February 5, 2012 8:09 pm

Forget Fred and focus on the real banking scandal

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Capitalism works because the discipline of the marketplace keeps greed, folly and incompetence in check, writes Nigel Lawson

There should be no sympathy for the treatment meted out to Mr Fred Goodwin. Through a combination of vanity, greed and sheer incompetence, he presided over the biggest banking disaster in British history, to the great cost of the taxpayer and the British economy, and showed no practical contrition for having done so. The fact that his behaviour was simply the most egregious example of a culpability shared by many other bankers is neither here nor there. There are occasions when an example needs to be set, and this is one of them.

But the RBS disaster, and the excesses of the bonus culture in general, are symptoms of a complex cancer at the heart of modern banking. It is dealing with this disease, rather than its symptoms, that needs to be the focus of policy.

It is three years now since, writing in this newspaper’s Future of Capitalism series, I called for a new Glass-Steagall Act – a complete separation between classic commercial banking and investment banking. I am glad that the Vickers Committee came to a similar conclusion about the dangers of so-called universal banking, and that it recommended at least a considerable degree of separation with the imposition of the so-called ring fence between the two; and that the government has accepted the Vickers recommendations and will be introducing the necessary legislation.

Capitalism works – and works far better than any other system – because the discipline of the marketplace keeps greed, folly and incompetence in check. When this is lacking, when businesses are considered too big, too important, or too interconnected to fail, this crucial discipline disappears, and disaster is almost inevitable. Separation is essential to avoid this.

I would have preferred to see complete structural separation. I am concerned on two grounds. First, that clever bankers will find ways round the ring fence, when there is such a clear incentive for them to do so. Second, because what is needed is to restore, in commercial banking, the old culture of banking prudence – in sharp distinction to the adventurous culture of investment banking. I am apprehensive about the ability to have two completely separate and opposed cultures in a single organisation with a single set of shareholders. But at least half a loaf is better than none at all.

More still needs to be done. When I introduced the legislation that became the 1987 Banking Act, with the explicit purpose of strengthening the system of bank supervision, one of its more important provisions was to break down the iron curtain between bank auditors and bank supervisors and to replace it with an ongoing dialogue. This is important, not least because even if bank auditors detect a serious cause for concern in a bank they dare not qualify its accounts for fear of starting a run on the bank. So they need to be required to inform the supervisors of their concern – just as the supervisors need to be able to alert the auditors to any concern they may have.

Regrettably, this essential dialogue fell into desuetude following the coming into office of the Blair-Brown government in 1997. Had it not done so, some of the banking disasters of 2007-8 might well have been averted. I am glad that the Bank of England and Financial Services Authority have now recognised the importance of this dialogue, and have proposed a code of practice designed to restore it. But, in the light of experience, I do not believe that goes far enough. In a unanimous all-party report last year, the Economic Affairs Committee of the House of Lords, on which I sit, called for a statutory obligation for this dialogue to occur.

The auditing of banks’ accounts, however, is fundamentally flawed in itself. The IFRS accounting system itself has proved to be damagingly pro-cyclical, and the ability to pay genuine (and genuinely large) bonuses out of purely paper profits, which are never subsequently realised, is at the heart of both the bonuses that cause such public and political outrage, and the reason why bank management consistently does so well when bank shareholders do so badly.

In an important speech last December, the Bank of England’s Andrew Haldane argued that the accounting system for banks needed radical reform. He concluded: “A distinct accounting regime for banks would be a radical departure from the past. But if we are to restore investor faith in banking sector balance sheets, nothing less than a radical rethink may be required”. He is absolutely right.

He is right, too, I believe, in his proposal in last year’s Wincott Lecture (a name that brings back fond memories to older readers of this newspaper) that corporate debt interest be no longer tax deductible. The tax deductibility of debt interest, coupled with the non-tax-deductibility of dividend payments, gives banks a strong incentive to finance themselves via debt rather than equity, wholly contrary to the interests of banking stability. And the practice of basing bank bonuses on the (notional) return on a wholly inadequate equity base further exacerbates the quasi-Ponzi nature of the current banking culture. If the chancellor is looking for a useful tax reform measure for his Budget next month, a move in this direction should be a strong candidate.

The writer was the UK’s chancellor of the exchequer from 1983 to 1989

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