The Trusty Servant

The Qatar/Barclays news this morning seems an appropriate moment to ask where we are on bank reform. First a brief recap on Qatar. Stage 1 of the banking crisis in the UK was the run on Northern Rock in September 2007. That led to gradually increasing worries about other UK banks. Meanwhile, Bear Stearns, a major UK investment bank, started to collapse and had to be taken over by JP Morgan Chase in March 2008. That was a major red flag. Barclays carried out a £4.5 billion equity issue in July 2008. Only 19% of shareholders took up their rights. Qatar Investment Authority and Challenger (a Qatar fund apparently owned by the Qatari prime minister Sheikh Al-Thani) increased their holdings and ended up with 8% (ie about 0.67 billion shares out of 8.37 billion). The price was 282p.

Then in September 2008 Stage 2 began with the collapse of Lehmans. The UK government quickly required the major UK banks to hold much larger Tier 1 capital, offering to subscribe for new equity itself if necessary. Barclays decided not to pay a final dividend for 2008 (thus saving about £1.5 billion, the corresponding 2007 figure) and not to resume dividends until the second half of 2009 (maybe saving another £0.5 billion).

It also raised a further £4 billion from Qatar and Abu Dhabi by issuing 2.64 billion shares (held as convertible debt until last month) at 153p. Qatar and Abu Dhabi also got 5-year warrants to acquire another 1.52 billion shares at 198p. There were also various non-dilution provisions, which are probably of little relevance now, although they were important protections to the Arabs’ downside at the time.

The Barclays price has been over 350p for most of the period since early August 2009, so the warrants are now comfortably in the money. Post Lehmans, the Arab investors effectively acquired or got the right to acquire 4.16 billion shares (worth £14.6 billion at 350p) for just over £7 billion. They have already doubled their money – in fact almost trebled it, because they only had to risk £4 billion for a gain of more than £7 billion.

Before trading opened this morning Qatar announced its intention to exercise warrants for 0.38 billion shares and to sell the shares. The Barclays price fell about 20p at the London opening to around 365p. So Barclays gets another £0.75 billion and Qatar reduces its risk (one could regard the proceeds as reducing the acquisition cost of its remaining shares/warrants). The small size of the fall on the announcement suggests that investor worries about Barclays are firmly in the past.

After the dust had settled from the blind panic triggered by Lehmans collapse, it became apparent that many of the things most talked about in the London had not actually been relevant to the performance of the UK banks. Indeed John Varley (the Barclays CEO) toured the newsrooms after the interims (results for the half year to 30 June 2009) pointing out that Barclays’ substantial investment banking operations had substantially helped it during the crisis, because it had diversified risk. He thought all the problems had occurred in “monolines”, banking groups which had a single type of business.

At the time this much annoyed me, but I failed to explain why. I simply gave a transcript of his interview with Channel 4 News, regarding it as self-evidently wrong. That is an error I must try to avoid in future, because rereading the interview I cannot immediately see why he was wrong!

Nonetheless, four things seem both fairly evident from first principles and to be supported by the events of the last two years:

(1) the government cannot allow the bankruptcy of a large bank which is involved in money transfer (ie current accounts etc) and/or lending to ordinary individuals and businesses, because the consequences would be too disruptive to the rest of the economy;

(2) regulators find it hard to ensure adequate capital for investment banking operations, simply because the real risks inherent in these operations are extremely hard to divine;

(3) the “bonus culture” puts heavy pressure on both individual employees (such as traders) and on senior management to take big risks, because as individuals the risk they face is “asymmetric” – if it pans out they get rich, if it doesn’t they do not suffer much;

(4) there was a major failure by senior managements, auditors and regulators to stop bad lending (both residential mortgages and lending to businesses, especially to property developers).

Note that (4) is nothing new. It has happened in every property crash in the last 40 years (ie the period in which I have been old enough to take an interest) and probably longer. But there were some hopes that better regulation would avoid it this time.

The most obvious solution is some form of Glass-Steagall legislation. As Vince Cable puts it, to separate casino activities from plain banking. The FSA is against such legislation, claiming it is impractical. That is obvious bunk. Certainly, a solution is not as simple as demerging the investment banking operations from the plain money transfer/lending operations. You also have to ensure, probably through revised capital requirements that the plain banks do not lend to investment banks, but it is eminently doable given a willingness to upset the banks.

The political problem is that such a move faces huge opposition from the banks. Senior executives always want big organizations, because they get bigger rewards if the organization is bigger (a generic problem, not confined to banks). The banking lobby is extremely powerful. It has been used to getting its own way for a long time under New Labour.

Of course, the more immediate problem is that the current government does not have time to force anything through ahead of the election. Just maybe it might have managed it with enthusiastic support from the FSA, but it does not have that. The bankers are confident, probably correctly, that the Tories will never push through anything radical, and so would determinedly stall anything they did not like.

Some limited steps will probably be taken on bonuses. The terminology is extremely unfortunate of course and is probably sufficient to blight more serious action on its own. It makes no difference whether high remuneration is paid as a bonus or as regular pay. It would be relatively straightforward to remove all bonuses without affecting the amount anyone was paid. That would certainly not help. Indeed the whole point of “bonuses” – effectively pay whose precise quantum is only set when it becomes clear how much the bank can afford – was to enhance the financial stability of the bank.

[Parenthetically, it is amazing how successful such nomenclature problems can be in confusing public debate. The leading example is probably "national insurance contributions", which are just part of ordinary income tax, but which almost everyone fails or forgets to include when talking about the rate of income tax.]

It currently looks as though there will be a slightly longer time lag before a bonus is paid. I doubt that will help. Many problems lie dormant for years before they become toxic.

Nonetheless the FSA appears to be introducing some other modest improvements which may have more effect. More staff are being put into key areas. When Hector Sants become CEO of the FSA he asked to see the team regulating Barclays. One person showed up. That person could not have managed more than a paper shuffling exercise (dealing with the numerous reports Barclays is required to file every year).

Then some attention is being paid to competence as part of the classic “fit and proper person” test for senior management. Until the crash, the FSA did not regard it as its role to examine competence for the senior management of major institutions. It remains to be seen how far it will go.

It has apparently had the courage to veto some non-execs since the crash on the grounds of lack of relevant experience. But if another James Crosby sought appointment as a bank CEO, would the FSA have the courage to veto it? I doubt it. Crosby was a sales type appointed CEO of Halifax in 1999, became CEO of HBOS following the merger and proceeded to wreck it by reckless lending. In my view he was manifestly unfit to run a bank, and the problem was compounded by the appointment of a marketing type as chairman.

The Northern Rock case was even more clear-cut. Adam Applegarth and his chairman were worse than Crosby and Stevenson. Applegarth came across as a used car salesman and Matt Ridley was a popular science writer (actually a good one) cum local squire who apparently had nil knowledge or experience of banking.

Finally, the FSA is apparently working hard to get the Basle capital rules strengthened.

There is a sense in which none of it matters. The pattern is always the same. Memories are fresh for a decade or so, then they fade and people start paying no more than lip service to important procedures. Take the amazing case of the financial controller at Barings who signed increasingly large authorizations for cash transfers to the Singapore office (from memory, a few million, then a few tens of millions, then a hundred million). Each time he was fobbed off with the explanation “client account”. But if this was client business, why wasn’t the client putting up the funds? Of course, the harassed signatory had umpteen other things to do, he would routinely have dozens of slips to countersign every day, perhaps rising to a hundred on occasion. But that is no excuse. Senior people need an ability to wake up and focus hard when they see something odd.

That is why I still like my idea of a prestigious lecture series – maybe every six months – where someone recounts one of the many past banking disasters and points up the morals for the future. They could be black tie events for top executives and others at the Guildhall with a fancy dinner.