How the Treasury could really raise standards in the banking industry

 
Andrew Lilico

THE Treasury has responded to the Banking Standards Commission, promising to introduce a criminal offence of reckless misconduct for senior bankers and various other foolishness. What should it do instead?

In any industry, standards are maintained by a combination of competitive pressures (“customer power”), ethical standards (“peer pressure”), owners scrutiny, creditors scrutiny, and regulatory oversight. Banking has always been subject to considerable regulatory oversight. But regulatory oversight sufficient, by itself, to maintain high standards in an industry as complex and multi-faceted as banking will almost inevitably involve such onerous intervention as to stifle the healthy functioning of the sector. It is a delusion to imagine that, in a modern economy in which banks are the main allocators of capital, regulatory supervision could ever be the main mechanism for maintaining standards.

And ethical standards operate most sustainably when they run broadly with the grain of incentives in a sector. If honest dealing and best endeavour are generally rewarded by market and government intervention processes, it is easier to maintain ethical norms promoting honesty and best endeavour. If the incentives in the system punish ethical behaviour, standards will at best fray over time, if not totally collapse.

Property should be the centrepiece of regulatory incentives. The notion that owners do not attempt to look after their own property should, in general, be subject to great suspicion, regardless of the details of a specific case.

Competition maintains standards principally via consumer pressure. If a bank does not scrutinise the activities of its staff and those it deals with, in a competitive environment consumers would leave. Poor scrutiny of standards will be interpreted as a signal that senior staff have relatively weak oversight of internal processes, with the consequence that a bank’s risk management is poor, so consumer investments are at risk. Consumers may also object to dealing with firms they consider unethical. Other stakeholders (like wholesale counterparties) may have similar concerns.

But competition requires creditors to be exposed to risk of loss. Creditor scrutiny maintains standards in the following way. If a small business borrows money (eg from a bank), the lender will often want a detailed business plan and regular update reports on the business. Lenders scrutinise the activities of borrowers, so as to ensure that those activities leave the loan likely to be repaid. Weak internal scrutiny procedures, publicity about unethical practices, excessive remuneration, and other indicators of risk might make loans unlikely in the first place and could trigger recall of loans already made.

If, on the other hand, governments guarantee loans to banks, creditors will not take the same interest in their risk management activities, and so have limited, if any, interest in the banks’ standards. Government guarantees of creditors thus destroy both the competitive pressure to maintain standards and the creditor scrutiny process – the two most important processes for limiting risk and thus driving ethical, accountable and transparent behaviour.

Fractional reserve banks (the ordinary high street banks we have in Britain) have two key classes of creditor: bondholders and depositors. For banks to function healthily, both in respect of their economic contribution and their ethical standards, both bondholders and depositors must bear genuine and material risk of loss.

Deposits in UK banks are presently hugely over-insured, guaranteed up to a total of £85,000 per depositor, per authorised institution. But removing deposit insurance is not a matter of regulatory declarations about insurance limits or political will. Academics and think-tankers that urge politicians to be braver in not bailing out banks should realise that no-one is going to stick their head on a pike if the banks fail. But that could happen to the politician. Deposit insurance can only be removed credibly if the public becomes disinclined to be sympathetic to the bailing out of depositors.

The public is sympathetic to bailing out depositors because some deposits are perceived as savings, not as investments. The solution is to disentangle savings from investment deposits by having two explicit and legally isolated forms of deposit available in every bank – “storage deposits” for savings, 100 per cent backed by government bonds and 100 per cent insured without limit by the state; and “investment deposits” that are not insured at all. If the public feels that everyone putting their money into investment deposits must have been fully aware they were at risk of loss, and had always turned down the opportunity to save in fully insured deposits, the public appetite to bail out investment depositors would vanish.

With government insurance of investment depositors removed, competition could function and creditors would scrutinise bank activities, driving up standards.

Andrew Lilico is chairman of Europe Economics.