1. In the aftermath of the financial crisis, many want more radical banking
reforms than those proposed by the UK government and the Conservative
opposition. Moderate Financial Times columnists agree that current reforms
will not make finance safe; senior regulators like Adair Turner and the
Governor of the Bank of England raise fundamental questions about the size
and usefulness of the financial sector. The public expects something to be
done about bonuses while it waits for public expenditure cuts now required
after the bail-out wrecked public finances.
2. The UK government has added some rhetoric about bonuses but not moved
beyond its timid proposals in the July 2009 White Paper Reforming Financial
Markets which is inadequate. This report explains how and why there is such
a gap between the political classes and expert demands or the public mood.
The report also examines what can be done to assert greater democratic
influence over financial markets.
3. The inaction of government results from the influence of the ‘distributive
coalition’ in and around the City of London, which has co-opted the political
leadership of both major parties. The alignment of finance and politics works
because the crisis has reinforced government reliance on finance insiders to
form policy and frame choices.
4. Current and ex-investment bankers and fund managers took key positions in
the process of crisis management and resolution after 2007. At the same time,
HM Treasury and the Mayor of London commissioned reports from the same
City finance groups about the importance of maintaining the competiveness of
London as an international financial centre.
5. The resulting Bischoff and Wigley reports represented a new kind of politics
where finance reports on finance by telling stories about finance. Bischoff
group members collectively had 662 years of work experience and 75% of
those years were spent in City occupations or servicing City needs. Wigley
called expert witnesses but 90% of its witnesses came from finance or
consultancy with revenue links to finance.
6. This represents a break with earlier pluralist practice in inquiries into finance
from the Macmillan Committee of 1931 to the Wilson Committee of 1980.
Here multiple points of view were represented on the committee and in
written and oral evidence which produced “balanced” reports. In the case of
Macmillan, dissents plus reservations and addenda accounted for one-third of
the pages in the final report.
7. The distributive coalition around the City of London frames political choices
through the insider reports. Bischoff and Wigley construct a narrative about
the ‘social value of finance’ in terms of tax contributions, job creation and the
diffusion of prosperity. This inhibits reform because the policy implication is
that nothing should be done that inhibits competitiveness.
8. Through the buy-in of leading politicians like the Chancellor and through
copy-out in official reports like the July 2009 White Paper, the end result is a
kind of regulatory closure because problem definitions are framed by elite
members of the distributive coalition and the world of possible policy
interventions is narrowed as radical options are painted out.
9. Closure has not been achieved when senior regulators like the Governor of the
Bank of England or the Chair of the FSA openly question the social value of
finance. But the distributive coalition has co-opted leading politicians from
both major parties who need the City’s political donations and need the City’s
success story which justifies their political a priori about a transformed,
strong post Thatcherite economy.
10. The major obstacles to reforms for safer and sustainable banking are political
not technical. The solution is not to insulate reform from elite politics but to
promote reform through democratic politics. Broader social representation on
committees and regulatory boards is vital if unaccountable elites are to be
questioned. But effective representation requires greater knowledge and
perspective about what finance is doing and should be doing.
11. It is important to challenge the distributive coalition’s narrative about the
social value of finance, which makes exaggerated claims and uses evidence
selectively:
i. The tax revenues from the finance sector in recent years are offset by the
immediate cost of bank bail-out. In five years up to 2006/7, the finance
sector paid and collected £203 billion in taxes, but the upfront costs of the
UK bail-out are £289 billion, rising potentially to £1,183 billion.
ii. In terms of job creation, the finance sector directly employs no more than
1 million workers (mainly in retail) and numbers employed do not increase in the boom years. If we add jobs in consultancy, accounting and law
sustained by finance, the number of those directly and indirectly employed
by finance still accounts for no more than 6.5% of the UK workforce.
iii. The business model of wholesale banking and the geographical clustering
of wholesale activity, together ensure that the finance sector concentrates
rather than diffuses employment opportunities and prosperity across the
UK. Retail banks control the costs of high street jobs, while wholesale
pulls a small number of well-paid financial actors towards its centre.
In its present form, finance is a pro-cyclical activity with limited job creating
capacity and a proven ability to disrupt the economy at great cost to the
taxpayer.
12. Banking delivers little social value and instead operates ‘for itself’. Under
pressure for shareholder value, banks overcame the handicap of high fixed
costs, intensifying competition and low spreads. They did so from the 1990s
onwards by pushing into new activities like proprietary trading in wholesale
and mass marketing in retail. They created a new sectoral business model that
fused retail and wholesale through securitization and turned banking into a
giant ‘transaction generating machine’.
13. Financial innovation allowed senior wholesale bankers to expand transactions
and turnover, increasing bonuses and fees by trading complex derivatives.
Meanwhile the drive for shareholder value in retail banking encouraged an
incentivised workforce in the high street branches to “sell to” retail customers
who provided the wholesale markets with feedstock. The outcome of this
bricolage was inherently fragile with long, convoluted circuits where one
retail transaction could generate many fee earning opportunities.
14. This ‘transaction machine’ created huge amounts of unsustainable shareholder
value in the bubble years when finance and insurance accounted for more than
30% of all FTSE 100 profits and British banks sustained Return on Equity of
15-25%. Corporate governance was an ineffectual brake on risk-taking which
was actively encouraged by a dysfunctional joint venture between wholesale
‘talent’ and shareholders. The ‘comp ratio’ was an explicit understanding that,
the wholesale workforce was entitled to around 45% of net turnover.
15. Amongst the many invisible and unremarked problems of retail was an
unlevel playing field which systematically disadvantaged mutuals and smaller
firms. Mutual building societies pay higher costs of deposit insurance and all
smaller banks are handicapped by the requirement to buy clearing services from an existing clearing bank. The incumbent major PLC banks are protected
by their branch systems which are both barrier to entry and a basis for cross
selling to a customer base which is still more likely to divorce than to switch
current account provider.
16. The problem of the pre-2007 bubble was not that there was too much debt, but
that too little credit was applied in the right places. The finance sector
undermined sustainable growth by inflating asset price bubbles rather than
underwriting any kind of productive investment. Productive business
investment remained at a steady 10% of GDP between 1996-2008, but
declined sharply from 30% of all bank lending towards 10% as banks
expanded their lending on property and to other financial institutions.
17. Put another way, the UK has an economic co-ordination problem because all
debt is ultimately a claim on future resources, and the sustainability of debt in
one phase is linked to the amount of resources that an economy can create
going forward. Finance allocated capital to (leveraged and unsustainable)
asset price growth and not into productive, socially useful investment that
might generate the sustainable returns to support debt repayments.
18. Despite its track record, the distributive coalition now borrows the language of
social innovation to argue that new financial products can address ‘unmet
social needs’ such as care in old age. This implies more funds routed through
the wholesale markets which would benefit the senior workforce, but could
well increase economic instability without solving our social problems.
19. Any challenge to the extension of financial markets will meet political
resistance from the distributive coalition around finance who are hostile to
anything that crimps their own money making activity. If banking reform is to
succeed, it will only do so by building a political alliance for reform which
makes immediate demands that are intelligible and actionable and develops a
mobilising vision of sustainable finance.
20. Most reports on banking end with a list of recommendations chosen from the
menu of policy measures currently being discussed. These stock measures
include separating retail and wholesale, sharply increasing capital adequacy
requirements and inventing a new practice of macro prudential regulation. But
many of these measures will predictably be frustrated by the distributive
coalition and we should not make choices now which pre-empt democratic
discussion.
21. Hence, we offer ‘principles for action’ which are coherent with our problem
definition and suggest a political direction for travel without specifying the
technical details of intervention. If we consider immediate reform demands,
the four principles for action below are designed to increase the accountability
of financial elites and the transparency of their activity as well as to transform
retail mass marketing:
i. Top slice the lump of revenue now allocated to the senior wholesale
workforce under the comp ratio system which gives them the right to
nearly half of net turnover. Claiming 25% or more of the comp fund is
politically justifiable because it was elite traders who created the fragile
system that failed, and because it recompenses taxpayers for state funds
spent on bailing out banks and markets. The proposal is to create a smaller
comp fund rather than regulate how banks distribute bonuses.
ii. De-risk the sector by simplifying wholesale and explicitly engineering
shorter transaction chains. This could be addressed via a Tobin tax which
puts sand into a system that currently seeks to increase the volume and
value of transactions for senior workforce gain with little obvious social
benefit.
iii. Shrink the sector by reversing the long standing policy bias in favour of
finance. Introduce ‘no favour’ policies because wholesale activity is not so
valuable that it justifies concessions over low effective tax rates for high
income bankers or disclosure exemptions for their corporate vehicles.
Greater transparency is a necessary prerequisite for a more democratic
finance. Encourage shrinkage by reducing rather than increasing the flow
of feedstock from retail by, for example, preferring graduate tax to student
loans.
iv. Introduce a new kind of regulator in retail, broadly advised by a retail
banking committee drawing on the expertise of SMEs, Trade Unions and
NGOs. The regulator would have a broad brief to include extending the
range of advice available in high street banks and curbing banking
business models that are currently too sales-based. A different regulatory
regime in retail finance would build on the competences and motivations
of the retail workforce which restricts sales performance-related pay.
22. Beyond these principles, there is a need for a mobilising vision about how a
different kind of finance could design sustainable circuits between credit and
debt and apply credit to our unsolved problems. This opens up new
possibilities for different approaches to job creation in a low carbon economy.
Possibilities here include state sponsorship for projects which meet social and
environmental needs, new industrial contracts with indicative investment and
employment goals, or tax breaks for green or other socially useful
technologies. Other major problems about security in old age could be
addressed by channelling savings directly into lower yielding infrastructure
projects and low carbon technologies that would meet social needs, reduce the
intermediary clip and switch funds out of the secondary shares market.
23. If we are to reassert democratic influence over finance, it is necessary to raise
big questions and suggest imaginative solutions. However the democratic
process should not be abridged. Hence this report’s principles and vision are
all subject to subsequent debate, decision and action within a democratic
process.