Opinion

Hugo Dixon

How to clean the banking cesspit

By Hugo Dixon
August 6, 2012

Five years after the credit crunch erupted in August 2007, banking still looks like an industry running amok. Scandals keep tumbling out of the closet: an alleged ring of banks including Barclays that attempted to rig interest rates; money laundering by HSBC; insider tips passed by Nomura to its clients; and terrible risk management by JPMorgan, where traders have so far lost $5.8 billion.

True, some of these scandals date from the rip-roaring days of the bubble. And the industry is now being reformed. But the public is growing impatient with the slow pace of change, especially as recession bites in large parts of the industrialised world. Some observers therefore want to clear out the entire old guard. The idea is that only new teams can clean the cesspit. There are also increasing calls to break up banks into supposedly low-risk retail banks and casino-style investment banks. Even Sandy Weill, the man who created Citigroup, now advocates splitting up financial conglomerates.

Something must be done. The financial industry has made a mockery of capitalism. Despite endless bailouts, bankers are still paid far too much. Profits are privatised, while losses get socialised.

The regulatory noose around the industry is tightening. After the credit crunch, there was a global push to jack up capital and liquidity buffers, while reining in risk-taking. If lenders get into trouble in future, the idea is that they will be wound down safely rather than bailed out. Bankers’ compensation is also being modified – for example, allowing pay to be clawed back in future years if there are losses.

This battery of new regulations is putting pressure on the industry’s profitability – and its pay. Banks are reviewing their business models. They are cutting back on proprietary risk-taking, slashing jobs, and even pulling out of some business lines.

The snag is that it will take until the end of the decade for all these changes to be implemented. That’s partly because the technicalities are complex; and partly because policymakers fear that, if they come down too hard on such a crucial industry, their economies will be driven even deeper into recession.

In the circumstances, proposals for wholesale management change and breakups have strong popular appeal. But they are not the best options.

Last month, both Bob Diamond, Barclays’ chief executive, and Kenichi Watanabe, Nomura’s chief executive, rightly fell on their swords. But if everybody with a senior position in a troubled firm departed, novices would be in charge. That’s just too dangerous.

If managers are tainted by scandal, however remotely, they clearly need to go. They must also quit if they are unable to shift their mindset from the money-grabbing culture of the past to the more service-orientated culture of the future or can’t apologise sincerely for the excesses of the past.

These yardsticks should be used to determine whether the managers currently in the firing line – such as JPMorgan’s Jamie Dimon and Deutsche Bank’s co-chief executive Anshu Jain, whose chairman has just cleared him of involvement in the Libor scandal – should walk the plank.

Meanwhile, it is naive to think that breaking up banks would be a quick fix to the sector’s problems. It’s just not true that a combination of investment and retail banking caused the crisis. Plenty of retail-only banks – the UK’s Northern Rock and America’s Washington Mutual, not to mention Spain’s savings banks – got into trouble. And remember: the biggest failure of all was a pure investment bank, Lehman Brothers.

What’s more, breakups can’t happen fast. Given the continued euro crisis, a standalone investment bank such as Barclays Capital would struggle to finance itself in the market. The only way it could survive would be through liquidity injections from the public sector. It might even need to be nationalised. Once these investment banks are shrunk, de-risked and recapitalised, breakups may be possible. But that’s at least a five-year job.

So what should be done in the meantime? Further action is possible on at least three fronts.

First, pay. Capping bonuses, as the European Parliament is proposing, is not sensible as it merely encourages banks to boost salaries. A better idea is to require lenders to pay a big chunk of their managers’ compensation in the form of the bank’s own subordinated debt. If the bank then got into trouble, executives would lose a lot of money. That should concentrate their minds on better risk management.

Second, the industry is under-taxed. The best solution here is not the financial transaction or “Robin Hood” tax proposed by the European Commission. That wouldn’t make the industry safer. Better options are to impose VAT on financial services and require banks to pay a levy to the extent that they finance themselves with hot money – a tax that has so far only been adopted in some countries.

Third, boards have too often failed to hold powerful executives to account. That was a big weakness at Barclays and other banks such as Britain’s RBS. Both regulators and shareholders need to insist that bank boards have more clout.

If the existing regulatory package was supplemented along these lines, some of the public’s indignation would be sated. There would also be less chance of the industry running amok in the future.

Comments
20 comments so far | RSS Comments RSS

Thanks for your insight into a complicated problem. I’m a banker, and I would say for my part, regarding credit default swaps, that they should simply be made illegal, unless some actual holder of underlying debt seeks insurance from a reliable party during the time he holds the actual debt. Otherwise, no free trading. Conservatives are always griping about governmental regulations and intrusion into their affairs. Simply make naked CDS illegal, and there won’t be anything to regulate. There would be no need to grow the regulatory bureaucracy further, and the taxpayer would have less bureaucracy to finance. At least with respect to CDS.

Posted by skimish | Report as abusive
 

A few thoughts to share, beginning here:
“if everybody with a senior position in a troubled firm departed, novices would be in charge. That’s just too dangerous.”

True, and almsot certain to result in disaster. There is a common misconception of late, namely, that anyone with expertise, training or education is corrupt, no longer credible i.e. wisdom of crowds, debunkers of false prophets, blah blah. Isn’t necessarily true though! Juniors would be just as likely or worse to make the same, or different but no less harmful mistakes, if there were no longer any experienced staff. I have worried about a comparable situation since June 2011, in the United States, with the legislation accompanying Dodd-Frank. My concern pertains to the sections which removed the mandated role of credit ratings agencies (the NRSRO’s of S&P, Fitch, Moody’s), without instating a replacement mechanism of assessing creditworthiness and risk. There was such a hue and cry to excise the credit ratings agencies! What is there now, to replace them? Nothing, as yet. I don’t think it would be prudent to do the equivalent, in haste, with banking reform.

Secondly, regarding banker salaries, I am uncertain about this:
“Capping bonuses, as the European Parliament is proposing, is not sensible as it merely encourages banks to boost salaries.”

Admittedly, I don’t know what mechanism could be put in place in order to cap bonuses. It would be awkward to implement in the U.S.! Yet I don’t believe that capping bonuses would necessarily lead to higher salaries. Salary-based compensation is a committment, both legally and for financial statements and reporting. Banks (or any employer) would be hesitant to ratchet up employee salaries by several hundred percent. That is why bonuses ARE so problematic; in the U.S., in the sort of financial service firms that have seen the most trouble of late, it is typically the case that one’s salary is less than 25% of compensation, particularly for trading type positions.

I have no alternative suggestions though. It is ofter easier for me to find fault than to think of viable alternatives.

Posted by EllieK | Report as abusive
 

How to start cleaning up? Start with prosecuting John Corzine. It would be a start in regaining confidence in the financial services industry.

Posted by tmc | Report as abusive
 

One of the issues not mentioned in this artcile is how we stop the financial system gaming central banks.

Lenders lent to banks with 30+ times leverage as they had been conditioned (via the Greenspan /Bernanke put) to expect that central banks would supply a liquidity backstop whenever required which would enable lenders to get out scot free and bank shareholders had been conditioned to expect that this backstop would be provided WITHOUT any onerous conditions.

In effect the banks business model has evolved to a point where they rely on this backstop being available, condition free,24/7. When the liquidity backstop wasn’t provided in Lehmanns case all the providers of this short term debt (money market funds, repo financing, securities lending, asset backed lending, interbank finance, traditional wholesale) ran for the hills and crashed the system.

This is why regulators are still terrified to resolve any major bank given that the banking system as a whole still relies heavily on these short term funding sources.

So how do we start to change this – well Central Banks should start applying conditions to any backstop financing they provide (as is common for any lender of last resort). Restrictions on cash dividends, cash bonuses and share buybacks should be put in place. Bank recipients should also have to increase their capital in accordance with a schedule agreed with the central banks (and if they cant recipients would have to give Central Banks the option of converting the latters loans into capital thus diluting existing holders). In addition recipients would have to agree to increase their term funding and reduce their maturity mismatch.

All this should (and would) cost bank shareholders thereby providing an incentive for them to reduce their leverage and increase their term funding in the future.

Posted by Maunsell | Report as abusive
 

Wanna “fix the banks”? Take your money out leaving just enough to pay the monthly bills. Those corrupt institutions can’t blow what they don’t have. Cash is still king.

Posted by sjtom | Report as abusive
 

Reinstate parts of GlassSteagall that were repealled by GrammLeechBlilely; separate retail/deposit banking from the trading/investment banking.

DoddFrank, in all of its excess, has not corrected this obvious problem.

Simple as that.

Posted by jaham | Report as abusive
 

Thank you, jaham – succinctly put and the most important point – reinstate Glass Steagall.

On the issues of compensation and skills of upper level employees. Overcompensation of CEOs and high level employees is rampant but perhaps worst in the financial industry. Weak boards made up of CEO cronies, failure to separate President and Chairman of the Board offices, and ignoring the owners (shareholders!) are big problems. However, Jamie Dimon and his ilk are NOT bankers – they are gamblers and experts at avoiding responsibility for their own mistakes. True bankers live in a community, make good loans by knowing the community well, and are involved over long periods of time in their community. The problem is that the corporate players have been in control so we have now a generation with too few people who know how to be real bankers. It will take time to clean up this mess, but let’s get started.

Posted by QuietThinker | Report as abusive
 

Bank solvency problems are a function of bank solvency. When asset values can gyrate by 100% (see: CDOs), banks need a lot more than 8% capital. Before the go-go years, banks had 20% capital and were core-funded. Now they get by with as little capital as possible by using off-balance-sheet stratagems like SIVs, and fund themselves on the repo market. There is such a thing as sound banking, but we haven’t seen it since 1960.

Posted by nixonfan | Report as abusive
 

Bank solvency problems are a function of bank solvency. When asset values can gyrate by 100% (see: CDOs), banks need a lot more than 8% capital. Before the go-go years, banks had 20% capital and were core-funded. Now they get by with as little capital as possible by using off-balance-sheet stratagems like SIVs, and fund themselves on the repo market. There is such a thing as sound banking, but we haven’t seen it since 1960.

Posted by nixonfan | Report as abusive
 

Regulation so far has been weak. As Salmon correctly pointed out the problems are structural in nature.

Completely sever commercial and investment banking. Glass-Steagall was repealed a little over two decades ago. The banks have gotten enormous in size, have bought enough political influence and have been decreed to be too big to fail. Nothing short of separating commercial and investment banking will do.

Break up the banks. Increase competition.

The entire financial industry is bloated and should be much, much smaller than it is currently.

The Volcker rule has been watered down, mangled and turned into 300+ pages of complex mumbo jumbo. Just how the banks like it. Glass-Steagll was under 40 pages, simple, clear and effective.

So there is no real ‘battery’ of regulations occurring. There has been no fundamental changes to the industry, to the system. The lack of criminal prosecutions means that banks are above the law and are to remain that way.

Posted by paddletoe | Report as abusive
 

Cleaning up the cesspool will not happen or be possible if Romney is elected or if republicans control either House of Congress. This is a simple reality that every person needs to understands. The money flowing into the republican party after Citizens United is appalling. Corporations have become the supreme entity of our political system and this was caused by conservatism. It must be eradicated as soon as possible.

Solutions can only come from a party that thinks there’s a problem that needs fixing. Republicans have never fixed a problem, they only create them.

Posted by zzpat | Report as abusive
 

This blog post suffers from being too short and offering many opinions, without discussing the nuances. For instance, yes, Lehman was an investment bank, but they did have to compete against combined investment and retail banks.
It does go without saying that implementing Glass–Steagall again would not help the economy in the short term. The process would need to have a long implementation period to work. That doesn’t mean we shouldn’t do it.
The Glass–Steagall Act oversaw the longest expansion of the economy and the largest expansion of the middle class, not just in American history, but in world history. If done by a wrecking crew, it would certainly be destructive, but if done by a surgeon, it might even promote growth. Again, here there is an opinion lacking discussion and analysis.
The Robin Hood tax was never meant to really make the banks safer. The tax is microscopic. It is a means to collect tax revenues for cash starved government, on the back of activities that do nothing to help the economy, ie the buying and selling of securities within hours or minutes of each other. The problem, of course, is that it would need to be implemented across all major markets simultaneously, or the behavior would simply shift to save the 0.1%.
Again, here is a discussion of one side of the issue. I’m sure many of you could counter. But, I did at least say what I mean. To say Robin Hood tax–wouldn’t make us safer, and then just leave it at that? Disingenuous? lazy? rushed? I don’t know, but this opinion piece is incomplete.

Posted by jphn37 | Report as abusive
 

Limit investment banks to doing domestic business within only the federal reserve area in which they are incorporated. Then “too big to fail” banks become less of a threat to the national economy; and the original megabanks, divided into eleven or so subsidiaries, would be worth more to stockholders than the originals. Would need one more Federal Reserve area for this to work, assuming Richmond is maintained.

Posted by JamesSutton | Report as abusive
 

Limit investment banks to doing domestic business within only the federal reserve area in which they are incorporated. Then “too big to fail” banks become less of a threat to the national economy; and the original megabanks, divided into eleven or so subsidiaries, would be worth more to stockholders than the originals. Would need one more Federal Reserve area for this to work, assuming Richmond is maintained.

Posted by JamesSutton | Report as abusive
 

Diamond and Watanabe fell on their swords?

More like these two were beheaded, isn’t it? They were thumbing their noses all the way to the, well, to the bank.

Good riddance. Two down. How many to go?

Posted by WeWereWallSt | Report as abusive
 

@zzpat

I think you need to take a better look at reality. Your simplified view of the problem has this idea that Democrats are angels.

The “simple reality” is that Democrats will not do anything meaningful to take on the banks. Democrats are a corporate party as well. To not see this is unbelievably naive.

“Solutions can only come from a party that thinks there’s a problem that needs fixing.”

Do you see Obama, Geithner or Bernanke calling for the break up of the big banks? Do you see them promoting or calling for meaningful EFFECTIVE regulation? They will parade the Volcker rule before you and you will hail it as some regulatory triumph I suppose.

Organized money has taken over the entire political landscape. You just choose to ignore the money that is going to your candidate which includes corporations, the insurance industry, the healthcare sector, big pharma, and Wall Street.

Few Witnesses to Obama, Romney as They Raise $1.5 Billion
bloom.bg/PGBuj0

The Obama/Democratic supporters are continually played against this lesser of two evils argument and made to compromise, rationalize, and go on continually lower their moral bars. It’s only the other guy that’s bad. So what if he’s carrying on Bush’s legacy regarding civil liberties? Patriot Act? No big deal. Surveillance state? Shrug. I mean it’s Obama this time so it must be ok!

As Greenwald states, Obama is indeed a pioneer: bit.ly/MjUFu1

“In fairness to Obama, he did campaign on a promise of change, and vesting the President with the power to order the execution of citizens in secret and with no oversight certainly qualifies as that.

…Here we have the political campaign of the same President who, in another moment of trailblazing, has waged an unprecedented war on whistleblowers, and whose top aides secretly met at coffee houses with industry lobbyists to draft bills so as to evade disclosure and record preservation requirements, marching, apparently with a straight face, behind the banner of transparency to demand disclosure of his opponent’s tax returns…

So to summarize the Obama campaign’s apparent argument: it’s absolutely vital that we know all about the GOP nominee’s tax shelters and financial transactions over the last decade (and indeed, we should know about that), but we need not bother ourselves with how the Democratic nominee is deciding which Americans should die, his claimed legal authority for ordering those hits, the alleged evidence for believing the target deserves to be executed, or the criteria used to target them. So low are one’s expectations for an American Election Year that there are very few spectacles so absurd as to be painful to behold, but the Obama campaign’s waving of the transparency flag definitely qualifies…

Posted by TheUSofA | Report as abusive
 

Glass-Steagall worked for almost 70 years until it was repealed.

It would not be all that difficult to reinsitute it.

Banks don’t want it. They would like to see schemes like those proposed here that are relatively easy to beat. And they are.

Posted by JessesCafe | Report as abusive
 

It was against the law for Standard Charter to do business with Iran, but they did anyway. Why? Because it was against the law. Standard Charter surely charged a premium under such circumstance.

It’s not only boards that should hold their CEO’s accountable, but high-flying bankers should also be accountable to the law in the same way I would be if I robbed a bank. Fines are not enough, scoldings by politicians are not enough, resignations are not enough.

In America, high finance offenders could be prosecuted under RICO laws that allow for the perpetrator and everyone who knowingly assisted in the crime to be prosecuted and RICO allows for all ill-gotten gains to be confiscated by the court… and RICO allows for some serious prison time.

That is the only thing that will bring about change. Bankers are not very afraid of breaking laws… and that is the problem.

Posted by breezinthru | Report as abusive
 

But if the problem is not one of regulation or business model, but banking culture then surely these actions are likely to go the same way as those that they are replacing? That is, either avoided, circumvented or obfuscated.

Have we become beholden to a myth that the banks can be preserved as they are reformed? Can those within it begin to change their behaviour while they maintain the semblance of control?

The models used for dealing with addiction may provide some interesting frames for a new type of discussion on these issues:

http://www.mindfulmoney.co.uk/13494/sect or-watch-/bankaholics-anonymous-12-steps -to-reforming-the-banking-system.html

Posted by MindfulMoney_T | Report as abusive
 

Glass-Steagall.

Break up the big banks.

Rein in the derivatives market.

Posted by TheUSofA | Report as abusive
 

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