FSA: Banking at the cross-roads: Where do we go from here?

Speech by Lord Turner, FSA Chairman at Bloomberg

Two weeks ago the Economist front page headline was  ‘Banksters’.  When a respected magazine, read throughout the world, suggests that banking is riddled with malpractice, its ‘credibility shot’, trust evaporated, we have a major problem.

A problem, because the banking system – and the wider financial system – plays a crucial role in a market economy. It connects savers and borrowers, investors and users of funds, it allocates capital, it provides payment services, it insures against risk.  It performs complex and vital functions, functions whose effectiveness depends crucially on the integrity of those who operate within the system, integrity which in turn earns trust.

And lack of trust in financial services is a problem for Britain in particular, because the City is a vital contributor to the UK economy.  But the City’s overall reputation can be undermined by excesses and failures in particular areas of activity – excesses and failures to which competitors abroad are only too happy to draw attention.

So we must consider where we go from here.  In this speech I will do three things:

First, identify three key drivers of declining trust in the banking system.

• Second, consider what the essential problem is – why banking is different from other sectors of the economy.
• Third, suggest implications for prudential policy, for industry structure, for conduct supervision and, most crucially, for the management and boards of banks.

Collapsing trust

Trust in banks and bankers has eroded.  Three factors explain that collapse: people have come to doubt the economic benefits of financial liberalisation and of much banking activity; they doubt banks’ values; and they doubt whether banks have their interests at heart. 

Economic impact

Ahead of the crisis, experts confidently asserted the great benefits of increasing financial intensity and innovation.  Global financial flows were driving more efficient allocation of capital: ever more liquid markets were improving price discovery; the alchemy of securitisation was dispersing risks into the hands of investors best placed to bear it; derivatives were enabling better risk management; and, the rapid growth of UK-based banks, such as RBS, was seen as good for the UK economy.

Huge bonuses may have amazed and bewildered the ordinary citizen, but the experts were on hand to explain that in some mysterious way ever more intense and complex financial activity was increasing the total size of the economic cake, with the prosperity of all enhanced, even if less richly than that of some bankers.

And that proposition was essential to the social acceptability, or at least the tolerance, of huge individual rewards.

But we now know that it wasn’t true.  Some forms of financial innovation probably did have potential to deliver economic benefit, but much was of little true economic value; and far from making the financial system and overall economy more stable, it contributed to the financial crisis of 2008 and the Great Recession which has followed.  The complexity and opaqueness of investment bank innovation contributed to that crisis: so too did excessive commercial bank lending, in particular to the commercial real estate sector.

Central to the collapse of trust in banking is people’s feeling that they were sold a story about the benefits of increasing financial activity which turned out to be untrue.  Part of the solution must therefore be policies which ensure that finance is in future focused on its valuable and essential functions, and that we more effectively offset its potential to create harmful instability – whether in investment bank activities or in plain old commercial bank lending.

Values

People are angry with banks and bankers – and with the policy makers who set the rules within which they operated – because of a Great Recession whose origins they believe, quite rightly, lay within the financial system itself.  But the outrage which led directly to the headline ‘Banksters’ is also a fury about values, provoked by the quotes revealed in the Libor scandal: “come over …and I’m opening a bottle of Bollinger”¹, so we can celebrate fixing the Libor rate.

Those quotes reveal a dealing room culture of cynical greed.  So too do the attitudes revealed by Michael Lewis’s brilliant book The Big Short – securities salesmen knowingly selling securities whose value they doubted to customers whose judgement they disparaged – the “idiots in Dusseldorf”.

And of course there is nothing new about dealing room culture, nor sharp practice.  Anyone who thinks that there was no insider dealing before ‘big bang’ is looking at the past through rose-tinted spectacles; anyone who thinks that testosterone-driven dealing room culture is new didn’t visit an FX dealing room back in the early 1980s.

But what is new, is that the sheer scale of financial activity has increased, its share within the economy is much larger, and that, as a result, the size of the potential corporate and personal benefits from malpractice have grown greatly.

People are more concerned by poor values in finance, simply because finance got much bigger. 

Customers’ interests

Malpractice in dealing room and in wholesale sales and derivatives matters.  It is not a victimless activity even when, as is sometimes the case, it is not prosecutable as a crime. But shady practice in the esoteric arena of Libor fixing might still not have provoked quite as much public anger if it had not come on top of scandals which more directly affected the average citizen.

In the UK, mis-selling of payment protection insurance to personal customers and of interest swaps to SMEs, and in the US, the activities of mortgage salesmen enticing borrowers into unsustainable credit commitments, have convinced many consumers that retail banks are out to serve their own interest, not the interest of their customers.

So the collapse of trust in bankers which led to the ‘Banksters’ headline is the product of three factors.

• A story of beneficial economic impact which turned out to be untrue.
• Poor values and malpractice able to operate on an increasing scale.
• And direct consumer experience of exploitative product sales.

The way forward to a more trusted banking system must address each of these three problems.

And addressing the problem is important, not just for banking, but for all UK financial services, for the City, and for the UK economy. 

Yes, there have been severe faults in some parts of our financial system.  But financial services – including complex wholesale financial services – play a crucial role in a vibrant market economy; and the UK is good at providing those services to the rest of Europe and to the world, and should continue to do so in future.  Wholesale insurance services, equities research and trading and distribution; asset management; corporate finance advice: these are services which the City provides and has continued to provide well throughout the crisis.  And while some investment bank product structuring and dealing activity appears to have added little to economic efficiency, the core functions of underwriting equity and bond issues and of providing liquidity via market making in key fixed income and foreign exchange markets, are valuable and essential ones.

So let me be clear:

• I do not believe it is the role of the regulator itself to have responsibility to promote the competitiveness of the City, because the moment you introduce that requirement, you create a confusion of objectives and open the door to regulatory arbitrage.
• But as a citizen of the UK, I am clear that the City is now, and should be in the future, a leading global financial centre, making a large positive contribution to our economy.

Financial services are essential to a complex modern economy, and Britain has a comparative advantage in their provision.

But while recognising that, we also need to recognise that financial services in general – and banking in particular – are in some crucial respects different from other services and markets.  And those differences help define what regulators and what industry leadership need to do to help restore trust.

Distinctive features of financial services and banking

Financial services in general, but banking in particular, are different from other sectors of the economy – retailing, manufacturing, leisure services, transportation – for four reasons:

• First, financial markets and institutions, and in particular those involved in the process of credit and money creation, can introduce instability to the macroeconomy, fuelling booms and busts.  If a retailer expands too rapidly, gets into trouble and goes bankrupt, that is a problem for the retailers’ shareholders and their workforce.  But over-rapid bank expansion and subsequent bank failure can be fatal for the whole economy.  That has implications for the responsibilities of bank management and boards.
• Second, there is far greater potential in retail financial services than in other sectors for producers to rip off consumers.  That’s because of the asymmetry of information and knowledge between the provider and the customer.  The car buyer is well-equipped to test drive different cars and select the one he or she prefers; the unsatisfied supermarket customer can take his or her business elsewhere.  But individuals cannot test drive complex investment and insurance products: they rely on trusted providers to give explicit or implicit advice. And many purchases are too infrequent and too large to make switching provider an effective market discipline.  Either regulatory intervention, or producer responsibility and ethical values, have to compensate for the ineffectiveness of markets.
• Third, and particularly in wholesale financial services markets, there is far greater potential for the proliferation of activities which are, in the economist Roger Bootle’s words,² merely “distributive” rather than truly value “creative” – activities which simply redistribute money from one group of citizens to another, rather than increase the size of the economic cake.  A significant share of what is described as innovative product structuring in the investment banking world is not innovative in a social value sense – but dedicated to either regulatory, accounting, or tax arbitrage – to seeking economic advantage from describing an unchanged set of risks in a more favourable regulatory or accounting form, or to redistributing an unchanged economic pie from the generality of tax payers to the bank’s customers or to the bank itself.  And in the provision of complex financial services to end investors, there is much greater opportunity than in other sectors of the economy for purely rent extracting activity, for instance through unnecessary portfolio churn, which detracts rather than enhances investor return.³
• Fourth and finally, ethical risks are created by the immateriality of finance and by distance from end customers, particularly but not exclusively in the wholesale arena.  One of the best books written on the origins of the financial crisis is Raghuram Rajan’s Fault Lines.⁴  Rajan is one of the few mainstream economists who identified the potential instability of the financial system ahead of the crisis – his warnings at Jackson Hole in 2005 were sadly not only ignored, but overtly rejected.  In Fault Lines he gets behind the immediate causes of the crisis to some of the fundamentals – to global current account balances, and to over-rapid US credit extension deliberately encouraged for political reasons.   But one of his chapters is about ethics, and entitled ‘When money is the measure of all worth’.  And the point Rajan makes is as follows:
  • In all activities within a market economy, self-interested money-seeking motivation plays an important role.  It was after all Adam Smith’s great insight that the interaction within competitive markets of self-interested individuals can lead to socially beneficial results.  In many areas of economic activity, however, those self-interested pecuniary motivations are balanced and constrained by others – by pride in the service or product you are delivering, by desire to please customers as an end in itself, by enjoyment of the esteem in which you are held by customers or business counterparts with whom you have a sustained relationship.
  • But what is distinct to finance, and in particular to the areas of finance where savers and users of funds are connected via multiple steps in complex chains – is that many of the key participants have no direct contact with the end customers whose lives they are affecting, and only transient contractual relationships with their counterparties.  And it is simply easier to make huge amounts of money out of a multi-step chain which connects ill-informed investors in one country to ill-informed sub-prime borrowers in another, and still go home believing that you are a fine upstanding member of society, than knowingly to sell a bad product or service to a customer with whom you have more direct contact.

When money is the measure of all worth, constraints on the temptation to fix Libor or knowingly sell shoddy products, are greatly reduced.

Where do we go from here?

So where do we go from here? How will we rebuild trust in the banking system and rebuild recognition of the vital role which a well run banking system plays within our economy?  I suggest five elements of the response.

• Better prudential rules and new macro-prudential policy approaches.
• Structural change – the importance of the Vickers Commission recommendations.
• Better, more intense and more robust conduct supervision and enforcement, but recognising also their limitations.
• Action by the leadership of banks to improve culture and values – a difficult area but a vital one.
• And finally, some recognition by regulators, politicians, consumer groups and the general public of the complexity of the challenge and the constraints which banks face.

Prudential rules and macro-prudential approach

It may seem odd to start with prudential rules.  After all we are talking about lack of trust, about mis-selling or market manipulation in retail and wholesale markets, about bankers perceived as ‘banksters’: where do capital and liquidity rules come into the story?

Well, they are fundamental; because the biggest thing that has destroyed trust in the financial system, and in banking in particular, is that people were told that complex finance would make them more prosperous but that instead it caused a great recession.  And the economic losses suffered as a result – the losses to wealth and income and employment, and the increased public debt burdens, are far far greater in value than any customer detriment resulting from malpractice. 

When the serious economic histories of this Great Recession are written, I am sure that they will concentrate on the policy mistakes which led to the crisis, with the role of individual miscreants or poorly run institutions likely to seem less significant over the years.  Just as in the serious economic histories of the Great Depression public policy mistakes are to the fore, not the many examples of unscrupulous activity and bad individual business decisions which flourished ahead of the 1929 crash.⁵

• Ahead of the crisis, we had totally inadequate rules on bank capital and liquidity, agreed by apparent experts from regulators and central banks across the world, which allowed banks to run with a fraction of the capital reserves we now believe essential for a stable system.
• We also had a flawed theory of economic stability – believing that low and stable inflation was sufficient to ensure financial and economic stability, and failing to identify that credit and asset price cycles can be key drivers of instability.
• And in the UK we had a dangerous institutional underlap between an inflation-targeting central bank and a rule-driven regulator, with no one responsible for assessing the big picture risks, or equipped with tools to address them.

Putting all that right is crucial – and we have already made significant progress.  Key elements of that progress are:

• the Basel III capital and liquidity standards;
• measures to ensure that all banks are resolvable, to which bail-inable debt will be central;
• a changed FSA prudential supervisory approach, focused on the essentials of capital, liquidity and asset quality; and
• the creation of the Financial  Policy Committee, responsible for deploying macro-prudential levers which can lean against excessive cycles in credit provision.

In all of this we face a very complex balancing act – how to make progress towards a sounder system in future, while not exacerbating the deflationary dangers created by deleveraging after past excesses.  But at the end of the transition I am confident we will have a more stable system and that in itself will be central to the restoration of trust.

And new prudential rules will also be central to reducing the potential for the proliferation of unnecessary activity of little social value.  As already said, conduct problems in financial markets are not new – they were there in the much simpler financial markets of the 1960s and 1970s.  But the scope of them exploded with the rapid growth in the scale and complexity of investment banking activities, the rapid increase in the size of bank balance sheets and of trading volumes relative to GDP which occurred between 1980s and the crisis.  Part of that increase in financial activity was inevitable: the natural consequence of globalisation in the real economy, and of the move to floating exchange rates and open capital flows after the collapse of the Bretton Woods system.  But part was unnecessary, and made possible by bad prudential rules which allowed investment banks to conduct trading activity on absurdly light capital bases, maximising the implicit put option onto the tax payer in the event of systemic crisis.

Higher capital requirements overall, tighter leverage constraints and much higher capital against trading activities will reduce the scope for malpractice in complex wholesale finance, simply as a by-product of limiting the potential for unnecessary and risky activity overall.

Structure: implementing the ICB’s ring-fencing proposals

So better prudential rules and the macro-prudential role of the Financial Policy Committee are essential to a more stable system, which people can trust because it is less likely to generate financial and economic crisis.

Structural reforms, such as those recommended in the UK by the Vickers Commission, or to be implemented in the US via the Volcker Rule, will also play an important role.  They are not sufficient to ensure stability.  Yes, complex investment bank trading activity played a role in the origins of the financial crisis – the failure of Lehman’s was a crucial event; but so too did over-rapid expansion of plain old lending to commercial real estate companies: HBOS also failed.  And any idea that, having isolated retail and commercial banking within a ring-fence, we can then be indifferent to the development of risks outside it, is both wrong and dangerous.

But structural reforms which create either entire banks or units within wider banking groups more exclusively focused on classic retail and commercial banking activity still have a vital role to play. 

In the UK the implementation of the Independent Commission on Banking’s recommendations will, I believe, deliver three important benefits.

• First, it will increase the array of resolution options available to the authorities in the event of crisis, creating at least the possibility that we may choose to rescue the ring-fenced entity while allowing non ring-fenced entities to fail.  That possibility will in itself reintroduce market discipline into a system characterised by too-big-to-fail assumptions; which in turn will help constrain the unnecessary proliferation of complex structuring and trading activities, reinforcing the impact of higher capital requirements.
• Second, it will give us the option – provided the vast majority of SME lending is conducted within the ring-fence – of applying macro-prudential policy levers at the ring-fenced level instead of or as well at group level.  That will create a tighter link between macro-prudential levers and the dynamics of credit supply in the real economy, and increase the likelihood that we could limit the impact of booms and busts in commercial  bank lending.
• Third, but perhaps this will turn out to be most important, it will give banking groups the opportunity to build institutions very explicitly focused on the excellent provision of essential banking services to households and SMEs, institutions which – provided banks grasp the opportunity – could play a major role in rebuilding customer trust.

More intense and robust conduct supervision, but recognising the limitations

On the prudential side, more effective rules need to be supported by a new more effective supervisory approach; and the FSA has been putting that in place since 2008.  On the conduct side the changes which the FSA has begun to make are equally important.

In retail markets, the FSA has already described a major change in intended approach – seeking to identify emerging threats of customer detriment at an earlier stage, intervening to prevent or significantly limit a major mis-selling wave such as payment protection insurance, rather than simply ensuring customer redress after the event. 

In wholesale markets meanwhile, we are also considering whether our past traditional approach is still tenable.  In the past, it’s fair to say that the FSA did tend to assume that relationships in wholesale markets, for instance the sale of products to apparently sophisticated institution investors such as pension funds, should be governed largely by a caveat emptor, market discipline approach.  But increasingly we are aware that at the end of the chain of wholesale institutional relationships there will typically lie a retail consumer – the pension fund policyholder for instance.  And that shoddy wholesale market conduct is certainly not a victimless activity.  A somewhat more interventionist approach to wholesale conduct issues is therefore likely to be appropriate; and the FCA’s approach document –to be issued in the autumn – will discuss some of the options, and the implications for FSA resources and skills.

But today I would like to stress not what more intense supervision, of either retail or wholesale conduct can achieve, but what it cannot.  It cannot possibly prevent all malpractice in advance, without employing a hugely increased army of supervisors and probably not even then.  And if we did deploy that army, we might well add more cost to the industry than the cost of customer detriment averted. 

The LIBOR scandal has thrown this challenge into relief: in that scandal there are two distinct phases and categories of manipulation – the low-balling of LIBOR submissions in the 2007 to 2008 for reputational reasons, and the earlier manipulation of rates, sometimes up and sometimes down, by a single or a few basis points, to benefit derivatives positions.  There is a debate as to whether the authorities could have been more alert to the 2007 and 2008 manipulation – and I will not comment on that today.  But in relation to the earlier period, to the manipulation of rates by a minute amount for a short period in either direction, I do not believe these problems could have been spotted from outside except via supervision so intensive as to be prohibitively expensive. 

Alongside more intense and better focused supervision, therefore, robust after-the-event enforcement action and sanction will have to remain a key regulatory tool.  But alongside both, we also need strong management commitment to better culture and better values.

Culture and values

What do we actually mean by cultural change: what does it imply for bank leadership?

At its core, I suggest, must be recognition of the distinctive features of finance and banking described above, and recognition that the top management and boards of banks have a responsibility to offset the dangers which those distinctive features create.

Banks are different because their failure has consequences for the macroeconomy.  There is therefore a social interest in bank boards and top management having a different attitude towards risk return trade-offs than would be acceptable in other sectors of the economy.  We need them when assessing an organic growth plan, a funding strategy, or a major acquisition, to care more about the downside risks of failure than they would if running a retailer, a manufacturer, or a hotel company.

They need to be custodians of institutions of great public interest, as well as custodians of shareholder value. 

There are therefore strong arguments for ensuring that bank directors face different personal risk return trade-offs than those faced in other companies. That is the logic behind the proposal set out in the government’s recently issued consultation document on Sanctions for the Directors of Failed Banks that, when banks fail, there should be some category of automatic sanction for directors which does not apply in other sectors of the economy.

But banks, and other financial institutions, are also different because of the greater potential to engage in pure rent-seeking activity, the greater potential to exploit consumers, and the greater danger that ethics are undermined when money becomes the measure of all worth.  So banks are only likely to earn the trust of customers and the respect of society at large, if from the very top there is a clear message that there are many things which may be profitable, which may be within the legal rules, and which neither the customer nor the supervisor will necessarily ever spot, but which go against firm values and which the bank therefore will not do.

What does that mean concretely?  Well, the only way to make it concrete is to give specific examples.  So let me pose the following questions:

• If the top management and board of a retail bank observes that it is making huge profit margins on an ancillary product sold by a commission-incentivised sales force: what does it do?  Congratulate the sales teams and increase the targets, or ask searching questions about whether the product is truly in consumers’ interest, and whether the controls in place to ensure appropriate sales are sufficient to offset the dangers of bias introduced by high margins and commission incentives?  If it is serious about values and culture, it has to do the latter: but that’s not what happened in most UK retail banks in the case of payment protection insurance.
• And in an investment bank, if a fancy new product design will enable a corporate or a country to conceal from the market the scale of its indebtedness, or if a trading desk manages to offload a problematic position onto an unsuspecting customer, does the top management and the board say “Congratulations, take a bonus” or does it say, “That’s not what we do”? 

There is no value in beating about the bush.  Unless management and boards themselves shift the tone from the top in such specific ways, and in addition make effective controls against dishonest behaviour the highest priority throughout the organisation, then we are not going to change the external perception of bankers which led to the Economist headline.

Public recognition of constraints and trade-offs

Much of the responsibility for restoring public trust in banking therefore lies not with the regulators but with the leadership of banks.

But the challenge may prove an impossible one unless regulators, politicians, consumer groups and society at large are in turn willing to recognise the many good things that banks already do, recognise the constraints under which banks operate and honestly debate a crucial trade-off.

• All of our banks are already providing many good products and services to customers, and they employ many devoted staff to do that.  We need to say that and point out that it’s true even in areas of activity currently under a cloud – such as interest rate swaps sold to small businesses.  Many of the structured swaps sold in the past were clearly not hedges but gambles; even some of the simple swaps were mis-sold: redress must be paid.  But selling a simple interest rate swap product to a small business, for instance a cap and floor collar which protects the business against rises in interest rates in return for limiting the benefit of falling rates – could be perfectly responsible provided the customer truly understood the choice they were making.  We need a tone of public debate which moves beyond simplistic category assumptions – that all interest rate swaps or all of any other products are bad.
• And banks operate within constraints.  They need to earn a reasonable return on equity, since we need new equity to support future lending to the real economy: and they need to cover their cost of funds.  Banks have been accused recently of failing to lend enough money to the real economy, or of lending it at too high a rate.  But if we look at banks’ Net Interest Margin in the UK, the difference between their lending rates and their cost of funds, it’s flat to slightly down over the last four years, not up.  The fundamental problem banks face in supporting lending at reasonable rates is that their cost of funds is high in wholesale markets because of continued concerns about bank credit worthiness, and in retail markets because of intense competition for term funds.  We need honestly to recognise that reality, and devise public policies, such as the new Funding for Lending scheme, which help overcome the constraints, not demonise banks as the source of all our economic problems.
• Finally, we need to recognise a central problem in UK retail banking – the impact on competition of free-if-in-credit banking.  One reason many people don’t like banks is that in the short term customers are locked in, and in the medium term competitive choice appears muted.  So we need to facilitate new market entry into retail banking.  But that is continuing to prove difficult.  Some say that the FSA’s rules and approval processes are an impediment: I don’t believe that is the case, and we have taken several steps to ensure it is not.  But one important barrier to competitive entry into UK personal sector banking is obvious – the fact that the core product, the current account, is usually given away for free, sold at below cost of production.  Which means that it may be difficult for a new entrant to make a business plan stack up unless they assume the sale in some future year of high margin ancillary products – products which if we are not careful may be for both the incumbents and the new entrants, the next PPI.  UK personal sector banking has for years achieved reasonable overall profitability on the basis of large cross-subsidies between different customer segments: many who stay in credit get a good deal, subsidised by others who pay though, for instance, unauthorised overdraft charges and PPI insurance premiums.  It is not a sound basis for a long-term trust-based relationship between a competitive banking system and its customers.  But if the industry is ever to move away from this model onto a sounder base, it will only be able to do so if confident that at least some regulators, politicians and consumer groups will admit the case for doing so, rather than accuse them of profiteering.

The last three weeks have been very bad for the reputation of British banking.  Rebuilding trust will be a huge challenge.  Some of that challenge falls to regulatory authorities – we made big mistakes before the crisis.  Much falls to the leadership of banks themselves.  But it is a challenge that must be met, given the vital role which the banking industry plays in our market economy.

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^1. FSA Final Notice on Barclays LIBOR fixing: paragraph 83.
^2. Roger Bootle, The Trouble with Markets, Nicholas Brealey, 2009 and 2011
^3. See the Kay Review of UK Equity Markets and Long Term Decision Making, July 2012.
^4. Raghuram G Rajan, Fault-Lines, Princeton University Press, 2010.
^5. See e.g. Liaquat Ahamed, The Lords of Finance, Penguin Press, 2009.