The Pin Factory Blog

Last week, I dreamed of Financial Authorities that were good for Britain. Unlikely, I know, but in this fantasy The Financial Conduct Authority had given up on its mission to eviscerate the UK’s financial services and embarked on a crusade to make them stronger.  This Paulene conversion had begun with the Treasury’s brief to strengthen competition, particularly in the banking sector.  This was puzzling for them as they had previously been trying to standardise everything.  But competition is about choice and choice means allowing businesses to be different.

Albeit fewer than before the regulators started interfering, we still have four big banks but customers mostly do not transfer because they think they are all the same.

Economics is not just the dismal science; it is the dead science.  In the world of economics everything is standardised except the price.  The mortgage market is a bit like that.  Either firms match and therefore do not compete, or they compete, prices are driven down and they go bust.  The science of the living, however, i.e. biology tells us that firms compete through evolution.  They change and adapt and the ones that best adapt to the environment, i.e. the market, thrive.  They compete by better meeting customer needs, that allows premium pricing and that in turn prompts innovation and further growth.

Contrast that with the FCA view that premium pricing is wicked and should be stopped at once.  In almost every consumer market the brand leader is also premium priced.  That is not because consumers are stupid but because they want what they consider to be best.  They are the judges, not some arbitrary quango in Canary Wharf.

When the FCA woke up to the need to promote differences, not destroy them, they changed their working lives.  No longer did them spend them inventing new regulations to inflict on financial services, they began removing the ones we do not need.  That turned out to be almost all of them.  The FCA staff had never been so busy.

Fired up with enthusiasm, they took their crusade to Brussels.  “Either,” they said, “we need the regulations in which case the whole world does.  Or the rest of the world does not need these regulations, and therefore, nor do we.”  Joy broke out across the regulators’ offices and also those of the financial services sector.  And consumers were the happiest of all.

Then I woke up.

It will be a while before the inside story of the Co-op’s pull-out from the Lloyds HBOS deal emerges, if it ever does, but some aspects are immediately apparent.  The HM Treasury has failed, at least for now, to achieve their twin goals of downsizing Lloyds HBOS, as required by Brussels, and bringing competition to the retail banking sector.  The deal could have transformed the Co-op from a small player to a serious retail bank.

Any deal would be a commercial issue, but surely HM Treasury played some part.  Apparently excessive regulation is a major reason for the pull-out, a direct government responsibility. Whatever happened to de-regulation?  Yes the Financial Services Authority was eliminated but it was replaced by two further monsters, the Financial Conduct Authority and the Prudential Regulatory Authority.

As the IEA has pointed out, we do not need capital ratio regulations, or not now anyway and as this institute has pointed out, financial services markets are now global and therefore need global, not local, regulation.  The UK simply hobbles itself by adding its own unilateral regulations and regulators.

Capital Ratio regulation is a good example of the right medicine at the wrong time.  It was needed in the boom times up to 2008 but is counterproductive in recession: more capital means less lending.  It is like going to the doctor, asking for a cure for a throat infection and being given a prescription for piles because the doctor has suddenly realised that he should have provided that when you last visited.

Osborne also bungled by handing out cheap money for the banks to lend out only to find they put it in their own pockets.  The fact is that he does not understand banks, bankers or banking.

The Co-op has effectively told government that the climate is unattractive for this deal.  And since it has been in the works since last year, they must have been saying so for some time.  The collapse tells us that HM Treasury failed to deliver.

Lloyds HBOS won’t mind too much.  Yes they are under pressure to dispose of the packaged up TSB but they’d rather sell to a newcomer or a tiddler than create a serious competitor as the Co-op could have become.  It is nonsense to say that HM Treasury cannot manage the market since they contributed to the current mess and own, in effect, two of the big four. HM Treasury could have leaned on Lloyds HBOS to sweeten the deal to make it attractive to the Co-op but they evidently did not.  Another bungle.

Maybe some white knight will ride in and save the situation.  Let us hope so but I would not bet on it.   

The Bank of England’s Financial Policy Committee has announced an increase in capital ratio requirements for banks and the FSA announces a reduction.  The former is, of course, for existing banks and the latter for new banks.  Higher capital ratios are intended to stop banks going bust so, on the surface, it is odd that those that are unlikely to be at risk now their days of profligacy are over, at least for the time being, are having further bolts applied to the empty stable door whereas those banks most at risk, namely the small new ones, are being encouraged to expose themselves further.

Maybe handicapping the big banks in this way is good, in the long run, for competition. Perhaps we should not care if small banks go under and worry only about the systemic banks.  That shows a misunderstanding of the economic cycle.  Cyprus was the last domino in the 2008 crash, not the beginning of a new one.  Whatever happens in Cyprus will not put large British banks at risk.

Some economists, and the Bank of England, fail to grasp an elementary piece of accountancy.  Capital adequacy ratios decline if cash is replaced by loans to small businesses. New small banks are going to have an insignificant effect, in the short term, on lending to small business and we need those loans to rebuild the UK economy.  It is the clampdown on lending by the big banks which is mostly to blame for the UK’s sluggish economic recovery.

The Chancellor nearly got it right when he arranged for big banks to borrow at subsidised rates.  He hoped they would pass it on with more lending at lower rates.  Instead they put the money in their pockets, widening their margins and bolstering their capital ratios.  Instead of sending them to gaol for defrauding the rest of us, the Bank of England is now patting them on the back.

Complain about anything in an NHS hospital and you will face a wall of unknowing. Not sympathy, not a recognition of the mistake and certainly not an apology.  This has nothing to do with a lack of care or humanity by NHS staff and everything to do with the scale of legal costs and fines faced by the NHS.  The sums are now huge (£15bn in 2010 according to the Daily Telegraph, 3rd August) and rising fast, thus draining the funds that should be spent on front line care.

The reality is that transparency by the hospital (or whatever) will simply provide evidence for the ensuing law suit.  If patients and their relatives are given more information about their treatment, then that too can be used in evidence.

Harold Wilson is to blame.  When the NHS was set up, patients could not sue and everything was more open.   Those are the days of caring we look back on with a warm glow.  The reason they could not sue is because there is no contract between NHS and patient: the patient does not directly pay for NHS services, the state does.  So the patient had none of the usual customer’s rights.  Harold Wilson was lobbied by patients’ representatives saying this was unfair and they were entitled to recompense when things went wrong.  The law changed and the patient became the customer with a right to sue for damages.

The unintended consequences are now plain: lawyers instruct NHS staff not to admit liability, or indeed anything.  The costs to the NHS are not just the lawsuits but lawyer interference in management at all levels.  Sweep the cock-ups under the surgical gowns and no one will learn from mistakes or even know about them.

I had personal experience of this when a famous London hospital nearly killed my uncle by not following standard hygiene procedure during his operation. The infection was serious and kept him in hospital for quite a while. My uncle did not want to make a fuss, still less sue, but I insisted on having a discussion with the surgeon.  I hit a brick wall.  Most people would have given up but eventually, after giving assurances that we would not sue, we met.  He was accompanied by a young man whom I took to be a lawyer.  He tried to write everything down until, by now quite cross, I reminded them that we were not suing.  The meeting was entirely to ensure the surgeon understood what had happened, since we had no reason to believe he did, and to press him on how these things could be avoided in future.  I got some satisfaction on the former and none on the latter which was, in fairness, not strictly my business.  There was no apology.

The idea that mistreated patients deserve some recompense is now so ingrained that we are unlikely to revert to the pre-Wilson era.  But the present system is lose-lose: it contributes to the problems such as those now exposed at Mid Staffs whilst simultaneously destroying the NHS budget and the costs are escalating.  Following Mid Staffs all sides are issuing platitudes about transparency but, with the lawyers circling the sky like vultures, it will not happen.

One solution is to have a menu of damages that an ombudsman can award once the facts have been transparently exposed.  In the event the hospital, or the patient’s representative, is less than open, the damages are doubled or eliminated following the more arduous investigation.  Any hospital playing the odds, i.e. getting doubled too often, would be required to discipline, and possibly sack, the manager most responsible for the lack of transparency.  In this solution, no lawyers would be allowed to participate on either side.

In terms of employment growth, regulation must be the UK’s most successful enterprise.  And we have been attempting to export it worldwide.  The 4,000 strong Financial Services Authority (FSA) has now been divided into two main successors, the Prudential Regulation Authority (PRA), made part of the Bank of England, and Financial Conduct Authority (FCA), and a few minor ones.  Hydra-like we can expect the combined total employment by the new bodies comfortably to exceed that of the FSA.

A couple of ironies here are firstly that financial services regulation was handed over to Brussels by Prime Minister Brown in 2009, leaving all these UK bodies merely with supervision of the rules set by the EU.  Secondly, the level of malfeasance by banks in particular has grown in proportion to the numbers of regulations and regulators.  The more regulators and regulations we have, it seems, the worse the banks behave.  Part of the explanation is that the regulators have been incompetent at worst and invisible at best.  If you doubt me, see the comments this month by the Commons Treasury Committee about the appointment of the new Chairman of the FCA.

And talking of invisibility, where were the auditors when this naughtiness was taking place?  Auditors are theoretically employed by shareholders but, in reality, by the directors of the companies they audit.  So you do not get a lot of auditors reporting that the directors are up to no good or turning blind eyes to practices they should be correcting.

To return to the issue of the numbers employed, the number of regulators, or regulatory supervisors, is not of much interest to a government which is cutting the size of the civil service (good) but recharging all the financial services regulatory staff costs back to the firms in the sector.  Pontius Pilate was no better at hand-washing.

And the number of external regulatory staff is only a fraction of the total, arguably one third.  The firms themselves have myriad compliance officers infiltrating the veins of the business and taking up the time of those managers trying to run it.  The upside of that is that the better the internal compliance system, the less need there should be, in terms of person-hours, for the involvement of the external supervisors.

Much the same applies to internal audit: the better job they do, the less the audit fees should be.

But what, when all is said and done, is the difference in roles between external and internal auditors on the one hand and regulatory supervision on the other?  Would it not be better to have fewer people combining audit and compliance and doing it properly, rather than the legions now employed and failing?  And let us prohibit directors from appointing their own watchdogs, or rather poodles.  A joint appointment committee of shareholders and PRA would give the audit/compliance team true independence.

The Daily Telegraph reported (16th January) that UK taxpayers would likely be called to contribute up to another £30bn. to further bail out RBS and Lloyds TSB.  Their source was the Bank of England’s Financial Policy Committee’s (FPC) evidence to the Treasury Select Committee.  The problem is largely artificial: banking fogeys see the crash as having arisen from inadequate capital to withstand shocks.  They are wrong: more capital may have averted the need for the bailouts but capital shortage did not cause the crash.

The new international regulations-to-be (Basel III) focus on complex increases in tiered capital requirements.  The fogeys, in pressing for higher capital ratios, are pressing for shareholders, including us, to bail out the banks once again. This new money, if the EU allowed the Treasury to do that, would sit on bank’s balance sheets waiting to withstand another 2008-like crash.

In the middle of a recession that is not going to happen. You may as well treat a patient dying of hypothermia with a liberal application of ice packs.

Requiring higher capital ratios will also cause banks to lend less and especially less to SMEs, the very businesses which could lead us out of recession if they had the cash to do so.

The FPC has a built in problem with trying to balance growth, which always involves risk, and stability, i.e. the absence of change.  The problem is partly cyclical: just now we need growth but if and when growth again becomes unhealthy, we will need the ice packs.

Select Committees involve a lot of MPs showing and witnesses avoiding the questions.  The best example of this time wasting during this particular session (yes, I watched two hours of it) was when Andrew Bailey was asked why UK borrowers paid higher interest rates, and UK lenders to banks lower, than their continental counterparts, i.e. why are UK bank margins wider at both ends? The British Bankers’ Association must have been proud of Bailey’s evasion but why did the Chairman, Andrew Tyrie, let him get away with it? The reality is that banking debates are full of technical confusions. 

The high point of the session was the discussion between Brooks Newmark MP and Michael Cohrs, an independent, and independent minded, member of the FPC.  It was this exchange that gave the Daily Telegraph its headline but it was a lot smarter than that.  Rather than cut back on lending or increasing shareholder equity, banks could, and should, sell off their other assets.

The EU Federalists have already written the script for the UK’s new relationship as an “associate member”.  We will be subject to all the regulations and costs of EU membership without any influence or voting rights.  That is roughly the deal Norway currently has.

So is this decision time as we choose between attractive alternatives or derision time as we crawl pathetically back into our hutch?

The Federalists believe the UK has little negotiating room and Cameron will be out of office before the talks get tough.  At the next election, UKIP will not be taking many, if any, Westminster seats but they will be drawing away the key marginal voters.  Any Lib Dems remaining will undermine negotiations. 

So is the EU now a lost cause?  If it was left to the FCO, it certainly would be.  Our diplomats have no blueprint of an EU, nor of an exit, that we would like, nor any plan to achieve either of them.

What can we do?  Cameron needs to agree the seriousness of the issue with Milliband – forget Clegg.  The UK’s national interest needs a negotiating team and a strategy  that will survive the next election whatever the outcome.  The team should work in secret and bring together some of the more thoughtful MPs and MEPs, both Conservative and Labour, as well as the City – our most crucial economic interest.  Unfortunately it will also need diplomats, but retired ambassadors rather than serving civil servants, because it will be essential to know the extent to which we can bring other EU members along with us.

The team should be given a year, no more, to come up with an A and a B scenario to compare with scenario C, and plans to achieve A and B:
A. What is the best “staying in” deal we can reasonably expect to achieve?
B. What is the best “opting out” deal we can reasonably expect to achieve?
C. If we are blocked from both of those and continue to be dragged, whingeing, along, how will that look?

A referendum should be deferred until we are ready but that is easy.  If a premature referendum comes to the wrong answer, have another a year later.

We can win this campaign but not if we continue to deal with the EU in the manner we have for the last 40 years.  If we lose this campaign it will resemble our last Eurovision Song Contest entry: a tired old gent being derided by a bunch of countries with whom we have lost touch.

David Cameron is expected to make his long awaited EU policy speech shortly.  We are told it will be radical and bold. The consequence, we are told again, will be a major renegotiation of our EU terms or departure with our head held high.  That choice will be for the UK to make on the basis of an in/out referendum.

Cameron is in the weakest negotiating position of any British Prime Minister since Edward Heath.  With her Bruges speech, Thatcher turned us from a respected contributor to a moaning Minnie, complaining at every step of the EU way and thereby alienating our friends.  Major dismantled what could have been a powerful trading partner for the EU leaving a rump EFTA today.  He led our potential allies into the arms of Brussels.  Now they want our money but not us.  Blair, to appease the unions, gave away John Major’s opt-outs and, to curry favour with new EU members, much of the Thatcher rebate. Brown handed City regulation over to Brussels.

So far Brussels has been helpful on Scottish independence because Spain is terrified that Catalonia will go the same way.  But if the Federalists can use Scottish independence as a further way to undermine the UK position, they surely will.

The track record of our City, regulators and civil servants has been weak.  Much of the EU treaty and regulatory wording has been drafted by our people.  They claim, naturally, that the treaties and regulations are better than they otherwise would have been. From the Federalist perspective these civil servants look remarkably like a Fifth Column, advancing the EU cause under British colours.

And finally consider the witlessness of our MPs. Have any have sat down and worked out what we are trying to achieve and how that can be done?  Bill Cash is thoughtful but no one listens to him any more. On fisheries, did we not sell most of our rights to Spanish fleets?  Will the courts allow us to repatriate those rights without compensation and will the compensation not be higher for an independent UK?

Our MPs and our media have further alienated Brussels and other member states by blaming them for UK intervention and undermining our sovereignty  when, for example, far more regulations have arisen from Whitehall and Westminster than ever came from Brussels.  Transparently, it has suited Whitehall to escape the odium that should be theirs.

In short, the UK will begin the negotiations with the worst possible background. 

The Parliamentary Commission on Banking has reported this morning and, like most of the talk leading up to and since the Vickers Report, is pre-occupied by ring fencing.  Vickers, as you will recall, dealt with the demands for separating retail and investment banking by proposing that those banking groups involved in both should have separate subsidiaries for those sectors with no links between them.

Government discussions since then have been seen by some as, under pressure from the bankers, watering down the Vickers proposals.  The Parliamentary Commission, au contraire, claims that Vickers did not go far enough and the fences should be “electrified”, i.e. any infringement would lead immediately to full separation.  Sir John Vickers himself, in an email to the Today programme, quickly responded by saying that full separation would be an own goal.

What is weird about all this is that the financial crisis had little if anything to do with the lack of such separation.  Retail banks, like Northern Rock, and building societies created a bubble of huge unrepayable debts and, quite separately, banks packaged up those “assets” to conceal their true nature and then played pass the parcel with the packages.  Lehman Brothers was purely an investment bank.  The entities that created the crash were already separated and separating the other groups would do nothing to prevent a future crash.

What is even weirder is the failure to recognise that banking today is an international, if not fully global, market.  Financial solutions have to be found internationally.  The Basel group are doing their best to achieve that and we now have three “Accords”. They focus, quite sensibly, on ensuring banks are adequately capitalised for the businesses they run.  One can, and I have, criticised their proposals as an over-reaction which will penalise small businesses, but the point here is that the rest of world’s top regulators are not worrying at all about ring-fences.

Another part of the international dimension which the Parliamentary Commission fails to recognise is the EU involvement.  Uncertainty about that undoubtedly contributed to the Northern Rock crash as Professor Tim Congden and others, including Sir Mervyn King, have pointed out.  The UK is in course of handing financial regulation over to Brussels but what is for us to do and what for Brussels is unclear.  The only thing that is clear is that the EU’s interventions will damage the competitiveness of UK banks and increase the costs for taxpayers.

So, not unusually, British chattering classes are dancing around playing ring-a-ring-a-ring-fence when the rest of the world gets on with regulating the real financial market.  It is truly astonishing that this Commission should choose to focus its entire attention on the area that matters least.  The consequence of adopting their suggestions, as Vickers himself seems to be pointing out, can only be that we will hobble our own financial sector at great cost to the economy and the British taxpayer.

Six years ago Keith Boyfield and I wrote a report for this Institute showing that both the EU options then under discussion, exit or accepting the EU as it then was, were sub-optimal.  Since then both those options have worsened.  We called the paper “EUtopia” and painted a picture of an EU that would be better for the members as a whole, better for the UK and, at least in our view, achievable over a longish process of charm, leadership and negotiation. The report was well received especially by the man who is now our Foreign Secretary.

While the report was still in draft, we had a meeting with the then chief of EU matters at the FCO.  The person concerned was, as one would expect, both charming and intelligent.  We asked about the FCO’s vision for the EU and the UK’s place within it and about the strategy for achieving that ideal.  This was greeted with astonishment. The FCO, we were told, had not such forward plan, indeed no planning of any such sort, and should not be expected to operate in that way.  The FCO, and the government on the FCO’s advice, purely reacted to events.

We pointed out that the French strategised their goals and worked purposefully towards them.  That was why the EU worked so well for France.  That cut no ice and the meeting broke up.

Talking with senior politicians, albeit not FCO civil servants, it seems little has changed.  Indeed it may have got worse as the UK’s room for manoeuvre has reduced and we are more and more seen as sulking in a corner.  Apparently, the FCO today thanks that no strategy for the EU is required because it is more or less right as it is.  The FCO, after all wrote many of the rules including the Lisbon Treaty.  For “FCO” today read “Brussels Fifth COlumn”.

Lib Dems apart, few others take that view: not politicians, not business people, and not the electorate.  Doubtless the FCO justify their lofty view by claiming to be better informed than the common people.  The reality is that these civil servants have forgotten the meaning of the word “servant” and that we pay their salaries.

We need an FCO that can visualise an EU that is best for the EU as a whole, best for the UK and achievable and then create a plan to achieve it.  The UK has plenty of potential allies.  Most member states should applaud a reduction in governance costs and accounts that auditors can approve.  French peasant farmers could be brought back to the barricades to fight against EU farm subsidies going to the huge agri-corporations, not the small farmers.  The biggest sufferers from the idiotic EU fish policies are the fishermen themselves. The German on the Hauptstraβe likes being a main contributor to the EU budget as much as we do.

Contrast that with sitting on the sidelines and being isolated as Mr Grumpy.  The Eurovision song contest tells us all we need to know about how many votes the UK attracts in the modern Europe.  Using the veto merely adds to the antipathy.

In short, the Foreign Office is not up to the job. We would probably be better off if we did not have one at all but that is not realistic.  It should be replaced by an FCO that understands what the UK needs and wants and can create the charm offensive needed to achieve it.