The regulatory environment for banks is indeed tough and becoming tougher. The Prudential Regulatory Authority is determined to clamp down on risky activities and force banks to protect themselves and the financial system from failure through increased capital buffers and liquidity reserves. And the Financial Conduct Authority is imposing tighter supervision of larger banks, and serious restriction on products and funding strategies that it considers to be not in customers' best interests - which include many of retail banks' more profitable activities. Nowhere does the need to make profits feature in the terms of reference of either regulator. They don't seem remotely interested in ensuring that commercial banks can be profitable.
Yet both should be. An unprofitable bank is a risky bank. And an unprofitable bank is unlikely to give good value to customers.
Firstly, the risks. These centre around the ability of banks to absorb losses. Banks are at risk of insolvency if the value of their assets falls - for example through a spate of bankruptcies among borrowers. They are also at risk of running out of money if depositors decide to remove their funds, although this can be mitigated by an effective central bank acting as lender of last resort provided that the banks in question have sufficient acceptable collateral. The risk of running out of money is therefore mitigated by banks holding high-quality liquid assets such as government bonds. And the risk of insolvency is mitigated by capital.
Contrary to popular opinion, capital is not "cash". Nor is it deposits, or any other sort of debt. It is shareholders' funds - what in other companies would be called "equity". Just to remind you (I know I've written about this before), banks can raise capital in three ways:
- directly from shareholders by means of new shares (rights issues). Shareholders are unlikely to want to buy more shares in banks that are already offering a poor return on their existing shareholdings.
- by retaining earnings (profits) instead of dishing them out to shareholders as dividends, employees as increased wages and/or customers as reduced prices. This of course requires them to be making profits.
- by reducing the overall size of their asset base, either by reducing the risk profile of the assets or by selling them. Put bluntly, this means limiting lending to better risks, selling off parts of their business, and reducing the amount of lending they do.
Having a banking system made up of the living dead is an incredibly unhealthy state of affairs for the economy. I am personally of the opinion that a large part of the UK's stagnation is caused by the fact that two of its five big banks are badly damaged (RBS and LBG), one more is undergoing major restructuring (Barclays), and a fourth (HSBC) has suffered serious reputational damage due to criminal activities in one of its overseas operations. RBS and LBG are currently making losses, and Barclays is generating a return on equity that is well below its cost of capital. This is not sustainable. These banks simply are not in a fit condition to support the economy.
Nor can they give good value to customers. I've worked for a bank that wasn't making any money. In 1989, Midland Bank declared a full-year loss following writedowns of its holdings of Latin American debt and a ridiculous mistake on money market positions. The following year it managed to scrape together £11m, a dismal return for the UK's fourth largest bank. Midland was desperate to make money: it had very little capital and a huge portfolio of dodgy loans. So it took stupid risks - hence the position error. And it cut costs. Particularly staff costs. It embarked on a programme of redundancies and restructuring across its entire business. No-one knew where the axe would fall next. It became a demoralising place to work, not only for staff but for the managers whose job it was to make redundancies and if possible encourage people to leave before being made redundant - after all redundancy is a cost....
Staff who are worried about their jobs don't generally give good service to customers. And it is unreasonable to expect them to do so. Their first priority is their families. It's not that they become any less competent, but they become preoccupied with their own concerns and see little point in going out of their way for customers when they do not know how much longer they will be around to serve them anyway. I don't know what it's like to work for Barclays at the moment, but I imagine the situation must be pretty grim: the bank is making job cuts across the board and restructuring large parts of the business. There was recently a serious shakeout of senior management, and in my experience that is nearly always followed by weeding-out of the people perceived as being "followers" of the senior managers who have lost their jobs. Barclays is busy re-educating all its staff in its new "core values", which include a commitment to customer service - but how effective will this be when staff are worried about their own futures? The job market in financial services is very difficult at the moment.
Yet the FCA makes no mention at all of the critical need for banks to take care of their staff. They seem to think that good customer service can come through intrusive (and expensive) supervision coupled with strict limits on the types of business banks can do. No it can't. Banks are people businesses. If the staff aren't happy, neither will the customers be.
Nor can a bank that is desperate to improve the returns to its shareholders give good value to customers. This is a fundamental conflict of interest: customers want low prices, but shareholders want profits. Reading the Barclays' strategic review announcement from February 2013, it is (to me at any rate) very clear where their focus is:
"Based on the results of its strategic review, Barclays is today making several commitments. Barclays seeks to:
Barclays' adjusted return on equity in the quarterly results just announced was 7.6%. Admittedly this did reflect restructuring costs, but I struggle to see how they will achieve a return on equity in excess of 11.5% within two years while ALSO giving customers good service and value for money. And the cost-cutting targets are extremely challenging. The FCA should be looking at the viability of these financial targets in relation to the new regulatory focus on customer value.
- Deliver a return on equity for the Group in excess of the Group cost of equity in 2015, which we have assumed will remain at the current 11.5% level;
- In 2013, reduce headcount by at least 3,700 across the Group, including 1,800 in the Corporate & Investment Bank and 1,900 in Europe Retail and Business Banking. This is expected to result in a restructuring charge of close to £500m in Q1 2013;
- Reduce the Group’s total cost base by £1.7bn to £16.8bn in 2015, including interim cost estimates of £18.5bn and £17.5bn in 2013 and 2014 respectively. This excludes ‘one-time’ costs to achieve the strategic plan of £1bn in 2013, £1bn in 2014 and £0.7bn in 2015, delivering a Group cost to income ratio in the mid 50s in 2015;
- Target Risk Weighted Assets (RWAs) of £440bn by the end of 2015, after mitigating the estimated impact of CRD IV (£81bn) through legacy asset and other RWA reductions (£75bn), enabling RWA investment in selected areas;
- Report a transitional Common Equity Tier 1 ratio above its target ratio of 10.5% in 2015; and
- From 2014, accelerate our progressive dividend policy, targeting a payout ratio of 30% over time."
Which brings me neatly back to the Co-Op. You see, the Co-Op is a mutual. It is owned by its customers. Here is the Co-Op's statement explaining the reasons for withdrawing from the Lloyds deal (my emphasis):
"The Co-operative Group announces that it has withdrawn from the process currently being run by Lloyds Banking Group for the disposal of branch assets (“Verde”) after The Co-operative Group and The Co-operative Bank plc Boards decided that it was not in the best interests of the Group’s members to proceed further at this time. This decision reflects the impact of the current economic environment, the worsened outlook for economic growth and the increasing regulatory requirements on the financial services sector in general."Taking on the Verde business would have made the Co-Op Bank the fifth largest retail bank in the UK. It would have been subject to tighter regulation, higher capital and liquidity requirements and more intrusive supervision - all of it in a difficult economic environment. This was not in the best interests of its customers.
And therein lies the problem. The tougher regulatory environment for banks is supposed to reduce the risks to taxpayers and improve value for customers. But in a stagnating economy where profitable lending opportunities are hard to come by, banks are already struggling to make money. Tougher regulation increases their costs and circumscribes their earning opportunities. As Noble Cause put it on twitter:
The PRA are banning loss making products and the FCA are banning all the profitable ones. What are we meant to sell? #banking #regulationSuch severe limitation perversely may mean that risks to taxpayers actually increase and value for customers declines. The approach to regulation needs to be rethought. Banks must be able to to take reasonable risks in order to make money. An unprofitable banking sector is in no-one's interests.
— Noble_Cause (@Noble_Cause) April 18, 2013
Co-Op Bank's £1bn black hole - This Is Money
Will the Co-Op pull out of banking? - Robert Peston, BBC
Cyprus and the financing of banks - Coppola Comment
Approach to banking supervision - Prudential Regulation Authority
FCA Risk Outlook 2013 - Financial Conduct Authority
Barclays Announces Senior Management Changes - Barclays
Strategic Review Announcement February 2013 - Barclays