Time for banks to pay the piper

Downsizing US and UK banks would drive activity into the shadows, but there's a sense something needs to be done – and revulsion over salaries tied to excessive risk-taking is warranted.

The rigging of Libor by Barclays and probably others is just the latest in a stream of controversies that has undermined confidence in the major global banks since the global financial crisis erupted, providing more ammunition to those who want to see the big banks punished and broken up.

It doesn’t help that the major banks don’t appear to have learned from the public and lawmakers’ response to the implosions in the global financial system at the onset of the crisis, the taxpayer bailouts they forced and the austerity they unleashed in much of the developed world. It is astonishing that bank compensation remains such a major issue in the UK and US after what has happened in the past few years.

The Libor manipulation might appear to be a discrete issue, a piece of skull-duggery not directly related to the kind of reckless risk-taking that characterised much of the crisis. It is, however, symptomatic of a cultural sickness that infected the system during the boom years as well as revealing how trusting and how slack regulators had become during the years of the credit bubble.

Old-fashioned banking of the type that generally characterises banks in Australia and Canada, the two strongest banking systems, isn’t without risk – the leverage in banks makes them inherently risky – and has produced the occasional blemish. It has, however, strong prudential foundations and reasonably solid cultural underpinnings, despite the frequent controversies about mortgage rates.

The problem with the likes of Barclays and its peers, or the Wall Street banks, or the big European banks, is that they aren’t old-fashioned banks but rather relatively new-fangled universal banks accommodating a range of sophisticated, complex and even riskier activities.

It has imported into what were once traditional banks focused on maturity transformation a range of investment banking and non-banking activities, many of which involve accepting real balance sheet risk.

As importantly, it has imported the investment banking culture of risk-taking and remuneration tied to risk-raking into once conservative organisations and allowed/incentivised the hyper-leveraging of relatively low-cost bank capital and big balance sheets into trading and other short term risk-taking.

The Libor scandal, and the earlier shockwaves created by the revelations that JP Morgan Chase had blown billions of dollars on a proprietary trading strategy that backfired, along with the continuing revulsion at the scale of remuneration being awarded at institutions that had to call on taxpayer support, have added to the sense that something drastic needs to be done to the banking system, beyond the already drastic measures in train.

In the UK the Vickers Commission last year made some radical, but sensible, recommendations in relation to the UK’s High Street banks, proposing that their core traditional domestic banking functions should be ring-fenced from their global wholesale and investment banking activities and should carry even higher capital levels than those being implemented by the global banking authorities.

Only the activities inside the fence would have taxpayer support in an emergency, with shareholders and creditors fully exposed to the activities outside the fence and therefore presumably more vigilant in understanding and disciplining them.

The High Street banks, all of which are regarded as too big to fail, are being forcibly downsized but the issue isn’t necessarily one of size but character – both the character of the banks themselves and their leadership.

After the Libor scandal, there are plenty of calls in the UK for the government to go further and force structural separation on the major banks in a reprise of the US Glass-Steagall Act that was repealed in 1999 – a decision now blamed for many of the problems within the US system.

The problem with re-introducing a 21st century version of Glass-Steagall – and there are plenty of US advocates for it as well – is that it would simply drive more activities into an already vast and opaque and unregulated shadow banking system.

While the regulators are also trying to bring some sunlight to bear on that system by forcing more derivative trading onto transparent platforms, it would be impossible to bring the same level of oversight and regulation that can be (and progressively is being) brought to bear on the banking system onto the non-banking system.

To a large degree the shadow system lives off the universal banking system so in some respects it is possible to influence its workings and its interactions with the banks by the way the non-traditional operations of the banks are regulated.

The Swiss developed an interesting approach to the problem of its two giant universal banks, UBS and Credit Suisse, imposing minimum capital requirements on them that are about twice those that will have to be adopted by the rest of the banking world.

That doesn’t force them to shed their investment banking activities (although that might have been the Swiss authorities’ unstated intent) but it is causing them to re-think the kind of activities they should be involved in and the terms of which they should do non-traditional business.

The other mechanism for controlling banks’ risk-taking is through the remuneration of their chief executives and senior executives. If they aren’t rewarded for excessive risk-taking they are a lot less likely to take excessive risks. If their remuneration is driven by the growth and prudential quality of their traditional banking operations they’ll prudently grow those operations.

The revulsion in the UK and US in relation to remuneration is warranted and business – boards and shareholders – do need to respond to it if they want to minimise government intervention in their routine affairs.

The banking scandals have given big business generally a bad name and made it vulnerable to substantial re-regulation, which isn’t necessarily in the long-term interest of economies or businesses, whether banks or non-banks.