COMMENT: High Noon in the Last Chance Banking Saloon

Brendan McSweeney
Professor of Management at Royal Holloway, University of London

The UK government has just announced that it plans to create three new High Street banking chains by 2015. This may¹ introduce more competition. There are just four large banking groups in the UK so banking here is exceptionally concentrated. But the proposals fail to engage with a far deeper flaw in UK banking: its dominance by ‘investment’ banking – “casino-banking” (FSA, 2009).² The damage caused by unreformed ‘investment’ banking is twofold. First, its main activity is not investment but gambling – speculation on a massive scale. The net effect of that focus has been to diminish investment, not as its name suggests increase it. It diverts resources away from, not into, productive activities. Secondly, the vast gambling of this banking sector was the main cause of the growth and ultimate collapse of the immense speculative bubble which has greatly damaged the real economy and real lives. As John Maynard Keynes observed: “When the capital development of a country becomes the by-product of a casino, the job is likely to be ill-done” (1936: 159).³ Ill-done it was, and ill-done it will be unless radical structural changes are made. The most essential change is the separation of banks into utility banks and investment banks and the removal from the latter of the safety-net of a tax payer rescue.

Utility Banking

Banking which facilitates flows of money to provide organizations and households with a liquid means by which to pay for goods and services and to protect savings and channel it to finance investment is vital for our economic and social well-being. Utility banking through real investment – that which creates sustainable growth – benefits current and future generations. In short, such banking is systemically essential. However, the major banks in the US, UK and in some other countries, did not, and do not, confine themselves to such useful and productive activities. Instead, and increasingly, they emphasised, and temporarily made immense fortunes from, gambling in securities – stock, bonds, and an ever growing zoo of concocted composites. Ironically, this activity is called ‘investment’ banking falsely implying that the activity is creating new resources. It does not. At best it diverts resources away from investment. And it was over-large and over-protected ‘investment’ banking which was the prime cause of the massive speculative bubble, which like all bubbles ultimately collapsed. This perverse banking, mainly in Anglo-American countries, created the greatest economic crash since the ‘Great Depression’. In the future, if unchecked, ‘investment’ banking will continue to divert resources away from real investment and in the longer term will again generate another economic crisis – one which societies, at least many in the West, economically weakened and further burdened with far greater public debt from rescuing these private sector organizations – will be even less able to withstand.

Gambling Not Investment

‘Investment’ banking is in reality camouflaged gambling. Speculative buying and selling of securities from others (secondary market trading) is spun as real investment in potentially growth generating activities. And yet, only a miniscule quantity of securities traded create new investment. In bull markets ‘investment’ banking gambling temporarily seems to boost economic growth simply by increasing activity in the market and increasing speculation. But it does not lead to finance being channelled into productive activities. The images we so often see on television of the fevered activities of expensively suited men and women surrounded by batteries of computers in ‘investment’ locations in Wall Street, the City of London, and elsewhere are not pictures of a highly paid elite investing in productive activities for all our benefit – most of the time they are simply gambling, not on horses or the spin of a roulette ball but on the future movements of security prices. Unlike gamblers at a racetrack or in a casino who use their own money and do not create wider social evil, ‘investment’ bankers gamble largely with our money (including our pension funds). ‘Investment’ banking is the modern equivalent, and on a vastly greater scale, of the medieval parasitical practice of clipping or sweating gold coins. The casino bankers clip chunks of money from the capital they churn. It is our money and our futures that the ‘investment’ bankers gambled with and as it turned out gambled away. As well as gambling with our money, ‘investment’ bankers feed further off our money by charging enormous commissions. In the UK, for instance, it has been estimated that a pensioner with a private pension will pay out 40% of their contributions in fees to investment bankers over the lifetime of the plan.

The Rich Get Richer

Unreformed ‘investment banking’ does not just cause immense economic damage, it also damages humans. How? First through the unemployment its reckless behaviour has created. So far six million jobs have been lost in the US, over 2½ million in the euro area, over half a million in the UK, and many more world-wide. And the numbers will rise. Unemployment leads to poorer health and earlier death. Individuals’ circumstances, such as family assets and earnings, are good predictors of the quality of health and of longevity – the age of death.

But ‘investment’ banking has also damaged people in another way. Absolute levels of poverty or wealth are respectively bad or good for a person’s health. But so too is relative inequality. Inequality is the most important limitation on the quality and duration of life in modern societies. Multiple studies, across a wide range of countries, have related relative inequality to infant mortality, life expectancy, height, eyesight, mental breakdown, morbidity – even tooth decay. The richer live longer, the poorer die earlier, the richer have fewer ulcers, the poorer more, and so on. The lower down the social ladder one is, the more detrimental the health effects. One dies earlier and whilst alive the quality of ones health is inferior, not necessarily because one is poor but because one is poorer.

Wealth inequality has grown enormously in ‘investment’ banking dominated countries. By 2001 the richest tenth of the US population owned over three-quarters of non-residential wealth. The richest 5% owned nearly two-thirds. By contrast, the bottom 50% of the population owned less than 2%. The distribution of wealth in the UK is also highly skewed, with extreme concentrations also in the wealthiest 5% of households. In the UK inequality is back to the levels it was in 1900. By 1979, both income inequality and relative poverty were at, or near their lowest levels. What followed was the most brutal reversal of all countries in the world with the exception of New Zealand. Prior to the crash £43 billion in savings have been accumulated by the 35,000 people who work in the City of London; there has been a 29% rise in the sales of Bentleys and a waiting list of five years for Rolls Royces. Partners/directors in City firms earned enormous bonuses. And yet during this supposed boom period the average expected number of years spent in poor health in the UK rose from 6.4 to 8.8 for men and from 10.1 to 10.6 for women. Among the developed countries it is not the richest societies which have the best health, but those which have the smallest wealth differences between rich and poor. Average life expectancy in the US, the world’s richest country, has fallen. Its world ranking is a lowly 50th. But that is average life expectancy. For the rich US elite, life expectancy has increased.

Unbalanced Economy

Between ‘Big Bang’ (and acts such as the removal in the US of the restriction on retail banks engaging in ‘investment’ banking in the course of the 1980s and 90s)⁴ and the first great economic crisis of the twenty-first century, lending to productive businesses – in ‘investment’ banking dominated countries – declined sharply whilst lending to other financial firms and property speculators ballooned further inflating the speculative bubble. It is not surprising therefore that it is in the most ‘investment’ banking dominated of the major countries – the UK – that recovery prospects are the worst. The UK’s Prime Minister claimed that the UK would be the quickest to recover. It is going to be the slowest. During the frothy boom time, the UK government boasted about the superiority of its economic policies. The UK was, it was said, the modern knowledge-based free-market economy, whilst countries like France and Germany were ridiculed for being ‘stuck in the past’, for their emphasis on industry and employee rights. Yet it is these countries, not the UK which have emerged from recession. The future of the UK, the cradle of the industrial revolution, with an engineering legacy of such quality that most Formula 1 constructors were located there, was bet not on manufacturing or on a balanced economy but on banking. It lost. We lost.

As yet we do not know what the ultimate consequences of the collapse of the ‘investment’ banking generated speculative bubble will be. In unbalanced societies such as the UK – unless ‘investment’ banking is reformed – worse is yet to come. Public services are going to be slashed, insufficient resources will be invested in productive activities, the migration of productive industries eastwards will accelerate, and the wealth and influence on unaccountable elites will grow even greater. The full effects are not captured by dry measurements of negative Gross Domestic Product growth. For multitudes the quality of life will be diminished, their, and their children’s hopes thwarted. There will be more stress, more worry, more pain, and more poverty. Lord Turner, the new head of the UK’s historically ineffectual Financial Services Authority has, much to the annoyance of the unchastened City of London, described many of the City’s activities as “socially useless”. He did not go far enough. Many of its activities are socially destructive.

Global Burden on UK Taxpayers

Wall Street and the City of London are unrepentant despite their catastrophic failure and rescue by the state. The scale of support from the state (via our taxes) to the banking sector has been astounding. In the UK alone, it has not been far short of a trillion (that is one thousand billion) pounds – almost two-thirds of the annual output of the entire economy.⁵ An extra ‘whammy’ for UK taxpayers is that they have not only rescued and recapitalised the home country activities of UK headquartered banks but they have done so for the entire global activities of those banks. Although the banks they rescued, such as the Royal Bank of Scotland, had their headquarters in the UK their activities were also located in many other countries. But the taxpayers of those other countries have not had to pay for the rescues and recapitalisations – UK taxpayers have had to do so. The cuts in public expenditures and the various increases in stealth taxes which will follow the ‘bail-out’ of these UK headquartered global banks will be borne exclusively by UK citizens. Excluded from this burden will, of course, be many UK-based ‘investment’ bankers who pay no taxes as they have ‘non-domicile’ status.

The staggering amount of public money used to rescue the banks has been given with scarcely any obligations. Admonishment from government that banks should lend more to businesses is just toothless froth, words to calm and mislead an angry public. No real action – notwithstanding the ownership of the majority of shares in many banks by government has been taken. The belief in the fundamental efficiency of ‘self-regulating’ banking which dominated the UK government’s thinking prior to the crash retains its deluding power. And it's bonus time again. Well it’s bonuses for the rescued bankers but not for the rescuers the taxpayers.

Too Important to Fail

Vast salaries, bonuses, dividends, and many other perks were justified before the crash on the false grounds that these were rewards for risk taking. But there was no risk. ‘Investment’ bankers were able to be reckless in their activities and pay themselves obscene amounts of money because they knew that should they be in danger of failing, the state would rescue them. Correctly they believed that governments would regard them as: “too important to fail”. Without that belief in the inevitability of rescue the size of ‘investment’ banking would have been much smaller and the speculative bubble which lead to the crash would not have developed or would have been considerably smaller. So why were banks - even stand alone ‘investment’ banks – so sure that they would not be allowed to fail? Because much of gambling banking was undertaken by banks which also undertook essential utility banking. The panic ‘run’ on these banks following the collapse of Lehman Brothers reinforced belief that all banking, including utility banking, would collapse without government support. Many banks are hybrids – combining utility banking and gambling banking. Banking in the US was more dispersed than in the UK before the crisis, but a small number of exceptionally large hybrid banks now dominate.⁶ Allowing banks which undertook ‘investment’ banking, whether exclusively or not, to fail would have also meant the elimination of much utility banking with catastrophic consequences. ‘Investment’ banking was, and remains, like a hostage taker using the hostage (utility banking) as a shield. Because the two types of banking are overwhelmingly grouped within the same organizations one cannot be allowed fail without the other also failing. That guarantee of rescue, above all else, enables and encourages recklessness by ‘investment’ bankers. It is a guarantee which continues to shield bank gambling from facing the consequences of that gambling and passing the immense burden of its consequences to society. The banks are fully insured, but it is not they but taxpayers who pay the cost of that ‘insurance’. How can this toxic “moral hazard” be removed without also threatening utility banking with all of the unacceptable consequences such failure would cause?

What is to be Done?

There are two public policy choices – apart from retaining the clearly undesirable status quo. First, accept that banks are “too important to fail” – allow the continuing intertwining of utility and gambling within the same banking group – but regulate banks more than before to try to prevent failure. Or alternatively restrict banks to one, or other, activity – utility or gambling. So utility banks would be prohibited from owning and trading in risky securities and thus for instance would not be allowed to own or sponsor hedge funds and private equity funds.⁷ The former would continue to be regarded as too important to fail – and by the nature of their narrowed activities would be much less likely to fail – whilst the latter would not be rescued by taxpayers if they do fail.

In the US the first, the increased regulatory approach, is advocated by Larry Summers (Chief of President Obama’s National Economic Council) and in the UK by Lord Turner, chairman of the Financial Services Authority. The second – separate the ‘hostage’ from the ‘hostage taker’ – is supported in the US by Paul Volcker (former Chairman of the Federal Reserve and current head of President Obama’s Economic Recovery Advisory Board) and in the UK by Mervyn King (Governor of the Bank of England, the UK’s central bank). Not surprisingly, the ‘investment’ banking elite unashamed and undaunted by the massive public rescue are loudly opposing separation. They want to retain their shield, their hostage – utility banking – because that guarantees the continuation of their riskless recklessness and the lavish rewards it brings them.

The first policy alternative would be ineffectual. History teaches us that the regulatory route would not succeed. Regulators have not demonstrated that they are independent (or allowed to be independent) of what they are supposed to regulate and in any event bankers find ways around the regulations. This is what happened in the past and there is no reason to believe that it will be any different in the future. As Mervyn King has stated: “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion”.⁸ Worst of all it would allow the re-expansion of socially destructive gambling by banks.

In contrast, the separation of utility banking from bank gambling and thus the latter’s guarantee against failure would have many benefits.⁹

1. First, gambling banks could be allowed to fail without endangering utility banks.
2. Secondly, the size of bank gambling (constrained by the absence of the “too important to fail” guarantee) would be much smaller and the level of the riskiness of their activities reduced.
3. Thirdly, the amount of resources put into real investment would grow as less would be diverted into faux investment, that is, into gambling.
4. Fourthly, UK citizens would not bear, as they currently do, the burden of rescuing and recapitalising failed banks in other countries which are owned by banks headquartered in the UK.¹⁰

What is needed is a contemporary version of the 1933 US Glass-Steagall Act.

We cannot hope for, or necessarily desire, what John Maynard Keynes advocated: “the euthanasia of the rentier, the functionless investor” (1936: 376). But we can rearrange matters so that their guarantee of state rescue is removed, that the scale and status of ‘investment’ banking is diminished, and that there is some ‘sunlight’ on the real effects of its perverse activities. The last chance for the UK to remain even as a middle-range economy in the 21st Century will be lost unless it reforms such banking.

 

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The views here are those of Professor Brendan McSweeney, and not necessarily those of the School of Management. Professor McSweeney has worked in both commercial and investment banking, he has a banking qualification, and is an expert on international business. Professor McSweeney’s analysis of the causes of the current global economic turmoil can be viewed at:

• Is Denial of the Possibility of Financial Asset Market Failure Responsible for an Economic Holocaust

Also, recently published by Professor McSweeney:

• B. McSweeney (2008) 'Maximising shareholder-value: A panacea for economic growth or a recipe for economic and social disintegration?' Published in Critical Perspectives on International Business, 4.1, pp. 55-74, 2008. » Download a copy of the paper  

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Footnotes

¹ Given the extensive collusion between banks there is no guarantee that more banks will generate more competition.

² Financial Services Authority (2009), Turner Review Conference Discussion Paper, London: FSA, available at: http://www.fsa.gov.uk/pubs/discussion/dp09_04.pdf

³ Keynes, J. M. (1936) The General Theory of Employment, Interest and Money, London: Macmillan.

⁴ In the US, for example, in 1999, after 12 attempts over 25 years, The 1933 Glass-Steagall Act based on the experience of the great ‘Wall Street Crash’, had prohibited utility banks from engaging in gambling banking. Throughout the 1980s and 90s that constraint was increasingly eroded. In 1999 the Act was replaced by the Gramm-Leach-Bliley Financial Services Modernization Act which removed these firewalls. Amongst other effects, this allowed retail banks to engage in far riskier activities by levering up their bets, greatly increasing their vulnerability to illiquidity and helping to fuel the massive growth in exotic financial ‘innovations’.

⁵ Speech by Mervyn King, Governor of the Bank of England, to Scottish business organizations, available at: http://www.bankofengland.co.uk/publications/speeches/2009/speech406.pdf

⁶ Working Group on Financial Reform (2009) Financial Reform: A Framework for Financial Stability, Washington: Group of Thirty available at: http://www.group30.org/pubs/recommendations.pdf

⁷ See Statement by Paul A. Volcker Before the Committee on Banking and Financial Services of the House of Representatives, September 24, 2009 available at:  http://media.ft.com/cms/db7fafe2-a90b-11de-b8bd-00144feabdc0.pdf

⁸ King (2009) op cit.

⁹ Vital as separation is it would not resolve a number of  undesirable banking practices. See CRESC (2009) An Alternative Report on UK Banking Reform available at http://www.cresc.ac.uk/publications/documents/AlternativereportonbankingV2.pdf

¹⁰ In contrast with the “narrow banking” proposals of Professor John Kay (Kay, J. 2009, Narrow Banking: The Reform Of Banking Regulation, London: CSFI) the proposals here would retain the rescue guarantee for commercial lending, that is such activities would be defined as part of utility banking and the gambling part of banking would not, as he suggests, be unregulated, but would be subject to ‘micro prudential regulation’. The latter suggestion by Professor Kay puts unfounded hope in the regulatory ability of unregulated financial markets (See McSweeney, B. , 2009, The Roles Of Financial Asset Market Failure Denial And The Economic Crisis: Reflections On Accounting And Financial Theories And Practices, Accounting, Organizations & Society, 34, 835-848).

02/11/09