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Report on UK Microfinance
Dilemma: How do we make our banks serve the common good without endangering our prosperity?
13th June, 2013
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Agenda: TIMETABLE (June) Monday 3rd 9.30-‐11am: Plenary (Streatham A): 9.30am Richard Seaford and Gary Abrahams, Introduction 10am Richard Seaford, 'Money' 10.30am John Maloney, 'How is money created?' 11.30-‐1pm: Registration and meetings of sub-‐groups. 2-‐3.15pm: Guest lecture: John Sutherland. 3.30pm Discussion by sub-‐groups? Tuesday 4th 9.30-‐11am: Plenary (Streatham A) 10am Charlie Masquelier, 'The Contradictions of Capitalism' 10.30am Annie Pye, 'Corporate Directing -‐ the people side of governance'. 11.30-‐1pm: Meetings of subgroups. 2-‐3.15pm Guest lecture: Gary Abrahams (Streatham A) on securitisation 3.30pm Discussion by sub-‐groups Wednesday 5th -‐ 9.30am-‐1pm: Research and Discussion by sub-‐groups -‐ 2-‐3.15pm Guest lecture: John Bone (Streatham A) 'Debt Wars: Financialisation, The Credit Crisis and its Social Implications’, . -‐ 3.30pm Discussion by sub-‐groups Thursday 6th -‐ 9.30am-‐1pm: Research and Discussion by sub-‐groups -‐ 2-‐3.15pm Guest lecture: Adrian Ball (Streatham A) on The role that building societies play and can play in the future of banking.. -‐ 3.30pm Discussion by sub-‐groups Friday 7th -‐ 9.30am-‐1pm: Research and Discussion by sub-‐groups -‐ 2-‐5pm: Guest debate: David Sismey (Goldman Sachs) ) on why banks like Goldman Sachs already work in the best interests of society, countered by Christina Laskaridis (Corporate Watch). (Streatham A)
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Weekend: Festival Monday 10th -‐ 9.30am-‐1pm: Research and Discussion by sub-‐groups -‐ 2-‐3.15pm Guest lecture: Tim Congdon, 'Do Banks help or Hinder Capitalist Economies' (Streatham A). -‐ 3.30pm Discussion by sub-‐groups Tuesday 11th -‐ 9.30am-‐1pm: Research and Discussion by sub-‐groups -‐ 2-‐5pm: Research and Discussion by sub-‐groups Wednesday 12th 9.30-‐1pm Finalisation of output by sub-‐groups 2-‐5pm: Plenary (Streatham A): Production of Final statement (1) Thursday 13th 9.30-‐1pm: Plenary (Streatham A). Production of final statement (2). 2pm. Forum ceremony. Friday 14th 2pm Session with Ben Bradshaw MP (Streatham A) THEMES FOR SUB-‐GROUPS 1) How did the crisis occur, CHARLIE, facilitator Heng Yong 2) Contradictions of capitalism, CHARLIE, facilitator Chris Calvert 3) How much of what banks do has social value, RICHARD, facilitator Lawrence Choo 4) How do we incentivise the banks, GARY, facilitator Minjuan Gao. 5) Socially responsible banking and building societies, GARY, facilitator Jess Groling 6) Banks and micro finance, GARY, facilitator Tom White 7) Business ethics, GARY facilitator Bai Yuting 8) Spreading financial literacy, GARY, facilitator Keren Asente. 9) Model of regulation, JOHN, facilitator Sam Adebiyi.
FINAL PLENARIES -‐ Producing a final statement (with or without minority report). -‐ Educating our politicians and holding them responsible.
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Table Of Contents:
1. The Causes of Financial Crisis of 2007-‐08
2. Importance of Greater Financial Literacy
3. Socially responsible banking: local banks and building societies
4. How Much of What Bankers do have Social Value?
5. Report on UK Social Finance
6. Report on UK Microfinance
7. Capitalism: Systemic Problems that Endanger it’s Sustainability
8. How can the interests of bankers and society be aligned via changes to the incentive system within the banking structure?
9. Business Ethics
10. Improving our Model of Regulation
11. Plenary Notes
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The Causes of Financial Crisis of 2007-‐08
To: The Vice Chancellor of the University of Exeter
Presented by: Agarwal, Manya
Cowen, Lucy Marion
Daniels, Emma Jane
Ferrer, Alexandrea
Gloyne, Christopher Martin
Hunter, Louise Rachel
Li, Xuan
Roberts, Joshua
Smith, Nicola Jane Charlotte
Verspyck, Natasha
McMillan, Christian
Mak, Kayla
INTRODUCTION The causes of the financial crisis have been concentrated in various specific areas, with political figures often focussing on bankers and the greed of financial institutions. However, from an unbiased and holistic standpoint, the true cause is
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in fact impossible to pinpoint, but rather is the intersection and sum of complexity of the modern financial industry and underestimation of risk which occurred between 2001 and 2008, ineffective and rather poorly thought out government policy, inappropriate, exploitable and narrowly focussed regulatory policy, narrowly focussed monetary policy and a swath of social factors which all contributed to the build up in late 2008.
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Section 1 – Investment Banks Borrowers with relatively low credit risk are known as prime borrowers whereas high credit risk individuals with no income or jobs were known as subprime borrowers (Mankiw and Taylor, 2011). A critical reason why subprime credit expanded was that there were significant hot money inflows into the US in a global reach for yield simultaneously caused and financed by low interest rates principally in response to the Greenspan put. This led to a housing boom where US homeownership increased from 64% in 1994 to 69.2% in 2004, despite a 124% house price appreciation between 1997 and 2006 (Buckley, 2011). This unsustainable gain in prices which theoretically backstopped subprime borrowers, as credit remained easy and demand for yield-‐rich securities continued to remain strong. Asset backed securities (ABS) are a debt security collateralised by a pool of assets, such as mortgages, credit card debt, corporate debt or car loans (Buckley, 2011). Collateralised Debt Obligations (CDO) are an example of an ABS which is usually split into tranches with different levels or riskiness determining rights in terms of interest, receipt and redemption. The result of dividing these tranches was greater risk minimisation (Buckley, 2011). This process of pooling mortgages and selling it on is known as securitisation (Mankiw and Taylor, 2011). CDOn consists of tranches of many CDOs which each consist of tranches of MBS which in turn consist of mortgage loans as shown below. Securitisation explains the fact that there are far fewer deposits in the modern financial system than loans. Riskier credit, e.g. subprime mortgages, high yield
Mortgage Loans
MBS
CDO CDOn
The Great Pyramid of Securitisation. Exeter University BEE1029 Economic Principles Course Materials – Dr Jack Rogers.
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loans and consumer credit, are generally securitised (Friedman, 2011) Special purpose vehicles (SPV) are set up to acquire and hold assets off balance sheet, ensuring banks can minimise reserves set aside to cover liabilities. This improved the appearance of their balance sheets and was widely used before and during the crisis (Buckley, 2011). Investors insured against credit risk in holding CDOs using Credit Default Swaps (CDS) (Bone, 2009) or synthetic CDO portfolios. This meant that one party would make a series of payments to another party, which would pay out if the CDO defaulted (Buckley, 2011). These CDSs were traded to such an extent that they became far removed from the initial loans.
Complexity Metrics in MBS and CDO instruments
Credit rating agencies (CRA) played an important part in the financial crisis by what in hindsight seems a significant understating of risk mainly on MBSs and CDOs. The three main competing CRAs are Moody’s, S&P, and Fitch. In the five years preceding the crisis, an estimated 3 trillion dollars were used in subprime lending. These loans were believed to be justified by certain credit enhancements such as offering collateral theoretically in excess of the issued debt, and credit default insurance. However in reality major CRAs knew about their misleading ratings. Emails sent before the crisis in the US suggests employees were aware of the pending housing crisis but had no financial incentive to change due to the increase in revenues and stock prices that they were experiencing. The rating companies
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earned as much as three times more for grading these SCPs than corporate bonds, their traditional business. US Senate investigations panel says that the ‘sudden mass of downgrades were the immediate trigger for the financial crisis’. In the first four quarters from the crisis nearly 2 trillion dollars in downgrades had to be made. This led to major problems, particularly in the US, but the optimistic ratings also created false confidence elsewhere in the world so global investors were unprepared for the financial meltdown that ensued. Furthermore there was deemed to be a conflict of interest between CRA’s and commercial banks as the banks would pay the agencies for their rating services.
Figure 3 US Home Foreclosures 2005-‐2013 (Bloomberg LP)
US Seriously Delinquent Subprime Loans 2001-‐2013
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In late 2004, the Bank of England and the Federal Reserve started to increase rates to combat growing inflation rates (Mankiw and Taylor, 2011). As interest rates rose, subprime borrowers began to experience rising mortgage payments. Consequently the number of people defaulting on their mortgages increased and many people tried to sell their properties, which lead to a fall in prices. This fall in house prices meant that when people sold their house they would often still be left with a large debt due to negative equity (Mankiw and Taylor, 2011). The increasing number of defaults destroyed the value of derivative ABSs and CDOs some of which were leveraged creating multiplications of the original mortgage losses. As there were fewer mortgage interest payments being met (Buckley, 2011). As the CDO’s started to default, there was an increase in the number of CDS claims. The systemically important financial institution (SIFI), Lehman Brothers, were at the forefront of the subprime and CDS market, as they borrowed heavily to finance their ABS/CDO prop trading desk (Mankiw and Taylor, 2011). This left it very vulnerable when the market started to collapse due to the bursting housing bubble. The collapse of Lehman led to billions of dollars of claims on CDS payments mainly at insurer AIG. Their bonds were auctioned off to try and meet the CDS obligations; however the sale of the bonds did not raise sufficient capital (Mankiw and Taylor, 2011). Later in 2008, the US Treasury bailed out AIG on all its outstanding obligations including 100¢ on the dollar for its Lehman CDS and synthetic CDO instruments the principal holders of which included investment bank Goldman Sachs. However, due to the nature of the OTC derivative market and risk exposures across the global financial system meant losses were multiplied and quickly spread as nodes in the network failed.
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Fedwire (Federal Reserve Wire Network); Source LSE-‐PKU Summer School Beijing
Due to the mortgage defaults, banks which lent to SPVs had to recall their debt. Furthermore, banks that had set up the SPVs then had to place them on their balance sheets. As a result they had to set aside capital reserves to cover these liabilities, which damaged their ability to lend (Mankiw and Taylor, 2011). Banks grew fearful of one another’s solvency and as a result stopped lending to each other, becoming increasingly illiquid (Buckley, 2011) as the interbank market dried up.
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LIBOR-‐OIS Spread 2008 Spike as Interbank Lending Froze
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Section 2 – Government Policy and GSEs Given that the median US family’s personal wealth consists largely of real estate, the Bush administration adopted policies that attempted to increase the value of existing homes. One such important policy was the Mortgage Interest Deduction, which led to an increase in demand for mortgages, since being adopted in 1913. These policies, along with rising family income levels, caused home prices to keep rising steadily since the end of the Great Depression. The growth of housing prices rose further in the period of 2004 to 2007 as the MBS and CDO markets ballooned.
US House Price Index (All Transactions) Source: http://research.stlouisfed.org/fred2/graph/?id=USSTHPI
The two institutions – Federal National Mortgage Association (FNMA-‐ Fannie Mae) and Federal Home Loan Mortgage Corporation (FHLMC-‐ Freddie Mac) also played a key role in sustaining house prices. Fannie Mae purchased mortgages from banks and insured them, adding liquidity to the home mortgage market. Freddie Mac made loans and loan guarantees and created the MBS market. Eventually, both were turned into public companies, but managed by Government appointees. The US Department of Housing and Urban Development (HUD) encouraged extension of loans for ‘low-‐ and moderate-‐income housing’, sustaining a market for subprime mortgages and Mortgage-‐Backed Securities. This was especially
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encouraged by the administrations of Bill Clinton and George W. Bush, in the name of ‘living the American Dream’.
Section 3 – The Role of Regulation in the 2007-‐2008 Financial Crisis The role of regulation in the financial crisis can be split into three main categories: too little regulation, incorrect/misguided regulation and overregulation. A lack of regulation in areas of the financial sector, such as securitization and derivative trading, significantly contributed to the financial crisis. Regulations on securitisation were increasingly loosened through the late 90s, culminating in the legalisation of synthetic securitisation in 2003. A key act in late 1999, the Gramm-‐Leach-‐Bliley Act was instrumental in allowing banks such as Citigroup to be created (merger of Citicorp and Travelers Group) legalising the universal bank model in which retail bank deposits can be used for proprietary trading activities in the investment bank. This act effectively reversed the Glass-‐Steagall Act of the 1930s, which separated these funds. However, Lehman, Bear Sterns and Wachovia were not retail banks, but rather investment banks or asset managers. These institutions would not have been covered by Glass-‐Steagall.
UK Total Seuritisations by UK Banks 2000-‐2010
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Misguided regulation also played a significant part. There was too much of a focus on capital requirements. This led to banks ignoring the basic fundamentals of risk management. In addition, of value at risk models were used inappropriately with inaccurate stochastic models inappropriate to rely on for use in day-‐to-‐day business. This allowed financial institutions to leverage and increase exposure to risky derivatives, as institutions believed they knew the maximum possible daily losses, which they could incur. The inadequacy of regulation could also be attributed to regulatory capture due to the growth rates and tax revenue being produced by the financial sector in the lead up to the financial crisis, but also the revolving door between key financial institutions and regulatory bodies such as the SEC, CFTC or FSA/BoE (UK), mainly due to the highly technical expertise required to understand and successfully regulate the financial markets. Another important effect of regulation on the banks was the emergence of the shadow-‐banking sector, which allowed banks to conduct risky activities ‘off balance sheet’. The contribution of these effects is arguably as great if not greater than that of the lack of regulation. In fact it is widely regarded that more prescriptive regulation will only make the problem worse as banks are forced to take more risks in order to maximise shareholder value.
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Section 4 – Central Banks in the run up to the crisis In this post-‐crisis world of new normal since the lows of late 2008, many have pointed to key players in the economic and financial system to explain the major causes of the 2007-‐08 crisis. However, by far the largest ‘elephant in the room’ is monetary policy. Between the late 80s and the beginning of 2006 there was a persistent long-‐term trend of falling rates without economically significant asset bubble bursts. In 1987 the Federal Reserve’s Target Rate was at 725bps and by the 2004 low it was at 125bps. This broad easy policy was mainly reciprocated to varying degrees across the developed economies from Europe to the Asia-‐Pacific. This policy was a boon to the financial sector and effectively set off the 30-‐year bond bull market. Under favourable regulatory decisions, such as Gramm-‐Leach Bliley, and globalisation, financial institutions were able to significantly grow their bottom lines. Easy policy in the early 2000s and late 1990s importantly coincided with favourable price effects from the globalisation of manufacturing, curbing consumer price inflation, which would otherwise likely have manifested itself under ultra-‐easy central bank policy. Credit grew immensely in this period fuelling GDP growth, with the advent of securitisation, electronic and stated income loan origination in the late 1990s, and equally the median level of compensation across the financial industry. By late 2004 and early 2005, inflation rates started to diverge from the Fed’s target and prompted tighter policy until 2006/2007. Despite tightening, the CDO, CLO and ABS markets grew immensely in these years due to prior easy policy starting a reach for yield as interest rates fell on fixed income securities, consequently fuelling the housing market. US net notional in CDS hit $62.2tn by the end of Q4 2007. Delinquencies began to hit their height in 2006/7 and the Fed eased, but it was too late as convexity events and margin calls ensued as losses were multiplied by significant factors in systemic leveraged OTC derivative trades which propagated systemic risk through the financial system. Global central banks were not focussed on financial stability prior to the near failure of key SIFIs. Fed officials including Chairman Greenspan, were especially focussed in a rather narrow fashion on the dual mandate of inflation and unemployment, and had a rather artificial free markets attitude which allowed derivative markets to run wild under distorting monetary policy.
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Fed Funds Target Rate 1987-‐2013 (Bloomberg LP)
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PCE CYOY Index (US Personal Consumption Core Price Index YOY SA (Bloomberg LP)
iShares iBoxx $High Yield Corporate Bond Fund ($HYG) 2005-‐2013
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Section 5 – Social Factors It is a popular belief that bankers, government and regulators are to blame for the financial crisis of 2008. However, this would be a rather narrow reading. Most did not question the driving force behind the behaviour of bankers, government and regulators. Popular society has forgotten that many were performing their jobs at a micro level, without an understanding or consideration of the big picture. Many have undervalued the notion that a fundamental cause of the crisis was society and human nature. Tim Geithner (2012) suggests that greed played a primary role in the build-‐up to crisis (Thomson Reuters, 2013). Of course, bankers acted in greed in many cases, but it would be a misconception to say the only source of greed at the time was the financial sector. Broader society equally displayed greed and unsustainable spending preferences. According to David Beim (ThisAmericanLife, 2009), greed has created excessive and aggressive consumption of discretionary products. In order to satisfy greed, people had to take on credit to support their lifestyle due to stagnant real wages. People overleveraged to the point that many were underwater, creating delinquencies on bank balance sheets (ThisAmericanLife, 2009). Among other causes, greed incentivized bankers to lend to ponzi borrowers1 in order to generate the highest profit as possible under securitisation. Politicians hungry for votes and rather naïve, had no qualms deregulating the financial sector, to facilitate credit creation and raise incomes in the economy. In the end, it was simple human behaviour which played a key role pre-‐2008. Harman (2008) suggests that capitalism system may have caused the pre-‐2008 optimism. The practice of maximising shareholder value endemic to the system may have led to reckless management decisions. As people acquire a certain threshold of wealth, net worth becomes more than a mechanism for survival, rather a status symbol. Each individual may have believed in the system and focus on their own interests as opposed to the common good. Essentially, Harman suggests the capitalist system failed, leading to greedy, self-‐centered behaviour which can increase the mispricing of assets, i.e. a bubble which can precede a financial crisis. A key social issue before and still after the crisis is financial illiteracy, both with 1 Minsky have separated borrowers into three groups and one of them is the Ponzi borrowers. Ponzi borrowers are borrowers who cannot repay the interest and principal payments Hyman Minky, 1992
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respect to theory and the financial mathematics involved. According to Lusardi and Mitchell (2005), a large portion of US retail investors cannot answer simple questions about risk modelling and compound interest, meaning borrowers are likely to have been ignorant and thus made bad decisions that contributed to the instability of the system. For instance, if people misunderstand terms of a mortgage and falsely believe it is affordable, borrowers can lock into ARMs with steep rate rises in the second period contributing to default risk. When such subprime borrowers found it difficult to refinance and defaulted on their mortgages, systemic financial institutions collapsed transmitting systemic credit risk through bullish leveraged OTC credit derivative bets on the underlying mortgage backed securities. This led to a noticeable disruption of the global economy. To reduce the serious repercussions of financial illiteracy, people need to develop a better understanding of the financial system, which could potentially be achieved through the state education system. Conclusion As has been examined, a combination of social factors, central bank policy, inappropriate and in some cases non-‐existent regulatory policy, government social policies and complexity and greed within the financial industry. One would hope that things have changed since 2008, and in some ways they have, and yet key banks across the globe still present systemic risks to the global economy and complex and illiquid financial products are still being bought en masse. Financial illiteracy is still a major problem across the globe and will take a long time to fix, and critically, central bank policy has moved to ultra-‐easy quantitative easing potentially creating the largest fixed income, equity and to some extent real estate bubble in history if one factors in global hot money flows to emerging market economies. Crucially, investors are still reaching for yield as central banks holds rates down artificially, creating some distortions will be truly evidenced once QE is removed from global financial markets. Maybe the only thing that has changed slightly is government policy which is broadly contractionary across the globe which is sadly extending pain in fragmented global labour markets.
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Reference List: Minsky Hyman, 1992, The Financial Instability Hypothesis [pdf] p. 7, Available at: <http://economics.illinoisstate.edu/gawater/eco441/documents/Minskypaper.pdf> accessed 10 Jun 2013 The Socialist Party of Great Britain, n.d., What is Capitalism?, http://www.worldsocialism.org/spgb/what-‐capitalism, accessed 9 June 2013 ThisAmericanLife, 2009, 375: Bad Bank Transcript, http://www.thisamericanlife.org/radio-‐archives/episode/375/transcript, accessed 9 June 2013 Thomson Reuters, 2012, Financial Crises Cause by “Stupidity and Greed”: Geithner, http://www.reuters.com/article/2012/04/26/us-‐usa-‐economy-‐geithner-‐idUSBRE83P01P20120426, accessed 6 June 2013 Lusardi, A. and Mitchell, O., 2005. Financial literacy and planning: implications for retirement well being.3-‐7. [Online] <Available at:http://www.dartmouth.edu/~alusardi/Papers/FinancialLiteracy.pdf> [accessed 06 June 2013] Mankiw, N.Gregory and Taylor, Mark.P. (2011) Economics, Second edition, Andover: Cengage
Learning Friedman, Jeffery. (2011) What caused the financial crisis, Philadelphia: University of
Pennsylvania Press Buckley, Adrian. (2011) Financial Crisis – causes, context and consequences, Harlow: Pearson
Education Limited Bone, John.D. (2009) The Credit Crunch: Neo-‐Liberalism, Financialisation and the Gekkoisation of Society
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2. Importance of Greater Financial Literacy
Introduction
A key driver of the 2008 financial crisis was consumers’ lack of knowledge
regarding financial products (FPs) and securitization methods which were
popularized through the last two decades. Furthermore, lack of financial nous in
choosing suitable savings plans and making sensible decisions regarding pension
provision has and will create pressures on the public finances, causing the fiscal
position to become unsustainable in the long-‐run. A key element in avoiding
another financial crisis of the magnitude experienced in 2008, ameliorating the
effects any future crisis produces, and preventing macroeconomic problems
emerging is greater financial literacy. ‘Financial literacy’ is defined as the ability to
use knowledge and skills to manage financial resources effectively for a lifetime of
financial well-‐being (Hung, 2009). In this report we have come up with some
suggestions for the regulators in the United Kingdom (UK) to improve the level of
such financial knowledge based on a succinct review of the literature on ‘financial
literacy’, our primary research, as well as drawing upon ideas based on our group-‐
discussions.
Literature review
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In RAND Corporation’s research paper published in September 2009, financial
literacy was found to be generally higher for men, older individuals, those with
bachelors’ degrees or higher education levels and those with more income; such
financial literacy tended to be strongest amongst those who had both higher
incomes and educations (Hung, 2009). Some such studies treated various financial
education programmes as a proxy for such literacy whilst others measured
different aspects. Policy formulation necessitates a clear and defined distinction is
made as to what definition is used for financial literacy and that any educational
programmes that are implemented have clearly defined objectives that prevent
distortions in the results of such programmes.
The Federal Reserve’s 2002 study on such literacy not only highlights the concept
of ‘financial literacy’, but also delineates the role played by public policy in
alleviating consumers’ lack of knowledge of FPs. The facilitators of financial literacy
programmes in the US have been a diverse group including employers, military,
community-‐based-‐organisations, and more importantly, commercial banks
(Braunstein, 2002, p. 448). However these initiatives proved to be unsuccessful in
promoting financial literacy sufficiently to the wider population. Whilst the Fed
preached about the role of an educated and financially literate population in
maintaining a stable macroeconomic environment, it did not come close to
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achieving that objective in the lead-‐up to the financial crisis. The substantial lack of
financial literacy amongst consumers led to them making poor financial decisions
which contributed to the implosion of the financial sector in 2008 and severely
damaged the macroeconomic environment.
Robert Shiller argued in the chapter on ‘financial democracy’ in his book ‘The
Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do
about it’, that prevention of another subprime crisis could be achieved by way of
extending the idea of sound financial principles to a larger segment of society
(Shiller, 2008, p. 115). Shiller writes that the continuing growth of ‘smart’
technology, computers and various other technologies is likely to provide tools to
deal with another possible subprime crisis. He considers six ways of improving the
information infrastructure, promoting comprehensive financial advice, establishing
a consumer-‐orientated watchdog, adopting default conventions and standards that
work well for most individuals, improving information disclosure of financial
securities, creating large national databases of fine-‐grained data pertaining to
individuals’ economic situations and creating a new system of economic units for
measurement (Shiller, 2008, p. 122). These types of measures are necessary in
forming a solution to improving financial literacy. On reviewing the literature
produced in the United States on financial literacy, one comes to the conclusion
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that financial education and the importance of a well-‐informed and financially
erudite population is a more important public policy priority in the United States
than it is in the United Kingdom.
Findings from Primary Research
Our primary research consisted of a survey, a meeting with Exeter businessman
Bruce Priday, and an interview with Steven Hawkins from Benevolent Society, a
charitable organization based in Australian providing financial advice targeted at
lower-‐income groups. The majority of respondents we surveyed were students,
including mature students whilst others were in full-‐time employment. The
following paragraphs analyse our findings and present recommendations for
Parliament to consider.
Questions Responses 1: What kind of financial products do you use?
10% use no financial products. 90% use some kind of financial product. Majority use student loans, credit and debit cards.
2: If you needed advice about purchasing a financial product, who would you turn to first and why?
20% turn to friends or family, especially parents. All students. 20% bank managers. 60% internet search.
3: Thinking now about people who provide financial advice on a professional level who would you go to for low-‐cost, reputable assistance?
50% bank or citizenship advice bureau. 40% didn’t know such advice was available.
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10% financial advisor.
4: Would you be interested in a program that taught you more about financial issues through a class or seminar in your community?
50% said yes to joining a class or seminar in the community, if it is free and focuses more on financial products such as mortgages and pensions. 10% said no on the basis that finance is a broader genre than solely financial products. 40% were unsure if such courses could be structured effectively.
Of the ten people we surveyed, 10% of respondents did not use any kind of
financial product as they felt interest rates charged on financial products were
untrustworthy thus showing the need for promoting greater literacy. The other
90% used a variety of FPs, the most popular being student loans and credit and
debit cards. We also found that in order to make a new FP purchase, the majority
of respondents (60%) would use online resources to do their own research, since
they feel they are able to make a sensible choice. Whilst this response suggests
that online advice was more easily accessible; it does not necessarily preclude the
possibility that these people over-‐estimated their understanding of FPs. Of the
remaining 40% of our sample, half would consult their bank manager, who has a
position of trust. The fact that just 20% of sample respondents would choose to
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turn to a professional advice service supports our above finding on people’s self-‐
reliant nature. The remaining 20% of respondents would first seek advice from
friends and family, particularly their parents. This 20% is comprised of students. It
is likely their lack of experience prevented them from doing their own research;
such advice is easily accessible and perceived to be highly reliable.
When respondents were asked about their preference for seeking professional
financial advice, 50% of respondents would consult their bank or the Citizens
Advice Bureau, since these are trustworthy, as well as low-‐cost or free services.
Although this result may sound positive for the current attempts to improve
people’s literacy, a further 40% of those surveyed had no idea whether such
affordable services were already available. This indicates the need for better
advertising of the existing offerings which people could safely use. The remaining
10% would seek structured financial advice. The result does not lessen the need for
an overall improvement in financial literacy in the UK-‐ in particular people of
school age. When asked if they would attend a programme at their workplace or
local college designed to improve their literacy, 50% would if it was free and
included more complex commercial products such as mortgages or pensions,
rather than current accounts and credit cards. 10% said that a personal finance
course should be cover broader subject matter, while 40% thought such a course
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would be ineffective or irrelevant to them. However, this group did mention that if
such courses contain more real-‐life cases it would be more beneficial to their
requirements.
The group interviewed Steven Hawkins via Skype on the role he has played in
spreading financial literacy, the problems that exist with the current institutional
framework, and any suggestions that we could incorporate into our own work on
improving financial literacy in the UK. Mr Hawkins elaborated on two programmes
his organisation promotes: Money-‐Minded and Saver-‐Plus (Hawkins, 2013).
Money-‐Minded is a textbook that takes people through the range of ways one can
manage their money more efficiently (Hawkins, 2013). One of the advantages of
Money-‐Minded is that it can easily be converted into school materials (Hawkins,
2013). Saver-‐Plus has been very successful in Australia; ANZ bank fund the
programme, and the idea is that consumers on less than $40,000 per annum, the
consumer must save up to $50 for ten consecutive months and then ANZ bank
matches the amount saved (Hawkins, 2013). An evaluation of graduates after
leaving the programme indicates that the saving habits have been ingrained
(Hawkins, 2013). The institutional framework according to Mr Hawkins is that in its
current constitution, it assumes one has the requisite skills to be financially literate
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(Hawkins, 2013). This has meant that Money-‐Minded and Saver-‐Plus have had to
step in to plug the educational gap (Hawkins, 2013).
A meeting with Exeter businessman Bruce Pridday was engaging and productive.
Mr Pridday works closely with small and medium enterprises (SME) in the South-‐
West region (Pridday, 2013). Mr Pridday gave us an insight into the lack of financial
literacy amongst entrepreneurs, and how this is exploited by commercial banks
(Pridday, 2013). Furthermore, newly appointed directors to various businesses do
not possess sufficient financial literacy, and, do not have much of an idea on what
constitutes financial governance (Pridday, 2013). One suggestion that Mr Pridday
put forward to rectify this problem, is for an online modular course provided by the
Institute of Directors (IOD) or the Confederation of British Industry (CBI) for all
probationary directors (Pridday, 2013). On the issue of lack of financial literacy
amongst prospective entrepreneurs, Mr Pridday suggested that commercial banks
provide a six week course on financial literacy (Pridday, 2013). During the
discussion, the issue of moral hazard was raised (Pridday, 2013). Moral hazard is
when financial institutions lack an incentive to guard against risk, because they
know they are protected from the consequences of their bad decisions (Oxford
Dictionaries , 2013). It was the Government that protected some commercial banks
from the consequences of their lending decisions. Therefore there is a strong moral
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argument that the partially state owned Royal Bank of Scotland (RBS) should be
encouraged to put aside money into a fund that can be directed at schools
teaching financial education and funding the six week course previously mentioned
(Pridday, 2013). Yet it is not just money that forms this moral case for greater
financial education provided by RBS. Mr Pridday also suggested that commercial
banks should substantially increase advertisement of consumer rights (Pridday,
2013).
Recommendations
Recommendation 1: The Government should play a more active role in increasing
the amount and quality of advertising for free and low-‐cost sources of financial
advice. For example, many people are unaware of the existence of freely available
government services which could improve their financial knowledge. Profit-‐seeking
sellers of FPs bombard consumers with advertising through television and radio,
flyers in public places, including banks and even sending personalised letters to
their houses. However, free advice services remain virtually unheard of. Whilst the
difference in available funding between the two types of organisation is clearly
evident, some extra fund allocation towards advertising the government’s financial
advice schemes might go a long way to raise the level of such literacy among the
population. This fund would be miniscule compared to the colossal governmental
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bailout provisions that had to be forsaken in the aftermath of the crisis. This could
also potentially reduce the government’s compulsory spending on benefits.
Commercial banks should increase advertisement of consumer rights.
Recommendation 2: Government should play an active role in targeting specific
groups identified as having low financial knowledge. The increased government
spending and advertising in this area would allow these groups to allocate their
income more efficiently. Banks should work with non-‐profit organisations to
improve the financial advice provided. For example, NatWest gives away charts
and stickers with every young savers account to help teach children the
importance of savings at an early age. This could be an example for other banks to
follow. Another example of incentivised saving already in practice is the Saver-‐Plus
scheme by ANZ Bank in Australia which allows people with low incomes to save up
to $50 a month, for 10 months with that amount being matched by a combination
of the bank, government and community organisations. The extra $500 could only
be spent on specific items relating to education and the money will only be given if
the saver attends 10 hours of financial education workshops and has regular
meetings with their ‘Saver Plus’ worker. The ultimate goal of this programme is to
inculcate and encourage savings habits. A similar programme could also be set up
in the UK through RBS if organisations willing to provide the finance can be found.
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If finding organisations to match the savings is too difficult in the UK, just allocating
the ‘financial worker’ to those on low incomes could be a less costly option. The
Government should encourage the IOD or the CBI to provide an online modular
course for probationary directors. Finally, through RBS, the Government should
promote a six-‐week course on financial education for all prospective entrepreneurs
to improve financial literacy in the SME sector.
Recommendation 3: Financial education should be made a compulsory part of the
school curriculum. This could be integrated with other life-‐skills such as healthy
eating, alcohol awareness, etc. but would need to be taught to every student at
GCSE level on a weekly/fortnightly basis to prepare them for entering adult life.
The incentive of a certificate would help to motivate both the students and
teachers. The content of such classes should not be overly mathematical. Greater
focus on macro issues such as how inflation and unemployment affects gross
domestic product (GDP) of an economy, as well as practical skills, for example,
understanding a mortgage application. Although 14-‐18 year olds will not be
considering a mortgage until adulthood, this subject will teach them the skills that
will ensure they make the correct decisions as financially-‐literate adults.
In conclusion, the group acquired a lot of knowledge on the importance of financial
literacy and the role a more greatly informed population can play in maintaining
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stability of the financial system. Furthermore, our research over the past two
weeks has led us to conclude that a key driver of the financial crisis was the
exploitation of a financially illiterate population. There is room for Government to
play a much more active role in promoting awareness of the low-‐cost and free
sources of financial advice available. This support must be targeted primarily at
those in the lower-‐income bracket. By helping to ensure consumers are making the
right financial decisions concerning savings and pension provision, this eases
pressure on long-‐term social security spending and thus stabilises the medium to
long term fiscal position. It is imperative that financial education is incorporated
into the curriculum. By imbuing into school children the importance of making
sensible financial decisions, and a greater understanding of the different macro
variables in the economy, this too will ensure a more stable financial system and
economy. There is also a moral dimension to improving financial literacy. A more
financially erudite consumer base is less likely to be beguiled by financial
institutions seeking to exploit them. There is a strong economic and moral
imperative for these recommendations to be implemented, and we urge that they
are done so imminently.
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Bibliography Hung, A. P. (2009). Defining and Measuring Financial Literacy. RAND Corporation .
Braunstein, S. a. (2002). Financial Literacy: An Overview of Practice, Research and Policy . Federal Reserve .
Shiller, R. (2008). The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about it. Oxford: Princeton University Press.
Hawkins, S. (2013 йил 6-‐June). Questions on Financial Literacy . (M. Doyle, J. Clough, & S. Ray, Interviewers)
Pridday, B. (2013 йил 11-‐June). Improvements to Financial Literacy in the UK . (M. Doyle, S. Ray, & G. Abrahams, Interviewers)
Oxford Dictionaries . (2013). Retrieved 2013 йил 11-‐June from Oxford Dictionaries Web Site : http://oxforddictionaries.com/definition/english/moral-‐hazard
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3. Socially responsible banking: local banks and building societies
By Chloe Alexandra Bitcon, Luke Hayes, Zhongyuan Liu, Maria Smedoiu
Social responsibility is about more than the components usually listed by banks under ‘corporate social responsibility’, which include donations to charity and volunteer opportunities for bank employees. Social responsibility, which should encapsulate values such as sustainability, accountability, stewardship and transparency, must be embedded in the structure of the banking industry itself and should be reflected in the decision-‐making models of all financial institutions. Socially responsible banking is, by definition, about sustainability. In other words it is conducive to a reduction in systemic risk as well as being conducive to the common good, environmental sustainability, strong local economies, poverty reduction and wellbeing. Lessons can be learnt from financial institutions that are accountable to a wider group of stakeholders than a select group of shareholders and that are focused on long-‐term productive investment as opposed to short-‐term profiteering. The aim of this report is to outline the problems with the current banking system, conduct an inventory of existing socially responsible financial institutions and highlight the barriers to entry and effective operation faced by new local banks, credit unions and building societies in particular. The UK banking industry and its failings
“Our banking system is too concentrated. We want new banks on our high streets offering real competition and challenging for better customer service.” (George Osborne in Treanor 2013)
A crucial feature of the UK economy is the concentration and control of wealth with only a handful of large banks. There is a real lack of competition in the commercial banking system, which – unbeknownst to many – has been granted the privilege of generating 97% of our money supply (Werner 2013). Six major national banks account for 92% of personal current accounts, 85% of mortgages and 88% of small business accounts (Greenham 2011). In the aftermath of the financial crisis of 2008, this led to what Ed Miliband referred to as a “bonus as usual” culture (BBC 2013). The government are fearful of getting on the wrong side of the big banks
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but acknowledge that there is an urgent need for greater competition within the industry. Furthermore, local economies and vulnerable sections of the population are suffering. People on a low income find it difficult to get loans and around 2 million people do not have access to decent banking services (Rahman 2010). Small businesses and entire communities have become credit deserts, and town centres increasingly feature empty shops. The resulting influx of large supermarkets and fashion outlets brings some advantages but also reduces diversity and resilience in the local economy (New Economics Foundation 2005). SMEs in particular, which account for somewhere between 50-‐80% of employment (depending on the industry), are struggling to access funds.
“Half of UK businesses want to grow, but two fifths applying for finance aren’t getting it.” (Andy Willox, Federation of Small Businesses (FSB) Scottish policy convenor)
There has also been a loss of trust in the banking system because of bonuses, pay inequality, speculation and risky or unethical investments. In addition to calling for stricter regulation of the large high street banks, there appears to be an appetite among the general public for switching to local, mutual and ostensibly more ethical financial institutions (Move Your Money 2013). In the aftermath of the LIBOR scandal, Nationwide reported an 85% week-‐on-‐week increase in new account enquiries, and some of the smaller banks and credit unions also reported growing interest (Parsons 2012). Socially responsible banking models Credit unions A credit union is a not-‐for-‐profit organisation that is a type of financial cooperative or mutual. It is run by a board of volunteers meaning that all profits go directly to members through dividends. A credit union’s members must also have a common bond (Credit Union act 1979). This means that there must be something that links the members such as geographical location or employment and as a result credit unions generally have much more of a community feeling. Although they do predominately focus on lending and savings, a few larger credit unions offer current accounts and insurance. In Great Britain currently only 2.4% (World Council of Credit Unions 2011) of the population bank with credit unions, however in the decade before 2007 membership of credit unions increased by 170% (Jones 2008), showing that there is an increase in their popularity. It is suggested that their local remit makes them more trustworthy in comparison to the larger financial institutions. In Ireland,
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credit unions are considerably more popular with 72% of the population holding an account. Similarly in the USA 44.9% have a credit union account (World Council of Credit Unions 2011), making it more surprising that Great Britain has so few. In Ireland, even after the credit crisis they remained relatively stable, with reserves increasing (although they did benefit from €1 billion in government support)
(World Council of Credit Unions 2011), suggesting that the UK could learn something from how other nations use the credit union system. One key example of this is the Irish regulation that is being introduced in the industry to support it and retain its community focus. The focus on standardising the credit union model, stabilising it and providing support laid out in the Credit Union Bill 2012 is something which any British legislation should build upon. The collapse of the North Yorkshire Credit Union, a credit union with local authority support, showed that monetary support is not enough and consequently regulation was adapted to allow credit unions more opportunity to compete (Jones 2012). The DWP’s Credit Union Expansion Project, which involves £38 million of government funding to help credit unions is aimed at supporting them to create a shared infrastructure to try to increase financial inclusion (Department for Work & Pensions 2013). Financial inclusion is one of the main benefits of credit unions as they aim at allowing all in a community to access financial services, which particularly with the increase in popularity of “pay day lenders” charging interest rates of over 4000% is something that is very necessary in our current economic situation (Osborne 2012). When the APR rate a credit union can charge is capped at 26.8%, these loans are considerably better for the consumers and should be encouraged. For many reasons the credit union is something which is very desirable in the British economic landscape for its “socially responsible banking”. Its board of volunteers, not-‐for-‐profit mentality and community focus mean that they can achieve goals which are simply not possible for profit-‐making organisations. One of their main goals is financial inclusion as demonstrated by London Community Credit Union (LCCU). The credit union was established in one of the most deprived boroughs of London as part of the council’s anti-‐poverty policy and consequently has allowed many individuals to set up a bank account and gain access to many more services. LCCU also demonstrates how credit unions can be used to support more vulnerable individuals through their “Jam Jar Account” which allows members to syphon off money and have a very structured bank account to help them with budgeting and tries to ensure that they can afford essential living costs (London Community Credit Union 2013). This is a service that a high street bank would not offer. It is not realistic to suggest that credit unions become the sole
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form of British banking, however increasing their popularity would increase financial inclusion and could help SMEs, through lending. To do this effectively the DWP’s Credit Union Expansion Project (Department for Work and Pensions 2013) will help considerably by helping to fund a shared infrastructure which will consequently allow credit unions to more effectively compete in the market. This project, paired with legislation similar to what is being implemented in Ireland, focusing on support and standardised structure, will allow these institutions to operate as effectively as possible and allow them to flourish whilst maintaining their core principles. Additionally, an increase in the knowledge of credit unions among the public will allow them to grow. Local banks Many of the advantages offered by credit unions might also apply to local banks, i.e. those that have a defined geographical remit. Currently only 3% of banking assets in the UK are in local banks (New Economics Foundation 2013). Metro Bank is the first new fully-‐licensed bank in the UK in over 100 years, founded by Vernon Hill. It aims to reinvent banking by pursing excellent customer service and convenience. It provides the same range of services as one of the big banks but is open 7 days a week. Unlike a mutual, it is a profit-‐driven organisation; however it is currently making a loss, with pre-‐tax losses to date more than £100m (Thompson 2013). Metro Bank tripled their lending to small businesses between 2011 and 2012 and their mortgage lending also increased from £7m to £62m. This is due to the investment required to create new branches and build the infrastructure and operating systems necessary; and its aim to build 200+ stores by 2020, from its current 18 today (Thompson 2013). It has been successful so far, with customers encouraged by the longer opening hours and better service, as account numbers tripled to 136,000 in 2012 from 2011. Customer deposits grew 279% to £576m in 2012 (Thompson 2013). To raise more capital, Metro Bank aims to float on the London Stockmarket in 2014, with its expansion plans focused on London and the south east. Metro Bank is a young business, and therefore it is hard to conclude much about the local banking model on the basis of it. It is clear that local banking has been successful in Germany (see Appendix I), however to fully assess the impact it might have in the UK the local banking sector must expand. Metro Bank has been greeted with much enthusiasm, but it still suffers from teething issues (Hyde 2013). To fully understand whether local banking will be successful, it must first be encouraged. If local banks can gain community support, then they can become a major part of the financial system. However, to achieve this, the government will
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have to support the creation of more local banks as well as a joint infrastructure that these banks can share. The geographical limits on local banks are a limitation as well as an opportunity, and local banks could become part of a larger network. This could be achieved in the short-‐term by making use of the infrastructure owned by RBS, which itself is now predominantly owned by the taxpayer (Greenham 2013). However, to fully encourage more community banks they should be set up from scratch by local people, rather than being the remains of a failed giant. Local banks should also be encouraged to sell shares only within the local area and not to float on the stock exchange. Building societies A building society is a mutual financial institution, which means that it is owned by its savers and borrowers. Most importantly, building societies do not have shareholders and therefore their goal is not to maximize profits for shareholders but to optimize profit for the benefit of the building society. Additionally, their structure enables them to focus everything they do around the needs of the customer and they are therefore widely perceived as being significantly more customer-‐focused. Members are able to hold their building society to account at regular member talkback or forum events, although it is not clear to what extent members make use of this opportunity. In turn this helps these institutions to gain high levels of trust from customers. 79% of consumers said that their trust in building societies had increased or remained the same compared with 66% of consumers who said that their trust in banks had fallen (McVitty 2012). One key reason that the building society sector is associated with higher levels of trust is due to the fact that they were not as badly hit by the financial crisis, due to their lower risk appetite and limited exposure to the commercial market, as the Building Societies Act 1986 states that at least 75% of their assets must be in residential land and a minimum of 50% of their funding must derive from savings. However, this trust is also established through business policies. For example, both Nationwide and Yorkshire Building Society, two of the biggest building societies in the UK (Cowie 2012), try to maintain this trust through staff policies. Nationwide have their “PRIDE” values and Yorkshire Building Society have a similar policy through their key values. The benefits of building societies are particularly useful currently as an increase in trust in the banking sector will improve it as a whole and the customer focus results in the lower risk appetite meaning they are more likely to be protected in these unstable times. However importantly, their structure means they are more able to be ‘socially responsible’, ensuring that their activities benefit society
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because they are not as driven for short-‐ term profit. Equally this allows them to commit to investment projects to update infrastructure, as Yorkshire Building Society is doing currently, as they are free to look at the long-‐term benefit. Many within the industry perceive regulation to be one of the greatest potential threats to building societies as they are very stringently regulated particular through the ‘Nature Limits’ which could potentially mean that particularly smaller building societies may find it difficult to compete. Building Societies are definitely desirable to the economic landscape of Britain as they add diversity. Although in many ways they are very similar to banks in the products they offer, their specialization in the mortgage market and mutual step up means that they can effectively serve their members and arguably are more accountable and socially responsible as a result of this. However to make building societies as competitive as possible and therefore able to legitimately challenge the big banks, which in turn will help make the whole sector more socially responsible, regulation must allow them to compete effectively. This is especially prudent for smaller building societies in order for them to serve their communities. However, relaxing regulation may not be realistically feasible in the political environment due to the tensions surrounding the financial sector. However there should be more support provided for small building societies to enable them to thrive. To do this a program of investment similar to what is being used with credit unions at the moment is needed to create a shared infrastructure to reduce costs and therefore make them more competitive, thus allowing them to be more socially responsible. Encouragement should also be given to larger “umbrella” building societies who merge with smaller societies to keep them as separate entities, as Yorkshire Building Society does with Chelsea Building Society and Norwich and Peterborough Building Society in order for them to be “local” and community focused. This equally allows these smaller building societies to operate independently, however with the support and infrastructure of something much bigger. Local authority involvement in banking The centralisation of financial power is a problem for democratic accountability, especially when the abuse of this privileged power has such detrimental consequences for society. Some have suggested that government ought itself be involved in banking. Whereas the banks are only accountable to their shareholders, government is democratically accountable to society. One advantage of a state-‐
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backed bank is that it may be inclined to take a more long-‐sighted and community-‐focused approach to lending than the high street banks. Public, geographically exclusive banks play a significant role in Germany, accounting for over a third of the German banking industry and being the primary lenders to SMEs (see Appendix I). The strength of the Sparkassen model is its emphasis on serving the needs of the local community on top of generating a profit. The Sparkassen were able to continue lending during the financial crisis, enabling local businesses to expand and contributing to the relative stability of the German banking system (Clarke 2012). The Sparkassen benefit from being locally autonomous but collaborate to gain cost efficiencies and spread risks. Furthermore, although the concept of local authority involvement in banking is often frowned upon in Britain because of fears of political meddling, the Sparkassen demonstrate that the use of money for party political purposes can be avoided if the supervisory and executive boards of the bank are kept separate. Airdrie Savings Bank in Scotland also operates successfully on the basis of such a separation because their operations receive oversight by a board of volunteer trustees (see Appendix II). Barriers to entry and effective operation
The UK banking industry would benefit from greater diversity and the above-‐mentioned alternative models ought to be encouraged.
There are currently many barriers that dissuade new banks from entering the market. Most of these are the culmination of FSA (now FCA) regulations and preferences. It currently takes around 6-‐12 months to apply for a licence (Clarke 2012), however the Bank of Dave and other recent start-‐ups have demonstrated that the process is fraught with complications and uncertainties, making it very difficult to create a solid business model, mobilise capital and personnel and set in place infrastructure planning. Nevertheless, the PRA and FCA have recently announced that they will introduce much-‐needed pre-‐application support, be clearer on requirements for authorisation and offer an alternative 3-‐stage route to authorisation that may better suit the requirements of start-‐ups that want to minimise uncertainty (via a faster authorisation turnaround but with restrictions) (FSA and Bank of England 2013). The regulator also has a bias towards banks that are going to maintain a high street presence, discriminating against those who have chosen to operate online or who
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cannot afford branch infrastructure. Experienced executives are preferred, however this may lead to a reproduction of orthodox business models, as the regulator has a track record of not helping inexperienced entrepreneurs (Clarke 2012).
The first major problem that new entrants face is the requirement for capital reserves of 8.5% for all banks, a percentage that is usually higher for new banks. They are also penalised by liquidity requirements because liquidity ratios are based on the quality of deposits (Clarke 2012). Those considered ‘low quality’ include deposits in online-‐only accounts, deposits exceeding £85,000 and those acquired quickly, all of which apply disproportionately to new banks. This system unfairly discriminates against new banks – their operations pose less systemic risk in the first place – and thereby damages the prospects for a diverse and competitive UK banking sector. However, in a recent review published by the FSA and the Bank of England (2013) it was announced that some of the additional capital requirements for start-‐ups (“add-‐ons and scalars”) would no longer apply and that liquidity requirements for new banks would also be reduced.
For a new bank to operate it must be able to access the payments systems. This is very expensive and there is little choice, with VocaLink Holdings Ltd having a near monopoly. As new banks are unable to meet the criteria to directly join, they must join through an ‘agency bank’. This is through one of the incumbent banks and at a price they set (Clarke 2012). The government have recently announced a consultation to consider the possibility of setting a fair price for access to payments infrastructure or directing the big banks to deliver new innovations in these systems. Alternatively, they may consider ending the ownership of payment systems by the big banks in the interest of fair access and competition (HM Treasury 2013).
New banks are at a disadvantage to the incumbent oligopoly, as the incumbent firms have a far higher market share and can offer cheaper services. The big banks can offer free current accounts, paid for by fees when other banks’ customers use their ATMs. However, new banks and those with less than a 10% market share cannot compete because they have fewer ATMs (Clarke 2012). Small banks and credit unions could consider joining a network to share infrastructure (as is successfully done with credit unions in the USA) and the government could also opt to give small banks access to public infrastructure such as the Post Office. Another recent proposal has been to make use of existing RBS infrastructure (e.g. branches and ATMs) and turn it into a network of local banks (Greenham 2013).
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Significant start-‐up costs could be further reduced by encouraging the market for low-‐cost off-‐the-‐shelf banking software.
Most recently the ‘one size fits all’ regulation that Basel III sought to impose would have unfairly subjected new firms to tighter regulations aimed at the big banks, without taking into account the relative size and risk of the banks. However, Basel III has been implemented by applying to new banks only the 4.5% minimum Core Tier 1 capital requirement, not the 7-‐9.5% requirement that is aimed at existing big banks. In conclusion, to encourage new firms, regulation must be tailored to the different segments in the industry, geared towards encouraging new socially responsible and local banks, credit unions and building societies and supporting the activities of those currently in the market. The FCA must remove some of the remaining barriers to entry for new financial institutions. New banks would also benefit from sharing resources and as such, new infrastructure networks should be encouraged and accessing the payments systems made more competitive and easier. Recommendations: Credit unions
1. Public awareness campaign
Research has shown that many people are not aware that credit unions exist (people usually hear about them by word of mouth), many (including those who join credit unions) don’t really understand what they do, and they currently play a much less significant role in the UK than they do in many other countries (e.g. Ireland and the USA). The Association of British Credit Unions could be supported to run a TV advertising campaign to raise awareness of the existence of credit unions and inform the public about how to find their local credit union. The awareness campaign also needs to shift the credit union narrative so that it is not just seen as a good alternative for people on a very low income or on state benefits but as an alternative for anyone who wants more community-‐led banking services and good rates. Having said that, there is already cross-‐party political awareness of the fact that credit unions can play an important role in increasing financial inclusion especially in the face of recent welfare reforms (e.g. Universal Credit) and that they help to deter people from loan sharks and pay-‐day lenders. The DWP has already committed £38 million in support of the credit union movement to help expand the sector and provide financial services for 1 million more consumers by 2019, also enabling credit unions to modernise and become
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financially sustainable. We believe that some of this money needs to be directed towards a public awareness campaign.
2. Infrastructure
The DWP Credit Union Expansion Project will also help set up shared infrastructure, which is largely what is behind the success of the American credit union movement. Credit unions can increase their popularity if they can offer current accounts. To do this, they need to have affordable access to payments systems and infrastructure such as ATMs. The government could also give the credit union network access to public infrastructure such as the Post Offices. There is definitely scope for improved collaboration and efficiency through shared services arrangements between the credit unions, and this is something that the Irish Credit Union Bill (2012) is currently trying to support. This would also involve shared IT services (online banking platform) and standardising processes that could reduce costs and improve efficiency. We think that legislation to contribute to the standardisation and improved efficiency of credit unions is a good thing but there needs to be flexibility to account for the diversity within the credit union movement. Part of new credit union legislation could be aimed at creating a governance standard for credit unions, focusing on the role of the board and oversight committees.
3. Encouraging new credit unions
There are significant barriers to entry for new credit unions, including start-‐up costs and the difficulty generating a common bond where one doesn’t exist. Part of the Irish success is down to the fact that the Catholic Church provides a natural common bond. Where local councils already have a poverty reduction strategy, they could be encouraged to facilitate the development of new credit unions as part of that strategy (as the London Community Credit Union did in Tower Hamlets), be that through creating a local finance advisory role or by providing start-‐up funding to help new credit unions (e.g. expenditure subsidy to cover start-‐up costs or capital subsidy). Building Societies
4. Remutualisation of nationalised banks
When demutualised building societies such as Northern Rock fail, the taxpayer has to bail them out. We propose that in recognition of the social benefits of mutuality, existing mutuals should be given first refusal when newly nationalised banks are offered up for sale. Alternatively, when all the debts of the failed institution are paid back, it could be converted back into a building society by the government.
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Local banks 5. Shared infrastructure
Local banks are run along commercial lines like the big banks but their remit is constrained to a particular geographical area, which means that they have many of the same advantages as credit unions but can offer more services. Local banks suffer from many of the same constraints as credit unions, especially with regards to accessing payments systems, ATMs and branch infrastructure. The creation of joint infrastructure that local banks can share would help and this could be achieved in the short-‐term by making use of the infrastructure owned by nationalised banks such as RBS. Regarding the government’s recent announcement of a consultation to consider access to payments infrastructure we believe that setting a fair price for access to payments systems has the greatest likelihood of success out of the options they have identified. Core recommendation: Creation of and support for shared infrastructure (ATMs, branches, payments systems) to remove barriers to entry and effective operation for credit unions and new local banks. This is likely to improve diversity and competition within the British banking industry. APPENDIX I The German Sparkassen model Unlike in Britain, where the banking system is dominated by a handful of major banks, the German banking system is often given as an example of a complex one. It is characterised by variety and is often described as ‘three-‐pillared’. The private
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commercial banks, the cooperative banks and the public banks make up the three pillars of this banking system. The latter is also divided into German Federal State banks (Landesbanken) and savings banks (Sparkassen) (Clarke 2012). Each of these plays a different and significant role within the economy as well as within the society, meeting the diverse needs of all potential customers. Commercial banks are focused on multinational businesses, with wealthier clients, trading services for them while also engaging in investment banking. On the other hand, cooperative and savings banks focus on SMEs and the rest of the population. Their resources are allocated to serving the needs of households and local businesses by offering a variety of financial services (current accounts, mortgages, and savings). While the large commercial banks lend to sectors that are seen as more profitable such as capital intensive firms, the savings banks focus more on smaller, more local clients such as hotels, construction industries or agricultural industries. As a result, 75% of SMEs are linked to a Sparkasse (savings bank), hence, UK, new and more German businesses have access to credit. In order to understand how Sparkassen work, it is crucial to understand their constitution. The Sparkassen are part of the Sparkassen Finanzgruppe and are provided with wholesale banking service and liquidity management by Landesbanken. Besides this, Landesbanken offer financial services to other firms that do not benefit from the help of the Sparkassen. The Banking Act states that profit should not be the main purpose of the Sparkassen and also that they have to strengthen competition while providing services for local economy. Following these regulations, the Sparkassen are municipal bodies with no shareholders and are guided by the legal requirement to serve the local economy. Very important is that Sparkassen benefit from an effective system of credit guarantees for loans, run by the guarantee banks. These are not-‐for-‐profit institutions owned by financial players (banks, insurance companies) and organise themselves through the Association of German Guarantee Banks (VDB). During the financial crisis, the VDB received increased support from the German government. The contribution of the VDB to the German economy has been shown to be extremely important by helping SMEs and start-‐ups to work with a Sparkasse. An important and controversial aspect is that, during the financial crisis, often described as a credit crunch, many banks stopped lending, but in opposition to this trend, Sparkassen continued to offer lending. As a result, businesses continued to increase production (3.6% growth in 2010) (Clarke 2012).
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In conclusion, the low profitability of the German banking system should not be blamed on the Sparkassen, as this was the most profitable and stable banking group. The large commercial banks are less profitable perhaps due to their engagement in riskier activities. APPENDIX II Trustee saving banks: The Airdrie Savings Bank The Airdrie Savings Bank is the only remaining independent Trustee Savings Bank in the central belt of Scotland with eight branches. It is proved a success despite the difficult financial situation. BBC News reported that ASB’s annual lending rose for the fourth consecutive year to reach £52.2m and its customer deposits also increased by 3.6% to £142.5m. The bank is now moving towards a situation where 50 per cent of its deposits are used for loans, 37.5 percent are placed in gilts and 12.5 per cent are funds held on deposit with other banks for day-‐to-‐day operations (Clarke 2012). Thanks to ABS’s increasing-‐lending policy, it stayed profitable during the financial crisis. Profits were ploughed back into the bank to ensure it was well capitalized. Its success set an example in the modern British banking market. Bibliography BBC News (2013) “Regional banks needed to restore trust and boost lending – Miliband” [online] Available: http://www.bbc.co.uk/news/uk-‐politics-‐21779956 . Accessed: 11.06.2013. Clarke, S. (2012) Street Cred: Local banks and strong local economies. Civitas: Institute for the Study of Civil Society, London. Cowie, I. (2012) “Cowie’s Quick Guides, part 2 – building societies” The Telegraph [online] Available: http://www.telegraph.co.uk/finance/personalfinance/building-‐societies/9719277/Cowies-‐Quick-‐Guides-‐part-‐2-‐building-‐societies.html . Accessed 11.06.2013. Department for Work & Pensions (2013) “Credit union 38 million expansion deal signed” [online] Available: https://www.gov.uk/government/news/credit-‐union-‐38-‐million-‐expansion-‐deal-‐signed. Accessed 11.06.2013.
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FSA and Bank of England (2013) “A review of requirements for firms entering into or expanding in the banking sector” [online] Available: http://www.fsa.gov.uk/static/pubs/other/barriers-‐to-‐entry.pdf . Accessed 11.06.2013. Greenham, T. (2011) “Why the banking reforms proposed by Vickers today are ineffectual” [online] Available: http://liberalconspiracy.org/2011/12/19/vickers-‐report/. Accessed: 11.06.2013. Greenham, T. (2013) “Ed Miliband is right, Britain lacks local banks – RBS could fill that void” [online] Available: http://www.guardian.co.uk/commentisfree/2013/mar/14/ed-‐miliband-‐local-‐banks-‐rbs. Accessed 11.06.2013. HM Treasury (2013) “Government plans to open up banking sector take a step forward” [online] Available: https://www.gov.uk/government/news/government-‐plans-‐to-‐open-‐up-‐banking-‐sector-‐take-‐a-‐step-‐forward. Accessed 11.06.2013. Hyde, D. (2013) “Is Metro bank any different to the big banks after all?” [online] Available: http://www.thisismoney.co.uk/money/pensions/article-‐2266409/DAN-‐HYDE-‐Is-‐Metro-‐Bank-‐different-‐big-‐banks-‐all.html. Accessed 11.06.2013. Jones, P. (2008) “Breaking Through to the Future” [online] Available: http://www.ljmu.ac.uk/Faculties/HEA/HEA_docs/15_Breaking_through_to_the_future_-‐_Final_report__4th_December_2008.pdf . Accessed 11.06.2013. Jones, P. (2012) “Savers reassured after North Yorkshire Credit Union collapses” The Guardian [online] Available: http://www.guardian.co.uk/money/2012/nov/02/north-‐yorkshire-‐credit-‐union-‐collapse. Accessed 11.06.2013. London Community Credit Union (2013) “Jam Jar Accounts” [online] Available: http://londoncu.co.uk/?page_id=666 . Accessed 11.06.2013. McVitty, H. (2012) “Press release: Trust in building societies remains solid” [online] Available: http://www.bsa.org.uk/mediacentre/press/trust.htm . Accessed 11.06.2013. New Economics Foundation (2005) “Clone Town Britain”. [online] Available: http://www.neweconomics.org/publications/entry/clone-‐town-‐britain. Accessed: 11.06.2013. New Economics Foundation (2013) “Transforming finance: a ‘how to’ guide forged in the public interest” [online] Available: http://www.neweconomics.org/blog/entry/transforming-‐finance-‐a-‐how-‐to-‐guide-‐forged-‐in-‐the-‐public-‐interest . Accessed 11.06.2013.
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Osborne, H. (2012) “Credit unions win funding boost to expand services” [online] Available: http://www.guardian.co.uk/money/2012/jun/27/credit-‐unions-‐funding-‐boost-‐expand-‐services . Accessed 11.06.2013. Parsons, R. (2012) “Co-‐op, Nationwide ramp up marketing to tap into public disquiet” [online] Available: http://www.marketingweek.co.uk/news/co-‐op-‐nationwide-‐tap-‐into-‐public-‐disquiet/4002596.article. Accessed 11.06.2013. Rahman, F. (2010) “The bank’s computer still says no to poor people who are a good risk” The Guardian [online] Available: http://www.guardian.co.uk/society/2010/may/26/banks-‐risk-‐low-‐incomes-‐flexible. Accessed 11.06.2013. Treanor, J. (2013) “Radical FSA shakeup eases rules for new banks to start up”, The Guardian, [online] Available: http://www.guardian.co.uk/money/2013/mar/26/fsa-‐eases-‐new-‐bank-‐rules. Accessed 11.06.2013. Thompson, J. (2013) “Metro Bank triples lending to business” The Financial Times [online] Available: http://www.ft.com/cms/s/0/51edcf9e-‐cecc-‐11e2-‐ae25-‐00144feab7de.html#axzz2VtZrAJHO. Accessed 11.06.2013. Werner, R. (2013) “Fuel for the Real Economy: Access to Finance for SMEs – The case for Local Banking” [online] Available: http://www.youtube.com/watch?v=8pShecMoY7w. Accessed 11.06.2013. World Council of Credit Unions (2011) “Statistics Report” [online] Available: http://www.woccu.org/publications/statreport. Accessed 11.06.2013.
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4. How Much of What Bankers do have Social Value?
Mai Nguyen-‐Phuc, Gao Yue, Teoh Seh Ming and Frederick J. Godding
1. Introduction This essay was inspired by the assertion of Lord Turner2, the former chairman of the FSA, that most of what bankers do are “socially valueless”. We believe that such assertions are contingent on the philosophical references of the debate. If reference is that banks directly “create wealth”, then we are inclined to agree with Lord Turner. However if the reference is that banks facilitate the creation of wealth, then our research is incline to disagree with Lord Turner. For the duration of this essay, we will refer to social value as social welfare. In economics, social welfare is often denoted as the bundles of consumptions goods available to economy at a specific period of time. These consumption bundles are both intrinsic and extrinsic in nature. With this in mind, we examine the marginal changes to social welfare on two of the central activities in the modern banking industry, namely, Credit Expansion and Lobbying. While the role of the former might be intuitively straightforward, we examine the merit of credit expansion contextual on the health of the economy. Furthermore we extend our examination towards the role of Securitization and the creation of Mortgage banks securities (MBS), in facilitating the expansion of credit. It is difficulty to see how the process of lobbying, which we show to have diverted a substantial amount of economic resources over the years, adds anything at all to social welfare. However when one considers lobbying as the process of democracy, then perhaps it is of social value. We will examine lobbying in context of the creation of “Mega-‐Banks” and the repealing of the Glass-‐Steagall Banking act (GSBA).
2 Adair Turner, “Securitization, Shadow Banking and the Value of Financial Innovation” 2012
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2. Credit Expansion In the last 10 years, the global economy has witnessed a surged in the availability of credit, most probably to the expansion of the shadow-‐ banking sector. a collective unit of financial institutes eg. Investment Banks, Insurances funds, hedge funds Structured Investment Vehicles (SiV). In 2011, the FSB3 estimated the flow of funds to the Shadow Banking sector to be $27trillion in 2004 but $60trillion in 2010. And consequently contributed to 25-‐30% of the banking sector. The conventional wisdom is that any credit expansion directly increases social welfare. We find such wisdom to be myopic or naïve. Firstly the injective of credit only increases the welfare of the economic if that economy is below a certain productivity threshold. Beyond such threshold, the marginal benefits of credit expansion are eroded by the consequential inflation. Furthermore there is a propensity for rapid credit expansion to create “bubbles” in the real economy create divert economic resources away from investment and savings. In this setting, credit expansion creates social welfare and thereafter destroys the same welfare as the real economy corrects itself. However it remains ambiguous if marginal benefit to social welfare had actually increased after the correction. To illustrate this scenario we will discuss about securitization.
2.1 Securitization Securitization is a process where various loans, such as mortgages or credit card debts, are pooled together and sold as securities. Under normal circumstances, if a bank issues a 30-‐year mortgage it has to keep the mortgage on its balance sheet for 30 years to receive the interest and principal. However, a bank can use securitization to turn illiquid mortgages to cash. The process starts with pooling thousands of mortgages together and dividing them into smaller pieces according to their risk of default. These smaller pieces are then sold to keen investors who receive interest for bearing the risk. When payments come in for the whole mortgage pool investors are paid according to their share. This often results the creation of MBS, Figure 1 presents the total value of MBS in the global economy since 1985. Proponents of securitization cite the increased liquidity, risk management and lowered financial markets volatility, as the social benefits of securitization. From the social welfare standpoint, this should be evidential in the decreasing of mortgage rates that odd to channel itself into higher home-‐ownership ratios.
1. 3 Financial Stability Board, “Shadow Banking: Strengthening Oversight and Regulation,” October 2011.
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Figure 1: Issuance of MBS 1985-‐2009 (Billions of Dollars)
Widespread securitization started in the early 1990s, with its peak right before the crisis. With the help of MBS, banks could monetize their future cash flows and have cash for immediate spending and investments. Many banks in the United States chose to use the additional liquidity to give out more mortgages, thus bringing the mortgage rates down. In the Figure 2, we can observe a sharp decrease in the mortgage rates in the US in early 2000’s as banks started securing their mortgages. Low mortgage rates enabled rising home ownership hitting a record high in 2004 at 69% ownership rate. Thus, we can observe a positive relationship between securitization and home ownership in the US Home ownership is a key to developed economies. Firstly, home ownership provides shelter, stability and security. According to Maslow's4 hierarchy of needs, an individual has five levels of needs. The two most basic levels are physiological needs, such as food and shelter, and a need for safety. Home ownership provides these two basic needs of an individual. Secondly, by owning a house in a community families are more interested in the common good of the community. It is because their lives are tied to the community and because good community increases the value of their property. This results in higher civic participation, cleaner streets and better schools. Home ownership is a pillar of an economy and banks serve an important role in facilitating it.
4 Abraham Maslow, “Motivation and Personality”, 1954
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FIGURE 2: Mortgage Rates vs Home Ownership rates (US)
Source: Federal Reserve Bank of St. Louise
There is provisional evidence that the increase in securitization had resulted in a steady fall in mortgages rates that indirectly increase the home-‐ownerships rates in the United States. Furthermore, securitization helps banks, which do not want to hold the risk, to transfer the risk to willing investors. Therefore banks can easily manage their risk that results in lower risk concentration. Risk, being an abstract concept, can be measured through a volatility index or VIX index. In the Figure 3, we can observe low volatility of the markets during the height of securitization in the mid 2000’s. FIGURE 3: The VIX Index
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Source: Bloomberg
However, securitization should be approached with caution. Liquidity and low rates decrease the quality of mortgages as less suitable customers are allowed to borrow. If a bank can sell the mortgage to investors it can lend to unsuitable people without consequences. This creates moral hazard problem that may lead to higher default rate within a pool of mortgages. Moral hazard problem can be avoided if banks were to keep a portion of secured mortgages on their balance sheets – also known as “skin in the game”. Moreover, as securitization lowers overall risk many investors underestimate the risk they are taking on. This problem of neglected risk combined with glut of low risk securities creates market fragility if these risks are realized outcomes. Neglected risk is an externality that can be minimized with better functioning of credit rating agencies. It is worth to mentioned that the financial crises of 2008 although primarily derived by the same MBS products, were due to specific vintage of MBS created during the years of 2004-‐2007. Even though securitization does possess inherent risks it is an advantageous process for both banks and society. It manages banks liquidity and risk issues consequently bringing down mortgage rates and volatility. Society also benefits from a social value of high home ownership. The problems of moral hazard and neglected risk are externalities of securitization that can be minimized with sensible regulation.
3. Lobbying Lobbying is the act to seek influence to the decision made by business and government leaders and create legislation or conduct an activity that will help a particular organization. Figure 4, presents the expenditure of commercial banks in lobbying activities over the duration of 1998-‐2013. In 2000, only $20 million were spend on lobbying activities but by 2012 the figure had increased to $60 million. In recent years, huge amounts of money was spend on the lobbying with the introduction of Dodd Frank Act (Bandon and Padovan; 2012), which regulates the financial markets and prevent economic crisis. It plays an important role in the financial market and possibly broke up any banks that are determined to be “too big to fail”. The amount of money lobbied increased rapidly from 2009 to 2012, and by 2012, it increased to $60millions. However, this has increased the accountability and transparency in the financial system, and protecting taxpayer by ending bailout. This could lower the risk that taxpayer needs to bear. Furthermore, it keeps borrowers from abusive lending and mortgage practices by banks through Consumer Financial Protection Bureau (CFPB), and this protects consumers. Money could be used for infrastructures that support society, such as telecommunication, transportation and road and thus enhancing the standards of living. These infrastructures are public goods and contributed to the production of goods and services, such as hospital and schools. On the other hand, there might be free rider problem in the society. Public goods are
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divided into non-‐excludable goods and excludable goods. Excludable goods, such as radio broadcast, exclude those who cannot afford to pay and caused economic inequality. Therefore, lobbying money into infrastructure could be ambiguous. Figure 4: Expenditure of Lobbying (1998-‐2013)
Source: Center for Responsive Politics
Instead in this section, we examine two of the most contentious effects of lobbying, the decrease of competitions among banks, which had resulted in “Too Big to Fail” arguments and the repealing of the GSBA and its implications on the crises of 2008.
3.1 Repealing the GSBA The conventional wisdom is that lobbying activities lead to the repealing of the GSBA, which eventual led to the financial crises of 2008. In this was indeed true, then lobbying expenditure is surely a detriment to social welfare. GSBA that was enacted in 1933 and altered in 1999 contained in legislation what is known as the Gramm-‐Leach-‐Biley Act (GLBA). The act separates commercial and investment banking therefore, affiliation between the two and engagement of commercial banking in business of investment bank were prohibited. Although commercial bank could not underwrite or deal in securities and investment banks could not take deposits, the ability of banks to “purchase and sell” securities they acquired for investment was not illegal under the GSBA. For example, a bank purchases a security, such as a bond, and sells it later. This is different from dealing which inventory of bonds is bought for the purpose of selling them. Some argue that repealing of the GSBA had directly contributed to the 2008 financial crises, this essay will show that such conventions might have overstated the role of the GSBA in preventing
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such crises. The central conclusions are that although repealing the GSBA might have accelerated the crises, it was by no means the direct source of the crises. The GSBA prevented the mixing of banking and securities activities within the commercial banks. Such restrictions were however not extended towards affiliation of banks eg. Securities brokers,mutual funds. Commercial banks could also engage in derivative activities, such as credit derivatives and swaps, as long as the underwriting business was not the firm’s primary activity, they are allowed to affiliate with firms underwriting securities. Suppose that repealing of the GSBA did drastically lead to commercial banks exploiting their deposit base, we should observe an increase in leverage ratios by such banks. Figure 5 presents the average leverage ratios in US banks. Figure 5: Leverage Ratios in US Banks (Post GSBA)
Source: Ozcan, Sorensen and Yesiltas (2011)
There does not seem to be a significant change in leverage ratios for the large non-‐investment banks. Furthermore, in 1999, safety and soundness standards were not lowered by the federal legislation. It deregulates permissible activities and geographic areas in which a bank can operate but not lowering the supervisory or the power of bank regulators. In 1991, “prompt corrective actions” were taken for banks whose capital levels fell below certain thresholds and discretionary authority to believe a bank “undercapitalized” when its activities appeared risky. GLBA only allow “well capitalized” and “well managed” institutions to use the benefits of that legislation. During this period, restrictions on insider lending were strengthen. Moreover, further bank transactions with affiliated companies were controlled. The laws were implemented new criminal penalties for violating banking laws and money laundering regulations. Consumer
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privacy protection were adopted, including limitations on high cost mortgage loans, truth-‐in-‐savings disclosures, and the limit on the period a bank could hold a deposit before making funds available for withdrawal. However, in the past 30 years, there is no instance that deregulatory legislation reduced safety and soundness standards for depository institutions or hampered the enforcement powers of the federal banking agencies. Overall, there is no evidence that repealing of GSBA prevent financial crisis. In fact, it might accelerate the crisis. Mixing of baking and securities activities is still occurring.
3.2 Reduced Competition and the “Too Big To Fail” Argument The concept of ‘Too Big To Fail’ (TBTF) entails the idea that financial institutions in the UK have become so large in terms of market share that the government in general will protect them from any major collapse. It is important to highlight that TBTF is not a recent phenomenon originating from the Great Depression in the 1920’s, but it has truly amplified in the recent years. As you can see below, Figure 6 presents the combined assets of the world’s 50 biggest banks as the percentage of world GDP. The collapse of a handful of these 50 banks would most likely lead to a systematic knock on effect on the rest, leaving the financial system in crisis. Figure 6 Combined assets of the world’s 50 biggest banks (% of World GDP)
Source: Barth, Prabha and Swagel (2012)
The distortionary effects of TBTF are well understood in the conventions building up to the 2008 and consequential financial crises. Take the example of JP Morgan, the largest commercial bank in the world in 2011, held $1.8 trillion of assets equal to 14% of US total assets this poses a significant economic risk. This was uncovered in the recession by the systematic failure of several major financial institutions by the reliance on subprime mortgages and financial products in the shadow-‐banking sector. This reliance could be accounted to moral hazard or competition that encouraged banks to give out riskier and lower quality loans, as they feel secured by guarantees such as the Federal deposit insurance in making these decisions.
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Going forward, the “talk in town” is that banks may have exceeded their minimum efficient scale (MES) leading to the desire for regulatory policies to break up banks into smaller units. However our concerns pertains to the timing of such regulations, whether the present period of the recessionary world might be suitable for the applications of such policies. We present here the benefits of TBTF in the recessionary world. ‘Too Big to Fail’, In a Recessionary World We are interested in the social welfare of “depositors perceived safety” in this recessionary world. Namely does TBTF actually have any marginal benefits to social welfare? One major benefit of banks in the UK being ‘Too Big to Fail’ is the fact that this additional government support has increased the security and safety of both employees and customers in the financial system. Employees other than the risk of internal competition for position in a company are more confident in the security of the company for the future. Furthermore they work secured by the fact they are protected against the high volatility of the financial market which is the most important service the UK provides globally. The second point is driven by depositor security; we must ask the questions; There are many answers to these questions but I think the basis relies on two things security and reputation. In terms of security there are various forms of protection against a crisis in the financial system but the main concern is depositor safety. This is covered by the service provided by the Financial Services Compensation Scheme (FSCS) on behalf of the major banks, which gives UK regulated accounts £85,000 worth of protection cover. This provides a safety net against any major collapse but also encourages depositors to spread their money if they are large depositors in order to spread the risk. Take the example of Northern Rock, during the meltdown of this bank it was interesting to see that the percentage of branch accounts that withdrew their money from the bank was far less than the postal and offshore accounts. In these areas deposits fell by more than half that made recovery almost impossible but also showed the greater belief of the general public in the security of their deposits. In addition, security of the ‘big four’ in the UK gives them a reputation of credibility, in fact the term TBTF alone gives them a serious advantage over smaller institutions in terms of deposits and makes in nigh on impossible to enter the market successfully. To this effect the largest banks can benefit from economies of scale (by which cost decreases as output increases) by lowering risk premiums demanded and getting an additional funding advantage over smaller banks. In our opinion they need this advantage in fact to deal with the increasing taxed costs of banking services, which cause smaller institutions to suffer. Our final point is the implications TBTF has on the management on the financial system. Herein lies the crux of dealing with a recession, as without efficient communication between the government and the financial services there can be no real effort made to deal with the problems. This is where having a small number of banks really takes the advantage, as it is easier
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to manage a problem with fewer variables; it must be much easier to manage a financial crisis with fewer banks.
4. Conclusion In this essay, we briefly highlight the contributions of the banking industry to the social welfare of the economy. This has been a self-‐reflective journey. The irony is that as the journey continues, we find ourselves more incline to argue that many aspects of what bankers do actually have social value. The central disagreement is the mechanism to which the social value manifests itself in the real economy. Going forward we are concerned with the multiplicity of suggestions that have risen with the presumption that banks have no social value. With this assumptions, the proposers have seldom considered if their propositions have created a win-‐win situations for both society and the Banks. Through history we have learnt that social enforcement without mutual benefits would often lead to parties renegading on their commitments. Such arrangements in our opinion are doomed to fail.
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5. Report on UK Social Finance Written by: Phillip Brice Edward Dobell Thomas Rhys Reginald Ellis Nicoletta Pellegrini Victoria Volodina Shenru Wang Facilitator: Thomas White
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Content Page Foreword from Thomas White 3 Introduction 4 1 The Social Value Act and Social Returns 6 2 Government Legislation and Incentives 10 2.1 Social Enterprise Reforms 10 2.2 Bank Industry Reforms 11
2.3 Recommendations for social investment industry as a whole 12 2.4 Recommendations to encourage banks to directly participate 12
in the social investment industry
3 Project Merlin 14 4 Education 16 5 Conclusion 18 Summary of Recommendations 19 Bibiliography 21
Foreword from Thomas White
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I have been honoured to lead this group of students through the Grand Challenges. My studies and experiences with LaSalle Investment Management and HSBC Investment Bank have given me working knowledge of the financial industry: knowledge that I have been able to utilise and share in facilitating the discussion and ideas of these students. The Grand Challenge these student were involved in was “How do we make banks serve the common good?” and how can we make the Government ensure this: this report answers this question by focusing on Social Finance. The market for social investment in the UK has great potential in terms of both its impact on society and as a target for commercial investment, providing both financial and social returns. The report concludes with a number of recommendations that the Government should consider as a means for developing the maturity and accessibility of the social investment market in the UK. The recent financial turmoil has had a profound impact on society as a whole and as the recovery of the economy takes hold we should use it as a chance to direct investment into society and allow social enterprises to flourish. These recommendations can help this industry mature and allow the Government to develop a more dynamic and robust economy. This report has required intense effort by the students over a very short period of time. They have researched the industry extensively, contacted business leaders to gain an understanding of what the industry needs and constructed relevant and feasible solutions for consideration by HM Government. My sincere thanks to my students for their commitment to the Challenge and the support of our academic lead, Gary Abrahams, for his advice and experience in preparing this report. Thomas White
Introduction
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Social enterprise is a growing and essential sector in the UK economy. According to the Annual Survey of Small Businesses UK 100, there are approximately 68,000 social enterprises in the UK, which are contributing at least £24bn to the UK economy (Social Enterprise UK 2012). Social finance is a fundamental and a crucial component for further development of this sector. The topics that will be covered in our report include: The Social Value Act and social returns, a perspective on how we can use government legislation and incentive schemes to attract banks to participate in the social finance market, an analysis of Project Merlin and how to improve public awareness of social finance via education.
Social Investment is crucial, especially in the current age of austerity, as it produces not only financial but also a social benefit to the UK economy. The social investment market has changed significantly over the last 20 years. It used to be the case that many of the social enterprises were supported significantly by government grants and funding. However, times have changed and with the UK running a huge budget deficit, the Government is implementing significant budget cuts, which are negatively affecting the capital available for social enterprises. We believe the solution to this funding gap is to attract commercial banks into the sector to not only use their funding but also their knowledge of the financial sector to develop the market further.
‘Solutions to financial exclusion will require the involvement of the banking sector. As public funding shrinks, the only long-‐term, sustainable funding available will be commercial finance.’ (Rahman 2011)
Another reason for increased private sector involvement is the problem with the short-‐term decision making of the Government. According to Jamie Hartzell, managing director of retail investment network Ethex, government funding could be withdrawn from social projects in the future if its policy changes. Private sector funding is certainly a more reliable source of social finance, outlasting political terms. However, the banks might be reluctant to be involved in social finance market, because of its high-‐risk nature and low financial returns in comparison with commercial firms and projects.
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‘Lending for micro enterprise, for example, generates big social benefits but is also characterised by high business failure rates, high transaction costs and dis-‐economies of scale.’ (Understanding Social Investment 2010)
Despite providing low financial returns, social returns provide positive externalities to society as a whole. We are going to consider this in the following section.
1. Social Value Act and Social Returns
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The Social Value Act of 2012 “require[s] public authorities to have regard to economic, social and environmental well-‐being in connection with public services contracts; and for connected purposes.”(HM Government 2012) Without a doubt, the Act itself is aiming to ensure that, rather than blindly following profit in purely economic terms, service providers will be aiming towards building, and sustaining, services which are beneficial to a community in the context of social issues. As of yet, “it is not yet clear how a local authority or other public body will be held to account legally for failing to address the Act’s intent” as the guidelines that form the Social Value Act fail to specify any measure of social benefit (Tizard 2013). There have been no cases where a company has been legally prosecuted for failing to adhere to the Social Value Act; and whilst this is not to say that the scheme has performed perfectly, we can be assured that it does “encourage engagement in social enterprise” via governmental legislation (HM Government 2012).
The suggestion for ‘How to make the banks work for the common good’ is thus, that the Social Value Act of 2012 should be extended to the major banks of the UK, such as HSBC, Lloyds Banking Group and Santander as it exists in its current form. As the situation demands, we must accept that the social initiatives and goals the Act seeks to promote investment are ultimately, long-‐term and likely low-‐yield (except from a governmental spending vs. social benefit standpoint). Forcing sole investment into these social industries, over the more profitable, may at this point ultimately lead to short/medium term economic collapse or a significant reduction in the growth of the UK economy. However, should the banks not react to governmental encouragement, it will be necessary to expand the Social Value Act in order to include spending targets and an independent body responsible for monitoring the social impact of bank investments. In this era of pseudo-‐austerity “we are witnessing the degradation of services and communities stripped of wealth as these firms seek to maximize shareholder profit. Private companies are cutting back, delivering inadequate services … putting the most vulnerable people in society at risk. These include children, the elderly in care homes, disabled people.” (Robinson, 2013)
In response to this issue, social finance and enterprise are essential, especially top down from the banks that have access to huge funds derived from profits. Companies and initiatives, for example Social and Sustainable Capital, the Emerge Venture Lab or The Big Issue all have a significant role to play in determining the future development of social issues within the UK and hence
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deserve financing outside of government subsidies and personal wealth-‐generating strategies. These enterprises highlight where the Social Value Act can be most effective, generating a social return on investment first, over a singular interest in economic profit margins. They signify a long-‐term investment in the economy also, for example; The Big Issue mission statement describes how the organisation enables those individuals living in dire circumstances to “earn a legitimate income” and act as “the first step on a persons’ journey away from homelessness.”
However, determining to what extent social returns can be monetised, as well as what rate of financial return on investment can be created, is crucial to the idea of bringing banks into the practice of social investment. In order to fully illustrate this, it is necessary to examine a few past examples of returns on investment schemes, as well as Benjamin Rick’s ideas to produce incentivised social investment from the banks. (Benjamin Rick 2013)
Patently, it is always difficult to assess the exact monetary amount that social returns bring, due to variations arising when conducting social schemes and initiatives. A timeframe of several years means that a reliable result concerning monetary returns on social investment can be produced. A scheme which gives a figure of how social returns have been monetized is from the group ‘Tomorrow’s People’, who ran a scheme in Merseyside entitled ‘Get Out to Work’, which was focused on helping offenders find work, as unemployment is a prominent problem in Merseyside in 2004 (New Economics Foundation 2004). ‘Get Out to Work’ cost £51,000 per year (input), but it helped 110 people (output) and 19 found a job and were still employed at the end of 10 months (New Economics Foundation 2004). Statistics show that 2 would have been employed anyway without ‘Get Out to Work’, therefore the impact is 17 people still being in employment 10 months later, which created an impact of a 15% reduction in the number of people re-‐offending (New Economics Foundation 2004). Therefore, if the standard five year time frame were used, then ‘Get Out to Work’ is worth £543,000 per year if one were to monetize the social returns, taking into account the employment of the people and the lack of costs associated with reoffending, which shows the profit of giving an input of £51,000 per year (New Economics Foundation 2004).
This shows in principle how profitable social returns can be, and how it is possible to monetize them. Although the figure which was reached may not be
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entirely accurate, it does show the scale of returns that a social investment can bring. However, Governments have also seen the worth of these initiatives and invested in them themselves, an example being the ‘Local Enterprise Growth Initiative’ which was created by the Government in 2005. LEGI focused mainly also on employability activity, with the cost ratio being 2.8, (Communities and Local Government 2010) which although lower than ‘Get Out to Work’s’ ratio of 10.5, does show the great benefits on offer (New Economics Foundation 2004). Nevertheless, the problem with banks is that they might be unwilling to just give their money away, as there are obvious chances of schemes failing, although the benefits on offer are also vast if the schemes succeed.
Benjamin Rick has suggested that banks could give social investment, with the prospect of receiving some return of their money if the scheme succeeds, rather than giving to charity (Benjamin Rick 2013). We have already shown that it is possible, to a greater or lesser extent, to monetize social returns, so they could have the incentive of receiving some return, and if the scheme fails, the bank’s losses would be no different to when they donate to charity. These basic ideas are by no means unemployed at present, as examples can be found with organisation such as St Mungo’s, which is a charity for the homeless (BBC News Business 2013).
The technicalities of this deal involve St Mungo’s merging in financial business with a group of social investors who put up £650,000, while St Mungo’s itself gives £250,000 (BBC News Business 2013). After this, the Greater London Authority (GLA) have offered £2.4 million to St Mungo’s if they can achieve their targets with getting homeless people off the streets, therefore the investors can then also earn 6.5% of their money, which would come out of the fund paid by the GLA (BBC News Business 2013). It appears that this is an even simpler way of how to monetize social returns, as there is a simple reward if a target is achieved. It would also work with the model which Benjamin Rick proposed, because there is an incentive for the banks to invest, yet there is also a risk that this could go wrong (Benjamin Rick 2013). Triodos Bank, who carefully chose the investors for this, made sure that they would be able to remain financially solvent if the deal were to go wrong. This was apparent because the head of corporate finance, Dan Hird, supported this with the statement "we have to be very careful about the risk profile of the investment as the results are definitely not guaranteed" (BBC News Business 2013).
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If banks were to be encouraged to follow schemes such as this, there would need to be a certain amount of success for many to invest. However, St Mungo’s are confident of proving the trust of the social investors correct, which is summarised by the statement of the operations director, Mike McCall: “we would not have gone into it unless we were confident of the results" (BBC News Business 2013).
The Public Services (Social Value) Act is a relatively new act. It became a law on 31st January 2013; however it’s hard to find any example of its effect on the social investment industry. In short, it should help social enterprises compete with commercial firms for the public services contracts. It is the legal obligation for local authorities and the NHS to consider the public good that the bidders can deliver along with the price and quality. According to the social enterprise law firm Bates Wells & Braithwaite, the provision of public services is worth £82 billion a year. This means that the law might give a competitive advantage to social enterprises in this market and the opportunity to generate higher financial returns, which could attract banks to cooperate further with these firms. The consecutive section will take into account the legislation and incentives that the government could provide in aiding high street banks and social enterprises to be involved in social finance market.
2. Government Legislation and Incentives
We decided to consider government legislation from two different perspectives: social enterprise and banking industry. In particular we will focus on social impact bonds, the red tape challenge, and national loan guarantee scheme. We will also suggest some recommendations from us as a student research group on the improvements that can be implemented in legislation.
2.1 Social Enterprise Reforms
Social Impact Bonds
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Social impact bonds are a type of financial product that aims to attract private investors into social enterprise market. It’s a contract between investors, services providers and government commissioners, where investors pay upfront costs for the project and the public sector rewards the investors if the social outcome is met. The payment received from the Government consists of the initial investment plus the financial return. Triodos Bank is a commercial bank that is deeply involved in social impact bond projects. In 2012, Triodos Bank participated in two social impact bond projects: Connexions Greater Merseyside and St Mungo’s which helped raise bond issues worth £2.15 million from investors. Such projects could be considered risky for the commercial banks, but if the projects are successful, they will provide banks with a financial return. (Triodos Bank 203)
The Red Tape Challenge
The Red Tape Challenge is a government initiative to reverse the trend of “red tape” and reduce the overall burden of unnecessary regulation. Social Enterprise UK “very much welcomes this review into regulatory barriers surrounding social investment” (Embling 2012). Whilst this review into unnecessary regulation is a fairly broad and wide ranging one, there is a belief that it will greatly increase the supply of social finance over the years to come. However, there is also a feeling that more in depth action needs to be taken rather than a general assessment of the whole sector. These will be detailed below under “recommendations for the social investment industry as a whole”.
2.2. Bank Industry Reforms
National loan guarantee scheme
National loan guarantee scheme was launched on the 20th of March 2012 and is the result of Funding for Lending Scheme. This scheme has allowed the banks and building societies to borrow from the Bank of England at a cheaper rate for periods of up to 4 years. The banks are obligated to pass the entire benefit through to cheaper loans. The business is entitled to this benefit if it is small or medium-‐sized. The banks that are involved in this scheme are Bank of Scotland, Barclays, Lloyds TSB, Lombard, Natwest, RBS, Santander and Ulster Bank. According to the HM Treasury information, the scheme has been successful, with
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£2.5bn offered in cheaper loans to 16,000 businesses( HM Treasury 2012).This is a great opportunity for social enterprises to obtain cheaper loans. However according to the Social Enterprise UK’s budget analysis 2012, the scheme might not have the significant effect on social enterprise industry as these firms are considered to be risky and have the problem of accessing credit in the first place (Social Enterprise UK’ budget analysis 2012).
2.3 Recommendations for the social investment industry as a whole
1. Place a Social Investment duty on the two regulators succeeding the FSA
(prudential Regulation Authority and the Financial Conduct Authority) to ensure each considers the distinctive features of social investment (i.e. different financial products and motives of investors) and regulates it appropriately.
2. Reform the financial promotion rules to provide exemptions for social investors who are often exercising social motives when deciding to take investments.
3. Ensure suitability assessments consider social goals as at the moment there are a number of legal barriers preventing financial planners from advising on social investments which has lead to perceptions of social investment as being too high risk and in some cases have been excluded altogether.
These reforms, outlined by Bates Wells and Braithwaite (2012), will increase the supply of social finance, encourage growth in the social investment market and will make investment by commercial banks more feasible.
2.4 Recommendations to encourage banks to directly participate in the social investment industry
There is a lot of intervention going on in the social investment market. However, we have some suggestions on how to directly incentivise the banking sector to cooperate:
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1. Create a Social enterprise industry-‐wide index similar to the RBS SE100. According to Challenges and opportunities in social finance in the UK by Ellie Howard the social enterprise industry is suffering from lack of awareness of its success both socially and financially. (Howard 2012) There is no database of the performance of social enterprises; as a result the banks are reluctant to participate in this market. An industry-‐wide index will provide the banks with information about their performance and increase competition within the market, thus encouraging firms to be more efficient.
2. Give tax breaks to banks to encourage participation in the sector. The idea is to reward banks with tax breaks should they invest in pro-‐social activities such as affordable loans to social enterprises, microfinance involvement, investment in social impact projects, etc. The current tax incentives mainly target individual investors. (E.g. Community Investment Tax Relief, Venture Capital Trusts, Seed Enterprise Investment Scheme). The chancellor’s latest budget set out plans to introduce a tax relief in the 2014 finance bill. The details have not been released however it is likely to give tax breaks to those who invest risk capital in business whose aim is to improve society. We strongly believe that this relief should give special consideration to the banks to unlock their potentially huge financial support.
3. Government support in the development of innovative products in social finance industry. Current social financial products do not offer larger institutions protection of capital or liquidity and thus banks are reluctant to invest. Social financial entrepreneurs such as Benjamin Rick (Partner and Co-‐founder of Social and Sustainable Capital) are realising this and are developing new products such as tranched loans to not only attract more investment from the banks but also to reduce the costs (by increasing the scale). The Government must support new products like this to allow the sector to develop and attract investment from the banks.
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In conclusion, government attention to the social enterprise industry has helped to develop the sector greatly over the past couple of years. The UK is at the forefront of this relatively new and exciting industry and has the potential to lead the way in this sector. However, we believe it is a priority that the Government seek to develop partnerships with all areas including banking and social enterprise to unravel the colossal potential social enterprise has.
3. Project Merlin
Project Merlin was an agreement made in 2011 between the UK Government and five of the biggest banks in the UK (Barclays, HSBC, Lloyds Banking Group, RBS and Santander UK). While the overall lending was £25bn above target, reaching £214.9bn, the target of £76bn lending to small and medium enterprises was missed by £1.1bn (Treanor 2012). Due to the failure in reaching the target, the project was not repeated the following year. In this section the causes of the failure are analyzed, the extent to which the project was actually a failure is discussed and the possible alternatives to this project are explored. There are a variety of causes which led to the failure to reach the target lending to small businesses which include a decline in borrowing money from banks, lending costs being too high and RBS not meeting its targets. Over the past two years there has been a decline in small firms using bank loans (BBC News Business 2012). A survey of 11,000 firms by the Federation of Small Businesses
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illustrated how only one in ten firms obtained a bank loan in 2011 (BBC News Business 2012). The government suggested that it is a reflection of the poor economy (BBC News Business 2012). Moreover, one of the main aims of Project Merlin was to facilitate access to credit especially for smaller firms. Phil McCabe, from the Forum of Private Business, stated that: ‘despite the Project Merlin targets, banks have consistently failed substantially to increase lending to the small firms that need it most” (Barrow and Duncan 2012). This is due to the reluctance in lowering lending costs, in fact, only businesses that can “[provide] robust financial information” argues Phil McCabe, obtain a loan (Barrow and Duncan 2012). Furthermore, a part of the blame is attributable to the Royal Bank of Scotland as it was the only bank out of the five who failed to meet its targets (BBC News Business 2012). In fact, some of the other banks lent out more than their benchmark. For example, Barclays lent £14.7 bn against the promised £14bn and Lloyds had a target of £11.7bn but lent £12.5bn (Barrow and Duncan 2012). RBS’ failure to reach the target was particularly harmful as it is responsible for almost half of all High Street lending (Barrow and Duncan 2012) and this was defined by Lord Oakeshott, a Liberal Democrat, as “a knife in the back for growth and jobs” (Barrow and Duncan 2012). Project Merlin is an example of how the banking industry can play a role in helping the economy and therefore serve the common good. After operating for just one year, it was harshly criticized by the media as failure and was not repeated in 2012. We think that the project was a valid proposition; however, it lacks clarity in certain parts. For example, the government did not reveal how the lending targets were attributed for each of the banks (Barrow and Duncan 2012). This might suggest that some targets were too high. We think that this project should be reconsidered as it did play a part in the economy as some banks managed to even go above the required target. It is also important to take into account that only the small and medium enterprise target was not reached and this could be due to reluctance in borrowing caused by the slow economy. The banks have been blamed for not decreasing their interest rates; however, we think that the Government should help the banks by perhaps giving incentives to lower their credits. The Government tried to force the demand for lending however, one cannot artificially force the market but has to find alternative solutions to solving the wider problem. In today’s economy there is much insecurity and as mentioned previously only firms who provide robust financial information get loans.
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Therefore, a solution might be to look away from the high street banks and consider micro financing institutions as a more plausible alternative for small businesses. Barclay Lamony, a former investment banker, argues that micro financing “has two major advantages over Merlin. It costs less to nothing to administer and it makes no value judgements” (Lamont 2012). Therefore, should the Government change its perspective on the situation and rather than forcing banks to decrease their interest rates, consider a completely new outlook which facilitates smaller businesses as it is specifically targeted towards them.
4. Education In this section, we are going to discuss how to increase the awareness of social finance among two groups: the public and the banks. Our student research group is going to give the recommendations on this topic.
There are different ways to help raise students’ awareness of social finance. For the children of school age, the Government could add a financial education course, where social finance could be one of the main topics. For university students, another approach could be used. The specialists from the social investment industry like Benjamin Rick and Faisel Rahman could lecture on social finance to increase awareness about the market. Also the workshops and discussion groups could be added to the learning process to make it more interactive for students.
However, the task to increase social finance awareness among the more
mature population could be challenging. Although they are more likely to have financial ability to invest, they will be reluctant to attend educational lectures on social finance due to the lack of time and family commitments. Therefore, our
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student research group came up with solutions that will provide easy access to information, without taking too much time.
The first method is to set up an online video-‐course website providing general information on social finance and useful links in the industry. The lecturers in these videos could be either senior members of banks or social investment providers which will increase the validity of their talks. The online website can also contain stories of the successful investees and their talks about the experience they have gained from the industry.
The second way is to launch a festival on the high street which could attract people’s attention in a very quick and targeted way. If the potential investees are interested in the idea of social investment, they will have the option of talking to experienced advisors. The experts could be volunteers from the bank or members of social investment providers. Moreover, the potential investees may be reluctant to invest immediately as it is a new industry, therefore, if they are interested in social investment; the website can offer them further advice so that they can consider their options.
Education should be provided to the banks as well. We strongly believe that the major banks in the UK don’t consider social investment as a long term option which could improve their social images among the public. Moreover, we don’t think that the banks are willing to investigate the benefits of a specific social investment since they are mistakenly not expecting any financial returns. According to Benjamin Rick, social investment project would be a better option to donations for the banks because donations are 100% loss while social investments could generate financial return in the long run (Benjamin Rick 2013). The information about new innovative products in the social finance market such as tranched loans, which are the loans made up by various sources that can put banks’ risks to minimum, should help the banks to be aware about different trends in this market.
In conclusion, our research group believe that the reason that banks are not
actively involved in the social investment market is mainly because of the lack of essential information about this industry. They need more information from experienced social investment providers in order to be more willing to take part in this business because social finance is a market with a huge potential.
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Conclusion In our report we have proven how Social Finance has many benefits for society and the UK economy. We recognize, however, that some aspects of legislation lack of clarity and structure. Therefore we have highlighted some recommendations that we as a student research group think opportune for the industry. Social investment needs to have a different treatment: financial institutions should take into account the distinctive features in particular high financial risk and significant social returns. Our recommendation to the government would be to apply a more laissez-‐faire approach by helping banks through incentives and supporting the development of innovative products in the social finance industry. This could be done through tax breaks and partnerships with social finance intermediaries. We believe that Project Merlin could be reconsidered and suggest that the Government should subsidize the banks instead of putting pressure on them by trying to generate artificial demand for loans to small and medium enterprises. This would allow banks to lower their interest rates to small businesses. Alternatively, the Government should take their focus away from banks. With this last approach we considered microfinance as a valid alternative as it does not require small firms to have robust financial information and offers lower rates than
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a high street bank. Furthermore, we must consider that even though these recommendations have been suggested to the social finance industry, the public and banks must to be educated about this new and vibrant sector. In our report we suggested the possible ways in which the society could be educated. The changes and the amendments in the social finance industry mentioned in our report will generate extensive social benefits. However, we understand that this requires time and therefore we believe that in the long run change is possible but it is important to be patient with this new industry and gain support from the public and media.
Summary of Recommendations
The Social Value Act and Social Returns v We recommend that the Social Value Act of 2012 be extended to the major UK
banks to encourage socially responsible banking. The schemes progress should then be monitored, and if proven ineffective, it should be extended to include profit based spending investment and an independent body to track the Act’s success.
v We encourage the banks to invest socially so that they can get a return on their investment, rather than it being a 100% donation.
Government Legislation and Incentives v Reform current financial services regulation to encourage more investment in
the social enterprise sector. This should include:
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• Place a Social Investment duty on the two regulators succeeding the FSA to ensure each considers the distinctive features of social investment and regulates it appropriately.
• Reform the financial promotion rules to provide exemptions for social investors.
• Ensure suitability assessments consider social goals as at the moment there are a number of legal barriers preventing financial planners from advising on social investments.
v The creation of a Social Enterprise Industry-‐Wide Index .The industry-‐wide index
will provide the banks with information about their performance and increase competition within the market, thus encouraging firms to be more efficient.
v Tax breaks to banks to encourage participation in the sector. Rewarding banks with tax breaks according to the pro-‐social activities that they implement.
v Government support in the development of innovative products in the social
finance sector such as the idea of tranched loans, which will help to attract investment and reduce the costs.
Project Merlin
v The Government should reconsider Project Merlin as it was criticised by the
media as a failure after only one year of trial. However, the clarity and structure of the project needs to be improved. For example, the method used in attributing the lending targets for each of the banks was not disclosed, suggesting that some benchmarks might have been too high.
v A problem with the structure of banks is the need for firms to provide robust
financial information and the reluctance of lowering the rates of interest. We suggest the Government should consider micro financing institutions as an alternative. These firms are targeted towards small business who struggle
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obtaining loans, therefore the Government should incentivise them by providing subsidies.
Education v Increase the awareness among youth through teaching of social finance as part
of the curriculum at schools, and lectures in universities. The professionals from social finance industry will develop the material for the classes.
v Increase awareness about social banking among the more mature population. This could be done through the video-‐course website and high-‐street festivals. The emphasis was placed on finding quick and targeted ways to attract adults.
Educate the banks about the benefits that social investment could provide. In our opinion, there are a number of banks that are not involved in this vibrant and developing industry due to the lack of information about the products in the social finance market and the returns that could be achieved.
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Bibliography Barrow, Becky and Duncan, Hugo. (2012) Banks Fail to Hit Small Firms Lending Targets -‐ and RBS Is to Blame, [Online], Available: http://www.dailymail.co.uk/news/article-‐2099592/Banks-‐fail-‐hit-‐small-‐firms-‐lending-‐targets-‐-‐RBS-‐blame.html [09 June 2013] Bates, Wells and Braithwaite. (2012) Ten Reforms to Grow The Social Investment Market. [Online] Available: http://www.bwbllp.com/file/bwb-‐20ten-‐20reforms-‐20to-‐20grow-‐20the-‐20social-‐20investment-‐20market-‐20july-‐202012-‐pdf [07 June 2013] BBC News Business. (2012) Project Merlin: Bank net lending fell in 2011, [Online], Available: http://www.bbc.co.uk/news/business-‐17009985 [09 June 2013] Bowler, Tim (2013). BBC News: Charities turn to markets as traditional funding slows, [Online], Available: http://www.bbc.co.uk/news/business-‐2180348[09 June 2013] Communities and Local Government (2010). National Evaluation of the Local Enterprise Growth Initiative Programme, [Online], Available:
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https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/6289/1794470.pdf [06 June 2013] Embling, Peter (2012) Social Enterprise UK: Response to the Cabinet Office’s Red Tape Challenge on Social Investment. [Online] Available: http://www.socialenterprise.org.uk/uploads/editor/files/Response_to_Red_Tape_Challenge_on_Social_Investment_July_2012.pdf [08 June 2013] Ferguson, Will. (2013) Social Impact Bonds [Online] Available: http://www.triodos.co.uk/en/about-‐triodos/news-‐and-‐media/colour-‐of-‐money/social-‐impact-‐bonds/ [06 June 2013] HM Government. (2012) Public Services (Social Value) Act 2012:2012 Chapter 3, [Online], Available: http://www.legislation.gov.uk/ukpga/2012/3/enacted [07 June 2013] HM Treasury.(2012) National Loan Guarantee Scheme. [Online] Available: http://www.hm-‐treasury.gov.uk/nlgs.htm [08 June 2013] Howard, Ellie. (2012) Challenges and opportunities in social finance in UK. [Online] Available: http://www.cicero-‐group.com/Research-‐Analysis/Pain_in_spain_report.pdf [09 June 2013] Hurd, Nick. (2013) Press release Significant boost to social enterprises as the Social Value Act comes into force. [Online] Available: https://www.gov.uk/government/news/significant-‐boost-‐to-‐social-‐enterprises-‐as-‐the-‐social-‐value-‐act-‐comes-‐into-‐force [08 June 2013] Lamont, Barclay. (2012). Move over, Merlin, [Online], Available: http://www.growthbusiness.co.uk/growing-‐a-‐business/business-‐finance/2108038/move-‐over-‐merlin.thtml [09 June 2013]
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6. Report on UK Microfinance Written by: Sophie France Josephine Mulder-‐Brussen Giorgi Lomidze Christian Davis Judith Foster Facilitator: Thomas White
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Table of Contents
Foreword from Thomas White 2 1 Introduction 3 2 Outline of the Proposed Partnership 5 3 Education 8 4 Advertisement and Awareness 10 5 Incentives 13 6 Conclusion 16 7 Summary of Recommendations 17 8 Bibliography 18
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Foreword from Thomas White
I have been honoured to lead this group of students through the Grand Challenges. My studies and experiences with LaSalle Investment Management and HSBC Investment Bank have given me working knowledge of the financial industry: knowledge that I have been able to utilise and share in facilitating the discussion and ideas of these students. The Grand Challenge these students were involved in was “How do we make banks serve the common good?” and how can we make the Government ensure this: this report answers this question by focusing on microfinance. There is a need for microfinance in the UK, with multitudes excluded from mainstream finance and it should be the aim of the Government to help include these people. The report concludes with a number of recommendations that the Government should consider as a means for increasing the availability and awareness of microfinance in the UK, utilising the scale and expertise of the biggest British commercial banks to achieve this. Should the Government implement these recommendations it could help millions gain access to basic finance and help to reduce poverty in the UK. This report has required intense effort by the students over a very short period of time. They have researched the industry extensively, contacted business leaders to gain an understanding of what the industry needs and constructed relevant and feasible solutions for consideration by HM Government. My sincere thanks to my students for their commitment to the Challenge and the support of our academic lead, Gary Abrahams, for his advice and experience in preparing this report. Thomas White
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Introduction Micro Finance and Economic Development Due to the fact that credit plays a key role in beginning and expanding businesses, microfinance has been treated as an essential tool for developing the economy. Microfinance institutions offer relatively small loans to start-‐up as well as current businesses compared to high street banks, they help people access traditional ways of financing and offer job opportunities to the local communities. Generally, the size of micro credit could vary from lender to lender and can range from as low as $20 to $2500. Micro finance plays a crucial role in developing the economy through job creation, financial stability and tackling global poverty issues (Wallstreet Microfinance, 2012). Firstly, businesses which are financed by micro financial institutions are capable of creating the same number of jobs for the community as it is generated by huge financial corporations. Most of the micro finance organizations lend money to people living in inaccessible areas of the world and because of the fact that in those areas jobs are particularly rare, micro finance institutions make the substantial and significant difference to local communities. People from those developing areas earn extra income, which is mostly spent within their communities and this plays a key role in stimulating economic activity (Wallstreet Microfinance, 2012). Secondly, one of the principal roles that microfinance has played in encouraging economic development is providing financial stability to people, who contributed substantially in local communities. As small loans offer an opportunity to create extra income, poor people have their own ways to deal with the extreme necessities, they do not depend on government assistance and beneficial programmes, which consequently is undeniably advantageous for the local economy. Finally, the supporters of microfinance consider that offering financial stability to poor and low income families by providing small loans may reduce the poverty of future generations. As many of these communities started growing, local economic activity started booming, the gross domestic product of countries started increasing and the gap between the poorest and wealthiest has also declined (Wallstreet Microfinance, 2012). Poor access to credit is the main reason that most economies struggle to expand and increase economic activity. Microfinance is capable of providing financial help, which helps to facilitate access to financial technologies. Sustainable micro finance systems with various resources
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can stimulate economic activity and development from a very basic level. The most successful microfinance institutions work in developing countries, where in some areas the most important source of finance for start-‐up and developing companies is microcredit. For instance, the microfinance sector is one of the main sources of finance for Georgia. According to the National Bank of Georgia, in 2013 there are 63 licensed microfinance institutions in the country with a population of 5 million. Despite having such a small market, microfinance plays a key role in creating GDP growth and stimulating economic development of Georgia. In 2010 the numbers of licensed microfinance institutions in the Republic of Georgia was 38 when GDP at that time was $13 billion, in 2012 when the country increased to 62 licensed micro institutions GDP reached $16 billion (Geostat B, 2013). By increasing the number of the microfinance institutions, the Georgian financial market has become more competitive and consequently made 23% increase in gross domestic product, which considerably stimulated the economy. Additionally, during 2010 and 2012 approximately 98 thousand new jobs were created, therefore the local community significantly benefited from increasing the number of microfinance institutions (Geostat A, 2013). To conclude, microfinance institutions play a fundamental role in job creation, financial stability and tackling global poverty issues. Increasing the number of microfinance institutions stimulates the economy, advancing local communities. Therefore, helping to expand and promote microfinance institutions should be one of the main objectives of any country. Giorgi Isakadze, CEO of Georgian Small and Medium Size Enterprises Association (The Financial, 2011), Adrian Ball, area director of Nationwide Building Society and Benjamin Rick, partner and co-‐founder Social & Sustainable Capital believe that “people need an alternative source of financing’’. Due to the need for alternative methods of finance, the microfinance sector will be a successful industry in the UK. Different ways of microfinance development could be taken into account like partnerships between high-‐street banks and small and medium sized micro-‐finance companies. Those partnerships could be one of the most effective ways of dealing with unemployment, economic growth and crucial issues regarding the recent economic crisis.
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Outline of the Proposed Partnership The partnership suggested to ensure banks serve the common good in the United Kingdom aims to reduce the number of low income households without bank accounts. According to The Poverty site, 5% of low income households are financially excluded. In addition, the partnership’s objective is to facilitate lending to the 2% of households with above average incomes who equally have no bank account (Palmer, 2010). The principal goal of this partnership is to reduce the number of people resorting to loan sharks or predatory loaners such as Wonga, who charge over 4214% APR (Wonga, 2012). On the other hand microfinance loans can improve the welfare of society. Community Development Finance Institutions in the UK have achieved this through the creation of 8,300 jobs, support of 177 social enterprises, saving 18,850 from high cost lenders, which would have represented a dead weight loss to society (Glaven, 9). The partnership incorporates two key aspects. Firstly, the provision of direct finance to microfinance company’s (such as Fair Finance and other CDFI’s) from the 4 largest banks. This will increase the capital base of the microfinance organisations, artificially enhancing their growth, enabling them to have the reserves which facilitate these companies to lend greater sums to individuals, businesses and home owners. An example of this scheme being successful is that of Fair Finance, who partnered with Royal Bank of Scotland in 2006 ‘offering access to bank accounts direct from its office in partnership with RBS through the trusted partner’s scheme, opening 200 accounts through this scheme’ (Fair Finance, 2012). However five years later interest in microfinance began to dwindle and unfortunately RBS pulled out in 2011 and renounced the loan to Fair Finance, despite the billions of pounds injected into the company as state support, whilst support from the two largest French banks remained (Wilson, 2011). This demonstrates how these partnerships need to be mandatory and promoted by the state. Too many government initiatives regarding the banks have failed and have not been modified in order to succeed. For instance, the Merlin Project was deemed a failure by the press, however it came very close to targets regarding lending to the smaller businesses, ‘£74.9billion was lent to smaller firms, less than the £76billion target’ (BBC, 2012). Andrew Cave from the Federation of Small Businesses in reference to
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the commitments made by the UK's five biggest banks to lend more money to businesses in 2011: ‘Talking to our members, 30% of them say they missed a growth opportunity because they weren't able to access finance at the right times, so there is still a problem.’(BBC, 2012) Therefore these schemes should not be forgotten as they have significant influence over economic growth and prosperity. Modifying and improving initiatives may render them successful. From a microeconomic perspective, the demand for these schemes is substantial, CDFI reported ‘annual demand for community finance is in the order of £5.45 to £6.75bn’ (Glaven, 2012,7). This highlights the on-‐going necessity of these partnerships to provide direct finance demonstrating the importance of the market and bridging the gap in the financial services sphere through the provision of fair access to affordable credit to all markets. The second aspect of the partnership involves the essential exchange of information between the commercial banks and the micro finance providers. This element is vital in the partnership as it is a free moving transfer of information regarding a person’s financial history. This involves passing on the details of a potential customer that did not have a suitable credit history to be accepted by the commercial bank, however, instead of being rejected and resorting to loan sharks their application is passed immediately to a microfinance scheme. This renders the public aware of alternative, sustainable methods of borrowing money. In addition, to this there needs to be an exchange of expertise on a pro bono system to raise financial literacy and transfer skills and knowledge between the commercial sector and the microfinance sector. Barclays bank staff have provided their expertise to Fair Finance, however, this provision of expertise needs to be done on a larger scale contributed to by all commercial banks. To guarantee the fair transition of information, government legislation should be implemented. This will ensure micro finance lenders do not profit from successful and efficient borrowers, who have a strong credit history after borrowing from micro finance schemes for long periods of time; they too should be able to access lower commercial interest rates after having proven their reliability in the credit market. The partnership between the commercial banks and microfinance provider should also provide a long term standardised product for the successful borrowers in order to enable them to have the lower APR% rates whilst still reducing the risk for the banks. These borrowers should have the option to borrow at a midway APR% between the microfinance and commercial
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bank rates. This gives an incentive to the commercial banks to provide sufficient financial expertise in order to gain an increased pool of customers in the long run. The linking of information between these two financial institutions enables the greatest efficiency within the financial market. The long term result of this will ensure an expansion in the commercial banks’ customers enabling growth and reducing financial exclusion which in doing so reduces inequality in society. Microfinance providers like Fair Finance need the support and increased capital funds to expand in order to be able to provide loans for people on a national scale. The economies of scale they will benefit from as a result of the partnership will reduce their transaction costs and promote more efficient lending. Overall, this partnership will successfully reduce the number of financially excluded within the UK, whilst improving the population’s financial literacy and responsibility.
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Education
Microfinance is not just about providing financial support to those who need it. Education is also a vital factor if such investments are to have a sustainable impact within society. It is often overlooked that banks are capable of making a difference in the microfinance sector even if they do not loan to ‘risky’ clients. They have access to an intelligent workforce and the right resources that could enable them to advise the financially uneducated about how best to handle their personal finances, thus helping people avoid getting into debt in the first place. A major reason which causes many to fall into the debt trap is the lack of official training about financial management. According to the National Association of Citizens Advice Bureaux ‘The lack of financial literacy puts consumers at a disadvantage in many ways’ (National Association of Citizens Advice Bureaux, 10). The majority of people have very little understanding of the economic system which governs so many aspects of their lives, let alone how it affects their personal wealth. Up until very recently financial education was not compulsory in the national curriculum. As a result of successful campaign, it was announced in February 2013 that the government is planning to integrate it into ‘Citizenship’ -‐an obligatory school subject that aims to teach 11-‐16 year olds ‘life skills’. ‘The proposals are due to be enshrined in the curriculum from September 2014’. (Knapman, 2013). Whilst this is a major step towards national financial literacy, it is also evident that more can be done to support the initiative. Banks should get involved directly with schools and colleges to help equip young people with monetary knowledge. This would tackle debt problems at the root before they degenerate into uncontrollable issues. In order to achieve long term solutions, it is imperative to encourage a culture of responsible personal finance in our society. This is something banks could look into contributing to, either combined with corporate social responsibility (CSR) or as a separate scheme altogether. Banks could play an active role in education by giving speeches in schools, running summer courses, or by producing leaflets about responsible financing. In addition, the banks could make their websites more understandable and accessible to young people regarding their personal finance issues.
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A possible option for banks would be to send interns into local schools to run workshops on responsible money management. They could engage with young people on a personal level, promoting awareness about the dangers of organisations such as ‘Quidquid’ and ‘Wonga’ and helping to advertise respected microfinance organisations such as ‘Fair Finance’. The main advantage of this idea is that it would not be disrupted by changes in government policy or newly elected parties. If financial education does succeed in entering the curriculum next year, it will complement student’s studies and give them a ‘real life’ incentive to take charge of managing their money outside of the classroom. It would also create many advantages for the banks themselves. As a form of CSR it would be good for their reputation, giving them a trustworthy image (helping combat the one destroyed during the 2008 crisis) and thus attracting both clients and positive press. In the long term it would help attract customers from a young age, and may even be a way to spot talent and entice future employees.
Advertisement and Awareness Microfinance is a relatively new and promising industry. It is not simply the provision of a loan. Increasingly more often, micro credit comes in a package deal including long-‐term guidance, counselling, education and a loan. (The Guardian, 2013) What is regularly omitted from that package is the awareness of the existence of such a service. General awareness
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and advertising is vital to the success of the microfinance sector. It is questionable how people would be able to apply for a micro credit loan if knowledge about the availability and existence of micro finance organizations is lacking. Advertising the sector as a whole is needed to reach a greater audience, both to attract more investors and to inform people about the availability of Community Development Financial Institutions (CDFIs) such as Fair Finance. According to the Inside Community Finance report published in 2012, an estimate of the total potential annual demand for community finance is from £5.45 billion to £6.75 billion. However, over 2012, CDFIs delivered 200 million to 33,000 people which is relatively small compared to the total potential demand for finance. These figures illustrate the potential for growth in the micro finance sector. The report also highlights the fact that enquiries for CDFI finance close to doubled from 2010-‐2012, increasing from nearly 48000 to around 94,500 enquiries in 2012. Evidently, such an increase in demand must be met by an increase in capital available. The report outlines that capital provision roughly halved in 2012, two principal sources of this decline were banks by 65% and national government sources by 87%. To overcome the impediments examined in the report, JUST finance suggests amongst others bundling ‘public support for community finance under one government ministry’, ‘communicate, publicize and promote community finance’ and the ‘provision for additional capital’. (CDFA, Inside Community Finance, 2012) A possible solution to this is advertisement of the sector as a whole. An extensive advertisement campaign raising awareness of the microfinance industry will benefit both the people in need of micro credit and may lead to increased investment in microfinance organisations. Banks could work together with the Government, funding and developing a national campaign outlining the possibilities provided for by CDFIs, illustrating the potential and success up to date of the microfinance sector. The effectiveness of advertising and marketing has not been proven or disproven by any report because those elements often fall short within CDFIs. Nonetheless, an interview with Faisel Rahman, founder of Fair Finance run by Fig tree stated that: ‘With a product that people genuinely need in place, the marketing does itself. A massive 70% of Fair Finance’s new business comes from word of mouth (the undisputed holy grail of marketing), with one particularly vociferous advocate recommending over 250 customers.’ (Fig Tree, 2013) This suggests that the most
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effective way of reaching new clients would be through word of mouth. Furthermore, a report reviewing marketing approaches used by CDFIs in the UK and the US came to the conclusion that in developed countries such as the UK, ‘most of the UK CDFIs saw referrals as being a key source of enquiries but their results from this source were mixed.’ (European Microfinance Network, 2003). They also stated that: ‘One of the two CDFIs who regularly place adverts in local papers was dissatisfied with the volume of enquiries generated in this manner. The other CDFI generates half of its enquiries through advertising. ELM (East Lancs Moneyline), who does not advertise, receives plenty of enquiries through word of mouth and is on track to become self-‐sufficient in the course of 2004’ (European Microfinance Network, 2003). In general, the most effective way of advertising is orally, however, there were concerns as to the ‘difficulty in finding gatekeepers to potential clients’ (European Microfinance Network, 2003) suggesting that there is room for effective advertising, marketing the simplicity of the micro loans and emphasizing the flexibility of the products on offer. Government campaigning may lead to greater public awareness of the service and if one manages to direct the public to a common body of CDFIs in the campaign, it may overcome the gatekeeper problem of attaining new clients. The advertising campaign would not solely be concentrated on reaching a greater clientele. One of the principal aims of advertisement of the sector would be to make the sector more appealing for investment, leading to a greater provision of capital. Increasing public awareness of the need of investment in the sector may encourage the banks to increase their contribution towards to sector considerably. Simple and understandable statistics would be most effective in demonstrating the importance of the sector. In a recent article in the Guardian, Peter Kelly, Barclays Bank’s head of financial inclusion refers to figures such as the number of adults in the UK that do not have bank accounts and cannot borrow at high street bank rates. (Guardian, 2013) Keeping the facts transparent and using simple terminology will help educate the public effectively. Another option which may lead to an increase in the bank’s investment in the microfinance sector would be to launch a microfinance mark either in combination with the government campaign, or on its own. The mark could act in a similar way to the Fair trade mark. It could act as a general sign of recognition that banks have invested in the microfinance sector. Either the Government or an independent organisation may set
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the criteria the banks will be required to meet to use the mark in their individual marketing strategies. In combination with increased public awareness of the need for investment in microfinance, this form of recognition may stimulate banks to direct more of their investment towards the microfinance sector. The Fairtrade mark has been very successful with many companies currently producing Fairtrade products. It is now more of a regularity than an exception. In a review of the impact of Fairtrade over the last ten years carried out by the Natural Resources Institute it is stated that: ‘Fairtrade provides a favourable economic opportunity for those smallholder farming families able to join producer organizations and provide products of the right specifications for the market. Thirty-‐one of the thirty-‐three case studies contained evidence of positive economic impact.’ (The Fairtrade Foundation, 2010) The Fairtrade mark acts in a complete different industry, however if backed by the major micro finance organisations, the Government and overshadowing bodies such a microfinance mark may lead to a rise in social investment amongst banks. To conclude, the current microfinance sector would be ameliorated through a sizeable Government campaign raising public awareness and investment in the sector. It is essential that banks and investors understand the social aspect of CDFIs. If CDFIs are put under pressure to lend at a more profitable rate and take on fewer risky customers, the system of microfinance is endangered altogether. (The Guardian, 2013)
Incentives Small and medium-‐sized enterprises (SMEs) are abundant in the UK and play a fundamental role in the health of the economy. However, despite the strong economic potential of many SMEs, a large percentage cannot secure the growth capital required to expand in order to capture new opportunities at -‐ what a business owner would see as being -‐ a reasonable rate of return. The Rowlands Review of 2009, which had a focus on ‘The Provision of Growth Capital to UK Small and Medium Sized Enterprises’, found that it
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was possible to locate a gap at between £2 million and £10 million in terms of the amount of growth capital sought by SMEs. The report went on to suggest that this funding gap reflects the £2 million upper limit of existing Government interventions and the £10 million floor below which private equity and venture capital rarely invest, leaving a range of about £8 million within which SMEs are finding it increasingly difficult to source long-‐term growth capital. One business owner stated ‘There are great opportunities to expand... [I looked into] venture capital but they wanted too much. There has got to be something in it for me and if I dilute my share any further I see little point continuing’ (Rowland Review, 2009, Section 2, Page 9). The evidence makes it clear that the Government must find a way to plug the growth capital funding gap to help the economy drag itself out of the slow lane, either by creating and supporting an independent institution that specialises in the £2 million to £10 million loan region to SMEs, or by providing enticing incentives to existing institutions that are willing to lend these amounts of growth capital to SMEs at reasonable rates of return. However, there are numerous reasons detailed in the Rowlands Review for why bank loans and venture capital investments are currently not appropriate for many SMEs. Firstly, banks base the amount they are willing to lend to SMEs on the value of the assets the SME owns, which the bank will then hold as collateral against the loan. This restricted approach can smother opportunity for growth and expansion in the smaller SMEs, which are commonly held afloat by business angels in the early stages of growth. Secondly, although venture capital organisations are often willing to invest within the £2 million to £10 million range, they demand an enormous rate of return of up to a 50% stake in the business (Rowlands Review, 2009, Section 2, Page 8, Figure 1). An alternative or additional measure to offering incentives such as tax relief to existing organisations would be to create a mezzanine product which delivers investment in the £2 million to £10 million range to expand those SMEs with turnovers of around £1 million. ‘High growth SMEs can usually attract the interest of equity, but those with more pedestrian growth will have problems, but the availability of mezzanine debt can in part address this’ (UK fund manager, Rowlands Review, 2009, Section 5, Page 22). Projects have been set up in the past which have attempted to deal with this funding gap, namely ‘Project Merlin’, which saw the major UK banks commit to lend a collective £76 billion to SMEs in 2011. The project fell short of its target by £1.1 billion, lending £74.9 billion to SMEs by the end of the year (Bank of England Project
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Merlin Data, 2011), and was subsequently deemed a failure by the media and dropped by the government for following years. Other organisations are also in existence, such as the Business Growth Fund (the BGF), founded in the same manner as Project Merlin and run by five of the major UK banks. The BGF is designed to plug the £2 million to £10 million gap in SME growth capital funding by providing funding in a long-‐term manner and for a minority stake in the business. The BGF is certainly a step in the right direction, however the BGF’s target investment for 2013 was a only £200 million, which, when compared to their £2.5 billion in capital, makes their investment in only 25 SMEs so far in 2013 seem like a hesitant and cautious start to operations. Placing further Government legislation in place to ensure that the BGF and other similar organisations do not limit their investments to companies which display only the most promising long term returns would enhance the potential that these firms possess to fund many struggling SMEs that could be the household names of the future. ‘Our economy cannot afford the dynamic SME segment to be constrained in its growth and competitiveness, especially with recovery ahead’ (Rowlands Review, 2009, Foreword, Page 1). A scheme already in existence is the Community Investment Tax Relief (CITR), which ‘encourages investment in disadvantaged communities by giving tax relief to investors who back businesses and other enterprises in less advantaged areas by investing in accredited Community Development Finance Institutions (CDFIs)’ (HMRC, CITR, 2011). The HMRC makes this tax relief available to both individuals and companies and is worth up to 25% of the value of the investment, spread over five years. Similar to the BGF, this scheme is a step in the right direction however is not considered enough of an incentive to attract large investments and many social enterprises continue to go wanting. Criticism has been directed at the CITR programme for having ‘too many limitations: the investment ceiling is too low and the repayment period too short’ (Swinson, The Guardian, 2011). The most prominent message from the abandoned Project Merlin, the overly corporate BGF, and the CITR is that these organisations are lacking the clear long term vision and commitment from the government required. By injecting minimal additional effort into these schemes a disproportionately large consumer base could be immeasurably better served, and the industry as a whole could attract the investment it sorely needs to compete successfully at an international level.
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Conclusion In conclusion, microfinance plays an essential role in developing the economy of a country. Many developing countries such as Georgia, Bangladesh and India have already significantly benefited from the provision of partnerships demonstrating how the microfinance industry should also be promoted in the UK. Due to the evident differences between the British financial economy and that of the developing world, different styles of microfinance like partnerships should be implemented which will stimulate the economy and tackle the issues associated with economic crisis. To satisfy the demand for microfinance and eliminate the high number of people from financial exclusion the proposed partnership needs to be established. This partnership will facilitate the transition of people’s credit history to and from the commercial banks. As a result financial literacy will be increased, demand from loan sharking companies will be reduced and the overall welfare of society will rise, reducing inequality within society. Regarding education, banks and schools should act pre-‐emptively educating the younger generation about managing personal finance.
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Consequently, fewer people will need to resort to loan sharks, with the long-‐term goal of reducing poverty. General awareness of the microfinance sector can be enhanced through co-‐operation between banks and government resulting in an extensive informative campaign. Creating a microfinance ‘mark’ may also augment the recognition of the sector, simultaneously stimulating investment. Several existing organisations already have the potential to act as premium sources of growth capital for individuals and SMEs. However, these existing organisations need to be incentivised further. The main considerations should be to refocus the overly corporate standing of organisations such as the BGF in order to widen the scope of investment opportunities, and to improve tax relief schemes such as the CITR to make investing in smaller businesses more attractive and rewarding to potential stake holders.
Summary of recommendations
• It is well established that microfinance works well in developing countries, consequently it should be promoted and developed in the United Kingdom to help stimulate the economy.
• Partnerships between microfinance institutions and banks are essential. This involves the provision of finance to microfinance institutions from the four largest banks and the exchange of information between these organisations.
• Banks should take an active role in financial literacy by getting directly involved with schools to educate the younger generation about managing personal finance.
• The government should work with banks to promote and advertise microfinance. For example, through a campaign produced in co-‐operation by banks and the government. Additionally, a microfinance ‘mark’ can be implemented to recognise banks supporting the industry.
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• The full potential of several existing organisations to stimulate growth in the SME sector could be realised through the introduction of certain incentives. These could include an increase in the tax relief made available to organisations investing in smaller, socially focused companies, and striving to widen the scope of investment for institutions such as the business growth fund.
Bibliography BBC, (2012) Project Merlin: Bank net lending fell in 2011, Available from: http://www.bbc.co.uk/news/business-‐17009985 [Accessed: 07/06/2013] BBC, (2012) Project Merlin: Banks miss small company lending target, Available from: http://www.bbc.co.uk/news/business-‐16987063 [Accessed: 08/06/2013] Community Development Finance Association, 2010-‐2013 [Online] http://www.cdfa.org.uk/about-‐cdfis/icf/ [Accessed: 09/06/ 2013] Community Development Finance Association, Inside Community Finance, CDFIs in the UK 2012, 2012 [Online] http://www.cdfa.org.uk/wp-‐content/uploads/2010/02/CDFIs-‐in-‐the-‐UK-‐report-‐web.pdf [09/06/ 2013] European Microfinance Network, Attracting Clients, The challenge of marketing for CDFIs in the UK, new economics foundation (nef), 2003 [Online] http://www.european-‐microfinance.org/data/file/Attracting_clients_-‐_final.pdf [09/06/ 2013]
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Fair Finance, (2012) History, Available from: http://www.fairfinance.org.uk/index.php?option=com_k2&view=item&layout=item&id=15&Itemid=168 [Accessed: 08/06/2013] Fairfinance, 2013 [Online] http://www.fairfinance.org.uk [09/06/ 2013] Fig Tree, Fish Faisel and fairer finance, Joe Ryrie, 2013 [Online] http://www.figtreenetwork.com/about-‐us/show/fish-‐faisel-‐and-‐fairer-‐finance/ [09/06/ 2013] Glaven, H. (2012) Inside Community Finance CDFIs In the UK, Available from: http://www.cdfa.org.uk/wp-‐content/uploads/2010/02/CDFIs-‐in-‐the-‐UK-‐report-‐web.pdf [Accessed: 09/06/2013] HMRC Web Page -‐ ‘Community Investment Tax Relief (CITR)’: http://www.hmrc.gov.uk/specialist/citc_guidance.htm [09/06/ 2013] Knapman, H, 2013, Financial education to be added to the national curriculum, Available from: http://www.moneysavingexpert.com/news/family/2013/02/financial-‐education-‐to-‐be-‐added-‐to-‐the-‐national-‐curriculum [Accessed: 07/06/13] National Bank of Georgia, the President of National Bank of Georgia Met Microfinance Organization Managers, http://www.nbg.gov.ge/index.php?m=339&n&newsid=2151&lng=geo [10/06/ 2013] National Statistics Office of Georgia A, Employment and Unemployment, http://geostat.ge/index.php?action=page&p_id=146&lang=eng [10/06/ 2013] National Statistics Office of Georgia B, Gross Domestic Product (GDP), http://geostat.ge/index.php?action=page&p_id=119&lang=eng [11/06/ 2013] Palmer, G. (2010) The Poverty site, Without a bank account, Available from: http://poverty.org.uk/73/index.shtml [Accessed: 08/06/2013] The Fairtrade foundation, A review of the impact of Fairtrade over the last 10 years, Natural Resources Institute, University of Greenwich, March, 2010 [Online] http://www.fairtrade.org.uk/resources/natural_resources_institute.aspx [09 June 2013] The Financial, Georgia: The Number of Micro Finance Organizations Increased from 38 to 47 through, http://www.syminvest.com/news/georgia-‐the-‐number-‐of-‐micro-‐finance-‐organizations-‐increased-‐from-‐38-‐to-‐47-‐throughout-‐2010/2011/1/24/2655 [Accessed: 07/06/2013] The Guardian, Antonia Swinson ‘Briefing from Scotland: Highland social enterprises make the case for tax relief’, 24 January 2011: Accessed:
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[09/06/2013]http://socialenterprise.guardian.co.uk/social-‐enterprise-‐network/2011/jan/24/antonia-‐swinson-‐on-‐scottish-‐social-‐enterprises The Guardian, Inspire and Innovate -‐ Microfinance: how to grow a business from grassroots and grit, 2013? [Online] http://www.guardian.co.uk/inspire-‐innovate/microfinance [09/06/2013] The Guardian, Social Enterprise -‐ If CDFIs are forced to get ruthless, social enterprise will suffer, May, 2013 [Online] http://socialenterprise.guardian.co.uk/social-‐enterprise-‐network/small-‐business-‐blog/2013/may/20/cdfi-‐ruthless-‐social-‐enterprise-‐suffer [09/06/2013] Wallstreet, Microfinance, Role of Micro Finance in the Economic Development, http://www.wallstreetmicrofinance.org/microfinance-‐guide/role-‐of-‐micro-‐finance-‐in-‐the-‐economic-‐development.html Accessed: [09/06/2013] Wilson, H. (2011) The Telegraph, Fair Finance garners little interest, Available from: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/8433791/Fair-‐Finance-‐garners-‐little-‐interest.html [Accessed: 08/06/2013] Wonga, Wonga and APR: the Facts, Available from: http://www.wonga.com/money/is-‐this-‐apr-‐expensive/ [Accessed: 08/06/2013] National Association of Citizens Advice Bureaux, Consumer detriment and financial literacy, p.10 Available from: http://www.citizensadvice.org.uk/summing_up_bridging_the_financial_literacy_divide.pdf. [Accessed 12/06/2013])
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7. Capitalism
Systemic Problems that Endanger its Sustainability
A report by
Jasmine Burton, James Cao, Andy Corbett,
Thomas Cosgrove, Esme Hart, Alex Lewers,
Augustin Lorne, Bethan Price, Chaoyuan She
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Introduction
Capitalism is a system based on private property and markets. The means of production are owned mainly by private companies and some individuals. Resources are freely exchanged by negotiation. Labour is a commodity and is bought and sold for less than the value of what is produced. In capitalism the focus is always the accumulation of profit; any decline in capital, growth or profit is seen as a failure.
Today most of the world is capitalist and although this kind of society may seem normal to us, before the rise of capitalism Western society was centred upon agricultural production in a social system called feudalism. The beginnings of capitalism can be traced to fifteenth century Europe and it flourished during the industrial revolution. Capitalism soon expanded to cover almost the entire globe by the late nineteenth century. Since then capitalism has improved the average living standards of citizens. It has enabled production of a large variety of products and services. Moreover, it has improved the quality of goods and services, for example, transport services, which allow global travel and increased mobility and interconnectedness.
However, in light of the recent crisis questions have arisen over the sustainability of capitalism. Although there has been a tendency towards blaming bankers, we are looking at the capitalist system as a whole, analysing its flaws and whether the crisis was inevitable. We believe that this broad perspective is necessary in order to find solutions that will help prevent a future crisis. In our report we are going to look into the main contradictions of capitalism and consider whether these can be overcome, and if so, how this might be achieved.
Use Value and Exchange Value
The underlying contradiction of capitalism is between use value and exchange value. For example water is more useful than diamonds, yet diamonds are more expensive. The exchange value of water is lower than diamonds and does not reflect its high value in use. A house has use values such as shelter but also has an exchange value. In past times this exchange value was small. In past times, houses were built from readily available natural resources, perhaps with help from family and friends where the only exchange value may have been nails or tools used for construction. The use value was dominant because the house was built for life, rather than to be exchanged for profit.
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Over time as housing became more speculative, use value was subordinated to exchange value. This meant that when the housing bubble burst, the exchange values evaporated, millions were left without access to the use values of their homes necessary for a decent life. The world is now driven by exchange value. Housing speculation is a common activity with many people looking to profit from increasing house prices.
This tension between exchange and use values is difficult to resolve. Exchange value is relational and quantitative, whereas use value is qualitative and specific to the individual commodity.
The Relationship Between Employers and Employees
One of the intrinsic contradictions of capitalism is that of employer versus employee. This contradiction stems from the fact that the economic interests of employer and employee are fundamentally opposed: workers must be paid less than their work is actually worth if their employer is to extract surplus value. It is therefore in the interests of employers to cut costs by keeping wages low, thereby impoverishing workers.
Employers are able to keep wages low through the accumulation of capital. The accumulation of capital reduces the demand for labour, which raises unemployment, and eventually creates a body of unemployed workers. This ‘reserve army of the unemployed’ increases the power of the capitalist in wage determination, as unemployed workers will accept lower wages if it means being employed. As a result, the capitalists accumulate capital through surplus value, and the workers are paid an increasingly low wage. This allows the capitalists to sustain a continuous flow of profit. However, the reduction in incomes can create a problem of low consumer demand that will be a drag on the economy, as was observed in the late 20th century.
Marx believed there would be a ‘race to the bottom’ whereby wages would spiral downwards until they reached bare subsistence level. He did not foresee the emergence of the welfare state in developed countries, which has to some extent mitigated the effect of unemployment on wage determination. For example, most workers in developed countries must by laws be paid a minimum wage which is above subsistence level. However, the race to the bottom still applies in the international labour market with the ability of capital to move easily from one source of cheap labour to another.
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Poverty and Wealth
The conflict between employer and employee has serious long-‐term implications for wealth distribution. Statistics show that the gap between the wealthy and the poor is widening. The graph below shows the tendency of income distribution between the wealthy and poor in UK from 1960 to 2005, showing how the problem of income inequality has become more pronounced.
Fig 1: UK Gini coefficient (a measure of wealth inequality) from 1960 to 2005
(Source: http://flipchartfairytales.wordpress.com/2013/04/17/did-‐the-‐left-‐win-‐the-‐20th-‐century/)
Large companies have better access to resources, enabling them to establish a competitive advantage in the market. For example, they have more money to invest in advertising which gives them an advantage in sales. The result of this is a tendency towards monopoly or oligopoly. Large companies can also raise barriers against new entrants into the market, through capital requirements and economies of scale, leading to an unhealthy lack of competition. One possible solution to this problem is for governments to introduce laws or regulations to encourage competition in order to reduce the power of monopoly. Anti-‐trust laws have been widely implemented and tend to have a positive impact.
On an individual level, there is a vicious cycle that exacerbates income inequality. Richer individuals have more money available to invest and make profit on, thus increasing their income, while poorer people have less disposable income to devote to investment. Here, the
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government could use more progressive taxation to tackle income inequality. For example, the government could raise taxes on the capitalists in order to provide more unemployment benefit, leading to a healthier distribution of wealth.
The Rise of Credit and Consumerism
The 1970s and 80s were a turning point as manufacturing industries were gradually moving to the Far East and being eclipsed by the service sector in Western economies. Since then, real wages have not risen in line with economic growth, while productivity has been increasing due to cheap labour overseas. Little increase in consumers’ purchasing power has led to low aggregate demand. Businesses need to accumulate more profits, but without the increase of aggregate demand this target cannot be fulfilled. The problem was overcome by the extension of credit to poorer consumer, which played an important role in changing people’s lifestyles.
Fig 2: Adverts for consumer goods and consumer finance
Over the last 50 years, people’s lives have been penetrated to a considerable extent by mass media and company marketing campaigns. For example, Apple’s advertising campaign for the iPhone restructured people’s ideas about phones and created a desire for people to own one. Typical car advertisements will show consumers in an ideal life and owning a car, and providing finance terms to facilitate purchasing. Due to the influence of such images on people’s perceptions, and the ease and flexibility of borrowing, people start demanding a better life that corresponds to these media presentations. Capitalists successfully
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stimulate demands by lending people money and earn both interests and profits.
Fig 3: Recent trends in consumer credit (Source: Katie Hughes, Consumer Credit and Debt 2012, Key Note, http://www.keynote.co.uk/market-‐
intelligence/view/product/10633/consumer-‐credit-‐%26-‐debt/chapter/8/credit-‐cards)
Market research suggests that there was an increasing trend in credit card and payday loans usage from 2007–2011. The culture of credit has been embedded into people’s lives, and the effects of this result in a social phenomenon of instant gratification where people seek to enjoy life now and pay for it later on. However, the consequence is that people are stuck in a ‘debt prison’ where current wages are unable to satisfy their consumption and the repayment of their debts. Therefore they end up borrowing more to repay those debts.
The culture of credit was the product of capitalists’ eagerness to drive demand and to maximise profits. However, it planted a ticking bomb which not only resulted in this crisis, but probably also future ones. The government and financial institutions should minimise the effects of this irresponsible culture by regulating the process of offering credit, educating people with insufficient financial knowledge and promoting healthy consumption patterns. Most people are not aware of how the credit and mortgages work in the financial system. Illiteracy in finance and economics is one of the reasons why irresponsible lending and ‘debt prisons’ have been features of recent capitalism. Once people are equipped with essential knowledge, they would know the pros and cons of borrowing and this would largely reduce the potential of future crises. Socially responsible lending and borrowing should be promoted to the public for the benefits of sustainable and healthy economic growth.
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The Role of Technology
Technology and capitalism has had a great effect upon the diminishing power of the worker within society. It has enabled companies to post huge revenues with a small workforce, in order to maximise their profits, with Dobbie (2013) saying about Exxon they need “1,700 people to create a billion-‐dollar profit”. With Amazon now tracking their warehouse workers to record their productivity, the rise in technology is now holding the workers to the ransom of their managers. With the introduction of machines it appears that the worker may start, under capitalism to take a back seat to the rise of the machines. Greater overall efficiency comes at the cost of consinging people whose jobs are replaced by technology to unemployment or insecure conditions.
Environmental Limits
Capitalism’s compound growth means that production needs to constantly increase and therefore environmental resources are constantly being used, despite the fact that they have natural limits. We currently live in a society where short-‐term concerns about the economic crisis are more dominant than long-‐term concerns about the environment due to the need to solve present social issues, thus environmental questions are being ignored. If the economy slows we get unemployment and more debt defaults and so returning to growth becomes the priority even if this is what causes environmental problems.
Concerning the use of the non-‐renewable resource of oil, it is in the interests of oil companies, for example, to continuously mine oil to sell to maintain profits. However, there seems to be little concern for the environmental effects of this activity. There is a conflict between interests of particular businesses and society as a whole; capitalist market competition rewards businesses that seek maximum profit and penalises those that seek the common good if this comes at the expense of short term profit. The use of oil and other non-‐renewable resources for power has two major impacts; firstly, the resources required by the economy are being used faster than they are being replaced, and so, for instance, the quantity of oil is diminishing rapidly. We are currently extracting the maximum amount of oil possible, some believe we are at a point where oil extraction has peaked and will slowly start to decline as shown in the graph below. Secondly, the use of these resources
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produces harmful materials such as gases and waste which further destroy the environment and limit the amount of resources that the economy has access to.
Fig 4: Hypothesised peak in oil production (Source:
http://www.thepelicanpost.org/2011/03/02/shell-‐study-‐affirms-‐peak-‐oil-‐theory-‐3/ )
Though attempts to find alternative and renewable resources have been made, these are still viewed as less profitable than non-‐renewable resources and will therefore only be used when non-‐renewable resources have become unprofitable. We need to look beyond economic growth and consider the implications it has on the wider world. Therefore a recommendation could be that if the economy were to become steady and less focused on the short-‐term effects in its production and use resources at a steady pace, the time created by this could be used to study the long-‐term issues and find alternative resources to tackle these problems.
Globalisation
Globalisation is certainly an important agenda to be considered in terms of the prevention of future crisis. Most economies are nowadays not isolated or closed any more; on the contrary, countries are all actively
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engaging in global trade and cooperation which utlised the specialised division of labour and increases national income. However, it is not possible to completely avoid a future crisis by relying purely on one nation’s own regulations. Because globalised economies are all interlinked, if one country’s economy breaks down, it will surely affect other countries. The 2007 financial crisis has already proved this point where US housing bubble burst affected the whole of Europe.
One possible suggestion in the area of globalisation is that countries need to cooperate to reach agreement on a global-‐scale regulations or a framework which financial institutions within the member nations must comply with. This framework should aim at strengthening the firewalls between countries to prevent knock-‐on effects, promoting international corporate responsibility to ensure healthy and ethical growth, regulating international companies globally to avoid any serious misconduct happening around the world, and establishing a regulatory body, which consists of representatives from all member nations, to oversee the world’s financial institutions. Despite the fact that some countries may disagree on certain terms due to their self-‐interest, the need for global cooperation could definitely reduce the impact of a future crisis on other innocent countries. The G8, G20, EU, IMF and other organisations and agreements could be used as a platform for carrying out this process.
Conclusion
As students at the University of Exeter we feel that it is very important to consider the wider perspective as well as the particular technical aspects of the economic and financial system. We have looked at several systemic contradictions that we feel could have consequences if not addressed.
We have come up some ideas to consider in order to mitigate potential future crises:
• Revision of taxation with increased emphasis on properties and
savings, rather than earnings to regulate excessive individual accumulation
• Increased financial literacy and education is important for understanding risks with personal finance
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• Alternative measures of economic health and the population’s wellbeing other than economic growth rate to facilitate a shift from standard of living to quality of life indicators
The structure of the capitalist system means that it is subject to fluctuation, with economic growth and recession being common features. Therefore we feel that a future crisis is inevitable, though its gravity depends upon the influence of these contradictions. It is important to consider the broader perspective when agreeing on economic regulations because if we ignore these contradictions and simply focus on short term financial solutions, they will not be effective in preventing future crises. Though in the recent crisis there was a tendency to hold the individual behaviour of banks responsible, it can be said that the capitalist system encourages this behaviour, and this is an issue that needs to be addressed. Bibliography
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Princeton: Princeton University Press Speth, J. G. (2008) The Bridge at the Edge of the World: Capitalism, the
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Wolff, J. (2003) Why read Marx today?, Oxford: Oxford University Press
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Wolff, R. (2012) Democracy at Work: A Cure for Capitalism, Chicago: Haymarket
Yilmaz Genç, S. (2008) “The Historical Evolution of Capital Accumulation in the Capitalist System”, International Journal of Business and Social Science, 2(9): 268–274
8. How can the interests of bankers and society be aligned via changes to the incentive system within the banking structure?
SIMON OYETUNDE BAJULAIYE JOSHUA BENFIELD CHRISTOPHER JOHN GRIFFEN CAROLINE JULIETTE HUGHES ALEXANDER MCHATTIE ZAHARY NINOV HARRY RAVI
RACHEL MARGARET VAUGHAN JAMES ROBERT WALKER JASWANI VIRASHA
Following the devastation caused by the recent financial crisis, it is seen as being vitally important that the incentives facing bankers are altered to prevent the banks building up increased levels of risk. Recently, George Osborne declared that no measure “is off the table” with regards to bankers’ bonuses5. The controversial culture within the financial sector of handing out large bonuses as incentives which leads to a
5 BBC News. (2011). George Osborne warns banks to heed bonus concerns. Available: http://www.bbc.co.uk/news/uk-‐politics-‐12159898. Last accessed 10/06/2013.
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system of taking excessive risks, has led to an enormous political backlash and to a very vocal press campaign. Our goal is to present credible solutions and suggestions to prevent bankers’ incentives from contributing to any further collapses in an industry with huge strategic value to the UK economy.
The tail risk undertaken by the banking sector became systematic within the crisis due to the large performance related bonuses and lack of accountability bankers faced which promoted risky activities. It therefore became almost rational for bankers to take decisions that were detrimental to the welfare of not only the company but also of society itself. To compound this, these bankers were still being rewarded for their mistakes, with the CEO of Lloyds earning £1.5m in 20126, in addition to his salary. The notion of an incentive has been said to provide those in the financial sector with self-‐worth and as such adds to the self-‐inflated mind-‐set of these bankers, breeding a culture of greed and irresponsibility.
In the public eye, the size of these incentives is inexcusable and calls for capping and a sophisticated implementation of the “S-‐curve” graph (diminishing returns to performance) have arisen. This is especially relevant given the scale of the government’s bailouts of the banks, with 81.7 percent of RBS being owned by the taxpayer7. The scale of the government bailouts highlights the fact that bankers do not face the full consequences of their actions and encourages irresponsible behaviour. However academics, such as the Squam Lake working group, have identified that a more effective method of change is to restructure bonuses, with the “bonus-‐malus” and “claw-‐back” methods both being suggested strongly8.
We understand the complexity of implementing universally accepted solutions which are undertaken unilaterally by all financial institutions however we believe that these ideas of restructuring will not affect the international competitiveness of the banking sector as a whole.
6 Bowers, S., Treanor, J., Walsh, F., Finch, J., Collinson, P., Traynor, I. (2013). Bonuses: the essential guide. Available: http://www.guardian.co.uk/business/2013/feb/28/bonuses-‐the-‐essential-‐guide. Last accessed 10/06/2013. 7 National Audit Office. (2012). Taxpayer support for UK banks: FAQs. Available: http://www.nao.org.uk/highlights/taxpayer-‐support-‐for-‐uk-‐banks-‐faqs/. Last accessed 10/06/2013. 8 Greenberg, M. (2010). Regulation of Executive Compensation in Financial Services. Council on Foreign Relations. p4. Available: http://www.cfr.org/content/publications/attachments/Squam_Lake_Working_Paper8.pdf. Last accessed 10/06/2013.
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The task we have set ourselves may be nigh on impossible to achieve in practice but the recent financial crisis has shown us that urgent change is needed within the financial sector.
There have been numerous proposed solutions to incentivise the banks fairly. After lengthy analysis of these propositions we have concluded that the majority would not work with the current system. Firstly, some left wing lobbyists have argued for the governmental control of banks, so that the banks’ interests are aligned with those of society. However, we believe that this is not the way forward for the banking industry. Our argument here is strengthened by David Sismey of Goldman Sachs who, during a debate at the University of Exeter, used the analogy of replacing a doctor, who has made a mistake in surgery, with a civil servant. His slightly bold yet clear simile portrays how only bankers can decide incentives and solutions for themselves.
Recently the European Union has implemented measures to cap bankers’ bonuses, however economists and other banking professionals have seen this merely as a way of appeasing the public and not doing the right thing for the economy. We feel that the best way to combat the problem would be to target the structure of bonuses rather than the size. Dan Ariely (2010) in his book “The Upside of Irrationality” explains that excessive payment is doesn’t necessarily increase performance. Drawing on hypotheses made in graphs he presents, we have come up with a system that would reward positive behaviour rather than risk-‐taking behaviour.9
The black line represents the simplest relationship between incentives and performance with the higher incentives bringing higher performance. The blue curve represents an “inverse-‐U relationship”, which means that after a certain point, the higher the incentives are, the lower the performance of bankers becomes. This is due to the encouragement to take excessive risks. The relationship that we want to create is represented by the green curve. This represents the use of the law of diminishing returns present in incentivising bankers. A directly 9 D. Ariely, (2010). The Upside of Irrationality: The Unexpected Benefits of Defying Logic. Harper Perennial.
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proportional relationship is not necessary to sufficiently incentivise performance. With the right incentives, the overall level of performance could have a relationship that increases at a decreasing rate with respect to incentives, providing the incentives are properly structured not to be too distracting, or to encourage excessive risk.
Alternatively, some economists suggest using the “Credit Suisse” method to remedy this issue. Stephen Mimh (2010) explains the situation accurately in his book “Crisis Economics” when he writes, “at the close of 2008, Credit Suisse announced that it was shifting some $5 billion worth of toxic assets off its own balance sheet and into a special fund. It then paid bonuses to employees out of this fund, replacing the usual form of compensation”10. Although Credit Suisse ensures that bankers are accountable for the trades they make, we are not entirely convinced that this method would be beneficial for the banking sector or the economy because incentivising the bankers with toxic assets may not reduce risk taking as they would not be personally accountable, rather their actions affect bankers’ bonuses as a whole. As a result of this, many bankers have protested against this scheme, as many of them weren’t involved in the trading of toxic assets.
Following our research, we have developed a combination of approaches linking to the structure of how bonuses are measured and how they are paid out. These approaches include an “S-‐curve” method of quantifying the bonuses11, and holding back bonuses for a length of time in order to build a pool of capital to be used as insurance in the event of the need for liquidity. We feel that this would be the most effective way to ensure that the long run interests of shareholders, bankers and society are aligned.
In place of bonuses being awarded on the basis of constant returns to performance, risk and other factors may be taken into account by using an “S-‐curve” model:
10 Mimh, S. Roubini, N. (2010). Crisis Economics: A Crash Course in the Future of Finance. Penguin Press HC. 11 Institute of International Finance (2009) Compensation in Financial Services, Industry Progress and the Agenda for Change. p.21. Available: http://www.iif.com/press/press+101.php
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In order to achieve what the green curve on the previous graph accomplishes, the “S-‐Curve” is a better model for incentivising performance. This is because the banks will be able to match performance with a bonus pay-‐out, using the points at which returns change between increasing and decreasing as boundaries for the desired performance metric. This metric would ensure that the risks being taken by bankers would affect their compensation, adding a level of accountability to their actions, and decreasing the overall possibility of excessive risk leading to government-‐backed bailouts that would damage society.
This shows that whilst there is no limit on compensation that would disincentivise bankers, rational behaviour will be dictated by the structure of the “performance metric”. It is therefore important that this metric takes into account both high returns on equity and more importantly for protecting against bailouts, a lower level of overall risk-‐taking. Non-‐financial aspects that also need to be taken into consideration are client satisfaction and internal department cooperation8.
In order for this model to work, however, better risk modelling within both the banks and the credit rating agencies has to be developed. They should not solely rely on rating agencies but also try to question as much as possible the risk of the assets they are holding. Moreover, when measuring the performance metric, the equity and bonds bought by the traders should also be tracked as risk versus return where the higher the risk is, the lesser the bonus would be awarded to the banker, regardless of the level of profit gained by the institution. Another factor that might be taken into account could be previous
Bonus Payout
Performance Metric
S-‐curve Payout Ratio
Fig. 1 (“S-‐Curve Payout Ratio”)7
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performance rating so that bankers would be encouraged to work towards improving the welfare of the bank in the long term.
Another effective way of incentivising the bankers is by focusing on the structure of bonuses as opposed to the level. The Squam Lake Working Group supports this notion as it is believed that bonus caps on a number of firms could have undesirable effects such as pushing away highly skilled and talented individuals to other unregulated firms in the industry or in an extreme scenario, other receptive countries12. This paper proposes a form of holdback mechanism whereby in one year, a proportion of a banker’s bonus e.g. 40% is paid out at the end of the year while the larger proportion is held in a separate escrow account to be used as a buffer for the bank’s capital reserves. The bonuses held in this account will remain liquid and readily available in case the bank goes bankrupt or requires extraordinary government backing in which case this bonus pool will be used to meet bailout requirements. We explore the situation of Bear Stearns, a systemically important mortgage lender which the US government loaned the sum of $12.9billion13 to meet its obligations. Our holdback mechanism will ensure that the cost to the tax payer will be limited by making systematically important banks more responsible for their failures.
According to the Financial Times, most banks are now using this method of delayed remuneration payment (for three to five years) including Barclays, HSBC and Goldman Sachs, who are using the “claw-‐back” method of taking bonuses back from the fund created by these delays if deals fail in the long-‐term (according to David Sismey of Goldman Sachs, 07/06/2013). This long-‐term payment option for bankers encourages them to be more cautious about the risk associated with their deals, as excessively risky deals could lead to the failure of the firm and therefore a loss of bonuses. This system would boost employee loyalty to their company; if the bank goes bankrupt, the banker loses much more money than he/she would have done under the previous system. This scheme aligns the interests of bankers, shareholders and society, who all benefit from conservative deals that do not put banks in danger of collapse. Additionally, the government seems to agree;
12 Greenberg, M. (2010). Regulation of Executive Compensation in Financial Services. Council on Foreign Relations. p3 Available: http://www.cfr.org/content/publications/attachments/Squam_Lake_Working_Paper8.pdf. Last accessed 10/06/2013. 13 Federal Reserve. (2012). Bear Stearns, JPMorgan Chase, and Maiden Lane LLC. Available: http://www.federalreserve.gov/newsevents/reform_bearstearns.htm. Last accessed 11/06/2013.
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according to the Financial Times, UK bankers may be barred from accessing the payouts for as long as ten years14, in a Parliamentary Commission due to be published on 13th June 2013. This paper suggests that the ‘clawback’ should be increasing in percentage over time, adjusting in line with the business cycle yearly, in order to ensure that there would be a substantial level of funds available if there was a financial crisis.
In conclusion, while we find this solution to be one of the most effective, there are still flaws that cannot be solved without systemic change. Regulation alone does not have sufficient power to properly safeguard against future asset bubble crashes. To maximise the success of these proposed solutions, we will have to ensure that there is adequate pressure on the banks from the public, the media and the government. Furthermore, global implementation of these policies would maintain stability in the labour market of the financial sector; “first-‐mover disadvantage” would have to be prevented. Lastly, systemic change requires time: the system is complex so years may pass before effective change is seen. To continue into the future, the ethics of the industry must change. Ideally, such change would also help to curb the bonus culture and risk-‐taking mindset of the financial industry, which in the long-‐run would increase its reliability and independence, reducing its burden on the taxpayer. We believe that this should be achieved by increased regulation, rather than allowing the banking executives’ perverse incentives to rule over the wealth of society.
14 Jenkins, P. Thompson, J. (June 2013). Bankers face 10-‐year delay on bonuses. Available: http://www.ft.com/cms/s/0/d137c834-‐cf96-‐11e2-‐be7b-‐00144feab7de.html#axzz2VohX4Xgt. Last accessed 10/06/2013.
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Bibliography: Ariely, D. (2010). The Upside of Irrationality: The Unexpected Benefits of Defying Logic. Harper Perennial. BBC News. (2011). George Osborne warns banks to heed bonus concerns. Available: http://www.bbc.co.uk/news/uk-‐politics-‐12159898. Last accessed 10/06/2013. Bowers, S., Treanor, J., Walsh, F., Finch, J., Collinson, P., Traynor, I. (2013). Bonuses: the essential guide. Available: http://www.guardian.co.uk/business/2013/feb/28/bonuses-‐the-‐essential-‐guide. Last accessed 10/06/2013. Greenberg, M. (2010). Regulation of Executive Compensation in Financial Services. Council on Foreign Relations. Available:http://www.cfr.org/content/publications/attachments/Squam_Lake_Working_Paper8.pdf. Last accessed 10/06/2013. Institute of International Finance (2009) Compensation in Financial Services, Industry Progress and the Agenda for Change. Available: http://www.iif.com/press/press+101.php Last accessed 10/06/2013. Jenkins, P. Thompson, J. (June 2013). Bankers face 10-‐year delay on bonuses. Available: http://www.ft.com/cms/s/0/d137c834-‐cf96-‐11e2-‐be7b-‐00144feab7de.html#axzz2VohX4Xgt. Last accessed 10/06/2013. Mimh, S. Roubini, N. (2010). Crisis Economics: A Crash Course in the Future of Finance. Penguin Press HC National Audit Office. (2012). Taxpayer support for UK banks: FAQS. Available: http://www.nao.org.uk/highlights/taxpayer-‐support-‐for-‐uk-‐banks-‐faqs/. Last accessed 10/06/2013.
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9. Business Ethics
Matt Callaway
Meia Harnett
Adam Mascarenhas
Yawen Wang
Alex Crosby
Facilitator: Yuting Bai
Business Ethics
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Business ethics is the conduct by which businesses act in relation to morality, law and regulation, and also sustainability. Within this inquiry, the group has set out to discuss the prevalent relationship that existed between the financial crisis and business ethics, and which still continues today. Thereafter, various solutions have been explored such as why there is cheating in the business sector, and how we could go about fixing this by means of implementing business ethics in a educatory sense, at schools in particular, but also at University. Finally we have addressed the notion of government intervention, and how politics can strive to make a difference when it comes to the ethical stance of the financial sector. The relationship of business ethics and the financial crisis is a turbulent issue that is undeniably indefensible due to the simple fact that ethics cannot be separated from economics, for ethics governs the goals which economics sets out to achieve. Whilst Dr. Joakim Sandberg has attempted to argue that there is a ‘separation thesis’ between ethics and economics, the overwhelming attitude of academics is that the two subjects are inextricably linked. The notion of ethics can be considered on a personal level and also an organisational level, and these are equally important in understanding the relationship between the crisis and ethics. There is an excessive desire for more money in life because of greed and resulting selfishness, and bankers are no exception to this. With this mindset in place, ethics became contorted around the time of the crisis when bankers were trying to squeeze every available asset in order to attain maximum profit for themselves, for example the concept of collateralized debt obligations is fundamentally flawed for consumers, but to bankers there are no attached consequences. Whilst this is wrong, it can be argued that this is showcasing that bankers are in fact human, and simply want to provide as much as possible for their families; however this sympathetic viewpoint becomes tarnished when you learn of other virtues which became trampled: for example, despite realizing what was happening some managers decided to evade difficult decisions that might have jeopardized their careers even though it affected consumers and brought the banks into even more disrepute. Further reifying this, Torres (2009) states that ‘there were grave behaviours of pride, arrogance and hubris where financiers felt that they
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were above the law’, in other words, self-‐interest was at heart for bankers. Moreover there existed moral hazard problems, for example when financial institutions took advantage of the limitation of their risks, by exploiting consumers effectively, thanks to the legal provision of limited liability or the existence of guarantees that limit their losses (Sinn 2008). There was a rise in situations of ‘induced greed’ by encouraging and rewarding those who succeeded in their greedy behaviour, but most importantly, it made it much harder to behave otherwise. Hence it can be argued that the culture within the banking sector thwarted any sense of ethicality, and it was not so much the case that each individual could be labeled as unethical, but instead the structure in place was always destined to fail – reward those who bring in the most money, by all means necessary. The incentives on offer to bankers far outweighed their ethical stances, so much so that they manipulated their own beliefs to believe they were acting ethically, but in actuality they were only acting out of their own self-‐interest. Examples of this are CDO’s and the Credit Default Swap, which created the illusion that risk had been eliminated from institutions’ portfolios, without caring for the fact that risk was reintroduced in other ways (Kane 2008). This may sound as though the bankers were knowingly being deceitful; however they would argue that instead they had become ‘willfully blind’, missing the obvious things in pursuit of their key goal – money. Similarly, ‘ethical numbing’ meant that ethics were overlooked, albeit subconsciously, and this perversion of ethics is what led to the financial crisis. The relationship between ethics and the aftermath of the crisis still remains in turmoil, evidence of this coming in the form of the recent Libor scandals, ‘regulatory arbitrage’ and also the all too frequent misselling of PPI. It is therefore evident that the relationship between ethics and the crisis was unavoidable and is arguably the main reason as to why the crisis came about. It is a debated question as to whether unethical behaviour by individuals derives from conscious decisions or not. It is widely accepted that unethical behaviour is a result of ethical fading; this involves the
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elimination of the ethical dimension to a decision. It leads to individuals viewing what would be ethical decisions into just ‘business’ decisions, removing the ethical nature to a decision and in turn convincing oneself that the decision is being made rationally. A further reason as to why people cheat is that individuals are driven by ‘details’, rather than ‘abstract principles’ – ethics; which can be looked at using System 1 and System 2 thinking. System 1 thinking is our instinctive system of processing information. This way of thinking is fast, automatic, effortless, implicit and emotional; it is efficient and therefore is the most appropriate decision making tool in the majority of day-‐to-‐day decisions. Contrastingly, System 2 thinking is conscious, effortless, explicit and more logical; it is slower as the pros and cons are debated within this type of thinking (Blind Spots, 2013: 35). Modern life and business decisions rely heavily on System 1 way of thinking, hence leading to people being more likely to cheat because it takes more cognitive energy to reflect enough to stop one’s impulse to cheat. Similarly, when one comes to actually making a decision, our thoughts are dominated by what we ‘want’ to do rather than what we ‘should’ do. For example if one was asked how one would act previously to a decision, a more ethical ‘wanted’ response would be given. However when it comes to the actual decision time, ones ‘should’ self-‐wins as ethical fading occurs. Once reflecting on how one had acted, an individual likes to believe that they acted in the most ethical way and thus believe that they did, this is known as memory revisionism. (See diagram below)
Prediction Forecasting Errors
Recollection Memory Revisions
Shifting Standards
Decision Time Ethical Fading
Should
Want
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(Blind Spots, 2013: 67) Behaviour is overlooked; this is down to three main reasons; motivated blindness, indirect blindness and the slippery slope. Motivated blindness is the failure to notice others unethical behaviour. An example of this can be described from a fictional film, ‘The Reader’ where German guards lead hundreds of prisoners to their death when the prisoners camped in a church for shelter and the guards locked them in. The church was bombed and caught fire and the guards failed to unlock the doors, resulting in the deaths of all the prisoners. When questioned about their actions, the guards failed to see that they were acting unethically, and that instead they were complying with the roles of their jobs ‘to guard the prisoners’. The guards proclaimed that if they were to have unlocked the doors, there would have been chaos and some of the prisoners would have escaped, and subsequently they would not have been doing their jobs. (Blind Spots, 2013: 80) This fictional example portrays clearly that the guards did terrible things without even recognising the ethical implications of their actions – motivated blindness. Motivated blindness is a condition which encourages individuals to ‘cheat’ by acting unethically; this could be due to fear, i.e. with the above example, fear of the repercussions with senior officers if the guards had released the prisoners. Additionally motivated blindness continues to happen due to organisational loyalty and culture, in which others within the organisation are acting in this way, and thus as a result it encourages others to do so as well. Indirect blindness is the second reason in which the conditions for cheating occur; indirect blindness is holding others less accountable for unethical behaviour when it is carried out by a third party. For example, consider two similar situations; firstly a major pharmaceutical company raises the prices of a drug from £3 to £9 per pill. Secondly, a major pharmaceutical company X sells the rights of its company, to company Y. So company Y can recover their costs, they raise the price of the pill to £15. A study found that the first situation was judged more harshly than
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that in the second example, even though the financial effects were smaller (Blind Spots, 2013: 88). This highlights that by engaging in unethical behaviour indirectly, decision makers trigger indirect blindness in the eyes of observers and are therefore less accountable for the ‘harm’ that they cause – encouraging unethical behaviour. Thirdly, the slippery slope is a final condition in which cheating occurs, the slippery slope is when unethical behaviour happens gradually in small incremental amounts, it is unlikely that it will get noticed. For example consider the following two scenarios, imagine an accountant in charge of auditing the accounts of a large company. The company follows strict financial regulations and is ethical for three years in a row; in the fourth year the company breaks the law in its accounting procedures. The second scenario is that the auditor in year one notices a few stretches in the law, but nothing that breaks it; in the following year minor violations occur, with the violations being even more severe in the third year. In the fourth year the same accounting laws are broken as they were in the first scenario (Blind Spots, 2013:92-‐93). However in the second scenario it is far less likely that the law being broken will be recognised as severely. Highlighting that shocking unethical behaviour is unlikely to be perceived as seriously when it occurs gradually over time, thus creating conditions for cheating to occur. Teaching business ethics normally divides people’s opinions into two branches: business ethics is intrinsically linked to one’s character and the innate ability to decipher a situation into what is morally and ethically correct or secondly, that through education of business ethics, people will be more aware of their decisions before entering the business environment into which their ethics will be tested. Without too much knowledge or understanding of business ethics, it would be easy to cast a vote towards the former opinion. Our human perspective and raw opinion is that solely each individual makes individual decisions in the corporate world and therefore their own personal ‘moral compass’ dictates whether a decision is ethically wrong or right. However, after listening to guest lecturers and reading journals and articles, our perspective completely changed to the latter group of people. Understanding what is ethical fading, cognitive dissonance and hearing personal stories of experienced financial advisers has changed our opinion on whether educating the commerce students within
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universities is essential to creating a more ethically aware and in turn an more ethically correct atmosphere within the finance sector. Few universities around the country place enough emphasis on ethics as a subject. In the Exeter Business School, there is no compulsory module on ethics but an optional module in the third year. The current module, “Ethics and Organisation”, tries to engage the student into making ethical decision making, problem solving, and considering the social impact of decisions. Out of the 7000 students in the Exeter Business School, only 600 students take a business ethics course voluntarily. Although, according to the module lecturer, Jackie Bagnall, the students are normally “students really commit themselves” in their “thinking to the ideas” that the module explores. Ms. Bagnall agreed that turning the module to a compulsory module would require different approach to delivery. The key is challenging students about the question “What does it mean to manage in a responsible manner?” We presume all the theories mentioned throughout the report are taught excellently in this module but the best impact on our studies was the previous experiences by people who were or are in the position to make ethical decisions. Financial advisers who used to work in the industry elaborated on what they did when facing the ‘slippery slope’ of unethical decisions or what policies were in place regarding the treatment of unethical decisions. Overall, we believe that personal anecdotes are the most powerful tool in teaching business ethics to aspiring financial managers. Some Practical Recommendations for Change Regarding Education would be: -‐ Implement One-‐Day events within Universities about Business
Ethics with guest lecturers with previous experience in finance -‐ Suggest to Finance Banks to run business ethics training days to
bring ethical behaviour to the forefront of managers’ decisions -‐ Talk to Universities regarding making Business Ethics a compulsory
module.
There is a considerable overlap between business ethics and the law. In fact, the law is just an institutionalization of ethics in to specific rules, regulations and proscriptions. Therefore, the government has an
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obligation to step in after recent turmoil to help improve the current situation and prevent such events from reoccurring. There are a number of proposed actions we feel the government could take to improve the business ethics in the UK, such as business ethics day, local programme related to ethics and some protection law for whistleblowers. First, by creating business ethics day, people can be reminded, or even informed, of business ethics. This is because recent research has shown that when people are reminded of the right thing to do, be it legally right or morally right, they are less likely to behave unethically. We believe we could utilize this by creating an annual event in the UK. The event could be an annual fair where all possible information is available. We could expand this to make it a national day with the sole focus of enforcing the idea of business ethics. This could include workshops and speeches for those working in the business sector and university students, playing on our previous idea of incorporating business ethics into education. Secondly, local programme or other social media are useful tools to create an ethical environment. To explain the reason behind this recommendation, we feel that it is imperative to address the broken window theory and the ‘slippery slope’ theory previously mentioned. The broken window theory states that if there existed a new building with undamaged windows they are likely to stay as such. If one window was to be broken and left untouched by maintenance then before long all windows would be broken. Hence, once people feel they can get away with unethical behaviors they will continue to act as such and may even escalate, encouraging others as they do. This can be rectified with a zero tolerance stance. We must ensure all unethical behavior is addressed. This could be through sanctions of a financial basis or through demotion of ones position. We could also utilize the media and create a “naming and shaming” atmosphere, much like the current programme Watchdog but for the financial sector. Last but not least, the government should strengthen the protection laws for whistleblowers. Although there is an Act, called the Public Interest Disclosure Act, 1998 which attempts to protect employees who reveal evidence of illegal or unethical behavior. However, it has been criticized for the lack of provisions preventing the "blacklisting" of the whistleblowers, and failing to protect employees from libel proceedings
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should his allegation turn out to be false. We suggest that we can learn from the experiences in the U.S.: whistleblowers can be allowed to initially report fraud anonymously by filing a claim through an attorney (Dodd-‐Frank Act); and employers are prohibited to retaliate against whistleblower, which means that employers may not fire, demote, suspend, threaten, harass, or discriminate against a whistleblower. Whistleblowers who suffer from employment retaliation may sue for reinstatement, back pay, and any other damages incurred. (Sarbanes-‐Oxley Act of 2002) Finally we have four recommendations that once more need to be illustrated and reified. Firstly, we feel having a compulsory ethics module will boost the student satisfaction levels, as well as ingrain an increased level of ethical nature within each individual of the Business School. The final three recommendations link to government policy and how this can be implemented to create an improved ethical system in place. A National Ethics day is a reminder in keeping ethics at the forefront of an individual’s mind, whilst the watchdog programme encourages a zero tolerance policy that would maintain a high standard of ethics. The most important recommendation in our eyes is the need for growing protection of whistleblowers to encourage people to speak out to the authorities, which in turn would of course diminish the extent of unethical behaviour prevalent in society today.
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References: Bazerman, M. H. and Tenbrunsel, A. E, ‘Blind Spots’, 2013 Kane, E. J. (2008), “Ethical failures in regulating and supervising the pursuit of safety net subsidies”, Terre Haute, IN, Indiana State University, Networks Financial Institute Working Paper 2008-‐WP-‐12. Sinn, H. W. (2008). “The end of the wheeling and dealing”, CESifo Forum, 4, pp.3-‐5. Sandberg, J. 2008. “Understanding the Separation Thesis,” Business Ethics Quarterly 18(2): 213–32.
Tebrunsel A. E. and Messick D. M. 2004 “Ethical Fading: The Role of Self-‐Deception in Unethical Behavior” Torres, M. (2009) “Getting business off steroids”, in Friedland, J. Doing Well and Good: The Human Face of New Capitalism.
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10. Improving our model of regulation
By
Jack Chamberlain
Sophie Clarke
Nitika Dandawate
Lee Foster
Felix McKechnie
Emma Needham
Joshua Weston
Charlotte Winterbourn
Eng Kheng Yak
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Contents
INTRODUCTION 3 EXECUTIVE SUMMARY 3 CONTAGION 4 CAPITAL RATIOS 6 COMPETITION 8 CREDIT RATINGS AGENCIES 9 CONCLUSION 11 RECOMMENDATIONS 12 REFERENCES 13 APPENDIX 15
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Introduction Having taken into account the recent Vickers Report and the mess the financial meltdown has caused since 2008, we feel regulation of the banking system needs to be readdressed and more stringently enforced. This report has particular focus on regulating our banks in the UK, but will to a certain extent have EU-‐wide implications. With our proposals we hope to achieve a move towards a more stable and credible financial sector, with specific reference to the design of banks; their competitive nature; capital requirements and more independence in the way in which financial vehicles are rated.
Executive Summary We have written this report to uncover fundamental problems within the financial sector and provide some propositions to improve the current regulatory system that overlooks this crucial segment of the economy. We look at issues with financial contagion, which result in instability throughout the system. We suggest a splitting of the banks’ investment branches from their retail branches and further moving towards a more narrow banking system. We also propose increasing the capital ratio towards 25%, which would improve the banks’ security compared to the 8% proposed in Basel III. Competition, we feel, is not strong enough between banks. More competition results in greater efficiency, which can be achieved by empowering consumers through more information and choice. We also believe that the ratings agencies need to be brought to the forefront of regulation, as they inaccurately rated financial vehicles to improve their own financial position. If they rate highly they are more likely to be employed again. We thus want to reduce this conflict of interest. This report has been written in order to bring more light to these issues and, with our recommendations, we aim to create a more stable, effective and credible system through tougher regulation. Recommendations discussed include: • Separating the retail banks from their investment counterparts
with no interaction between these two subsidiaries. This could stem from an initial stage of ring-‐fencing.
• The capital ratio requirement should be increased significantly above the Basel III requirements of 8%. This will benefit customers and the economy greatly by forcing the banks to better manage their levels of risk.
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• Easier switching for consumers: greater transparency in the pricing of bank products and services to help them make informed choices from a diverse range of suppliers; publication of statements showing interest foregone on accounts; greater use of comparison websites.
• The formation of an EU-‐wide Public Ratings Agency to provide impartial risk analysis and greater regulatory power for the Financial Conduct Authority in the credit ratings market.
Contagion In this section we are going to focus on the implications of contagion within the financial industry. Financial contagion is the interconnection between the banks within the UK and the rest of the world, where one bank is intertwined with another, resulting in mass instability when there are shocks on both a domestic and international scale. Evidence of this can be seen by the failure of Lehman Brothers in 2008 spreading to the UK banks and causing withdrawals of deposits by savers. Such actions lead to government bailouts, most famously of RBS, at the expense of the UK tax payer. There has also been a severe loss in confidence by consumers overall in the banking industry and a reduction in vital lending by banks to consumers and SMEs (small to medium enterprises). We need to reduce the effects of the connections between the banks to improve financial security during crises, and thus reduce the detrimental effects on consumers and small firms.
One form of regulation to redesign the scope of activities within banking institutions is the ring-‐fencing of retail operations from investment banking, a measure outlined in the ICB’s (Independent Commission on Banking) 2013 Banking Reform Bill. Whilst this may provide greater clarity in terms of the separation of lower and higher risk activities, full institutional separation is not achieved as both subsidiaries of the bank would be subordinated to the holding company. This allows banks to reap the “benefits emanating from the integrated business model” [e.g. economies of scale] (Chow, J &Surti, J; 2011). For such a model to work, it must be monitored extremely closely, and strict limits placed upon the interaction between retail and investment banking in order to minimise the risk of contagion. However, it is very questionable as to how feasible
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it is to prevent the crossover, as highlighted by Paul Volcker, who has suggested that by implementing ring-‐fencing, the ICB has simply “bowed to practicality” (Ebrahimi, H; 2012). It is possible that banks will push the boundaries to gain an advantage, therefore there needs to be a sufficient disciplinary procedure in place to deter banks from breaking, and attempting to break, the rules – “electrify the ring fence”.
With the threat of manipulating the rules of ring-‐fencing, a further measure is required in case the fence is breached. We propose a full separation of the banks, splitting the investment banks from their retail counterparts with no potential for interaction between; this has been proposed as the Volcker Rule in the USA, which advocates an outright ban on all forms of risky investment activity, such as proprietary trading when a bank trades on its own account. This would minimise conflicts of interests between the bankers and their clients. Although the measure may be fragile and take a long time to fully implement, the long-‐term benefits would, theoretically, be worthwhile.
Should investment and retail banks be split, a strong focus on consumers and their money should be implemented. This can be done through a movement towards “narrow banking”, a model whereby the banks’ reserve ratio is increased; a higher percentage of deposits would be held by the banks. Banks should be forced to hold assets as safe and liquid as their liabilities (Wolf, M; 2009). Narrow banking would restrict the lending of consumer deposits to engage in risky investment; leading to a more stable system since loans would be made by other financial intermediaries. There would be significant introductory costs and it would be expensive to maintain but potentially cheaper compared to the loss of trust (from consumers) and bailout packages. If it was imposed, the efficiency of banks could be enhanced as they focus on core banking activities such as maturity transformation and provision of payment services (Chow, J &Surti, J; 2011). Narrow banking presents a trade-‐off between stability and profit. It depends on your agenda as to whether you want to please the public or the bankers.
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In bullish times contagion can be advantageous; however, when markets begin to decline, the negatives and consequences overshadow any good that contagion can bring.
Capital Ratios Capital ratio measures a bank’s capital against its risk-‐weighted assets. The regulation of capital ratio “focuses on the bank’s ability to absorb losses without becoming insolvent” (Admati, A and Hellwig, M; 2013). In other words, the regulation of capital ratio states that banks need to hold enough cash to cover any money lost in financial difficulties. The Basel III Act states that banks need to have a capital ratio of at least 8%. However, many people feel that itshould be at a much higher level as low capital ratios were a big cause of the 2007-‐08 crisis. Had there been regulation requiring a higher capital ratio, for example a ratio of 25%, then there may have been less money lent,reducing the exposure to bad debt. Another reason is thathaving to hold a higher level of capital reduces the incentive for bankers to take higher risks on investments. This measure does not restrict banks’ activities or investments, but causes them to analyse risk more conservatively when choosing investment projects. Furthermore, holding higher reserves “reduces fragility in indirect ways” (Admati, A and Hellwig, M; 2013) as the likelihood of liquidity problems falls as a result of reduced solvency risk because depositors are less nervous about their money.Admati and Hellwig (2013) have noted that “if a bank has more equity, more of the downside of its activities will be borne by the bank and its shareholders”. There are a few downsides to a bank having a higher capital ratio. Bankers claim that “equity is expensive” (Admati, A and Hellwig, M; 2013), the CEO of Deutsche bank comments that “higher equity requirements would restrict ability to provide loans to the rest of the economy. This reduces growth and has negative effects for all” (Admati, A and Hellwig, M; 2013). This means that banks earn little or no interest on reserves held which may ultimately lead to them charging higher fees for their services. The Institute of International Finance (IIF), a keylobbying organisation for the banks, forecast that the planned Basel III reform would substantially raise interest rates on bank loans in the United States and Europe and lower real growth rates for a number of years. As forecasted by The IIF, an increase of more than 1%in interest rates; leads to, for real growth rates, a reduction of roughly 0.6% in the short run. However, viable banks should be able to increase their
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reliance on funds which are not borrowed, without any reduction in lending so they should still be able to meet their demand. This means that banks should be able to use equity held by shareholders and investments to fund their activities and as a result should still be able to offer the same level of lending. However, there is a flaw in the banks’ claim that “equity is expensive”(Admati, A and Hellwig, M; 2013). If banks hold more equity and borrow less, then the risk on investment by shareholders in the corporation falls and the required rate of return is lower. This means that equity can in fact be less, or as, expensive under a higher level of capital held. Living wills are “documents that detail [banks’] structure and main assets to assist regulators and administrators to dismantle a bank in the events of its collapse” (Qfinance). Therefore the introduction of living wills should make it easier and quicker for regulators to limit the effects of the collapse of a bank on customers. When living wills were first implemented, they were only imposed on “the 29 most significant banks worldwide” (Masters, B; 2012). However, many banks are taking too long in producing the wills, with only “one bank out of 29 globally considered itself to have finished a draft” (Masters, B; 2012) as of March 2012. This hints that regulators need to become stricter and possibly impose penalties on institutions not producing the report by a deadline. From a banker’s perspective, any regulation that constrains their activities or reduces their profit is expensive. However, what is expensive for the banks need not to be expensive for the economy. Bankers, typically, do not take into account the costs of their actions on the rest of the financial system and the overall economy when making financial decisions. Public policy must consider all the costs and it is precisely the point of government intervention to hold banks accountable to society. If equity requirements were viewed as something that could be used flexibly, it is not as if a significantly higher ratio (e.g.up to 25%)should be implemented at all times. In fact,we must look at the banks as a whole; the extent of their leverage, systemic risk, and what theyhold as assets. Only then can the regulators decide on a healthiercapital position,leading to a powerful and flexible tool, where we could all savein the event of another financial crisis. Competition There have been recent concerns over the existing levels of competition within the UK banking industry. The Commons Treasury committee
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noted in 2011 that competition in the retail banking sector is ‘not strong enough’ and the British Bankers' Association has said it is working with regulators to improve competition (Peston, R; 2011). The Vickers Report has addressed concerns of the ‘weakening of competition’ in UK retail banking (Edmonds, T; 2013). Lloyds, Barclays, RBS and HSBC now hold 75% of the current account market, valued at £9 billion (BBC News; 2013). This oligopolistic market can result in various forms of collusion, which reduces competition and leads to higher costs for consumers; for example, the anti-‐competitive practices of manipulating interest rates in the Libor scandal.
Competition is an essential part of an efficient financial system. A more concentrated banking system imposes a loss of economic efficiency by allowing banks to charge a greater lending rate which would limit firms’ abilities to invest in capital. In the long term, this will slow economic growth (Cetorelli, N, 2001). While the existence of competition is likely to lead to a greater quantity of credit available, it will also invite banks to take greater risks through means such as looser acceptance criteria to attract more demand. This in turn could lead to greater financial instability by increasing the risk of default by borrowers. To avoid this, a more stringent regulatory framework is required in order to limit bank failure by using Capital Adequacy Requirement (CAP) which both tightens acceptance criteria and forces banks to hold higher reserves, as previously suggested above (Bolt, W &Tieman, A, 2004).
The Vickers Report proposes ways in which competition may be improved. It highlights the difficulties for customers switching accounts which ought to be ‘free of risk and cost to consumers’ (Trenor, J, 2011). It recommends mechanisms in place such as greater use of comparison websites and the annual publishing of statements showing interest foregone on current accounts. In addition, allowing customers to switch their current account within 7 working days compared to the current 30 days, in line with the Payments’ Council’s recent proposals, would help to enhance consumer choice and, in turn, competition.
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The FSA took steps to relax the barriers to entry for new bank entrants such as no longer applying the additional add-‐on requirements and lowering capital requirements for start-‐ups; for example, being allowed to open with core capital at 4.5% of their assets. Reducing the time new banks have to wait for approval from one year to as little as 6 months should also improve competition in the market.
Furthermore, to avoid an overly concentrated banking industry we suggest placing a limit upon the size of the UK’s biggest banks, similar to US proposals. US banks are currently limited by their inability to acquire more than 10% of the country’s deposits, and new proposals include implementing a cap based on a bank’s other borrowings (non-‐deposit liabilities) relative to a percentage of gross domestic product. These measures also include limiting the safety nets available to these banks by restricting the funding they get from sources other than traditional deposits. We can also add liquidity and capital requirements that will make it more expensive and burdensome to be too big (Nasiripour, S; 2012), by using a tier system wherein bigger banks have to comply with a higher capital ratio requirement than smaller banks. This will also help smaller firms to compete effectively with the larger established banks, thus enhancing competition in this sector. This may see a break-‐up of the UK’s biggest banks, which may consequently have to be restructured, thus improving competition.
Credit Ratings Agencies There are several issues with the current format of credit ratings agencies (CRAs) that made them an integral part of the financial crisis of 07-‐08. The most serious, and a key cause of failure in the mortgage-‐backed-‐securities (MBS) market, was that debt-‐based financial packages were being rated incorrectly according to their risk. A 2010 Federal Reserve Bank of New York staff report found that “Prior to the crisis, 80-‐95% of a typical subprime MBS deal was assigned the highest possible triple-‐A rating”(Ashcraft, A; Goldsmith-‐Pinkham, P; Vickery, J; 2010). This was because the CRAs models underestimated the likelihood of sub-‐prime mortgage defaults.
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The existing ratings market is flawed as a result of limited competition and an entrenched conflict of interest. The three main CRAs – Moody’s, Standard and Poor’s and Fitch -‐ possess a combined market share of 95% (Jakobs, J; 2011) and are funded by ‘selling’ their ratings to financial institutions. As for-‐profit companies, the CRAs must gain, and keep, business. This encourages ratings that ensure repeat custom rather than complete accuracy. The market’s ingrained dependency on ratings also has huge financial implications: data from one CRA (Standard & Poor’s) showed that if a product “went from a category BBB to a category BB, its borrowing costs were reduced by almost 50 percent” (Bahena, A; 2010). There is clearly a huge financial incentive for firms to push for inflated ratings and as they depend on banks to stay solvent, it is easy to see how the ratings agencies may have allowed it to happen.
Given the role CRAs played in the financial crisis and their importance in the current system, it is our recommendation that they be subject to greater regulation and supervision. As a result, we advise the formation of an EU-‐wide Public Ratings Agency (PRA) that would provide objective ratings on financial vehicles, free from the conflict of interest inherent in today’s model. Additionally, they would rate CRAs themselves, offering the market an impartial judgement on their reliability and accuracy.
Since the crash of 07-‐08, many individual components of the financial machine have been subject to detailed scrutiny. CRAs, however, have suffered little examination given their intrinsic structural importance. We believe that this oversight needs to be resolved and are proposing that the newly formed Financial Conduct Authority (FCA) be given the power to monitor the CRAs. Firstly, it would be able issue fines if ratings were consistently proven to vary from reality. Secondly, the FCA should be able to deregister a CRA when they were deemed to be performing against the long run interest of the market as a whole. This could take the form of exclusion either from select markets or, in extreme cases, from the entire market. Any threat must be seen as credible to help foster a more conservative attitude in the ratings process.
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Not all blame can lie with the CRAs as investors must take more responsibility for their own financial positions. Consequently, the PRA would encourage firms to promote analytical education so that ratings are no longer seen as the final stage of investment decisions. If implemented, these proposals will increase competition and stabilise the market. When large funds such as pensions invest based on misinformation, it is ultimately hard-‐working families who feel their failure most painfully, and it is on their behalf that action must be taken.
Conclusion Since the financial crash of 2007-‐08 it is clear that there is a need for change within the regulatory system. In this report we have suggested which areas need specific attention and offered solutions to the problems raised. Starting from the central difficulties created by underlying contagion, this document has argued that the ring fencing of retail banks from their investment branches – regardless of fence ‘electrification’ – is insufficient to curtail widespread contagion and that total separation of the two aspects is a more viable suggestion. From this position it has developed theories on suitable capital requirements, boldly suggesting ratios far in excess of those advocated by Basel III. To provide balance, however, it has recognised that individual cases of bankruptcy occur and has therefore suggested the implementation of ‘living wills’ – directions to mitigate societal damage in the case of financial failure. Given that large institutions have the ability to effect sizeable swathes of the population, the report has aligned itself with the recommendations of the Vickers report on the subject of competition. Competition is a vital aspect of a free market economy and yet one that has been somewhat lacking within the financial system in recent years. As a result, this paper has argued for the implementation of regulation to ease entry into the market for new competitors and empower the individual through greater choice, ease of use and increased information. Finally, this report has tackled the problem caused by a system dependent on unreliable credit ratings. Credit ratings agencies have escaped in depth scrutiny despite their pivotal role in the financial crash and it is this document’s suggestion that they be held responsible for regular inaccuracy whilst reducing their importance within the system as a whole.
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Recommendations • Separating the retail banks from their investment counterparts
with no interaction between these two subsidiaries. This could stem from an initial stage of ring-‐fencing.
• Moving our retail banks towards a narrow banking system, whereby they must increase their reserve ratio and lend from other financial intermediaries rather than consumer deposits.
• The capital ratio requirement should be increased significantly above the Basel III requirements of 8%.This will benefit customers and the economy greatly by forcing the banks to better manage their levels of risk.
• Introduce legislation that all banks must produce a living will by a certain deadline or otherwise be eligible to receive a penalty.
• Banks should have more equity and borrow less, so the equity investment will become less risky for the shareholders. Thus, the rate of return shareholders require is lower, making equity less expensive.
• Easier switching for consumers: greater transparency in the pricing of bank products and services to help them make informed choices from a diverse range of suppliers; publication of statements showing interest foregone on accounts; greater use of comparison websites.
• Relax barriers to entry for new bank entrants: lower capital requirements for start ups, being allowed to open with core capital at 4.5% of their assets; reduce time new banks have to wait for approval from one year to as little as 6 months.
• Restrict the size of the UK’s biggest banks by placing a limit on the funding banks get from sources other than traditional deposits and adding liquidity and capital requirements to make it more expensive and burdensome to be too big.
• The formation of an EU-‐widePublic Ratings Agency to provide impartial risk analysis and greater regulatory power for the Financial Conduct Authority in the credit ratings market.
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• Promotion of increased investor analysis of financial security to reduce dependence on credit ratings.
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References Admati, A &Hellwig, M. (2013) The Bankers’ New Clothes. 81-‐148, 184-‐185
Ashcraft, A; Goldsmith-‐Pinkham, P; Vickery, J. (2010) Federal Reserve Bank of New York Staff Reports: MBS Ratings and the Mortgage Credit Boom. New York
Bahena, A. (2010) What Role Did Credit Rating Agencies Play in the Credit Crisis? [Internet] Available at: < http://blogs.law.uiowa.edu/ebook/uicifd-‐ebook/part-‐5-‐iii-‐what-‐role-‐did-‐credit-‐rating-‐agencies-‐play-‐credit-‐crisis> [Accessed 06 June 2013] Bolt, w &Tieman, A. (2004).Banking competition, risk and regulation.The Scandanavian Journal of Economics. 106 (4), 783-‐804. Cetorelli, N. (2001). Competition among banks: Good or bad?.Economic Perspective-‐ Federal Reserve Bank of Chicago. 25 (2), 38-‐48. Chow, J &Surti, J. (2011).Making Banks Safer: Can Volcker and Vickers Do It?. Available: http://www.bankofengland.co.uk/publications/Documents/events/ccbs_workshop2012/paper_SurtiChow.PDF. Last accessed 10th June 2013. Ebrahimi, H. (2012). Paul Volcker: ring-‐fencing banks is not enough. Available: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/9561624/Paul-‐Volcker-‐ring-‐fencing-‐banks-‐is-‐not-‐enough.html. Last accessed 10th June 2013.
Edmonds, T. (2013).The Independent Commision on Banking: The Vickers Report. Available: http://www.parliament.uk/briefing-‐papers/SN06171. Last accessed 10th June 2013.
Jakobs, J. (2011) Europe Aims to Regulate Credit Rating Agencies [Internet] Available at: <http://atlanticsentinel.com/2011/07/europe-‐aims-‐to-‐regulate-‐credit-‐rating-‐agencies/> [Accessed 07 June 2013] Masters, B. (2012) Banks drag heels on living wills[WWW] Available from: http://www.ft.com/cms/s/0/44a6a4fc-‐6391-‐11e1-‐9686-‐00144feabdc0.html#axzz2Vo7b9flH. Last accessed 9th June 2013
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Nasiripour, S. (2012).Top Fed official suggests US bank size cap.Available: http://www.ft.com/cms/s/0/a2c6ece4-‐131e-‐11e2-‐bca6-‐00144feabdc0.html#axzz2Vnjuucm3. Last accessed 10th June 2013
Peston, R. (2011). Retail banks not competitive, says Treasury committee. Available: http://www.bbc.co.uk/news/business-‐12935228. Last accessed 7th June 2013.
Qfinance. Banks “planning for failure”[WWW] Available from: http://www.qfinance.com/capital-‐markets-‐checklists/banks-‐planning-‐for-‐failureliving-‐wills-‐as-‐resolution-‐and-‐recovery-‐plans. Last accessed 10th June 2013
Trenor, J. (2011). Vickers Report: Key points.Available: http://www.guardian.co.uk/business/2011/sep/12/vickers-‐report-‐key-‐points. Last accessed 7th June 2013.
Wolf, M. (2009). Why narrow banking on its own is not the finance solution.Available: http://www.ft.com/cms/s/34cbca0c-‐ad28-‐11de-‐9caf-‐00144feabdc0,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2F34cbca0c-‐ad28-‐11de-‐9caf-‐00144feabdc0.html&_i_referer=#axzz2VQtgRw. Last accessed 10th June 2013.
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11. Plenary Notes
Notes from Plenary 1 12/06/13 (Creation of final summary document, containing all recommendations/statements/observations made and highlighting core recommendations. Core and additional recommendations. 2pm 13/06/13)
1. Causes of the financial crisis
Recommendations • Financial education-‐ school level-‐ ask right questions and not
lacking in info • Tighter screening process by Credit Rating Agencies • Increase competition in the financial sector-‐ introduce more
banks, building societies and other financial institutions to keep each other in check-‐ competition
• Repeal Gramm-‐Leach-‐Bliley Act • Raise Liquidity Requirements-‐ ensure banks do not end up relying
on government bailouts and monitor credit policies-‐ can always be repaid
• Increase % share of equity in capital composition-‐ not fair that deposits fund speculative activity
∗ Discussion points ∗ Ring-‐fencing (John) ∗ Gramm-‐Leach-‐Bliley Act (US-‐ not relevant to us in UK???) ∗ Interest rates on assets as well as on borrowing-‐ another way in
which real interest rates fed into crisis (John) ∗ CBs have control of short term interest rates-‐ could central bank
control long term interest rates as well? ∗ CRAs-‐ if have info please make available to investors investing in
it-‐ give them full disclosure-‐ engine of whole crisis (conflict of interest-‐ paying RAs who giving them ratings)
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→ Central/core recommendation?-‐ Financial education-‐ individual taking the loan
2. Socially Responsible Banking 1. Credit Unions: Increase public awareness campaign-‐ TV and
advertising campaign-‐ tell people about where local credit union is-‐ can play important role in creating financial inclusion such as universal credit and help avoid loan sharks etc; money to modernise, financially sustainable Infrastructure: Expansion project-‐ infrastructure behind CUs-‐ offer current accounts-‐ must have affordable access to payment systems; gov could give access to public infrastructure; share services agreement between credit unions (Ireland); shared IT service for online banking-‐ improve cost and efficiency; need for flexibility within credit union movement-‐ different per neighbourhood-‐ new legislation
Encouraging new credit unions-‐ barriers to entry still substantial-‐ Ireland-‐ Catholic Church natural common bond; local finance advisory role or funding to help set up new credit unions such as catholic subsidy
2. Building Societies-‐ Mutualisation of nationalised banks-‐ existing mutuals should be given first refusal; convert back to building soc by government
→ Local banks: Removing barriers to entry; longer opening hours; shared infrastructure-‐ make use of that used by nationalised banks such as RBS; complicated process, long time to switch (6-‐12 months); pre-‐application support, clearer on requirements for start-‐ups; BofE report-‐ additional capital req.s for start-‐ups no longer apply and liquidity req.s reduced; possibility of setting fair price for access to payments for infrastructure or innovation of these systems;
→ Fair price option has most likelihood of success
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→ Core recommendation? Shared infrastructure-‐ government funding of infrastructure-‐ would be better if smaller banks didn’t have to pay larger banks to use infrastructure (as currently do).
∗ Discussion: Government currently privileging one kind of bank over another kind-‐ opposes free market? Doesn’t go against free market? Fact that smaller banks can’t even get foot in door means larger banks can do what want-‐ credit unions and building societies willing to help people-‐ can be done without damaging free market.
Free market doesn’t matter?? About the consumer? Have oligopoly anyway?
Question? Potential for building soc.s to venture overseas? Response-‐ important that don’t-‐ by not being allowed to exit UK makes more local and allows to specialise in UK market and major differentiating factor from big banks
→ All group in favour of shared infrastructure as core recommendation-‐ no objections.
3. Regulation
Recommendations ∗ Separating the retail banks from their investment counterparts
with no interaction between these two subsidiaries. This could stem from an initial stage of ring-‐fencing.
* Moving our retail banks towards a narrow banking system, whereby they must increase their reserve ratio and lend from other financial intermediaries rather than consumer deposits.
* The capital ratio requirement should be increased to 20-‐25%. This will benefit customers and the economy greatly by forcing the banks to manage their levels of risk better.
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* Introduce legislation that all banks must produce a living will by a certain deadline or otherwise be eligible to receive a penalty.
* Banks should have more equity and borrow less, so the equity investment will become less risky for the shareholders. Thus, the rate of return shareholders require is lower, making equity less expensive.
* Easier switching for consumers: greater transparency in the pricing of bank products and services to help them make informed choices from a diverse range of suppliers; publication of statements showing interest foregone on accounts; greater use of comparison websites.
* Relax barriers to entry for new bank entrants: lower capital requirements for start ups, being allowed to open with core capital at 4.5% of their assets; reduce time new banks have to wait for approval from one year to as little as 6 months.
* Restrict the size of the UK’s biggest banks by placing a limit on the funding banks get from sources other than traditional deposits and adding liquidity and capital requirements to make it more expensive and burdensome to be too big.
* The formation of a National Ratings Agency to regulate the market and provide impartial risk analysis.
* Promotion of increased investor analysis of financial security to reduce dependence on credit ratings.
→ 4 main recommendations:
1. Separation (complete separation of retail and investment counterparts)
2. Increase capital ratio (at least 15%) 3. Living Wills-‐ become more forceful-‐ legislation-‐ more compulsory
basis-‐ fines etc if don’t meet 4. Improve competition: more information-‐ more informed decision;
easier switching; removing barriers to entry for start ups
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5. National Ratings Agency
∗ Discussion
a. Creation of NRA-‐ risk involved: not only rating mortgages/corp bonds, also sovereign bonds-‐ if have NRA rating other sov debt, could create more trouble in bond market because-‐ response: DON’T RATE SOVEREIGNS; never really problem with rating of sovereign bonds, but financial packages where fell short of what should have been-‐ wouldn’t be dealing with sov debt
Because of model wrong/wrong assumptions-‐ why would NRA be able to make better model-‐ all brightest mind to private market to get higher wages-‐ public-‐ better model? Who would listen to this? Conflict of interest means not likely to go back to model to change it-‐ if top of ratings agency not going to change model-‐ just want to sell-‐ NRA don’t have same incentive-‐ issue= conflict of interest which led models to continue to fail
Reasons isn’t NRA= practicality-‐ cost, time, expertise required huge
Brightest minds won’t necessarily go to private sector-‐ have to pay public servants well! Issue= times of austerity! Paying relatively small sum of money to prevent even greater future crisis?!
CRAs central to cause of crisis-‐ conflict of interest an unsustainable situation-‐ something must be done-‐ not immediate, going to be gradual-‐ small initially, but at least a recognition that too important to be ignored/allowing those skewing ratings to carry on what doing.
Have got breathing space-‐ banks cautious before banks start taking excessive risks again-‐ recovered by then and can set up NRA
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→ ‘Public ratings agency’?-‐ needs to be international to work-‐ European Ratings Agency-‐ setting standards for other ratings agencies
Not intended to be direct competitor-‐ not ‘big 4’ but an alternative to make investors think.
Small ratings agencies no-‐one trusts-‐ NRAs would be the same?? Response: As long as generally believed and respected ok?; Can’t do as bad a job as one already.
Ratings works as visual image-‐ only if others think true-‐ would it est. general confidence?
→ Accept or reject? For-‐ 24, oppose-‐ 16à passed
b. Separation
Wouldn’t tackle issue of contagion-‐ issue contained solely to investment sector-‐ more about complexity of financial system. Not enough. Response-‐ common good-‐ protecting the consumer and the retail sector; idea is to protect consumer deposits, taking risks, throwing away money; retail banking not entirely innocent.
Point: how protect contagion? John: if convinced other points will solve issue, will solve contagion because= what banks fear of each other’s insolvency
Best way to tackle= making sure market complete to spread out risk-‐ banks spread out
Government thinks will solve the issue of contagion
Sam: does lead to solving contagion-‐ if separating contagion stops at investment bank rather than encroaching into retail sector-‐ restricting amount of players in market-‐ political benefits. Response-‐ not necessarily true because everyone fishing from same pool.
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→ Nobody opposed to first recommendation?
c. Capital ratio
Point: Not feasible-‐ if put up to 15% won’t get sort of lending like to see (John Sutherland proposed figure)-‐ response-‐ at least 15%-‐ at least can cover loans etc by using their equity-‐ method against necessity for bailout.
Accept suggestion-‐ lowering capital requirements for start-‐ups to increase competition
15% made up with treasury bills and how would enforce? Gary: over what period of time increase capital ratios-‐ if do really suddenly can be crippling for banks-‐ should be over really long period of time and across jurisdictions.
Sets out a principle.
Can’t just be on domestic scale-‐ may need to be international in implementation.
John: if have v thin capital base= v risky and have to pay v high return to compensate for high risk-‐ not quite such a serious problem.
→ Vote: For-‐ 27, Against-‐ 30: Vote= based on 15%-‐ don’t affirm-‐ everyone agrees should be increased in principle
d. Living Wills
No arguments against
Not a core recommendation
→ Approved
e. Competition
→ Approved recommendations
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4. The contradictions of capitalism
‘Recommendations’ Introduce more meritocracy/social mobility Education-‐ bridging gap between state schools and privates More jobs Companies more of social responsibility-‐ invest in local community etc
∗ Discussion
Oil, following publication of report, found in Brazil. Do we want to find any more? Seeing a relationship doesn’t mean causality. Narrowing gap b/ween state and private sector-‐ increase competition in education-‐ educational vouchers?? 5. How much of what bankers do has social value?
Statement-‐ banks do not create wealth, but facilitate the process of creating wealth. Have very important role in society-‐ shouldn’t throw every regulation at them: a. lobbyists, b. big picture-‐ as a total, a collection of regulations might not work.
∗ Discussion ∗ Facilitating creation of wealth in best possible way? Which
processes do create wealth/which don’t? Much of what do ‘socially useless’/what is socially valuable?
∗ An unregulated banking system would serve common good better than a regulated one?
∗ Lobbyists? ∗ Response: acknowledge that do have lobbyists-‐ rather than
throw 100 regulations at, few ideas as to how going to work. ∗ Group: G-‐S Act, firms under protection not ones that failed ∗ World changed-‐ banks given public money no longer have
autonomy over profit making-‐ strong moral argument that should work for common good if given autonomy to do so.
∗ Point: Increase securitisation; increase CDOs-‐ however should ensure that; banks often securitise without MBS-‐ efficient market hypothesis-‐ should diversify-‐ securitisation form of diversification-‐ yet means securities have to be given to everybody-‐ problem= circulating among same players all the
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time, so need diversification. Comment: Highlighting lack of accountability. Response-‐ not highlighting, but assets not allocated properly
→ Statement: More transparency in securitisation, whereby can break into smaller chunks.
6. Incentive system
Proposed solutions: 1. Government control of banks?-‐ bad idea-‐ lose competitive edge-‐
gov run banks inefficient. 2. Ceiling for bankers’ bonuses-‐ not best way forward because of
global market-‐ would move abroad where isn’t restricted 3. ‘Credit Suisse’ method-‐ took millions of toxic assets/products
traded and sold bankers accountable for; more of a retrospective solution-‐ next crisis not same root causes so wouldn’t help reduce risk against bailouts overall
Group’s Solution: ‘S-‐Curve’-‐ performance metric along the bottom (return on investments, profit etc, risks take, customer satisfaction etc), vertical= bonus payout. Diminishing returns to risk-‐ more risk you take no more bonus-‐ not worth taking risk to bankers themselves. Holdback mechanism (similar to ring-‐fencing); reinvest bonuses in bonus securities; will result in bailout fund to bailout in future financial crisis-‐ bankers can’t touch-‐ not such a burden on society-‐ incentivise people to think long-‐term because only get pay-‐out in long term and if need bailing out, got security Conclusion: Global implementation Pressure on banks, particularly from public Ethics and mind-‐set of financial industry must change
∗ Discussion ∗ How give banks sense of urgency? ∗ Lower bonus but high starting salary?
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∗ Why bankers paid so much money? concerned with money-‐ temptation to scoop into pocket. Proposal-‐ bankers will find a way around it? If no limit, bankers may go elsewhere where can get bigger bonus.
∗ Should gov. try and restrict quantum bankers paid? Maximum salary?
∗ Cash-‐scheme-‐ banks require pool of cash-‐ will allow banks to draw from.
∗ Don’t need to pay huge bonuses to do good job-‐ doesn’t improve performance
∗ Governments shouldn’t put restrictions on bankers’ incomes. ∗ Wouldn’t want people to stay here who do so just to hold onto
their £10 million/year ∗ How do we legislate??? ∗ Got to come from within
→ Holdback mechanism accepted as recommendation → Principle of limits/maximum income? → In favour of principle of maximum income: 10; lost by massive
majority
Plenary session 13/06/13
→ Principle agreed: Government should take certain practical steps to promote social value and material wealth-‐ process of intervention. In past have left too much to free market. Need to privilege certain activities over others.
Micro and social finance Micro finance-‐ recommendations:
→ Should be promoted and developed in UK → Partnerships between microfinance institutions and banks
essential: provision of finance to microfinance institutions from the 4 largest banks as well as an increase in the exchange of info between these organisations
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→ Banks help to improve financial literacy-‐ schools and Universities directly: interns into schools/Unis to deliver workshops-‐ CSR or separate scheme altogether-‐ low cost, loss risk way to serve common good without lending to risky clients themselves. Legislation to ensure transfer between banks and microfinance schemes so that vulnerable consumers not caught out
→ Gov promote and advertise microfinance e.g. microfinance ‘mark’ that can be awarded to banks supporting the industry-‐ recognition that banks have invested in the sector; lead to greater investment in microfinance sector
→ The full potential of several existing organisations to stimulate growth in the SME sector could be realised through the introduction of certain incentives. Could include an increase in tax relief made available to organisations investing in smaller, socially focused enterprises (currently 25% investment made over period of 5 years), and striving to widen the scope of investment for institutions such as the BGF (Business Growth Fund)-‐ invest in smaller but still financially competent institutions
Social finance-‐ recommendations: Enhanced regulation of social enterprise institutions-‐ even if just mention Express social motives rather than purely financial ones Suitability assessments and social goals-‐ currently legal barriers, leading to perception that social investment too risky-‐ been excluded altogether
→ Reform current financial services regulation → Creation of a Social Enterprise Industry-‐Wide Index → Tax breaks to banks to encourage participation in the sector → Government support in the development of innovative products
in the social finance sector
Project Merlin-‐ between 5 main banks and UK government-‐ should be reconsidered-‐ overall lending much less than expected but SMEs, banks failed to meet target-‐ called a failure. Decline in borrowing due to lack of confidence, interest rates too high and need for better information. Reconsider PM (valid solution) but better structure which allows more clarity e.g. lending targets not clear
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Target small firms in partic-‐ micro finance a good alternative-‐ targets SMEs Education: Gov provide financial courses and experts from social finance sector; older generation-‐ info from home; high street festivals-‐ targeted customers with ability to invest, tell benefits will get from. Conclusion/summary of recommendations:
• Extension of The Social Value Act • Gov support development of innovative products • Reconsider PM • Education
∗ Discussion: Need to fund SMEs and social value-‐ how define it? NO MEASURE OF SOCIAL VALUE-‐ only offers encouragement/motivation to sector. Encouragement on one hand and incentives on the other-‐ which do the group favour? Micro finance-‐ incentives (tax breaks etc); and education
What is social investment? Provides social returns as well e.g. Tomorrow’s People 2004-‐ helping re-‐offenders-‐ lowered rate and with it government expenditure (£500,000); getting people to invest in more ‘socially worthwhile’ schemes
Government measures-‐ each investment will set targets e.g. prison scheme-‐ reduce re-‐offending by certain %-‐ then government gives financial return to investor
Problem= how apply micro credit? e.g. Bangladesh, once have money start paying next week-‐ once start paying, whatever credit get doesn’t get to be used in productive manner because have to start re-‐paying loan straight away
Micro credit is exclusive: principle= we collaterise debt obligations; in this market, would you ever invite someone you don’t know-‐ always going to be the same people receiving micro credit-‐ based on trustà need to think how going to implement/structure
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→ Need to set out which group thinks most important
Business ethics → Statement-‐ if could have better level of business ethics, could
have helped to prevent financial crisis
Recommendations: ∗ Education-‐ compulsory course lasting a day, focusing on
educating University students on business ethics ∗ Behavioural ethics ∗ Public sector-‐ Public Interest Disclosure-‐ disclose illegal
behaviour-‐ yet does not prevent employers hiding malpractice of employees in previous work; still subject to libor:
o National business day-‐ one day event, people can be reminded/informed of business ethics
o Watchdog: zero tolerance and name and shame-‐ must ensure all unethical behaviour is addressed
o Whistle Blower Protection Act
∗ Discussion-‐ extent to which business ethics embedded in everything do/employees in an organisation-‐ should be part of everything? Makes it seem like an ‘add-‐on’. Response: harder to implement? Different gradients as to how to vote on-‐ One-‐day course? Every student compulsory 15-‐ credit course? Additional desire to see ethics embedded in courses?
Enough naming and shaming as there is-‐ encourage gov to pick on people even more than already do. Response: has been very effective naming and shaming e.g. exposing tax scandals-‐ sets ethical standard-‐ companies have had to react. Regulation not enough-‐ with development of ethical practices, could be very powerful.
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WBPA-‐ in practice difficult to distinguish between those really want to protect and those who really set themselves up as a whistle blower.
Issue of culture-‐ he/she getting away with it-‐ requires a feel-‐good factor
Watchdog for name and shame-‐ who? don’t want destructive vigilante. Political party? Response: Parliamentary Committees naming and shaming those who evade tax?-‐ positives outweigh potential negatives-‐ effects cultural shift.
Government honours to reward ethical behaviour. Response-‐ taking honours away a strong ethical signal?
Should be expressing our values as a society-‐ which mechanisms have to do so? Honours system
Compulsory one-‐day course: 20; shouldn’t: 5
Compulsory 15-‐credit module on ethics: 18; shouldn’t: 19
Ethics embedded in courses: passed unanimously
Financial literacy Recommendations:
• Increase amount and quality of advertising for free and low-‐cost sources of financial advice
• Government should play active role on targeting specific groups identified as having low financial knowledge
• Introduce Saver-‐Plus scheme through partially owned state bank • Financial education should become compulsory part of
curriculum-‐ theoretical and practical
Discussion: CAB-‐ a lot of people who will not ‘get it’-‐ financial literacy places responsibility on the individual-‐ is a power relation between vulnerable individual and loanshark lending at rocket high interest
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ratesà unrealistic that education will make 100% financially literate population. Emphasis should be on responsible lending not responsible borrowing. Response: addressing early on will help improve financial literacy. Exactly why should promote alternative forms of lending such as Credit Unions-‐ pay-‐day loans with capped interest rates. OVERLAP. Education key-‐ will eventually filter through whole population. Can financial literacy be a substitute for regulation? Citizenship due to be introduced 2014? Government should ban certain kinds of financial advertisement?
→ All of recommendations approved
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