The financial crisis of 2007 have made a huge effect on UK economy, the current UK debt is almost five times its GDP. (Turner Review, 2009) The current crisis has exposed number of weaknesses in the banking system. Banking plays a major role in UK in 2007 it contributed £58bn to the UK economy, equivalent to 4.7% of GDP and employs over a 435,000 people. (www.ifsl.org.uk) Major financial institutions in UK such as RBS, Lloyds, Northern Rock were bailed out from failure by massive government support scheme, costing £900bn of tax payers' money. There were number of causes which led the current financial crisis such as, overdependence on securitisation, complex derivative market, regulatory issues, credit ratings, remunerations etc. It could be argued that banks ignored number of risks it was exposed to and gambled with people's money. Plenty of weaknesses have been uncovered in the functioning of the bank, so to develop a stronger banking system, banking commission is established to give recommendation on building a strong banking system.
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As per the Basel Accord only keeping more capital aside wouldn't be enough but need to develop a sustainable banking sector. The banking commission has given recommendations in three broad areas i) The reform to Banking Structure, ii) New approach to Regulation, & iii) Ethical Framework. We will look into all three areas in more detail and point out the recommendations
Reform to Banking Structure:
Banking changed dramatically in 1990's & early 21st century. Historically it was a straightforward business of collecting deposits and lending to borrowers but this traditional business has almost disappeared and many have argued that current banking products have become more complex, expensive, & risky from time to time. Banks which were seen as service providers are more seen as a casino bank where people's money are gambled. Increasing customer complaints, higher service charge, expensive interest rates, overdraft fees, complex products, etc. are some of the glooms that customers have shown towards bank. There are some recommendations given by the banking commission to develop a stronger banking structure, such as resolution regime, protecting depositors, formal separation of banking activities, breaking up investment banks, & derivative trading. These look good and promising to develop a stronger banking structure but yet there are some implications to the above such as protecting the retail depositors up to £50,000 by financial service compensation scheme. This could be argued that it could in fact motivate the banks to do risky business, as the depositors would be protected and banks would enjoy a free cover for its depositors. The other shortfall been that the customers could be mislead by banks saying all its products are protected under financial service compensation scheme, so it is important that clear signs are placed throughout and in bold letters to differentiate the products which are protected and which not. The other recommendation given is 100% guarantee on certain deposits which are invested only in safe assets, this scheme would currently develop a confidence in market, motivate to trust on banks again, reduce systemic risk, and bring investors to deposit their money into banks again, but it could be argued that from recent financial crisis a huge sum of tax payers money was used to bailout the troubled banks and buried UK in 5 times debt, so in future when there would be another banking failure more debt and more tax payers money would be eroded with this scheme.
The other recommendation been given is formal separation of banking activities. Huge banks which are diversified into different business should be split into three core categories, i.e. retail banks concentrating on traditional business of looking after deposits and making loans, corporate banks providing services to corporate of mid size and above, finally the investment bank concentrating on activities as advising corporate, government and financial institution. By this the depositors would be protected from other riskier business, but Lord Turner have shown discomfort to narrow banking, saying 'breaking up of banks is not feasible'. Jon Danielsson says 'narrow banking is a bad idea because universal banking is no riskier then narrow banking'. the separation of banks would protect the depositors, lower the risk for retail banks, would be able to manage cultural & ethical standards, increase transparency, increase competition, easy entry for new entrants, & easy to manage, but it has some drawbacks as well such as, banks wouldn't benefit from economies of scope & scale, it would limit the growth, separating banks would require close supervision by regulators, it would be expensive as it would require different preparation of accounts, auditing, etc, investment banks will have to rely more on secondary market to raise money then to use the deposits from retail bank, it would be a lengthy process, limit utilisation of resources, could be confusing for shareholders, and could be implied that if in future if we have a similar crisis to recent then investment banks would collapse first because of the nature of its business, and retail bank would remain stronger, so to save these investment banks there would be no other option then to take over the investment bank. So depositors money could be used for takeover, so it could all turn to be the same at the end.
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The other reason to current crisis was the derivative trading, derivatives is the other mechanism which banks use for raising funds & defraying risk. Due to its complex nature and risk involved many banks collapsed and were exposed to systemic risk. There are three common type of derivatives Forward & Future, Option & Swaps. Banks use different types of derivatives to reduce risk and protect from losses. Number of recommendations is given to use of derivatives as, all securities above a certain size shall only be tradable if registered under stock exchange daily official list (SEDOL), investors, Speculator & traders to disclose material position in a company, whether held as a stock, option or other derivatives; the price and volume of all securities and derivatives trades should be known when the trade takes place, thorough & ongoing review of these developing practice. The other recommendation that could be added is investors to accurately calculate the risks involved & accordingly set the capital aside to meet any losses. Many companies like Barings, Daiwa, Natwest Markets, Allied Irish Bank, and many other have suffered huge losses.
To the above recommendations given by commission a number of suggestions could be given like charging banks for underwritten services, or in good time's banks to hold capital buffers with central bank.
New Approach to Regulation:
From the current financial crisis a number of regulation issues have been uncovered by the commission. Some issues such as lack of competition, ineffective market, customer dissatisfaction, higher prices, complex products, poor quality, etc the commission argues that the current financial regulator is ineffective and cannot prevent from any future financial crisis; it is very generous and inefficient. We need regulation which could develop a stronger financial system, be competitive, consumer protected, & without putting taxpayers at risk. A broad consideration is given to redevelopment of financial regulation. Commission has given recommendation in three different areas, 1) Consumer protection regulation, 2) Prudential Regulation, & 3) Systemic Risk Regulation.
Consumer protection Regulation: From the current financial crisis it is argued that the financial regulators have loss focused on consumer protection. It is been argued that the customers do not have a clearer understanding to the financial products, financial risk, terms & conditions, non protection to failure, overdraft fees, poor advice, asymmetric information, etc are some signs that were seen from the recent crisis. Number of recommendations are given to protect consumers, such as customers to easily transfer products and accounts, not to overcharge on overdraft, set default settings to customer best interest, allow customers to choose on unauthorised overdraft, not to take advantage of existing customers, full and transparent disclosure on all products, simple and easy to understand terms & conditions, prohibit commission structures which incentivise mis-selling, and to prevent obscure charges, or unfair asymmetrical contract terms.
To the above recommendation there are some implications which could be made are the protecting customers from mis-selling by prohibiting commission structure, it could be implicated that products could yet be mis-selled as every bank wants to increase its sales, & make more profits, so senior managers could pressurise by giving targets, using different sales techniques, if not motivating sales staff by commission then motivating by promotions, awards, etc. so it is important that the culture of a bank is so developed that it gives a fair and true advice on it products, disclosing any charges, fees, adverse effect that a product may hold. The other way to protect consumers is by educating the consumers about their power, their rights, and by conducting regular surveys on their satisfaction on different products and services, regulator to check on survey results and banks which have higher rate of customer complaints and dissatisfaction to be fined and instruct on product simplification.
Prudential regulation: The aim of prudential regulation is to develop a safe and sound financial system. Under the new prudential regulation no institution would remain 'too big to fail' it would break up the institution so there would be no contagion, systemic risk to the highly interconnected financial sector. The other step it would take is to protect ordinary depositors, by putting basic deposits above all other creditors in liquidation preference, it would ensure all essential service are provided by the institution. It is been argued by the commission that capital adequacy and accounting standards such as Basel II, had created perverse incentives for banks to 'game' the rules and increase their leverage to the maximum permitted levels. It is argued that increase in regulatory supervision or increasing the capital adequacy is not the solution to the problem, it could be helpful to some limit bu the main solution is to the banks itself to manage the risk. Other recommendation that could be given is if the banks want to make any risky investments then it has to be approved by shareholders, and for this banks need to simplify the shareholders voting procedure, such as online voting. The other implication could be that according to Basel III recommendation banks will have to hold more capital but this could be argued that it would reduce the shareholders returns and could make difficult for banks to raise money.
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In previous chapter we have looked into development of structure and regulation of the banking industry but the two are not enough and would not work strongly until the overall culture of the business is right. An appropriate culture is essential for successful banking system. The institute of operational risk, (2010) says "a firm's organisational culture it values and valued behaviours will under pin the risk culture, the openness, trust, honesty and integrity form a strong risk culture of an organisation". The commission recognises cultural change is difficult to bring about, and cannot by its nature be accurately prescribed. There were a number of failures to crisis like, Non executive directors, auditors, credit rating agencies failed to alert, NED's not performed their duties well, commission and bonuses motivated agents and directors to take excessive risk and sell flawed products. Commission recommends some changes on culture and corporate governance. It recommends that NED's should make a greater use of their powers to independently appoint adviser to assess risk and spend more time on their job. NEDs should regularly develop their self with the changing business and work in best for the customers favour. It is been argued that remuneration & bonuses to the bankers is far too much compared to other services provided which motivates to short-term profits by taking long term risk. It is noted by bank of England that if the payouts to staff had been trimmed by 10% over the period 2000 to 2007, the UK banks would have retained an additional 50bn capital. Commission recommends that rewards for senior executives should be for longer-term service and must be given on creating long-term shareholder value over a 5-10 year period. Rewards to seniors at retail banking must be given on overall customer satisfaction, complaint levels and their fair resolution. Commission or bonus should be received on customer satisfaction and fair resolution of complaints. Banks need to develop a culture where it thinks about its customers first and then about everything else. As recommended by the banking commission " if the banking sector is to win public confidence then it needs to change from being seen as self interested industry, to something more akin to a profession.
From the current crisis government has become the largest shareholder in the UK banking system, by holding stake in Lloyds, RBS, & Northern rock, government should work to ensure the system is sustainable, and in interest of long term shareholders, creditors and customers. The government will need to sell significant stakes of the banks at the highest possible price for the taxpayer, with a need to promote competitive banking sector. The other recommendations are given on corporate governance accounting and auditing. Accurate, clear financial reporting and auditing of banks is crucial to the stability and integrity of the financial system. Accounts and audits are the first alarms, but in current financial crisis it failed to alert the oncoming crisis. The recent crisis highlights the importance of accurate accounting practices, and auditors to provide a comprehensive, true & fair report. It is argued that auditors failed to report the higher levels of risk and leverage. There should be reinstatement of law that accounts represent true and fair statement of the position of a company and any risk it is exposed to must be clearly mentioned in the statement. Auditors to give true and fair statement company affairs, and report all significant risk factors that come to their attention. The other recommendation that could be given is to regularly give training to auditors to better understand the company risk, their effects and future impacts it is expose to. Independent internal auditors to be selected by the NEDs who regularly audit the company accounts, process, system, risk exposure and could independently give any recommendations for the best of the company.
The other criticisms made are of credit rating agencies (CRA) as there were number of flaws to their operation. The CRA are paid by the debt issuer and not buy the company who is buying them so it could create a huge conflict of interest. Recommendations given by Lord Turner "CRA should be subject to registration and supervision to ensure good governance and management of conflicts of interest and to ensure that credit ratings are only applied to securities for which a consistent rating is possible" other recommendation is CRA to be audited. The other recommendations could be given to develop a strong culture is to develop a code of conduct for the banking industry. Every person directly or indirectly connected to a bank so banking development is essential for country's prosperity. Banks need to develop a culture which encourages fairness, prudence, sustainability and positive contribution to society. Developing a right culture wouldn't be possible without support from the senior authority, so compulsory formal ethical behaviour training should be given to all bankers.
So in this paper we have aimed to give a number of recommendations which could be best to reform the banking and to protect it from any future crisis. It would take time to implement all the recommendations but of all the principle changes that need to be allied is to develop a stronger banking structure, then improvements in regulatory system, and the development of the culture. But most important would be to create a competitive market, by consumer protection, openness to financial products, remuneration policy, removing commission on sales, giving bonus to directors on longer-term profits and on customer satisfaction, and conducting regular surveys on consumer satisfaction.