February 20, 2019

The days between the collapse of Lehman Brothers on 15 September 2008 and the Government’s second bailout of the Royal Bank of Scotland on 3 November 2009 were a torrid and gut-wrenching time. For a few tense weeks, it seemed that we – the Western world, I mean – were teetering on the brink of an economic Armageddon. Then, Gordon Brown stepped in and saved the world – or so we were led to believe anyway.

The trouble is that the Kirkcaldy and Cowdenbeath MP’s “comprehensive bank rescue plan” (he didn’t like calling it a bailout) may have ensured the banks’ survival, but it did not do enough to reform them. It let the bankers off scot-free, saving them from the consequences of their own folly, mismanagement, and greed. Instead of triggering some much needed soul-searching, the bailout encouraged them to get back to business as usual, as quickly as possible – which essentially meant acting as if they were above the law.

In the process it hard-wired risk and moral hazard into the UK financial system, and made the banks no less likely to trigger another financial crisis.

The overall cost of Brown’s rescue plan was £1.3 trillion. This included the world’s costliest bailout – the injection of £45.5 billion of taxpayers’ money into the insolvent Royal bank of Scotland, of which at least £26 billion has been lost forever. It was the collapse of RBS, plus those of the former building societies Northern Rock, Alliance and Leicester, Bradford and Bingley and HBOS, that fuelled the UK’s longest and deepest recession since the Second World War. The property market reeled, the FTSE-100 sank to 3,665.2 (almost half its value today) and UK unemployment soared to nearly 2.5 million. During 2009 there was even talk we might be on the cusp of a 1930s-style slump.

In the throes of this economic carnage, I was expecting the UK government and its regulators to propose radical reforms to ensure that the UK’s corrupt and broken financial system did not get back to its old tricks of inflating unsustainable asset price bubbles and taking customers for a ride. Possible themes for reform might have included breaking up the UK’s five or so ‘too big to fail’ banks, forcing banks to retain much higher levels of capital, driving greater diversity of ownership in the banking and financial sector, and, perhaps most importantly, removing the flawed incentives.

Instead, Brown’s Government appeared to have zero appetite for substantive reform, failing to attach any meaningful conditions to the bailouts of 2007-9. Perhaps, having championed a bank-friendly ‘light touch’ regulatory regime for years, and having imagined that in their unfettered Nietzschean state the banks would bring a ‘new golden age’ to the UK, Brown was simply too shell-shocked to lead any campaign for reform. Rather than the nirvana he envisaged, his policies had brought nothing but economic carnage and social disaster.

The banks’ failure to grasp the need to change their behaviour was revealed in the shocking scandals – including Libor rigging, foreign exchange market rigging, and the trashing of business customers by RBS’s global restructuring group – which carried on long after the crash.

We had to wait until the arrival of David Cameron as prime minister in May 2010 before any real attempts at reform were made. Cameron’s first stab at it was the Independent Commission on Banking, led by Sir John Vickers. From the Government’s perspective this handily kicked the problem of what to do about the banks into the long grass. Amid all the furore over bankers’ bonuses and Fred Goodwin’s pension, it meant that whenever Cameron, George Osborne or cabinet colleagues were asked what they were doing about the banks, they could respond that they were awaiting Vickers’s findings.

In the end the ICB’s main recommendation – that each relevant bank erect a “ringfence” between its “utility” businesses (its supposedly lower risk, high-street and commercial banking operations) and its “casino” businesses (investment banking activities, including gambling complex and opaque derivatives on global financial markets) – was a good idea in theory, but in practice it has been a let-down.

The proposal was watered down following lobbying by the banking sector. The deadline for putting in place the ringfence was last month, but there is a risk that the division will end up being rather porous – meaning capital, liquidity and assets can flow through it – at times of extreme financial stress. It has turned out to be an elegant but costly fudge that’s unlikely to make a huge difference to the culture or behaviour inside the UK banking sector.

At least one of the reforms that were pushed through by the former Chancellor of the Exchequer George Osborne has, however, had some success. Following what is called a ‘twin peaks’ approach to regulation, Osborne split the Financial Services Authority (the failed regulator that Tony Blair’s Government had launched in 2001) in two. A new Prudential Regulation Authority (PRA) become part of the Bank of England, taking charge of high level and systemic issues, and a new Financial Conduct Authority (FCA) was formed to take care of misconduct in the finance sector.

So far, the PRA has been a hundred times more effective at monitoring and addressing systemic weaknesses (such as identifying and forcing banks to replenish a capital hole) than the previous regime was.

The FCA, however, is showing dangerous signs of being ‘captured’ by the sector it purports to regulate, just as its predecessor was. It doesn’t help that its inaugural chairman was the former boss of KPMG in Europe, and its current chairman, Charles Randell, was a ‘magic circle’ lawyer who has been involved with a dodgy tax avoidance scheme.

Some experts think we’re in an even more precarious position now than pre-crash. Kevin Dowd, professor of finance and economics at the University of Durham, recently told me that while the post-crisis policies including the bailouts and QE held the system together in the short term, they have done so “at the expense of aggravating the underlying problems, including regulatory inducements to excessive risk-taking. These policy responses make a new crisis inevitable.”

The macroprudential approach to systemic issues that’s been adopted by the PRA, he told me, “unwisely presumes that policymakers have the incentive and the ability to time the economic cycle”. He also said that because leverage in the banking sector is, in market value terms, even higher than it was in 2007, banks are even more vulnerable than they were then.

“I am fairly confident that the next crisis will be worse than the last: banks are weaker, debt levels higher, there is more hidden risk, policymakers have less room to move than they had before, etc.” Not very reassuring then.

Steve Keen, professor of economics at Kingston University London, said the post-crisis reforms are bound to fail because the policymakers, regulators and economists who put them together “fundamentally misunderstand the role of credit in an economy”. He believes they still equate credit with the “lubricating oil inside an engine” and invariably regarded the crisis as “the engine seizing up because it ran out of lubricant”.

In fact, he said, they should view credit as fuel, and recognise that sudden increases or decreases in supply tend to prove disastrous. It is a fundamental misunderstanding that has driven deeply flawed remedies, argues Keen.

If anyone was serious about ensuring there is no rerun of the crisis of 2008, they would have urgently reformed the accountancy sector. One of the things that fuelled the banking collapses of 2008 was that the banks were basing their accounts on International Financial Reporting Standards, introduced in January 2005. But these numbers flattered their balance sheets in myriad ways and meant that some banks believed they were solvent when in fact they were bust – they were flying through a thunder storm with faulty instruments.

Yet the pace of change in the accountancy profession has been glacial. The now disbanded regulator the Financial Reporting Council refused for years even to look at bank audits – like KPMG’s audits of failed Edinburgh-based banking giant HBOS – largely because it didn’t want to open a can of worms. In a recent submission to the Business, Innovation and Skills committee’s ‘Future of Audit’ inquiry, Tim Bush and Alan MacDougall of Pensions & Investment Research Consultants said there remains “a cartel” in the audit market in which “pervasive conflicts” are undermining auditors’ scepticism.

There have been some post-crisis tweaks to the accounting rules, but these have been insufficient to ensure investors can get a clear picture of banks’ balance sheets and capital ratios. Financial Times City editor Jonathan Ford recently wrote that behind the confident façades presented by banks’ directors, auditors and regulators, the sector remains an impenetrable black box. “Accounting is supposed to paint a picture that allows investors to assess the current valuation of a company. But in the topsy-turvy world of banks, it can conceal more than it reveals ”. In short, banks’ balance sheets are no less opaque than they were in 2008.

Perhaps most galling for taxpayers is the lack of punishment of those responsible for the unprecedented tide of financial crimes committed from the early 1990s to the mid-2010s. There have been a string of massive penalties, including ‘no fault’ out-of-court settlements with regulators and deferred prosecution agreements with the US Department of Justice – including a $4.9 billion settlement for state-rescued RBS over the “misselling” of about $32 billion worth of toxic mortgage backed securities. But the trouble with such deals is it is the shareholders, not individual bankers, who bear the cost.

Increasingly it seems the banks treat fines as a cost of doing business, a bit like a speeding motorist treats a speeding ticket. They pay the fine, accept the points on their licence, then quickly get back to doing 110 mph. If you really want to punish and deter bad behaviour inside a bank or corporation, you should be penalising the individuals who committed it.

One of the sensible reforms introduced since May 2010, the Senior Managers Regime, was supposed to address precisely this issue by making it easier to hold individuals to account for wrongdoing that occurs on their watch. It seeks to eliminate the time-honoured ‘Murder on the Orient Express’ defence in which bankers erect an accountability firewall by claiming they ‘all did it’. The senior managers’ regime also ushered in the new criminal offence of reckless mismanagement of a bank, for which the maximum sentence is seven years in jail.

Pathetically, the FCA said it was unable to really do much, as commercial lending was “outside the perimeter of our regulatory powers”. It seems a spurious excuse, not least because the FCA has imposed hundreds of millions of pounds in fines on British and international banks for Libor rigging, which is also an unregulated activity.

Speaking at the Finance Watch conference in 2015 Robert Jenkins, ex-member of the Bank of England’s Financial Policy Committee and adjunct professor at London Business School, said it’s no surprise that the public has lost trust in finance. “If wrongdoing is left unpunished, much less rewarded, then we deserve what we get.”

He added, “without better behaviour we cannot have faith in the market that underpins it. Without penalising the perpetrators and their seniors we will not get better behaviour. And without greater courage from policymakers and regulators, we will get none of the above and more of the same. When timidity triumphs, the taxpayer pays. Alas, timidity is the order of the day.”

David Cameron’s “we’re all in this together” has a hollow ring to it, given that the Government was involved in RBS’s 2008-2013 campaign to lay waste to many of its SME clients.

By focusing on rescue rather than cure, the Labour government missed an unprecedented opportunity to force through change but it instead entrenched bad habits. The financial system, says Mervyn King in The End of Alchemy, published 2016, even after all these reform efforts, remains wired so that a handful of well-connected people capture the benefits from risk-taking, while society as a whole bears the cost.