Five tips for George Osborne on banking reform

These simple steps would provide the direction for deeper reform of the banking system

• 
• • Prem Sikka
  • theguardian.com, Tuesday 26 November 2013 18.31 GMT

Public pressure for better banking reform from George Osborne, the chancellor, is growing. Photograph: Chris Ison/PA

Some six years after the banking crash, the UK taxpayer is still providing £977bn of loans and guarantees (pdf) to support the ailing banking sector. The reform process is painfully slow. The banking reform bill currently going through parliament (pdf) has grown from 35 pages to 170 pages, but still does not deal with the flaws that led to the crisis. Public pressure for a tougher approach is growing, with figures including the archbishop of Canterbury demanding firmer government action. The chancellor, George Osborne, should at the very least do the following five things. On their own, they won't necessarily solve the deep-seated crisis in our financial institutions, but they would provide the direction for deeper reforms.

1. Think outside the ringfence

Introduce a statutory separation of retail banking from speculative banking and not just the weak "ringfence" he is proposing. Despite the crash, banks remain addicted to gambling with other people's money. They bet on everything from the movement of interest rates, price of commodities, oil, wheat, foreign exchange and much else through complex financial instruments known as derivatives. Derivatives have been described by investment guru Warren Buffett as "financial weapons of mass destruction". Derivatives brought down Lehman Brothers, Northern Rock, Bear Stearns, MF Global, Countrywide, Merrill Lynch, Wachovia and Washington Mutual, just to mention a few. Yet no lessons have been learned.

The Bank of International Settlements (BIS) shows that the notional/face value of over-the-counter (OTC) derivatives is about $693tn. In addition, derivatives are traded on exchanges; adding up to a whopping $1,200tn. The exact economic exposure of the UK banking system is probably considerably lower, but is not known. The Treasury's response to requests for information is that the information "is not currently available". So what do bank balance sheets show us? The financial statements of Barclays Bank (pdf) show the dangers. Its derivatives assets and liabilities of £469bn and £462bn respectively need not net off and could expose it to anything from £7bn to over £900bn. The UK, with a GDP of £1.5tn is in no position to absorb the losses and the knock-on effects. Even Nobel prize winners in economics have been unable to manage the risks in derivatives.

2. Hold banks responsible for losses

Withdraw limited liability from speculative banking. Merely separating the banking arms is not enough because banks use monies from savers, pension funds and insurance companies to finance their gambling habit. Major losses from their bets will ultimately infect the rest of the economy and affect every household. Therefore, the owners of these vast casinos must be held personally liable for the losses.

3. Make them balance the books

Force banks to address their gross undercapitalisation. Barclays has gross assets of £1,500bn against capital of just £63bn. A decline of just 4.22% in the value of its assets could wipe out its entire capital. HSBC has gross assets of $2,700bn (£1,687bn) compared to capital of $183bn (£114bn). It can barely absorb the decline of 6.75% in its asset value. Capital ratios in these ranges have not been and will not be good enough to cushion losses. No doubt some will say that some assets are less risky than others and banks will get away with modest capital ratios, but none of this saved banks previously. So a healthy capital adequacy ratio of at least 12.5%, and higher, should be aimed for.

4. End fat-cattery

Risk capital should be built by clamping down on executive pay. No executive should receive more than 10 times the minimum wage until the required capital levels are reached.

Despite the taxpayer-funded bailouts excessive executive pay is rife and remains linked to reckless risk-taking. The long-term solution is to empower bank employees, savers and borrowers to vote on executive remuneration. They all have a long-term interest in the wellbeing of banks and can curb reckless risk taking.

5. Crack down on the auditors

Bring in a fundamental overhaul of the auditing of banks. Big accounting firms, acting as auditors of banks, are supposed to be the eyes and ears of financial regulators, but the lure of profit is too strong. Almost every ailing bank received a clean bill of health (pdf)from its auditors who received millions of pounds in auditing and consultancy fees. In some cases, banks collapsed within days of receiving the all-clear. Even worse, in some cases auditors were complicit in dubious practices. It is time to remove the accounting firms from audits in the financial sector. That task should be performed by a specially created body, equivalent to the National Audit Office. Unlike the present situation, the financial regulator should have unhindered access to all data held by the auditors.

Call the fat cats’ bluff and tax their preposterous pay fairly

September 2, 2007
Simon Jenkins

Prison officers last week went on strike over a pay rise of 2.5%, phased. The heads of Britain’s 100 biggest companies have had 37%, unphased, as presumably are its recipients. The bosses won 28% more last year, 16% the year before and 13% and 23% in the two preceding years, yielding an average pay of £2.8m a head or 20 times the rise in price inflation. Under Labour, these company directors have stretched their remuneration to almost 100 times average earnings, a gap unprecedented since the rise of modern taxation.

Is this a good or bad thing? Any pay package is, like beauty, in the eye of the beholder. But for an entire class of workers to receive sequential increases of 37%, 28% and 16% suggests a serious leakage of cash from businesses into the pockets of those at the top. Nor is there any noticeable relationship of pay to company size or success. Last week Eric Nicoli left as boss of EMI after eight years in which the company faltered and its share price fell by 40%. Yet he received £800,000 a year in salary and was given a leaving present of £2.8m.

Cash bonuses mostly in financial services are beyond the imaginings of wage slaves. Bob Diamond, who works at (but does not even run) the floundering Barclays Bank, took a bonus of £10.4m this year. Sir Fred Goodwin of the Royal Bank of Scotland took £2.7m. Last month’s Guardian/Office for National Statistics survey reported that bonuses overall increased 30% in 2007 to £14 billion, double last year’s rise. Readers may be tempted to ask how people contrive to dispose of such sensational winnings each year.

The apologists have been in full cry. A simple response is to play the comparisons game. These companies are the size of small states and their leaders have a right to tax their workers and shareholders accordingly. So implies Peter Newhouse, the survey’s author, and a consultant with Reward Technology Forum. He says we should publicise rewards as “an important message to able and aspirational young people”. The CBI adds that companies must pay “the going rate” or competitive talent will float offshore and something called UK plc will suffer. Britain now depends for a third of its income on financial services, so do not kill the geese that lay the golden eggs.

Nor is that all. As this money swills through the pockets of bonus recipients, say the apologists, it “trickles down”, finding an outlet not just in blue-chip properties but in cars, restaurants, holidays, nannies, clothes, hunting stables and Cotswold interiors, most with a high labour content. The incomes of the very rich allegedly redistribute to the poor faster through personal expenditure than through taxation. This is plausible given how much of the latter goes on white collar salaries, fees and subsidies.

But all this is special pleading. In allowing himself to be bluffed by the super-rich, that they will emigrate if he properly taxes their earnings, Gordon Brown falls for the Mandy Rice-Davies retort: they would say that, wouldn’t they. As for dangling £2m bonuses before the young, it is like Margaret Thatcher telling young women to find themselves rich husbands. Other proffered comparisons, such as between executives and Elton John and David Beckham, ignore the fact that such celebrities operate in a truly open market, do not determine their own incomes and, unlike City firms, receive no public money.

Anyone who has served on a corporate remuneration committee knows how it operates. It puts pay decisions out to consultants who, like the nonexecutives, the headhunters and senior management as a whole, have a vested interest in inflated incomes. Everyone scratches everyone’s back.

Discussion is not concerned with market forces but public relations. How will an outrageous bonus look to the press? Can shareholders and investors be fooled?

Apart from such rare company doctors as Stuart Rose of Marks & Spencer, who can add value out of proportion to their price, Britain is experiencing the same breakdown in top pay restraint that JK Galbraith noted in America. Corporate remuneration, he remarked, was nothing to do with the marketplace but was a heart-warming gift from executives and their friends to each other, a gift that had grown so large as to “verge on larceny”.

I suspect that wildly extravagant short-term “incentives” are as likely to distort performance as boost it, as is the case with Whitehall public service targets. As for the idea that a 37% pay rise will trickle down to help the poor, this might pass muster as an economics essay but it will get short shrift in the canteen where 2.5% is the norm. Why does trickle-down not apply to them?

The claim that executives with families well installed in London and country houses will suddenly vanish to Monaco or the Cayman Islands if not paid millions more each year (or if fully taxed on those millions) is absurd. It ignores the role of location, lifestyle and other nonpecuniary perks in a modern executive’s career package.

Being well regarded for running a successful company should be more satisfying than a reputation for greed, as BP’s Lord Browne and the privatisation “fat cats” of the 1980s found to their anguish. London’s financial preeminence is based primarily on its lax market regulation and its agreeable living conditions for those not reliant on public services. Businesses will leave Britain not when executives are properly taxed but when they start losing money.

I prefer to kick all this out of court. The rich, like the poor, are always with us. There is no morality in economics. The exponential rise in corporate pay is a hangover from the 1986 Big Bang phase of Thatcherite capitalism. If it had anything to do with free competition, there would have been a rush of talent into this market sector and a consequent fall in pay. That has not happened.

Two forces are influencing top people’s pay. The first is structural. The fortunes recently made in the City are largely due to a shift from lumbering corporate suppliers of financial services, such as banks and brokers, to fast-moving individuals and partnerships. I see no harm in this. More worrying is the new cartels, like those that the Big Bang supposedly smashed. Just four accountancy firms control large-scale audit and have spilt over into public/private finance. Half of management consultancy, again involving a small group of firms, relies on work from government. The rise in statutory regulation under Labour has sent legal and other professional bonuses soaring. As Adam Smith said, people of the same trade never meet “even in merriment” but to conspire to raise prices. This is government’s doing.

The other force is political. The widening of the pay gap, which has not occurred in continental Europe, followed the disempowering of organised labour by Margaret Thatcher and Tony Blair, vigorously supported by Brown at the Treasury. This has released corporate Britain from any sense of self-restraint. Indulging tax loopholes for the rich while ordering workers to shoulder the fight against inflation may help Brown sound macho in the City, but it is high-risk politics.

A real sense of unfairness greeted the revelation that a number of the richest participants in economic success were, de facto, being subsidised by the rest through private equity tax evasion and/or nondomicilary status. The same anger was unleashed by the disclosure that a shift in the economy from manufacturing to financial services had led to a shift in profits to offshore tax havens.

Any lobbyist can cobble together special pleading for such antics, but they will not wash for millions of hardworking, tax-paying Britons. Low taxes for all are good, but tax breaks for a privileged few are wrong. The rising tide of wealth should float every boat, not just executive yachts.

As most people see their incomes slide ever further behind those about whom they read in the papers, they will be more inclined to cry halt. Democracy may not be the force it was, but it can deliver politicians an occasional kick, as can industrial relations. The prison officers may yet prove a straw in a wind that sweeps up others in its tail.

The days of statutory pay restraint are mercifully past, replaced in Britain by the most fluid labour market in Europe. But government vigilance is needed to retain that fluidity, and a regard for fairness to back it up.

Capital and labour will never coexist in a climate of equality, but some respect for equity must underpin the nation’s social contract. Otherwise we shall be back to the bitter divisions of the 1970s, where nobody wants to go.