by Iain Martin
When it was happening the growth was hailed widely as evidence of the UK’s supreme success as a financial centre, although little attention was paid to the size of balance sheets or the implications if there were ever a major economic reverse. It was all deemed to be a tremendous innovation – until the banking system blew up. Whereas previously the failure of a major bank would have been a serious but manageable event for the authorities, now the biggest banks were operating on such an incredible scale that if one fell over it threatened the rest of the banking system and the entire economy.
Who decided this experiment was a good idea? The Left blames what happened on the deregulation of the 1980s and on reckless bank CEOs such as Fred Goodwin, which is the ‘they started it’ defence. The Right blames the badly designed regulation of the post-1997 period and the addiction to private sector and then public debt. To borrow a phrase sometimes used in the City, both sides are ‘talking their own book’, that is talking up their own position and refusing to acknowledge that the crisis presents a challenge to their worldview.
While it is true that the chronic difficulties the banks helped create in 2007 to 2008 led to the economy freezing up, from which flowed large annual deficits and a ballooning total national debt, it is not credible for members of the Labour government of that period to present themselves as innocents knocked off their feet by global forces. When the times were good Labour leaders feted the banks and knighted those who ran them. Indeed, they enjoyed spending the tax revenues which came from financial services and even publicly attributed the nation’s success in large part to their own policies. Gordon Brown claimed to have ended boom and bust. Of course the British banking boom was also facilitated by the international authorities devising rules that made it easier for banks to expand their activities globally, increase leverage and grow profits. But the fuel – the petrol poured on the fire by policymakers that made it all possible – was excessive cheap money.
The Conservatives, and Thatcherites, can hardly escape responsibility either. Tory politicians tend to blame the disaster almost entirely on Tony Blair and Gordon Brown’s Labour government, saying that it was spending too much and not regulating the banks properly. For public consumption some add in a little light ‘banker-bashing’ in case the outraged taxpayer – who pays the ultimate bill for the economy blowing up – suspects they are too close to rich men in the City.
It is easy to elide over the decisions contributing to disaster. The rise of British banks such as RBS, and their emergence as cross-border entities that were so big they could do such damage when they got into trouble, did not begin when Gordon Brown became Chancellor. Of course the process accelerated rapidly while he was in office, and he enjoyed the reflected glory that came from the City and the banks being such strong players in the global markets. Nevertheless, the roots of the so-called financialisation of the economy, meaning that banks and financial institutions became such a large part of our national life that their needs gradually became paramount, run deeper than that.
Undoubtedly the UK banking system had needed to change. The 1960s model of banking was too small and underpowered to cope with the demands of a flexible modern economy. Banks and building societies often behaved loftily towards potential borrowers or depositors, as though the customer was lucky to be allowed through the door. But what then happened went beyond modernisation and an attempt to become more responsive to demand. British banking became three things.
First, on the retail side banks turned themselves into selling machines with targets for growth. Traditionally banks were viewed as custodians of customer deposits, now some of them were remodelled as financial supermarkets who sold what they could get away with whether the customer needed it or not. The payment protection insurance racket across the industry is a prime example. Weren’t banks just like any other retailer? As if to prove the point, at the height of the boom HBOS hired a Harvard Business School-trained supermarket executive, Andy Hornby from Asda, to succeed James Crosby as chief executive. It later turned out that banks really are not like supermarkets. They are the conduit for much of the money supply and it is highly problematic when they go bust, particularly if their balance sheet is the size of the country’s economy.
Secondly, the investment banking and to a lesser extent the corporate banking side became an industry with an exotic sheen, where pay and bonuses attracted the brightest who might previously have gone into industry or the professions. Undoubtedly that sprang from the reforms of the 1980s. The instinct that propelled the overhaul of the City was certainly sound in one sense. Contrary to what is sometimes believed in Britain, those reforms did not invent the internationalisation of modern finance, they were partly a response to what was already happening here and elsewhere. Aided by the rapid spread of computerisation and financial innovation, finance was becoming steadily more global. In the Victorian era, London had been the trading capital of the world in terms of real goods as well as finance. If there was a sufficiently radical restructuring of the City in the 1980s, and foreign money and institutions were allowed to flow in and British money to flow out to seek better returns, the Thatcherites hoped London might once again build on its advantage and become the undisputed leader, at least in financial services. While it is true that the ‘Big Bang’ legislation of the 1980s did not directly deal with banking it did enable foreign investment banks to buy City firms and create London-based modern institutions which banks such as RBS rushed to emulate. Big Bang reinvigorated the trading culture and helped create a mania for expansion, scale and takeover. Can anyone credibly argue that those obsessions didn’t seep into mainstream banking and even into those institutions that did not have investment banking arms?
Thirdly, there emerged the idea of the large British bank as an enormous corporation, or mega-bank with a vast headquarters and a dominant personality as CEO. Fred Goodwin wanted RBS to transcend old-fashioned humdrum notions of banking by joining the ranks of transcontinental, globalised big business.
Being too big was not just a problem at RBS, as became clear after the financial crisis. It was revealed that subsidiaries of HSBC, a giant institution that had twice tried to buy the Royal Bank of Scotland and is registered in London but trades mainly outside the UK, had been caught being used by money-launderers and drug dealers while Lord Green was chief executive and chairman. Green, who subsequently became a government minister, knew nothing of this. He is an ordained Church of England vicar and a fine and upstanding individual. He is even the author of a volume entitled: Serving God? Serving Mammon? When the scandal broke, his friend Lord Butler, the former cabinet secretary and a member of the HSBC board for a decade, robustly defended Green in the House of Lords. Perhaps unwittingly, Butler made the case for smaller and more manageable institutions: ‘While it may be the case that the chairman and chief executive officer of a major international company is accountable for everything that happens in that company, there is no possible way in which the chairman and chief executive can be responsible for everything that happens in a worldwide group of the size of HSBC.’2
Quite. But if a bank with the potential to blow up the economy is so large and complex that even its supporters admit people of ability and impeccable moral authority cannot control what it does, then what is the point of it existing in such a form? Should we simply shrug, and say this is just the way of the global economy, get used to it and be ready to stump up for more bailouts in an emergency?
Any argument that not all the big banks screwed up is of limited comfort. Of the UK’s big four, two (RBS and Lloyds) ended up being partially owned by the taxpayer. A third, Barclays, had the luckiest of escapes, coming within a whisker of taking over the toxin-riddled ABN Amro. It subsequently had to seek a recapitalisation from the Gulf. Then the fourth, HSBC, had those money-laundering difficulties. Registered outside the UK, some of those who navigated the sub-prime mortgage crisis most deftly, and were smug as a result, later hit trouble. In 2012 the ultra-safe J. P. Morgan was temporaril
y beached by the ‘London Whale’. Its trading vehicle based in London ran up losses of $6.2bn that stunned those in charge in New York. J. P. Morgan’s celebrated risk-control processes had simply failed.
The scale and potential ungovernability of the biggest banks does not mean that small is always beautiful. Some of the banks and building societies that had to be rescued during the crisis were relatively small, and narrowly focused on particular types of lending, with no investment banking activities. However, the critical difference is that when they went bang the bailouts they demanded were nothing like the £45.2bn shareholding the taxpayer took in the enormous RBS. When a big enough bank explodes, it can help blow up the economy.
Do we want extremely big banks, if they can do this much damage? The argument from the largest banks is, unsurprisingly, that we do need them because their size creates efficiencies of scale.3 Being so big means they can pool services and back-room facilities to create better products and more profit for shareholders. This was the Fred Goodwin model. Since the financial crisis that notion has been challenged, most notably in the UK by Andrew Haldane of the Bank of England. It is a well-established theory that some banks were so systematically important that when the crisis came they were ‘too big to fail’. Government felt it had no choice other than to rescue them. Haldane refers in addition to them being ‘too big to be efficient’ in the first place. Academics have explored the ‘implicit subsidy’ of ‘too big to fail’ banks, which suggests that they obtain lower funding costs from the markets because it is factored in that we, the taxpayer, will not let them go bust if it comes to it.4 So their apparent efficiencies of scale may well depend on us being there to foot the bill and bail them out.5
As Professor John Kay has pointed out, this is not a sustainable set-up in a democracy: ‘When the next crisis hits, and it will, that frustrated public is likely to turn, not just on politicians who have been negligently lavish with public funds, or on bankers, but on the market system. What is at stake now may not just be the future of finance, but the future of capitalism.’6
If they are too big to fail and too big to be efficient, then ultimately the mega-banks are too big to be useful. So far the UK government has been resistant to radical ideas of ordering the break-up of the banks, although it wants to encourage new entrants to the banking market and has done a little, not much, to encourage that. It has moved, on the recommendation of the Vickers Commission, to force banks to create a ‘ring-fence’ between investment banking and plain old retail banking. In the case of RBS, if such restrictions had been in place Johnny Cameron in GBM would have been ring-fenced in a separate part of the company from Gordon Pell at retail, with distinct pots of capital and so on, so one could not leech from the other. Would that really have prevented Fred Goodwin from growing RBS at too fast a rate? I doubt it. The new capital rules, which force banks to keep much more than they did before the crisis, are likely in time to make more of a difference. There is also talk of the new ring-fence being ‘electrified’, although everything I have learned about senior bankers during the research for this book tells me that even if it had 50,000 volts coursing through it they would find a way to tunnel under or vault over the fence.
The UK banks are still enormous, with balance sheets that have come down although they continue to dwarf GDP. As of the end of 2012 the combined figure was £5.9 trillion, or 383 per cent of GDP. This worries policymakers. In front of the Parliamentary Commission on Banking Standards, Mervyn King mused on this topic as he prepared to leave office in 2013. Just think of the trouble that might have been averted in Britain if he had focused on such themes at the start of his tenure in 2003.
Yet that was simply not the mood of the time. The intellectual climate was such that there was an over-reliance on the application of new economic theories, mathematical modelling and the growing ‘tyranny of data’. The ‘efficient market hypothesis’, developed in the 1970s, dominated thinking on financial markets for most of the next four decades.7 It held that markets are self-correcting and that if investors all have the same information they will make entirely rational decisions. What a nice idea, if you presume that everyone has access to and takes time to read the same material. You also need to exclude awkward human concepts such as greed, fear, confusion, stupidity and a weakness for manias.
In the same period hedge funds were developed, often at the instigation of academics, to exploit theories about probability and establish how ‘data-mining’ and computer power might help when it came to understanding the market and spotting opportunities. Why trust the gut instinct of an excitable old-fashioned trader, when a calm appreciation of trends and potential outcomes could deliver much better returns? This smart insight made a small number of people extremely rich. In turn, ambitious banks hired ‘quants’, or ‘quantitative analysts’, to help them use similar techniques in the creation of new products. Hence the collateralised debt obligation (CDO) and other innovations. The ratings agencies would, for a fee, even stamp such products AAA and accountants would give their sign-off. On top of the assumption that the new thinking made the world safer, because it had originated from such clever people, were gradually built risk-management systems, and bank-regulation and accountancy standards that accepted as a given the viability of the underlying theories. Banks such as RBS were actually rather late arrivals on the scene, and pretty hick in their understanding of what was really happening. Goodwin plainly did not give it much thought, or if he did he never mentioned it to his closest colleagues. But the emphasis throughout was on the production and measurement of data, data and more data. If the numbers added up in a neat line for the auditors and fitted with the theoretical models designed by those outside the bank, and the ratings agencies had done their AAA thing, then it must be OK, surely? One can see why this would make sense to Fred Goodwin, an accountant. It simply seemed that finance was getting simultaneously safer, bigger and more profitable as a result of innovation.
Data and modelling are useful in all manner of human activities, such as measuring performance in business, health, education or sport. The potential danger comes in elevating it to such an extent that insufficient room is left for the application of common sense. Data can point the way, but if we let it tell us what to think and feel we are in trouble.
Inevitably, in finance, it turned out that the quants and analysts had made some simple and very expensive mistakes with their numbers. The models used by many of the banks were only as good as the underlying assumptions that they had been built on. If you constructed your model based on data from the last fifty years, assuming that a US housing crash on the scale of the Great Depression was highly unlikely because it was a long time ago, and we’ve moved on a lot since then, then you had a problem when the eventual crash was bigger than allowed for by the models.
Suddenly, when circumstances changed, old-fashioned human doubt was reintroduced. Theoretically risk had been diluted, with different types of it mixed together into the giant alphabet soup of the CDO, all several steps removed from the original sub-prime mortgage being taken out by people who could not afford it. Yet the underlying models were wrong. American house prices could fall further than was thought. Trust vanished. It became hard to tell what anything was worth. Cue a panic. Disaster.
Having been such an enormous success in high finance, these ideas are obviously next being applied to politics. The victory of Barack Obama in the 2012 US election was attributed in some quarters to his campaign’s mastery of vast amounts of data and ‘micro-targeting’ of voters. Forget ideas, or ethics, or arguments. Look at the numbers. ‘The Victory Lab’ by Sasha Issenberg talked of a new ‘data-driven order’. It attracted the attention of party strategists in Britain. Says the promo for Issenberg’s book: ‘Armed with research from behavioural psychology, data-mining, and randomized experiments that treat voters as unwitting guinea pigs, the smartest campaigns now believe they know who you will vote for even before you do.’
This is sounding familiar. Data-mi
ning, probability, quant theory. It is what the hedge-fund industry and other financial innovations were built on. The ‘micro-targeting’ done by Team Obama enabled the harvesting of many tiny groups of voters that together added up to victory. The politician’s equivalent of profit is votes. Similarly, hedge-funders worked out that if they could harvest small individual profits but do it so many times on an epic scale, playing with huge sums of money, then that would add up to victory, or a very large profit.
We are entering a world of ‘big data’. Global companies such as Google, which are very friendly with big governments, collect vast amounts of information about us and design algorithmic models which we are told can work out what we want to buy or eat before we know we want it. Many of us enjoy some of the benefits, even if it is remarkable how trusting we are. Google and Apple are not philanthropic endeavours, they are giant businesses that want our money and maybe more, eventually. We once unquestioningly enjoyed the benefits of big finance and easy money provided with the approval of policymakers on the basis that we were now safer and smarter. Or we enjoyed it until it blew up the economy and ushered in years of recession and flatlining growth.
This is not a Luddite appeal for the rejection of technology or a call for a return to an imaginary pastoral idyll. It is a plea for scepticism and the human scale. To say that there is little that can be done to deal with dangers of monopolistic Internet companies or oligopolistic big banks that cannot be controlled even by those paid to be in charge, is a counsel of despair. As if twenty-first-century ‘bigness’ is simply the equivalent of the weather and we are powerless to do anything but accept it and stump up for the repairs after the next storm. The American President Theodore Roosevelt was particularly interested in similar themes. More than a century ago he was ‘trust-busting’, using the law to prosecute and break up exploitative and giant business monopolies such as that owned by John Pierpont ‘J. P.’ Morgan, to empower consumers and citizens. Not everything Teddy Roosevelt did worked, and his critics say he vested too much power in government instead. But he was attempting to deal creatively and intelligently with a question that faces us again. Do we exist to serve banks and companies? No. They should exist to serve us.
