Business

Turner's 'radical' changes at the banks

BBC business editor Robert Peston on reforming finance

While I was away for a few days, Lord Turner gave a remarkable speech, which seems - curiously - to have been almost universally ignored.

The address given by the influential chairman of the City watchdog, the Financial Services Authority, was called "Reforming Finance: are we being radical enough?"

His answer seems to be "probably not".

I am going to focus on two aspects of what he said, that the new capital ratios imposed on banks, especially on big banks, remain too low, and that reforms to the way that bankers are paid may have the effect of actually increasing their total remuneration.

Actually he made a third striking related point: that the underlying problem may be that banks are excessively profitable, that much of their frenetic activity adds little to general economic growth and is designed to extract "rent" or income from the rest of us in a way that increases social inequality. One of his conclusions: that the optimum way to address this problem of rent extraction may be through new taxes on financial activities or direct state intervention.

First, here is what he says on the recent agreement by international regulators to increase the ratio of loss absorbing equity or core capital to assets from 2% to (in effect) 7% - an agreement that goes by the moniker (as if you didn't know) of Basel lll:

"Basel lll is a major step forward, but in an ideal world equity ratios would be set much higher".

How much higher? Well at least double, or even perhaps treble that 7%.

But for regulators like Turner, all is not lost. Top of this year's agenda for the global rule-setting bodies for banks, the Basel Committee and the Financial Stability Board, is what extra capital requirements may need to be imposed on mega banks, or Systemically Important Financial Institutions (SIFIs) - banks like Barclays, HSBC, RBS, Deutsche Bank, JP Morgan, Citigroup, UBS and so on.

Now Turner makes clear that he believes they need to hold a good deal more equity, because he sees that as by far the most efficient form of capital for absorbing losses, and thus protecting taxpayers from future crises.

Interestingly, he is sceptical that forcing banks to hold new-fangled instruments, bonds that convert into equity when capital ratios slip below comfortable levels, or Cocos, will be of much use in the long term - because he is persuaded that investors as a breed will systematically ignore the risk of conversion, and the bonds will therefore end up being owned by institutions unable to tolerate the equity losses as and when they materialise.

So, as I have pointed out before, our biggest banks - and their shareholders - probably need to brace themselves in the coming months for new rules forcing them to significantly increase the amount of capital they will have to hold relative to the loans and investments they make (so the arguments made yesterday by HSBC have already fallen on deaf ears).

Oh, and by the way, he and Paul Tucker - the deputy governor of the Bank of England who responded to Turner's address - pointed to a second priority for the Basel committee this year: a fundamental review of the capital requirements for banks' trading books; and if that doesn't lead to increased capital requirements for the likes of Barclays Capital, the investment banking arms of universal banks, I will eat any number of hats.

And what about bankers' pay? Well Turner makes the compelling point that the trend to defer bonuses and award them in shares will almost certainly lead to an increase in bankers' pay in the long term, unless the profitability of banks were to fall dramatically.

How so? Well with bonuses paid in shares and subject to clawback, the risk of non-payment increases - which is precisely why heads of G20 governments demanded those pay reforms (to better align bankers' pay with banks' long term performance).

But if the risks of non-payment rise, bankers will demand extra potential rewards by way of compensation. And they will get that extra reward, says Turner, unless there is a significant reduction in the long-term profitability of banks.

Which links to perhaps the heart of Turner's argument, which is that a significant proportion of the explosive growth of financial activity over the past 15 years is in a sense fatuous: it has generated no increase in the size of the economic cake for the rest of us.

He gives four examples of how banks simply extract rent from the rest of us, with no net economic gain - and arguably some social loss.

First he points to the banks' "tax management activities, which benefit the financial service sector's clients, but also, through fees earned, the industry itself" (some of you, I am sure, will at this point be saying a big hello to Barclays).

Turner adds: "a depressingly large proportion of what is labelled 'innovative product structuring' is based on tax management activities".

Then there is rent extraction via ferociously complicated products that obscure the risks for investors - both retail investors and astonishingly gullible financial institutions (such as UBS, which loaded up its balance sheet with AAA rate CDOs that turned out to be poison).

Third, there is all that financial innovation that claims to offer protection but actually increases market volatility, thus creating the demand for yet further financial protection (much of the growth in the OTC and exchange-based derivatives markets may have been otiose in that sense).

Finally there are the super-normal returns which accrue to those "dominant" market makers that are perceived by investors to be the loci of liquidity.

Where does all this lead?

Well to the conclusion that bankers' bonuses will only fall if the potential for banks to extract rent from the rest of us is tackled.

Has that happened?

No.

How could it happen? Turner says: neither taxation nor state provision should be excluded from the policies considered".

He repeats that financial activity taxes, Tobin taxes, may be justifiable.

And he adds: "in retail financial services we should be open to the possibility that the state could sometimes be a more efficient provider of some services, removing the churn and excess cost which pure private competition can create".

Or to put it another way, if the UK's banks think that the anything-goes world of the years before the crash will return any time soon, the senior City regulator would beg to differ.

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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