Your Bank: Fiduciary or Predator?

In the old days when banks were local, and owned either as partnerships or mutuals, bankers had a stake in promoting the prosperity of their clients. They wanted to see their clients do well so that savings in the bank would increase, and then the banker could lend more and do better too. Bankers were meticulous in evaluating the credit quality of local borrowers, because a loss hit their own capital and equity in the business.

Largely as a result of this happy local alignment of depositor/banker/borrower interests, bankers came to be regarded as trusted fiduciaries. Depositors expected the banker to exercise discretion in the lending of capital. Borrowers expected the banker to provide loans on fair and reasonable terms which would help the borrower's business to grow and perform on repayment obligations.

As we know, those days are long past. Banks are rarely partnerships or mutuals. Remuneration models that promote fierce competition and short term bonus mania are unlikely to leave much scope for ethical reflection on the promotion of either depositor protection or borrower prosperity. Modern bank funding models are focused on money markets and shadow banking conduits rather than making depositors secure long term. Their lending models are seeking ever higher margins on transactional speculation, cross-selling and hidden fees. They seek opportunities globally rather than the long duration lending that sustained growth of local businesses. Banks are no longer geographically dependent on the local community for either deposits or borrowers.

We are now forced to re-evaluate the role of banks. They clearly have little interest in performing as fiduciaries. They have a powerful interest in becoming predators.

But if banks are predators, then their beneficial social functions are undermined, and indeed, they become a threat to social welfare, economic growth and non-bank prosperity. If that is true, then they no longer warrant state protections.

It is the depositors and borrowers who now need the protection.

In the UK some banks have threatened to leave if the successor to Mervyn King is not less "hostile" to their predations.

This is like a fox threatening to go elsewhere unless the farmer makes the chicken coop more accessible. Worrying.

UPDATE: Today Greg Smith, head of equity derivatives at Goldman Sachs, very publicly resigned in the pages of the New York Times. It sums up his resignation to say that he preferred the days when he could be a fiduciary to the firm's clients rather than their predator.

Complexity Costs

I have had to deal with the idiocy of modern financial regulation rather more than I would like lately. The issue involves FSA regulations which create a bias in favour of the TBTF banks. (As almost all FSA regulation is biased in favour of TBTF banks, this isn't much of a clue.) The FSA acknowledges that their rule creates a bias. They acknowledge that the bias was created in error, without principled justification. (They allowed outside counsel retained by the big banks to write the rule for them.) They acknowledge that the restrictive rule is inconsistent with European Union directives on the subject matter, and inconsistent also with UK government objectives of reducing the implicit subsidy to TBTF banks and reintroducing competition to financial services. They acknowledge that a change to the rule could improve sector competition, consumer choice and reduce costs.

Will they change the rule? No. Changing the rule would require an expensive public consultantion and cost-benefit impact assessment that hasn't been budgeted by the relevant division of the FSA for this fiscal year. Additionally, there is no proof of a market demand for the benefits of the rule change, as the existing users of the rule - the TBTF banks - are telling the FSA that existing customers aren't asking for a rule change.

It's a good thing that this is a marginal issue for the business. If it were serious, I'd have to advise doing business elsewhere than the UK. It might be wise to do that anyway, as being subject to a regulator like the FSA will be such a miserable experience based on current observation that locating a business somewhere more sensible would probably help ensure the business succeeds longer term.

The frustration of this one case raises a broader issue. Is it possible to reform a failed regulatory system sufficiently to restore a functioning market?

Regulators operate monopolies and are virtually impossible to discipline for their errors. Being bureaucrats, most regulators do not really have a stake in whether their rules do more harm than good. No one outside the regulator knows or cares who had responsibility for crafting a particular regulation, much less how it promoted or restrained market efficiency in the long run. It's almost always easier and less risky to do what they are asked by powerful incumbents than to attempt to level the playing field in favour of consumer protection or increased competition. Fifteen years of the FSA pretty much proves this point, as complaints to the financial ombudsman were at record levels last year and financial services concentration is consolidating at a very rapid clip leaving consumers very little real choice.

And then there is the complexity of modern regulation. Changing any regulation requires a publication of proposals, a consultation period, a cost-benefit impact assessment, legal consultation to ensure compatibility with EU directives, etc. Consultation responses are more likely to be from TBTF incumbents with a stake in bad regulation, and very unlikely to be from ill-informed consumers or would-be market entrants who might benefit from good regulation.

The FSA is being disbanded for its failure to properly regulate UK banks in the run up to crisis. It will be split into three, with some functions going to the Bank of England, some to a new Prudential Regulatory Authority and some to a new Financial Conduct Authority. A change in structure does not necessarily yield a change in ethos or policy. Sadly, the same bureaucrats will turn up at the same desks and largely follow the same courses that led to failure of the old system. If anything, the added complexity of co-ordinating among the three new regulators will be an additional incentive to make as few changes as possible to regulations going forward.

I am reminded of a friend who went to Eastern Europe just after the Berlin Wall came down in hopes of investing there to modernise the economy. He came back determined never to venture an investment because the same bureaucrats as held office under Communism were still showing up to work in the ministries every day and following the same rules as before.