Last updated:September 12, 2012 8:50 pm
Incentives for banks to stray will persist
If regrets, apologies and promises to behave better were redeemable for cash, the world’s banks would be rolling in it.
On Monday, Rich Ricci, Barclays’ head of investment banking, promised to “redefine what we are here to do, and the way in which we conduct ourselves”. On Tuesday Anshu Jain, Deutsche Bank’s joint chief executive, conceded that “tremendous mistakes have been made”. Vikram Pandit of Citigroup talks of “a profound responsibility to keep [the financial system] safe”.
The words have been matched by some action. Barclays and Deutsche have lowered profit targets from the high levels that encouraged banks to take trading risks, sell poor products to customers, and gamble with their reputations. Barclays will shrink its infamous and highly profitable “tax structuring” unit.
There is plenty for which to apologise. Rampant personal and corporate lending during the bubble, followed by a squeeze on credit; the invention and trading of volatile credit derivatives; the mis-selling of costly payment protection insurance by UK banks; distortion of Libor by traders; global tax avoidance and arbitrage. And so on.
But what are the odds of these noble promises enduring past the usual period of sackcloth and ashes at the bottom of the banking cycle? Not very high, I’m afraid. Although the new generation of bank leaders probably has good intentions – as well as needing to assuage public outrage – these pledges will be difficult to enforce, or even recall, when it matters.
The structure of modern finance, and the pressure from shareholders to increase revenues and keep them growing, makes it difficult to impose much restraint. Incentives to misbehave are deeply embedded in the system and have outlasted all past efforts at reform.
Here is an example. A quarter of a century ago, I was mis-sold an endowment policy tied to a mortgage that was designed to repay the capital while I met the monthly interest. Like other innocents, I had no idea of how such policies worked and took the word of a salesperson – an expensive mistake that has crystallised 25 years later.
My policy embodied several problems in the reform of finance. One is the complexity and opacity of many products, which give those selling them plenty of leeway for abuse. Whether the buyer is a mortgage borrower or an insurer seeking a mortgage-backed collateralised debt obligation, he or she is easy to hoodwink.
The second problem is time. This incident happened shortly after Big Bang, the deregulation of the City of London that revolutionised finance. By the time the damage became clear, about a decade after I had bought my policy, the seller had long moved on. If you buy a television, it is immediately plain whether the product works; in finance, it can take years to discover.
The third problem is financial incentives. I don’t suppose that the person who sold me the endowment believed it would underperform but nor, probably, did he care. He was being paid a commission to persuade me to buy that product and so was hopelessly biased.
In theory, individual incentives are soluble – investment banks are altering bonus structures to stop traders from exploiting customers for short-term gain and retail banks plan to do the same in branches. But the biggest incentive problem binds the banks themselves.
The core profitability of both investment and retail banking has steadily eroded. The end of fixed commissions in securities broking made the sale of ordinary low-margin securities uneconomic. Meanwhile, many retail banks ceased charging those in credit. The bulk of profits had to come from trading and “innovative” products, ranging from my endowment to CDOs.
Reducing the targets for return on equity – in Barclays’ case to just above its cost of capital – is a sound first step because it reduces the pressure on staff to sell high-risk products. The key is whether banks will gain financially from behaving more ethically.
That, I doubt. It need not be rational to grab short-term revenues at any long-term cost. Many banks seemed to be highly profitable in the good times but later lost the lot in one-off writedowns. More cautious institutions achieved a higher risk-adjusted return on capital.
But having a bad reputation is not as financially damaging as making a bad loan. In my case, it was so long ago that I can hardly remember which building society directed me to the salesperson. Even those who dislike their banks tend to stick with them because it is hard to move and the alternatives are similar.
Take Goldman Sachs, the investment bank whose reputation was badly hurt by the 2008 crash. It is a byword for Wall Street excess, yet it did not lose many customers by settling with the Securities and Exchange Commission on charges of securities fraud. The US Treasury this week named Goldman as one of the group of underwriters that will try to sell $2.7bn of its AIG shares.
For now, shareholders will accept lower targets for return on equity and will swallow, and even support, initiatives that reduce revenues. In the longer-term, when the self-flagellation is forgotten and exciting new opportunities arise, they will be less indulgent.
This generation of bankers is no doubt genuine in wanting to redeem past sins. No one likes to be vilified and, as Giles Fraser, the Church of England priest who resigned from St Paul’s Cathedral in protest at the eviction of the Occupy London demonstrators, says: “I reject the idea that bankers are more morally corrupt than anyone else.”
Despite that, the smart money is against them.
Copyright The Financial Times Limited 2012.
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