Too Small To Matter
“The time has come to return to basics. Bankers need reminding that it is not their money they are playing with, and that they have a duty of care to the depositor and the shareholder, whose money it is. In future, they will have to content themselves with the smaller profits of yesteryears if they wish to regain the respect and trust of the people. As for the shareholder, a smaller dividend is surely better than losing everything in case of failure…”
— TD FUEGO
Up to the 1980s, banks were mostly regional/national outfits serving a regional/national clientele in the main. The banking mostly comprised of bread and butter stuff like deposit taking and loans; and foreign transactions to cater for import and export business. Save for a few exceptions like Barclays and Standard which had a branch network in the British colonies, international presence was typically marked by a representative office, usually in the cosmopolitan centres like London and New York.
Whilst this state of affairs remained the status quo, management and regulation was relatively easy to carry out.
Liberalisation, deregulation and globalisation put paid to all that. Soon, the whole world began to believe in the maxim imported from the US that “Big is Beautiful” (BIB). Only much later, would it discover to its utter dismay that obesity can kill! But, at the time, an absolute belief in the BIB mantra coupled with globalisation impelled many a Western bank to have ambitions to become a mammoth. And the bigger it became, the harder it became possible for it to fall. Lehman, the fourth largest investment bank in the US, the UK’s Royal Bank of Scotland and Lloyds are significant examples.
In the case of Lehman’s collapse, there is a popular view that it was in fact used as a test case by the US authorities who did not quite appreciate the dramatic effect it could have. However, having witnessed the unprecedented havoc on the world markets in the wake of its fall in 2008, monetary authorities everywhere scurried to rescue failed and failing banks. A new expression got added to the lexicon to justify the spending of hundreds of billions of taxpayers’ money in the rescue exercise—the banks had become “Too Big to Fail.” (2B2F)
The fact of the matter is that, in the unfettered expansion in banking activities and complex financial products seen in the last 30 years, some financial institutions had not only become 2B2F, but also Too Big to Manage (2B2M), Too big to Understand (2B2U) and, consequently, Too Big to Regulate (2B2R). For, unless you understand something fully, how do you go about its supervision and regulation? In the complex and complicated “Big is Beautiful” scenario, it is to be wondered if there is one single supervisor or regulator who fully comprehends all the products, the activities and the associated risks of modern banking.
In a recent interview, former British PM Blair tellingly had this to say, “I think this global financial crisis was a product of a whole new way that the financial and banking sector has been working in this past 20 or 30 years. It is where you have got deep integration of the global economy and where you have a lot of financial instruments that were created whose impact people didn’t properly understand.” In this context, people is just politician-speak for Governments and their Regulators.
Originally, banks including Lehman were small family affairs mostly involved in deposit taking and lending. So long as the loans were made with all the prudence needed to safeguard depositors’ money, there was little risk of default and, therefore, insolvency.
The management knew their customers and understood their own enterprises. At the same time, supervisors knew what they were supervising and regulators knew what they were regulating. Furthermore, the size of the operation being on the human scale, problems were relatively quickly and easily spotted; and prompt action taken to remedy these within the shortest delay.
However, the years following the 1980s saw an explosion in the banking sector, particularly in foreign exchange (Forex) activities. Foreign exchange was no longer confined to servicing customer import/export and travel needs, but a parallel global market also emerged purely out of speculation on exchanges rates. Billions began to be traded just so dealers could make a quick buck on their hunches.
At the same time, and this is very important, besides their regular wages, traders and their bosses started receiving bonuses based on results. The more profit they made, the higher the bonuses they earned.
Consequently, natural human greed took hold and heralded a new category of international bankers. In their search for yet higher profits, they started to invent all manner of derivative products (with no intrinsic value) that would undermine the very essence of prudential banking and cause many a bank to fail as these products turned toxic. Some, as the public is gradually finding out, have even gone into money laundering and other illicit activities in a big way.
The warnings were all there prior to 2008, but the collapse of Guinness Mahon (one of the oldest UK banking groups) and the like was ignored. Far too much was at stake. Shareholders demanded bigger and bigger dividends every financial year, and the traders were happy to oblige because bigger profits also equalled bigger bonuses. Thus million Dollar bankers were born. But, bankers they were not in the true tradition of the guy who looked after your money. Many were no more than sophisticated barrow boys plying their dubious trade on the back of the savings of the pensioner, the widow and small children.
The rest, as they say in Outer Mongolia, is history. Ongoing, living history because the crisis is far from over and no one knows when and if it will end. Yet everyone — bankers, governments and regulators alike — carries on as if everything was hunky-dory with the status quo. But, to the bewildered onlooking public, it is abundantly clear that there is something very rotten and smelly in the kingdom and that the whole system needs a thorough cleansing and sanity restored.
I know what I am going to propose is total anathema to the BIB expansionist view that sees no limit to the size of banks’ balance sheets and, in particular, off balance sheet activities.
But, the time has come to return to basics. Bankers need reminding that it is not their money they are playing with, and that they have a duty of care to the depositor and the shareholder, whose money it is. In future, they will have to content themselves with the smaller profits of yesteryears if they wish to regain the respect and trust of the people. As for the shareholder, a smaller dividend is surely better than losing everything in case of failure.
Compartmentalisation is the answer. Banking has got so complex that I doubt if there is one single board of directors which understands fully what it is overseeing. The solution is to break large banks into neat, easy to manage, easy to understand, and easy to regulate parts. For example, retail business could be one stand-alone unit, derivatives another, insurance business yet another, and so on — with bamboo curtains demarcating each operation, each one with its own capital and management structure.
In this new scenario, there is no room whatsoever for the bonus culture which will have to be banished forever. If shareholders think their Banker is worth a million dollar, then by all means let them pay him his worth. But, do not pander to his greed by performance-based bonuses. The consequences, as we have seen, can result in the dramatic collapse for their institution.
Simultaneously, legal provisions have to be tightened and Regulators’ powers enhanced where necessary. It should no longer suffice for negligent, irresponsible bankers to resign and offer an apology whilst laughing all the way to the bank to collect their severance pay; they will have to face legal sanctions.
Of course, restructuring will mean expending additional resources for the banks and the authorities. But the alternative can only mean the sort of chaos from which the world is still reeling five years later.
Safe as a Bank
At the end of the day, the humble depositor needs to be reassured that his money is safe in the bank. As for the derivatives customer, he will be aware that he is into speculation, if not outright gambling and the risks associated with this business. In the compartmentalised scenario where sanity prevails, even if the Derivative bank fails, the Retail should survive. From 2B2F, banks need to be cut down to neat-sized units rendering them Small Enough to Manage (SE2M), Small Enough to Understand (SE2U) and Small Enough to Regulate (SE2R).
Hindsight reaction to irresponsible sub prime lending, wild derivatives trading, dishonest Libor rigging or wholesale money laundering is no balm to the horrid wounds inflicted on the rest of us by greedy bankers in the pursuit of ever-higher bonuses!