Money does grow on trees

The government’s White Paper on Financial Services has been both celebrated and criticised this week. Some say the proposed regulatory changes will never come into force, while others view the changes as necessary evils, and still others want to see the ‘big banks’ suffer for getting us into this mess in the first place.

The ins and outs of the White Paper have been well documented, but at its core is the premise that “systemically significant” financial companies have more scope to damage the wider financial system when things go wrong than do smaller institutions. But surely the key isn’t how big a bank is but rather how well it’s run? After all, aren’t all banks significant when it comes to system failure? Northern Rock certainly was and yet in size terms it was a relatively small player. Sure, I’m happy to concede that the bigger and more complex a bank is, the easier it may be for problems to be brushed under its large carpet or to go unnoticed by those who are so high up at the top that their heads are in the clouds. And it seems to make sense that if a tree develops rot and crashes to the ground, the larger the tree, the greater the shockwave when it lands. However, rather than tackling the breadth and complexity of such institutions, would it not make better sense to focus our efforts on ensuring that those in charge of these banks are really up to the job?

To continue the tree analogy, the White Paper suggests slicing and dicing the largest trees in the wood so that if rot does set in, affected branches can be sacrificed one by one, thereby avoiding the need to fell the entire tree. I don’t see anything fundamentally wrong with this plan, but it does seem rather passive: dealing with the problem once it has occurred. Can we not, instead, sidestep the sticky subject of how much regulation is too much and instead strive to inject a new paradigm of thought into financial institutions whereby consequences, and specifically the consequences of risky activities, are held in the forefront of managements’ minds?

Increasing capital requirements for those “systemically significant” institutions is at the centre of the proposals, with the Financial Services Authority set to attempt to calculate the cost and likelihood of a bank's failure on an individual basis in order to set each institution’s level of required capital. I applaud this approach as the financial sector is clearly not one of homogeneous players and each case should be assessed separately. However, given the evidence that we now have of how spectacularly ineffective the FSA has been in the past, is this really a task we want to entrust it with? Granted, the new tripartite system of the FSA, the Bank of England and the UK Treasury means that there are more eyes on the situation and each set of eyes is observing from a slightly different viewpoint. And furthermore, a minimum level of industry regulation is paramount. But it seems to me that what is really needed is a shift in the financial industry’s moral psyche.

Bankers, ‘City boys’, ‘suits’—and other less respectful monikers—have developed a distinctly negative reputation of late. To be sure, their reputation was not hugely positive before the global meltdown, not in my lifetime anyway, but since the blame for the economic crisis has been firmly laid on the shoulders of financial institutions, it is palpably worse. Bankers may well have been reputed as being overpaid and arrogant, but at least they were also seen to be partly responsible for the strength of the British economy. Now, however, they are seen not only as responsible for its current weakness but also as money-grabbing and money-squandering individuals. I am not condoning or expressing agreement with either of these views—I don’t see that demonisation is especially useful here, instead I feel that the banking community needs to readdress the balance.

Of course it will take time, but what is needed is for the government to incentivise a moral shift in the industry, whereby banks aren’t discouraged from becoming “systemically significant” but are instead discouraged from getting so carried away with the speed and strength at which they can grow money that management loses its grasp on the basic principles of running a stable and successful business.

By all means, set in motion regulatory change that enables companies to assess the ability of their ‘branches’ to succeed and encourages management to calculate the cost of those branches' failing and having to be sawn off. But to complement this approach, let’s also strive for a new approach to bank management—whether big banks or smaller banks—that holds industry players accountable for the risks they take on and makes them think at least twice about their operations and the consequences of their actions.

Call me an idealist (or a tree-hugger, if you will), but I think what is really needed is an organic approach that starts with the roots. There should be nothing wrong with wanting to be the tallest tree in the forest, but that tree should also want to be the sturdiest, with the strongest roots and the supplest of branches that can flex to accommodate the winds of economic change.