I can still remember as a child, the English bank manager was the pillar of the community.
He was a most respected and trusted person because he took a deep personal interest in the people to whom he lent money; always making sure that the borrowers could repay; refusing to lend to people who could not afford to borrow. He knew his customers very well, was often a family friend, believing he and his bank did well when his customer benefited from the relationship. It was a win-win’ world most of the time, based on trust and the industry had the support of the public and regulators.
Financial services innovation brought us the credit card, allowing more people to live their dreams and to limit the amount of cash people had to carry with them. Banks invented securitisation, allowing companies to invest with greater flexibility by bringing forward the returns from future cash flows. The use of options and derivatives reduced risk for genuine trades based on underlying transactions. Above all, banks served their purpose as conduits for excess money from savers to cash-starved investors, allowing economies to grow and people to get richer.
Then we had the era of low interest rates because of Alan Greenspan’s attempts to keep the US economy going after the dotcom bust in 2001 and 9/11. This period of low interest rates and excess liquidity drove investors and bankers to hunt for yield to meet the unsustainably high returns investors demanded of bank CEOs and their boards. CEO pay was linked to ROE, encouraging CEOs to gamble recklessly with leverage, using the rapidly growing derivatives markets, which were given wrong ratings by conflicted credit rating agencies.
The resulting behaviour of banks, in particular investment banks, led to reckless disregard for the systemic risk they posed, destroying the trust the public, politicians and regulators in the UK and US had in banks. In last year’s Edelman Trust barometer’, five out six people in the UK and three out of four in the US did not trust their bank to “do the right thing”. That was before the Barclays LIBOR scandal, the JP Morgan “London Whale” surprise loss and HSBC’s money laundering problems. I dread to think what the scores will be for 2012!
Yet the dramatic fall from favour in the UK in 2011 is not surprising given the enormous fines the leading banks and insurance companies are paying for mis-selling products to retail clients, fines totalling £8bil at the last count. Add the enormous pay packages bankers were awarding themselves after they had brought the global economy to its knees, costing millions of hardworking people their jobs and everybody a need to tighten their belts packages which bore no relationship to the value created for investors – and I understand why they fell from favour.
THE PILLARS OF CAPITALISM
What happened to the concept of trust? After all, few industries depend more on trust than financial services where a stranger asks you to give him your money so he can make you richer as a result of his advice and the skills of the bank’s investment department. I think there are four reasons for this decline in the trustworthiness of Western banks.
First, the three pillars of capitalism – deferred gratification, mutuality and trust have been weakened by changes in what is offered and how it is offered. Deferred gratification is the basis of investment: we invest today for something better tomorrow. I grew up with the saying “Anything that is worth having is worth waiting for”. Unfortunately the invention of the credit card destroyed that belief. The original advertisement for Access, one of the first two credit cards in England put it bluntly: “We take the waiting out of wanting!” Mutuality assumes you will treat people the way you want to be treated. It depends on long term personal relationships because bad behaviour will destroy the relationship so people avoid upsetting each other. When a relationship is impersonal or one-off, bad behaviour does not get punished because there is no possibility of pay-back. As banks did away with branches and replaced them with ATMs and e-enabled transactions, relationships became impersonal. Increasingly people could get away with bad behaviour because they no longer knew each other. The subprime value chain undermined the last element of trust because it was built on the “greater fool theory of finance” a kind of musical chairs where toxic assets were passed from one company to another so nobody felt responsible for or understood the creditworthiness of the underlying asset. This was made possible by credit rating agencies rating junk as Triple A. Finally commission selling creates such pressure on bank sales forces it is not surprising there have been mis-selling scandals.
Second, the culture of banks in the West seems to have become really toxic so regulators, commentators and legislators in both the US and the UK are calling for a need to fix it. A recent survey of 500 top managers of banks in Wall Street and London shows just how toxic: 39% believed their competitors had behaved unethically or illegally; 26% said they had first-hand experience of unethical or illegal behaviour; 24% believed they had to be unethical to succeed in financial services; and 30% said that this was because of remuneration.
Third, was it perhaps a mistake to combine different types of business in the attempt to create financial supermarkets? Life assurance was combined with branch banking because it was a cost effective way of distributing products through the branch. Yet nobody thought about the brand implications of combining highly respected retail banking with selling life assurance an industry which, in the UK at least, was regarded as on a par with used car selling for trustworthiness. Investment banking was combined with deposit taking so that they could get access to the huge balance sheets of deposit takers and use leverage to raise ROE.
The original idea was that commercial bankers would control investment bankers and keep the system safe. In practice, however, the investment bankers won and took over leadership positions in the combined banks introducing a different culture. As a result both customers and shareholders suffered because financial innovation became less customer-centric than it had been in the past.
In the words of Nobel Laureate, Joseph Stiglitz: “Innovation means greater customer satisfaction at lower prices, except in financial services where it means more opacity and higher fees”.
Investors have also fared badly as is shown by the big US banking conglomerates’ market capitalisation being worth less than their book value.
Finally, pay seems to have risen remarkably fast in banking and the result seems to have been to reward short term risky behaviour without due regard for the long term consequences of front-end loaded business, making short term profits with long tail losses.
Could Malaysia face the same problems? It depends on whether there are banks deemed too big to fail’ which then take excessive risks with their balance sheets because of the implicit government guarantee.
It depends on CEO KPIs and how they are set. If KPIs reward excessive short term risk taking at the expense of long term sustainability, then we should not be surprised if there are problems. It also depends on whether the pressure of commission selling undermines the effectiveness of banks’ Know Your Customer’ policies.
Above all, it depends on banks adhering to their own risk management and compliance policies and not violating them.
Making sure the compliance and risk management functions have the power they need and that the policies are followed in practice is the role of the CEO supported by the board, as was made abundantly clear to the chairman of Barclays during the Parliamentary hearings into the LIBOR case and the Congressional hearings into the HSBC case.
As was pointed out time and again it is the responsibility of the board to ensure the soundness of the culture and Tone at the Top’. This is just as true in Malaysia as it is in the UK.
Preventing a replay in Malaysia of the scandals plaguing banks in the West is the responsibility of bank boards, guided by Bank Negara supervision. It is a heavy responsibility given the systemic impact of bank scandals.
Photo credit: Flickr user epSos.de