Reforming Financial Markets and the Bankers Ranp

Inspecting the tatters of its financial services industry, following the banking crisis, the UK Labour government produced a White Paper, setting out its remedies. Yet here, there is but a single reference to 'moral hazard' and to issues of credit control. Such an omission is remarkable and seems to reflect a total misunderstanding of how to avoid a recurrence of events which have caused, and will continue to cause for years to come, enormous costs for the country as a whole. Is recent and current economic policy management instead simply a reflection of the needs of bankers - what Keynes in the 1930s called the bankers' ramp?

Indeed the primary conclusion of the great economist, John Maynard Keynes' General Theory was that economic systems are inherently unstable, in part because of irrational expectations which drive the system towards exuberance sometimes, and the opposite at other times. George Soros, one of the most astute participants in global finance, has argued strongly for effective regulation of financial markets precisely because of the inherent instability of economic systems.

But what we currently have, and seem likely to be left with, are financial institutions of enormous size which are functioning in a globalised market, and which continue to exhibit risk-taking behaviours that are destabilising both nationally and internationally. Many of them are simply Too Big To Fail - TBTF - and given their systemic importance cannot be allowed by policy makers to fail, causing enormous economic and social costs.

Since major financial institutions know that they are TBTF then they also know that, irrespective of their risk behaviours, Governments will bail them out. In these circumstances why should financial institutions behave differently in the future from the way they behaved in the past since they know they will be rescued irrespective of the financial and other costs to Governments?

That this is, of course, the problem of 'moral hazard', the Governor of the Bank of England well knows. But it is more or less dismissed in the present policy debate. It is a problem ducked by the British government since it does not want to take on powerful vested interests in the financial services industry (who incidentally are also major funders of all of the main political parties).

Remedies such as a separation of investment banking from retail banking with real competition between companies; effective regulation of private equity companies which have generated enormous costs in terms of asset stripping and the casualisation of employment in many sectors of the UK; effective international regulation of hedge –funds so as to minimise their destabilising impact on global asset and commodity markets - none of these are being put centre stage. The proposals on how to regulate the financial markets in the UK, written by those from the industry, offer a good deal of cosmetics but relentlessly pursues their interests to the neglect of the rest of the economy and society.

When times are good and everyone seems to be making money, no one cares too much about the details. It's only after the crash that the regulators and the ethicists come in.

Between 1999 and 2007 financial corporations in the UK increased their share of total corporate profits from 8.9% to 12.2% for reasons which must relate to increasing application of maths and scientific skills in the development of new financial products such as collateralised debt obligations (CDOs in the parlance), that is bundles of loans packaged together by a lender and then sold on, In such circumstances no one had an interest in ensuring that loans were made to those who could afford to repay, and once they were bundled no one could assess the underlying riskiness of the CDOs. A recipe for chaos in financial markets.

Indeed all that leverage and risk-taking, turned out all to be much more problematic than was initially assumed by the banks and others.

In a very insightful paper called 'All those Arrows', in the London Review of Books, back in the summer of 2009, Donald MacKenzie describes the analytical failures of those undertaking risk assessments of different categories of securities, and wrapping these up in CDOs, and argues that the approach is fundamentally flawed. MacKenzie concludes that:

In a situation of severe economic stress- falling house prices, rising unemployment-it wasn't just that some of these securities would perform badly, they all would....[ and] the crux of the problem has been not in CDOs per se but in the uncomfortable encounter between the world of CDOs and that of mortgage-backed securities… increasingly risky loans were made to private equity firms and to other highly indebted corporate borrowers because it was possible to package and sell on these loans...

And then, sure enough, came the payback. To get a better idea of the costs in monetary terms, adjusted for inflation, it is reported that United Kingdom Treasury estimates made in 2008, applying IMF methodologies, found that the output losses over the 4 years since the start of the banking crisis amounted to £280billion. This is probably an underestimate if anything.

When the decline in GDP, that is the total value of all goods and services in the economy, is added to the loss of potential growth that would otherwise have occurred then the impact of the reckless greed of bankers and others managing financial institutions becomes much clearer – and is vastly greater than is generally estimated.

Over the whole period 2008-2012 the effective loss of GDP looks as if it will be around 13-15%, and representing a dead-weight economic loss for every citizen in the UK. These costs are much larger than the purely financial costs of the support provided through the Treasury and the Bank of England to the banking sector.

Of course it is this decline in demand that accounts for the inexorable rise in unemployment since 2008. If the present recession is at all like the one in the early 1990s, and it seems likely to be both deeper and longer, then it will take many years for the level and rate of unemployment to return to their pre-recession levels (in the late 1990s it took 6 years). Since income from employment is by far the largest source of income for the economy as a whole then it is unsurprising that living standards overall will fall in the coming years.

It is estimated that about 1.5 million workers from Eastern Europe came to the UK after the opening of the borders in May 2004 and that by the end of 2009 some 50% of these had returned home. Many of those who remained continued to work in low paid and unskilled jobs. The outlook looks very bleak for labour, and especially for young workers entering the labour market in the coming years.

One of the factors that are likely to have strongly negative effects on employment is the unwinding of the excessive leverage of private equity companies. Between 2000 and 2006 there was a frenzy of lending, mainly by the pension funds, so that what economists call 'leveraged buyouts' in the UK racked up an incredible £1.9 trillion of property and securitisation debt. As a result private equity companies now own one-fifth of corporate Britain! Yet more than 60% of their outstanding loans will need to be repaid within the next 5 years (starting in 2012). Major companies face enormous financial liabilities with inadequate levels of assets to offset against their debts, and in the changed climate no easy way to raise new loans.

There are two other large-scale effects of the banking crisis neither of which received much if any attention. One of the consequences of the huge financial sector in the UK in a globalising world has been huge inflows of capital. The consumer boom and price inflation, especially in the house market and commercial properties, as well as the continued public sector fiscal deficits would not have been possible without this huge expansion of domestic credit. This credit expansion pushed up the value of sterling, and pushed down the UK's competitiveness particularly in manufacturing.

In this way too, the favouring of the Financial Services industries in the UK will have long term and negative implications for growth and employment.

Bank lending to the public sector - for things such as motorways or new hospitals - during the so-called boom years permitted a huge rise in public expenditure without the need to raise taxation. Such expenditure was treated by the Treasury as if it was off the books. This practise was not dissimilar in purpose to that of private companies, such as Enron, the giant US energy business that eventually collapsed under the weight of its debts.

And so, given the fact that the government itself was compromised in being a beneficiary of the excesses of the past several years from the growth in domestic credit then what confidence can anyone have in any system of regulation where the government continues to have a decisive role? This is a matter I will come to below. For the moment it is enough to reflect that it is estimated that some £904 billion has already been spent by the UK Government on rescuing the banks – a sum so large, and with consequences so damaging, as to be beyond comprehension.

For economists, the telling figure is that the debt/GDP ratio is expected to double over the next five years to nearly 100% of GDP. There will inevitably have to be drastic cutbacks in public expenditure which will affect all areas of public expenditure. These cutbacks will have significant effects both on employment in the public sector, and on the level of services to the population.

Since the choices facing Government are so stark it is unsurprising that they would obviously prefer a return to continued credit creation - an addiction that would enable relatively easy financing of the crisis. And so, again the element of self-interest will affect government proposals for the regulation of the financial services industry.

There does not exist, as far as I know, any detailed research on banking compensation in the UK for the medium and long term but such research has been undertaken for the financial sector in the USA. This has concluded, as one might have expected, that employees in the financial sector are overpaid. More specifically, as a 2009 research paper put it, that:

From the mid-1990s to 2006 the compensation of employees in the financial industry appeared to be too high.... Overall we conclude that bankers were paid about 40% too much.

One of the most unfortunate and costly impacts of the excessive rates of remuneration paid to many employees in financial services has been to destabilise the structure of pay and rewards in the UK. Thus even in the public sector there has been pay inflation for senior management on a totally unjustified scale, together with the introduction of a bonus culture that has no place in such areas of employment. How to restore traditional pay structures across the economy and how to rein back the ludicrous and unjustified levels of pay of many managers, directors etc is indeed one of the major problems that remains almost completely unaddressed.

Indeed these matters, of excessive pay and bonuses, have been left to the recommendations of a Committee chaired by a banker, Sir David Walker, who was himself a major beneficiary of this culture. That there remains a critical need to curb bonuses which have had the effect of inducing reckless lending is the populist remedy of all politicians. But it is also clear that unacceptably large payments are still being made to senior executives irrespective of the general situation and that the bonus culture is alive and well at this time.

The hope that bonuses can be restrained by more information about their payment and greater vigilance by Boards of Directors and shareholders is precisely that – a hope. Expecting so called 'risk sub committees' of the Boards of banks to restrain excessive risk taking is another institutional recommendation which seems unlikely to be successful. All of these proposals are simply tinkering with structures that need to be fundamentally changed. Until executives and board members of banks are required to internalise the costs incurred by the rest of the economy as a result of their excessive risk taking and greed then nothing much will ever change.

Not only have pay structures been distorted by the practices of the Financial Services industry and their generalisation to other sectors of the economy, but the levels of pay and other rewards have totally skewed the patterns of consumption everywhere. Inequality of income and wealth was dramatically increased during the past decade in the UK – more so than in any recent period in UK history. Again this reflected government policy – a relaxed view about the filthy rich and accompanying low rates of taxation on persons and on companies. A study by the Institute of Fiscal Studies concluded as follows:

Income inequality has risen [on most measures] in each of the past 3 years and is now at its highest level since our comparable time series began in 1961.....[between 1996/7 and 2007/8] income growth at the very top and very bottom of the distribution looks similar to the pattern under the Conservatives- with the lowest growth at the very bottom of the income distribution and the fastest growth at the very top. (Poverty and Inequality in the UK, 2009)

The result is a drawing-out of the reward structure in the UK with an accompanying increase in social anomie and alienation. The Gini coefficient, a measure of equality and social justice, was for the UK 0.25 when Margaret Thatcher came into office and it is now 0.36. In other words, the UK now sits alongside countries like Greece, Lithuania, Latvia and Portugal within the European Union, in terms of income inequality, with their uneducated underclasses and skeleton social provision, and far away from Europe's economic success stories, like Sweden (with a Gini of 0.23) and Germany (with 0.28). The rich in the UK became richer at a price paid in terms of social cohesion. Not least in the areas of private education and private health care which have expanded dramatically in recent years.

It is worth reporting one of the key conclusions of the National Equality Panel in 2010 which found that,

Inequalities in earnings and incomes are high in Britain, both compared with other industrial countries, and compared with thirty years ago......there remain deep-seated and systematic differences in economic outcomes between social groups across all of the dimensions we have examined including between men and women, between ethnic groups, between social class groups, between those living in disadvantaged and other areas, and between London and other parts of the country.

Missing from the policy dialogue apart from bemoaning excessive bonuses in the FS is any commitment to reducing inequality in the UK. It seems no longer to be an important policy objective – but it should be.

Of course, governments always face the risk of being captured by special interests. As mentioned already, writing in the 1920s and 1930s Keynes himself was very exercised by 'the bankers ramp' which he saw as undermining economic policy. But this is not a mere fanciful supposition of the Left. That most conservative of institutions the International Monetary Fund has concluded that,

Findings seem to be consistent with moral hazard interpretation whereby financial intermediaries lobby to obtain private benefits, making loans under less stringent terms....Under such interpretation, specialised rent- seeking and short-termism might justify reining in lobbying activities....our analysis suggests that the political influence of the financial industry can be a source of systemic risk [and] the prevention of future crises might require a weakening of the political influence of the financial industry... (A Fistful of Dollars: Lobbying and the Financial Crisis, IMF Working Paper December 2009.)

Certainly, looking at the UK government's proposals, it is evident that financial interests have again succeeded in manipulating policy to their own benefit and irrespective of the tremendous damage they have visited on every man, woman and child in the UK. Costs which will have to be met for many years into the future.

It is remarkable that as I write this paper that the usual suspects: J.P.Morgan, Wells Fargo, Barclays, Goldman Sachs, HSBC, Credit Suisse, and so on, are all announcing huge profits and the setting aside of billions for the payment of bonuses. In part these profits reflect the demise of Lehman and Bear Stearns and the opportunity to move into markets that they were active in before they failed. But in large part the profits are due to booming bond markets due to the massive borrowing by Governments caused in large part by their rescue of the banking system.

It is truly a world where 'heads I win, tails you lose'. Indeed this is exactly the term used by Mario Cuomo in a July 2009 report called No Rhyme or Reason. The 'Heads I Win, Tails You Lose' Bank Bonus Culture. Cuomo is absolutely damming in its condemnation of US banking compensation practices and of the underlying so-called competitive processes that determine pay and rewards in all of the big US banks. The scale of the bonuses that were paid by lenders in the US in 2008 was huge: 9 banks that were all in receipt of government assistance paid bonuses of at least $1million each to 5,000 employees – a total of $32.6 billion. Six banks paid out more in bonuses than their total profits!

Mind you, the rebound in profits during 2009 has been truly amazing. While 'Main Street' has suffered the bonus pool at J P Morgan, Morgan Stanley and Goldman Sachs increased by 31% in 2009 over the previous year, and Wall Street banks as a group increased bonuses by 17% in 2009 to a staggering $20 billion (£13 billion). If the scale has been somewhat muted in UK, nonetheless personal bonuses of £95,000 (a politically astute whisker under six figures) seem to have been the norm at Barclays Capital. At RBS, a bank that is now publicly owned, in spite of losses of £3.6 billion in 2009 a bonus pot of £1.3billion has been awarded. It is worth noting that as the banks major shareholder, the UK government could have vetoed the RBS bonuses but chose not to do so.

The culture and excessive level of bonuses remains largely unaffected by the crisis. Indeed, it seems to have been coated with Teflon, and even the one year payroll surtax of 50% on bonuses in the UK in excess of £25,000 paid in 2009 has not dented it.(That this tax was not renewed by the Coalition Government is hardly suprising...)

It is worth quoting the conclusions of the Cuomo report again, since they have perfect resonance with the situation in the UK, where it is hoped by Government that a Code of Conduct will be enough to change the culture of excessive bonuses. If only pigs could fly! Urging moderation on banks is 'spitting into the wind' and just as useful.

One thing is clear from this investigation to date: there is no clear rhyme or reason to the way banks compensate and reward their employees.... Thus when the banks did well the employees were paid well. When the banks did poorly, their employees were paid well. And when the banks did very poorly, they were bailed out by the taxpayers and their employees were still paid well. Bonuses and compensation did not vary significantly as profits diminished...[and] our investigation suggests a disconnect between compensation and bank performance....bank compensation structures lacked consistent principles and tended to result in a compensation system that was all 'upside'.

On the face of it perhaps the best way to restrain bonuses and shift pay systems to a rational and fair basis is through restraining the profits of the banks. Hence the need for both more effective regulation and much greater competition.

Since bonuses and other forms of compensation are at the core of risky behaviour then they should be subject to regulation by the authorities. But instead we are told that the bonus culture can be controlled and changed through the application of a 'Code of Conduct'. Indeed, it is evident from the most recent statement by the British government's regularly body that they are wholly unwilling to regulate pay and compensation while freely admitting that existing systems have contributed to excessive risk taking and thus the destabilisation of the economy.

Instead, it looks as if Government believes it can return to business-as-usual plus some marginal changes in the framework of regulation. It is evident that so far there have been no fundamental changes either in bank regulation or in the conduct of monetary policy in the UK despite the severity of the collapse of the economic and financial system. While the Government has set up a Banking Commission to advise it on reform it is evident from statements it has made that they have more or less ruled-out structural changes such as the separation of retail and investment banking. So we will be left with banks that are Too Big To Fail with all the risks that this entails.

This strategy holds out the possibility, nay the probability, that next time the system will indeed collapse, with unknown but dire consequences for the people of the UK. In this respect it is worth quoting the Governor of the Bank of England who is clearly supportive of the need for structural reform of the financial sector and as such is at loggerheads with Government who continue to believe either that structural reform is not feasible or would be ineffective. Mervyn King could not have been more outspoken in rejecting the position of the Government:

It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble in the first place....The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion...The case for a serious review of how the banking industry is structured and regulated is strong.