Banking Standards

Submission from Virgin Money (S028)

 

Summary

 

1. We support the full professionalisation of banking, with training and CPD that would support proper understanding of banking risks, a professional code of conduct that would guide bankers to make decisions that are responsible, and a fair and transparent process leading to sanctions for breaches of the code. We regard the full professionalisation of banking as an important but not in itself a sufficient step to restore trust in banking.

 

2. The Chartered Banker Code of Professional Conduct is consistent with the format which we consider appropriate, in that it contains a short set of principles that are easy to understand and remember, and that can be applied to situations as they arise. The code of conduct can be supported by professional standards as required.

 

3. In addition to the introduction of the full professionalisation of banking, we believe that measures to improve standards in banking, and trust in banking, should address conflicts of interest arising from trading activities, high concentration and limited diversity in retail banking, high remuneration apparently regardless of performance, and methods of assessing banks' risks and minimum capital requirements which reduce trust between banks and their regulator.

 

4. We believe that personal and business customers are entitled to a better deal from their banks, as a result of the introduction of standards and cultures such that customers can trust their banks and have confidence in their products and services, and as a result of greater competition between banks in ways that benefit personal and business customers.

 

5. Various surveys have shown that trust in banking is low. To restore trust in banking, we believe that two key issues are the introduction of a professional code of conduct with simple principles, and the separation of retail banking and investment banking.

 

6. There appears to be need for some regulatory parameters for bonuses and total remuneration (at least in ring-fenced banks), supported by shareholder oversight. For shareholder discipline to be effective, we suggest that banks should be required to give information about their bonus schemes and bonus payments, and about their total risk exposures and changes in their risk exposures. We believe that 'manipulation' to enhance bonuses should be liable to sanctions under the professional code of conduct.

 

7. In the context of the globalisation of banking, the Chartered Banker Code of Professional Conduct sets out principles that form a common code for all chartered bankers, whatever their background.

 

8. The extent of regulatory arbitrage suggests that banks' regulatory capital requirements should be determined on a basis that is standardised and straightforward, with as little scope for manipulation as possible. This would support financial stability, and would create a more level playing field between large incumbents, smaller banks and new entrants.

 

9. In retail banking, we welcome the introduction of simple financial products, which set good standards, support trust in banks and encourage greater competition. We encourage the FCA to examine cross-subsidies, both within products and between products, and introductory offers, since these practices can inhibit competition and limit incentives for efficiency and innovation in ways that benefit consumers.

 

10. We believe that shortcomings in standards in risk management in some banks, made possible by the use of powerful technology, should be addressed by the use of a standardised approach rather than of banks' own internal risk models, by disclosures about the full extent of banks' risks and regulatory capital requirements, and by the inclusion of an executive summary in banks' risk reports.

 

11. Retail banking and investment banking are different businesses. Retail banking is about long-term customer relationships, investment banking is about short-term transactional activities. The cultures in retail banking and investment banking are quite different. The fundamental differences between retail banking and investment banking are reflected in the different accounting treatment of loans in the banking book and assets in the trading book. We believe that there is a strong case for the full separation of retail banking and investment banking.

 

12. In retail banking, particularly in personal current accounts and in SME banking, concentration is high, and diversity is limited. We believe that, to improve competition in retail banking, the key issue is to encourage wider provision of personal current accounts by a greater diversity of providers, including smaller banks and new entrants with different business models, and that, to achieve this, it is necessary to give consumers confidence that switching current accounts will be easy and reliable, and to provide consumers with greater transparency about the cost of their current accounts. We therefore support the ICB's recommendations to improve switching and transparency, and hope that they can be in place by the end of 2013. If it is thought that further measures are required at this stage, to improve competition by reducing concentration and increasing diversity, and to improve financial stability by diluting the 'too big to fail' problem, we suggest that consideration be given to further divestments, access to infrastructure, and free-if-in-credit banking. We suggest that simple financial products should be extended to personal current accounts and basic bank accounts. More broadly, to improve competition in retail banking, we suggest that the FCA should state how product regulation will improve competition as well as protect consumers, and should ensure that competition is not trumped by financial stability.

 

13. While it is desirable that banks should not have leverage ratios as high as in 2008, we are not sure to what extent changing the corporate tax deductibility of debt interest would encourage banks to maintain low gearing in any future 'bubbles'.

 

14. To support more effective market discipline by shareholders, we suggest that banks should be required to make greater disclosures, including about their risks and regulatory capital requirements, risk factors associated with intended acquisitions, and bonus schemes and bonus payments. We suggest that UKFI might take a lead in setting standards for the expected behaviour of shareholders, for example by establishing shareholder forums as suggested in the Kay Review.

 

15. We support the additional market discipline on banks that is likely to arise from the ICB's recommendations that unsecured debt should be capable of being bailed in and that insured deposits should be preferred.

 

16. Stronger challenge by non-executive directors may be achieved by limiting executive positions on bank boards (possibly just to the CEO and finance director), by encouraging greater diversity of non-executives on bank boards (possibly advertising for at least some positions) and by Lord Turner's proposal that there should be automatic bans on the directors of failing banks. Given that the compliance function and internal audit may not identify some major risks, and may be reluctant to escalate concerns, we suggest that consideration be given to the appointment in large banks at a senior level of a risk strategy executive, whose role would be to identify major risks and discuss them with the executive management team and board. To strengthen governance on remuneration, we suggest that consideration be given to the composition of the remuneration committee, to the role and responsibilities of its chairperson, and to the need for independence of any advisers on remuneration.

 

17. The full professionalisation of banking, with exams and CPD, a code of conduct and sanctions for breaching the code, would make it easier for banks to assess candidates for recruitment, and would make it easier for people moving from one bank to another to maintain the required standards and behaviour.

 

18. It is desirable that the view is communicated that whistle-blowing about legitimate concerns is responsible rather than disloyal, that the routes available to whistle-blowers, for advice and for raising concerns, are made clear, and that as much protection as possible is given to whistle-blowers, possibly including financial compensation for adverse consequences.

 

19. To support confidence in banks' reported results, we believe that there should be dialogue between auditors and the regulator, that the published report of audit committees should detail significant financial reporting issues, and that consideration should be given to the gradation of accounts by auditors. We support the proposal to change the accounting basis for loans on the banking book back to expected loss accounting. We believe that the different accounting standards for loans on the banking book and assets on the trading book, with the possibilities of capital arbitrage and of pro-cyclical impact, support the case for the full separation of retail banking and investment banking.

 

20. We believe that it is important for banks and their regulator to be open with each other, and to be able to trust each other. We suggest that the use of a standardised approach to assess banks' regulatory capital requirements (along the lines suggested by Barclays Equity Research) would support trust by reducing 'RWA optimisation', would support financial stability, and would create a more level playing field between large banks, smaller banks and new entrants. We believe that differentiation between large banks, including in the assessment of the capital surcharge for large banks, and of any capital 'add-ons' (possibly including an element for the quality and openness of communications), would incentivise low risks and high standards. We believe that greater disclosure about banks' risks and regulatory capital requirements, by both banks and their regulator, is desirable, to support more effective market discipline by shareholders.

 

21. We believe that, to restore trust in banking, public concern about the lack of sanctions on individuals needs to be addressed. We think that this should be done by ensuring that the law is appropriate, that the automatic incentives based approach is applied to directors of banks, and that employees who break the professional code of conduct (which we think should be mandatory) should be liable to sanctions, up to expulsion from the banking profession.

 

Parliamentary Commission on Banking Standards

 

Submission by Virgin Money

 

1. To what extent are professional standards in UK banking absent or defective?

 

22. Three behavioural shortcomings were evident in the period leading up to the banking crisis, and subsequently:

 

· Some bankers did not understand their risks properly, for example in complex securities with sub-prime exposures, or the limitations of their risk models in extreme conditions.

 

· Some bankers made judgements that were not responsible, in serving their customers and in managing their risks.

 

· Banking regulators have found it difficult to sanction bankers (at least so far) for allowing banks to fail, or for behavioural shortcomings such as LIBOR manipulation.

 

23. We believe that the full professionalisation of banking would enable each of these three issues to be addressed, through professional exams and CPD, a professional code of conduct, and sanctions by the professional body for breaches of the professional code. We regard the full professionalisation of banking as an important but not in itself sufficient step to restore trust in banking.

 

24. In June 2010, the Future of Banking Commission recommended the professionalisation of banking in the UK, with compulsory formal training, including in ethical behaviour, the development of a "Good Financial Practice Code", and the introduction of a "new professional standards body along the lines of the General Medical Council, or the Legal Services Board". [1] Virgin Money echoed this view in its response to the ICB Issues Paper, [2] and was disappointed that the ICB did not consider and make recommendations on this issue - presumably because the ICB understood that behaviours and bonuses did not fall within its remit. [3]

 

25. At that time, the professional body in Scotland for bankers was known as the Chartered Institute of Bankers in Scotland (CIOBS), which is now known as the Chartered Banker Institute. The equivalent body in England had transformed itself into IFS School of Finance. We strongly supported the initiative led by CIOBS and a number of banks to support professionalism in banking on a voluntary basis. We supported the establishment in December 2010 of the Chartered Banker Professional Standards Board (CB:PSB), its launch in October 2011 of the Chartered Banker Code of Professional Conduct which "sets out the values, attitudes and behaviours expected of all banking professionals", [1] and its development of the Foundation Standard for Professional Bankers, which was published in July 2012. [2]

 

26. Building on what the Chartered Banker Institute has already achieved, we think that consideration should be given to:

 

· whether professionalism should remain voluntary, or be made mandatory.

 

· whether the professional code of conduct should apply to all employees of ring-fenced banks, not excluding specific groups such as senior executives or dealers in bank treasuries. We realise that it may be difficult to apply UK standards to the UK operations of global investment banks without international agreement to do so.

 

· whether the professional standards board should have an independent chairperson, and a number of lay members.

 

· how quickly the Chartered Banker Institute can complete its Advanced Standard, for experienced and senior bankers, and its Intermediate Standard, for specialist roles.

 

· whether the Chartered Banker Institute should have power to investigate possible breaches of the code of conduct, working with the FCA.

 

· whether a whistleblowing route should be open to the Chartered Banker Institute, working with the FSA and subsequently the PRA.

 

· how the professional code of conduct and professional standards should relate to the conduct requirements of the FCA. We think that they should complement each other.

 

Conclusion

 

27. We support the full professionalisation of banking, with training and CPD that would support proper understanding of banking risks, a professional code of conduct that would guide bankers to make decisions that are responsible, and a fair and transparent process leading to sanctions for breaches of the code. We regard the full professionalisation of banking as an important but not in itself a sufficient step to restore trust in banking.

 

How does this compare to (b) other professions?

 

28. In connection with the Lord Mayor's Initiative on Restoring Trust in the City, Cass Business School carried out an analysis of 48 codes of conduct applicable to people working in the City. [1] This analysis considered employers' codes, professional codes, regulators' codes and other codes. We agree with its assessment of codes:

 

29. "Similar topics appear in many of the codes, with some patterns in which topics tend to appear in employers', professional or regulators' codes. 45 out of 48 codes, including all the employers' and regulators' codes, use words related to 'ethics', 'honesty' or 'integrity'. 34 mention "ethics" or 'ethical' explicitly, while only one uses the word 'moral'. 38 out of 48 codes discuss 'conflicts of interest', 'bias', or the need to be 'impartial', including all the employers' codes, 16 of 18 professional codes and 3 of 4 regulators' codes. 29 codes discuss matters which lead to 'penalties', 'punishment', 'discipline', 'termination', 'suspension' or 'expulsion'."

 

30. "Perhaps the most obvious variation in how the codes are written is length. [...] Among the codes analysed, the longest codes are from the Solicitors Regulation Authority, which runs to about 16,000 words, and JPMorgan, with almost 13,000 words. At the other end of the scale, the Declaration of Freeman, sworn to gain the Freedom of the City of London, is only 114 words, and the Code of Professional Conduct of the Chartered Bankers Institute (CBI) contains a statement of nine principles in less than 200 words. The Actuaries' Code gives five principles, each with explanatory paragraphs, in about 850 words."

 

31. "The codes' length relates to other issues of style, as the shorter codes tend to give general principles, while longer codes set out more detailed rules for particular circumstances. Longer codes tend to be written in the style of legal contracts, while shorter codes typically try to provide a memorable set of positive maxims."

 

Conclusion

 

32. The Chartered Banker Code of Professional Conduct is consistent with the format which we consider appropriate, in that it contains a short set of principles that are easy to understand and remember, and that can be applied to situations as they arise. The code of conduct can be supported by professional standards as required.

 

How does this compare to (c) the historic experience of the UK and its place in global markets?

 

33. While it is important not to view behaviour in the City before Big Bang through rose-tinted spectacles, various factors encouraged good behaviour. The Stock Exchange code "My word is my bond" set a standard for the City as a whole. Members of the Stock Exchange who failed to uphold its standards could be expelled. Financial services businesses were smaller, and it was easier to know what employees at all levels were doing in relation to both customer relationships and risk management. Proprietary trading was strongly discouraged by the unlimited liability structure of partnerships and by the limited capital of merchant banks.

 

34. Twenty years after Big Bang, media articles commented that the changes had caused some problems, but that they had enabled the City to maintain a leading position in banking and investment banking. [1] Now, after the banking crisis, and after another five years, there is greater concern about behavioural problems. Since Big Bang, five key issues seem to have led to declining standards, and to declining trust in banking:

 

35. Firstly, at the time of Big Bang, there were good reasons for ending the system of fixed commissions charged by stockbrokers. However, the introduction of dual capacity sales and trading, and the acquisition of brokers and jobbers by banks, led to a fundamental conflict of interest between making profits for the bank (and bonuses for employees) and supporting its customers. [1] The resulting behaviour has contributed to a breakdown in trust between banks with trading activities and their customers.

 

36. Secondly, over the 25 years since Big Bang, there has been a remarkable consolidation in banking in the UK, leading to the concentration of retail banking in the hands of five large universal banking groups. This consolidation has led to a significant change in the mindset and behaviour of the managements of these large groups. Smaller banks had to be ever mindful of the possibility that they might be taken over, and this encouraged them to work with their customers, employees and shareholders to deliver sustainable organic growth to justify their independence, and to avoid unnecessary risks which could lead to them 'getting into play'. Larger banking groups were 'too big to buy' before they became 'too big to fail': the fact that they could not be taken over made them more inclined to take risks in trading or other activities, and to achieve growth by making acquisitions (where their size gave them advantages which enabled them to offer higher prices than other bidders).

 

37. Thirdly, during the years ahead of the banking crisis, the prevailing view was that the benign economic conditions would continue, and banks were under pressure from their shareholders to continue to increase their profits, even if that meant taking on higher risks, and to return capital through increased dividends and share buy-backs, even if that meant lower capital ratios. The process of increasing leverage, followed by decreasing leverage, is of course typical of 'bubbles', [1] but it was made worse this time by the availability of complex securities with sub-prime exposures, and by the failure of the risk models that were used (including the Gaussian copula) [2] to anticipate the extent of the losses which arose.

 

38. Fourthly, for whatever reasons, over the years ahead of the banking crisis, the remuneration of the CEOs and senior executives of large banks increased dramatically, to levels that do not seem justifiable to ordinary people, and has remained high since the banking crisis, despite the poor performance of some banks, and despite the pressures on household incomes in general. Excessive remuneration and the associated lifestyle may have contributed to an apparent lack of awareness and of humility in some senior bankers, exacerbating the lack of public trust in bankers.

 

39. Fifthly, a further problem is the approach to risk management used by large banks. Under Basel I, the assessment of regulatory capital was relatively simple, although approximate, and many banks also calculated their economic capital - the amount of capital which they judged necessary to cover their risks. Under Basel II, banks qualifying for advanced treatment have used their internal risk models to assess their regulatory capital, and this has led some banks to flex their risk models to reduce their risk-weighted assets (RWAs) and their regulatory capital requirements - as is evident in the FSA's letter to Barclays dated 10 April 2012. [1] More general use of 'RWA optimisation' was discussed by the Bank of England in its December 2011 Financial Stability Report. [2] This behaviour seems to have contributed to a breakdown in trust between some banks and their regulators.

 

40. Unfortunately, behavioural problems, and declining trust, have not been limited to investment banks, or to the investment banking arms of universal banks. Some retail banks have mis-sold payment protection insurance (PPI) and interest rate swaps to their personal and business customers, and have offered products with complex and at times opaque pricing. In managing their risks, the converted banks, Northern Rock, Bradford & Bingley and Alliance & Leicester, all experienced problems in the banking crisis. The reasons for these disappointing outcomes in retail banking could include some or all of the following:

 

· The "casino banking" culture may have spread to other parts of large universal banks, and then been carried across to other retail banks.

 

· It has been difficult for retail banks to compete effectively and grow their customer base without matching the pricing of their peers in areas such as "free" banking on current accounts, low introductory rates on credit cards and mortgages and high introductory bonuses on deposits. And, for a number of years, it was difficult for banks to match market-leading rates on personal loans without expectations of cross-selling payment protection insurance.

 

· Ahead of the banking crisis, it was difficult for banks to match the financial performance of their peers without accepting similar levels of risk, for example in buying complex securities with sub-prime exposures. [1]

 

Conclusion

 

41. In addition to the introduction of the full professionalisation of banking, we believe that measures to improve standards in banking, and trust in banking, should address conflicts of interest arising from trading activities, high concentration and limited diversity in retail banking, high remuneration apparently regardless of performance, and methods of assessing banks' risks and minimum capital requirements which reduce trust between banks and their regulator.

 

Parliamentary Commission on Banking Standards

 

Submission by Virgin Money

 

2. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole?

 

Consumers, both retail and wholesale

 

42. Ahead of the banking crisis, as a result of weak competition among the effective oligopoly of five large banks, there was a transfer of value from consumers, and from non-bank companies, to banks (although some of this is now being paid back in compensation for PPI and interest rate swap mis-selling). In preparing for our response to the ICB Issues Paper, we were surprised by the strength of opinion that weak competition is good for financial stability because it supports high profits. [1] However, weak competition did not prevent the banking crisis, in which tax-payers had to support banks, and as a result of which both consumers and non-bank companies faced difficult economic conditions. For the banking sector as a whole, as for dealers' bonuses, there has, regrettably, been a 'heads we win, tails you lose' outcome at the expense of consumers and non-bank companies.

 

43. The possibility of further bail-outs by tax-payers has been greatly reduced by the much higher equity capital ratios that are now required, by the ICB's recommendation that unsecured debt should be capable of being bailed-in, and by the establishment of recovery and resolution plans. [1] Over recent years, financial stability has, understandably, taken precedent over competition in retail banking, most notably in allowing the acquisition of HBOS by Lloyds TSB to go ahead despite the OFT's objections. [2] We believe that it is now time to give a better deal to consumers and non-bank companies by encouraging greater competition, by implementing the ICB's recommendations and by considering what other actions are, or may be, necessary to address the high concentration and limited diversity in retail banking.

 

The economy as a whole

 

44. History will probably describe the banking crisis of 2008 as the inevitable result of a 'big bubble'. Ahead of the crisis, house prices and mortgage borrowing expanded strongly, and the gearing of banks rose sharply. It was thought that this time would be different, because of the expectation that benign economic conditions would continue, and because of the view that risk could be reduced through packaging and distribution. 'Bubbles' are not unusual. [1] But this 'bubble' and 'bust' were made worse this time by the availability of complex securities with sub-prime exposures, by the failure of the risk models that were used (including the Gaussian copula) [2] to anticipate the extent of the losses that arose, and by the additional risk taken on by some banks where dealers were incentivised by high personal bonuses.

 

45. We regard the establishment of the FPC, with appropriate powers of direction and of recommendation, as an important improvement, which is likely to give early warning of emerging risks, and to limit the recurrence of 'bubbles' in future. To enable banks to regain public trust and confidence, and support economic growth, we believe that some cultural issues need to be addressed, and, while regretting its need, we are pleased that the Parliamentary Commission on Banking Standards had been established to look at these issues.

 

Conclusion

 

46. We believe that personal and business customers are entitled to a better deal from their banks, as a result of the introduction of standards and cultures such that customers can trust their banks and have confidence in their products and services, and as a result of greater competition between banks in ways that benefit personal and business customers.

 

3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector?

 

47. Media articles have commented on various polls pointing to low public trust in banks since the banking crisis, especially after the disclosure of LIBOR manipulation. For example: "Nearly two-thirds of banking customers no longer trust their lender to look after their money, a poll has revealed. As public outrage over the unfolding banking crisis grows, a YouGov poll commissioned by the Sunday Times showed 60% of people losing faith in their bank. Some 49% believe the high-street banks to be dishonest while 45% think of them as incompetent, the poll revealed. And just 1% of respondents believe that senior executives of the biggest banks have improved their behaviour since the financial crisis began." [1]

 

48. Commenting on public trust in banks at the launch of the Kay Review, Professor John Kay said, "A recent poll for ITN showed that only 10% of the population trusted bankers - less even than journalists and politicians. But restoring trust is not something you achieve by lecturing people about how honest you are. Trust and confidence is something that is earned or forfeited by behaviour, and the reason trust has gone is that the objective basis for trust has gone. The central issues for this review arise from the replacement of a financial services culture based on relationships by one based around transactions and trading." [1] Professor Kay's comments, which we endorse, support the case for introducing a code of conduct with simple principles which bankers can understand and remember, and can 'live and breathe'. They also support the case for separation of relationship banking and transactional banking.

 

49. Public antipathy towards large banks has, unfortunately, persisted for some years. We are concerned that it may damage the perception of all banks (including smaller banks and new entrants), perpetuate low trust in banks, and restrict economic growth.

 

50. A disappointing aspect of a recent poll by Which? was the finding of low public expectations that things will get better: "Nearly three-quarters - 71% - of people surveyed by Which? do not think banks have learnt their lesson from the financial crisis, up from 61% in September last year. Consumers have low expectations of a parliamentary inquiry into banking ethics, with only 26% confident that it will lead to positive change among the UK's lenders." We do not share this pessimism. We believe that the questions raised by the Parliamentary Commission, which we have found both interesting to consider and challenging to answer, get to the heart of the matter, and that, by addressing these questions, the Parliamentary Commission can make a real difference to UK banking in ways that are good for consumers and for the economy as a whole.

 

Conclusion

 

51. Various surveys have shown that trust in banking is low. To restore trust in banking, we believe that two key issues are the introduction of a professional code of conduct with simple principles, and the separation of retail banking and investment banking.

 

Parliamentary Commission on Banking Standards

 

Submission by Virgin Money

 

4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (a) the following general themes:

 

the culture of banking, including the incentivisation of risk-taking;

 

52. Much has been written about the extent to which the lure of large bonuses led to short-termism and to a 'heads we win, tails you lose' culture. It does seem that expectations of high bonuses led to some investment banks, and the investment banking arms of some universal banks, taking on high financial risks, most notably in securities with sub-prime exposures which became seen as "toxic". Equivalent problems were not evident in all parts of banking, but, even in retail banking, targets for bonuses may have encouraged mis-selling of PPI and of interest rate swaps. It may be that the investment banking culture contaminated parts of retail banking. However, whether in investment banking or in retail banking, the targets for bonuses were set by management teams, which themselves were under pressure from shareholders to continue to increase profits.

 

53. We do not believe that issues relating to bonuses and total remuneration should be addressed only by regulation. We believe that excessive remuneration reflects weak market discipline by shareholders. There appears to be need for some regulatory parameters for bonuses and total remuneration (at least in ring-fenced banks), supported by shareholder oversight. For shareholder discipline to be effective, we suggest that banks should be required to give information about their employee bonus schemes and about bonus payments, for senior executives, investment banking employees and retail banking employees. In parallel, we suggest that there should be greater transparency about their risk exposures and about material changes in their risk exposures, in a written statement that can easily be understood by shareholders.

 

54. The desire to achieve financial targets set for bonuses may have encouraged some bankers to engage in LIBOR manipulation, to increase profits, and in 'RWA optimisation', to reduce risk-weighted assets and regulatory capital requirements, and increase returns on capital. We suggest that 'manipulation' should be addressed through a professional code of conduct, and that a disciplinary body should be able to impose sanctions for breaching the code.

 

Conclusion

 

55. There appears to be need for some regulatory parameters for bonuses and total remuneration (at least in ring-fenced banks), supported by shareholder oversight. For shareholder discipline to be effective, we suggest that banks should be required to give information about their bonus schemes and bonus payments, and about their total risk exposures and changes in their risk exposures. We believe that 'manipulation' to enhance bonuses should be liable to sanctions under the professional code of conduct.

 

the impact of globalisation on standards and culture;

 

56. The globalisation of banking has brought people with outstanding talent to the City, and this has enhanced the role of London as a leading centre of international and investment banking. However, globalisation can present some challenges in standards and culture:

 

· In a global bank, it is more difficult to control risks effectively across all locations, as was seen recently in the losses suffered by JP Morgan in its Chief Investment Office in London.

 

· In a global bank, there is likely to be a degree of matrix management, and this can easily lead to tension, or even conflict, between mangers with product responsibilities globally and others with geographic responsibilities for all products.

 

· With people from different geographic and cultural backgrounds, there may not be a shared intuitive response to issues as they arise. This may lead to reliance on the rules as stated - or even to the view that, if something is not specifically prohibited in the rules, it is permitted.

 

Conclusion

 

57. In the context of the globalisation of banking, the Chartered Banker Code of Professional Conduct sets out principles that form a common code for all chartered bankers, whatever their background.

 

global regulatory arbitrage;

 

58. One of the strongest reasons for introducing full professionalism in banking, including a professional code of conduct that guides bankers to make judgements that are responsible, is that regulation has not been sufficient, or sufficiently effective. Banks (which typically have greater resources than regulators) have been adept at 'gaming the system', getting round the rules and exploiting loopholes in them. [1] For example, banks got round Basel I by securitisation, and got round Basel II by holding assets (including risky assets) in off-balance sheet vehicles.

 

59. Regulatory arbitrage practices revealed in the FSA's letter dated 10 April 2012 to Barclays include Barclays' desire to move assets from its trading book to its banking book and its proposed extension of model approaches, both of which were intended to reduce Barclays' risk-weighted assets and its regulatory capital requirements. [1] More generally, the December 2011 Financial Stability Report observed that some (un-named) banks had been engaging in 'RWA optimisation', flexing their risk models to reduce their risk-weighted assets, to achieve the higher minimum equity capital requirement (of 9% by June 2012) set by the European Banking Authority (EBA), without having to raise new equity capital. [2]

 

60. RWA optimisation has led to two different problems:

 

· There is declining trust in banks' assessment of their risks, and greater uncertainty as to whether their capital is adequate. In his opening remarks on the December 2011 Financial Stability Report, Sir Mervyn King said, "The Committee recognises that concerns about the opacity of the internal risk weights used by banks in calculating regulatory capital ratios can undermine confidence in those measures." [1] A recent poll by Barclays Equity Research showed that the confidence of most investors in RWAs had gone down, and that most investors thought that model discretion should be removed. Barclays' conclusion was that, "To restore confidence in the actual output (i.e. the resulting RWAs) in the face of growing scepticism of models in general following the financial crisis, we believe that the best route for the Basel Committee to follow would be to abandon (or perhaps suspend) the entire IRB [internal ratings-based] approach." [2]

 

· Large banks, using the internal models-based approach and engaging in RWA optimisation, can gain "unfair" advantage over smaller banks and new entrants which largely use the standardised approach. In a recent paper on market risk, the Basel Committee commented that, "the potential for very large differences between standardised and internal models-based capital requirements for a given portfolio is a major level playing field concern". [1] The approach proposed by Barclays would support financial stability by increasing the regulatory capital requirements of banks that have engaged in 'RWA optimisation', and would create a more level playing field between large incumbents, smaller banks and new entrants.

 

61. An additional problem is that regulators may have had reasons to accept a degree of manipulation, to support financial stability. The EBA seems to have tacitly accepted RWA optimisation, because of its desire to present a positive message that European banks are strong enough to withstand possible losses arising from problems in peripheral Eurozone countries. Earlier in 2011, when announcing the initial results of its 2011 EU-wide stress test, the EBA seemed to take an overly-positive view of possible write-downs on the Government debt of peripheral Eurozone countries, particularly Greece, justifying this view on the technical basis that, "The reality is that shocks to sovereign bonds only impact the regulatory capital position via the trading book. The regulatory treatment of holdings in the banking book means that the impact of short term price shocks is limited." [1] In April 2012, the EBA postponed its 2012 EU-wide stress tests, leading to speculation that the EBA was concerned that the results might not be sufficiently positive. [2]

 

62. The scope for regulatory arbitrage is increased by differences in accounting, risk management and other regulations between different geographic areas. The threats by some UK banks to move to other areas, with less onerous regulatory requirements, may or may not have been empty threats, but they add to public disenchantment with big banks and to an impression that some banks seem to think that they are 'above the law'. [1]

 

Conclusion

 

63. The extent of regulatory arbitrage suggests that banks' regulatory capital requirements should be determined on a basis that is standardised and straightforward, with as little scope for manipulation as possible. This would support financial stability, and would create a more level playing field between large incumbents, smaller banks and new entrants.

 

the impact of financial innovation on standards and culture;

 

64. In retail banking, it is remarkable how little innovation there has been over recent decades, at least in the sense of developing new products that offer sustainable benefits for consumers. The management team of Virgin Money is proud to have been involved in developing and launching (in 1997) The One Account, which offers significant benefits in convenience and flexibility for customers for whom this product is appropriate.

 

65. Many of the 'innovations' which have occurred in retail banking have centred around pricing (for example, low introductory rates on credit cards and on mortgages, and high introductory rates on deposits) and bundling (for example, packaged current accounts with "free" insurance). These reflect questionable standards and cultures, in that the complexity and opaque pricing of such products makes it difficult for consumers to compare offers from different providers.

 

66. In product markets where such "innovations" have become prevalent, it is difficult for providers which aspire to high standards and cultures to maintain their values and compete effectively. For example, new entrants to credit cards are effectively forced to match the low introductory rates that are widely available. A similar challenge faces new entrants to deposit savings.

 

67. A different problem exists in the core retail banking product of personal current accounts, where there has been no real innovation, other than the introduction of packaged current accounts and the addition of phone and Internet banking. The widespread availability of "free" banking (with cross subsidies between groups of customers and between retail banking products) means that it is not possible for new entrants to develop low-cost models and offer simpler products at lower prices, [1] in the way that Direct Line and others did successfully in motor insurance, bringing benefits to consumers and transforming the market.

 

68. We welcome and strongly support the introduction of simple financial products, which should set good product standards and encourage banks to offer products that can be trusted, with appropriate features and with fair and transparent pricing. We are disappointed that this encouraging development did not happen as a result of competition between incumbent banks and new entrants, but that it required intervention, in this case by HM Treasury. [1] We suspect that intervention may be necessary to address some other market practices which inhibit competition, since it is not clear that there is a market solution where new entrants can set high standards, win substantial business and force change in the market as a whole.

 

69. In investment banking, there was, over the decade ahead of the banking crisis, substantial innovation, particularly in the securities, such as CDOs and CDSs, that became seen as toxic. A general theme was the development of complex products with opaque pricing. If banks distributed these products, it was difficult for customers to assess fair pricing; if banks retained these products on their trading books, there was scope for 'manipulation' in marking them to model (rather than to market), using banks' own internal models.

 

Conclusion

 

70. In retail banking, we welcome the introduction of simple financial products, which set good standards, support trust in banks and encourage greater competition. We encourage the FCA to examine cross-subsidies, both within products and between products, and introductory offers, since these practices can inhibit competition and limit incentives for efficiency and innovation in ways that benefit consumers.

 

the impact of technological developments on standards and culture;

 

71. In retail banking, technological developments have brought clear benefits for consumers, for example in the convenience of phone and Internet banking for checking balances and making payments 24 hours a day 7 days a week, and for getting information about retail banking products. The availability of comparison websites has made it easier for consumers to compare the pricing and features of competing products, and to purchase the product they select. We welcome HM Treasury's proposal that simple financial products should be available online, including through comparison websites.

 

72. In risk management, banks have been able to use technology to build comprehensive data warehouses and complicated risk models (even for the securities that became seen as toxic), to quantify their total risk-weighted assets. However, several behavioural problems have arisen in some banks:

 

· The availability of the risk models seems to have given a false sense of security that banks' risks were being measured accurately and measured properly.

 

· Sight was lost of the underlying risk exposures, and relationships between them, and of the limitations of the risk models, particularly in extreme conditions.

 

· Powerful technology has allowed the manipulation of large volumes of data, and has been used to 'play the game' rather than 'run the business' in the 'optimisation' of risk-weighted assets.

 

Conclusion

 

73. We believe that shortcomings in standards in risk management in some banks, made possible by the use of powerful technology, should be addressed by the use of a standardised approach rather than of banks' own internal risk models, by disclosures about the full extent of banks' risks and regulatory capital requirements, and by the inclusion of an executive summary in banks' risk reports.

 

corporate structure, including the relationship between retail and investment banking;

 

74. Although there can, at least in theory, be benefits from cross-selling, cost savings and diversification between retail banking and investment banking within a universal bank, these benefits may be more than offset by cultural problems that can arise:

 

· Trading activities can easily lead to fundamental conflicts of interest between making profit for the bank (and bonuses for employees) and supporting its customers. [1]

 

· The transactional nature of investment banking does not sit well with the relationship nature of retail banking; nor does the short-term nature of market risk sit well with the long-term nature of credit risk.

 

· The accounting treatment of assets in the trading book (which are expected to be short-term) is different from the accounting treatment of loans in the banking book (which are expected to be long-term).

 

· Investment banking is essentially about global markets, while retail banking is essentially domestic, even if it supports customers with international activities.

 

· The senior management of universal banks may not be equally capable in both areas.

 

· Within a universal bank, investment banking can easily attract more attention, and investment, than less glamorous retail banking. SME banking is particularly liable to become a somewhat unloved area.

 

75. Within universal banks, subsidiarisation should go some way to increase focus on retail banking, improve its governance and the transparency of its performance, and support greater competition. But subsidiarisation may not address the cultural problems set out above. As Sir George Mathewson has said, "This then seems to point to a natural division of a banking group into a commercial bank (not merely a retail bank) and a trading bank (investment bank), where the commercial bank includes the vast majority of the functions of our large banks (nearly 100 per cent in the case of Lloyds). I should say that, during my career in banking, I perceived that the introduction of the individualistic culture of investment banking to the corporate culture of commercial banking was always problematic." [1]

 

76. More recently, Andrew Haldane said, "restoring trust in our banking system is an urgent priority". He suggested that this will require, among other things, "a reconfiguration of the structure of banking so that in future basic banking services are no longer contaminated by investment banking services". [1] Jayne-Anne Gadhia has expressed similar sentiments, in response to questions on this topic in a recent media interview. [2]

 

77. We note and support comments made by Lord Lawson that, "in order to recreate the culture of prudence in core banking, there should be a complete separation between retail banking and investment banking. I am delighted that, thanks to the Vickers commission, the Government are going halfway towards that by creating the ring-fence. However, I do not believe that a ring-fence will be impermeable or wholly effective. Bankers are very clever, or most of them are, and they will find ways round it. We are also talking about culture, and the prudent culture of retail banking and the adventurous culture of investment banking are two diametrically opposed cultures. With the bets will in the world, it is difficult to see how we can have two quite different and opposed cultures within the same corporate entity. There should be a complete separation, not just the ring-fence." [1]

 

Conclusion

 

78. Retail banking and investment banking are different businesses. Retail banking is about long-term customer relationships, investment banking is about short-term transactional activities. The cultures in retail banking and investment banking are quite different. The fundamental differences between retail banking and investment banking are reflected in the different accounting treatment of loans in the banking book and assets in the trading book. We believe that there is a strong case for the full separation of retail banking and investment banking.

 

the level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects;

 

79. As has been recognised in reviews by the OFT, the Treasury Committee and the ICB, there is not adequate competition in UK personal and SME banking, [1] and there are significant barriers to entry and expansion. [2] These reviews have recognised the centrality of personal current accounts, which enable banks to establish long-term relationships with their customers, and provide information about them, and can act as a "gateway" product to other retail banking products. [3] Personal current accounts can also act as a step towards SME banking.

 

80. In personal current accounts, concentration is high, and diversity is limited. As a result of the consolidation in banking, including in particular the acquisition of HBOS by Lloyds TSB (despite the OFT's objections) [1] at the height of the banking crisis in 2008, there is now an effective oligopoly of five large banks with combined market shares of about 80% in personal current accounts [2] and almost 90% in SME banking services. [3] As well as high concentration, there is limited diversity: to many consumers, the five large banks seem very similar to each other. In our submission to the ICB, we recognised that Nationwide has been very successful in growing personal current accounts, from about 2% in the mid-1990s to about 7% in 2010. Nationwide is clearly different: it is a retail-only mutual building society. But the benefits of diversity are not limited to mutuals: diversity is also enhanced by 'non-banks' such as Virgin and Tesco, which have strong consumer brands whose value they wish to protect. In this context, we note and welcome the intentions of Marks & Spencer and Asda to increase their activities in banking.

 

81. In personal current accounts, switching is low, whether because of consumer inertia, possibly influenced by limited choice and the sense that "all banks are the same", or because of concerns that switching may be problematic, or because, with the prevalence of 'free' banking, there is not a clear economic incentive to switch provider.

 

82. We therefore believe that, to improve competition in retail banking, the key issue is to encourage wider provision of personal current accounts by a greater diversity of providers, including smaller banks and new entrants with different business models, and that, to achieve this, it is necessary to give consumers confidence that switching current accounts will be easy and reliable, and to provide consumer with greater transparency about the cost of their current accounts. [1]

 

Switching

 

83. The ICB suggested that a current account redirection service should be established, by September 2013, to 'smooth the process of switching current accounts'. We are happy to support this recommendation, which has been endorsed in the Banking Reform white paper. However, we are not sure that it will be sufficient to overcome consumers' inertia, and their concerns that switching may be difficult. In our submission to the ICB, we expressed a preference for full account number portability, and suggested that, "banks should be required to introduce current account portability, to address the perception (and, too often, the reality) that PCA switching will be problematic". We noted that Sir Donald Cruickshank had pressed for mobile telephone number portability, despite industry protestations, and we suggested that switching current accounts should be at least as easy as switching mobile phone operators. [1]

 

Transparency

 

84. The ICB suggested that annual statements to current account customers should include estimates of interest foregone. We are happy to support this proposal, with statements including estimates of interest foregone along the lines illustrated to the Treasury Committee by Lloyds. We are not sure how well consumers understand the concept of interest foregone, or how strong an economic incentive for switching an estimate of interest foregone will provide, especially when interest rates are so low, but we regard transparency about interest foregone as an important step foreword, and were disappointed by the apparent lack of urgency on this matter in the Banking Reform white paper, which states that, "As a first step, the OFT will host a roundtable in October 2012 to gather views on the proposal from all relevant stakeholders." [1]

 

85. In normal circumstances, we would be happy to allow time for the measures on switching and transparency to be implemented, and for interested parties to assess their effectiveness, before considering the possible need for further measures to improve competition such as those suggested by the ICB: full portability of current accounts and a review of retail banking by the Competition Commission. However, in current circumstances, it seems important that any necessary actions are taken within a reasonable period to improve standards in banking, to give consumers a better deal and to restore trust in banking. We believe that this should be done as far as possible by encouragement of greater competition in ways that brings benefits for consumers (as well as by the professionalisation of banking, and the separation of retail banking and investment banking), rather than by more and more regulation. If it is thought that further measures are required at this stage, to improve competition by reducing concentration and increasing diversity, and to improve financial stability by diluting the 'too big to fail' problem, we suggest that consideration might be given to the following possible actions.

 

Further divestments

 

86. One way to reduce the size, and power, of the large retail banks, and to create more challenger banks, would be to split up some of the large banks, or at least require them to make further divestments. In our submission to the ICB, we supported the TSC's view that the ICB should give consideration to further divestments over and above the RBS and LBG divestments required by the EU, and we supported Andrea Leadsom's suggestion that parcels of branches should be sold to groups, outside the big five banks, which would add to competition. [1] We did not agree with the ICB's view that a challenger bank has to have a large share of at least 6% of personal current accounts to be an effective challenger, and we pointed out that Nationwide had been very successful in growing its share of personal current accounts from about 2% in the mid-1990s to about 7% in 2010. [2]

 

87. Although a requirement for further divestments seems a straightforward way to reduce market concentration and create greater diversity, we are not now sure that it is practical. According to media reports, the sale of branches by RBS to Santander has been delayed by technology problems, [1] while Lloyds has found it difficult to get a buyer for its divestment and is reported to have reduced its price. [2] It has recently been suggested that the big five banks might be required to sell branches to create two new challenger banks. [3] However, the creation of new banks through combinations of branches of the large banks would be operationally and culturally challenging, and it would probably take some time before such new banks could become effective challenger banks.

 

Access to infrastructure

 

88. As an alternative to requiring further divestments, to reduce concentration and increase diversity in personal current accounts, we suggest that consideration might be given to allowing new entrants and smaller banks to provide personal current accounts (and, subsequently, SME banking services) by "piggy-backing" on the established infrastructure of the large banks. This approach would be comparable to allowing telecom companies to gain access to British Telecom's infrastructure, to create competition to the privatised monopoly, [1] rather than breaking up British Telecom, as happened with AT&T in the United States through the creation of the "baby Bells". Variants on this alternative to divestments include transferring current accounts infrastructure and payments systems to a not-for-profit organisation which would operate as a regulated utility, and encouraging specialist firms such as FDR and TSYS to offer current account processing and other services in the way that they currently offer credit card services.

 

Free-if-in-credit-banking

 

89. 'Free' banking is not free, because of insufficient funds charges and interest foregone (of which many consumers have been relatively unaware), and fees for withdrawing cash and using debit cards abroad.

 

90. We welcome the recent debate on free-if-in-credit banking. This has raised a number of important issues relating to the "free" banking model:

 

· Firstly, strong barriers to entry. John Fingleton observed that, "it may be difficult for entrants to attract customers from their existing provider if those customers perceive that their banking is free, or to use a different charging model when the 'free if in credit' model prevails across the sector". [1] Clive Maxwell subsequently said that, "it isn't just numbers of competitors that matter - identities can have an impact too, with 'outsiders' typically playing a key role in shaking up established patterns of competition - this is certainly what we have seen in other types of market" [2]

 

· Secondly, cross-subsidies between current account customer groups and between retail banking products, and risks of mis-selling, as happened with PPI. Lord Turner said that "It is not a sound basis for a long-term trust-based relationship between a competitive banking system and its customers." [1]

 

· Thirdly, the lack of an obvious market mechanism leading to an outcome that is better for consumers. Andrew Bailey observed that, "it is hard for the industry as a whole to break out without appearing to collude. So it may require intervention in the public interest, not least because it is a way to encourage greater competition." [1]

 

· Fourthly, the comment by Which? that, "The suggestion that banks should increase charges to avoid more scandals defies logic and is a slap in the face for consumers who are being hard hit by one of the worst financial crises in recent times." [1] The end of 'free' banking would not be popular, unless there were clear offsetting benefits.

 

91. We therefore believe that it is important for the OFT, in its market study of personal current accounts, to consider competition in a broad sense, including the impact of cross-subsidies between current account customer groups and between retail banking products on competition in ways that are good for consumers, and which support good standards in banking and trust in banking. We suggest that the OFT should come to a view as to whether it is appropriate to make a reference to the Competition Commission at this stage.

 

Simple financial products

 

92. An intervention that might act as a catalyst for better standards and greater competition, and for addressing 'free' banking cross subsidies between customer groups and products, would be the introduction, as soon as practical, of simple financial products for personal current accounts and for basic bank accounts. Consistent with the general approach to simple financial products, this would set industry-wide standards for products that could be kitemarked (and, by comparison, for other product variants), but would allow banks to determine their own pricing, and continue to offer whatever product variants they wish to offer.

 

Product regulation

 

93. In our submission to the FSA about the Mortgage Market Review, while strongly supporting the overall objective of improving consumer protection, we expressed concern that some of the current proposals could limit consumer choice and restrict competition. We are pleased that the FCA has been given the responsibility to promote competition, as well as to protect consumers, and we suggest that, in product regulation such as the MMR, the FCA should be required to state how its proposals will enhance competition in retail banking, as well as how they will protect consumers.

 

Financial stability versus competition

 

94. Over recent years there has, understandably, been greater focus on financial stability than on competition, most notably in allowing Lloyds TSB to acquire HBOS, at the peak of the banking crisis in 2008, despite the OFT's objections and without a review by the Competition Commission. Subsequently, the sale of RBS branches to Santander was a lost opportunity to create a new challenger bank, and greater diversity.

 

95. While financial stability obviously remains very important, especially against the background of the ongoing eurozone crisis, the level and quality of banks' capital is now much higher than it was before the banking crisis, and effective recovery and resolution plans should now be in place. [1] We believe that it is now appropriate to encourage greater competition in personal and small business banking.

 

Conclusion

 

96. In retail banking, particularly in personal current accounts and in SME banking, concentration is high, and diversity is limited. We believe that, to improve competition in retail banking, the key issue is to encourage wider provision of personal current accounts by a greater diversity of providers, including smaller banks and new entrants with different business models, and that, to achieve this, it is necessary to give consumers confidence that switching current accounts will be easy and reliable, and to provide consumers with greater transparency about the cost of their current accounts. We therefore support the ICB's recommendations to improve switching and transparency, and hope that they can be in place by the end of 2013. If it is thought that further measures are required at this stage, to improve competition by reducing concentration and increasing diversity, and to improve financial stability by diluting the 'too big to fail' problem, we suggest that consideration be given to further divestments, access to infrastructure, and free-if-in-credit banking. We suggest that simple financial products should be extended to personal current accounts and basic bank accounts. More broadly, to improve competition in retail banking, we suggest that the FCA should state how product regulation will improve competition as well as protect consumers, and should ensure that competition is not trumped by financial stability.

 

taxation, including the differences in treatment of debt and equity;

 

97. A critical problem in the banking crisis was that, although banks had total capital ratios that seemed reasonable by historic standards, the levels of the equity capital ratios of the banks that failed were not sufficient to absorb the losses that arose. According to the ICB interim report, the median leverage of UK banks increased from about twenty times in 2000 to almost fifty times in 2008. [1] Commenting on the high gearing of banks, Sir John Vickers said that, "Senior debt has generally been poor at absorbing losses (but junior debt less so). Equity is good at it, but (privately) somewhat more expensive, in part because of unintended consequences of the general corporate tax system." [2]

 

98. There appears to be a case for considering whether tax relief on debt interest contributed to the high gearing of banks in 2008, and whether changes to the tax system should be made to encourage lower gearing of banks. However, consideration of other sectors suggests that tax incentives were not the principal reason for the high and increasing leverage of banks:

 

· The gearing of the personal sector increased markedly over the decade ahead of the banking crisis, principally as a result of mortgage borrowing, even though individuals no longer got tax relief on mortgage interest payments.

 

· The gearing of the non-bank corporate sector (where non-banks, like banks, qualify for tax relief on debt interest) did not increase markedly over the decade ahead of the banking crisis.

 

99. Reasons for the high and increasing gearing of banks up to 2008 included:

 

· Firstly, in the mid-2000s, strong pressure from shareholders to return capital through higher dividends and share buy-backs;

 

· Secondly, a willingness by banks to accept higher leverage because of the widespread view that benign economic conditions would continue;

 

· And thirdly, as the mood changed, recognition by banks that raising equity capital would be expensive, and difficult.

 

Conclusion

 

100. While it is desirable that banks should not have leverage ratios as high as in 2008, we are not sure to what extent changing the corporate tax deductibility of debt interest would encourage banks to maintain low gearing in any future 'bubbles'.

 

Parliamentary Commission on Banking Standards

 

Submission by Virgin Money

 

4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (b) weaknesses in the following somewhat more specific areas:

 

the role of shareholders, and particularly institutional shareholders;

 

101. Ahead of the banking crisis, it seems that there was a lack of challenge to banks by institutional shareholders on matters such as higher risk and higher leverage, [1] acquisitions such as ABN Amro and HBOS, and remuneration including bonuses. Reasons for this lack of challenge, ahead of the banking crisis, may have included the short-termism of capital markets, [2] and their bias towards optimism, especially in 'bubbles'. [3] As warning signs of sub-prime losses emerged, following HSBC's profit warning in 2007, further reasons may have included the fact that many UK funds are indexed or quasi-indexed, the reluctance of fund managers to engage [4] and practical difficulties faced by institutional investors wishing to challenge banks, [5] and the reluctance of banks to disclose information about their sub-prime exposures until forced to do so by falling share prices towards the end of 2007.

 

102. As a general approach to addressing these issues, we prefer ways that incentivise shareholders to apply market discipline to banks, rather than more regulation. We support the view expressed by Professor John Kay, when introducing the Kay Report, that, "The approach we favour is one which favours giving people incentives to do the right thing, rather than presenting rules to prevent them doing the wrong thing in a situation where commercial incentives encourage them to do the wrong thing. It is an approach which emphasises structure and incentives, rather than prescriptive rules." [1] However, we believe that there may be need for some regulation, such as disclosure requirements, to support the incentivisation of effective market discipline by shareholders.

 

103. It is clearly hard to address the short-termism of markets and their bias towards optimism. However, the FPC will now monitor emerging risks, will increase awareness of such risks, and will have powers to limit 'bubbles'. In addition to the initial macroprudential toolkit proposed for the FPC, we suggest that it should have powers to require banks to make disclosures, in the way that it might have required banks to make discloses about the extent and nature of their sub-prime exposures after the HSBC profit warning in early 2007. We recognise that the criteria set by HM Treasury for FPC powers of direction may have to be amended to allow for this. [1]

 

104. Index funds, and institutional funds with approximately indexed weightings, are less worried that share prices might fall, since this will not affect their performance relative to the index. It is not clear how the managers of index funds could be incentivised to be concerned about the possibility of falling prices. It is therefore desirable to encourage diversity of fund managers, including hedge funds and other funds interested in absolute rather than relative returns. Short-selling by hedge funds contributed to pressure on some banks, in the autumn of 2007, to disclose their sub-prime exposures, and, in the autumn of 2008, to admit their need for equity capital.

 

105. In relation to engagement between investors and banks, the Walker Review found shortcomings on both sides. An opportunity exists for UKFI to take a lead in setting standards for the expected behaviour of shareholders through its interaction with RBS and Lloyds. For example, UKFI might establish shareholder forums, as suggested in the Kay Review. [1]

 

106. Among the options available, we believe that requirements for greater disclosures are the most straightforward, and probably effective, way to empower shareholders and incentivise them to discipline banks, either by engaging with them or by selling shares in them. The financial performance of banks, and trust in them, was damaged by higher risk and leverage, acquisitions and remuneration. Taking each of these in turn:

 

· We suggest that banks should be required to disclose information about all their risks (not just their Pillar 1 risks) and regulatory capital requirements for these risks, and the results of their stress tests. We suggest that banks' risk reports should include an executive summary covering material risk exposures, changes in their risk exposures and changes in the risk environment. We suggest that banks, or their regulator, should disclose their Individual Capital Guidance, including the amount of any capital "add-ons".

 

· For acquisitions requiring shareholder approval, we suggest that consideration be given to requiring banks to include in their document for shareholders an assessment of risk factors associated with the acquisition, as might be done for an IPO.

 

· We suggest that banks should be required to make disclosures about bonus schemes and bonus payments, for senior executives, investment banking employees and retail banking employees.

 

Conclusion

 

107. To support more effective market discipline by shareholders, we suggest that banks should be required to make greater disclosures, including about their risks and regulatory capital requirements, risk factors associated with intended acquisitions, and bonus schemes and bonus payments. We suggest that UKFI might take a lead in setting standards for the expected behaviour of shareholders, for example by establishing shareholder forums as suggested in the Kay Review.

 

creditor discipline and incentives;

 

108. We hope that greater transparency by banks and by their regulators, and leadership by UKFI, will support more effective market discipline by shareholders. In addition, we support the additional market discipline on banks that is likely to arise from the ICB's recommendations, which are endorsed in the Banking Reform white paper, that unsecured debt should be capable of being bailed in, and that insured deposits should be preferred.

 

109. For these additional sources of discipline on banks to be effective, we suggest that:

 

· It should be made clear to relevant categories of bond holders that their bonds will be bailed-in instead of, or at least before, any bail-out by taxpayers, despite what happened in 2008, and despite the reluctance of the European Central Bank to force bondholders in failed banks to accept writedowns before 2018. [1]

 

· It should be made clear to depositors that deposits above £85,000 with a bank are not guaranteed, despite the possible perception, based on what happened in 2008, that all retail deposits are implicitly guaranteed. However, in making this clear, care should be taken to avoid shrinking the pool of deposits by encouraging depositors to move to national savings or gilts, or to deposits in banks of countries where all retail deposits are preferred or implicitly guaranteed.

 

Conclusion

 

110. We support the additional market discipline on banks that is likely to arise from the ICB's recommendations that unsecured debt should be capable of being bailed in and that insured deposits should be preferred.

 

corporate governance, including

 

- the role of non-executive directors

 

111. Ahead of the banking crisis, it seems that the boards of some banks did not challenge management sufficiently on matters such as higher risk exposures, the adequacy of capital and liquidity, acquisitions, and remuneration.

 

112. One reason for the lack of challenge appears to have been the practical difficulties for non-executive directors in challenging strong and forceful chief executives. We support the Treasury Committee's suggestion that, "The Parliamentary Commission on Banking Standards' examination of the corporate governance of systemically important financial institutions should consider how to mitigate the risk that the leadership style of a chief executive may permit a lack effective challenge or to the firm committing strategic mistakes." [1] In this context, we note that, after the banking crisis, Sir Richard Greenbury was reported as saying that, "There was 'a good chance' that a two-tier board would have prevented the collapse of RBS challenging and curbing the actions of Fred Goodwin". [2] We are not sure that a two-tier board would be better overall for UK banks, but we support the concept that executives on the board should be limited to the chief executive and the finance director.

 

113. More generally, it seems desirable to ensure that there is challenge and debate at board meetings, and to ensure that desire for collegiate culture among board members does not lead to dissenters going along with the majority 'for the sake of peace'. It seems desirable to achieve greater diversity on bank boards (but preferably not through quotas): this may imply that consideration should be given to advertising for non-executive board positions (as in the public sector) to allow access by some candidates not on the lists of HR firms (which may be limited by a requirement that candidates already have experience on other boards). Low challenge resulting from an overly-collegiate board culture would be addressed by Lord Turner's proposal for automatic bans on the directors of failing banks, "unless they could positively demonstrate that they were active in identifying, arguing against and seeking to rectify the causes of failure." [1]

 

- the compliance function

 

- internal audit and controls

 

114. It is likely that people who choose to work in these areas have good standards, and wish to ensure that their bank complies with the regulations, and does not do things which, while not illegal, might damage the banks' reputation. But the power of these functions may be limited. They may not be invited to comment on major corporate initiatives such as, before the banking crisis, investments in securities such as CDOs and CDSs, or acquisitions such as ABN AMRO and HBOS. And, even in activities where they are involved, they may be reluctant to escalate issues, and concerns, either within their bank or to the regulator, in case they suffer the same consequences as whistle-blowers, becoming out of favour and possibly losing their jobs. While it would be unwise to generalise from Barclays, the preliminary findings on LIBOR says that, "It is important to state that Barclays' internal compliance department was told three times about concerns over LIBOR fixing during the period under consideration and it appears that these warnings were not passed to senior management within the bank". [1]

 

115. There is therefore a case for establishing in banks (or at least in large ring-fenced banks) a senior position for a person who has strong technical skills and a track record of good judgement, and who is bound by professional standards, who would have a duty to raise any concerns with the executive management team and with the board, with whom the bank would have to learn to live, and who could not be dismissed, or encouraged to leave or to retire, as a result of carrying out his duty to identify and escalate major risk issues. This senior position could be established in either of two ways:

 

· It could be a 'risk strategy executive' who would not oversee the banks' risk management activities, but who, with appropriate seniority and authority would be free to consider strategic risks (such as, in 2007, sub-prime lending, and, currently, risks that could result form the eurozone crisis) and would discuss the areas of perceived risk on a regular basis with the executive management team and with the board.

 

· It could be a 'public protagonist' as suggested by Matthew Hancock and Nadhim Zahawi: "To strengthen the effective power of shareholders, a public protagonist would have the authority to convene special shareholder meetings on behalf of the public, and publicly test a course of action contemplated by the management. The management would of course remain under their obligation to shareholders, but shareholders would now hear both sides of any argument. Faced with this challenge, and with their monopoly of the supply of information to shareholders broken, a culture of challenge would be strengthened, and the senior executive would consider their options more carefully." [1]

 

- remuneration incentives at all levels;

 

116. It is clearly a matter of public concern that executive remuneration (in banks and more generally) has expanded rapidly over recent years, while average remuneration has grown only modestly. The 2011 BIS discussion paper on executive remuneration showed that, "between 1998 and 2010, the median total remuneration of FTSE100 CEOs increased from £1 million to over £4 million, and that the year-on-year increases were not impacted by fluctuations in the FTSE100 Index". [1] The BIS paper also showed that, while base salary has increased, most of the growth in CEO remuneration has come in the form of bonuses, deferred bonuses and LTIPs. [2] To support market discipline by shareholders, we believe that there is need for greater transparency about executive bonus schemes and bonus payments, and about the total remuneration of senior executives. We also suggest that consideration should be given to the role and responsibilities of the chairperson of the remuneration committee (and whether there should be any external representation on this committee), and that firms giving advice on executive remuneration should have no other business relationship with the bank. We suggest that banks should be required to make disclosures about bonus schemes and bonus payments, for senior executives, investment banking employees and retail banking employees.

 

Conclusion

 

117. Stronger challenge by non-executive directors may be achieved by limiting executive positions on bank boards (possibly just to the CEO and finance director), by encouraging greater diversity of non-executives on bank boards (possibly advertising for at least some positions) and by Lord Turner's proposal that there should be automatic bans on the directors of failing banks. Given that the compliance function and internal audit may not identify some major risks, and may be reluctant to escalate concerns, we suggest that consideration be given to the appointment in large banks at a senior level of a risk strategy executive, whose role would be to identify major risks and discuss them with the executive management team and board. To strengthen governance on remuneration, we suggest that consideration be given to the composition of the remuneration committee, to the role and responsibilities of its chairperson, and to the need for independence of any advisers on remuneration.

 

recruitment and retention;

 

118. An important social change over the last fifty years is that many people change jobs, possibly several times, during their career, rather than stay with the company they join from school or university. Greater job mobility is good for people who wish broader career experience and opportunities. For employers, it brings a broad range of skills and experience. However, employers may have to spend a lot of time on recruitment, while recent recruits may take some time to understand how things work at their new employer.

 

119. The full professionalisation of banking would help in both areas:

 

· It would be easier to for banks assess candidates for recruitment on the basis of their performance in the professional exams and in their CPD, and it would be possible to check whether they had been subject to any sanctions by the profession.

 

· It would be easier for people moving from one bank, whether at a junior or at a senior level, to maintain the required standards and behaviour.

 

Conclusion

 

120. The full professionalisation of banking, with exams and CPD, a code of conduct and sanctions for breaching the code, would make it easier for banks to assess candidates for recruitment, and would make it easier for people moving from one bank to another to maintain the required standards and behaviour.

 

arrangements for whistle-blowing;

 

121. In the acquisition by banks of the securities that became seen as 'toxic' and in LIBOR manipulation, common themes were that only small numbers of employees within large organisations were responsible for the actions, [1] and that senior management did not seem to know what was going on at the time.

 

122. In the smaller banks and partnership businesses that existed before Big Bang, it was easier to know what was going on, lines of communication were shorter, and upward communication of problems and potential problems was often encouraged, because of concerns that financial or reputational damage might cause a bank to falter and be taken over, or that a partnership business might lose the confidence of its customers and fail.

 

123. However, within large organisations, the upward flow of information may well be less effective than the downward flow. One reason is that senior management have to establish formal processes for downwards communications, but may be too busy for, or less interested in, upward communications. Another reason is that middle management may be reluctant to pass on "bad news" about problems or potential problems in their areas of responsibility. There is therefore a case for establishing arrangements for "whistle-blowing" as Social Partnership Forum and Public Concern at Work did for the National Health Service. [1]

 

Concerns

 

124. A problem with whistle-blowing is that, if it is to be useful for preventing problems arising rather than subsequently for allocating blame, it is desirable that concerns should be raised at an early stage. However, as Matthew Hancock and Nadhim Zahawi described in their book, people raising concerns at an early stage may be labelled 'fools in the corner', and may be ignored. [1]

 

125. For many whistle-blowers, the consequences of whistle-blowing have been bad. Research carried out in Australia showed that the consequences of whistle-blowing were uniformly negative. Among 35 cases of whistle-blowing considered in the analysis, 29 had experienced victimisation immediately after their first internal complaint. Eight of the 35 were dismissed, ten were demoted and a further ten resigned or took early retirement because of ill health. These people found it difficult to get another job, and suffered vary large reductions in income. Among wider consequences, 29 of the 35 reported symptoms of stress, 15 were recommended long-term treatment with drugs which they had not been prescribed before, and 17 considered suicide. [1] These cases may or may not be typical of financial services, but other case studies support concerns about the possible consequences for whistle-blowers. [2]

 

Possible approaches

 

126. A possible approach is to establish anonymous whistle-blowing hotlines in banks. However, these could be mis-used by people with grievances, and expressions of concern that are anonymous may not be taken seriously, as was the conclusion of a US study of whistle-blowing to audit committee members. [1] The NHS paper on whistle-blowing arrangements recommended that concerns should be raised openly. [2] However, there could be value in a confidential whistle-blowing advice service, for employees to discuss whether, or how, they should raise their concerns.

 

127. To encourage whistle-blowing in an open manner, it is desirable to encourage the view that whistle-blowing is not disloyal, but that it is responsible, to protect the bank and the reputation of the banking profession. [1] The most obvious route is for people to raise concerns, as early as possible, with their immediate superior. If people are concerned about the possible consequences, an alternative route would be for people to raise their concern with the regulator. However, it is likely that many bankers are not aware of any duty to report concerns to the regulator, or how to do so. In any case, reporting concerns to the regulator might be seen by the bank as more disloyal, and might lead to more serious consequences for the whistle-blower.

 

128. An alternative route would be for people to approach the banking professional body. A code for whistle-blowing could be communicated along with the professional code of conduct, and people would probably find this route easier because they would already have some contact with the professional body. This route might be particularly useful for employees who feel that expressions of concern to their bank are not being taken seriously, for senior executives who are afraid of the consequences of expressing their concerns to their CEO or chairman, and for early-stage concerns based more on intuition than on hard evidence. If considering this route, consideration might be given to established processes for whistle-blowing in other professions, [1] how the regulator would be informed and possibly involved, and what protection could be given to the whistle-blower and to the professional body.

 

129. In the event of a whistle-blower, who had expressed legitimate concern, being victimised, the banking profession could give support, and might be able to prevent him or her being dismissed. But it could probably not stop the whistle-blower being 'encouraged to leave'. Given the extensive evidence of serious and long-term consequences for whistle-blowers, there is a case for considering whether they should receive financial compensation, either (as can happen in the US) as a percentage of any fine levied by the bank's regulator, or as an amount agreed with the bank by some appropriate body, probably including representatives of the profession and of the regulator.

 

Conclusion

 

130. It is desirable that the view is communicated that whistle-blowing about legitimate concerns is responsible rather than disloyal, that the routes available to whistle-blowers, for advice and for raising concerns, are made clear, and that as much protection as possible is given to whistle-blowers, possibly including financial compensation for adverse consequences.

 

external audit and accounting standards;

 

External audit

 

131. It is a matter of concern that auditors signed off the accounts of UK banks at the end of 2007, and in the middle of 2008, without reservations, shortly before some banks had to raise equity capital from investors (RBS and Barclays) or from tax-payers (RBS and Lloyds), or experienced difficulties and had to be taken over or nationalised (Bradford & Bingley, Alliance & Leicester and Northern Rock). Concern about the failure of auditors to give warning of the banking crisis, and broader concern about the effective oligopoly of four large accounting firms, were expressed clearly in the opening paragraphs of the House of Lords report on auditors: "Identification of the shortcomings of the large-firm audit market is easy enough. It is clearly an oligopoly with all the attendant concerns about competition, choice, quality and conflict of interest. It gave no warning of the banking crisis. The narrowness of the assurance it offers is much criticised. [...] Yet investors, regulators and commentators regard rigorous and reliable external audit as an essential underpinning of business and the capital markets which finance it, in Britain and elsewhere. The assurance offered by audit is especially needed in the case of banks, with their attendant risks and where loss of confidence can imperil the financial system." [1]

 

132. We await the outcome of the Competition Commission's investigation audit services. [1] We believe that there is a case for requiring auditors to be re-appointed, or even rotated, every five years, and possibly for prohibiting audit firms cross-selling some consultancy services. But, in the context of restoring trust in banking, we believe that the most important issue is whether, and how, auditors can indicate any concerns they have about banks' reported accounts. We support the recommendation of the House of Lords Select Committee on Economic Affairs that there should be "two-way dialogue between auditors and supervisors about the financial health of banks". [2] However, while the qualification of a bank's accounts might be a 'nuclear' option that could undermine confidence in the bank, [3] it seems desirable to learn lessons from risk management, where market discipline by shareholders has been constrained by the disclosure of less information to shareholders and to the regulator. So we suggest that consideration should be given to the Committee's suggestion that, "the published report of the audit committee should detail significant financial reporting issues raised during the course of the audit", [4] and to Lord Lawson's suggestion that, "It may be worth considering a gradation, rather in the way the rating agencies grade financial instruments, starting with AAA and going down to wherever they eventually go. It would be possible for the auditors to grade the accounts, and there could be a requirement for them to do so." [5]

 

Accounting standards

 

133. We have concerns about three aspects of the IFRS accounting regulations:

 

· Whether intended or not, they removed the need for judgement, for example in loan loss provisions and in the valuation of trading assets. While this may reduce the scope for 'manipulation' in some respects, it encourages a 'tick-box compliance' mindset, by banks and their auditors, that is not consistent with HM Treasury's intended approach to financial regulation, based on proper risk analysis and judgement." [1]

 

· The IFRS accounting regulations increased the pro-cyclicality of banks' reported results. Two reasons for this impact were the use of incurred loss accounting rather than expected loss accounting for loans on the banking book, and mark-to-market (or mark-to-model) adjustments for assets on the trading book. We support the proposal to change the accounting basis for loans on the banking book back to expected loss accounting. For assets on the trading book, we believe that mark-to-market adjustments are appropriate, although their reliability can be limited by thin trading in markets, or by the opacity of banks' internal model.

 

· The IFRS accounting regulations maintained the distinction between the banking book and the trading book, with different accounting regulations. This allows "manipulation" by switching assets from the trading book to the trading book (or, at times, in the opposite direction) to reduce risk-weighted assets and regulatory capital requirements. [1] Although the BCBS has proposed two alternative boundary definitions, the ability to trust banks' reported accounts may be reduced by this form of arbitrage.

 

134. Our conclusion is that the different accounting treatments for long-term bank loans and short-term trading assets, the possibility of capital arbitrage between the trading book and the banking book, and the pro-cyclicality of mark-to-market accounting for trading book positions, support the case for the separation of retail banking and investment banking.

 

Conclusion

 

135. To support confidence in banks' reported results, we believe that there should be dialogue between auditors and the regulator, that the published report of audit committees should detail significant financial reporting issues, and that consideration should be given to the gradation of accounts by auditors. We support the proposal to change the accounting basis for loans on the banking book back to expected loss accounting. We believe that the different accounting standards for loans on the banking book and assets on the trading book, with the possibilities of capital arbitrage and of pro-cyclical impact, support the case for the full separation of retail banking and investment banking.

 

the regulatory and supervisory approach, culture and accountability;

 

136. We believe that the objective should be "better" regulation, that builds trust between banks and their regulator, that encourages good standards and open behaviour (including when problems arise), [1] and that requires banks to hold adequate capital and liquidity, but not so much as to restrict their ability to support economic activity and economic growth.

 

Different

 

137. We believe that it is important for banks and their regulator to be open with each other, and to be able to trust each other. RWA optimisation practices revealed in the FSA's letter to Barclays dated 10 April 2012 [1] do not support trust; neither do the repeated statements that "banks should be very afraid of the FSA". [2] The establishment of greater trust between banks and their regulator should make it easier to implement HM Treasury's intended approach to regulation, focusing on proper risk analysis and judgement rather than tick-box compliance. [3]

 

138. Given the limitations of banks internal risk models (particularly if based on value-at-risk methodologies), [1] and the extent of 'RWA optimisation' that has taken place, [2] we suggest that the UK authorities should support the recent proposal by Barclays Equity Research that banks should assess their risks and their regulatory capital requirement for these risks on the basis of a standardised model, [3] with as little scope for manipulation as possible. We suggest that banks should be required also to form an honest assessment of their 'economic capital' requirements - the amount of capital which they think that they need to cover their risks, using whatever methodology they wish to use. The suggested approach would limit 'RWA optimisation' practices, would support financial stability, [4] by increasing the regulatory capital requirements of banks that had engaged in 'RWA optimisation', would create a more level playing field between large banks, smaller banks and new entrants, and would underline the fact that estimates of capital requirements represent different points on a distribution of possible outcomes.

 

139. We consider it appropriate that the regulator should continue to apply, within the supervisory review process, capital 'add-ons' to banks' regulatory capital requirements for their risks, to allow for matters about which they are concerned. In exercising their judgement about the size of any such capital 'add-ons', we suggest that the regulator might take account of the quality and openness of banks' communications about their risks. However, to encourage good standards and open behaviour, we consider it important that the regulator should hold out the prospect that the amount of capital 'add-ons' can be reduced if and when the areas of concern are addressed.

 

Differentiation

 

140. We believe that there should be differentiation between the capital requirements for the large banks that pose systemic risk, to incentivise low risks and high standards, as well as to disincentivise high risks and low standards. A key opportunity for differentiation is in the Individual Capital Guidance given to banks by the regulator, including any capital 'add-ons' (possibly including an element for the quality and openness of communications). A further opportunity is in the capital surcharge for large systemically-important banks: although the ICB has suggested that the size of this surcharge should be determined by the ratio of banks' RWAs to UK GDP, [1] we suggest that the basis proposed by the BCBS and the FSB, which takes account of five factors including size, interconnectedness and complexity, [2] seems more likely to create differentiation between the large banks, and to incentivise behaviour that could lead to the capital surcharge being reduced. And, as HM Treasury pointed out, there is merit in adopting a common approach internationally.

 

Transparency

 

141. For market discipline by shareholders to incentivise good standards and low risk, there has to be adequate transparency about banks' risks. Ahead of the banking crisis, limited transparency by banks and their regulator meant that shareholders effectively had to rely on the regulator for supervision of banks' risks and risk management. We believe that there should be more comprehensive risk disclosures by banks, and by their regulator.

 

142. Risk disclosures by banks, required under Pillar 3 of the Basel regulations, contain many schedules, but the information is limited to Pillar 1 risks. [1] The disclosures do not include Pillar 2 risks, or the results of stress tests carried out by banks. We suggest that banks should be required to disclose information about all their risks and the full extent of their regulatory capital requirements, and about the results of their stress tests. [2] In addition to this information, we suggest that banks should be required to include, at the beginning of their Risk Report, an executive summary which covers material risk exposures, changes in risk exposures and changes in the risk environment, and which is written in such a way that it is easy to understand. Under Solvency II, insurers will be required to provide a "short and easily understandable executive summary". [3]

 

143. We believe that there is also a case for disclosure, either by banks or by their regulator, of the amount of their Individual Capital Guidance, including any capital 'add-ons'. As we understand it, under Solvency II, the equivalent information for insurers will have to be disclosed, [1] at least after a transitional period.

 

144. In addition to this regular reporting, we suggest that the FPC should have powers to require banks to make disclosures, in the way that it might have required banks to make disclosures about the extent and nature of their sub-prime exposures after the HSBC profit warning in early 2007, and that, if necessary, the criteria set by HM Treasury for FPC powers of direction should be amended to allow for this. [1]

 

145. We recognise that there has been some reluctance to require full disclosure by banks about their risks (especially in respect of liquidity risk) because of fear of 'spooking the market'. [1] However, information about perceptions of the riskiness of individual banks is already available in ratings given by credit rating agencies, bond yields, spreads on credit default swaps and margins charged by clearing houses such as LCH Clearnet. Also, equity capital ratios are now much higher than they were in 2008, and effective recovery and resolution plans are now in place.

 

Conclusion

 

146. We believe that it is important for banks and their regulator to be open with each other, and to be able to trust each other. We suggest that the use of a standardised approach to assess banks' regulatory capital requirements (along the lines suggested by Barclays Equity Research) would support trust by reducing 'RWA optimisation', would support financial stability, and would create a more level playing field between large banks, smaller banks and new entrants. We believe that differentiation between large banks, including in the assessment of the capital surcharge for large banks, and of any capital 'add-ons' (possibly including an element for the quality and openness of communications), would incentivise low risks and high standards. We believe that greater disclosure about banks' risks and regulatory capital requirements, by both banks and their regulator, is desirable, to support more effective market discipline by shareholders.

 

the corporate legal framework and general criminal law;

 

147. There is public disquiet that action has not been taken against directors of banks that were failing and had to be bailed out (apparently because, although they exercised poor judgement, they did not break any laws), [1] or against people who engaged in LIBOR manipulation (despite the fine levied on Barclays and the fines expected to be levied on other banks). [2] The failure to take action against individuals adds to public concern that directors and senior executives of large banks seem to be 'above the law'. [3] It is not clear that fines, such as those which have been imposed on some banks, have a significant impact on standards and culture in banking. Even large fines may be regarded as 'a cost of doing business'. [4]

 

148. Public antipathy towards large banks has, unfortunately, persisted for some years. We are concerned that it may damage the perception of all banks (including smaller banks and new entrants), perpetuate low trust in banks, and restrict economic growth. In connection with the objective of restoring good standards and trust in banking, we believe that the public concern about lack of sanctions on individuals needs to be addressed, but in a controlled and responsible manner, rather than through periodic outbreaks of 'banker-bashing'. [1]

 

149. There does seem to be a strong case for a comprehensive review of the legal framework and criminal law applicable to banking, and more generally to white collar crime, to ensure that the laws are appropriate and adequate. However, a properly-considered review of the legal framework is likely to take some time. In the meantime, we believe that two actions, which could be taken within a relatively short period, would have a positive impact on standards and culture in banking, and would go some way to addressing public concerns:

 

· The first recommended action is to establish arrangements for sanctioning the directors and senior executives of banks that are fail ing and have to be bailed out . Of the two possible ways to achieve this put forward by Lord Turner in his Foreword to the FSA's report on the failure of RBS, we prefer the automatic incentives based approach, with the stated option of, "Establishing rules which would automatically ban senior executives and directors of failing banks from future positions of responsibility in financial services unless they could positively demonstrate that they were active in identifying, arguing against and seeking to rectify the causes of failure". [1] The possibility of automatic bans would address one of the main areas of public concern, and the suggested approach would encourage individual board members and senior executives to raise their concerns, rather than just go along with things, and so would reduce the likelihood of failures (and so of the need to impose bans).

· The second recommended action is to strengthen the ability of the professional body to apply sanctions for breaches of the professional code of conduct (even if no laws are broken), by making the code of conduct mandatory within the full professionalisation of banking, and by giving the professional body power to investigate possible breaches, working with the FCA .

Conclusion

150. We believe that, to restore trust in banking, public concern about the lack of sanctions on individuals needs to be addressed. We think that this should be done by ensuring that the law is appropriate, that the automatic incentives based approach is applied to directors of banks, and that employees who break the professional code of conduct (which we think should be mandatory) should be liable to sanctions, up to expulsion from the banking profession.

31 August 2012

 

[1] The Future of Banking Commission Report , June 2010, pages 76 and 77

[2] "A professional body should be set up for bankers, involving the introduction of professional exams and a professional code of practice, with processes and penalties for breaches of the code", Virgin Money response to ICB Issues Paper, page 17

[3] "I think there is a very important set of public policy issues around remuneration, around bonuses and around governance. I think those issues are very relevant to our remit, but I think they are not within our remit and I think there is a danger for us as a Commission of spreading too wide and too thin", Sir John Vickers, Treasury Committee, 24 May 2011

[1] Foundation Standards for Professional Bankers, Chartered Banker Professional Standards Board, July 2012, page 2

[2] Foundation Standards for Professional Bankers, Chartered Banker Professional Standards Board, July 2012

[1] Codes of Conduct in the City of London, Cass Business School

[1] 'London insiders remember Big Bang', BBC, October 2006

[1] See for example 'The Brandeis problem' in Can a return to Glass-Steagall provide financial stability in the US financial system? , Jan Kregel, 2010

[1] This Time is Different: Eight Centuries of Financial Folly , Carmen M. Reinhart and Kenneth S. Rogoff, 2009

[2] 'The Formula That Killed Wall Street'? The Gaussian Copula and the Material Cultures of Modelling , Donald MacKenzie and Taylor Spears, University of Edinburgh, June 2012

[1] Letter to Chairman, Barclays Bank PLC, Financial Services Authority, April 2012

[2] Financial Stability Report , Bank of England, December 2011, pages 39 and 40

[1] "As long as the music is playing, you've got to get up and dance. We're still dancing", Chuck Prince, Citigroup, July 2007

[1] " There are arguments that competition between banks can be bad for stability. One such argument is that c ompetition, by reducing profitability, encourages greater risk taking, to the detriment of stability", Issues Paper , Independent Commission on Banking, September 2010, paragraph 3.17

[1] 'New crisis management measures to avoid future bank bail-outs', European Commission press release, June 2012

[2] Anticipated acquisition by Lloyds TSB of HBOS , Office of Fair Trading, October 2008

[1] This Time is Different: Eight Centuries of Financial Folly , Carmen M. Reinhart and Kenneth S. Rogoff, 2009

[2] 'The Formula That Killed Wall Street', The Gaussian Copula and the Material Cultures of Modelling , Donald MacKenzie and Taylor Spears, University of Edinburgh, 2012

[1] 'Public trust in banks "obliterated" over scandal', The Independent , July 2012

[1] Professor John Kay, Speech at Kay Review Launch, July 2012

[1] See for example Don't Be Fooled Again: Lessons in the Good, Bad and Unpredictable Behaviour of Global Finance , Meyrick Chapman, 2010, Chapter 8

[1] Letter to Chairman, Barclays Bank PLC, Financial Services Authority, April 2012

[2] Financial Stability Report , Bank of England, December 2011, pages 39 and 40

[1] Financial Stability Report Press Conference, Opening Remarks by the Governor, December 2011

[2] Bye Bye Basel? , Barclays Equity Research, May 2012, page 1 and page 13

[1] Fundamental review of the trading book , Basel Committee on Banking Supervision, May 2012 , page 4

[1] Questions and Answers, EU-wide stress testing, European Banking Authority, 2011

[2] Minutes, 6 th meeting of the Banking Stakeholder Group, 20 April 2012, European Banking Authority, June 2012

[1] See for example 'Banks threaten to leave London over measures to prevent another bailout', Guardian , April 2012

[1] " across the market as a whole, there has been little incenti ve for innovation or efficiency" , Competition in the financial services sector, Speech by Clive Maxwell, June 2012

[1] Simple financial products: a consultation , HM Treasury, December 2010

[1] See for example 'The Brandeis problem' in Can a return to Glass-Steagall provide financial stability in the US financial system? , Jan Kregel, 2010

[1] Sir George Mathewson , A rticle in the Financial Times , September 2011.

[1] 'We are not "risk nutters" stifling the recovery', Article by Andrew Haldane, Bank of England, July 2012

[2] 'Interview: Virgin Money boss calls for radical action to end banking scandals', Jeff Prestridge, This is Money, July 2012

[1] Lord Lawson, Grand Committee debate on 'Auditors: Market Concentration and their Role', House of Lords, March 2012

[1] "More than a decade on from the Cruikshank report, we still have a banking sector where competition is manifestly not working well for consumers. This is not just the OFT's view - the ICB and the TSC a lso reached the same conclusion " , Competition in UK Banking, Speech by John Fingleton, February 2012

[2] Review of barriers to entry, expansion and exit in retail banking , Office of Fair Trading, November 2010

[3] Competition and choice in retail banking , Treasury Committee, April 2011, page 85, paragraph 9

[1] Anticipated acquisition by Lloyds TSB of HBOS , Office of Fair Trading, October 2008

[2] Interim Rep ort , Independent Commission on Banking, April 2011, page 121, Table 5.2

[3] Interim Rep ort , Independent Commission on Banking, April 2011, page 121, Table 5.2

[1] " Banks must be far more transparen t about their fees and charges s o that people can clearly see what they already pay", 'The true cost of 'free' banking ' , Which? press release, August 2012

[1] "Number portability, which you all enjoy now in telecoms, was something that I drove through in the 1990s, first on the fixed line and then mobile. In each case the estimates of the cost were huge. You could get an engineer sitting in front of a body like this demonstrating how expensive it was going to be. However, if you drive it through, that same engineer is delighted to have the challenge and the costs are trivial. The engineers get at it, they are legitimised to get at the issue and in today's world they should be able to deliver it very easily. I would go further: they should be able to deliver it in ways that are cost saving for the bank, as w ell as service improving for us " , Sir Donald Cruickshank, Treasury Committee, Competition and choice in the banking sector , March 2011, HC 612-iii, Question 130

[1] Banking reform: delivering stability and supporting a sustainable economy , HM Treasury and BIS, June 2012, page 54, paragraph 4.24

[1] 'What can Government do to compensate taxpayers for the pain caused by the banks?', Andrea Leadsom, conservativehome, May 2011

[2] Virgin Money response to ICB Interim Report , page 4, paragraph 16

[1] 'RBS suffers blow over branches deal', Financial Times , June 2012

[2] 'Co-operative Group set to approve deal on Lloyds branches', Financial Times , July 2012

[3] 'Miliband set to up the ante on big banks', Financial Times , July 2012

[1] Monopoly and Competition in British Telecoms , John Harper, 1997

[1] Competition in UK Banking, Speech by John Fingleton, February 2012

[2] Competition in the UK financial services sector, Clive Maxwell, June 2012

[1] Banking at the cross-roads: Where do we go from here? Speech by Lord Turner, July 2012

[1] The future of UK banking - challenges ahead for promoting a stable sector, Speech by Andrew Bailey, May 2012

[1] The true cost of 'free' banking, Which? press release, August 2012

[1] 'New crisis management measures to avoid future bank bail-outs', European Commission press release, June 2012

[1] Interim R eport, Independent Commission on Banking, page 18

[2] 'How to regulate the capital and corporate structures of banks', Speech by Sir John Vickers, Independent Commission on Banking, January 2011

[1] " Before the recent crisis phase there appears to have been a widespread acquiescence by institutional investors and the market in the gearing up of the balance sheets of banks (as also of many other companies) as a means of boosting returns on equity.", A review of corporate governance in UK banks and other financial industry entities - Final recommendations , November 2011, page 71

[2] "Our evidence suggests short-termism is both statistically and economically significant in capital markets.", The Short Long, Speech by Andrew Haldane, Bank of England, May 2011

[3] "This was not necessarily irrational from the standpoint of the immediate interests of shareholders who, in the leveraged liability business of a bank, receive all of the potential upside whereas their downside is limited to their equity stake, however much the bank loses overall in a catastrophe.", A review of corporate governance in UK banks and other financial industry entities - Final recommendations , November 2011, page 71

[4] "But despite potential benefits, reservations about increased engagement initiative that are frequently mentioned include [...] the scale of the senior resource commitment on the part of fund managers required for effective dialogue and the unwillingness of many or most end investors to the cost of such effort and the free-rider benefit that may be generated for those who do not contribute to the engagement process", A review of corporate governance in UK banks and other financial industry entities - Final recommendations , November 2011, page 73

[5] "On the side of boards, inhibiting factors in relation to such engagement have typically included [...] a degree of hubris or complacency about the board's strategy which makes a chairman or CEO reluctant to spend time on challenge from one or more institutional shareholders whose interests may not necessarily coincide with those of other shareholders", A review of corporate governance in UK banks and other financial industry entities - Final recommendations , November 2011, page 71

[1] Professor John Kay, Speech at Kay Review Launch, July 2012

[1] "In addition, the Committee agreed that powers of Direction over disclosure requirements would be desirable but that it could be difficult to meet the test set by HM Treasury in its February 2011 Consultation Document that powers of Direction should be specific.", Financial Policy Committee statement from it s policy meeting, 16 March 2012

[1] "Two central recommendations in our report are that [...] and that we should encourage large institutional investors to act collectively and establish a forum to facilitate such collective engagement.", Professor John Kay, Speech at Kay Review Launch, July 2012

[1]

[1] 'ECB shows signs of bailout flexibility', Financial Times , July 2012

[1] Fixing LIBOR: some preliminary findings , Treasury Committee, August 2012, page 111, paragraph 32

[2] 'Unitary or two-tier', Paul Gibson, September 2009

[1] The failure of the Royal Bank of S cotland, Financial Services Authority, December 2011, page 9

[1] Fixing LIBOR: some preliminary findings , Treasury Committee, August 2012, page 105, paragraph 4

[1] Masters of Nothing: How the crash will happen again unless we understand human nature , Matthew Hancock & Nadhim Zahawi, 2011, page 227

[1] Executive remuneration discussion paper , BIS, September 2011, Figure 3

[2] Executive remuneration discussion paper , BIS, September 2011, Figure 2

[1] 'This attempted manipulation of LIBOR should not be dismissed as being only the behaviour of a small group of rogue traders', Fixing LIBOR: some preliminary findings , Treasury Committee, August 2012, page 106, paragraph 7

[1] How to implement and review whistleblowing arrangements in your organisation , Social Partnership Forum and Public Concern at Work, 2010, page 17

[1] "In the play, the loyal court fool repeatedly warns Lear of impending catastrophe. First he's laughed at, then ignored.", Matthew Hancock and Nadhim Zahawi, Masters of Nothing: How the crash will happen again unless we understand human nature , 2011

[1] '"Whistleblowing": a health issue', KJ Lennane, British Medical Journal, September 1993

[2] See for example 'For a Whistle-Blower No Good Deed Goes Unpunished', New York University Stern Executive MBA, June 2011

[1] 'Anonymous Whistle-Blowing Systems Are Often Dysfunctional', University of New Hampshire, March 2010

[2] How to implement and review whistle-blowing arrangements in your organisation , Social Partnership Forum and Public Concern at Work, 2010, page 11

[1] "Both reviews [the review of Barclays' business practices being carried out by Anthony and Salz, and the Parliamentary Commission on Banking Standards] should recognise that encouraging whistle-blowers is an important tool in the battle to clean up banking and indeed corporate life in general. But change will have to overcome widespread prejudice against whistle-blowers and the deep scepticism of business leaders.", David Wighton, The Times , August 2012

[1] See for example Whistle-blowing: A guide for actuaries , and Whistle-blowing: A guide for employers of actuaries , The Actuarial Profession

[1] Auditors: Market concentration and their role , House of Lords, March 2011, Abstract

[1] Issues statement, Audit Market Investigation, Competition Commission, December 2011

[2] Auditors: Market concentration and their role , House of Lords, March 2011, Abstract

[3] "Under the present system the accounts are either qualified or they are not", Lord Lawson, Grand Committee debate on 'Auditors: Market Concentration and their Role' , March 2012

[4] Auditors: Market concentration and their role , House of Lords, March 2011, page 17, paragraph 4

[5] Lord Lawson, Grand Committee debate on 'Auditors: Market Concentration and their R ole' , March 2012

[1] "The Committee heard that IFRS were more rules-based than previous national standards and leave less scope for the auditor to exercise prudent judgement and as necessary to override a box-ticking approach in order to reach a true and fair view of a given financial statement.", Auditors: Market concentration and their role , House of Lords, March 2011, Abstract

[1] "Coupled with large differences in capital requirements against similar types of risk either side of the boundary, the capital framework proved susceptible to arbitrage. For example, prior to the crisis, it was advantageous for banks to classify an increasing number of instruments as 'held with trading intent' (even if there was no evidence of regular trading of these instruments) in order to benefit from lower trading book capital requirements. During the crisis the opposite movement of positions from the trading book to the banking book was evident at times in some jurisdictions.", Fundamental review of the trading book , Basel Committee on Banking Supervision, May 2012

[1] 'Firms must be encourage d also to report to the regulator instances they find of their own misconduct', Fixing LIBOR: some preliminary findings , Treasury Committee, August 2012, page 105, paragraph 6

[1] Letter to Chairman, Barclays Bank PLC, Financial Services Authority, April 2012

[2] See for example 'Hector Sants fright talk was badly judged', Money Marketing, March 2012

[3] A new approach to financial regulation: judgment, focus and stability , HM Treasury, July 2010, paragraph 1.7

[1] "A number of weaknesses have been identified with using value-at-risk (VaR) for determining regulatory capital requirements, including its inability to capture 'tail risk'", Fundamental review of the trading book , Basel Committee on Banking Supervision, May 2012

[2] Financial Stability Report and Press Conference, Opening Remarks by the Governor, December 2011

[3] Bye Bye Basel? , Barclays Equity Research, May 2012, page 13

[4] Bye Bye Basel? , Barclays Equity Research, May 2012

[1] Final Report , Independent Commission on Banking

[2] The Government response to the Independent Commission on Banking , HM Treasury, December 2011, page 40, Box 3. A

[1] See for example Pillar 3 Disclosure 2011 , RBS Group

[2] "Indeed, market participants have generally placed more value on the disclosure accompanying US and European stress tests than the quantitative results themselves", Instruments of macroprudential policy , Bank of England, December 2011

[3] "Executive Summary : 3.91. In order to assist readers of the SFCR, a short and easily understandable executive summary aimed specifically at policyholders should be provided. 3.92. The executive summary should also highlight clearly any material changes that have occurred in the undertaking ’ s or the group ’ s business written, risk profile, solvency position or system of governance since the last reporting period. This information should provide the reader with a brief summary of the contents of the SFCR." CEIOPS ’ Advice for Level 2 Implementing Measures on Solvency II: Supervisory Reporting and Public Disclosure Requirements (former Consultation Paper 58) .

[1] "The disclosure of the Solvency Capital Requirement referred to in point (e) (ii) of paragraph 1 shall show separately the amount calculated in accordance with Chapter VI, Section 4, Subsections 2 and 3 and any capital add-on imposed in accordance with Article 37 or the impact of the specific parameters the insurance or reinsurance undertaking is required to use in accordance with Article 110, together with concise information on its justification by the supervisory authority concerned", Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) (recast) .

[1] "In addition, the Committee agreed that powers of Direction over disclosure requirements would be desirable but that it could be difficult to meet the test set by HM Treasury in its February 2011 Consultation Document that powers of Direction should be specific.", Financial Policy Committee statement from its policy meeting, 16 March 2012

[1] "It is sometimes argued that enhanced disclosure may reveal information that triggers an adverse market reaction. This risk is likely to be particularly acute for liquidity risks, given the potential for funding to dry up rapidly", Instruments of macroprudential policy , Bank of England, December 2011

[1] The Failure of the Royal Bank of Scotland , Financial Services Authority, December 2011, page 7

[2] 'The Committee was surprised that neither the FSA nor the SFO saw fit to initiate a criminal investigation until after the FSA had imposed a financial penalty on Barclays', Fixing LIBOR: some preliminary findings , Treasury Committee, August 2012, page 115, paragraph 48

[3] "But where are the criminal charges? […] As an attorney who used to work on enforcement with the U.S. Treasury told Lake, 'This is absolutely indefensible. When someone other than bank officials willingly, knowingly, repeatedly does this kind of conduct, they go to jail.'" Banks: Too big to prosecute?, CNN, August 2012

[4] "But given the huge size of these banks, do these fines simply amount to a relatively small cost of doing business?", Is Flogging Bankers an Option?, Wharton, July 2012

[1] "We recommend that the Wheatley review examine whether there is a legislative gap between the responsibility of the FSA and the SFO to initiate a criminal investigation in the case of serious fraud committed in relation to the financial markets", Fixing LIBOR: some preliminary findings , Treasury Committee, August 2012, page 115, paragraph 49

[1] The Failure of the Royal Bank of Scotland , Financial Services Authority, December 2011, page 9

Prepared 22nd September 2012