The hollow case for bank bonus caps
Members of the European Parliament on the Economic Affairs Committee have agreed to introduce legislation to extend the bonus cap on bankers to fund managers as well. This is an indication of the envy, ignorance and economic illiteracy that drives much European policy.
The supposed purpose of the bonus cap on bankers is to make banks safer by reducing banks' ability to reward people for taking risks. It will have the opposite effect (as nearly all regulation does). Remember when Gordon Brown and the authorities in the United States were flooding the world with cash and a boom was raging? Then, certainly, the banks did reward people for simply doing deals because every deal succeeded. We are far from that situation now, and banks are no longer taking such risks. So why limit bonuses? Pure envy at the thought of bankers earning £1m bonuses.
Well, I know the feeling. But bonuses are how businesses in volatile sectors keep their salary costs under control. In bad years people earn less, in good years they earn more. If firms cannot manage those costs because of politically-imposed caps, and have to raise basic salaries instead in order to retain staff, the policy actually increases the risks that the banking sector takes.
But what about fund managers? They do not actually take the same risks as the banks at all. So why introduce a bonus cap on them? Again, it is just envy, not logic, that motivates the new move. The customers of fund managers are savvy, large-scale, well-heeled investors. Funds played absolutely no role in creating the financial crisis: they actually took much lower risks than the banks. Wealthy customers tend to want to conserve the fortunes they have built up over a lifetime, rather than gamble with them.
It is plain that MEPs do not understand the financial industry, which is largely based in London – much to the irritation of those in Paris, Frankfurt and Amsterdam, who seem to think that if they hobble London, the business would transfer to them. It wouldn't, of course: it would probably go to New York, Hong Kong, Singapore, Shanghai or at best Zurich.
The British government should read Tim Ambler's new ASI paper on financial regulation – and follow his advice to resist this latest, spite-inspired regulation and instead get the EU and other regulators to endorse proper competition in banking and financial services.
Two regulators aren't better than none
I’ve been working recently on the regulation of banks, insurers and financial advisers. I’ve concluded that these industries are over-regulated, and regulated in the wrong way – which causes more problems than it solves.
There is a strong case for financial services regulation. With many products you can see plainly what you are buying. But buy a pension or an insurance policy and you don’t know if you’ve been sold a pup until it’s time for it to pay out.
Kitemarking – by independent agencies – could probably solve that. And you want to make sure that the banks and insurers stay honest, get the Bank of England to do that – they are close to the market. Then let the Financial Ombudsman Service deal with consumer protection.
We should be regulating the products, not how they are sold. That makes regulation so complicated, with so many tick-boxes, that it strangles the life out of the market. It’s fine to insist that client money must be held in a separate account and suchlike. That’s a simple rule of honesty and probity. But you don’t need much more.
We should recognise that competition is the best regulator. And that brands offer consumers an important guarantee of quality. Trouble, is, if sellers are minutely regulated, then brands make no difference and customers are done a mis-service.
Problems like Libor-fixing and PPI-misselling were caused by regulation. Bank regulation has raised the costs of market entry and killed competition – it’s so hard to start a new retail bank that only one has been created in the UK in 130 years. If there were proper competition, cartels wouldn’t stick. And PPI was caused by the Financial Services Authority demanding it be offered to mortgage and loan customers, then not checking how it was actually being sold.
Regulators expand their empires by creating more and more rules for themselves to police. If they can pass the cost straight on to the regulatees, as in financial services, there is no cost control at all. And regulations make people feel safe, even when they are not, so people take more risks in what they buy. Regulations undermine competition and brands and everything else that might actually protect customers.
George Osborne wanted to scrap the FSA, which was so mesmerized by its own tick-boxes that it didn’t see the banking crash coming. But as of 1 April we will have two regulators instead of one. That’s bureaucracy for you.
Making a complete mess of Cyprus
The people in charge of economic policy in the EU appear to believe that they can create economic reality by passing laws and reaching decisions through negotiation. Their knowledge of human psychology seems to be even more flawed than their understanding of how markets actually work in practice. The decision they forced upon the Cyprus government is flawed on many levels. The bank levy punishes savers but leaves the bond-holders untouched, violating the principle that small savers should be protected, while the bond-holders who knew they were taking a punt should take a hit.
It is also a wealth tax, violating one of the principles of fair taxation that it is OK to tax transactions such as making money or buying goods, but not OK to take money from someone simply because they have it. A state might claim to justify a transaction tax by saying that it provides and maintains the infrastructure that makes it possible for people to deal with each other to mutual advantage, but not a wealth tax.
If the Eurocrats had studied game theory or psychology they could have anticipated the anger and outrage that their move has provoked. People mind losses more than they value gains. They mind precipitous losses more than they mind gradual ones. They mind visible losses more than invisible ones. People do not like it if their €200 in the bank will, through inflation and currency fluctuations, only buy them €180 worth of goods in the future. But they dislike it almost infinitely more if government removes €20 from their savings account. Indeed, 'dislike' is too mild a word. They are outraged because their government has stolen their money, even though they were not responsible for the crisis.
The signals this move sends out are that it is foolish to save, and foolish to keep money in banks. These signals are spreading to countries other than Cyprus. A precedent set in one place could be followed in another. It is entirely possible that this action will set in motion runs on several banks as savers seek to place their funds beyond the reach of predatory governments. The reaction of outsiders to this move can only be one of shocked incredulity.
Bring competition back to banking
The Parliamentary Commission on Banking Standards, headed by Andrew Tyrie, wants to electrify the proposed ring fence between retail and investment banking. Regulators should be able to force a complete split of retail and investment banking operations if a bank tries to resist the ring-fencing rules, it says.
We need smaller banks and more competition in banking, yes. But this proposal is a bad idea.
In the first place, the Vickers Commission ring-fencing proposals are the answer to the wrong question. The idea is to separate the 'risky' investment banking (or as the Business Secretary Vince Cable calls it, 'casino banking') from the supposedly less risky retail element (the 'Captain Mainwairing' business). However, it was not the investment banks that crashed back in 2007-08. As our report by Miles Saltiel explains, it was the mortgage banks and former building societies like Northern Rock that came to grief. Ring-fencing could actually increase risk. And it will certainly raise costs for retail bank customers, as their banks will not be able to pass on the savings from the savvy management of pooled funds by their investment arms.
Second, regulators are the last people you want telling the banks how to run their businesses. if they were empowered forcibly to split up banks, they would undoubtedly make a hog's ear of it. They would, in the process, damage UK banking and drive yet more banking business out of the UK. If you want to break up the banks, use the market: simply have more onerous capital ratios on the larger banks. That reflects the fact that the larger a bank is, the more damage its failure would do: small bank failures are manageable. It is the huge cost of regulation that has actually caused the elephantiasis of our banks: with smaller banks we would have more competition and we would need less regulation.
Third, the proposal is typical of politicians' belief that they can manage markets. In fact they are hopeless at it. A decade ago they were telling us how well they were managing the banking sector, and the Financial Services Authority had more than two thousand people on the job. They failed, miserably. Politicians and regulators don't know what is happening in markets. They wouldn't know whether a bank was getting round the ring-fencing rules or not. And they certainly wouldn't know what to do about it.
Fourth, our banking system is broken, but the politicians and regulators have done nothing to expose its problems. Nor would this proposal. The banks are still loaded with toxic obligations, but nobody outside the banks themselves knows how much. Banking depends on trust, but how can you trust them, if you don't know how many skeletons are in their cupboards?
A better solution would be to make the banks fess up and reveal their toxic 'assets'. Then put those assets into an isolation ward and let the healthy parts of their business get on with life. Then encourage more competition in banking by making market entry easier, reducing the regulations on smaller banks and raising the capital (and – see our forthcoming report by Robert Miller on this – their cash requirements). In other words, return banking to the real world of market competition. Job done.
How to privatize RBS
With Mervyn King saying yesterday that we ought to get on with re-privatising RBS, the issue becomes how to do it.
As we discovered in the 1980s privatisations, you have to take out all the bad and unsaleable bits of a business before people will buy it. For example, the highly-risky nuclear element had to be taken out of the electricity sale. Likewise we need to pull out ABN-Amro. And to set up a 'bad bank' and put into it all the toxic business of RBS, and for that matter, Lloyds TSB too. That would free up lending and crystallize or segregate the banks' zombie obligations. It takes a bit of time to root everything out, but there is plenty of international expertise around to help.
Should RBS and Lloyds RSB be split into retail and investment arms? After the Vickers Report this idea is wearing the yellow jersey, but retail banks are not inherently safer than mixed ones, as Northern Rock and others showed. It is also hard to define the retail/investment boundaries. A split like this would just slow the process down.
While we are setting up the bad bank, it seems sensible to split the banks so as to promote competition and reduce systemic risk. Lloyds TSB could be split into Lloyds, Halifax and BoS. RBS could be split into NatWest and RBS, or into smaller pieces. That again would take time, and would mean re-engineering some back-office systems (most of which, in RBS's case, are hopelessly outdated anyway), but it gets rid of the 'too big to fail' problem.
How then to privatise? We could just give out shares to taxpayers, since they were the ones who stumped up for the bailout. But nearly everyone is a taxpayer, paying VAT and other indirect taxes, and it would be controversial to give out more shares to people earning enough to pay more tax than others. So what about giving out shares to everyone? Well, the mess of Russia's 'voucher privatisation' suggests that is a bad idea. People just sell their shares on right away, probably for too little money, and conventional owners step in.
But share giveaways raise no money on what should be a valuable asset. So a better route is to sell the banks and then distribute the proceeds to everyone. A staged sale would help to maximise the returns, and people would get several cheques, not just one. Perhaps some of the proceeds could be returned to the public and some could be put to paying off the national debt.
A broad privatisation is preferable, as selling to another bank just re-concentrates risk. Of course, it might be possible to sell to a completely different outside player – an Asian bank, for example – but people are nervous about foreign ownership.
And a popular privatisation bonanza just before the 2015 election could give Osborne and Cameron quite a boost – which I am sure enters their calculations.
The truth is, we have no idea how much money bankers deserve
The daffodils are out and the annual uproar at bankers' bonuses is upon us. The EU’s bonus cap is a well-timed, predictably silly play to the gallery, but we shouldn't assume that our own banking rules are much more sensible.
Any rules about what private firms pay their employees are, of course, absurd. Aside from the base illiberalism of interfering in people’s privacy, there is the practical problem that a cap on pay would drive bankers abroad. Imagine if there was a cap on footballers’ pay – within a year, the Swiss Premier League would be world class.
A cap on bonuses will also make financial firms more sensitive to downturns in business. The purpose of bonuses is to give firms flexibility in how much they pay, so that they can pay employees much less in bad years than they would in good years without having to sack people.
In a free market, the problem of bonuses encouraging short-term profit maximisation at the cost of long-term sustainability would not be an issue – the firms that pursued that strategy would go out of business soon enough. The problem is that any large firm that acts badly like this is protected from its mistakes by things like deposit insurance and bailouts.
The other problem is that the government has already bailed out quite a few banks, and those banks also want to pay bonuses to their employees. On the one hand, this is perfectly sensible – it’s crucial that we have competent executives in government-owned banks to minimise the loss of value to taxpayers.
On the other hand, aren’t we against extravagant public sector pay? The big problem with the public sector is that, internally, it lacks the price signals that make markets work relatively efficiently. It’s true that the public sector can mimic market prices to an extent, but only very crudely. RBS can borrow money at a significant discount because of the implied promise of government backing. (All banks operate under the promise of an implied government bailout, and explicit deposit insurance.) Without a functioning price system, there’s no way of telling how much RBS’s CEO deserves.
The reality is that nobody really knows how much to pay RBS’s executives. Mimicking the private sector isn’t enough – without private shareholders to answer to and a genuine threat of loss, RBS’s bonuses are no more wiser spent than Bury council’s iPads for its binmen.
Yes, a cap on bonuses is a dumb idea. But so is any state involvement in the banking sector. If the government’s going to fight against the latest example of EU overreach, it would do well to get its own house in order as well.
The Bank of Dave and our broken banking laws
Channel 4's follow-up to the "Bank of Dave" made for highly enjoyable viewing. The programme was subtitled 'Fighting the Fat Cats', but it was bureaucrats rather than Fat Cats that caused the problems.
The show followed the experience of Dave Fishwick's Burnley Savings and Loans community bank. The bank offers 5% AER to savers and small loans to local businesses, with profits given to local charities. In many ways, the concept has much in common with the old Credit Unions, Mutuals and Co-ops as well as the German Sparkasse (which, as the programme showed, have had similar struggles with regulation). Without knowing the full details of the business, it seems that Fishwick had a very successful model and a very low rate of non-performing loans.
As the programme portrayed it, however, Fishwick was lucky to survive a heavy-handed assault by the FSA. The regulator appeared to object to the simple business model and tried to impose a greater level of complexity of the savings accounts. This is typical - regulators want all banking institutions to conform to a chosen model, which may well be inappropriate. How is a regulator to know what customers want and which is the best means for suppliers to provide that? Fortunately, Fishwick is a charismatic character and was able to motivate public support and win some influential backing, particularly the support of the excellent Steve Baker MP.
This serves to demonstrate exactly why there is so little competition in the UK retail banking sector and why there have been so many financial scandals (PPI, Libor). In banking, as in any other market, regulation creates barriers to entry to small businesses. Not every small bank is lucky enough to have a crusading Dave Fishwick, but they should not need to. The regulatory barriers to entry drive consolidation and prevent small businesses entering and outcompeting established players. It is this which allows uncompetitive practices and harms the consumer. Big businesses have a symbiotic relationship with regulators and there is frequently a revolving door between the two. This is why we have ended up with banks that are too big to fail, but yet we still have the cry of 'more regulation'.
We should remember that, with the possible exception of energy, banking is the most heavily regulated sector of the UK economy. Moreover, it is one of the few sectors where the prices are controlled by the state - the nominally independent Bank of England in this case. It is ironic that populist demagogues such as Vince Cable and Ed Balls jumped on the Fishwick bandwagon, as it is they who advocate heavier regulation of the banking sector.
Competition in banking, as in any area of the economy, can only come from deregulation. Lowering barriers to entry, allowing small banks to enter and allowing caveat emptor by both savers and lenders (together with the re-introduction of sound money and privatisation of the Bank of England) is the only way to fix the broken banking sector.
Article: Bubble trouble
Last week, Standard & Poor's, the rating agency, was sued by the U.S. Department of Justice (USDoJ) in a Los Angeles federal court for “knowingly and with intent to defraud, devis(ing), particpat(ing) in, and execut(ing) a scheme to defraud investors in (residential property securitisations) and CDOs, including federally insured financial institutions... and to obtain money from these investors by means of material false and fraudulent pretenses, representations, and promises and the concealment of material facts.”
Even to persons legally trained, this is weighty stuff. One of the most amusing ways I know to frighten an unschooled junior lawyer is to sit him or her down in front of a structure diagram of a securitisation, a jumbled mess of agreements, parties, cashflows, security arrangements, and hedging – and then change slides to display a CDO, a securitisation of securitisations, a stacked jumble of jumbles. (Instant fun.) Despite the visuals, however, such transactions are conceptually very simple: one takes assets that throw off a steady stream of income (such as residential mortgages), models the cashflows arising from them, and creates debt instruments which match the payments from the assets with the payments on the notes. Those notes or bonds are then sold, with the seller recouping the capital value of the assets in the present in exchange for investors' acquiring the future flows of income.
Certainly securitisation increased risk taking: that's the darn point of it
I thought this was an interesting little piece of research by the New York Fed.
There’s ample evidence that securitization led mortgage lenders to take more risk, thereby contributing to a large increase in mortgage delinquencies during the financial crisis. In this post, I discuss evidence from a recent research study I undertook with Vitaly Bord suggesting that securitization also led to riskier corporate lending. We show that during the boom years of securitization, corporate loans that banks securitized at loan origination underperformed similar, unsecuritized loans originated by the same banks. Additionally, we report evidence suggesting that the performance gap reflects looser underwriting standards applied by banks to loans they securitize.
However, the bit I missed in the subsequent discussion was the point that this is what securitisation is for: to allow greater risks to be taken. Not that I missed seeing what is there, I missed it because they don't mention it.
Just so that we all understand, securitisation is the idea of chopping up a loan or a pool of loans into bonds that can then be sold off to various different groups of investors. It's often associated with structuring the pool of loans: say, one group of investors takes the first 10% of losses, the next the next 20% and so on. But this structuring isn't necessary: securitisation is just the creation of the bonds that can be sold around.
And of course lending is, like any other form of provision of capital or debt to people, all about managing risk. There's the risk, after all, of absolutely any loan not being repaid. Further, there's a constraint as to how much banks can lend and to whom in the risk that is associated with any such loans. This constraint is something we'd rather like to find a way around, too.
We don't want the banks themselves to be taking more risks: but we would rather like those riskier projects to be able to find financing from somewhere. The economy would be a very boring and static place if no one did lend to anything that had any risk associated with it.
The answer thus is to make sure that these extra risks are not being carried by the banks. That they are spread out over some larger or different group of people. People who have both a greater appetite for risk and also a greater capacity to bear it. And that's exactly what securitisation does, is indeed the very purpose of it.
Finally, we find evidence that all loan investors, including banks, expect that securitized loans will perform worse. Banks appear to do so because they charge significantly higher interest rates on these loans than on the loans they don’t securitize. Institutional investors, who together with the originating bank and CLOs acquire the loans that banks securitize, follow the loan originator and choose to acquire a smaller stake in securitized loans.
And it appears that everyone was entirely aware of this greater risk: so much so that everyone took on a smaller portion of any one risk. Exactly and precisely what we desire to happen.
Our evidence that securitization led to riskier corporate lending is in line with similar findings unveiled by studies of the effects of securitization on mortgage lending. Taken together, these studies confirm an important downside of securitization.
This isn't a downside: this is the point, the very purpose. We're happy with greater risks being taken as long as those risks are distributed and laid off to those who can bear them. Which is what securitisation does.
One more thing:
While on average banks retain 26 percent of each syndicated loan they originate but don’t securitize, they retain only 9 percent of each loan they do securitize.
If the banks had held onto zero percent of the loans that they had securitised then there would have been zero financial crisis. If all of that risk had been passed on to the insurance companies, pension funds, individual investors, then we wouldn't have had highly geared banks falling over as they had to liquidate positions in bonds fast falling towards zero. And guess what the solution has been to this little point? Yup, you guessed it, laws that insist that banks must, must, hold onto a portion (usually 5%) of any securitisations that they originate. It's almost as if our rulers don't understand the world they rule. They're insisting on concentrating risk in exaclty the manner that caused the crisis instead of dispersing it in the manner that would have avoided it.
Ring-fencing is the wrong answer to the wrong question
The government is proposing to 'electrify' the ring fence around retail banking activities by warning them that they risk being forcibly broken up by the Bank of England if they try to get round the fence.
Ring-fencing is the wrong answer to the wrong question. Thanks largely to the rhetoric of Business Secretary Vince Cable, many people, including too many politicians who should know better, imagine that the financial crash occurred because of the failures of 'casino banks' – that is, the international investment banks. These, we have been told, crashed and brought down the retail banks that were attached to them. So to protect ordinary customers, we need to separate the two.
But as Miles Saltiel showed in an Adam Smith Institute report in 2011, it was not the investment banks that brought down the retail banks and threatened people's savings. The first banks to fail were the ex-building societies like Northern Rock that got out of their depth when they dropped their mutual status and started offering silly mortgage deals. Then it was the turn of the big banks who were buying mortgage assets – supposedly 'safe' retail-based business – that turned out to be rubbish.
Ultimately, it was politicians and regulators who caused the crash, by flooding the world with cheap credit and money for decades and then cutting back suddenly – as, again, John Redwood demonstrated in yet another Adam Smith Institute report. No wonder banks took risks that brought them down. And when the ex-building societies were offering 120% mortgages and other risky products, the regulators did nothing.
I certainly think that bank customers should know what the bank is doing with their money, so they can judge the risk they are prepared to take and balance safety against cost. But ring fencing does not cure any of the problems I have listed. What it might do is to deny the retail banks access to international capital, making retail banking more expensive for customers and continuing the problems faced by small businesses who cannot get loans. And since other countries have no plans to ring-fence their banks, Britain's financial sector will be setting itself at a self-imposed international disadvantage.
