A speech by Lionel Barber, Financial Times editor, at Hughes Hall, University of Cambridge, May 1, 2014. An accompanying video can be viewed here.
Ladies and gentlemen, distinguished guests, I am delighted to be here tonight at Hughes Hall in the University of Cambridge. This is the prestigious City lecture, but sadly I will not be providing slides. As Lord Acton might have said, power tends to corrupt, PowerPoint corrupts absolutely.
Tonight I want to talk about bankers and banking. These days, bankers are widely viewed as greedy, self-serving, amoral or actually dangerous. Estate agents, even journalists, are held in higher regard.
This past week’s kerfuffle over bonuses and remuneration at Barclays and Royal Bank of Scotland is a reminder that bankers continue to be held responsible for the financial crisis and the economic calamities which followed.
Bankers appear to be living in a parallel universe, where the rewards are far out of kilter with what the rest of society can expect. This speaks to a deeper unease about inequality which explains the unlikely best-seller on economics, Thomas Piketty’s Capital in the Twenty-First Century.
My questions tonight are: Can bankers mend their ways and their reputations? Is there a path to rehabilitation?
As editor of the Financial Times I have enjoyed a ring side seat watching the most serious financial crisis since the 1930s.
My first sense that something was going badly wrong came after a lunch in 2004 with Henry Kaufman, the Salomon Brothers guru known as Dr Doom for his warnings about debt bubbles and the bond market.
Henry, by now a director of Lehman Brothers, turned to me as we took a postprandial stroll down Sixth Avenue.
“The trouble with Wall Street is that everything has become so complex. Nobody at the top knows what’s going on down below.”
That same year, I was sitting in Washington with Stan O’Neal, the slave’s grandson who rose to become head of Merrill Lynch. Stan and his wife were my guests at the White House Correspondents’ Dinner, where Hollywood stars mix with political poobahs and the media commentariat.
Stan was in fine form, rattling off how he had cut costs by more than $4bn and now the business was booming thanks to a fancy new product. And what might that be, I inquired? “Mortgage-backed securities.”
My third memory is a conversation in late 2010 with Bob Diamond, then chief executive of Barclays. We were three years into the financial crisis and banker-bashing was à la mode. Bob, a brash self-made Bostonian who built Barclays’ investment bank from the bottom up, was not looking for sympathy; just a little more support. “The time for remorse is over,” he declared. A few weeks later, Bob tried the same line on the treasury select committee. Not his best move.
Three stories, three lessons for the banking industry. Leaders detached from businesses which had become too complex and risky. Leaders beguiled by the prospect of easy returns in an ever rising US housing market. Leaders detached from public opinion, still unable to understand the new post-crash world.
The rise of financial capitalism
For 20 years or more, between the mid 1980s and the great crash of 2007-8, banking and financial services experienced a gilded age. Some might go back to the 1960s and the growth of the Eurobond market, but to my mind the seminal moment came in 1985-6 when the City of London followed New York and embarked on sweeping deregulation.
Big Bang ended the strict separation between brokers and market makers known as jobbers, and with it multiple smaller firms and leisurely lifestyles. In their place came high-volume trading, mega-banks and higher – much higher – remuneration.
To borrow the title of Philip Augar’s book, Big Bang marked the death of gentlemanly capitalism. We all remember the story of the broker who, on hearing that his secretary lives on an estate in Romford, Essex, remarks: “How splendid. Do you keep horses there?”
The last big deregulatory step came in the late 1990s when investment banks were allowed to merge with commercial banks, ending the Glass-Steagall act separation which had existed since the Depression. All the ingredients – including, crucially, a laisser-faire Federal Reserve under Alan Greenspan – were now in place for high-octane financial capitalism.
The statistics speak for themselves: the rise of private sector debt in rich countries, where banking assets rose from about 50 per cent of GDP in the 1960s to around 200 per cent of GDP by the late 2000s. In the UK, driven by the City of London, banking assets swelled to about five times GDP. In Iceland and Switzerland, eight to ten times. In the US, they more than doubled in the years leading up to the crash to 126 per cent of GDP.
In his book The Road to Financial Reformation, Henry Kaufman shows how loosening of the rules led to a loosening of credit standards and questionable innovations, particularly the securitisation of bank loans. In his words, this “created the illusion that credit risk could be reduced if the instruments became marketable”. Along the way, the public perception of liquidity also changed, from one based on assets (what you could sell) to one centred on liabilities (ease of borrowing).
Now, not all financial innovation was bad. Sophisticated debt instruments allowed corporations to hedge risk much more efficiently. Securitisation and the development of sub-prime mortgages were originally devised to serve a respectable goal: the push toward universal home ownership in the US. Market capitalism drove world trade and wealth creation, not just in the advanced industrialised west but also developing markets, notably China. The problem was that once the party moved into full swing, nobody wanted or was capable of removing the punch bowl.
The crash of 2008 – and the backlash
This is not the time or the place to rehearse in full the causes of the crash. I have spoken earlier about flawed risk management and misguided belief in efficient market theory. To that must be added weak regulation, the pursuit of shareholder value uber alles, and broader global imbalances between high-spending Americans and high-saving Chinese, which distorted credit flows.
The point today is that the regulatory world in which bankers now operate has changed beyond recognition – not just in the UK but also in mainland Europe and the United States.
Here are a few examples.
1) Higher capital and liquidity rules: under new rules known as Basel III, banks will be obliged to have equity buffers about three times larger than under the old Basel II rules by 2019. Many banks are moving toward the target ahead of schedule. Those viewed as systemically important such as JP Morgan, Deutsche, Citigroup and HSBC, must have still thicker capital cushions.
2) The Dodd-Frank Act of 2010 in the US runs to 848 pages – more than 20 Glass-Steagalls. That is for starters. For implementation, Dodd-Frank requires an additional almost 400 pieces of detailed rule-making by a variety of US regulatory agencies. As of July 2013, two years after the enactment of Dodd-Frank, a third of the required rules had been finalised. Those completed have added a further 8,843 pages to the rulebook.
3) The Volcker rule – named after the inflation-busting former chairman of the Federal Reserve – proposes to stop banks trading for their own profit. For now, many banks are seeking ways round it – but in practice many activities which generated large amounts of investment bank profits are still banned and financial services companies are exiting the businesses, especially when there is the threat of litigation.
4) The separation – or ringfencing – of investment banking from retail banking. This is happening in the UK following the Vickers Commission and may happen in Europe in the wake of the Liikanen review. Both proposals are meant to ensure retail deposits cannot be used to finance investment banking businesses. They are therefore likely to raise banks’ funding costs (or as supporters such as the FT’s Martin Wolf would say, eliminate a de facto funding subsidy).
5) Resolution – the European Union has just adopted a slew of landmark reforms designed to make banks safer and more transparent. The centrepiece is an EU-wide rule book to ensure shareholders and bond holders – and not taxpayers – are first in line to pay for bank rescues.
In addition, a bank levy has been introduced in the UK on bank profits; EU-wide rules have been introduced on bankers’ bonuses – already deferred and subject to clawback – limiting them to two times salary; and a financial transactions tax is still on the cards, which threatens to affect the UK.
I could go on. The legal and regulatory scaffolding is turning bankers’ business models upside down. Risk management is at the heart of the matter. It is no longer regarded as a subset of the compliance function: in most firms it is now at the centre of the decision‐making process. Yet little of this improvement has yet registered in the public mind.
Why – and what can be done?
The cultural question
One year ago, the distinguished City of London lawyer Anthony Salz delivered his 244-page report on Barclays business practices. The independent review had been ordered by Sir David Walker, bank chairman, City grandee and former deputy governor of the Bank of England, after the Libor rate-rigging scandal. The Salz report makes for a sobering read.
On remuneration, performance “tended to reward revenue generation rather than serving the interests of customers and clients”. Pay “contributed significantly to a sense among a few that they were somehow unaffected by the rules”.
On its controversial tax avoidance – sorry, tax planning – division, Mr Salz said: “Barclays was sometimes perceived as being within the letter of the law but not within its spirit.” There was “an institutional cleverness” inside the bank.
Finally, “significant failings developed in the organisation as it grew. The absence of a common purpose or common set of values has led to conduct problems, reputational damage and a loss of public trust.”
Much of the above could be said of many of the integrated investment banks. Indeed, Lehman Bros before the crash was widely viewed as having one of the best managed cultures on Wall Street under Dick Fuld, now resident in Sun Valley, Idaho.
(The stunning private location probably does not make up for the public disgrace. The banker introduced himself at a party last year with the words: “Hi, I’m Dick Fuld, the most hated man in America.”)
One sentence in the Salz report stands out: “The absence of a common purpose or common set of values.” Bob Diamond would dispute this: he remains proud of the global investment bank that he more than anyone else built up. Still, these words about common purpose speak to the management dilemma at the heart of modern banking.
Barclays was a family bank with Quaker roots which post-Big Bang embraced de Zoete & Bevan and Wedd Durlacher, the pre-Big Bang stock broker and jobber, plus most of Lehman Bros. It was not alone. Royal Bank of Scotland grew out of National Westminster Bank and later ABN Amro; Deutsche grew out of Morgan Grenfell and Bankers Trust; JP Morgan Chase – Bank One, Chemical Bank, scrappy Bear Stearns, Washington Mutual and blue-blooded Cazenove.
These mergers produced a new distorted culture where money was paramount and clients’ interests were subordinated to those of individuals and firms. Banks thought what was legal was ethical. Wrong.
I doubt very much whether we can go back to the partnership model where you have your own capital at risk, not the shareholders. What is required is action on two fronts: the culture of banking itself – the way banks are run, the way bankers behave and what needs to be done to effect deep and lasting change in both; and lastly the desirable shape, scale, scope and revenue-generating capacity of the industry.
In my view, more needs to be done on the first score, where the Lambert review is working on new professional standards. But much more has been accomplished on this last than is generally appreciated. For example, returns on equity – the standard measure of profitability that pre-crisis routinely ranged from 20 to 25 per cent of GDP – is now more like between 10 and 15 per cent. In the new world, it may well fall to single digits.
All this is impacting on pay and general remuneration levels: by some counts down 20 per cent compared to the peak. The trouble is the headlines do not reflect the reality: probably because the economic recession has depressed living standards across the board. Furthermore, the clampdown on bonuses has encouraged banks to compensate in terms of higher basic pay, which in turn generates more negative headlines.
The public mood is hardly likely to improve is particularly when the authorities are still dealing with earlier cases of misconduct such as the Libor scandal and the £20bn mis-selling of payment protection insurance, as well as investigations into foreign exchange trading.
Ladies and gentlemen, banks today are operating in a new regulatory world which will significantly reduce their return on equity and profit margins. Yet there is a paradox: the crash and its resolution has led to the creation of even larger banks than before.
This in turn has increased the “too big to fail” problem and moral hazard which the regulators have so far failed to resolve. We have a more concentrated financial system overlaid by vast amounts of complex regulation which, in itself, is a barrier to entry to new competitors.
In one sense, we have the worst of both worlds: octopus-like oversight of banks which are becoming more like regulated utilities, but which still see themselves as profit-seeking enterprises.
How to resolve this dilemma? Well, one way is change culture. This is Antony Jenkins’s challenge at Barclays. We will see the fruits of his work next week. The broader challenge is to make money as an entrepreneurial entity without blowing up the world – and without having your employees engaged constantly in abstruse schemes to circumvent rules and regulations.
We should all wish Mr Jenkins well, but he might be advised to read the words of my FT colleague John Gapper. “There is no such thing as a banker. There are equity brokers, foreign exchange traders, mortgage salespeople, corporate financiers and all kinds of specialists under one roof but there is no single set of employees unified by a professional culture and a willingness to pull together.”
Now, there are instances of extraordinary leaders creating a common culture, or extraordinary institutions retaining a common culture. Jamie Dimon of JP Morgan Chase falls into the first category, even if the King of the Street’s halo has slipped in the past year. Goldman Sachs probably fits into the second: a shark with an acute sense of risk management and a low tolerance for intruders.
But these are very much the exceptions to the rule.
The creation of a common culture is made all the harder by the mercenary nature of the business, best summed up by the phrase “the global war for talent” in which banks pay extraordinary sums to prevent supposedly key employees from defecting to rivals.
If, as I suspect, it is too difficult to wed these differing cultures and businesses together, then maybe we should recognise that commercial banking and investment banking are indeed fundamentally different. That was, after all, what America concluded after the great crash of 1929 which led to the Glass-Steagall act.
In 2008, financial markets were in meltdown. The priority was to rescue the system. In the event, the system was not only rescued, it was restored, albeit with new rules. Rather than breaking up the banks, the authorities believed that concentration was a safer option. With the benefit of hindsight, that was a mistake.
Six years on, many believe the case for break-up of the financial giants is irrefutable. I am not sure whether we want legislation. We have had enough government involvement in the financial sector, particularly in Britain. Far better for the banks themselves to decide that it is indeed in their own interests to do so. For they, more than outsiders, must now realise that the commercial and trading functions no longer fit together.
Banks are essential for the transmission of credit needed to make the economy run. But this utility-type activity should be kept apart from trading activities which belong best in highly capitalised entities such as hedge funds.
We cannot turn bankers into saints. Nor should we banish risk-taking. It is the sine qua non of market capitalism. Bankers have begun to clean up their act. But more must be done – and they must reconnect to the community. The alternative may not be a living hell, but it will be a prolonged spell in purgatory.