.In banks, however, large numbers of employees tend to be involved in repeated, short term investments in rapidly moving markets where prices and profits are measured daily. Employees are able to point to profits as a measure of skill (and hard work) in capital allocation, and demand a high proportion of the gains. Senior managers also depend on this narrative to justify their own remuneration. In view of the implicit state guarantees, employees and senior management are not exposed to any downside risk. This is the context where a culture of excessive risk taking, high reward for low value activity, and disdain of long term investment emerged.
g.In the equity markets, horizons have also shortened. Shareholders and intermediaries are liable to let banks get on with doing what they like with their capital, accept that employees deserve to keep a high proportion of gains and assume that their legal duties of directors have been met. In short, they have not understood that a wider view of their own interests may run against short-term profitability. Limited liability shareholding compounds this detachment of shareholders from the business. They may loose the value of their investment, which may be substantial and serious, but there is no motivation for them to seek to influence anything other than the profitability of the bank. Indeed, owners and their intermediaries usually try and avoid the risk of a concentrated stock, and again their influence is diffused. In the context of banking understood as an economic utility, in which the wider stake of society must be represented, we must ask whether this detachment is acceptable.
h.Increased shareholder engagement or activism has often been seen as one way to correct the culture of the banking system. There are obvious barriers to this, even beyond those set out above. Even in existing mutual institutions, there are clear power imbalances between shareholders (even those who are wary, public spirited and sufficiently large to exercise influence) and boards. In the large combined high-street and investment banks, all the more so. Even large institutional investors of good will have neither the information nor skills to act as a brake on the interests of employees and boards. Non-executives, who exist theoretically to protect the interests of shareholders, have seemed similarly under-skilled in understanding the plethora of activity taking place and, again, were prepared to accept stable returns on equity as evidence that the bank was being run in the interests of shareholders.
i.In view of the above
(i)We should consider how banks can be structurally engaged with the notion that they have an important public purpose, and that as well as being bound by legal and fiduciary requirements for the members of the company, they are also bound to consider the common good. Academics have argued that Section 172 does not seem to have substantially changed the activity of directors, and indeed that its primary function is educative. Statements of purpose are also helpful in setting the tone.
(ii)Can shareholders be helped or encouraged to engage more substantially in corporate governance? The role here of non-executives needs to be reconsidered. Given the size of complexity of banks (see point 3), they are unlikely to be able to exercise strong oversight without greater external assistance. Could banks be obliged to offer customer groups representation on boards, offering greater recognition of the ecology of interests in seeing banks profitably but wisely run.
(iii)Ultimately, a series of factors have coalesced to allow individuals within the system to act for significant personal gain without risk of personal loss. Remuneration, at the minimum, needs to be re-focused to long term profitability as well as being adjusted for risk. This need not be seen as a moralistic censure against banker greed, but to accept that if that financial incentives are significant, then they should not be so structured as to incentivise short term investment which put institutions and financial stability at risk.
2. Questioning the role of competitive pressure
a.In a market environment, the prevailing assumption is that competition between similar businesses will give customers greater power and result in a more efficient allocation of resources. These lie behind the Vickers Commission’s proposals to make it easier to switch personal and small and medium sized business accounts. However, as the Vickers Report (albeit briefly) acknowledges, competition can—depending on the prevailing values and ethos of the sector, an institution or a part of a bank—have negative outcomes. In the pre-crisis period, for instance, it led to excessive leverage in order to maintain return on equity as returns on assets fell.
b.Debts, deposits and loans are not simply commodities traded at an isolated point in time, but ongoing relationships built around mutual trust. Nor are they necessarily an equal partnership—banks have a far greater level of knowledge than almost any customer, and wield considerable power over borrowers who may depend on their services. Customers could and should be able to move personal and SME accounts more easily, but it is not so easy to envision how this might apply to pensions, mortgages, or a host of other financial services. In any case, freedom to leave is not the same as the opportunity to seek redress. By analogy to the John Kay’s point about equity markets emphasising exit over voice (see footnote 2 above), will enabling customers to move more easily result in a significant improvement in customer service? Or will it in fact just result in more moving of banking accounts between providers who may or may not offer marginal improvements? Or with banks offering incentives to encourage customers to move?
c.Similarly, if the culture is already formed around the desire to maintain a bonus pool, to maintain share price, and to provide high dividends for investors (ie, if those are the things that are valued) then competitive pressure will create activity around activity around those goals, not in the interest of the customer. Without addressing the sector’s understanding of its fundamental objectives (ie, it is not a primary business, but a service and utility sector), then increased competition will have some positive, but perhaps largely negative effects.
d.The Vickers Commission recommended broadening competition, making space for new market entrants. But competition is not only too narrow, it is also too monochrome. Customers should be able to switch easily, but they should also have avenues for greater involvement, relationship and control—a factor of banking on a smaller scale. The issue is not just the number of competitors, but the kind of banking service on offer. Bolstering the position of smaller—possibly regional—banks, operating a partnership model, would mean that owners could exercise greater and more effective oversight. Improving the offer of credit unions, peer-to peer-lending, genuinely open mutuals or even faith-based banking would create more dynamic competition in the sector.
e.Regional banking would in turn address structural problems in the economy overall, which include a lack of capital to support SME’s in the regions. Local banks, established with the explicit purpose of supporting local economies, would be more able to take informed investment decisions, filling a gap in the market that has been vacated by the big high street banks, who have relied on impersonal central credit control models to govern regional lending. Quantitative Easing has effectively been used to rebuild the balance sheets of major banks, while the stock of lending to large businesses and SMEs continues to fall. Creating and endowing regional banks, providing a supply of credit to businesses in areas that have relied heavily on public spending to secure the local economy.
3. Culture in the context of size complexity and uncertainty
a.Investment banks are large and complex—often incorporating departments or activities which for regulatory reasons must be kept separate. In 2012, Barclays had over 150,000 employees worldwide. Lines of accountability are often muddy. The very fact that directors have claimed that, in cases of malpractice, they did not know what was taking place indicates that banks are too large. Non-executive directors and shareholders are massively disadvantaged in tracking and overseeing the range of activity across an institution. They are probably too big to govern prudentially.
b.This makes talk of a single culture of standards impossible. Banks of any size or complexity will have a number of cultures, and a variety of standards. Redressing the imbalance between the prevailing trading/investment culture, and the customer and relationship focused culture, will no doubt help. We should not, however, imagine that it will resolve all problems.
c.In addition to this, the basic business of investment banking, while not inherently speculative, is inherently uncertain. Bad outcomes are highly possible. Logically, this should lead to a high degree of caution. However, given the lack of job security in investment banking, this very uncertainty drives a mentality of short-termism and leveraged speculation. Again, the skewed payoff to employees (exposure to losses is capped at zero, exposure to upside is unlimited) creates incentives which are counter to the interests of shareholders and society as a whole.
d.Conversely, there is no consensus on the relationship between a bank’s size and efficiencies of scale, and any that do exists must be balanced against the considerable inefficiencies associated with managing and regulating complexity.
e.Scale is a problem on so many levels that attention should be given to addressing this. This will partly be through lowering barriers for new and alternative entrants, but whether this can be done while large multinational banks that still enjoy and implicit subsidy still dominate the market must be open to question.
Conclusions
The cultural problems in banks arise not just from changes in societal values, but from the interaction of a range of issues around structure, incentives and size. Changing culture is a daunting prospect, and it is always easier to will the ends than it is to define the means.
Above we have outlined three themes under which concrete action could be taken to change the culture of the banking system overall. We need to look for a realignment of interests—and particularly a structural recognition of the public interest in the effective operation of the banking system. We need to make sure that there is not just more competition, but more diversity and less uniformity in the banking sector. Finally, we need to ensure that banks are small enough to govern prudentially.
20 February 2013
