Monday, 26 September 2011

All bets are off on another financial calamity

Professor Prem Sikka

The banking crisis has been making headlines for the past three years. Bankers indulged in an orgy of irresponsibility, gambled other people’s money, lied about the quality of their products, published opaque and misleading accounts and collected telephone number salaries.

Yet there has been no public inquiry, no royal commission and no prosecutions, even though taxpayers initially coughed up £1.16 trillion in loans and guarantees to bailout the banks. This amount now stands at around £500 billion and is a major cause of the austerity programme.

The best that the Government has managed to do is commission a report from the Independent Commission on Banking, an organisation only created in June 2010. Its 358-page report shows no urgency and says that reforms can wait until 2019.

The ICB’s key recommendations include ring-fencing the retail side or the general deposit-taking and lending operations from the risky investment side of banking operations. Arguably, this would safeguard depositors and borrowers from any future banking crash. However, banks are given the option of deciding whether or not to ring-fence corporate deposits and loans. This leaves the door open for dubious transfers and creative games, and would make effective regulation difficult.

The banking crash showed that many banks were very highly leveraged and lacked the resources to meet their obligations. So the ICB proposes that large British retail banks should have equity capital of at least 10 per cent of risk-weighted assets. As a cushion against future losses, banks are expected to set aside a “loss-absorber” fund of between 17-20 per cent of certain assets. This is to protect taxpayers and reduce their exposure to future bailouts.

The proposals have generally been welcomed by the press and political parties in this country, but are unlikely to solve banking woes. A key problem has been the ability of the banks to create credit which has no relationship with the real economy. The ICB does not consider any of the issues arising from this. Why is the Government leaving the creation of credit and money to private corporations?

The Commission favours the corporate structure enjoyed by banks, but fails to address any of the systemic pressures that resulted in the current crisis. For example, as corporate entities, banks are susceptible to stock market pressures to report ever-increasing profits. This encourages banks to push shady products and indulge in excessive risk-taking. Banks, in common with many other corporations, are focused on the short term. The tenure of the typical FTSE350 chief executive is four years – and declining. In this period, they have to collect as much private loot as possible, because their economic success and media stardom is measured by remuneration. So there is every incentive to sacrifice the long term. Some of the pressures could be alleviated by alternative forms of banking ownership structure – for example, co-operatives, mutualisation, ownership by communities, employees or even nationalisation, but none of these are considered by the ICB.

Contrary to some press comments, the ring-fencing proposals do not embrace the Glass-Steagall Act, passed in the United States in 1933 and subsequently repealed in 1999. The ICB has not asked for a legal separation of the retail and speculative sides. Its “Chinese walls” proposals will not work. Many banks have complex corporate structures spawning the globe and many operate in tax havens with poor regulation. So it is not clear how these operations are to be classified or ring-fenced. Ring-fencing will not insulate banks from the pressures for higher profits and executive remuneration. Northern Rock did not have an investment arm, but went belly-up as directors sought cheap money to expand profits and remuneration. A legal separation and return to mutualisation for some banks may curb some of the worst excesses, but this is not recommended by the ICB.

Even if the banks are ring-fenced, the destructiveness of their gambling will still engulf society. In December 2007, just before the banking crash hit the headlines, the face value of the gambles (known as derivatives) on the movement of the price of commodities, interest rates, exchange rates and anything else, was $1,148 trillion. Global GDP is about $65 trillion. Just 1 per cent negative exposure or loss can wreck the global economy. Where will the money for gambling come from? Inevitably, it will be provided by financial intermediaries from ordinary people’s savings. If the gambles pay off, bankers and intermediaries will collect mega-bucks. If they don’t, then the savings of ordinary people will be decimated. Remember, ordinary people are never asked by fund managers or insurance companies whether their savings should be channelled into complex gambles. So the ring-fencing of investment operations will not shield innocent bystanders. The way to curb destructive gambling is by removing the benefit of limited liability from investment banking. Let the bankers play with their own money and do not permit them to dump their losses on others.

The ICB bemoans excessive remuneration for risk-taking, but thinks that voluntary codes will curb the excesses. Self-regulation has not curbed excesses in the past and will not do so in the future. An alternative would have been to empower bank employees, depositors and borrowers to vote on executive remuneration. It is doubtful that bankers engaging in aggressive practices would ever manage to secure enough votes for their telephone number salaries. But democracy does not enter into the Commission’s vocabulary.

The increase in the capital base may be welcomed, but the banks failed because they were unable to meet their financial obligations. Therefore, the focus should be on solvency or the availability of cash, but it attracts no particular suggestions.

Overall, the Commission’s report is a poor document. It has been produced without any public hearings and collections of facts. The holes in it make it unfit to be the basis of future regulation. For example, it says nothing about the conflicts of interests, incestuous relationship with credit rating agencies, predatory organisational culture that promotes dodgy products (such as payment protection insurance), opaque accounting practices, and the failures of

auditors, bank boards and non-executive directors, the capture of the regulators, or the need for responsible lending to generate jobs.

*This article first appeared in Tribune

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