Bad Banks: Greed, Incompetence and the Next Global Crisis
By Alex Brummer
Almost every sector of society was affected by some aspect of the misfiring banking system, whether it be the sale of payment protection policies by Britain’s high-street banks to hapless consumers, the reckless gambling in futures markets by the world’s most powerful bank, JPMorgan Chase, or the discovery that it was not just Libor that was being rigged but the foreign-exchange markets too. Even those banks that appeared immune to the crisis, such as Britain’s Asian-facing institution HSBC, found themselves in trouble over wrongful activity in areas of the world that stretched from Mexico to the Middle East.
This volume is intended to trace the battles since the financial crisis – many of them unfinished – and to remind readers of the depth of depravity that at times gripped the system. I find it personally remarkable, for instance, that some six years after Halifax Bank of Scotland (HBOS) all but collapsed an official forensic report into events still remains unpublished.
In terms of scale the scandal at the Co-operative Bank has been minor league compared to the bill of £18 billion for wrongful selling of payment protection insurance by all the high-street banks, the money-laundering fiasco at HSBC, and Libor rigging by Barclays. But the elements that make up the scandal are worryingly reminiscent of other banking disasters in recent years, and demonstrate that in this sector at least history had – and still has – a habit of repeating itself.
If there was too little introspection on the inside, there was also too little scrutiny from the outside. Such was the desire of successive governments to see a problem ‘fixed’ or an opportunity ‘taken’ that decisions were all too often made swiftly and unquestioningly. In such an environment, the regulators proved insufficiently strong to call a halt at pivotal moments
One might have thought that the banking sector would have put its house in order in the aftermath of the meltdown of 2007 and 2008, but recent years have seen scandals that range from efforts to rig the Libor interest-rate market, money laundering and wrongfully selling retail customers insurance products that they didn't need to massive losses run up by individual rogue traders. Every day, in fact, seems to bring news of a new crisis or instance of questionable behaviour.
Seven years after the credit crunch that brought down Northern Rock and more than five years after the Great Panic, the worst financial crisis for a century, the banking system and its regulation – both at home and overseas – are far from being fixed. The questions are why this should be so and what can be done.
If there was one bank that exemplified both many of the causes and most of the consequences of the recession, it was the Royal Bank of Scotland. Over three decades, the City of London and the financial services industry ballooned until the size of its assets reached 400 per cent of the UK’s gross domestic product (GDP). Over the same period RBS grew from a provincial Edinburgh bank to being – briefly – the largest bank in the world with a balance sheet in 2007 worth £2 trillion.
The Royal Bank of Scotland is far from being the only British bank where management ambitions of greatness have overwhelmed the ultimate interests of investors, consumers and the majority of the workforce. HBOS, the bank carved out of the 拢30 billion merger of the former Halifax Building Society and the Bank of Scotland in 2001, offers another forceful case of hubris getting the better of prudence. Indeed, in some respects, its fall from grace is even more shocking in terms of the circumstances and decisions that finally led to disaster.
Just how appalling the state of the HBOS loan book had become when the credit crunch bit did * not fully emerge until the Parliamentary Commission on Banking Standards reported in April 2013. Its study, the first serious analysis of the events leading to HBOS’s implosion, concluded that the quality of the loans HBOS made were so bad it probably would have failed even without the financial crisis. To that extent therefore it ‘was an accident waiting to happen’.
Britain’s banking system in 2008 and 2009 resembled a battlefield littered with the wounded and fallen. RBS and HBOS were the most notable victims. But along the way a number of smaller institutions, including buy-to-let lender Bradford & Bingley, Alliance & Leicester and the Dunfermline Building Society, all but vanished from the nation’s high streets. No bank was spared.
Ironically, one of the cures proffered for the catastrophe of 2007–9 was more of the medicine that had helped to cause it.
The varied approaches across the Western world to the crisis largely reflected different cultures. In the United States, after some initial fumbling, a can-do attitude was adopted by the federal government. Its North American neighbour, Canada, with a less buccaneering culture, was one of the few Western countries to avoid the banking implosion. Its record of stability in the eye of the financial storm was a key factor in propelling the governor of the Bank of Canada, Mark Carney, to the Bank of England in 2013. As for Britain,muddling through ultimately proved the chosen path, as the various authorities and individuals responsible for putting things right mixed firm action with deeply hedged compromises, second-guessing and much fruitless hand-wringing.
Europe, meanwhile, took its own, very individual path, and in so doing was to find the going very bumpy indeed.
When the bubble burst in 2007 it seemed initially that the eurozone was going to escape relatively unscathed. The focus of attention was on the disasters at such UK institutions as Northern Rock, the Royal Bank of Scotland, Lloyds and HBOS, and on the failings of American banks Bear Stearns,Merrill Lynch and Citigroup and the fractures at Goldman Sachs and Morgan Stanley. But if some hoped that this represented a triumph of more tightly regulated European finance over the laissez-faire Anglo-Saxon model practised in the UK and the US, they were to be disappointed.
The European credit boom had inflated real-estate bubbles in countries as far apart as Ireland and Spain that would prove as devastating as those in Britain and the US, if not more so.
Soon Athens found that it had no choice but to seek a rescue and the European Commission and ECB sought the assistance of the International Monetary Fund as an enforcer. It was the first time that the IMF had been invited onto European soil since the 1976 sterling crisis in Britain.
Ironically, until the credit crunch hit in 2007– 8, Ireland – the Celtic Tiger – was seen as euroland’s miracle economy.
In one glorious year, 2006, some 93,419 houses were built, more than three times the number a decade earlier. Lenders had embarked on an ambitious, uncontrolled and too often fraudulent spree of real-estate financing, much of which had no prospect of ever being paid back.
When it all came crashing down after the collapse of Lehman Brothers in September 2008 the true weakness of euroland decision-making was revealed.
In the years following the financial crisis of 2007–8 the Dutch banking system was all but wiped out. Some of Europe’s oldest banks in Italy and Switzerland came to grief. Spain’s banking system demonstrably proved a basket case. The same reckless, greedy and bonus-obsessed culture that placed bankers in the rogues’ gallery on the high streets of Britain and the main streets of the US had spread far and wide.
The risk for the UK was that Spain’s banking meltdown, like that in Ireland, could become very expensive for British taxpayers.
By the end of 2012 it must have been hoped that the worst of the crises in the eurozone were, if not over, at least being addressed. Ireland had accepted the harsh terms of the IMF-led bailout and the shock treatment was starting to work. Spain’s reorganisation of its banking system was starting to show some signs of success. But just a few months later, in March 2013, a new storm appeared on the horizon – and from a country that had not previously appeared on commentators’ radar. Now it was Cyprus’s turn to go into meltdown.
When Greece became the first country in the eurozone to go bust in 2010, Cyprus was immediately drawn into the crisis. The island had bought more than €4 billion of Greek debt and the banks had lent Greek companies €22 billion, more than the entire Cypriot €18 billion GDP. *
Cyprus suffered its banking crisis because it had no coherent national policy to handle its booming banking sector and failed to restrain the banks as they seemed to be ‘doing a good job’.
The Cyprus crisis, like those in Greece, Portugal and Ireland, demonstrated that policymakers do not treat all euro countries as the same.
But this two-tier thinking does not mean that the problems of Europe’s banks were – or are now –confined to ‘peripheral’ economies. Right across the eurozone, nations and their banks became locked in a drunken embrace (or what economists call a ‘doom loop’).
In just five countries – Greece, Ireland, Portugal, and most importantly Spain and Italy – banks hold an estimated €3 trillion of their government’s sovereign debt. It’s a house of cards that only the slightest of breezes could bring down.
A huge and present danger to Europe’s banking system is that many institutions have yet to acknowledge the bad loans and debts sitting on their balance sheets or to tackle big shortfalls of capital.
In other words, what is keeping the eurozone afloat is as much wishful thinking as economic reality. If one country can be said to embody both the wishful thinking and the huge problems still lurking in Europe it is Italy.
The 2014 crisis in Ukraine, for example, may well prove to cause not just a geopolitical but an economic crisis. Germany, after all, buys almost half its energy supplies from Russia and can ill afford an all-out economic dispute. This would be a concern even in times of strong economic growth. With the eurozone still weak, such shocks can all too easily prove seismic ones.
If the global economic landscape was transformed by the fallout from the banking crisis of 2007–8, the nature of the banks themselves showed remarkable resilience. Some banks might have crashed. Some might have had to make heavy cuts to expenditure and staffing levels. Some might have had to accept greater outside involvement, particularly from governments. Individual bank bosses might have been fired or replaced. But more striking than these changes was the remarkable continuity of the pre-crash banking culture.
Even when the financial crisis and recession were at their deepest, in the period 2008–10, and thousands of bankers and City workers lost their jobs, bonuses were the cash machine that never stopped paying out. Indeed, when regulators across the globe sought to curb the sense of entitlement among the bankers, the banks simply found ways to circumvent rules and guidelines. The contrast between the fat rewards in the finance industry and the misery of austerity and lost jobs for the majority of the population was the trigger for the Occupy Wall Street demonstrations that sprang up spontaneously in New York City’s Zuccotti Park in September 2011 and with the help of social media spread to the steps of St Paul’s Cathedral, in the City of London, and the rest of the world.
At the Royal Bank of Scotland Stephen Hester’s bonus levels caused enormous embarrassment to the Coalition government and played a part in the political pressure that ultimately led to his departure in 2013. At Lloyds Banking Group the chief executive Antonio Horta-Osorio picked up a £1.7 million bonus despite his bank having to pay out billions of pounds in compensation for mis-selling of payment protection insurance (PPI) and poor sales practices.
More than three years after the collapse of Lehman Brothers there was no indication that bonus structures which incentivise employees to take irresponsible decisions had been curbed, despite barrowloads of new rules and regulations intended to act as fail-safe devices against risky trades.
Over a three-year period JPMorgan went from saint to sinner, paying in total an astonishing $28.7 billion in fines. JPMorgan’s recent record has been a depressing one for that most blue-blooded of all American financial houses. But it’s also not a unique one, and it shows how little banking culture has moved beyond the dark days of 2007 and 2008.
The transition from crisis to repair offered the banking industry a profit and bonus opportunity. Lawmakers and regulators were still catching up with the public mood and were distracted by the need to build new structures, establish stronger rules and improve the quantity and quality of regulation. It was in this atmosphere that the bankers and traders played a game of regulatory arbitrage, finding the weaknesses in the system and exploiting them with scandalous and disastrous results.
Up until May 1997, when New Labour made the Bank of England independent of government, it had been customary for the governor of the Bank to keep a wary eye on the bankers.
If the financial crash of 2007–9 revealed real shortcomings in the way banks handled themselves, the Libor scandal of 2012 that brought Diamond down suggested that they had learned few if any lessons. More than that, it showed the risks inherent in high-street banks that had become investment giants.
While the technicalities of the London Interbank Offered Rate are complex, the underlying principle is simple enough. Libor, whose origins date back to the 1960s and 1970s, is the benchmark interest rate that banks use to set the cost of major market transactions.
In other words, the Libor rate determines the cost of borrowing for almost everything from what the largest businesses pay for loans to what families receive for their savings.
For such an important number, the Libor rate is calculated in a surprisingly unsophisticated way.
The rate is not formally supervised by any national authority – so it is entirely in that sense free-market – and herein lies a core weakness.
As a result, a rate brought in to ensure an independent and impartial process for the handling of unsecured loans by banks is open to manipulation. And, almost inevitably, that is precisely what has happened.
It should be noted that Barclays were not the only offenders.
US and UK regulators established, for example, that at RBS ‘misconduct was widespread’, with over 219 documented requests to fix the rate and ‘an unquantifiable number’ of oral requests.
Given how widespread the abuse appears to have been, it may seem surprising that when the scandal started to hit the front pages Barclays should have come in for particular criticism.
But Barclays suffered most because they owned up first.
This was a perfectly sensible decision on the face of it, but it was one that backfired.
At a stroke Barclays found that it had become the lightning rod for all that was perceived to be wrong in the financial community. Diamond himself became a target for criticism, not least because he was so well paid: during his tenure at the top he amassed 拢100 million in pay and perks.
Just 24 hours after Diamond was eased out of Barclays, and on a day when he should have been celebrating American independence with his family, he appeared before the Treasury Select Committee.
But Diamond also had his own bombshell to drop. In the course of questioning by MPs he recalled a phone conversation he had had with Bank of England deputy governor Paul Tucker on 29 October 2008.
Just a week after regulators had uncovered the rigging of the most important number in finance, Diamond was now saying that the central bank, backed by government, had told Barclays to manipulate its submissions as far back as 2008.
Chancellor George Osborne saw a chance to make some political mischief at the expense of his Labour predecessors. He claimed that ministers in the previous Labour government, including Ed Balls, now Shadow Chancellor, were directly involved in the Libor scandal.
Barclays was not alone in seeing the need for a moment of self-examination.
Prime Minister David Cameron announced that a review would be undertaken to demonstrate and ensure that the UK had the ‘toughest and most transparent rules of any major financial sector’.
All too often governments set up commissions to kick awkward issues into touch. If that was the hope here, it certainly didn't work.
The commission’s 600-page report, published 11 months later in June 2013, looked closely at the events and personalities involved in the Libor scandal, and came to some radical conclusions.
Part of the answer, it argued, was to introduce a new law to make it a criminal offence to engage in ‘reckless banking’.
The new banking act, which made reckless banking an offence carrying a seven-year sentence, was passed in December 2013 and came into effect in the spring of 2014.
So far as the acronym at the core of the scandal was concerned, Chancellor George Osborne asked chief executive of the FCA Martin Wheatley to look at what should be done about Libor itself.
In June 2013 it was announced that the future administration of and trading on the Libor market was to cross the Atlantic and become the responsibility of the New York Stock Exchange Euronext.
At one level, it looks as though the Libor scandal is now a thing of the past and that lessons have been learned. Offending banks have been fined. Individuals have been held to account. Libor itself has been overhauled and new regulation put in place. Doubts, however, remain about the underlying nature of a sector that could have allowed this to happen.
For his part, Mervyn King had no doubt that the Libor market was totally dysfunctional, particularly during the chaotic aftermath of the collapse of Northern Rock in September 2007 and Lehman Brothers a year later in September 2008.
Even so, although the Bank of England was aware that Libor had become a meaningless number, no one had reported to it on what were later deemed to be illegal actions.
What emerges from all this is a sense that key people knew that Libor wasn't working, but that no one thought to look under the bonnet to see just what was going on.
In other words, people in authority might have been suspicious but they also didn't want to know. And those who were perpetrating the manipulation of Libor must have known that what they were doing was at the very least questionable, but they carried on doing it anyway.
Given all these various misdeeds, the usual mantra that is used on such occasions – ‘Lessons have been learned’ – rings a little hollow.
The fact is, though, that while both HSBC and Standard Chartered rarely troubled the headlines in the tumultuous years of the credit crunch, in 2012, just as the furore of the financial crisis was starting to fade from view, they both found themselves directly in the line of fire. After lengthy and painstaking investigations, US regulators decided to fine the two institutions $2.6 billion. Unlike their rivals they were not found guilty of manipulating Libor, rigging the foreign-exchange market, issuing dodgy products, or indulging in questionable off-balance-sheet enterprises. Instead both were found guilty of offences that seem on the surface a thousand miles away from normal international commercial banking operations: money laundering and sanctions busting.
The State Department reported that by 2012 drug gangs were laundering ‘as much as $39 billion’ a year through Mexican and US finance houses.
2012 proved to be HSBC’s annus horribilis. In February the firm revealed in its annual Securities and Exchange Commission filing in the US that it might face ‘significant’ penalties from a number of US regulator investigations that were coming to a head.
The timing could not have been worse for HSBC so far as media attention in the UK was concerned. It was the same month that Barclays, Bob Diamond and the Libor scandal all made the headlines. Banks were very much back under the spotlight.
On the same day the subcommittee issued a coruscating report on HSBC. It accused the bank of being a conduit for ‘drug kingpins and rogue nations’ in Mexico, Saudi Arabia and Iran, among others, from 2001 to 2009.
The subcommittee’s reference to Saudi Arabia and Iran show that Mexico was not the only country to be giving HSBC a headache, and it also provides a hint of just how tricky global compliance can be for a bank of HSBC’s size and complexity.
Mexico presented one very particular set of challenges, Saudi Arabia and Iran a completely different set. In Mexico the challenge was drug trafficking. In Saudi Arabia and Iran the challenge was terrorism.
As if Mexico with its drugs cartels and the Middle East with its political turmoil weren't enough of a headache for HSBC, it also found itself in hot water in the unlikeliest of countries: Japan.
Senate subcommittee had no doubts about what had been going on. HBUS, it concluded, ‘enabled a number of Russians engaged in suspicious activity to use a relatively small Japanese bank with weak AML controls to gain access to over $290 million in US dollars in less than four years.’
In 2005 chairman Stephen Green robustly defended the bank against allegations, in a Bloomberg article, that the bank was involved in money laundering for Iran and other Middle Eastern countries including Libya, Sudan and Syria.
The Senate subcommittee that looked into all this, though, came to a rather different conclusion. In addition to activities in Mexico, Saudi Arabia, Iran and Japan, the subcommittee also found that HBUS carried out transactions for a number of countries against which America has a sanctions programme. These included Cuba, Sudan, Burma and North Korea. In 2012 HSBC agreed to pay US regulators a $1.9 billion fine in settlement of the money-laundering charges – a sum four times that levied on Barclays for its rigging of the Libor interest-rate market.
HSBC was not alone in clashing with American enforcers over money laundering. Britain’s lesser-known emerging-markets bank Standard Chartered also found itself in the dock.
New York’s Department of Financial Services, headed by the aggressive young prosecutor Benjamin Lawsky, accused Standard Chartered of carrying out 60,000 ‘secret transactions’ with Iran worth $250 billion between 2001 and 2007. The Department of Financial Services described Standard Chartered as a ‘rogue institution’. It added that the bank’s actions ‘left the US financial system vulnerable to terrorists, weapons dealers, drug kingpins and corrupt regimes, and deprived law enforcement investigators of crucial information used to track all manner of criminal activity’.
Standard Chartered saw a relationship with the Iranian central bank as a great business opportunity. The US saw it as trading with the enemy.
Many banks can be said to have betrayed their customers and clients. Some would argue that HSBC – and Standard Chartered – went one step further. Their actions, in the eyes of their critics, helped criminals and undermined the national security interests of Western democracies.
Bill Michael, UK head of financial services at accountants KPMG, said banks ‘treat customers like captive geese. Captive geese that can be force fed, or sold more product to – whether appropriate or not.’
In an era when the British were obsessed with the idea of ‘free banking’, profits had to come from somewhere. The result was that in much the same way as investment bankers were incentivised to take huge risks in their dealings in products such as sub-prime mortgages, so the retail bankers were enticed into selling a product that, more often than not, the customer did not need. Payment protection products could add 20–50 per cent to the cost of a loan, depending on its precise nature and duration.
Whatever justification banks may have felt they had for pushing PPI onto customers, the way many handled it is open to serious question.
Customers often signed up for loans unaware that the PPI paperwork would be added later without their knowledge. Some staff told customers they could not approve a loan or credit-card application unless insurance was attached.
In total 34 million PPI policies were sold between 2001 and 2012, generating sales of 拢5 billion a year for the industry at their height.
The FSA estimated in 2011 that PPI claims for banks and other firms – ranging from Tesco Bank to the Co-operative Bank and Land of Leather – would come to around £4.5 billion. By early 2014 the estimate had risen to an astounding £20 billion and was still climbing.
That £20 billion figure dwarfs the bill for the mis-selling of private pensions in the 1990s – £13.5 billion – and comfortably beats the bill of £15 billion that was notched up for the faulty sale of endowment mortgages over much the same period. PPI was officially Britain’s worst consumer scandal of all time.
The PPI, IRHP and small-business lending scandals arose in particular circumstances – banks seeking to guarantee profits in a period of economic turmoil and low interest rates saw opportunities and grabbed them. When it all turned sour, the usual mantra ‘Lessons have been learned’ was chanted. The problem is that each point in the economic cycle seems to bring in its wake evidence of poor practice and questionable dealing.
So far as bankers’ scalps are concerned, while many have left their jobs (willingly or unwillingly), only in Iceland and Ireland – two of the nations most acutely affected by the banking crisis – have individuals actually been jailed for offences leading up to the 2007–8 financial tsunami. *
That said, prosecutors have been at work elsewhere and have made a number of arrests. Across Europe there have been isolated cases of high-level convictions, notably in Germany and the Netherlands.
So far as the US and UK are concerned, those likeliest to be brought to book are those involved in the alleged rigging of Libor interest rates and foreign-exchange markets. Having said that, no senior executive at the large Wall Street banks has yet been convicted of any criminal charge relating to the financial crisis.
But if past misdemeanours are now being punished, the enforcers nonetheless still have a huge job on their hands.
Full disclosure is still not the order of the day.
And then there’s the opaque $60 trillion global shadow banking sector to worry about – a network of payday lenders, hedge funds, peer-to-peer lenders and other relatively unregulated financial groups, many of whom have taken advantage of the vacuum left when lending by traditional banks froze in the aftermath of the financial crisis.
Wonga is perhaps the best-known example.
In November 2013 the governor of the Bank of England Mark Carney announced that ‘identifying and addressing risks in shadow banking, while supporting diverse and resilient sources of market finance’ would be a key priority of the Bank’s Financial Policy Committee in 2014 and beyond.
Another separate but challenging area for the enforcers is that of complex financial instruments such as derivatives and options contracts. The size of this market is infinitely larger than that of shadow banking.
Enforcers, then, are not only dealing with an ever-expanding financial system but one that continuously mutates. It is a little like cleaning out the Augean stables, and simultaneously having to deal with the arrival of ever more horses.
Like King, his successor Mark Carney has recognised that the UK for one cannot continually prop up its banks. ‘Fairness demands the end of a system that privatises gains but socialises losses,’ he has argued. ‘And simple economics dictates that the UK state cannot stand behind a banking system that is already many times the size of the economy.’
The strongest weapon in the hands of the politicians and enforcers as they struggle to bring an end to reckless finance and combat the power of Wall Street, the City of London and other financial centres is, arguably, public anger.
Against such a background it is the politicians and the enforcers who, if they are minded to do so, are able to call the shots and impose tough regulation.
In Britain in the 1950s bankers earned salaries that were comparable with those of other professions, such as lawyers and doctors.
To a large extent the reason * for this was that merchant banks or investment banks, as they are now called, were traditionally run as partnerships. Partners in the business staked their own cash and in good times took generous sums out of business. In bad times, however, they had to show restraint and might even be asked to inject cash into the company.
In the late 1970s, however, financial regulation was relaxed in the US and the old barriers between commercial banks and investment banks, as required by the Depression-era Glass–Steagall Act, fell away.
Many of the investment banks chose to jettison partnership status altogether and float on the markets as public companies.
The zenith of this transformation came in 1999 when Goldman Sachs under the co-chairmanship of future US Senator Jon Corzine and Hank Paulson (US Treasury Secretary from 2006 to 2009) became the last of the major US investment banks to discard the partnership model and float on the New York Stock Exchange.
Change in Britain can be dated back to the Big Bang in October 1986 when Margaret Thatcher’s government swept the ancient structures of the City into the sea.
By the second decade of the 20th century, according to research from accountants PricewaterhouseCoopers, a UK banker could command six times what a doctor or lawyer earned.
In 2013, the year of Barclays’ disgrace over Libor, no fewer than 428 bankers at Barclays received pay packages worth £1 million each and a further five bankers earned more than £5 million.
A July 2013 survey by the European Banking Authority found that 3,529 bankers earned €1 million or more in 2012, of which 2,714 were based in the UK.
All this has had a distorting influence on society as a whole.
In 2013 the European Commission in Brussels introduced legislation that limited bankers’ bonuses across the region for those earning more than €500,000 a year to 100 per cent of basic pay, or 200 per cent if shareholders approved.
The legislation became virtually meaningless as soon as it was enacted.
The problem is that the worst aspects of the banking culture are so deeply embedded that they are astonishingly difficult to shift.
Indeed, there is even evidence that the fines imposed on banks for mis-selling to customers, cheating on Libor and foreign-exchange markets, and circumventing money-laundering law have now become so much a matter of routine that they are regarded in some quarters simply as an extra tax that has to be paid for bending the rules.
The fact is that banks remain fatally attracted to complex, short-term gambits that might yield quick wins. It’s become part of the culture.
In 1969 just 6.6 per cent of the UK stock market was held by institutions outside Britain. By 2013 this figure had leapt to 53.2 per cent.
Waves of British firms in key sectors such as energy, water and chemicals, including nuclear-power generator British Energy and the larger utility Thames Water, have been bought by foreign enterprises.