Saturday, 6 April 2013

Something's rotten in retail banking

The Parliamentary Commission on Banking Standards has released its report into the fall of HBOS. And it is damning. It paints a picture of HBOS as probably the worst-run bank in the UK - a poster child for how not to run a bank. Management incompetence and self-delusion, a highly aggressive and ill-thought-out expansion strategy, totally inadequate risk management and a culture that rewarded excessive risk-taking and silenced those who sought to raise concerns. It could hardly be worse.

More importantly, the findings for the first time brought to light the fundamental misunderstandings of the problems in banking that have persisted, and even been encouraged, since the financial crisis. I have felt like a lonely voice pointing out that HBOS, Northern Rock and the other UK banks that failed, with the sole exception of RBS, were RETAIL banks, and that neither ring fencing nor reform of investment banking was going to deal with the problems. But it seems that in the case of HBOS, the Committee agrees (their emphasis):
"As Sir Charles Dunstone, non Executive Director of HBOS 2001-08, observed, if HBOS had survived as an independent entity in the form it took in 2008, it would almost all fall within the proposed ring-fence. HBOS had no culture of investment banking; if anything, its dominant culture was that of retail banking and retail financial services more widely, areas from which its senior management were largely drawn. Whatever may explain the problems of other banks, the downfall of HBOS was not the result of cultural contamination by investment banking. This was a traditional bank failure pure and simple. It was a case of a bank pursuing traditional banking activities and pursuing them badly."
 And they go on to point out the limitations of structural reform:
Structural reform of the banking industry does not diminish the need for appropriate management and supervision of traditional banking activities.
HBOS was a traditional retail bank doing secured and unsecured lending to households and businesses. It did not have any proprietary trading activities at the time of its failure (these were closed down in 2005). It was active in financial markets only for the purposes of funding, not market-making. It did not have an "investment banking arm". It did, however, have a Treasury division, which lost £7bn on credit derivatives. Many people are confused about this: how can a Treasury division that is only concerned with funding lose so much?

Funding was a critical issue for HBOS.  It expanded its loan books far faster than it could acquire stable sources of funding, such as customer deposits, to fund them: By the time of its failure its funding gap was £111bn. In the years before the financial crisis it diversified its funding vehicles into the new credit derivatives, issuing an astonishing £13bn of RMBS in 2003 alone. This seemed like a reasonable thing to do: after all, they were  mortgage-backed, had AAA credit ratings and were widely traded. For an over-leveraged retail bank looking to diversify its funding sources, using these things looked sensible. It turned out to be anything but.

So lesson no.1 for today is: just because a bank is only doing retail lending doesn't mean it isn't using securities and derivatives. But a bank that is only doing retail lending is less likely than an investment bank to have the expertise to manage the risks in such investments. The Treasury division lost money because of its naivety as an investor. And this raises questions again about the direction of structural reform. If a bank is prevented from acting as an investment manager, either on its own account or on behalf of clients, how can it attract and retain the skills to manage the investments it needs to make for the purposes of funding? One of the trenchant remarks made by the Committee about HBOS's appalling risk management was "portfolio management was a distant dream". No wonder they lost so much. They hadn't a clue what they were doing.

Since then, retail banks have been improving their stable funding sources. Loan to deposit ratios have been narrowing and there is much less use of wholesale funding. But this brings me to lesson no. 2. I have been writing recently about Cyprus. Cypriot banks were funded almost entirely with deposits: they had little senior debt and not much equity. Consequently, when they failed due to over-aggressive expansion and risky lending, customer deposits had to be raided to bail them out. Increasing the proportion of customer deposits in a bank's liabilities base DOES NOT MAKE IT SAFER. It makes its funding more stable - because wholesale funding markets lend shorter-term and are more prone to runs than retail deposits - but it is no substitute for a prudent capital structure with sizeable layers of both capital and convertible debt. Like Anat Admati, I am unimpressed with banks' arguments that capital is too expensive. Banks have a responsibility to their customers. Putting customer deposits at unnecessary risk because of an inappropriate capital structure and inadequate risk and portfolio management is simply unacceptable. Lesson no. 2 for today is that ANY form of asset expansion funded entirely with debt puts customers' money at risk. Questions should be asked by regulators when any bank shows signs of embarking on such a strategy.

In fact the Committee's observation that HBOS's expansion strategy was "asset-led" was at the heart of the matter. The big problem with banks - especially retail banks - is the conflict of interest between their savers and their borrowers. Savers expect their money to be looked after: borrowers expect banks to take risk. Lesson no. 3 for today is therefore that it is the job of banks to accept AND MANAGE risks. It is unacceptable for banks to accept risks when they do not have the expertise to manage them adequately, as was particularly the case in HBOS's Corporate Lending division. Excellence in risk management across all areas of the business is the heart of banking: it is not an optional extra and should not be sidelined in the way it was at HBOS. When risk management in the financial industry fails, so does the industry.

There is a core competence problem in retail banking in relation to the management of customer funds. Retail banks see customers' savings as "funding" and both loans and deposits as "products". Staff are there to sell products, not to invest people's money. This to my mind is a fundamental misunderstanding of the nature of retail banking. Retail banks are fund managers: their job is to invest the savings of ordinary people productively for a return.* They need to develop skills in investment management. And more importantly, they need to develop a culture of respect for customers and their money. That, it seems, was completely missing at HBOS. And not just at HBOS: the Salz report into Barclays highlighted the aggressive sales culture and emphasis on short-term financial performance. Retail bank staff - often poorly paid and with large amounts of their remuneration stemming from commission on product sales - had enormous incentives for mis-selling, reinforced by aggressive sales targets. Professional management of customers' money was completely lost in the drive to sell products.

So the final lesson for today is that there needs to be a fundamental rethink of the nature of retail banking and the core skills required. Professional investment management and risk management skills need to be at the heart of retail banking just as much as other areas of the financial industry. And this change must come from within. Regulators may be able to curb the worst excesses, but they cannot fix the underlying cultural problems. Retail banks must stop "selling" and start "serving". Until they do, there will continue to be major failures in retail banking.

Related links:

An accident waiting to happen - findings of the Parliamentary Commission on Banking Standards re HBOS
Papering over the rot - Coppola Comment
Why do we never learn? - Coppola Comment
Faith in Grampian contributes to fall of Bent - Ian Fraser
A failure of compassion - Coppola Comment
Cyprus and the financing of banks - Coppola Comment
Supermarket banking - Coppola Comment
Risk versus safety, bank reform edition - Coppola Comment
Fallacies, Irrelevant Facts and Myths in the discussion of capital regulation - Anat Admati (pdf)
Salz Review - an independent review of Barclays' business practices - Anthony Salz (pdf)

* Yes, I know deposit creation through fractional reserve lending muddies the waters. But one person's loan is another person's deposit: loans become savings. Banks have a responsibility to manage the deposits they create through lending.


  1. If we sit around waiting for those “core skills” to be put in place “from within” (i.e. wait for banks to make the change voluntarily) we could be waiting for a very long time, and experience several credit crunches during that time.

    Why not just make it illegal for banks to play silly bug*ers with depositors money where a depositor specifically doesn’t want that? That should be easy enough to enforce. E.g. if a depositor wants their money invested just in UK domestic mortgages where relevant mortgagors have a decent equity stake, that’s where their money goes. And if the relevant bank does anything else with the money, then the relevant bank employees go to jail.

    In contrast, if a depositor wants their money to fund dodgy derivatives, that’s fine by me. They might double their money, or they might lose the lot.

    1. Depositors who DO want to place their money "at risk" are still entitled to have their property respected. It is reasonable for them to expect that their money will not be placed unnecessarily at risk through inadequate and unprofessional risk management and an inappropriate capital structure. Domestic mortgages are by no means a "safe" investment even with good LTVs: it would be wiser to diversify investment. Mass market depositors should be able to expect that banks will manage the portfolio of investments made with their money to generate the best returns for the lowest risk. That retail banks do not do this is the core problem in retail banking.

  2. Hi Frances,

    Does your 'lesson number 2' apply to government QE or
    do you think this is different?

    I feel very sorry for anyone who held Lloyds shares before the HBOS deal.

    P.s. do you have a blog post about government spending levels that focuses on multiplier effects?


    1. QE is entirely different. It is not debt in any meaningful sense of the word. It is more accurate to regard QE's money creation as an expansion of equity. The risk of course is that equity is not only expanded, it is diluted.

      I haven't looked at the multiplier effects myself. I'd recommend the IMF's paper on this:

  3. Replies
    1. All of the necessary skills exist in the banks, but the staff that have them have had no voice. I have been a banker since 1976 and have never missold, ot taken a risk that I was not comfortable with. There is a solid strata of such people in the industry, but who wants to listen to prudence and reason when there is a pot of gold for poor behavier. I am proud to be a banker but accept that our industry acting badly.

  4. Will Basel III prevent either Lesson 1 or Lesson 2 in future?

    1. Not really. It's too reliant on flawed risk weightings.