Two simple steps to transform the culture of banking and to forestall the next outrage

It’s time to privatise commercial risk in banking and insist on prudent accounts. Government should:

  1. Eliminate moral hazard from the financial system by implementing this measure to make bank directors strictly liable without limit and to treat as capital both directors’ personal bonds and, for five years, the bonus pool.
  2. Introduce prudent bank accounting so banks can’t game the rules using derivatives to manufacture illusory profits from unrealised cash flows.

The banking system isn’t capitalist

It’s not capitalism when private individuals stand to gain from their actions but the taxpayer carries the risk. When risks are socialised and potential profits huge, individuals are bound to be reckless: why be responsible?  It’s no good agonising about the culture of banking without considering the astronomical moral hazard endemic in the system today. Of course people who do not have to bear the negative consequences of their actions behave badly.

The truth is as Sir Mervyn King said in his 2010 Bagehot lecture (PDF): ”Of all the many ways of organising banking, the worst is the one we have today.” Here’s why:

  • Profits are privatised and risks socialised, creating incentives to be reckless.
  • The entire interest rate market is deliberately manipulated by the central banks to promote or restrain lending and saving.
  • Government has a monopoly on money and legal tender laws enforce it.
  • Fiat money – paper promises to pay and accounting entries corresponding to new loans – means that there is no effective restraint on the creation of new money by banks.
  • The banks own the money in your current account: they fund themselves from money which they owe you immediately on demand.
  • To deal with the problems created by banks funding themselves out of your current account, there’s taxpayer-funded deposit insurance and a lender of last resort. As the Bank of England admits, that means public subsidies which could be worth over £100 billion to UK banks plus an overblown financial system which draws resources from other sectors.
  • The system has been tightly but badly regulated for years. Anyone who thinks banking has been laissez-faire hasn’t worked in a bank or a regulator, tried to start a new bank or looked at the regulations.

The result is a centrally-planned, taxpayer-backed banking system in which money is loaned into existence by institutions which are systematically encouraged to be reckless by bad regulation. That’s why there was a tripling of the money supply between 1997 and 2010 in a vast credit boom which was bound to burst. That’s why individuals were prepared to manipulate market prices for unjust personal gain.

The next outrage?

As if this were not bad enough, banks create illusory profits and capital by using derivatives to game accounting rules under the International Financial Reporting Standards (IFRS). Gordon Kerr explains how in detail here.

That could be the next outrage. The present LIBOR scandal could look minor when the public discover that banks use derivatives to record as immediate profit monies which have not been received: bonuses will have been paid out of capital or even bailout funds. No wonder UK banks’ derivative exposures surged after IFRS accounting was introduced in 2005:

(Click for interactive BoE database)

And without prudent accounts to provide a true and fair view of banks’ financial positions, how are even basic laws to be applied?

What is to be done?

It’s time to privatise commercial risk in banking and insist on prudent accounts.

Risks cannot and should not be eliminated. Society needs a successful, entrepreneurial financial system to provide productive investment. But officials must stop pretending that the consequences of moral hazard can be regulated away. In a free society, people must take responsibility or there will be licence, lawlessness and chaos – just what we are seeing today.

My Financial Institutions (Reform) Bill and my Financial Services (Regulation of Derivatives) Bill would transform the culture of banking, enable a true and fair view and stop exploitation of shareholders and taxpayers by reckless individuals in the system.

There would be no need to claw back bonuses: they would already be treated as capital and taking losses.

Commercial error would receive financial penalties: there would be no calls for criminal law to deal with the consequences of bad business.

And, told well in advance that they would be taking unlimited personal liability for their banks’ losses, you can be sure that bank directors would soon split up our banking behemoths into the smaller, more manageable and competitive institutions that we need – without legislative intervention.

There may be little point in a further independent inquiry. The Vickers Independent Commission on Banking already reported and the Government is legislating but the proposed measures don’t deal with moral hazard or bad accounting. The rewards for risk-taking will still be huge and the risks will still be socialised: does anyone really believe that will lead to lasting cultural change?


David Cameron has said:

The country needs a new direction and new answers. I am clear about the new direction we must set for Britain. To meet the challenges of the twenty-first century, and to satisfy people’s aspirations today, this country needs a responsibility revolution.

Both King and Cameron were right: we have the worst possible banking system and this country needs a responsibility revolution. The LIBOR scandal shows it is time to take serious action. Government and officials should stop pretending they can regulate away the consequences of giving bankers freedom without responsibility. They can’t. They should adopt my bills.

This article was previously published at


Steve Baker on the Libor scandal and directors’ liability

TCC Board Member, Steve Baker MP, has been on the front line this week trying to bring his sound economic judgement to bear on the latest example of crony capitalism – the scandal over Barclays’ rigging of the inter-bank interest rate. Describing the banks as having “licence not liberty,” he highlights the overall problem with the banking system, that it is “not capitalism when the tax payer has to pick up commercial risks.”

Steve calls for the adoption of his Financial Institutions (Reform) Bill, which would make bank directors and board members liable for the losses their banks incur and force them to carry the consequences of their actions.

You can listen to Steve’s interview on The World at One on iPlayer (16 minutes in), or through this MP3.

Meanwhile, writing in The Express, Stephen Pollard also highlights Steve’s radical bill as emulating the system under which NM Rothschild and JP Morgan grew their banks into financial giants while at all times acting responsibly and being conservative in their risk taking.


Banking: from Goldman Sachs to David Fishwick?

Two days ago, Greg Smith, a Goldman Sachs executive director, resigned in sensational fashion, writing a column in the New York Times. In the article, he laid out the reasons for his resignation, citing the change in culture at the firm over the ten years he worked there. He wrote,

It might sound surprising to a skeptical public, but culture was always a vital part of Goldman Sachs’s success. It revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients. The culture was the secret sauce that made this place great and allowed us to earn our clients’ trust for 143 years. It wasn’t just about making money; this alone will not sustain a firm for so long. It had something to do with pride and belief in the organization.

In particular, he attacked what he sees as the 3 ways to get ahead at Goldman Sachs:

  1. “persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit.”;
  2. “get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman”; and
  3. “Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym”

While the article might have been dismissed as one disillusioned ex-employee’s rant, it will ring all too true across the financial sector. The Motley Fool reports Goldman Isn’t Alone in the Delicate Art of Ripping Off People. After quoting some illustrative returns, fees and rewards in the industry, the author writes:

The clients that Goldman and the rest of Wall Street rip off are skilled at ripping off their own clients, thank you very much. Each is part of the same game of inflating expectations and overcharging fees — a system summarized best by the title of Fred Schwed’s classic bookWhere Are the Customers’ Yachts?

And then he points out that the losers, the client’s clients, are people like you and me: savers, pension fund beneficiaries and retired schoolteachers. The article finishes by asserting that Goldman is just one example of “putting personal interests before clients.”

How did all this come to pass?

In 1999, just over ten years ago, Goldman Sachs went through a public listing. It had previously operated as a partnership but now it is majority owned by institutional investors.

Over on Forbes, an article explains the difference in incentives between a bank run as a partnership and one run as a traded corporation: the switch in incentives is from long-term success to short-term results. The author gives some persuasive arguments for the partnership model and says investment banks should be required to return to it. He finishes,

Real banking reform isn’t about lashing out, but about restoring the connection between bankers’ profits and the economy they serve.

Which is why, as part of my work on injustice in the financial system, I introduced my Financial Institutions (Reform) Bill. The Bill would minimise moral hazard within the financial system by ensuring that those who take risks are held personally liable for the consequences. It would realign bankers’ rewards, their risks and their actions in the real economy. I said,

Hard-working families and individuals paying tax out of typically modest incomes must never again suffer the injustice of carrying the risks, and consequences of risks, taken in the pursuit of often enormous private returns. Risks must fall to those who take them. Instead of vicarious liability of taxpayers, there must be responsibility in the banking system. The Bill represents an opportunity to free the banking sector and the public from regulatory capture and lobbying. It could raise standards from the bottom up, through the preservation and extension of commercial freedom and the development of professional, personal and mutual responsibility.

At the time, I had no idea that yesterday I would meet David Fishwick, founder of a savings and loans firm in Burnley, who is delivering just that. It began when he found people could not buy from his van business for want of credit, so he started making loans himself. He’s an entrepreneur, a self-made multi-millionaire from ordinary beginnings.

Channel 4 are now making a documentary about Dave’s attempts to start a decent bank which serves both savers and businesses.  The Lancashire Telegraph reports,

“My bank may be tiny but it will be better than a high street bank. I want to show how banking can be socially responsible and not greedy and reckless and I’m going to do what the high street banks just can’t bring themselves to do, give away any profits to charity.”

The venture will see him guarantee and underwrite all the banking activity from his personal fortune.

It’s quite a rebuff to all those who told me no-one would run a bank if they had to put their own assets at risk. As I pointed out, some of history’s greatest bankers bore their own risks without limit. Now, Dave Fishwick is demonstrating that the basic business of banking — intermediating savings to entrepreneurs through productive loans — is an enterprise which individuals will back with their own wealth.

Dave’s banking business is small. The FSA essentially won’t meet him and no wonder: they make their money from fees levied on those they regulate. Dave’s business is presumably too small to cover the FSA’s costs. So he doesn’t have a banking licence, accepting savings and making loans on a different legal basis. His business, as he tells it, is based on his personal guarantee, trust and entrepreneurship. In the terms Hazlitt explained, credit is something people bring to Dave, through running profitable businesses, and that’s what enables him to make loans out of people’s precious savings, personally underwritten by him.

Dave Fishwick may yet fail. His business may be crushed out of existence by a dull and clumsy state. But I have said time and again that we need a new generation of local financial institutions which reconnect savers and productive businesses. It seems Dave is redeveloping the teamwork, integrity, spirit of humility and sense of “always doing right by our clients” which used to engender pride and belief amongst Goldman Sachs’ staff. There will always be a place for large, sophisticated firms but, together with ideas like Funding Circle, Dave’s enterprise may indicate that a new, more responsible and productive financial system is emerging spontaneously in society.

I look forward to watching the documentary in the next couple of months.

This article was previously published at


The 2012 Baker Bill: a programme to end financial crises

Earlier today Conservative Steve Baker MP put forward a Private Member’s Bill, the Financial Institutions (Reform) Bill, which outlines a programme of radical reforms to the banking system and calls for an end to state meddling in banking. Steve is co-founder of the Cobden Centre, and has been MP for Wycombe since May 2010.

The underlying principle of his Bill is to minimize moral hazards within banking, by making those who make or preside over risk-taking as liable as possible for the consequences of that risk-taking. Since financial institutions often circumvent rules, the Bill also includes mutually reinforcing measures that minimize scope for evasion.

Within this framework, bankers would be free to do as they wished, but they would bear the consequences of their own actions.

Thus, Steve’s Bill addresses the rampant moral hazard problems within the modern banking system, and this is the central issue in putting the banking system back on its feet and restoring its integrity. Indeed, his proposals provide nothing less than a free-market solution to the current banking crisis

I would therefore ask all supporters of free markets to promote this Bill and to push for similar measures in other countries.

One key provision of the Bill is to make bank directors strictly liable for bank losses and require them to post personal bonds as additional bank capital. These measures reaffirm unlimited personal liability for bank directors, and will rule out all-too-familiar “It wasn’t my fault” excuses on their part.

The Bill also calls for bonus payments to be deferred for five years, and for the bonus pool to be first in line to cover any reported bank losses. Any reported losses would be covered first out of the bonus pool and then out of directors’ personal bonds before hitting shareholders.

These measures would provide strong incentives for key bank decision-makers to ensure responsible risk-taking, as their own wealth would now be very much at risk.

Amongst other measures, the Bill:

  • Proposes a tough bank solvency standard, and would require any insolvent bank to be automatically put into receivership;
  • Calls for the Government to propose a fast-track receivership regime for insolvent banks and to produce a plan and associated timetable to end all state involvement in the banking system;
  • Calls for accounts to be prepared using the old UK GAAP governed by Companies Act legislation, as proposed in Steve’s previous (2011) Private Member’s Bill, the Financial Services (Regulation of Derivatives) Bill. This would put an end to the various accounting shenanigans associated with IFRS accounting standards; and
  • Calls for the establishment of a Financial Crimes Investigation Unit to investigate possible crimes committed by senior bankers: this Unit would investigate all banks that have failed or received public assistance since 2007 and would replace the Financial Services Authority, which has proven to be utterly useless.

Further details of the Bill can be found on Steve’s website: