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Fixing the banks

Is there something rotten in the culture of banking today?  That is the question that a Parliamentary Commission under Andrew Tyrie MP has begun to address.

In the evidence that we submitted to the Commission last week, the IMA argued that the fundamental problems are of structure and incentives.  In the immediate aftermath of the credit crisis in 2007-08, many senior investment managers felt the time had now come for radical reform of the banking sector, and recent events, including the Libor scandal, have tended to reinforce that view.  

What is the interest of investment managers in this?  First, investment managers are dealing daily with the banks, which are key intermediaries in buying and selling investments.  Trust is all-important, and the Libor scandal has done immense damage there.  Equally, investment managers also depend upon banks to provide liquidity to the market, which means putting capital at risk.  Make the banks too safe and there is a question as to whether markets will function properly.

But second, banks are an important part of many investment portfolios.  The problem is not that they have proven highly risky investments – managers can cope with risk so long as they understand it.  But banks have become so opaque that many find it very difficult to understand the risks of investing in them and how therefore they should figure in client portfolios.

Reform, probably structural reform, is needed to sort these issues out.  Frustratingly, though, the response of regulators, particularly at EU level (where most of the regulation comes from these days), has consistently failed to address the fundamental points.  We have had measures on everything under the sun from hedge funds to short selling, and now new anti market abuse provisions to deal with situations like the Libor episode.

These are all very interesting, but amount to addressing the symptoms not the cause.  While debate continues about the contribution of regulators and of monetary policy, there is no doubt that the conduct of the banks, together with the incentives underlying that conduct, were key factors in what has happened with the banks and the economy over the last 5 years.

These incentives need to be addressed, including the business models of many banks, the impact on funding costs of the implicit (or these days not-so-implicit) Government guarantees they enjoy, and accounting rules which no longer err on the side of prudence.

Questions need to be asked about the “universal banking” model under which banks not only transact with their customers but also purport to offer advice and guidance.  There is an inherent conflict of interest between the two if you are holding yourself out as offering a service while in reality treating your customer as an equal party to a transaction.  The UK has begun to address this through the recommendations of the Vickers Commission, as has the US with the Dodd-Frank Act and the so-called “Volcker Rule”.  But there seems to be reluctance in the European Commission to take this on.  This perhaps reflects the very entrenched role that universal banks play in continental Europe.  But until it is addressed, the response to the crisis will remain superficial and the root causes will not be tackled.

In our paper to the Commission we express support for the Vickers recommendations for “ring-fencing” retail operations of banks, and indeed for beefing up the Government’s present proposals for implementing them.  We should not be deterred by European inactivity on this front and should press on with reform.

 

Richard Saunders
Chief Executive, IMA

29 August 2012

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Richard Saunders
Chief Executive, IMA

Investment management association

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