9 February 2015

Megabanks are too big to fail, bail and jail


Banks will continue to go bust from time to time just as banks will continue periodically to get themselves into trouble that stops short of collapse. They are, after all, run by human beings. All the regulation and micromanagement in the world will not eliminate the human tendency to over-excitement in a boom and the risk of a minority of participants behaving stupidly, unethically or illegally.

But that is not to say that there are no lessons to be learned from the epoch-defining financial crisis of 2007 and 2008. One of the central  lessons – in my view as a non-specialist who immersed himself in banking to write a book on the fall and rescue by taxpayers of the £2trillion Royal Bank of Scotland – is about the role of excessive scale and complexity.

Declaration of interest: Since my book on banking came out in late 2013 I have spoken to several of the biggest banks and other financial institutions at their management conferences about the lessons of the crisis. Encouragingly, some CEOs and boards are interested in hearing about the risks of leaders facing too little challenge.

One of the central points about the crisis is surely that if banks have always gone bust, and always will, it matters a great deal how big they are (as well as how they are run). In the UK, the fall of Barings in 1995 was an extraordinarily dramatic story. But at no point did it pose an existential threat to the UK or global economy. Certainly, it was embarrassing for the Barings management and UK authorities but it went bust for the sake of less than £850m (a rounding error now). Nick Leeson, the trader at the heart of the scandal, was imprisoned.

However, if a bank such as RBS has a balance sheet (total assets, meaning loans and assorted other activities) of more than £1.9 trillion, a sum in 2008 bigger by several hundred billion than UK GDP, its potential collapse obviously poses a problem of an entirely different order to that of Barings. Shortly after the crisis, the five UK clearing banks had balance sheets totalling £6.24 trillion or 450% of UK GDP.

Opt not to bail out RBS and the Treasury and Bank of England knew that the collapse of the payment system – on which supermarkets and the food supply chain rests – was highly likely. But bail it out, as they did, and it ends up costing £45.2bn (a sum the taxpayer is unlikely to ever get back in full.) Afterwards, you are suddenly in the territory of politicians such as Vince Cable and central bankers trying to micromanage the banking system, which is bad for the creation of credit and a threat to economic freedom. It risks crony capitalism and corporatism.

Then, if the banks are that big and systemically important it is very likely that politicians (who loved the tax that megabanks paid before the crash and became close to bank bosses) will not have been minded to create a legal framework in which the hitherto highly valued bosses of those banks go to prison if their institutions fail. You might say that it should not be this way and that the scale of these institutions means that the person at the top should go to prison when the organisation goes bust. But that would criminalise potential failure, an essential component of capitalism which to work requires risk and innovation. And then there is the question of whether anyone – no matter how smart – can really know everything that goes on inside an organisation with hundreds of thousands of employees spread over continents and whether they can realistically be prosecuted for not knowing.

In this way, megabanks are not only too big to fail. They are also too big to bail (without damaging consequences) and jail (fairly) if something goes wrong.

Now HSBC, one of the world’s leading banks, is under more fire over accusations about its activities before the financial crisis.

The BBC reports that:

“Britain’s biggest bank helped wealthy clients cheat the UK out of millions of pounds in tax, the BBC has learned. Panorama (the BBC current affairs show) has seen thousands of accounts from HSBC’s private bank in Switzerland leaked by a whistleblower in 2007. They show bankers helped clients evade tax and offered deals to help tax dodgers stay ahead of the law.

HSBC admitted that some individuals took advantage of bank secrecy to hold undeclared accounts. But it said it has now “fundamentally changed”. The documents, stolen in 2007 by computer expert Herve Falciani working for HSBC in Geneva, contain details of more than 100,000 clients from around the world.

Offshore accounts are not illegal, but many people use them to hide cash from the tax authorities. And while tax avoidance is perfectly legal, deliberately hiding money to evade tax is not. The French authorities assessed the stolen data and concluded in 2013 that 99.8% of their citizens on the list were probably evading tax.”

Stephen Green, now Lord Green, is the perfect illustration of the flaws inherent in the megabank model that was seen before the crisis as the highly desirable state of the art goal of consolidation and banking globalisation.

Green is – according to those who know him – a bright, hardworking and highly ethical individual. But even he couldn’t control an institution that vast and complex.

Many people are still angry and seem to have a difficult time believing this about those who ran the banks in the run-up to the crisis. The leaders such as Green must always have known all that bad stuff! Why? Because, they must, because… And they took the bonuses, so it doesn’t matter if they knew or not. Really?

Think of it this way. Want to imagine one of the more vulnerable megabanks such as RBS before the crisis? Imagine an already vast government department, such as the US Department of Agriculture or the Home Office in the UK.

Now imagine it with it hundreds of thousands of employees scattered in myriad businesses over several continents in more than 50 countries, with many of them set aggressive targets to grow areas such as mortgage securitisation that the busy CEO doesn’t understand (until it is too late).

Next, imagine computer systems that are less impressive than those of the Home Office (it is possible; it was at RBS) that have been patched together to save money as the rapidly expanding bank acquires rivals.

Next, give it a balance sheet bigger than the UK economy and  reduce its number of domestic competitors. Then give its chief executive a knighthood. Get the Governor of the Bank of England to focus on narrow inflation targeting rather than the stability of the financial system.

Finally, make a man Chancellor and then Prime Minister who thought that he could end “boom’n’bust” and then made the economic and political weather accordingly for a decade. What could possibly go wrong? Or rather, what is interesting is that most of us were at all surprised when it went so spectacularly wrong.

The answers are not simple, and anyone who tells you they have a master plan that will solve it all is even more deluded than Gordon Brown. But smaller institutions, and more of them, competing for custom should surely be a big part of improving the situation. More competition is required in banking.

Iain Martin is the editor of CapX and author of Making it Happen: Fred Goodwin, RBS and the men who blew up the British economy.