Banking Reform: Where Vickers Failed

The Professor of Economics at Boston University bristles at the mention of Sir John Vickers and the UK’s Independent Commission on Banking: “I think what they have done is a disgrace and they have brought shame on their country.” In Larry Kotlikoff’s view, the recommendations of the Vickers report will do nothing to halt a repeat of the misdemeanours that triggered the 2008 global financial meltdown which is still reverberating three years later. Instead, the commission has played to the vested interests of the banking industry.

“The financial crisis was not caused by a lack of liquidity. It was caused by the fraudulent manufacture of securities. Everyone suspected that banks were holding a load of crap, and when they got found out, there was a rush to the exit that caused the crisis,” he says.

If Kotlikoff sounds like he has an axe to grind, it’s because he has. Since the financial crisis, he has argued for the banking system to be fixed; it needs root and branch reform that eliminates proprietary information and leverage. In other words, stop banks from borrowing to take positions in financial instruments that they are not forced to disclose. Once you do that, you can stamp out fraud and re-instate trust in the system.

“It’s like the drugs industry in the US used to be, where people would sell pink liquid as some kind of elixir that turned out to be radioactive. The people who sold it got rich, meanwhile, you’re dead. Then Teddy Roosevelt introduced the Food & Drug Administration (FDA) in 1906 and suddenly you couldn’t lie about what you were producing anymore. Information is a public good.” Kotlikoff has a number of prominent supporters, not least Mervyn King, governor of the Bank of England, who raised eyebrows in the City of London at the end of 2009, when he boldly told an audience at London’s Mansion House: “Of all the many ways of organising banking, the worst is the one we have today.”

King publicly backed Kotlikoff’s views at a Commons select committee in 2010 and it was on the governor’s recommendation that Kotlikoff flew to London last autumn for an audience with the Independent Banking Commission as part of its consultation process. Vickers did not attend the meeting, but Bill Winters, the former boss of JP Morgan’s European operations, was present for what was an interesting conversation.

“What I proposed is not complicated, and it’s not utopia,” says Kotlikoff. “It already happens in the US and it’s called the mutual fund industry.”

Kotlikoff’s solution to the banking crisis is what he calls ‘limited purpose banking’. Under this structure, a bank’s checking account would convert to a mutual fund in which people invest in closed-end securities funds, which are vetted by a central regulator similar to the FDA. Banks would simply have no proprietary positions and would revert to their traditional role of acting solely as an intermediary matching buyers and sellers. The rest of their investment banking operations, such as providing advice on mergers and acquisitions, would convert to consulting businesses. Investors could still lose money, but they would know what they were betting on and banks would disclose their daily trading positions.

These reforms – set out in his book Jimmy Stewart is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking – are in place to protect taxpayers’ deposits from the “hucksters and snake-oil men” who take risks with those retail deposits. His arguments for protecting deposits by banning banks from lending money not matched in cash reserves would bring down the curtain on what Kotlikoff calls “trust me” banking and, paradoxically, re-instate trust in the banking system.

Alas, the ICB dismissed Kotlikoff’s model in two sentences: “While some of these proposals have sensible aims and could be welcome developments if banks chose to adopt them, the benefits of mandating these structures across the sector do not appear to outweigh the costs and risks. Accordingly, the Commission does not propose to pursue them further.”

Undaunted, the professor has recently been to Dublin and met Patrick Honahan. “I think somebody is going to adopt this. It’s not that radical and 30% of the US financial system is already in mutual funds. Denmark already has this system.”

The Professor’s thinking proved too rich for the City of London’s conservative palate, although senior finance professionals see it differently. Guy Davies, a former banker and now a partner at City executive search firm Hogarth Davies Lloyd, says: “Some of the trust broke down with the expansion of the multi-product global investment banks. I believe one of the consequences of the credit crisis is that some banks are trying to reposition themselves with an increasing focus once again on being trusted advisers which is, in part, represented in the emergence of several boutique investment banks attempting to differentiate themselves with the offer of independent advice.”

Advocates of a more open City say the City’s transformation from Oxbridge elite to global meritocracy is down to light-touch regulation and a system in which people want to forge careers. Certainly, in terms of diversity, the City has come a long way in a short space of time.

A little over a decade ago, partners at Cazenove could only be referred to by their initials, while button-collared shirts were regarded as a no-no. When US bank JP Morgan Chase bought a stake in Cazenove six years ago, one of the things it did was to establish a diversity programme. The joke doing the rounds at the time was that Cazenove already boasted a diverse employee base – it had staff from Cambridge and Oxford.

Just as Barbarians at the Gate, the book that gave a lurid account of banking excess on Wall Street in the 1980s, attracted a generation of bankers now in their 40s, so the financial crisis may have made a career in banking more – not less – exciting. A survey carried out a year into the financial crisis in 2009 by the careers office and students’ union of Oxford University revealed that not one of the 500 respondents regarded banks as ethical and only 15% of respondents felt the industry was ‘supportive of society.’

Despite, or perhaps because of, this searing indictment of the City’s morals, there was no sign of a drop in demand from students eager to forge a career in derivatives, insurance, asset management or investment banking. Certainly not at Oxford University, where 99% said the pay was excellent, and 100% said it offered a clear path to promotion. 

Opponents of radical reform of the banking system argue it would kill innovation and force a brain-drain from London to more vibrant financial centres such as Singapore and Hong Kong. If anything, the City’s ability to survive cataclysms such as the global crisis of 2008 is down to its paradoxical cocktail of pin-striped conservatism and open-minded innovation.

And survive they have, with a level of panache that would have even Bear Grylls doffing his trapper. It is hard to imagine another industry that would bring the world economy to its knees, receive billions in taxpayer bailouts and despite receiving the opprobrium of politicians and regulators, carry on and award themselves a pay rise.

As regulators clamped down on the bonus culture that encouraged short-term risk-taking, banks responded by doubling the salaries of staff in order to retain top performers. The basic pay of managing directors at the bigger banks has now jumped to £300,000 from £150,000 before the crisis.

Guy Davies adds: “Banks are trying to find ways of ensuring they can continue to pay their top employees as competitively as possible while staying within the prevailing (and continuously changing) regulatory framework. Clearly in so doing they are also keen to give themselves the best chance of continuing to attract new, young graduates.”

When taken out of context, such figures simply fan the flames of banker bashing, which if it became an Olympic sport, would guarantee a bullion van-load of British gold medals at London 2012. Bankers are used to being masters of the universe, and they have not taken kindly to the anger heaped upon them. When Bob Diamond, the boss of Barclays, told a Commons select committee that “the time for remorse was over,” he was accused of staggering arrogance. The unilateral loathing of bankers is not helping the reform debate, or the UK economy, which benefits from the strength of the financial service industry. And it’s true the vast majority of bank staff did not cause the crisis, a point that the Financial Services Authority has emphasised by only applying stringent pay reform to what it calls ‘code staff’ – people who have responsibility for taking risk.

The City’s argument is that while a lack of regulation caused the crisis, a new system shaped by excessive regulation will damage the City and by extension the UK. Leading City bankers point out the regulatory playing field is uneven and that far from giving the industry an easy ride, the UK is suffering because draconian pay curbs are yet to be adopted on Wall Street, or indeed in Asia, where the financial crisis is largely regarded as a western phenomenon.

“Mervyn was speaking as a central banker and central bankers would like to see the industry simplified because it is easier to understand and regulate,” says one prominent UK banker who has worked at the Treasury. As the hub of global capitalism, the mantra of the banking industry is that its continuing relevance and development are driven by market forces.

“The City is a service industry, and the complexity that exists within it today comes from the clients it serves,” the banker adds. “Clients like that complexity, they like getting the products they get from under a single roof.”

The City, like the cranes that soar above it as they shape the future, is constantly evolving and its advocates call for greater, not less flexibility. Despite the consequences of the financial crisis, the damage wrought upon the City of London either by increased taxes or greater regulation, not to mention the reputational damage, has done little to detract from its allure.

In March, the ninth annual global financial centres’ index placed London in pole position in a survey of 79 cities for the fifth consecutive year. The report, compiled by consultants Y-Zen Group with the co-operation of the City of London Corporation, struck a cautious tone arguing the City should not rest on its laurels with the continuing emergence of Hong Kong and Shanghai.

To this end, bankers welcomed the visit of the Chinese Prime Minister in July and many believe the key to the City’s ongoing relevance will be driven by its ability to attract China’s leading banks to London. With its time zone, popular international language, established market and, until recently, light-touch regulation, London remains hard to beat.

In the report’s foreword, Sir Michael Snyder, Chairman of the UK Government’s Professional and Business Services Group, urged “Government, regulators, professional, financial and trade bodies [to be] bold and innovative in the measures that are needed to keep the City internationally competitive.”

That chimes with recommendations from the ICB, which stop short of breaking up banks’ retail and investment arms, calling instead for a “ring-fencing” of retail operations, so they are protected from the fall-out when bets go wrong in the investment banking divisions.

Banks and regulators differ on radical reform. Regulators prefer an overhaul of the system to make it safer; banks regard any departure from the status quo as upheaval. Either way, the brave new city emerging from the rubble of the financial crisis is looking as exciting, cosmopolitan, vibrant – and risky – as ever.