21 October 2009
Worshipful Company of International Bankers Dinner, Mansion House, City of London
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Since the collapse of Lehman Brothers thirteen months ago, we have learned that what happens in the City matters for our economy, for the jobs of millions of people and for our public finances. We know that excessive and poorly understood risks were taken on by banks and not properly understood by regulators and central banks around the world. Shareholders failed to act to exercise effective control of the banks they owned. Boards failed to restrain egregious remuneration policies that rewarded behaviours that lead to personal enrichment in the good times, leaving the tax payer to foot the bill when, to quote the Governor of the Bank of England’s remarks yesterday evening, a ‘financial firestorm’ engulfed world markets.
As we look to rebuild our financial services system and rebuild our economy, we need to ensure that Government and regulators get our part of the bargain right. We need to deliver adequate capitalisation, liquidity and funding, proportionate regulation, tough standards and secure international agreement to protect our national economy. And let me assure you – fundamental regulatory reform is underway, and there is more to come. But our efforts will be in vain if the industry does not do its part. You, as leaders in the banking community, need to imbue your organisations with restraint, consideration for the wider economy and a responsibility to society.
We need to balance regulation and self-regulation. We need to balance self-interest with the interests of the consumers, pensioners and savers who have lost out during this crisis. It is this balance that I wish to address this evening.
The Government is committed to a successful financial industry in the UK, free from direct Government involvement. The City thrives on its successful financial services industry, indeed we need look no further than our host tonight and his work with the Mayor’s office, or the Government’s work with Sir Win Bischoff, to illustrate the importance we attach to maintaining the City’s prominence as a financial centre. Financial services are a source of comparable advantage for the UK; they have been for centuries and will continue to be so in the future.
We are committed to rebuilding a successful, strong and responsible banking sector. Government will also take action to promote effective competition; including encouraging new entrants. We need to ensure that we have an appropriate framework for customer protection and redress.
We believe that markets should run their course; transactions should be commercially driven. But I also believe that the unbridled pursuit of short-term profit needs to be tempered; self-interest should require a long-term view, a desire to see growth over many years, not overnight profits.
This requires action on several fronts. Firstly, we need to ensure that regulation and self-regulation – and by that I mean basic restraint and prudence - act in concert to produce better outcomes for business and individuals. Secondly, we need to ensure that remuneration policies reward enterprise and innovation, but not at the expense of unacceptable levels of risk that are ultimately borne by society. Thirdly we need to ensure that when this balance breaks down, systems are in place to protect firms, their customers and the taxpayer.
Regulation is necessary to protect firms, individuals and society. But notwithstanding this, the industry has a responsibility to provide an effective check and balance to its own activities. It is in the long-term interests of the wider economy and individual institutions that they are sustainable and able to weather changes in the wider economic climate.
Put simply, it is in no-one’s interest, for instance, for financial institutions to lend people money they will not be able to pay back or products that are not in their best interests. Recent events have thrown into stark relief the consequence of breaking this fundamental rule.
Accordingly, we expect all banks to lend responsibly, and where they show that they may not have the controls and culture to do so, the FSA can and will intervene.
Earlier this week the FSA published new proposals to reform mortgage regulation.
Buying a mortgage is one of the biggest financial decisions individuals can make, and indeed it is worth reflecting that in 2007, outstanding mortgage debt represented 85% of GDP, up from 50% in 1996. It is vital that the mortgage market works well for consumers, so that households do not take on debt that they cannot afford to repay.
The last few years have seen a rapid explosion in mortgage lending, including growth in higher risk lending, with a 370% increase in gross advances in the decade to 2007, with the average income multiple increasing from 2.6 to 3.2 over the last 5 years.
The balance in mortgage lending has broken down; sub-prime lending in America and around the world contaminated the global banking system. Self-interested financial institutions should have recognised and mitigated this risk; but the pursuit of short-term profits multiplied the risk and the effects were devastating.
We welcome the FSA’s discussion paper, in which they make clear their more intrusive style of regulation – intervening where necessary to curb high risk lending and supporting their approach through tough enforcement. This will be obtrusive, but will not stifle innovation and will not keep genuine, credit-worthy first time buyers out of the market.
I have already touched on the issue of excessive risk. The pursuit of personal profits did not lead to the financial crisis, but remuneration polices did encourage excessive risk appetites, compounding the problems associated with badly structured, opaque and overly complex products. The Government has worked to develop a suite of responses; both domestically and internationally. The regulatory response includes a focus on aligning pay with risk – remuneration should never again be a source of systemic risk.
But more needs to be done. The banking industry has a social obligation to the taxpayers of this country.
Many banks would have long since collapsed, let alone made any meaningful profit, had the Government not stepped in when it did. Government action here and overseas was necessary in order to protect the economy. But, somewhat ironically, a combination of the banking crisis and government and central bank responses have created benign business conditions for many aspects of investment banking. The profits currently being booked by banks are directly attributable to the actions taken around the world.
Restoring reserves, conserving and building capital should be each bank’s number one priority at present. The FSA has already made it clear that capital requirements are being reviewed across riskier activities and are likely to rise in these areas; prudent banks should be making provisions for this now, rather than paying out capital in unjustified bonuses, only to have to recoup money from shareholders through equity issues – another reason why investors should take an active interest. .
Exhorbitant personal rewards cannot be consistent with this overriding objective.
We are willing to take action if necessary, but I would like to see the sector address this situation itself. I accept that there are problems and that, as employers, you must compete for highly trained and skilled staff in a market where employee traction is very low. But the banking sector is not unique in this respect. Firms in the IT, engineering and legal professions, for example, all recruit and compete with rivals for accomplished staff. They manage to do so without agreeing remuneration packages that damage the integrity of the employer, and which drive behaviours at odds with the values of society. To say that the compensation practices in the City are ‘necessary’ is simply not the case; they are ‘culturally embedded’ in an industry that now needs to reform. Contemplation of big bonuses in these conditions is nothing short of a market failure.
Here again, the balance between self-regulation and regulation needs to be sought. The G20 has set out proposals for remuneration to realign incentives and risk; the UK has shown bold leadership in securing agreement to early implementation of these reforms. For the banks that we have direct stakes in, we are actively engaging as shareholders through UK Financial Investments; back in February, they drove through the most radical set of reforms to remuneration seen in any large bank in the world. UKFI has to tread a fine line.
On the one hand, some of the past practices – for instance, paying out 100% of bonuses in cash at year-end – were clearly flawed and contributed to the difficulties banks got into. So, as the custodian of our stakes in the banks UKFI has been right to demand serious reform.
On the other hand, while our banks need to lead the way in reforming pay practices, we have tens of billions of pounds of taxpayer money tied up in these banks. If we are to get this money back for the taxpayer, the banks must be competitive. So UKFI will not try to turn its banks into a unique experiment on pay.
This is not an impossible conundrum. UKFI as shareholder, along with all other shareholders, needs to take a robust approach on pay. In parallel, we, as the Government, must maintain a relentless drive with other governments and regulators across the G20 to ensure that the game changes – not just for RBS and Lloyds, not just in the UK – but all major banks across the world. This is not an easy task either, but we are making real progress.
Compensation is first and foremost a matter of corporate governance and share-holder stewardship.
Shareholders need to be aware of, and respond to, the remuneration architectures at work in the companies in which they have invested their clients’ savings. This goes well beyond Board level remuneration; investors need to take a deep interest in corporate values, the behaviours that Directors seek to encourage and discourage, and the overall philosophy architecture of reward. In financial institutions, as in wider society, extremes of inequity between those at the top and those on the ground create tension, and in financial firms, this tension can create risk. This is why I support proposals to greatly improve disclosure of remuneration structures and look forward to Sir David Walker’s final report. Sir David has already been clear on the need for shareholders to raise their game and he will ensure, they have the necessary information and influence to fulfil their fiduciary duties.
It could be argued that some shareholders in banks have been left holding not the ordinary shares they originally purchased, but a new form of subordinated, participating, non-cumulative equity that ranks behind rewards for the senior management, and executives of the firm in which they invested have a prior claim. This cannot be right.
In case anyone needs reminding, the profits of banks belong to their owners; not their managers and traders.
Real reform to remuneration should come from within and should start at the top. Through their own remuneration, the executive and senior management are best placed to indicate their commitment to the long-term future of their firms, their industry and their obligations to those backing them. Irresponsible rewards at the top will only fuel irresponsible behaviour on the ground.
Remco chairs need to be more searching in their evaluations of the real contribution of individuals, and how this tracks to their reward. The crisis has demonstrated clearly that simply adding zeros to bonuses has failed to deliver sustained performance – there must be a better way of building good businesses.
The men and women running banks from their seat at the board table or their desk in the executive’s office cannot demonstrate real leadership in the bonus debate. You need to be able to look your shareholders’ customers in the eye. If you plan to take a big bonus’ my advice would be to get ready to explain why your bank’s earnings are genuinely attributable to your performance, rather than the support of taxpayers across the globe, and the capital and infrastructure provided by your shareholders; and be prepared to justify yourself to your regulators, and customers. Customers can move their business, they will not take kindly to doing business with banks who eschew responsible values.
It would appear of late that some banks are adopting the tactics of the infamous Madagascan football team Stade Olympique L'Emyrne, who in 2002 intentionally scored 149 own goals, because they objected about the referee. Paying large bonuses in the present climate would be a clear own goal for the industry, and suffice to say that Stade Olympique forfeited that game, and so I would not advise emulating their approach.
Customers have choice – they will not want to do financial business with companies that do not have a deserved right to their trust. Banks need to build communities of trust with their customers, not alienate them with headline hungry bonus cheques.
Regulation has and will play a fundamental role in ensuring the UK financial markets endure and prosper. But the Government and regulators alike recognise that no matter how far they seek to avoid it, it is unrealistic to believe that no firms will get into difficulties. Theories of creative destruction are well and good, but they should not be applied to systemic firms integral to the fabric of financial markets.
So the question has arisen as to how to deal with firms that are so complex that their failure would pose a threat to the stability of the financial system as a whole. Please note that I do not relate this issue to the size of banks – there is no reason why a bank cannot be both large, and relatively simple in structure.
But it is equally clear that there may come a point when the complexity of the corporate structure or business model of a bank becomes a real concern to those with responsibility for maintaining the stability of the system.
This is where we find the case for ‘living wills’; the need for firms to plan for their own demise, as morbid as that may sound, through a resolution plan. It is in the interests of firms that the industry protects itself from the fall out of a crisis, starting with the presumption that they themselves could be at the centre of one.
The Government began the debate in this crucial area back in January 2008, and it has since gathered pace rapidly. The FSA will be publishing a discussion paper tomorrow setting out their approach to living wills, including an ambitious timetable for implementation. Living wills will be crucial in addressing the market failure that comes with a perception that a firm is ‘too big to fail’. Such moral hazard has an adverse effect on competition and the effective operation of our markets.
There are three levels on which Living Wills should function.
Firstly, pre-resolution. By that I mean that prior to a firm getting into difficulties, these plans should help to identify where firms can usefully restructure their operations to help avoid failure, or to limit the damage should this be unavoidable.
Secondly, in resolution. If problems do arise, these plans should be practical blueprints to aid authorities in enacting an effective resolution.
And thirdly, post-resolution, to help smooth out problems in the aftermath of problems occurring, providing continuity and certainty to the markets.
It is in the taxpayers’ interest if a firm finds itself in significant trouble, that a manual exists to deal with difficulties and, if necessary, unwind painlessly, without recourse to public funds. This is again something the Governor discussed earlier this week. While neither he nor I are proposing a return to a ‘Glass Steagall’ style regime, which would fail to address the complexities of modern markets and the inter-dependence of activities, the need to ‘carve out’ riskier aspects of a firm’s activities in the event of a wind-up is clear, if we are to limit contagion or severe economic damage.
Living wills will be an important supervisory tool in ensuring that banks do not become so complex that they cannot be allowed to fail in a way that is manageable for the rest of the system. And, in future, they will be a vital part of the prudential regulatory toolkit, allowing the FSA to better assess the riskiness of firms, and set their capital requirements accordingly. The process of capital setting will clearly be a vital component – banks will need more and better quality capital; systemically important banks will require a further increment of capital and the most risky aspects of banking will need the support of a multiple of the existing capital requirements – a process which will itself lead to a significant reduction in the profitability of “casino banking”, and its ability to pay high bonuses.
Long-term, the impact of this approach is that it should provide incentives for firms to dismantle corporate or capital structures that might have been developed to exploit tax or regulatory arbitrage.
I am not here to ‘bash bankers’. The vast majority of people working in banking are in branches and service centres on moderate earnings, with little or no bonus potential. And I have already reiterated this Government’s commitment to the sector.
Banking for some has become detached from a proper sense of ethical behaviour and awareness of the common good. Reform of the banking sector should not and cannot be left solely to bankers and regulators; society has, and must continue, to engage in the process. It is important to remember that arguments about banking reform are not just technical; they directly influence people’s lives and livelihoods.
The past year taught us some harsh lessons. Harsh; but necessary lessons. We – and I mean all of us – need to take seriously the responsibilities we have for rebuilding a sustainable banking sector, serving the interests of shareholders and society. Self-interest and the interests of society are not mutually exclusive; indeed, in seeking long-term growth, self –interest and the wider interest need to be much more closely aligned.
There is a real window of opportunity for the banking industry to work in partnership with Government and regulators in enacting and sustaining the crucial reforms that are to come over the next few years.
And we must remember that we do so under the microscope of public scrutiny. The next few months will set the blueprint for public perceptions of the banking industry for decades to come. The taxpayer will not be taken for a goostrumnoodle a second time – nor should they be allowed to.
I commend the industry for taking the first steps, and urge them to continue the journey.
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