Fixing finance: The missing piece in banking reform

The financial sector is one of the UK's great historic, globally competitive clusters. In 2010 the sector directly contributed 9 per cent of the UK's gross value added, paid £63 billion in taxes (or 12 per cent of the total UK tax take), employed over 1.1 million people (or more than 3.5 per cent of the UK workforce), and generated a trade surplus equal to 3 per cent of UK GDP. Its success is essential to the UK economy.

However, the 2008 crisis and subsequent events have revealed significant weaknesses in the sector, triggering a debate on the increased role finance has played in the British economy over the past few decades. This debate has been polarised between those who argue that the financial services sector is too large, creating too much risk for the British taxpayer and crowding out other sectors, and those who argue that a competitive sector delivering many benefits to the UK economy requires financial institutions operating on a global scale.

But the debate should not be about the size of financial services - there is no preordained optimal size for the sector. Rather the focus should be on how to address three critical sets of issues that have been highlighted by the crisis:

1. Protecting stakeholders, including depositors, borrowers, investors, and bank clients and shareholders.
2. Reducing implicit subsidies to the sector and future liabilities for UK taxpayers.
3. Addressing the excess economic rents extracted by the sector.

The British government is making important progress on the first of these and is working to address the second. But on the third it has done very little - the need to tackle the excess rents extracted by the sector remains.

Protecting stakeholders

The financial services sector has many stakeholders with an interest in how it operates. These include depositors, borrowers, investors, clients who pay fees for financial services, financial sector employees and shareholders. The entities involved range from typical households, to small businesses, to FTSE corporations, to pension funds and other institutional investors, to banks who transact with each other. The government has itself become a significant stakeholder through its large shareholdings in the sector and its growing role overseeing the stability of the system.

The past few years have revealed systematic and large-scale abuses of many of these stakeholder groups. For example:

• The fixing of Libor rates probably led to higher mortgage and other interest payments by both consumers and businesses for the benefit of bank proprietary trading operations. This has resulted in a major regulatory overhaul of the Libor system and a £290 million fine for Barclays bank. With more fines for other banks yet to come, estimates suggest that total fines and potential legal liabilities for the industry could total $22 billion.
• Banks were caught in the widespread mis-selling of payment protection insurance (PPI) to consumers, resulting in numerous fines and provisioning on a massive scale. Lloyds alone has set aside £5.3 billion for reparation, and the total for the industry now exceeds £12 billion. Greater regulatory oversight is inevitable as a result.
• Similarly, a number of banks engaged in mis-selling of inappropriate derivative products (swaps) to small businesses, leading to provisioning of over £600 million in anticipation of compensation payments to come.
• Various government investigations in the UK and US have revealed behaviours where banks actively traded against their own clients' interests. While not technically illegal, such actions have raised significant questions about banks' 'duty of care' with regard to their own clients.
• Recently, trading scandals at several banks, including JP Morgan, Soci?t? G?n?rale and UBS, have exposed lax risk controls, subjecting their shareholders to significant losses.

Protecting financial sector stakeholders from abuses by banking institutions is first and foremost the job of banks' own management and boards. And it is in shareholders' self-interest to pressure management and boards to prevent such abuse: the string of scandals and fines has destroyed significant shareholder value. But where management and boards have failed (or worse, ignored or even supported the abuse), government needs to step in and provide protection or restitution.

Arguably, this is the area where the UK government is making the most progress. The UK financial services regulator, the Financial Services Authority (FSA), is to be split into two new entities. The Prudential Regulation Authority (PRA) will be responsible for microprudential regulation (monitoring individual firms' financial stability) and the Financial Conduct Authority (FCA) will monitor the behaviour of financial firms to ensure that financial markets work well and consumers get a fair deal.

The chief executive designate of the FCA, Martin Wheatley, has set out in a series of speeches how the FCA will operate. In particular, he has emphasised that it will be much more proactive in protecting customers, even being prepared to ban whole product areas if it thinks there is a serious risk of mis-selling.

Reducing implicit subsidies and future taxpayer liabilities

The financial crisis created significant collateral damage through the socialisation of financial risk. The costs of the crisis have included £20 billion in direct transfers from taxpayers to UK banks, and estimates of the present value of permanent losses to UK output range from £1.8-7.4 trillion. The crisis showed that many UK banks are indeed too big to fail. By guaranteeing their survival, the government is in effect providing an implicit insurance policy or subsidy to the banks and lowering their cost of capital. Andrew Haldane, executive director for financial stability at the Bank of England, has estimated that the societal cost of this implicit subsidy to UK banks is greater than the market value of the entire sector.

Reducing this implicit subsidy requires actions to lessen the probability of future crises and to create mechanisms for recapitalising or winding up failed banks in a way that minimises both future taxpayer liabilities and the potential for financial contagion and other systemic impacts. This issue has received significant international and UK government attention, for example in the Basel accords and the establishment of the Financial Stability Board, the Independent Banking Commission, the Bank of England's new Financial Policy Committee and the Parliamentary Commission on Banking Standards. Increased capital requirements, ringfencing and other measures being considered go some way towards reducing the implicit subsidy, but do not eliminate it - the 'too big to fail' problem still exists.

The key issue that is not being adequately addressed is that UK taxpayers are being asked to guarantee global banks that happen to be based in the UK. A modest national tax base is thus standing behind and providing guarantees to massive global balance sheets. As Bank of England governor Mervyn King has said, 'Banks are international in life and national in death.'

So long as this is the case, UK taxpayers are in effect subsidising the global financial system in return for relatively modest benefits to the UK economy. There are essentially three ways to address this. One is to shrink UK banks back to national entities - this would reduce the taxpayer subsidy but would also lose the benefits of the UK's global role in finance.

The second is to force greater self-insurance on the banks. This could happen through capital requirements that exceed international standards, 'bail-in' resolution mechanisms, taxes to prefund bailout funds, or regulatory tools to manage systemic risk, such as those being considered for the Bank of England's new Financial Policy Committee. The industry argues that increasing the self-insurance burden would reduce returns to the sector and thus the UK's attractiveness as a global finance hub, eventually leading to a relative shrinking of the sector. This may be the case, though views differ on just how costly such measures would be.

The third route is to internationalise the mechanisms for bailing out and resolving systemically important global financial institutions - in essence 'sharing the pain' with taxpayers in other countries who also have a stake in not seeing a big global bank that happens to be UK-based go bust. (Conversely, UK taxpayers would be on the hook for the big banks of other countries that are important to the UK economy.)

Internationalising oversight and resolution for big banks has been seen by many in the industry and by government as preferable to shrinking the banks or imposing a tougher self-insurance regime in the UK. But getting international cooperation and agreeing clear governance rules and mechanisms is proving to be very difficult, both politically and technically. The Financial Stability Board, established in 2009 by the G20 countries as a successor to the Financial Stability Forum, is charged with the task of drawing up new rules - but so far it has made little progress. Currently, countries with relatively smaller banking sectors in essence get to 'free ride' on the guarantees being made by UK taxpayers, and so have little incentive to make politically difficult decisions to change the status quo. Likewise, politics have also proved a major barrier to creating a eurozone banking union that would be able to address cross-border regulatory and resolution issues.

If, as seems likely, progress is going to be slow and unsatisfactory in internationalising bailout and resolution mechanisms then the UK government will face a critical decision about whether it is still willing to give, in effect, massive subsidies to its global finance sector. It is hard to imagine someone coming before parliament and asking the UK government to subsidise the auto industry at a cost to UK taxpayers and society that is greater than the total value of the industry itself. But at the same time it is hard to imagine a full-scale retreat from global finance.

As a result, then, the most likely course is the second, with the UK forcing the sector towards greater self-insurance and tougher macroprudential oversight than is faced by banks in other countries. In its decision-making, the new Bank of England Financial Policy Committee should have an explicit requirement to weigh trade-offs between the implicit subsidies paid to the sector by UK taxpayers and the benefits the sector brings to the economy. Given the large imbalance in that equation revealed by the crisis, if the FPC swings the balance back towards taxpayers then its actions may ultimately result in a relatively smaller sector for the UK - but that may be the right trade-off.

The missing piece - addressing rent extraction

'Excess rents' is an economic term referring to the income a company or sector generates above what would be generated if it was subject to the full force of market competition. Finance is a sector where the free market is highly distorted in ways that enable very large-scale rent extraction. These excess rents flowing to finance harm other sectors of the British economy by misallocating capital and talent away from other, more economically productive uses. While the government has taken significant action on the first two issues, little has been done on this - it is the missing part of the debate.

There is growing evidence that the finance industry has generated outsized rents, not through economically productive innovation or competitive advantage but through institutional and market distortions. Sources of rent extraction include:

• incentives, including compensation structures, to take excessive risks when trading 'other people's money'
• implicit or explicit coordination or collusion on fee structures
• improper 'tying' across businesses
• lack of transparency on fees, activities and conflicts of interest
• regulatory distortions or arbitrage (for instance, CDOs not being regulated as insurance)
• concentration of key parts of the sector and lack of competition
• barriers to entry for new competitors.

While evidence of rent extraction is inherently circumstantial, there is macro-level evidence that financial deepening has outpaced the growth of the economy as well as micro-level evidence of excess compensation to the sector, in addition to anecdotal evidence of factors enabling rent extraction.

Finance represents a much bigger share of the economy in the UK than it did at the time of 'big bang' 25 years ago. Some of this growth may represent the success of the industry in winning a bigger share of the global market in financial services. But some of the growth is domestic, and the public does not appear to have benefited from this expansion. There is no evidence that capital is being allocated more efficiently, that investment returns are higher, or that capital costs are lower. It is perfectly valid therefore for policymakers, regulators and the customers of the financial industry to identify rent-seeking behaviour and to seek to eliminate it.

The Independent Banking Commission (IBC) conducted a detailed investigation into the lack of competition in the UK retail banking sector and concluded that there was indeed evidence of high concentration, barriers to entry, and a lack of pricing transparency - all conditions facilitating rent extraction. The IBC then made a set of recommendations for the government to use its shareholding in Lloyds to create a new challenger bank and to take actions to bring down entry barriers, make it easier for consumers to switch banks and increase transparency on fees. It also recommended that increasing competition in the sector be an explicit mandate of the new Financial Conduct Authority. The government white paper that followed accepted most of the IBC's conclusions on the issue, though it was short on specific actions. The main result is that the Financial Conduct Authority and Office of Fair Trading are now charged with further reviewing competition in retail finance and determining what action, if any, needs to be taken.

While increasing competition in the UK retail financial sector is a worthy goal, it only addresses a small fraction of the larger rent extraction issue. UK retail finance provides only 16 per cent of Barclays' income, 24 per cent for RBS, and 6 per cent for HSBC. The big profit pools for the UK's global banks are in large corporate banking, investment banking, proprietary trading and asset management. And it is not just the big multi-business banks that are engaged in rent extraction: there are also issues in hedge funds, private equity and other parts of the sector.

It is arguably the UK's large corporations and its institutional investors that are most harmed by the market distortions. They are the ones paying the inflated fees, greater spreads, and higher interest rates and other charges than they would in a truly competitive, efficient market. They are also the ones who suffer from a lack of transparency, conflicts of interest, and collusion among providers of financial services. A former Goldman Sachs employee recently revealed how its bankers referred to their corporate and institutional clients as 'muppets' to be milked for fees, and there is significant anecdotal evidence that this attitude pervades the sector.

An example of common practice that leads to rent extraction is the implicit coordination of hedge fund and private equity fee structures. Almost all firms in these sectors charge their institutional clients '2 and 20': a fee equal to 2 per cent of the assets under management plus 20 per cent of any investment gains. Studies show that almost all of the 'alpha' or market outperformance in both sectors is due to a small number of elite firms in the top quartile, yet even mediocre or poor firms shelter under this fee umbrella and are able to charge the same. High-performing firms earn more, as they should, because their gains are higher. But low-performing fund managers can still get quite rich from fat management fees. So why don't institutional investors push back against such practices? Some do - they fight to get fee discounts and, occasionally, a very large investor with sufficient power succeeds. But the funds put up a common front of 'this is the standard fee' and a fragmented investor base has little leverage to push back.

Other rent extracting practices include 'product tying', or even more coercive threats. For example, investment banks generate significant market intelligence from their proprietary trading operations, and Congressional investigations in the US have revealed banks using that intelligence both as a carrot - to win lucrative brokerage business - and a stick, to threaten to trade against clients who don't give more business. In theory, such carrots and sticks should not work - in an efficient market clients would just go with the lowest fees and best service. But in reality some banks have significant market power, informational advantages, and - in markets with limited liquidity - the muscle to move markets.

Such rent extraction from corporate and institutional clients ultimately harms the broader economy and UK households. The cost is passed on in the form of higher prices for consumers, misallocations of capital, less employment, and lower returns on pensions than would be the case in a more competitive, less distorted market. It also distorts the allocation of talent in the UK economy, as the brightest talent follows the money to where the rent inflated compensation is.

The solutions are not obvious or likely to be simple. More regulation alone will not address it: the governance, compensation practices and - notably - culture of the banks have to change. Specifically, banks need to reassert a client service culture that values long-term relationships and emphasises the duty of care towards their clients. Rent extracting practices significantly increased in step with the shift to a transactional, short-termist trading culture at many banks in the 1980s and '90s.

But where there are persistent market-distorting and anti-competitive practices then there is likely to be a role for government too. Innovations in the technology sector and the development of the web have forced updates to anti-competition law, interpretation and enforcement over the past decade. Now these need to be updated to address more effectively issues in modern global finance as well.

The government should establish a commission to specifically examine the issues that were out of scope for the Independent Banking Commission, focusing on rent extraction from corporate, institutional and wholesale users of financial services. Specific questions this commission might ask include:

• Is there evidence of explicit or implicit collusion, coordination of prices, product tying or other anti-competitive or market-distorting practices that facilitate rent extraction from non-retail customers?
• Does competition law and enforcement in the UK adequately cover financial services and ensure an efficient and competitive market for non-retail customers?
• What aspects of rent extraction are likely to be addressed by other measures under discussion (such as higher capital requirements, ringfencing) and which are not?
• Are there structural features of the UK and global financial system that may facilitate rent extraction and so which need to be addressed?
• Do factors such as bank governance, compensation systems, incentives, performance measures, and culture play a role in supporting rent extracting behaviours? How might governance and management practices be changed to address this? Is there a necessary role for regulation?

Financial reform must address all three issues

The net result of stakeholder abuses, implicit subsidies and rent extraction has been the misallocation of financial and human capital in the UK economy. These factors have caused the financial sector to be larger and more profitable, and created more opportunities for individuals to enrich themselves, than would be the case in their absence.

There are arguments that rapid growth in the financial sector has 'crowded out' growth in other sectors and contributed to the UK's rapid deindustrialisation versus peer countries. Employment in British industry (excluding construction) contracted at an annual rate of 3.8 per cent between 2001 and 2011, compared with other large European countries such as France (2.0 per cent), Italy (0.6 per cent) and Germany (0.4 per cent). It is likely that some of this is directly due to investment flowing towards high returns in the financial sector, while it is also the indirect result of capital flows into the financial sector causing significant upward pressure on the sterling exchange rate. In addition, there are arguments that the sector's high salaries have misallocated human capital and contributed significantly to Britain's growing inequality.

The UK needs a successful financial sector to provide capital for its businesses and households, and it benefits from being the home of a successful global cluster that provides its services to the world. But the sector must succeed on the grounds of its ability to fulfil those duties well, innovate, and compete - not on its ability to abuse stakeholders, take excessive risks with taxpayer money and distort markets to extract rents. The government and regulators have made progress on approximately half of the agenda of needed reform - it needs to focus on the other half as well. Specifically, further emphasis needs to be placed on internationalising institutions for guaranteeing, resolving and bailing out global banks, and a new effort is required to reduce competitive and institutional distortions that facilitate rent extraction - from retail customers, but also from corporate and institutional clients. Policy approaches to the sector need to be broadened to include competition policy and possibly even trade policy in order to remove disincentives for national governments to reduce implicit subsidies.

By addressing all three issues, Britain can lead the way in creating a 21st-century financial sector that positively contributes to its future prosperity.

This essay appears in the latest issue of Juncture, IPPR's journal for rethinking the centre-left.