While the HM Treasury White Paper on Banking Reform has softened the blow on the UK’s banks in some respects, it still bases itself on a misleading narrative of the cause the banking crisis in the first place.
Likewise the Mansion House speech of Mervyn King and the subsequent relief of capital and liquidity requirements (in terms of timing if not ultimate substance) are welcome, but they fall a long way short of an acceptance by the Bank of England of its share in the creation of the crisis – collusion in the appointment of non-bankers to top positions, a lack of regulation around secondary banks, and co-signature of a capital adequacy regime that fuelled the boom and exacerbated the bust. The Bank of England is, as a centralbank, the UK member of the Bank for International Settlements in Basel that is the author of the global capital adequacy frameworks, Basel I, II and III.
The focus of follow-up to the crisis on so-called ‘casino’ investment banking and on splitting that from the ‘sound’ parts of the business is a convenient distraction, because it exculpates regulators and politicians from their share of the blame. The UK’s financial crisis centred on secondary banks – former building societies in the provinces like Northern Rock, Bradford & Bingley, Halifax Bank of Scotland and Alliance & Leicester. It is the same in Spain where the problems were in the regional Caja de Ahorros.
The Cajas were partly owned by municipal governments, who nominated directors, who in turn appear to have benefited indirectly or very directly from the property loans that the Cajas made.
In the UK the regional lenders were reviving the UK rust belt as it developed during the Conservative years 1979-97. Banking became about ‘High Street’, allowing Fast-Moving Consumer Goods executives like Andy Hornby of Asda to qualify themselves as having relevant skills, and growth outside the City could be engineered via business models unfettered by ratios around capital and liquidity, or at least by traditional ratios.
The titans of growth – Andy Hornby (HBOS), Adam Applegarth (Northern Rock) – were lionised in Westminster until being comprehensively disowned when things went wrong.
National politicians – in the UK and elsewhere – wanted an appearance of robust economic growth and that was delivered by spending on or price increases in real estate, justifying an interconnected rise in government spending. The loans were disbursed and spent; the destination of funds was on materials – yielding VAT – and on labour – yielding national insurance and income tax – and on profits – yielding corporation tax – and not forgetting the rising take from Stamp Duty on every sale.
The illusion was enabled by the explosive growth of secondary banks, operating in politicians’ tribal reserves and benefiting from weak regulation. ‘Fit and proper person’ tests were rigorously applied to traders and salepeople in wholesale banking, but scarcely at all to employees – and let alone senior management – of retail banks.
Unfettered growth was in turn enabled by a bank capital adequacy regime that favoured lending to the two areas that the governments most wanted: Real estate, and themselves.
This was already evident in Basel I in the late 1980s, and it became embedded in banks’ internal Risk-Adjusted Return on Capital models, that were their unofficial internal models before they were institutionalised under Basel II. Then they were re-named Internal Risk-Based or IRB models, either Standard or Advanced. An ‘Advanced IRB’ bank, like Northern Rock, had a long run of data showing how unlikely it was that they would lose money on their loan book. Data supplied by companies like Experian and S&P was allowed to do place for data from the bank’s own research and experience.
Specialist banks, such as Northern Rock, were granted even more favourable treatment because their specialisation was taken to betoken increased expertise, imputing greater reliability to their risk model. Proper banking means models with risk diversification should be favoured – like models that combine retail and wholesale banking.
In the UK real estate business, the ‘long run’ of data underpinning an IRB model was permitted to start in 1990, after the last major price correction. Banks were allowed, by regulators and auditors, to peg Year Zero in the calculations at the bottom of the trough that resulted from the withdrawal of multiple MIRAS (personal mortgage interest tax relief) on the same property in 1988.
Against that data, with very low current credit losses and the constantly increasing value of security, it was possible to demonstrate that the loan book needed next to no capital to support it. Secondary banks, like Northern Rock, had capital adequacy models installed by their auditors that radically understated their risks. That is a problem not caused within the investment banking divisions of a big universal bank, but in a secondary bank that was an instrument of government policy and a ‘hands-off’ from the soft touch of the regulators (or was the phrase ‘light touch’?).
How do we do better going forward? How about more proper bankers at the senior management level in banks and in banking regulators? The latest appointment to head a banking regulator is a senior partner of KPMG; Fred Goodwin was a partner at Deloitte’s whose first job in banking was as Deputy CEO of Clydesdale. Lloyds TSB’s most recently appointed non-executive directors are from McKinsey’s. Where is the background in basic banking of these who would lead the industry and regulate it and, as far as the Vickers committee is concerned, shape its future structure?
One member of the Vickers committee was himself a prime example of this failure: a former CEO of Courtaulds whose first job in banking was CEO of Barclays. Now, once again, he has been brought in to an influential position to opine on matters outside his professional experience.
To sum up, banking regulators allowed the Basel capital adequacy accords to fuel unchecked growth in real estate lending and sovereign risk lending. Governments were delighted that they could record growth based only on real estate as a justification for their own increased spending. But, having failed to properly regulate and control the secondary banks, and having allowed them to become so bloated that they represented a systemic risk when the bubble burst, politicians and regulators go into distraction mode when apportioning out the blame.
Firstly, measures are mooted that are irrelevant to the causes of the crisis and will only cause damage: to banks’ international networks, to their ability to support British companies internationally, and to the ability of the banking system to support the recovery of the British economy from the crisis.
Secondly other measures, initially presented as vital to the stability of the UK banking system, are postponed when the obvious becomes clear: that increased capital and liquidity buffers can only be met by reduced lending if capital markets are shut and interbank markets illiquid.
How much confidence should one have in the governor of a central bank who can – at a town supper – cast overboard all the measures he had championed so forthrightly as being vital to stability?
How much confidence can one have in a committee proposing reforms that has not one single person on it that has worked as a banker, as opposed to being on the payroll of a bank?
How much confidence can one have in a regulator who was a senior partner of the audit firm that signed off the accounts in 2007 of both HBOS and Bradford & Bingley?
None of this bodes well for the future of the industry, in which far too many of the top seats are occupied by individuals who, if not contributing materially and directly to the crisis, certainly did not object loudly to what should have been starkly obvious.
Bob Lyddon is Managing Director of the IBOS Association Central Office. IBOS stands for International Banking – One Solution. It is an association which fosters inter-bank cooperation. Currently active in 49 countries and rapidly expanding, its members include Santander, HSBC France, Intesa SanPaolo, KBC, Nordea and UniCredit Bank.