Banking StandardsWritten evidence from the Oxford Centre for Mutual and Employee-owned Business, Kellogg College, University of Oxford
Summary
This submission argues that the relative lack of financial diversity within the UK financial services sector was a contributory factor behind the problems witnessed in banking over the past few years, and argues that a stronger presence of co-operative and mutual banks and financial institutions—a critical mass—would contribute towards greater systemic stability for the financial services sector and thereby for the economy as a whole. The submission argues that to achieve a healthier financial services sector in this way would require changes to the current regulatory system that resulted in regulators recognising properly the benefits that mutual organisations bring to the financial services sector—which includes reduced systemic risk, a focus on customer service, enhanced competition, and member engagement.
The terms of reference of the Commission are to consider and report on:
(a)
(b)
The Commission would welcome responses to the following initial questions:
1. To what extent are professional standards in UK banking absent or defective? How
does this compare to (a) other leading markets (b) other professions and (c) the historic
experience of the UK and its place in global markets?
No comment
2. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole?
No comment
3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector?
The degree of public and consumer trust in banks has fallen in the course of and as a result of the banking crisis. The evidence—some of which is reported below—suggests that customer relationships with plc banks and insurers are typified by convenience and price, and also in some cases by a perception of intransigence, whilst with mutuals, customers habitually report that they feel they benefit from value, service and a sense of belonging.
Research commissioned by the Building Societies Association from GfK NOP found customer service to be better in mutuals than in other organisations, with satisfaction levels at mutuals higher than at plc banks on both savings and mortgages, and with significant differences in mutuals’ favour on questions regarding value for money, fairness, trust, support for customers getting into financial difficulties, and comments and feedback being taken seriously (BSA, 2010). This BSA-commissioned research has been repeated each year since 2007, and the above results have been found consistently, each year.
The Association of British Insurers 2009–2010 Customer Impact Survey—which explores in depth the relationship a customer has with their company—found the score for the industry as a whole fell from 52% in 2008 to 51% in 2009 (ABI, 2010), but for mutual insurers the score in 2008 had been 57%, 1 and this rose to 58% in 2009. 2 Customers of mutual insurers and friendly societies were more likely than customers of plcs to believe that their company really cares about them and treats them fairly. 52% of mutual customers agreed or strongly agreed that the insurance industry has an excellent reputation, compared with 48% of customers of plcs.
The key point is that building societies, mutual insurers, friendly societies, credit unions, and cooperative banks have an alternative business model from plcs, as they are required to serve the interests of their members rather than maximising financial returns to external shareholders.
These organisations therefore have different incentives and will respond differently to new developments in the economy, thus reducing the risk of herd behaviour and hence producing a more stable and robust financial system. The different business models also provide competition to each other, of a qualitatively different type than is provided by just adding an additional firm with the same business model. Thus, firstly, the different business models have different behaviours and outcomes, and some may be more appropriate for some markets and functions and less so for others. That in itself is a reason for ensuring diversity of providers is not obstructed.
Secondly, the different behaviours and reactions to events mean that a diversified financial system is more stable and robust, and less likely to create bubbles and crashes. Given the costs of the 2007–2008 credit crunch, this stability is worth a lot—including in financial terms. Thus, if there are opportunities to boost corporate diversity, then even if these might be expensive in the short run, such policies would likely pay dividends in the long term. Avoiding the costs of investing in diversity may prove to be a false economy—and an extremely expensive one at that.
Thirdly, the greater degree of competitive pressure that will be produced by different business models competing against each other will tend to improve the service to customers over and above the improvement referred to in point one, of just greater choice. Corporate diversity promotes competition and drives further innovation and performance improvements.
4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (a) the following general themes: the culture of banking, including the incentivisation of risk-taking; the impact of globalisation on standards and culture; global regulatory arbitrage; the impact of financial innovation on standards and culture; the impact of technological developments on standards and culture; corporate structure, including the relationship between retail and investment banking; the level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects; taxation, including the differences in treatment of debt and equity; and other themes not included above; and (b) weaknesses in the following somewhat more specific areas: the role of shareholders, and particularly institutional shareholders; creditor discipline and incentives; corporate governance, including - the role of non-executive directors - the compliance function - internal audit and controls - remuneration incentives at all levels; recruitment and retention; arrangements for whistle-blowing; external audit and accounting standards; the regulatory and supervisory approach, culture and accountability; the corporate legal framework and general criminal law; and other areas not included above.
A major reason for promoting corporate diversity within the financial services sector relates to the problem of systemic risk and instability.3 What one wants is a diversity of appetite for risk within the system. Mutuals will tend to have less appetite for risk than will shareholder-owned banks. The case of the Dunfermline Building Society is the exception that proves the rule: it failed not because of the weakness of the building society business model but on the contrary, because it was tempted away from that business model and was adopting policies and practices more appropriate to a shareholder-owned bank. Ayadi et al. (2009) found there to be a natural business model associated with different types of ownership structure, and that institutions which got into trouble were those that deviated from that natural business model associated with the particular ownership structure they had. That was certainly the case for Dunfermline.
On appetite for risk, one of the features of a mutual and of many “stakeholder value” banks is that they cannot easily inject external capital, and this tends to limit their risk appetite, and that was precisely what Ayadi et al. (2009 and 2010) found to be the case, consistently, across Europe. The Dunfermline Building Society deviated away from the tolerance of risk associated with the inability to inject easily more external capital.
This feature of mutuals limits their risk appetite and thus means that a financial services sector containing a critical mass of mutual organisations will have a spread not only of business models but also therefore of appetites for risk. This is a positive feature and one that should be applauded and encouraged, to create a more stable and robust financial services sector. Ironically, the Regulator in practice takes the opposite view: this inability to inject easily more external capital is viewed as a weakness in mutuals. Similarly, the FSA is currently threatening to pursue a policy in relation to mutual capital for mutual insurers and friendly societies that could prove disastrous for the sector.
5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally?
The Government should:
(i)
(ii)
(iii)
6. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice.
Within the new regulatory framework, there needs to be a clear responsibility in the regulator’s charter to promote diversity of corporate ownership within the financial services sector. In the past, the objection to taking this step is that it would require legislation. But now there is going to be legislation in any case, and there is going to be a new regulator, so this is the moment to ensure that the regulator is given proper responsibility for fostering corporate diversity within the financial services sector, including through the promotion of mutuals.
So, firstly, the regulator must have a responsibility and a requirement to demonstrate that they are taking the need to promote greater corporate diversity in the financial services sector into account.
Secondly, the regulator needs to have somebody within the organisation who is at a senior level defined as a head of mutuals policy and who is therefore charged with demonstrating that regulation does not prevent mutual organisations from competing on an equal basis with nonmutual forms. (There is not anyone who has that particular remit currently and, therefore, there is no particular incentive for anyone in the organisation to think beyond the standard plc model.)
Thirdly, regulation needs to be proportionate. Regulation and the demands it makes represents a powerful competitive advantage for large incumbent players because they can absorb that cost. The resource costs and the monetary costs impact more heavily on smaller players, constituting a barrier to entry—you have to comply with regulation before you have done your first deal—and it stops the smaller people thriving in a way that would provide meaningful competition to the big incumbents. On the whole that disadvantages mutuals, and it is certainly a barrier to greater corporate diversity within the financial services sector. Ironically, it actually favours the “Too Important to Fail” banks that are part of the problem. There is a precedent with the rules relating to credit unions which much more effectively enable new organisations to be developed, and this approach could and should be translated for other forms of mutual, to remove the barriers to entry and early survival.
7. What other matters should the Commission take into account?
There is huge pressure from the regulatory environment, and from certain elements of the media, for mutuals to behave and measure themselves like non-mutuals, because that is how they get compared. There is little appreciation that a diversity of business models is precisely what is needed. Non-plcs should be encouraged to articulate why they are different, why they measure themselves differently, why their risk appetite is different, why their stakeholders are different, and why what success looks like is actually different. Firms with diverse ownership and business models are trying to do different things for different people with a different overall purpose.
It is important to view the whole—diverse—financial services sector as both innovative and fluid, and this applies within the various business models as well as to the balance of market shares between such models. Thus, the mutual sector could transform its own models; we are not necessarily talking about a photograph of today’s mutual model. For example, one of the findings of Ayadi et al. (2010), which analysed the role of co-operative banks in Europe, is that the UK is the only one of the countries studied that did not have what they termed “central network institutions”—the collective. For example, Rabobank is not only a bank in its own right but it is also a confederation of 52 “little Rabobanks”. So, while one difficulty for non-plcs may be their small size, there are models that can cope with that; the central network institutions enable their members to buy-in economies of scale from outside because they are too small to generate them inside—but the crucial difference between that and outsourcing is that the central network institution is actually owned by the members, and is an integral part of the business model. However, culture and tradition have tended to prevent such a model developing in the UK, and there would also be substantial difficulties combining legacy systems and co-ordinating the pooling of resources and procurement in order to benefit from cost reductions. Furthermore, such a model could be difficult to establish under current UK competition law. Nevertheless, it is important to stress that the mutual model is an evolving one, and there are a range of interesting success stories across Europe, and indeed in North America and elsewhere. The UK has a lot to learn from the experience of other European countries which clearly value the advantages of diversity in the financial sector.
Likewise, the third element of the Butterfill Act enables—subject to the passage of appropriate secondary legislation—all types of mutual institution to merge with each other (apart from credit unions which are exempt from the legislation), yet secondary legislation has so far been enacted only to enable a building society to merge with an industrial and provident society. Other types of mutual-to-mutual mergers are still not possible. This is an anomaly that should be corrected.
References
Association of British Insurers (ABI) (2010), 2009–2010 Customer Impact Survey, ABI, London.
Ayadi, Rym, Reinhard Schmidt, Santiago Carbo Valverde, Emrah Arbak and Francesco Fernandez (2009), Investigating Diversity in the Banking Sector in Europe: The Performance and Role of Savings Banks, Centre for European Policy Studies (CEPS), Brussels.
Ayadi, Rym, D.T. Llewellyn, R.H. Schmidt, E. Arbak, and W.P. De Groen (2010), Diversity in European Banking: Why Does it Matter?, Centre for European Policy Studies (CEPS), Brussels.
Building Societies Association (BSA) (2010), Customer service at mutuals is better than at banks, BSA, London.
Ownership Commission (2012), Plurality, Stewardship and Engagement: The Report of the Ownership Commission, Mutuo, London.
11 September 2012