The Great Debate UK

Bank bonus season again

–Laurence Copeland is a professor of finance at Cardiff University Business School . The opinions expressed are his own–

Bank bonuses are in the news again, and once more we see the spectacle of the Prime Minister indirectly pleading with the bankers not to be too greedy. Note the contradiction in the government’s position: even though we own two of the largest and most culpable banks, we dare not impose explicit limits on their pay lest they decamp to places where the political climate is more hospitable and the regulators more tolerant. But although enforced limits are out of the question, it’s quite OK to pressure them by every other means  – which, of course, raises the question: why should bankers be more willing to stay in Britain when their pay packet is limited by “voluntary” restraint rather than government intervention?

Of course, as I have argued here before, the likelihood of them moving any substantial part of their business overseas is grossly exaggerated and in any case is a far less worrying prospect than is often suggested. We should not be intimidated by dark hints about investment banking operations moving lock, stock and barrel to Frankfurt, Paris, Singapore or Shanghai. First, the world’s major investment banks typically employ hundreds, sometimes thousands of people in every major financial centre, so at worst we are talking about a marginal reallocation of staff from London towards the other four or five cities which are serious competitors. Is that such an awful prospect?

Recall that no less a figure than Adair Turner called for a reduction in Britain’s financial sector, on the grounds that it is far too large relative to our economy. Moreover, every time you hear mention of the contribution of investment banks to the UK economy – the taxes they pay and the number of people they employ – bear in mind that in the last two years they have cost us far, far more than they will ever provide in tax revenue, and that will still be true even if we are able to avoid another systemic banking crisis for the rest of the century.

Some readers may think I am exaggerating – far from it. There have been many estimates of the cost of bailing out the banks, most of which only include the more-or-less direct costs of recapitalising them, buying up their toxic assets, providing open-ended guarantees, and so on. But there are other costs which, though indirect, are no less real.

I was reminded of one major cost the other day, while checking my credit card statements. Consider the following facts: if I were tempted to borrow on my credit card this month, I would be charged interest of 23% on purchases or 28% on cash, compared to only 20% or 22% in mid-2006. Yet back then, before the crisis, the banks themselves had to pay around 4.5% to borrow in the money markets, whereas today they can raise funds for 0.5% or even less. In other words, banks have been allowed to exploit their monopoly power – greatly increased after the crisis mergers – to push their gross margins up by about 7 percentage points to what must be all-time record levels, simply so as to allow them to rebuild their reserves. By my back-of-the-envelope calculations, the cost to credit card borrowers of this dispensation must be something approaching £5bn per year.

Then bear in mind that credit cards are simply one form of unsecured lending, which is in any case dwarfed in volume by mortgages, where admittedly margins probably have not increased quite as dramatically. Nonetheless, in total the cost to the consumers and businesses (especially small firms) of refinancing the banks must be running at a level of £50-100bn per year, simply in additional interest cost alone – all of this on top of the billions (or trillions) officially acknowledged.

Why I have to sleep with the enemy

-Laurence Copeland is professor of finance at Cardiff University Business School. The opinions expressed are his own. -

A week or two ago, I posted a blog bemoaning the size of Britain’s public sector and expressing the fervent hope that the ill wind of the financial crisis would blow much of it away, leaving room for private industry to expand in its place.

In response, I received a number of mildly wounding (but fair) comments pointing to the fact that, as I myself work in the public sector, I was perhaps in a false position.

Now I could offer a defence along the lines that, when I started work, the City was a club which was closed to youngsters without money or contacts, that I have spent a few years in the private sector, albeit some years back, and that even now my main occupation involves teaching students, mostly from East or South Asia, who are almost without exception paying their own fees, which makes me a one-man export industry. I also keep the wolf from the door with the help of a little freelance consultancy and some book royalties.

However, instead of an apologia pro mea vita, I want to offer myself as an example of how corrupting government spending can be – or could be if I followed the advice to refrain from biting the hand that feeds me. After all, this view amounts to me being told to show my gratitude to my benefactor, HMG.

The lesson for politicians is clear. If the government of the day can buy my support (and presumably my vote) by the simple expedient of giving me a job, the way to retain power is obvious:  buy a majority.  Tax people so as to pay their wages. Every job “created” in this fashion is another household partly or totally indebted to you for its standard of living, and – more importantly – ready to vote against any party that dares to threaten it. No wonder the percentage of the labour force employed in the public sector keeps rising inexorably!

It’s time to call the bankers’ bluff

-Laurence Copeland is professor of finance at Cardiff University Business School. The opinions expressed are his own and do not constitute investment advice. -

I have just reread the blog I wrote for this column last September. A year has gone by, and neither the title – “It’s All Over: the Banks Have Won” – nor the rest of it seem out of date. In fact, last weekend’s Basel III deal looks very much like the final surrender by the authorities.

It is not simply a matter of the feebleness of the reserve requirements and the ease with which they will be emasculated by arbitrage, nor the fact that the regulators have given the banks a few years to satisfy them – “Please Lord, make us prudent…..but not yet”.

Rather, it is the way the banks have so easily fought off any attempt at more radical reform, and in particular their success in silencing the calls to enforce a separation of retail from investment banking and to break up the biggest groups into units which are no longer Too Big To Fail.

Quite the opposite in fact: there seems to be no sense of urgency about undoing the forced mergers we saw in the darkest days of 2008, so that banking in the United States and Britain is actually more concentrated today than it was before the crisis.

There is no secret about how this situation has arisen. As I said earlier, the authorities have given in because the banks are holding a gun to the head of the economy, with the threat: “one false move and the borrowers get it”.

Waiting for the other shoe to drop

-Laurence Copeland is professor of finance at Cardiff University Business School. The opinions expressed are his own and do not constitute investment advice. -

The unemployed and the terminal insomniacs who have nothing better to do than read my blogs will know that I have long been gloomy about most of the Western economies. How can you fail to be pessimistic when the world economy is still dominated by the U.S. – a basket case, becoming weaker every day, with a political class too blind or too scared to admit in public the obvious fact that the country cannot carry on living beyond its means?

Now house prices are plunging again and, with the dollar still strong, the prospects for an export-led recovery look bleak. In fact, a return to recession is far more likely, and the markets are starting to show signs of that sickening here-we-go-again feeling.

How will it all end?

Anyone who claims to know how this will all play out is on no account to be trusted, but there’s nothing wrong with trying to guess – in fact, that’s exactly what we have to do before we can decide what assets to invest in, or whether to invest at all rather than simply blowing it all on a long bankruptcy binge.

So here goes. I start from the observation that the bond and currency markets, in their infinite lack of wisdom, seem to have divided the whole membership of the United Nations into two classes, high-risk countries and low- (or no-) risk countries.

Inflation or deflation: a stress test for democracy

-Laurence Copeland is professor of finance at Cardiff University Business School. The opinions expressed are his own-

The policy debate is hotting up. On one side, we have the expansionists, arguing that it’s the Nineteen Thirties all over again, that Keynes is right now as he was then – we need more, not less government spending, we are digging our own graves by cutting back, especially as the fiscal retrenchment is continent-wide, covering thrifty North Europe as well as profligate ClubMed. According to this view, fiscal contraction will exacerbate the situation by magnifying the fall in the level of economic activity, leading to a downward spiral and, incidentally, making it harder than ever to repay our debts.

On the other side, the contractionists argue that comparison with the Nineteen Thirties is grossly misleading. Debt levels were far far lower for all the major economies in those days. Most important of all, in the Nineteen Thirties the threat (which duly materialised) was deflation, not inflation, so government spending financed by printing money was riskless.

The central question then is this: is inflation actually a risk today? Or is deflation the bigger risk?

On the one hand, falling prices could be catastrophic for two reasons.

First, ever since Keynes, economists have believed that deflation causes unemployment because wage levels rarely fall pro rata, so employers, squeezed between lower prices for the goods and services they sell and unchanged labour costs, are forced to lay off workers so as to protect their businesses.

Secondly, a falling price level implies a rising debt burden, or an increase in the real cost of repaying the country’s outstanding debts. If you think this is purely a matter of economic theory, just compare it with the situation facing a householder with a mortgage – inflation raises his wages and the price of everything he buys, making the burden of his mortgage lighter every year, while deflation does the opposite, meaning he has to struggle to repay a debt which remains unchanged while the value of everything else (including his house) is shrinking.

Not much stress, not much test

-Laurence Copeland is professor of finance at Cardiff University Business School. The opinions expressed are his own.-

Back in the 1950’s, when most women stayed at home while their menfolk went out to work, a favourite trick of life insurance salesmen was to walk into the prospect’s home at dinner time and ask the wife:

“Mrs Smith, have you ever thought what would happen if your husband keeled over and had a heart attack right now?”

Imagine the effect of this question on the poor guy sitting there eating his meat and two veg. It must often have been enough to make him choke on his roast potato there and then – maybe even die on the spot.

Not being in the business of selling life insurance, the European bank regulators were unwilling to take any chances with the client’s cardio-vascular system, so they have restricted themselves to asking the question:

“What would happen if the client had the flu and needed a couple of weeks off work?”

EU stress tests: for banks or governments?

- Laurence Copeland is a professor of finance at Cardiff Business School. The opinions expressed are his own.-

Worries about Europe’s banking system go back at least to 2007, but whereas the U.S. (and UK) banks appear to have weathered the storm, there are fears that for European banks the worst may lie ahead.  Concerns centre on four areas.

First, there are obvious worries about Greece and the other small countries facing debt problems, notably Portugal and Ireland, where the local banks have lent heavily to their governments and in addition may need to make provision for a substantial build-up in the level of bad debts in their respective corporate sectors as their economies struggle through the recession.

Second, there are worries about the small-to-medium banking sector in Germany, where some of the first signs of the oncoming crisis appeared early in 2007. It is hard to tell how seriously we should treat these concerns, because the Landesbanken are closely linked to their regional (“Land”) governments, so the question is unusually sensitive. Third, there are worries about the European giants, especially the big French and German banks.

Not only is it still unclear (to me, at least) how badly hit they were by Lehman and its aftermath, it is still a matter of conjecture how much sovereign debt they are holding.

Fourth, there is the enigma of Spain, worth a blog on its own. The bald facts about Spain are frightening – 20 percent unemployment (and nearly as much even before the credit crunch), the economy most dependent on construction of any in Europe, a large budget deficit, tourism suffering from the strong Euro.

The NHS: Back on the operating table

-Laurence Copeland is a professor of finance at Cardiff Business School. The opinions expressed are his own.-

“The NHS – the envy of the world”. This is one of the Great British Myths to rank alongside “A-level standards haven’t fallen”.

It makes you wonder why all those rich well-organised Europeans are looking longingly at Britain – it’s not as though they can’t afford their own NHS. The truth of course is that they take one look and say “thanks, but no thanks”, and you can’t really blame them.

By most indicators, the NHS produces outcomes that are very unimpressive compared to our European neighbours and are in many cases inferior to those achieved in far poorer countries.

The fundamental problems of the NHS can be seen by simply examining the boasts of its defenders. One oft-repeated claim is that it is the second-biggest employer in Europe (or is it the world?), behind only…………….the Red Army! What this tells you loud and clear, apart from plenty about the speaker’s role-models, is that the NHS is simply far too big and far too complex an organisation for anyone to manage properly.

That the problems are managerial is confirmed indirectly by another frequently-heard boast.

Confronting the immigration conundrum

-Laurence Copeland is a professor of finance at Cardiff Business School. The opinions expressed are his own.-

After being the third rail of British politics for a generation or more, immigration is suddenly a topic which can be spoken about in polite society.

Unfortunately, as far as policy is concerned, it is also a classic case of the politician’s syllogism familiar from Yes, Minister: something must be done; this is something; therefore this must be done. Most of the proposals on offer seem likely to make the situation worse, which is not surprising since many are based on a thoughtless acceptance of conventional wisdom.

Take for example a proposition which had the three party leaders nodding in agreement during the pre-election TV debate on this subject: that only the most highly-qualified immigrants should be allowed entry into the UK.

Really? This raises at least two issues.

First, what is the point of the foreign aid budget?

To spend, or not to spend?

-Laurence Copeland is a professor of finance at Cardiff University Business School. The opinions expressed are his own.-

There is really only one question on the agenda at the G8 and G20 meetings in Toronto and in policy circles throughout Europe and North America: to cut government spending and risk recession; or to keep on spending, risking a return to inflation, or more likely to stagflation – inflation with stagnant economic activity?

You won’t be surprised to hear that economists are divided – and, remembering the 364 of my colleagues who protested about government policy in 1981, you can be forgiven for disregarding our views altogether. Perhaps the best I can do here is to unpack one or two of the fundamental issues at stake in the current fiscal policy debate.

Suppose I spend 10,000 pounds on a new car. If I pay cash for it, I have 10,000 pounds less to spend on other things. So, aggregating total spending in the economy, the car industry benefits to the tune of 10,000 pounds, but my local restaurants, supermarkets, cinema, etc., lose the same amount of business – net effect, zero.

Now, instead of paying cash, suppose I borrow the 10,000 pounds – will the outcome for the economy be any different? Will I still cut back on my spending on other items, in recognition of the fact that I now have a debt of 10,000 pounds hanging over me? In an important sense, the situation is the same as if I had paid cash. I may still have the 10,000 poundsin my own bank account, but it is now mortgaged, earmarked for payment at some future date.

The privilege of being able to smooth my cashflow by postponing repayment is something I have to pay for in the form of interest, so that in accounting terms, I am committed to repayments whose present value is the same 10,000 pounds.  Whichever way you tell the story, it shouldn’t change the conclusion – prudent, rational budgeting requires me to cut back on my spending on everything else by as much as if I had paid cash for the car.

Now, instead of me spending 10,000 pounds, suppose the government spends. Does it matter whether it pays cash on the nail or borrows? The answer ought plainly to be no. After all, its spending is on my behalf, and I – as citizen and taxpayer – am going to have to pay for it, either now, through an immediate tax increase, if that’s what the government decides to do, or at a later date, if the government decides instead to borrow.