Back in May I posted on a distinctive message for the next election. This post looks at the defining global political issue since 2008: no, not the House of Lords; the financial sector.
Long before the LIBOR scandal, the financial industry dragged millions into poverty, awarding the perpetrators staggering salaries. But you already knew that. What we need is an intelligent, credible policy response. It is tempting to announce that millionaire bankers should be boiled in oil, but as some Liberal Democrats have bravely argued, finance is important in the UK, employing lots of people, not all of whom are rapacious millionaires. However, Mervyn King is right: “of all the many ways of organising banking, the worst is the one we have today”. We need to find a way to return banks to a service that enables other parts of the economy to grow.
Two policies would help: the first is rebalancing risk and reward. Directors of financial institutions should be strictly liable (meaning liable without the need to prove individual fault) for losses at their institutions. Directors should carry unlimited personal liability and post sizeable cash bonds as part of the capital of their bank. When RBS goes bust, Fred Goodwin goes bust.
At the institutional level, we must tackle perverse incentives. Few people realise that current accounting rules allow banks to book “profits” that have not been received; in other words these profits are illusory. Don’t take my word for it – the Adam Smith Institute (hardly anti-finance) has proved it. Casino accounting has led to an explosion in derivatives liabilities: UK banks’ derivative liabilities are three times what they were in June 2007 (in 2012, £4.6 trillion. UK GDP is a mere £1.45 trillion). So as well as making directors liable, banks must account for profits straighforwardly. This isn’t my idea – a Tory MP proposed it but his party didn’t support it. We should, whilst pushing not just for ring-fencing retail and casino banking, but full separation.
The second idea is one that might make the Chancellor shudder – a pasty tax for finance. Whilst VAT on hot food proved beyond George Osborne, extending VAT to finance (Financial Activities Tax or FAT) would prevent the finance sector becoming too large and limit excessive risk-taking. As Osborne defends bankers’ bonuses, whilst his boss attacks the Financial Transactions Tax (FTT), we should take the lead role in Europe converting the FTT, fraught with downsides, into FAT, which has IMF and central bankers’ support.
Osborne’s ruse is pretty clear – if we are the only place in Europe with uncapped bonuses and untaxed trading, the City will grow. That merely increases the unbalanced nature of our economy. Those who argue against a FAT will say that business will migrate elsewhere: but if the UK and Japan joined the rest of the EU, a massive proportion of global financial transactions would be covered. Making fat-cats into FAT-cats, or more simply, making bankers pay their way – proportionally and carefully, is something the Liberal Democrats must make their own.
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21 Comments
I genuinely don’t understand what this article is proposing. What is a FAT levied on, and how is it calculated?
A FAT is just a tax on the sum of the profits and remuneration paid by financial institutions. As for the level it’s set at, that’s something for further analysis but the clear objective is to disincentivise excessive risk taking. Many financial activities are VAT exempt so there is an underlying logic.
The IMF judged FAT has more credibility than FTT:
http://blog-imfdirect.imf.org/2010/04/25/fair-and-substantial—taxing-the-financial-sector/
This article is surely a joke? Who on earth would be the director of an institution without limited liability? Why banks and not any other company? All the banks would leave the country overnight. And I mean literally, we wouldnt have a single bank in the country. No director would want personal liability.
Do you know what a derivative is, the three ways of accounting for them and when and why you’re allowed to use them (I do). Do you know what assets they havent brought in with the liabilities? I’m on a phone at the moment so no chance to check the link in detail ,unfortunately.
Will check the FTT link now.
Limited liability applies to shareholders rather than directors, and is free downside insurance. It might be understood in terms of derivatives, perhaps an option which shareholders are able to exercise to have liability costs paid on their behalf when things go wrong.
As such it might readily be replaceable by a financial product in today’s market, perhaps giving rise to “insured liability” companies instead of “limited liaility” ones. This could be better than the present system, in which the costs of things going wrong are paid for by those who are wronged and through job losses.
Who knows, this might even lead to insurance companies putting pressure on shareholders of insured liability companies to appoint competent and socially responsible directors!
Maybe I should wait for @Andreas to get off the ‘phone, but, yes I do know what a derivative is. Also I know that its original purpose (to allow uncertain traders such as farmers to hedge against things like bad weather) has become completely distorted.
Why should finance be treated differently? Simple – when other companies go bust as a result of poor busines decisions, they do not endanger the global economy and need a massive publicly funded bailout. The key decision is one of incentive – clearly if the UK was the only place in Europe that introduced these disincentives we would suffer accordingly. But instead of being in the lead globally in minimising measures to limit risk in finance, what if we were in the lead actually advocating minimising risk?
Please click on the link below to understand the scale of the derivatives problem:
http://www.bankofengland.co.uk/boeapps/iadb/fromshowcolumns.asp?Travel=NIxAZxI3xSCx&ShadowPage=1&FromCategoryList=Yes&CategID=6&NewMeaningId=LTOTC&HighlightCatValueDisplay=Derivatives+-+total+liabilities+by+counterparty&ActualResNumPerPage=&TotalNumResults
@Charles.
Didn’t mean to sound condescending in my original post – just that about 98% of the time people tend to have no idea what they’re talking about and the answer to “do you know what a derivative is” is “no”.
The link above appears to show only liabilities and it doesnt make it clear whether it’s net or gross. Its also not clear from that link whether the liabilities are reflected in the financial statements in one of the possible ways. I’m not aware of which IFRS rule permits derivatives to not be displayed. They can be netted off the corresponding asset but the overall asset or liability must be shown as is my understanding.
@Andreas – no problem – I appreciate it’s a very technical issue and ultimately a lengthy technical discussion of derivatives is not going to serve the interests of LDV readers very well – although I’m boring enough to be happy to do that with reference to the IFRS rule book…
But to try to keep things simple – derivatives allow very ‘ambitious’ calculations of assets which is why they have mushroomed way beyond their original purpose. My argument is that we should reintroduce genuine, liberal, free-market risk into the financial system, rather than the current protected risk (where the protection is all in the banks’ favour). And combine that with full separation to insulate retail customers.
there is a saying “Never put all your eggs in one basket” and that is what we have almost done with banking. Whilst into proverbs and platitudes and before sending the bankers packing, don’t “throw out the baby with the bath water” or “kill the goose that laid the golden egg” : so let’s hold onto banking but from now on our national sources of income must have a broader spread . Then the pain will be felt less whenever one particular sector of the economy goes down.
In the past the UK has lead the world in inventions and engineering: the genius and the skills are still with us: it just happens that the talent here is latent. This has to the way forward
@Charles
A little unsure as to how IFRS rules allow for liberal calculation of asset values, how much the 4.6tn of liabilities linked to above are offset by assets. If assets are calculated wrong then this would appear to be an audit and calculation issue, surely?
Of course, this all ignores the fact that all banks would immediately incorporate in France if we did this.
Not sure about incorporating in France: “Under IFRS, RBS clearly was not charging its profit or capital for risk. It is therefore reasonable to assume that had RBS been subject to the same financial accounting and auditing constraints as French banks, what is described in the accounts of the Asset Protection Scheme as “aggressive growth” would have been checked as the accounting would have reflected the inherent risk of the lending.” (From Adam Smith Inst)
Your point about assets calculated ‘wrong’ assumes a level of simplicity in the calculations which doesn’t exist. But, according to the BoE, derivatives liabilities lagged assets (both at fairly stable levels) from 98-05. Then both started mushrooming. At the height of 08 boom/bust derivative liabilities were 33% above derivative assets. And what level of activity in the real economy justified a 1000% increase between 2005 – 2008? Or, what circumstances allowed this to happen and do those circumstances continue to exist?
Osborne is clueless – although to be fair not very far behind the rest of his party. Where does he suppose all the bankers’ profit – and bonuses – of recent years came from if not ultimately from ripping off others. The scale is far too big to come from running a service business, even a very large one. Libor is the scandal that is most in the public eye but there are others bubbling under. Like the oil market where there are well-founded suspicions that the oil price has been fixed to the detriment of motorists. A Daily Telegraph poll suggests that over 95% want a formal investigation. A bit of populism here in calling for an inquiry would not go amiss.
http://www.telegraph.co.uk/earth/energy/fuel/9401934/Libor-scandal-Was-the-petrol-price-rigged-too.html
And then there is money laundering for foreign dictators, oligarchs and organised crime. According to some, London is now the money laundering capital of the world.
http://www.ianfraser.org/how-london-became-the-money-laundering-capital-of-the-world/
Does anyone suppose this is a vaible business strategy for Britain? Does anyone (other than Osborne) think it’s what we should aspire to?
How we get from here to there is clearly a problem but not one to pussy-foot around. For starters, yes, strict liability for bank directors as was the case until 1868 (from memory – sorry can’t find the reference). Then Vickers ++ including complete separation of high street and investment banking. Then moves to tax banks over a certain size – economies of scale plateau out surprisingly fast and they then become Too Big To Fail. Also measures to direct banks away from short-term casino activities and towards lon-term productive investment. And finally tax (at a very low rate) credit creation by banks to capture for the public the value of seigneurage of credit creation they now enjoy. Loans might cost marginally more but other taxes could be correspondingly reduced to be tax neutral overall.
Taxing credit creation will add to the cost of borrowing, which is perhaps not what the economy needs at the moment.
Given that the cost of borrowing is as low as it’s ever been, but people are still not able to borrow, I’m not sure it’s the cost per se, but the risk calculations being made by banks which are the problem. That ‘Bank of Dave’ programme seems to suggest that plenty of sound schemes are being turned down for loans because the credit markets have mostly seized up altogether – rather than because it’s prohibitively expensive.
When it comes to costs, every little hurts, but yes, perceptions of risk must be a major factor now, plus need to recapitalize.
So our foucus should perhaps be on how to reduce risk and perceptions thereof, rather than on punishing misdeeds.
Whatever Osborne is, sticking to a plan no matter what does have that quality – it maps out a future that can seem more certain than one where the rules of the game are changed all the time. Companies can have a better chance of surviving doomsday if they know in advance how it’s going to play out.
I agree about giving people certainty and also that punishment is not a useful objective (a point I made in the original post). But equally, it seems important to demonstrate that we have a way out of the current death spiral where moral hazard has been eliminated and bankers are free to keep making the same bets, win or lose.
Let me amplify my earlier comment on seigniorage. It is the difference between the value of money and the cost of producing it. So manufacturing notes and coins produces a useful income stream for government. But notes and coins are not the only form of money – for practical purposes it also includes credit in that yu can buy a house or a car with it. And in a digital age credit accounts for about 97% of the money, notes and coins only about 3% and of course teh cost of creating credit is only a few mouse clicks – ie. it is vitually costless. So who gets the seigniorage from creating credit (which is after all a public good)? The answer is banks when they create a loan – it costs them nothing yet it confers the legal right to receive interest over the life of the loan and, if the loan goes bad, to seize the security. I don’t know of any estimate for the UK but it is clearly a HUGE amount of money and amounts to a covert subsidy of the banks at public expense. Hence Josiah Stamp, a Director of the Bank of England in the 1920s said,
“Banking was conceived in iniquity and was born in sin. The bankers own the earth. Take it away from them, but leave them the power to create money, and with the flick of the pen they will create enough deposits to buy it back again. However, take away from them the power to create money and all the great fortunes like mine will disappear and they ought to disappear, for this would be a happier and better world to live in. But, if you wish to remain the slaves of bankers and pay the cost of your own slavery, let them continue to create money.”
Or, as Mayer Amschel Rothschild put it, “Give me control over a nation’s currency and I don’t care who makes the laws.”
Several solutions exist but taxing away the benefit and using it for public benefit would perhaps be the easiest.
” Directors of financial institutions should be strictly liable (meaning liable without the need to prove individual fault) for losses at their institutions. Directors should carry unlimited personal liability and post sizeable cash bonds as part of the capital of their bank. When RBS goes bust, Fred Goodwin goes bust.”
This sort of idea isn’t restricted to the Lib Dems, you may be surprised to read the following:
http://conservativehome.blogs.com/the-deep-end/2012/07/casino-capitalism-a-disgraceful-slur-on-casinos.html#idc-container
Talking in the manner of this post changes the idea from one of punishment to that of responsibility (which does seem to be one of the major problems),
As I noted a Tory MP (Steve Baker) proposed some of these ideas. But his party ignored him. Why? Presumably because of the umbilical cord between the City and CCHQ. We should rejoice in our independence to look at this on its merits without giving way to special interests.
@Charles Beaumont
I haven’t honestly been watching the ins and outs of the tory position on this, so I couldn’t really comment – if this was from the MP you mentioned then I apologise for not realising.
I was really more interested in the use of language, there is a tendency for everyone to run around at the moment shouting “they must be punished”. Whilst it is fresh in the mind the public may agree, but the public can often be fair minded and they may not like the idea of punishment in the event of some one in the organisation doing something that the boss wasn’t aware of.
Changing the tone to that of responsibility and using the captain analogy would probably be more helpful in bringing something like this to fruition.
Agree entirely. Hence my point about (not) boiling bankers in hot oil.
This is a really good idea. It will bring the taxation of financial services into line with that faced by other businesses in terms of VAT. It’s also better than an FTT because it only taxes value added rather than transactions, which is a stupid approach that will cause arbitrary damage to the financial sector. FAT does not damage the very sector it raises taxes from in the same way making the tax for more productive in terms of revenue and sustainable in the long term.