Changing banking for good - United Kingdom Parliament

House of Lords House of Commons

Changing banking for good Report of the Parliamentary Commission on Banking Standards Volume V: Written evidence to the Commission

HL Paper 27-V HC 175-V

House of Lords House of Commons Parliamentary Commission on Banking Standards

Changing banking for good First Report of Session 2013–14 Volume V: Written evidence to the Commission Ordered by the House of Lords to be printed 12 June 2013 Ordered by the House of Commons to be printed 12 June 2013

HL Paper 27-V HC 175-V* Published June 2013 by authority of the House of Commons London: The Stationery Office Limited £0.00

Parliamentary Commission on Banking Standards The Parliamentary Commission on Banking Standards is appointed by both Houses of Parliament to consider and report on professional standards and culture of the UK banking sector, taking account of regulatory and competition investigations into the LIBOR rate-setting process, lessons to be learned about corporate governance, transparency and conflicts of interest, and their implications for regulation and for Government policy and to make recommendations for legislative and other action. Current membership Mr Andrew Tyrie MP (Conservative, Chichester) (Chairman) Most Rev and Rt Hon the Archbishop of Canterbury (Non-Affiliated) Mark Garnier MP (Conservative, Wyre Forest) Baroness Kramer (Liberal Democrat) Rt Hon Lord Lawson of Blaby (Conservative) Mr Andrew Love MP (Labour/Co-operative, Edmonton) Rt Hon Pat McFadden MP (Labour, Wolverhampton South East) Rt Hon Lord McFall of Alcluith (Labour/Co-operative) John Thurso MP (Liberal Democrat, Caithness, Sutherland and Easter Ross) Lord Turnbull KCB CVO (Crossbench) Powers The Commission’s powers include the powers to require the submission of written evidence and documents, to examine witnesses, to meet at any time (except when Parliament is prorogued or dissolved), to adjourn from place to place, to appoint specialist advisers, and to make Reports to both Houses. A full list of the Commission’s powers is available in the House of Commons Votes and Proceedings of 16 July 2012 on page 266, and the House of Lords Minutes of Proceedings of 17 July 2012, Item 10. Publications The Reports and evidence of the Commission are published by The Stationery Office by Order of the House. All publications of the Commission (including press notices) are on the Internet at http://www.parliament.uk/bankingstandards. Commission staff The following parliamentary staff worked for the Commission: Colin Lee (Commons Clerk and Chief of Staff), Adam Mellows-Facer (Deputy Chief of Staff), Lydia Menzies (Second Clerk), Sian Woodward (Clerk), Richard McLean (Lords Clerk), Lucy Petrie (Second Clerk), Jay Sheth (Commission Specialist), Gavin Thompson (Commission Specialist), James Abbott (Media Officer), James Bowman (Senior Committee Assistant), Tony Catinella (Senior Committee Assistant), Claire Cozens (Senior Committee Assistant), Emma McIntosh (Senior Committee Assistant), Rebecca Burton (Committee Assistant), Katherine McCarthy (Committee Assistant), Daniel Moeller (Committee Assistant), Baris Tufekci (Committee Assistant), Ann Williams (PA to the Chief of Staff) and Danielle Nash (Committee Support Assistant). The following staff were seconded from outside of Parliament to work for the Commission: Philip Airey, Amélie Baudot, Paul Brione, Suvro Dutta, Oliver Gilman, Oonagh Harrison, Sadiq Javeri, Robert Law, Zoe Leung-Hubbard, Mayur Patel, Julia Rangasamy, John Sutherland, Greg Thwaites and Elizabeth Wilson.

Contacts All correspondence should be addressed to the Clerks of the Parliamentary Commission on Banking Standards c/o the Treasury Select Committee, 7 Millbank, London SW1P 3JA. The telephone number for general enquiries is 020 7219 8773; the Commission’s email address is [email protected].

Volumes of this Report This Report is the Fifth Report of the Commission (and the First Report of Parliamentary Session 2013–14). It has nine volumes: Volume I: Summary, and Conclusions and recommendations Volume II: Chapters 1 to 11 and Annexes, together with formal minutes Volume III: Oral evidence taken by the Commission Volume IV: Written evidence to the Commission Volume V: Written evidence to the Commission Volume VI: Written evidence to the Commission Volume VII: Oral and written evidence taken by Sub-Committees A and B Volume VIII: Oral and written evidence taken by Sub-Committees C, D, E, F and G Volume IX: Oral and written evidence taken by Sub-Committees H, I, J and K Lists of witnesses who gave evidence and lists of people or organisations who submitted written evidence are given in the relevant volumes of the Report.

*House of Commons Printing Numbers This Report is printed under House of Commons Printing number HC 175. It also incorporates papers ordered for printing in Session 2012–13 under the following House of Commons printing numbers: HC 606-i to –xl, HC 619-i to –ii, HC 705-i to –viii, HC 783-i, HC 706-i to –v, HC 821-i to –iii, HC 710-i to –ii, HC 784-i, HC 881-i to –v, HC 804-i to –ii, HC 860-i to –iv, HC 945-i

Changing banking for good

List of written evidence to the Commission Written evidence to the Commission is on pages Ev 736 to 1642, FR Ev 1 to 199, and TR Ev 1 to 27. Evidence pages Ev 736 to 1184 are contained in Volume IV of the Report. Evidence pages Ev 1185 to 1642 are contained in Volume V of the Report. Evidence pages FR Ev 1 to 199 and TR Ev 1 to 27 are contained in Volume VI of the Report.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38

Accord Ev 736 Advisory Board of the Institute of Risk Standards & Qualifications Ev 1237 Affinity Trade Union Ev 740 Association of British Insurers Ev 742 Association of Corporate Treasurers Ev 1501 Association of Financial Markets in Europe Ev 750 Bank of England Ev 795, 798, 1380, 1499, 1500, 1539, 1606, 1607 Barclays Ev 798, 809, 813, 1502, 1504 Bellord, Nicholas J Ev 815 Black, Professor Julia and Professor David Kershaw Ev 820 Board Intelligence Ev 834 Brash, Donald T, former Governor of the Reserve Bank of New Zealand Ev 837 British Bankers' Association Ev 840, 852, 864, 870, 872, 879, 880, 1504, 1505 British Chamber of Commerce Ev 881 British Standards Institute Ev 883 Budd, Sir Alan Ev 885 Budden, Jennifer Ev 887 Building Societies Association Ev 890 Burnley Savings and Loans Ev 896 Bush, Timothy Ev 899 Butler, Cormac Ev 907 Campaign for Community Banking Services Ev 912 Campaign for Regulation of Asset Based Finance Ev 1508 Capie, Forrest Ev 1511 Cassidy, Michael Ev 1513 CBI Ev 913, 1514 Centre for Research on Socio-Cultural Change Ev 667 CFA UK Ev 919 Chadha, Professor Jagjit Ev 925 Chancellor of the Exchequer Ev 1116 Chartered Banker Institute Ev 926, 1516, 1517 Chartered Institute for Personnel and Development Ev 933 Chartered Institute for Securities & Investment Ev 937 Chartered Institute of Internal Auditors Ev 942 Chartered Insurance Institute Ev 947 Christian Council for Monetary Justice Ev 955 Church of England Ev 956 Church of Scotland Ev 962

Changing banking for good

39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85

Citizen's Advice Ev 965 City of London Corporation Ev 973; 976 Clarke, Donald R Ev 979 Crow, Malcolm Ev 1520 Cruickshank, Sir Donald Ev 981, Ev 982 Dalton, Bruce Ev 1522 Dorn, Nicholas Ev 983 Duijsters , J Ev 989 Ecumenical Council for Corporate Responsibility Ev 992 FairPensions Ev 1003 Professor Stella Fearnley and Professor Shyam Sunder Ev 1633 Featherby, James Ev 1008 Federal Deposit Insurance Corporation Ev 1489 FIA European Principal Traders Association Ev 1011 Fidelity Worldwide Investment Ev 1016 Financial Conduct Authority Ev 1527 Financial Ombudsman Service Ev 1018 Financial Reporting Council Ev 1019 Financial Services Authority Ev 1037, 1045, 1052, 1054, 1055, 1059, 1060, 1061, 1063, 1065, 1066, 1249, 1474, 1530, 1532 Financial Services Authority and Royal Bank of Scotland Ev 1068 Financial Services Consumer Panel Ev 1024, 1069 Financial Services Practitioner Panel Ev 1029 Foxley, Ian Ev 1073 Fraser, Ian Ev 1077 French, Derek Ev 1079 Global Witness Ev 1081, Ev 800 Goldman Sachs International Ev 1085 Goodhart, Professor Charles A.E. Ev 1537 Greenham, Tony Ev 1473 Harries, C S Ev 1103 Harris , Professor Richard Ev 1540 Hawkins, I Ev 1104 Hermes Equity Ownership Services Ltd Ev 1109 Hill, Geoff Ev 1112 HSBC Ev 1117 Hussey, Simon Ev 1640 ICMA Group Zurich Ev 1126 IFS School of Finance Ev 1126, 1558 Institute of Business Ethics Ev 1129 Institute of Chartered Accountants in England and Wales Ev 1131, 1560 Institute of Operational Risk Ev 1135 Intellect Ev 1137 International Academy of Retail Banking Ev 1560 Investment Management Association Ev 1155 Ipsos MORI Ev 1163 Jeffares, Neil Ev 1168

Changing banking for good

86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131

Jenkins, Huw Ev 1564 Johansson, Jerker Ev 830 Johnson, Dr Timothy Ev 1172 Johnstone, C M Ev 1182 JP Morgan Chase & Co Ev 1565 Kelton, Erika A. Ev 1185 Law Society of England and Wales, and Association of Corporate Treasurers Ev 1572 Law Society of England and Wales Ev 1189 Leadsom MP, Andrea Ev 1198 Legal Services Board Ev1578 Liikanen, Erkki Ev 1204 Lilico, Andrew Ev 1205 Lindsey OBE, Ian W Ev 1208 Lloyds Banking Group Ev1216, 1226, 1227, 1581 London First Ev 1233 Makar, Mira Ev 1239 Mayes, Professor David G , University of Auckland Ev 1250 Mitchell QC, Gregory Ev 1582 Mitchell QC, Iain G. Ev 1256 Moore, Paul Ev 1588 Lord Phillips of Sudbury OBE, Sir John Banham DL, Tim Melville – Ross CBE, and Sir Stephen O’Brien CBE Ev 1599 NAPF Ev 1260 New Economics Foundation Ev1473 Observatoire Finance Banking Ev 1263 Office of Fair Trading Ev 1269 Office of the Comptroller of the Currency Ev 1495 Oxford Centre for Mutual and Employee-owned Business, Kellogg College, University of Oxford Ev 1275 Payments Council Ev 1278 Personal Finance Education Group Ev 1280 Pope, David Ev 1282 Pringle, Robert Ev 1286 Pro-Housing Alliance Ev 1294 Public Concern at Work Ev 1299 Question of Trust in partnership with Financial Services Research Forum Ev 1306 Reynolds, John Ev 1309 Rippon, Mr Ev 1312 Robertson, James Ev 1319 Rohner, Dr Marcel Ev 1320, 1321, 1608, 1609 Royal Bank of Scotland Ev 1321 Santander Ev 1326, 1609 Sants, Sir Hector Ev 1333 Solicitors Regulation Authority Ev 1614 Spottiswoode, Clare Ev 1336 Stonehaven (Healthcare) Ev 1337 Sturmer, Raymund C. Ev 1340

Changing banking for good

132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147

Taplin, Ian TheCityUK Theos TUC Turner, Nikki and Paul UBS Unite the Union Universities Superannuation Scheme Virgin Money VocaLink Volcker, Paul Walker, Sir David Which? Wilmot-Sitwell, Alex Woods, Martin Worshipful Company of International Bankers

Ev 1342, 1350 Ev 1364, 1614 Ev 1620 Ev 1367 Ev 1381 Ev 1394, 1624 Ev 1394 Ev 1398 Ev 1417 Ev 1439 Ev 706 Ev 1443 Ev 1443 Ev 1613 Ev 1626 Ev 1470

cobber Pack: U PL: COE1 [SO] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1185

Written evidence from Erika A Kelton1 This memorandum addresses the reasons why financial incentives for whistleblowers are essential to the success of a whistleblower program, and further supports the adoption in the U.K. of whistleblower reward programs modelled on effective, fraud-fighting US statutes. It is submitted in response to the Parliamentary Commission on Banking Standards’ Question 4(b) (“arrangements for whistle-blowing”) and Question 5 (“What can and should be done to address any weaknesses identified.”) Summary — The U.S. has four government programs that offer financial incentives to private citizens who blow the whistle on wrongdoing, such as healthcare fraud, tax fraud and securities and commodity trading frauds. These programs have not only stopped wrongdoing and collected billions of dollars in damages, they have spurred stronger internal compliance efforts by businesses and saved billions more through deterrent effects. — For a whistleblower program to be successful, experience demonstrates that awards to whistleblowers must be mandatory when funds are recovered. Predecessor whistleblower programs failed and fell into disuse because they offered discretionary awards. Without the certainty of an award in successful cases, individuals in the banking sector and other industries are discouraged from stepping forward because of the professional and personal risks. — To demand that individuals set aside financial and personal considerations when deciding whether to blow the whistle is unrealistic. Whistleblowers risk not only their jobs and their careers but also their marriages, family and friends due to the emotional and social toll of whistleblowing. — Whistleblower programs are stronger when statutes create incentives for whistleblowers and their counsel to continue to collaborate with enforcement authorities during investigations and prosecutions in addition to providing the initial information. — British citizens are turning to the U.S. to report wrongdoing by British companies, schemes that use British institutions to carry out the wrongdoing and frauds that negatively affect British taxpayers and investors. If the wrongdoing falls outside the scope of U.S. jurisdiction, many potential whistleblowers keep quiet rather than report the matter to British authorities because there are no financial awards to compensate for their risks from reporting. — A well-structured whistleblower reward program in the U.K. would greatly enhance fraud enforcement efforts in the banking sector by bringing forward high-quality information from individuals who have knowledge of large-scale frauds. A. Background on U.S. Whistleblower Incentive Programs 1. The United States has four federal whistleblower incentive programs: (1)The federal False Claims Act’s (“FCA”), which address frauds against federal government programs, such as federal healthcare and defense spending; (2) the Internal Revenue Service (“IRS”) whistleblower program, which addresses tax underpayments and frauds; (3) the Securities and Exchange Commission whistleblower program, which addresses securities law violations; and, (4) the Commodity Futures Trading Commission (“CFTC”) whistleblower program, which concerns violations of the commodities laws. 2. These U.S. whistleblower programs have realized enormous success in helping expose fraud and corruption. Tens of billions of dollars otherwise lost to illegal practices that cheat the public fisc have been recovered as a direct result of whistleblower information. But the impact and importance of whistleblower matters goes far beyond the large dollar amounts recovered for US taxpayers. Whistleblowers have exposed grave wrongdoing, leading to changes that promote integrity and transparency in financial markets. Whistleblowers have helped stop massive mortgage frauds, gross mischarging practices, commodity price manipulation, and sophisticated money laundering schemes, among other misdeeds. Numerous other beneficial results have been realized outside the banking sector as well, from protecting patients, to safeguarding troops, to saving public employee retirement funds from plunder. Importantly, whistleblower enforcement has led to the proliferation of improved internal compliance efforts by businesses and is estimated to have saved additional billions of dollars for investors and taxpayers through deterrent effects. B. US Whistleblower Programs Provide Meaningful Financial Rewards 3. The FCA’s amended whistleblower—or “qui tam”—provisions,2 enacted in 1986, were the first to provide non-discretionary financial incentives to individuals for blowing the whistle on fraudulent business practices. Owing to its success, the FCA’s qui tam award structure served as a model for the IRS whistleblower program, enacted in 2006,3 and the Securities and Exchange Commission and the Commodity Futures Trading Commission whistleblower programs, enacted under the Dodd-Frank Act in 2010.4 (The SEC and CFTC whistleblower programs will be referred to collectively as “the Dodd-Frank whistleblower programs.”) 1

2 3 4

Erika A. Kelton, Esq., is a senior partner at Phillips & Cohen LLP, a U.S. law firm that has specialized in representing whistleblowers programs for more than 25 years. See 31 U.S.C. §3729 et seq. See 26 U.S.C. §7623(a) and (b). See 15 U.S.C. §78u-6, and 7 U.S.C. §26, respectively.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1186 Parliamentary Commission on Banking Standards: Evidence

4. Each program provides for non-discretionary financial rewards to whistleblowers that are intended to incentivize individuals with knowledge of frauds to provide information to the relevant federal authorities.5 In the case of the FCA and IRS whistleblower programs, the rewards range from 15% to 30% of the amounts recovered by the Justice Department and IRS, respectively. In the instance of the Dodd-Frank whistleblower programs, the rewards range from 10% to 30% of the judgment or settlement amounts. In all of these programs, the precise percentage share awarded to an individual within the designated ranges is determined by how substantially the whistleblower and his or her counsel contributed to the success of the government’s enforcement action.6 5. There is clear evidence that mandating non-discretionary awards has made a huge difference in both the quantity and the quality of whistleblower submissions given to government agencies. As described in more detail below, current U.S. whistleblower incentive laws have been enormously successful in bringing frauds to light that otherwise would have remained unknown to government investigators. Whistleblower incentive regimes are regarded as the government’s chief civil fraud enforcement tool7 to combat fraud and corruption. Their benefits are well recognized by top U.S. enforcement officials.8 C. Financial Incentives Are The Linchpins Of Successful Whistleblower Programs 6. Experience shows that meaningful, non-discretionary financial incentives are critical to establishing robust and successful whistleblower programs. From 1943 until the FCA was amended in 1986, the law’s qui tam provisions provided only discretionary awards to whistleblowers. Only about six whistleblower cases were brought each year. The uncertainty of whether an award would be paid even in successful cases discouraged individuals from stepping forward with knowledge of frauds. The Justice Department recovered only $27 million from FCA matters in 1985, the year before the FCA was amended to provide non-discretionary awards of 15% to 30% of amounts recovered.9 7. Contrast that with 2012, when the Justice Department recovered more than $9 billion in civil and related criminal fines in FCA cases initiated by whistleblowers. Post-1986 financial incentives, along with the certainty of payment in successful cases (with defined exceptions), moved the FCA qui tam provisions from near complete disuse to the central place in civil fraud enforcement. Since 1986, the FCA’s whistleblower incentives have encouraged more than 8,500 individuals to report instances of fraud against the federal government. As the successes and public awareness of the FCA’s whistleblower provisions grow, the number of individuals stepping forward each year has steadily grown. Now more than 400 cases of fraud against the government are reported each year through the False Claims Act’s whistleblower provisions. 8. A similar story is told by the IRS and SEC programs’ “before and after” experiences. Both of these programs had early, unsuccessful versions that had lackluster participation and failed due to their discretionary (and, in the case of the IRS, capped) award structures. The adoption of mandatory incentive awards, without limits on the total dollar amounts, generated a surge of whistleblower submissions. From 2007 through the end of fiscal year 2011, for example, the IRS Whistleblower Office received over 1,600 submissions from individuals, concerning alleged tax frauds and underpayments by over 10,000 taxpayers.10 Dozens of these whistleblower submissions are valued at over $100 million. 9. The SEC’s predecessor program—an insider trading whistleblower reward program enacted in 1988— also was rendered virtually ineffective by a discretionary award structure that failed to encourage informed insiders to step forward. In 22 years, this predecessor program only yielded six small cases and recovered an aggregate of $10.15 million. In contrast, in fiscal year 2012 alone, the SEC whistleblower program with its mandatory award structure has received over 3,000 submissions.11 SEC leadership has praised the program, noting that they are “seeing high-quality tips that are saving our investigators substantial time and resources.”12 10. Whistleblower incentive laws, thus, have repeatedly been shown to crack the “conspiracy of silence” that accompanies significant fraudulent practices. Without help and information from individuals who observe 5

6

7

8

9

10

11

12

Approximately 30 states have also enacted false claims statutes that include whistleblower provisions modeled on the federal False Claims Act. Each of the four programs is structured to discourage claims by those who devised the fraud in the first instance (so-called “planners and initiators”), as well as claims that are parasitic of information and allegations already widely reported publicly, (except where the individual has independent knowledge of the fraud and has voluntarily disclosed the information to the government). In these instances, the reward can be diminished to zero. See e.g., H.R. Rep. No. 99–660, p. 18 (1986) (“[T]he False Claims Act is used as ... the primary vehicle by the Government for recouping losses suffered through fraud”). See e.g., “Whistleblowers have helped us to enforce the law by bringing to light schemes that misuse taxpayer dollars and abuse the public trust,” Statement of Tony West, Assistant Attorney General (2011); “Whistleblowers tend to do a lot of the work for you, hand you something that’s pretty fully baked,” Testimony of Mary Schapiro, former SEC Chairperson (2009); Whistleblowers “can provide us with first-hand information about ongoing frauds that may otherwise not come to light. This type of information can be crucial for protecting investors or helping us return their funds,” Remarks of Mary Schapiro (2010). See The False Claims Amendment Acts of 1993: Hearing Before the Subcommittee on Court and Administration of the Senate Committee on the Judiciary, 103rd Cong., 1st Sess. 3 (1993). See “Fiscal Year 2011 Report to Congress on the Use of Section 7623” at Table 1, published at http://www.irs.gov/pub/irs-utl/ fy2011_annual_report.pdf. See U.S. Securities and Exchange Commission, “Annual Report on the Dodd-Frank Whistleblower Program: Fiscal Year 2012,” published at http://www.sec.gov/about/offices/owb/annual-report-2012.pdf (“2012 SEC Report”). Remark of former-SEC Chairman Mary L. Shapiro, published at www.sec.gov/news/press/2012/2012–162.htm.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1187

or are otherwise knowledgeable about wrongful activity, fraud detection is extremely handicapped. Indeed, as frauds become increasingly complex and extend across borders, the need for such “inside” assistance has become more profound. Incentivizing insiders with detailed and quality information about wrongdoing to step forward is one of the best and most efficient ways to address the substantial need to enhance fraud detection and enforcement. 11. The legislative history of the FCA’s qui tam amendments in 1986 reflects Congress’ concern that government fraud enforcement efforts were able to detect only a tiny fraction of the roughly $100 billion estimated at that time to be lost to frauds against government programs every year. The government’s inability to discover most frauds against it was a primary reason that Congress adopted the FCA’s strong, nondiscretionary, percentage-share awards to incentivize individuals to help recover the huge losses to fraud. In adopting the qui tam award structure, the Senate recognized pragmatically that no matter what the award amount, the Treasury would receive significantly more than the “zero percent it would have received had the person not brought the evidence of fraud to its attention or advanced the case to litigation.”13 The FCA’s qui tam award provisions, thus, “expresses Congress” understandable willingness to forbear between 15 and 25 cents per dollar of the recovery in order to reclaim a defendant’s ill-gotten gain.”14 D. Financial Incentives Motivate Knowledgeable Individuals To Take The Risks Of Stepping Forward 12. Critics of whistleblower financial incentives often contend that people should blow the whistle simply because it is the “right thing” to do. Such a categorical position ignores the fact that whistleblowing comes with a heavy price. Moral satisfaction doesn’t put food on the table or pay the mortgage when a whistleblower is fired for reporting the company has committed a serious fraud. In the 25 years that I have represented whistleblowers, our firm’s clients have been retaliated against, terminated by their employers and suffered “blackballing” by industry, making it impossible for many of them to ever again find work in their chosen professions. We have had clients who lost senior engineering positions at defense contracting firms and could only find work bagging groceries and mowing lawns. Others in pharmaceutical marketing lost their jobs for reporting fraudulent practices and for years earned income only sporadically by painting houses or selling insurance policies. In the financial services sector, clients who raised questions about questionable business practices lost their careers despite exceptional work reviews. 13. By far, the vast majority of whistleblowers first try to address their concerns internally by raising them with their superiors or compliance officers. Typically, whistleblowers only avail themselves of statutory reward programs when their concerns have been dismissed or unaddressed, or when they suffer retaliation. These individuals step forward because it is the right thing to do and because they are motivated by the guarantee of a financial reward if their matters are successful. To demand that a whistleblower set aside financial considerations is unrealistic. Consistent with my experience representing whistleblowers, academic studies also observe that while whistleblowers are motivated by the desire for greater integrity and ethics in business practices, few will risk the substantial downside of reporting wrongdoing to enforcement officials without relative certainty of a financial reward if successful. 14. A 2010 New England Journal of Medicine study examined the experiences of whistleblowers in reporting wrongdoing, and particularly the severe financial and emotional hardship suffered by numerous whistleblowers.15 This includes the threat of job loss, “blackballing” in the industry so that an individual is unable to work in a chosen career, loss of savings and pensions, and the loss of homes and possessions. Whistleblowers face formidable emotional stresses and challenges as well, including divorce, estrangement from their families and social communities. Often these emotional strains further lead to serious stress-related health problems.16 15. And just as practical experience counsels, these studies conclude that “a strong monetary incentive to blow the whistle does motivate people with information to come forward.”17 This can be particularly true in banking and finance where the individuals with detailed information about wrongdoing tend to be those in highly paid positions and would take a huge financial risk in blowing the whistle, no matter how much they might want to do the right thing. At the same time, the growing sophistication and complexity of most significant financial frauds make them extremely difficult for enforcement and regulatory authorities to detect without the insight and expertise of well-placed whistleblowers. 13 14 15

16

17

See S. Rep. No. 99–345 at 28 (1986) (the “Senate Report”). See United States ex rel. Alderson v. Quorum Health Group, Inc., 171 F. Supp. 1323, 1335 n.35 (M.D. Fla. 2001). A. Kesselman et al., “Whistle-Blowers Experience in Fraud Litigation Against Pharmaceutical Companies,” 362:19 New Engl. J. Med. 1832 (May 13, 2010). See also A. Dyck et al. “Who Blows The Whistle On Corporate Fraud,” 65 Journal of Finance 2213 (Sept. 2009) (finding that in over 80% of cases, the whistleblower suffered job loss by either being fired or constructively terminated, or was otherwise retaliated against). Id. at 5. The Dyck study also dispels the notion that strong financial incentives generate frivolous lawsuits, finding that in the healthcare industry (an area which accounts for many whistleblower cases) there is a smaller number of frivolous lawsuits than in other industries.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1188 Parliamentary Commission on Banking Standards: Evidence

E. The US Experience Shows That Whistleblower Incentive Programs Work 16. Programs providing solid, non-discretionary financial incentives to whistleblowers have changed the landscape of fraud and corruption enforcement in the United States. The FCA, IRS and Dodd-Frank whistleblower provisions have given individuals confidence that they will almost certainly receive a guaranteed award if the information they provide leads to a judgment or settlement. 17. The benefits of offering rewards have been huge. From the federal and state False Claims Acts whistleblower provisions alone, approximately $50 billion in civil settlements and related criminal fines have been recovered as a result of whistleblower cases since Congress strengthened the whistleblower provisions of the FCA in 1986. Nearly half of that amount has been recovered in just the past five years, as the public has become more familiar with the False Claims Act and the qui tam provisions. In 2012 alone, more than $9 billion in civil and criminal fines were recovered by virtue of the FCA’s whistleblower provisions.18 18. At the same time, the amounts recovered from individual cases continue to set records: $3 billion from a 2012 civil and criminal settlement with GlaxoSmithKline and $2.3 billion from a civil and criminal settlement in 2009 with Pfizer Inc., which are the largest and second-largest US recoveries in history; $325 million from a civil and criminal settlement in 2009 with Northrop-Grumman, which was the largest defense contractor settlement; and $302 million in 2009 from a civil and criminal settlement with Quest Diagnostics, which was the largest settlement ever paid by a medical lab company for a faulty product. 19. The IRS whistleblower program also has recovered billions of dollars in lost tax revenues. Though tax confidentiality laws limit disclosure of the precise amounts collected or the affected taxpayers, it is estimated that over $5 billion was collected by the IRS as a result of a single whistleblower claim involving massive evasion of taxes by thousands through the use of secret Swiss bank accounts. F. Financial Incentives Also Enhance Government Investigatory Resources 20. As mentioned above, each of the FCA, IRS and Dodd-Frank whistleblower programs provides for an award based on a percentage of the recovery determined by the contributions the whistleblower and his counsel made to recover the funds. By structuring awards based on contribution, these statutes create added incentives for continuing whistleblower collaboration with enforcement authorities during investigation and prosecution, long after the information is initially provided. This structure greatly enhances government enforcement efforts by bringing needed private resources to bear. As the Home Office’s 2007 “Asset Recovery Action Plan” noted, FCA whistleblower recoveries “far exceed the cost of prosecuting fraud—it has been estimated that for every dollar the federal government invests in investigating and prosecuting these cases, it receives $15 back.” 21. There are numerous examples of whistleblower counsel partnering with government prosecutors and investigators and investing heavily of their own time and funds to ensure a successful result for the federal government. In United States ex rel. Alderson v. Columbia/HCA Healthcare Corp., and United States ex rel. Schilling v. Columbia/HCA Healthcare Corp., my firm assembled a team of private lawyers to provide 30 fulltime equivalent attorneys to litigate the matter, incurring over 66,000 hours of time and risking over $29 million in up-front expenses and attorneys’ fees. The Justice Department provided only five attorneys. The two cases, which the government would not have pursued without the whistleblowers’ legal team, settled for a combined total of nearly $720 million. 22. More recently, my firm took the lead in building a case to prove our clients’ allegations involving the illegal and dangerous marketing of a particular GlaxoSmithKline prescription drug. Largely as a result of the thousands of hours we spent working to help Justice Department, that piece of the case against GSK returned $700 million to the U.S. Treasury as part of Glaxo’s $3 billion settlement last year. G. Guaranteed Financial Incentives of US Whistleblower Programs Are Attracting British Whistleblowers to File Submissions in the United States 23. The U.S. whistleblower programs are having significant impacts internationally, particularly in the UK. In 2012, more than one in ten SEC whistleblower submissions came from non-U.S. sources. Of those, roughly 25% came from the UK—more than any country outside the United States. See 2012 SEC Report, infra. Indeed, my law firm represents whistleblower clients who are Britons, or who have reported to U.S. authorities schemes that are undertaken by British companies, that use British institutions to carry out the wrongdoing, or that negatively impact British taxpayers, investors and public servants. While some UK policymakers may hesitate to embrace whistleblower incentive programs, British citizens are not. Instead, they are increasingly availing themselves of whistleblowing opportunities in the US because of the possibility of rewards and, in many cases, anonymity. 24. Evidence from U.K. citizens of fraud and corruption by British companies is welcomed by U.S. regulators provided there is sufficient jurisdiction to proceed under US laws. But it concerns me there are many other would-be whistleblowers who have contacted my law firm about corrupt and fraudulent practices by British entities or affecting British taxpayers and institutions who do not pursue their cases because jurisdiction is lacking in the United States. In each of these instances, the individuals have decided against contacting U.K. authorities in the absence of a possible financial award if the matter is successful. 18

See www.taf.org/blog/doj-hides-its-light-under-barrel.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1189

25. For all the reasons discussed above, would-be whistleblowers have weighed the downside risks to their professional and personal lives, and repeatedly opted to stay silent. Whistleblower “tip lines,” such as that now offered by the Serious Fraud Office (and previously by the SEC), are commendable. But as a practical matter, “tip lines” and other similar measures can never match the targeted and developed information and enhanced resources that enforcement agencies realize with well-designed whistleblower programs. Meaningful financial incentives are needed to convince the most valuable whistleblowers, who often sacrifice not only their current employment but any future employment as well, to come forward and report corporate wrongdoing. H. Conclusion 26. Twenty-five years of experience with whistleblower programs in the U.S. has shown that most whistleblowers with significant evidence of wrongdoing need the certainty of a reward that is commensurate with both the value of the information they provide and the amounts that are recovered by law enforcement as a result. Creating mechanisms for reporting wrongdoing that also reward individuals for the substantial risks they take should be a policy priority for Parliament as it considers ways to regulate and police the banking sector. To be effective, a whistleblower program should: (a) Provide non-discretionary rewards to whistleblowers from the recoveries their information generates. Whistleblowers face substantial personal and professional risks and require a clear financial upside to hedge those downside risks. Moreover, generous rewards in successful cases also motivate other whistleblowers to step forward with significant information of fraud, further realizing anti-corruption and anti-fraud enforcement priorities. (b) Create structures that foster partnerships with whistleblowers and their lawyers so that government enforcement efforts are enhanced by an inflow of private resources and expertise. Whistleblower enforcement mechanisms, such as the FCA, IRS and Dodd-Frank whistleblower programs, not only augment government enforcement efforts on particular matters, but also help enforcement generally by vetting and screening out weaker allegations before they are ever submitted to the federal agencies. (c) Keep whistleblowers’ identities confidential or anonymous as much as possible under the law. (d) Exclude or otherwise limit the architects of the fraud from collecting a reward and disqualify “parasitic” cases that bring no unique or original information to enforcement authorities. 27. A well-structured program in the U.K. will greatly enhance fraud enforcement efforts by bringing highquality information from individuals knowledgeable of large-scale frauds and wrongdoing in the banking sector. Just as has occurred in the United States, whistleblower programs in the U.K. stand to realize both large recoveries and greater transparency and regulatory compliance in the banking sector and other industries. These outcomes should be embraced by all stakeholder communities—be they business, employees, government prosecutors, investors, or ordinary citizens. 28. Some may say that there is no need for whistleblower programs or that cultural impediments stop them from being adopted. But the continuing string of headline-grabbing business scandals demonstrates a clear need, and the strong international response to the U.S. whistleblower incentive programs shows that cultural barriers are eroding. It is impossible to ignore either the value whistleblowers bring or the sacrifices they make. Whistleblowers not only deter fraud and help recover the billions lost to it, but they increase transparency in the banking sector and global markets—which have become increasing complex and opaque, even to regulators. 29. For these reasons stated above, I urge Parliament to adopt robust whistleblower incentive programs. 7 February 2013

Written evidence from the Law Society of England and Wales The Law Society of England and Wales (“The Society”) is the professional body for the solicitors’ profession in England and Wales, representing over 160,000 registered legal practitioners. The Society represents the profession to parliament, government and the regulatory bodies and has a public interest in the reform of the law. Criminal Sanctions On 3 July 2013, HM Treasury published a proposal to create a new criminal offence of serious misconduct in the management of a bank. The proposal considered four main possibilities for the kind of managerial misconduct by bank directors and senior management that might be subject to new criminal sanctions: (i) Strict liability—being a director at the relevant time of a failed bank. (ii) Negligence—failure in a duty of care which leads to a reasonably foreseeable outcome. (iii) Incompetence—failure to act in accordance with professional standards or practices. (iv) Recklessness—failure to have sufficient regard for the dangers posed to the safety and soundness of the firm concerned or for the possibility that there were such dangers.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1190 Parliamentary Commission on Banking Standards: Evidence

(1) What are your views on extending criminal sanctions to cover managerial misconduct by bank directors? 1. There has been extensive public pressure for criminal action to be taken in relation to the recent financial crisis. The Society appreciated the detailed and balanced approach taken by HM Treasury in its consultation. 2. The Society accepts the necessity of holding individuals to account where their actions have been responsible for the failure of a bank. However, there are already extensive criminal sanctions, provisions under the Companies Act 2006, regulatory requirements and robust processes in place to deal with such matters. Since the financial crisis the Financial Services Authority (FSA) has taken a more robust approach to enforcement which has resulted in greater civil penalties for approved persons, including notably higher fines and bans from working in the industry. 3. The Society does not accept that there has been a sufficient failure of the existing remedies and processes which would warrant such wide ranging new offences and the extension of criminal sanctions to matters which for good reason have been regarded as regulatory issues. 4. The Society is concerned that the measures proposed in HM Treasury’s consultations undermine fundamental and well-established principles of justice, and pose significant practical difficulties. Several of the measures outlined in the consultation overlap with existing powers that UK regulators have to hold financial institutions to account, many of which were given to regulators in the aftermath of the last financial crisis. 5. The consultation acknowledged that criminal sanctions already exist for offences that involve fraud and other forms of dishonesty, and instead considered whether managerial misconduct may be subject to new criminal sanctions. 6. The Society notes that the recently-published Liikanen Report considered the issue of sanctions for directors of banks where there has been a failure of corporate governance. That report did not recommend the introduction of new criminal offences, but said supervisors must have effective sanctioning powers to ensure that regulation could be enforced adequately. The FSA already has a broad range of sanctioning powers. The Society believes that these current powers are effective and is not aware of any evidence that has shown that the existing regulatory powers are inadequate. 7. Finally, the Society notes that in other jurisdictions, such as the USA, directors of failed banks are usually subject to civil, rather than criminal sanctions. To introduce new criminal sanctions for the directors of failed banks would put the UK at variance with other common law countries. (2) What are your views on the possible formulations of a criminal offence based on options (i) to (iv)? 8. The Society agrees with the position expressed by HM Treasury that creating an offence on any of the four proposed grounds would pose practical problems, including: 8.1 establishing causation—eg that a particular decision led to the failure of the bank concerned; 8.2 deciding which individuals involved should be prosecuted; 8.3 the length and cost of investigations, particularly assembling the evidence needed for prosecution; and 8.4 the volume of material that may need to be analysed. 9. Considering each of the Treasury’s proposed options (i) to (iv) in turn: 10. (i) Strict liability 11. This approach involves creating a strict liability offence of being a director of a failed bank “at the relevant time”. In its consultation, HM Treasury recognised that there are difficulties with creating a strict liability offence, including: 11.1 It would be controversial to impose criminal penalties on individuals who were not plainly at fault (eg the bank may have been a victim of outside events). 11.2 Difficulty in defining “relevant time” and what is meant by “failure”. 11.3 Issues of fairness—a strict liability offence would penalise a director who had been brought on board to rescue a bank while allowing a director who was responsible for decisions that contributed to failure, but had departed the bank before it failed, to escape liability. 11.4 Strict liability seems likely to deter people from taking up board appointments in rescue situations. 12. The Society concurs with HM Treasury’s reasoning, agrees that a strict liability offence would not be appropriate and would add that creating a strict liability offence would also cut across the well-established director disqualification scheme. 13. (ii) and (iii) Negligence and incompetence 14. In its consultation, HM Treasury argued that creating an offence based on negligence or incompetence would demonstrate that society is not prepared to tolerate such conduct. However, HM Treasury recognised that this approach may be problematic for the following reasons:

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1191

14.1 Regulators can already take action against individuals for negligence or incompetence. Regulators can also take action against firms where an individual’s negligence or incompetence means that the firm failed to comply with regulations or meet the threshold conditions for authorisation. 14.2 Negligence and incompetence can already give rise to civil law actions in tort or breach of contract. 14.3 In some cases it is possible for company shareholders to take action against individual directors. 14.4 It is more difficult to mount a successful criminal prosecution than for a regulator to take action under the Financial Services and Markets Act 2000. As a result, a new offence that imposes criminal sanctions may not have clear advantages. 15. The Companies Act 2006 is another example of how negligence on the part of management can be effectively redressed. Under that Act, a company and members are able to seek redress from a director where that director has been in breach of any of the general duties of a director as set out in the Act. The most relevant of the duties in this context are the duty to promote the success of the company and the duty to exercise reasonable care, skill and judgement. The consequence of a breach, or threatened breach, of any of the general duties are the same as if the corresponding common law rule or equitable principle applied. The Act also allows members to bring derivative proceedings in the name of, and for the benefit of, the company, subject to Court approval, in respect of causes of action arising from an actual or proposed act or omission involving negligence, default, breach of duty, or breach of trust by a director. 16. The Society concurs with HM Treasury’s reasoning and agrees that negligence and incompetence would not be appropriate foundations for criminal sanctions in this area. 17. (iv) Recklessness 18. HM Treasury suggested in its consultation that an offence based on recklessness would make bank directors think carefully before making risky business decisions and make it clear that society will not tolerate such conduct. However, HM Treasury acknowledged that, in order to define what constitutes recklessness, there must be a clear idea of what constitutes normal or non-reckless risk-taking. 19. The Society agrees there are clear difficulties with such an approach. 20. Recklessness is already widely used in the criminal law, particularly in relation to statements (for example, section 2 of the Criminal Justice Act 1987 and section 2 of the Fraud Act 2006). However, this approach would mean extending recklessness to areas that have previously been regarded as regulatory matters. 21. If recklessness was used as the basis for an offence, prosecutors would have to decide, possibly years after the decision was taken, whether it was reckless or not at the time. Business decisions will always involve a degree of risk; the commercial environment is unpredictable and, while a decision may be characterised as reckless with the benefit of hindsight, at the time it is taken it may appear to be a perfectly reasonable course of action. The risk of hindsight judgment must be very high in these circumstances. 22. An offence based on recklessness would make businesses much more risk-averse. Businesses may become wary of making bold but legitimate business decisions in case those decisions are categorised as reckless later on. A recklessness-based offence could also lead to the possibility of a failure to make a bold but legitimate decision being classed as reckless conduct in certain circumstances. Such concerns may mean that company decision-making processes become more time-consuming and conservative and this may impact negatively on growth, which would be in direct conflict with the Government’s growth agenda. (3) Do you think that an offence based on one of those options would be likely to discourage those considering positions of leadership within banks? 23. As outlined in the response to question 2 above, the Society believes that the lack of clarity in the proposed offences would be a factor considered by individuals looking at leadership positions in banks. This lack of clarity and the prospect of criminal sanctions may deter experienced, well-qualified candidates from taking up senior positions. This could have unintended consequences and lead to struggling banks facing a vacuum of quality leadership at a time when they most need it, perpetuating a quicker and more significant failure of the bank. (4) Will the possibility of criminalising behaviour which can already be sanctioned under Financial Services and Markets Act 2000 (FSMA) act as a greater deterrent? 24. As explained in the above responses, the Society believes that criminalisation of conduct in the manner proposed would undermine fundamental and well-established principles of justice, would be contrary to the principles of better regulation, and would be likely to bring about a range of unfortunate and unintended consequences.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1192 Parliamentary Commission on Banking Standards: Evidence

(5) Do you think that it is likely that the threat of criminal action will stifle perfectly legitimate activity and ultimately deter growth in the banking sector? 25. As explained in the response to question 2, the risk of stifling legitimate activity is a real potential consequence of these proposals. Business decisions will always involve a degree of risk; the commercial environment is unpredictable and, while a decision may be characterised as reckless or negligent with the benefit of hindsight, at the time it is taken it may appear to be a perfectly reasonable course of action. The risk of hindsight judgment must be very high in these circumstances. 26. Criminal offences may make businesses much more risk-averse. Businesses may become wary of making bold but legitimate business decisions in case those decisions are subsequently subject to criminal action. Such concerns may mean that company decision-making processes become more time-consuming and conservative and this may impact negatively on growth, which would be in direct conflict with the Government’s growth agenda. (6) What are your views on the statement that there appears to be significant reluctance from regulators to take criminal prosecution against banks or individuals responsible for compliance functions? To the extent you agree with the statement, what, in your opinion, are the reasons for this reluctance? 27. There are a range of existing criminal and regulatory measures available to deal with individuals and corporate entities who engage in criminal activity or otherwise breach acceptable standards of conduct as prescribed by regulation. In recent years both the FSA and the Serious Fraud Office (SFO) have demonstrated a greater willingness to use those existing measures in a more robust manner. The financial sector itself has recognised that effective sanctioning of bankers who act in breach of existing criminal an regulatory requirements is essential for the maintenance of public confidence. 28. However, it should also be recognised that criminal prosecution is not always the best course of action for dealing with a failure of compliance or corporate governance, and in some cases, there may be good reasons for not pursuing criminal sanctions. Criminal investigations are costly, lengthy, and once a criminal investigation is underway, this may make it difficult to pursue civil investigations or penalties at the same time or afterwards. Additionally, many civil penalties are severe enough to make them a credible alternative to criminal prosecution. Civil and Regulatory Sanctions Rebuttable Presumption On 3 July 2012, HM Treasury published proposals to amend FSMA in order to put in place a rebuttable presumption that a director of a failed bank is not suitable to be approved by the regulator as someone who could hold a position as a senior executive in a bank. The Government also proposed two groups of “supporting measures”, which could be taken forward by the regulators under existing FSMA powers: (a) Introducing clearer regulatory requirements on individual responsibilities and the standards required of people performing certain key roles; or, in the alternative, a “firm-led approach” (with the onus on the firm and individual to set out a detailed written statement of the responsibilities and duties of each role); and (b) Requiring banks explicitly to run their affairs in a prudent manner, and requiring bank boards to notify the regulator where they become aware that there is a significant risk of the bank being unable to meet the threshold conditions for authorisation. (7) What are your views on the proposal to introduce a rebuttable presumption that the directors of failed banks are not suitable to hold senior executive positions in other financial institutions? 29. The Society accepts that there is some precedent for using the approach of a rebuttable presumption in relation to company directorships and undisclosed bankrupts. However, the Society believes that the approach suggested by HM Treasury is wider than these existing provisions and presents several practical difficulties. 30. The proposal does not take into account the diversity of roles that company directors may have. Different directors may have been appointed at different times and for different reasons. All of these factors may have a bearing on their potential culpability. 31. If the proposed presumption were to apply automatically on failure of the bank, this would logically mandate the immediate removal of the existing directors, which could leave the administrators/liquidators without access to their (potentially) key knowledge and expertise. 32. Individuals may struggle to gather the evidence necessary to rebut the presumption if they have already left the bank and no longer have access to documents and other relevant material. The problem is particularly acute where the cause of a bank’s failure is a complex set of inter-related circumstances, some of which may have been outside the control (and possibly the knowledge) of a particular director. Gathering such evidence could be time-consuming and costly, and in some cases not possible at all for individual directors. This may mean that the director is unable to prepare a proper case to rebut the presumption, which raises obvious issues of fairness.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1193

33. It is important that there are clear means for rebutting the presumption, especially where this impacts on the affected individuals freedom to earn a living eg outside banking.i 34. On the other hand, law enforcement and the FSA have a variety of powers that can be used to compel the production of documents and other material, which they would then be in a position to disclose to the director and receive comment upon in the normal course of assessing that director’s fitness to take on another “authorised” role. 35. The concept of “senior executive in a bank” needs to be clarified given the variety of management structures across financial institutions. There also needs to be a clear definition of the situations in which a bank can be said to be “failed” for the reasons outlined above. 36. Clarification of whether the presumption will apply only to those individuals who are directors at the point at which the bank fails or whether it would apply to previous directors of the bank (and, if so, over what timeframe), is necessary for the following reasons: 37. If the presumption were to apply only to individuals who were directors at the point when the bank “failed” then: 37.1 directors might be incentivised to abandon a distressed bank before it failed (whether or not their actions are contributing to the bank’s failure) to avoid the risk of the presumption applying, leaving the bank without the experience that could prove most essential to ensuring the bank’s continuing survival (in the case of non-contributory directors) and allowing culpable parties to escape the presumption; and 37.2 a rebuttable presumption may also lead to difficulties in recruiting well-qualified people to try to rescue failing banks; potential new directors may be deterred by the fact that, if the bank fails despite their best efforts (eg it is unsalvageable for reasons beyond their control), then they will automatically disqualified from taking up a new role in another bank, whilst those responsible for the bank’s distressed state escaped the presumption. 38. If, on the other hand, the presumption were extended back in time to former directors who left the bank within a prescribed amount of time before it failed: 38.1 clarity is required on how and when the presumption would apply to a director who, before the bank’s failure, had received approval to carry out a director’s role at another institution. Lack of certainty surrounding the status of that approval would clearly also disrupt the functioning of the second institution; and 38.2 clarity is required as to what right of challenge would be available in respect of such a revocation. Under proposals in the draft Financial Services Bill, a challenge to approval decisions would not give rise to full Tribunal rights. 39. The picture is further complicated by the imminent reforms to UK banks. Currently proposed is the ringfencing of retail banking from other banking activities. The ring-fenced bank is likely to have its own corporate governance structures. The senior group management may not be on the board of the ring-fenced entity. This raises a host of additional complicating questions about the fairness of the presumption in the event of bank failures. For example, in the event of the failure stemming from the investment banking arm of the group, it seems unfair to have a presumption of suitability for those directors of the other banking businesses in the group (eg the ring-fenced retail bank) when they may not have been the source of the failure. The same issue holds for reverse situations. 40. The Society is firmly of the view that the existing Financial Services and Markets Act 2000 regulatory regime, including the “fit and proper” test applicable to all persons undertaking approved person roles, provides adequate scope for a regulator to withdraw approval or refuse to sanction future appointment of individuals. (8) Does the rebuttable presumption go any further than the current regulatory regime? 41. Yes—please see response to question 7. (9) Do you think that the introduction of the “rebuttable presumption” could discourage skilled individuals from accepting key management positions? 42. Yes—please see response to question 7. (10) Do you think introducing the presumption would send a clear message that bank senior executives and boards have a responsibility to ensure there is a strong focus on downside risks? 43. The Society believes that existing legislation and regulation already requires an appropriate focus on downside risks. Greater enforcement of those requirements by the FSA will crystallise the importance of those requirements for senior bank executives and boards. The Society believes that introducing the presumption would go too far in the other direction and place the emphasis on the downside risks to the detriment of legitimate activity, especially in situations where banks had already got into difficulty.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1194 Parliamentary Commission on Banking Standards: Evidence

(11) What are your views on the possible supporting measures aimed at clarifying management responsibilities and changing the regulatory duties of bank directors? Management responsibilities: HM Treasury proposed that there should be either: — clearer regulatory requirements about individuals’ responsibilities and the standards required of individuals performing key roles; or — a firm-based approach, whereby the onus would be on firms and individuals to provide a detailed written statement on the responsibilities and duties of each role. 44. The Society can see the attraction of clarifying the responsibilities of management roles. Such clarification may help to identify who should be held responsible for a particular failure and to establish causation. 45. However, a regulator-led approach risks creating a “one size fits all” approach to the myriad of management roles and structures applied in different banks, which may reduce legitimate flexibility and efficiency. 46. The FSA Handbook already provides for a firm-led approach, with firms required to maintain a clear and appropriate record of the responsibilities of its directors and senior managers: 46.1 Statement of Principle 2 requires approved persons to act with due skill, care and diligence in carrying out their approved functions. 46.2 Statement of Principle 4 requires approved persons to appropriately disclose any information of which the FSA would reasonably expect notice. 46.3 Statement of Principle 6 requires approved persons performing significant influence functions to exercise due skill, care and diligence in managing the business of the firm for which they are responsible in their controlled functions. 46.4 Statement of Principle 7 requires approved persons performing significant influence functions to take reasonable steps to ensure that the business of the firm for which they are responsible in their controlled functions complies with the relevant requirements and standards of the regulatory system. 47. It is not clear what further guidance is contemplated. A review of the way in which these requirements are applied in practice across different firms would help to inform any decisions about what, if any, further guidance or requirements might be necessary or appropriate. Some guidance as to how frequency the requirements would have to be updated might also prove helpful. Changing Regulatory Duties: HM Treasury proposes two changes in this area: — explicitly requiring banks to run their affairs in a prudent manner; and — requiring bank boards to notify the regulator when they become aware that there is a significant risk that the bank will not be able to meet the threshold conditions for authorisation. 48. It may be difficult to assess what constitutes “prudent” in any given context—particularly given that banking necessarily involves some degree of risk taking. Because an assessment of prudence would require a judgment to be exercised about the decision-making process (itself a matter of judgment), there is a greater need for clarity as to what is required. 49. The FSA Statement of Principles already requires approved persons to act with due care, skill and diligence when carrying out approved functions and to notify the regulator of material developments. 50. The FSA has recently acted pursuant to these existing requirements in relation to conduct arising out of the recent financial crisis. In September 2012, Peter Cummings (former head of corporate banking at HBOS), was fined £500,000 for not acting with due care, skill and diligence as a result of his role in the collapse of HBOS. He was also banned from working in the banking industry. This suggests that the FSA’s existing powers are appropriate and being used by the FSA to target inappropriate conduct. The Society does not see what the proposed duties would add. 51. In addition to the points made above in response to this question, the Society believes that any further clarification of management responsibilities or regulatory duties should be aimed at improving bank management in the future—it should not merely be used as a tool for assigning blame if a bank fails. Existing Regulatory Sanctions The Financial Services Act 2010 provided the FSA with greater enforcement powers. The FSA has the power to fine authorised persons and approved individuals for misconduct. The 2010 Act extended these powers to enable the FSA to suspend or limit an authorised person’s permission or an approved person’s approval. It also enabled the FSA to impose a fine on an individual performing a controlled function without approval in

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1195

addition to being able to prohibit the individual from working in the financial services industry. It also included provisions in respect of the disclosure by the FSA of decision notices. (12) Despite the range of enforcement powers currently available to the FSA, are additional powers necessary? If so, what would those powers be? 52. The Society does not agree that additional powers are necessary. (13) What are your views on amending FSMA to include a power to prohibit an individual from performing a controlled function on an interim basis? 53. The Society notes that section 66(3) of FSMA enables the FSA to suspend approval for a person to perform a controlled function for a period of time. We are not aware of any deficiencies in the use of this power. (14) Considering the current powers and measures, do you think the perceived shortcomings in being able to hold individual directors personally culpable are as a result of statutory or regulatory deficits or as a result of regulators and law enforcement agencies not utilising the powers already available to them as fully as they could? 54. The perception that there are shortcomings in regulators and law enforcement agencies being able to hold individual directors personally culpable may partly be fuelled by modern methods of news-reporting. Stories are reported 24 hours a day and headlines tend to highlight a particular individual. This focus has created an expectation that one person will have deliberately done an identifiable action which was the sole cause of the problem and that person should be located and dealt with in a public manner by the end of the week. As more detailed investigations into bank failures have shown, there is generally not one person entirely at fault. Though criminal and disciplinary proceedings do take place, it takes time for justice to be served and there are always lessons to be learned for next time. A balance must always be struck between the public appetite for someone to be punished for something going wrong, the interests of justice and the rule of law. 55. Additionally, the FSA and others have accepted that there were some failings in regulation and more use of existing powers could have made earlier. Although more could have been done by regulators in relation to bank failures, it should be noted that the current regulatory models are changing and the FSA is becoming more intrusive. (15) What are your views on extending the limitation period for taking action against approved persons? 56. No comment. Legislation versus Regulation (16) In order to make bank directors more accountable (due to the adverse impact a large failed bank can have on the wider economy), what are your views on amending the approved persons’ regime under FSMA rather than the Companies Act 2006 and the Insolvency Act 1986. To the extent you consider changes should be made to the legal framework, please articulate how you think this could be achieved given the legislation would apply to all company directors. 57. The Society cannot see any reason for imposing further regulatory burdens on companies. In light of the recent and extensive reform of the Companies Acts, the Society does not think that further amendment to this legislation is warranted. The Approved Persons’ Regime (APER) (17) The Upper Tribunal ruling in John Pottage v The FSA (FS/2010/0033) highlighted that enforcement action against senior managers is only likely to be successful where there is evidence of actual wrongdoing by the executive concerned. In your opinion, what changes could be made to some of the statements in APER about the standard of conduct expected of directors in order to make it easier to bring enforcement? 58. As stated in the response to question 6, approved persons are already required to act with due care, diligence and skill. The Society would be concerned about any proposals to make it easier to take enforcement actions against individuals without strong evidence of actual wrongdoing or failure to act according to established regulatory standards. Such proposals would be contrary to well-established principles of justice and fairness. (18) In your opinion, has a lack of direct senior management accountability inside firms for specific areas of conduct contributed to the shortcomings in holding individuals personally culpable? Do you think APER should be revised to remedy this? 59. No comment.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1196 Parliamentary Commission on Banking Standards: Evidence

(19) Would it be beneficial for the regulator to adopt a more intrusive approach to senior appointments as part of the Significant Influence Function (SIF) process? How could such an approach be adopted 60. The Society has no specific comments. The Society notes that the Solicitors Regulation Authority is providing separate advice on the legal sector as a separate regulatory regime. (20) Do you see merit in requiring the regulator to re-appraise SIF individuals at set intervals and on other occasions if it believes that circumstances justify it? 61. The Society has no specific comments. We note that the Solicitors Regulation Authority is providing separate advice on the legal sector as a separate regulatory regime. (21) What are your views on extending APER so that it applies to all bank employees in order to enable the regulator to take disciplinary action against employees who are currently outside the scope of APER 62. It is not clear from the question what circumstances would justify a regulator taking action against an individual who is currently outside the scope of APER. It is also not clear whether “all bank employees” is intended to apply to all bank employees working at a corporate level or whether it would also apply to, for example, branch cashiers or staff employed in ancillary functions such as human resources. Given the size of the UK financial sector, the Society would query the proportionality and resourcing implications of this proposal. (22) Do you see merit in the establishment of an independent professional body with mandatory membership which has the power to impose civil and possibly criminal sanctions? In your view, could such a body provide a solution for the issue of global matrix management structures that can exist within universal banks? 63. It is not clear what mischief this proposal is intended to address. The Society is concerned that the proposal to give an independent professional body the power to impose criminal sanctions is contrary to the rule of law and is at odds with principles of Better Regulation. 64. It is also unclear who would be mandated to be members of such an independent professional body. If it is intended to apply to all bank employees, then the Society would reiterate concerns about proportionality and resourcing implications that we set out in response to question 21. 65. The Society notes that the Which? sponsored Future of Banking Commissionii made a recommendation similar to that implicit in this question in their 2010 report, suggesting that “…bankers[should] receive compulsory formal training before they are able to fully practice in their profession. This should include training in the ethical behaviour expected of the members of their profession, including how to resolve conflicts of interest”.iii They recommended that a “…Code should be devised and enforced by a new professional standards body along the lines of the General Medical Council, or the Legal Services Board”.iv The report highlights the solicitors profession, suggesting it might be an example to be followed.v 66. However, we note that the FSA, through its conduct and other regulatory rules, already has in place a range of standards, requirements and mechanisms for punishing infringers which are aimed at ensuring that financial services firms and their staff operate appropriately. These can be seen as resulting in similar ends to that which the professions try to reach by their existence and the upholding of their ethical and other behavioural standards. Therefore we find it difficult to see what creating something akin to a formal profession for banking and bankers will add of any significance that outweighs the host of difficult questions, which will need to be resolved before the idea can be implemented. These questions include: 66.1 How will a banker be defined and will it be set out in statute? 66.2 Professions work best in relation to regulating expert individuals who are giving advice to clients. This concept may be less relevant to banking, especially where some of the problems may be considered institutional. In addition banking encompasses a wide range of activities. By necessity lines would have to be drawn regarding what a banker would be allowed to do (and how) under their professional codes and what they should not. Where would those boundaries be set and in the fast evolving world of financial services? Would there need to be mechanisms in place to ensure these boundaries could evolve with market innovations? 66.3 A number of professions have gone through a number of structural changes in recent years, for example in the legal profession representation has been split from regulation. There are questions as to how the profession of banking would be structured. Would it follow the changes that have occurred in legal services or follow the model of some other professions where both representation and regulation remain in the hands of the same body?

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1197

67. Would bankers be subject to a regime of indemnity insurance to compensate mis-advised clients? How would an individual become a member of the banking profession? One of the key elements in many of the professions, such as the law, is that individuals who want to become members of it take a considerable amount of time to qualify, and as part of the qualification process come to understand and imbibe the structures, culture and ethics of that profession. They serve something akin to an apprenticeship, by the end of which they are fully inducted into that profession. This is further buttressed by requirements on continuing professional development. Creating something similar to a new profession requires more than a new Code of Practice but the building of a wider set of foundations. Cost (23) Understandably, there is considerable cost in pursuing individual actions. What changes do you think could be made in order to ensure that cost does not act as a deterrent in pursuing all but the largest cases? 68. From a regulatory and efficiency perspective, pursuing criminal action is not always the most efficient use of court and Crown Prosecution Service time, nor the best method of meeting a desire for a swift resolution or the imposition of appropriate sanctions. Ensuring that a variety of civil and disciplinary options are available enable action to be taken against more individuals in a targeted fashion. International (24) Do you think introducing additional criminal, civil or regulatory sanctions would have an impact on the international competitiveness of UK banks? 69. One of the key factors that makes the UK a desirable business location is its effective justice system, which is founded on the rule of law and requires the law to be clear and proportionate. As previous answers have stated, the proposals outlined are challenging and face fundamental issues in meeting the requirements for clarity and proportionality and complying with the rule of law. If confidence that these requirements will be met is not maintained, possibly because proposals have been poorly considered, this may have a detrimental impact on the international competitiveness of UK banks. (25) In your opinion, are there other legal or regulatory regimes that the Commission should be considering? Please provide your reasons for suggesting the applicable regime. 70. No comment. Other (26) The regulator has an extensive range of enforcement powers but is arguably hesitant in using those powers. What are your views on the introduction of sanction(s) that could be imposed against the regulator to the extent they do not deploy their powers appropriately? 71. The Society notes that the Solicitors Regulation Authority is providing separate advice. The Legal Services Board is the overarching regulator for the legal profession and may also have its own view. However, the Law Society believes it is important that regulators maintain their independence and question whether their decision-making processes would be adversely affected by the prospect of their decisions leading to sanctions or judicial review in the future. Many regulatory bodies are already accountable to Parliament and their Chairmen or Chief Executives may be questioned by MPs. Although aspects of regulatory process may need to be strengthened, we do not believe that introducing sanctions that could be imposed on regulators is the most appropriate solution. (27) What are your views on applying different sanctions for different types of directors—for example, nonexecutive directors? 72. The Society believes the regulator should have a discretion to determine the most appropriate sanction in each individual case. One of the positive aspects of FSMA is that it provides the flexibility to deliver proportionate sanctions, because it provides for a wide range of sanctions. Creating “set” categories for different directors would need strong justification and there would have to be clear grounds for distinguishing between each role. (28) Are there any other measures or legal/regulatory changes that the Commission should consider? 73. No comment. 10 January 2013 References i

For example the City of London Law society have proposed a “declaration of fitness”. Source: Livingston, D et al (2012). “Re: criminal sanctions for the directors of failed banks”, letter to the Financial Regulation Strategy HM Treasury, accessed at: http://www.citysolicitors.org.uk/FileServer.aspx?oID=1271&lID=0

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1198 Parliamentary Commission on Banking Standards: Evidence

ii

Davis, D et al (2010). “The Future of Banking Commission”, pub: Which?: London, can be accessed at: http://www.which.co.uk/documents/pdf/future-of-banking-commission-report-276591.pdf iii

Davis, D et al (2010). “The Future of Banking Commission”, pub: Which?: London, pg 11.

iv

Davis, D et al (2010). “The Future of Banking Commission”, pub: Which?: London, pg 11.

v

Davis, D et al (2010). “The Future of Banking Commission”, pub: Which?: London, pg 77.

Written evidence from Andrea Leadsom MP FULL BANK ACCOUNT PORTABILITY Summary People have lost faith in the banking industry: small businesses are finding credit hard to come by, taxpayers are angry at the billions spent on the bailouts, pay for bankers is often unrelated to performance, and customer service levels are poor. A lack of competition in UK retail banking has contributed to this situation. It should be as easy for someone to change their bank account as it is for them to change their mobile phone provider. Only full account portability would make this a reality—the seven-day system of switching advocated by the Payments Council and endorsed by the Independent Commission on Banking would not. Seven-day switching should be part of the journey towards full-account portability. It should be supported to provide a quick-fix to some of the problems. And the government should announce now the intention to introduce full account portability with a long lead time, to tie in with the timetable for the retail ring fence. Consumer Choice Giving personal and business customers the ability to switch instantly would be a massive boost for consumer choice. Bank Competition Full account portability would be a radical and long overdue shake up for the competitive outlook in UK banking—new entrants would be encouraged as would product innovation; the “too big to fail” risk would be greatly reduced. Resolution The Regulator (in future, the Bank of England) would be able to shut down a failing bank whilst avoiding the risk of a run on the banks—because all personal and business accounts could be instantly transferred to survivor banks. Fraud The costs of account portability need to be set against the potential significant reduction in bank fraud, a great deal of which is the result of poor legacy systems that are easy to override and which would be replaced. A bit like the Victorian sewers, the legacy systems of banks need replacing at some point in the near future, and the introduction of full account portability could be the catalyst that drives this change. SMEs Differentiation Banks would be much better able to differentiate between SME customers; currently legacy systems and blunt credit scoring leads to impersonal and inaccurate assessments of the real risks of SME loans. An Idea Whose Time has Come Making it easier for people to switch bank provider is not a new concept. Don Cruikshank, who led a review of the banking sector published in 2000, has long been committed to the idea of full bank account portability. Halifax launched the stand-alone telenet bank Intelligent Finance in 2000, with the express aim of making it easier for consumers to switch bank accounts.19 In March 2001 the Competition Commission identified “reluctance” on the part of small and medium-sized businesses “to switch banks” as a major problem.20 Later that year Bank of Scotland announced its intention to capture business from the Big Four with a new “Easy to Join” service which would assign a staff member to oversee the account switching process and deal with direct debits, standing orders, international transfers and the like.21 19 20 21

Independent on Sunday, 7 January 2001. Daily Telegraph, 19 November 2001. Daily Telegraph, 19 November 2001.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1199

However, in 2001 the Office of Fair Trading asserted that introducing portable account numbers would “require major investment and significant changes to the operation of the current clearing systems. As the inconvenience of changing account numbers is only one of many constraints on switching, the costs of such a development are very likely to exceed the benefit”.22 As we will see, this finding is now out of date. In June 2002 James Crosby, chief executive of HBOS, said that he was concerned by delays to greater account portability and that the move was “vital” for competition.23 More recently the Independent Commission on Banking (ICB)—led by Sir John Vickers—called for a system that would make account switching easier. However, the ICB’s final proposals stopped short of full account portability. The ICB published its final report in September 2011 following an interim report that came out that April. The Treasury Select Committee (TSC) took evidence around both reports, in which several people said that account switching was important. After the interim report was published, Mr Horta-Osório, chief executive of Lloyds Banking Group, told the TSC that: “There has been progress made in terms of customers being able to switch effectively and without risk, but more progress can be made. We are proposing a seven-day automated redirection of direct debits whereby customers in seven days can be sure that their account and their direct debits are automatically redirected to the new account without any risk. All banks have now endorsed that solution and the Payments Council as well. That can be implemented in two years and has much lower costs and a much shorter timeframe than account portability, for example.”24 Lloyds told the TSC that “improving both switching and transparency would further enhance competition in the market,” adding that “a world-leading current account switching service could be introduced within two to three years,” but that: “full account number portability would take much longer to implement (between five and ten years), cost significantly more and would not offer significant additional customer benefits. Indeed, in practice, full account portability would not involve instantaneous (or same day) switching. Providers would have to put in place appropriate processes to protect customers against erroneous or fraudulent attempts to switch their account.”25 The TSC found that the ICB’s interim report had not given adequate consideration to switching and transparency, having devoted just one page to the topic.26 At a roundtable discussion in the House of Commons on 13 September 2012, representatives from the Bank of England, Lloyds, RBS, Barclays, HSBC, Metro Bank, Virgin Money, the Treasury Select Committee the Payments Council, Vocalink and the British Bankers Association discussed the idea of full account portability. Royal Bank of Scotland Chief Executive Stephen Hester sent the following message to participants in that discussion: “RBS supports competition in banking markets. We support moves to improve, speed up and simplify current account switching for retail customers. There are important technical challenges but these should be treated as issues to constructively work through not insoluble blockers to the end goal. The principle should be that if a customer wants to leave or join us, unreasonable obstacles should not be put in their way.” Following that event, Which? Executive Director Richard Lloyd said: “One of the most important ways that consumers can influence the broken banking culture in this country is by voting with their feet and switching to another bank. Yet half of consumers have never changed current accounts. With consumer trust in banking at an all time low, we want to see banks up their game and put customers first. We urge the Government to seriously look at introducing portable account numbers to make switching easier for consumers.” Jayne-Anne Gadhia, CEO of Virgin Money said: “We support moves that make it easier for consumers to switch their current account and recent surveys have highlighted that is what the majority of people want. It would be good for consumer choice, good for competition and would hopefully encourage banks to be more consumer-focused in future.” Andy Haldane, Executive Director, Financial Stability of the Bank of England said that “introducing account portability would help to compete away the problem of too big to fail rather than having to regulate it away.” 22 23 24 25 26

Office of Fair Trading, Supply of Banking Services by Clearing Banks to Small and Medium Enterprises 2001. The Independent, 19 June 2002. Treasury Select Committee, Nineteenth Report, Independent Commission on Banking, 19 July 2011. Treasury Select Committee, Nineteenth Report, Independent Commission on Banking, 19 July 2011. Treasury Select Committee, Nineteenth Report, Independent Commission on Banking, 19 July 2011.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1200 Parliamentary Commission on Banking Standards: Evidence

The ICB and Payments Council are somewhat timid When the ICB published its final report in September 2011, it advocated a system that makes switching easier but which stops short of full account portability. The ICB determined that what was necessary was a redirection service for personal and small business accounts that: caught all credits and debits going to the old account (including automated payments); was “seamless” and “problem-free” for the customer (including guaranteed no losses if mistakes were made); sent reminders to direct debit originators that details were updated; and was free to the customer.27 The ICB believes this new system should be up and running by September 2013.28 A major factor in the ICB’s policy decision cost. The ICB reported that: “Preliminary discussions with the Payments Council suggest that these costs could be in the order of £650 million to £850 million. These are predominantly one-off costs—the ongoing maintenance costs would be very low, and may be balanced out by savings from reducing manual processes. These estimates include costs to all those potentially affected by the change, including central payments schemes, banks that are members of these schemes, banks that access these schemes through agency arrangements, and service users of payments systems such as direct debit originators and merchants.”29 Members of the TSC have recently asked various witnesses what they made of the ICB’s final recommendation on switching. Bob Diamond, Chief Executive of Barclays, told me that: “Andrea, we believe that the easier it is for customers to switch banks the better it is going to be for Barclays, simply stated. What we are trying to evaluate is, what is the cost benefit of getting them there?”30 His colleague Antony Jenkins, chief executive of retail and business banking, stated that: “No, I don’t think that we agree that the proposed solution is going to be a superior solution for the customer, and I will tell you why. Firstly, if we have a seven-working-day window for transferring the account I think that is analogous to moving your mobile phone number, speaking as someone who has done it recently, but importantly I also think if we go down the route of true account number portability the cost is going to be enormous. The £2 billion number feels low to me. But equally, more importantly, it is going to tie up the industry and all of our technology development resources for several years to deliver that. It is not something that is going to be easy to be done in parallel with the ICB recommendations at all, and I worry that that is going to suck out innovation from the industry and doing things for customers that really matter, like improving how they make payments and bringing new products and services to the market.”31 It should be noted that the system that the ICB and Payments Council recommend is not account portability— customers would not be able to retain their bank account number. Being able to retain the same number evidently makes switching from one mobile phone provider to another more attractive and the same would surely apply to bank accounts. In January 2012, the Chancellor of the Exchequer came before the TSC and outlined the government’s response to the ICB proposal in an answer to me: “When it comes to the very specific question you have about account portability, first of all, Vickers looked at this and he came to the conclusion that the cost would outweigh the benefits. That ultimately the cost of changing the banking IT systems of the entire British banking system or all British banks so that you could take your account number and your sort code into any bank outweighed the benefit. He thought it was much more expensive than, for example, taking your mobile phone number with you. For example, sort codes currently are very branch specific, so if you keep your sort code that changes the nature of the sort code. So he came to the view that the switching option he proposed, that within seven days you would have in effect a guarantee provided by the industry that you can switch your current account, the numbers would change but all the direct debits and the like would follow without you having to contact all the individual companies that you have a direct debit with, he thought that was a better value for money option. Now, what we have done is-and as I said in the House of Commons, this is partly due to the work that you have done in drawing my attention to this-we have said that if this does not deliver what we hope, then we will look very seriously at account portability, so that was not in the Vickers report, it is something we put into the consultation document.”32 27 28 29 30 31 32

Independent Commission on Banking Final Report Recommendations, September 2011, p. 218. Independent Commission on Banking Final Report Recommendations, September 2011, p. 221. Independent Commission on Banking Final Report Recommendations, September 2011, p. 220. Treasury Select Committee uncorrected evidence, 14 December 2011. Treasury Select Committee uncorrected evidence, 14 December 2011. Treasury Select Committee uncorrected evidence, 11 January 2012.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1201

Why we Need Greater Competition The ICB concurred that there was an issue that needed to be addressed, stating in its final report: “Competition between banks is blunted by the actual and perceived difficulties for customers in identifying the right account for their needs and switching to it, and by poor conditions for consumer choice more generally. Without consumers being willing to switch between competitors, banks have weak incentives to provide better offers. The OFT study of PCAs in 2008 found that a significant proportion of consumers believe that it is complex and risky to switch accounts, with the result that switching rates are very low. Few consumers actively monitor the relative competitiveness of their accounts. It also found that many consumers are not familiar with the key fees associated with their PCA, and that they have difficulty understanding and calculating these fees.”33 The ICB reported that there was a switching rate of just 3.8% for personal current accounts in 201034, that three-quarters of consumers have never considered switching their current account,35 that 51% of small to medium-sized businesses had never switched their main banking relationship36 and that 85% of businesses surveyed by the Federation of Small Businesses had not switched their main banking provider in three years.37 These switching rates compare unfavourably with other industries. 15% of consumers changes their gas supplier in 2010 and 17% switched electricity supplier in the same year.38 Moreover, 26% of consumers switched telephone provider 22% changed insurance provider in 2010.39 It has been countered that this does not take account of customers who stick with the same bank but upgrade their account. Yet such transfers do little to encourage competition between providers and, as the ICB identified, “low switching rates … are an important barrier to competition not only for those products but also for others, because they define a customer’s main banking relationship and enable cross-selling of other products”.40 The ICB’s rejects the conclusion that low switching rates for banking are explained by near-universal contentment with services, finding that considerable savings can be had from changing accounts and that much apparent customer satisfaction can be explained as “passive”—focusing on an absence of negatives rather than positive enthusiasm.41 The ICB also found that only 40% of extremely dissatisfied customers were likely to switch.42 The market is not adequately producing competition. The ICB found that various banking markets “are considerably more concentrated than any point over the previous decade, and the number of challengers has fallen sharply”.43 Equally pertinently, the ICB concluded: “There is significant evidence to show that consumers are put off by the current switching process. To switch current accounts, it is necessary for all direct debit originators to update their records with the customer’s new account details, and for the customer to notify their employer and anyone else who makes payments into their account of their new account details. On average, this process takes around days, and requires action by the customer, both the new and the old banks, direct debit originators, and employers and other people or organisations that make payments to the customer.”44 The ICB itself provides evidence that a redirection service may not be comprehensive enough: “In the Netherlands, where a similar bank account redirection system (albeit with some significant differences) has been in place since 2004, switching rates are still very low, and there remains a perception among non-switchers that the process would be difficult, despite the fact that those who have switched using the redirection service found it easy. It appears that despite the positive customer satisfaction among those that did switch using the switching service, the existence of the service has not (yet) changed the perception among non-switchers that switching would be difficult, nor has it been transformational in raising switching rates. This is not a reason to conclude that the introduction of a similar service in the UK would not deliver benefits. However, it emphasises the need for such a service to be accompanied by improved transparency, and gives cause to be sceptical about claims that the impact of this measure on its own will be transformational for competition and consumer choice.”45 33 34 35 36 37 38 39 40 41 42 43 44 45

Independent Commission on Banking Final Report Recommendations, September Independent Commission on Banking Final Report Recommendations, September Independent Commission on Banking Final Report Recommendations, September Independent Commission on Banking Final Report Recommendations, September Independent Commission on Banking Final Report Recommendations, September Ofgem, 2011, The Retail Market Review—Findings and Initial Proposals. Consumer Focus, 2010, Stick or Twist. Independent Commission on Banking Final Report Recommendations, September Independent Commission on Banking Final Report Recommendations, September Independent Commission on Banking Final Report Recommendations, September Independent Commission on Banking Final Report Recommendations, September Independent Commission on Banking Final Report Recommendations, September Independent Commission on Banking Final Report Recommendations, September

2011, 2011, 2011, 2011, 2011,

p. p. p. p. p.

179. 180. 180. 180. 181.

2011, 2011, 2011, 2011, 2011, 2011,

p. p. p. p. p. p.

182. 184. 184. 198. 185. 220.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1202 Parliamentary Commission on Banking Standards: Evidence

The ICB also said that: “there may be a case for account number portability in due course, but the redirection service would be a cost-effective first step. If it does not achieve its aims, there could be a strong case, depending on cost, for full account number portability to be introduced (potentially through use of an alias database). Once the redirection service has been implemented, the FCA should assess whether it is delivering enough of an increase in willingness to switch to lead to effective competitive tension. If it is not, then the incremental costs and benefits of account number portability should be considered.”46 The government agrees with the ICB and the Payments Council is now formulating a plan for how to implement the proposal. It is my contention that it would be far better to take the plunge now and go for full portability. The Advantages of Full Portability One representative of a newer bank emphasised that banks have to update their IT and legacy systems all the time anyway and that the overhaul needed to implement full account portability needs to be seen in this context. They see this as a ten-year project but an eminently achievable one nonetheless.47 Intellect, which represents the UK technology industry, echoes these views in it’s recent report “Biting the Bullet—why now is the time to rebuild the foundations of the financial system”. A truly competitive environment requires “free entry” and “free exit” of market players. This is not the situation with banking in this country. Rather the trend has been towards consolidation and mergers. A small number of very large banks dominate. In 2000 there were 41 major British banking groups and subsidiaries, in 2010 there were just 22.48 Four banks have an almost 80% market share of the personal current account and small and medium enterprise lending market. Therefore there is evidently a need for genuinely comprehensive action. The government should demand that full account portability is achieved in the next ten years. Banks would need to establish a clearing system in common, which would hold all bank accounts with an identifying code to establish which commercial bank has the account. Several benefits would accrue from this policy. The ability to retain their account number would make it easier and more attractive to encourage customers to change provider. The possibility of almost instantaneous switching would result in much greater competition between banks. Any newly authorised bank would be able to buy a licence to use the system, which would be a boost to challenger banks and take away the unfair advantage enjoyed by long-established clearers. Accounts could be easily transferred from failed institutions to sound ones, which set in the context of a future financial collapse or potential run on a bank is obviously an additional massive plus for full account portability as it would obviate the potential need for a bailout. Introducing account portability would compete away the problem of too big to fail rather than having to regulate it away.” Contrastingly, the consumer organisation Which? believes that the Financial Services Compensation Scheme, which is the current compensation scheme of last resort, is not adequately understood among the public and that its existence would not prevent another run on a bank.49 This enabling of mass migration also means that the government’s wish to separate retail and investment banking could be effected through full account portability. Making it easier for consumers to switch providers would be a boost to new entrants in the market and therefore to competition, as the knowledge that they could always switch back would make consumers less nervous about going with a less established company. The principal objection to full account portability is that of cost, with technological feasibility another concern. Intellect, has undertaken research which allays these concerns and demonstrates that they start from false premises: “Under the PC’s [Payment Council’s] current proposal, which will not centralise payments information and attach this to a unique consumer identifier, mass migration of millions of accounts would not be possible in the required time frame. Therefore a new, separate system would need to be built to facilitate this requirement—resulting in significant duplication of effort and costs for banks. In the case of state-owned banks, this is public money that is being wasted and, as banks have stated in the past, the increased cost of compliance could be passed on the consumer and could also lead to a reduction in the availability of finance for SMEs … On average, major changes to banks’ legacy systems take between two and three years to implement—this would be a minimum extension to the time it takes to reform the financial system if a separate account migration system 46 47 48 49

Independent Commission on Banking Final Report Recommendations, September 2011, p. 222. Private conversation. British Bankers’ Association, Annual Abstract of Statistics. Intellect briefing note, The case for a central account portability system.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1203

has to be built as well. Ultimately, there needs to be a more joined up and forward thinking approach to the reform of the financial system by Government.”50 Intellect also assert that “banks’ own legacy systems are currently stifling innovation; pose a significant barrier to the timely and cost-effective implementation of regulatory reform; and are in significant need of renewal anyway”.51 This view supported by conversations between the author and banking industry insiders. Why Costs are Overestimated Estimates of expenditure always have to be set against the possibility of savings. Full account portability could profoundly reduce fraud: “Intellect members estimate that there could be a reduction of up to 40% on current fraud levels through a central account portability system. When taken in the context of recently released statistics on total fraud losses on UK cards of £169.8 million (between January and June 2011), this would to equate to a saving of approximately £68 million over six months. This level of saving would, over time, help to cushion the cost of establishing an account portability system. The current proposal for account switching would not provide a central view of all accounts and therefore would offer limited benefits for fraud reduction.”52 Intellect further believes that costs have been considerably overestimated: “Intellect believes that the costs estimated by banks of facilitating full account portability are extremely high, and a detailed evaluation of how an account portability system would be rolled out, both at the core at individual bank level, would prove this to be the case. … The maintenance of the system itself could be paid for on a subscription basis—weighted based on market share. An alternative could be a fee paid to the governing body every time an account is switched. This would need to be set at an appropriate level to ensure that it remains a commercial imperative for banks to retain existing and attract new customers. As set out above, cost savings on fraud would assist offsetting the cost, as would the reduction in costs for personnel involved in account switching at individual bank level, and a reduction in compliance activity (and therefore costs) around account switching activities.”53 The Experience from Abroad In August last year the Australian government announced that it was dropping a plan for full account portability. Former Reserve Bank Governor Bernie Fraser wrote a report which the Australian government accepted in full. Fraser concluded that “Full account portability is a deceptively simple concept” and that it “would be akin to taking a gold sledge hammer to crack what is really quite a small nut in the broader scheme of competition and account switching in banking services in Australia.”54 Fraser suggested that the Australian government adopt an electronic redirection system, in which a customer’s new institution can request details of direct debits and credits and the customer’s existing institution will provide that information “quickly and efficiently”.55 This is similar to what the UK government is currently planning to pursue. It is however very noteworthy that the Fraser report also found: “Although not widely known, a formal switching scheme was established in Australia in late 2008. Its stated aim was to make it easier for customers to switch their transaction accounts among financial institutions, and provide a boost to competition in the process … considerable switching of accounts has occurred since 2008 but the schemes’ contribution has been miniscule—less than 6,000 switches have been executed through the scheme since its inception.”56 This rather begs the question why something that stops short of full account portability is going to have a meaningful effect. India and Sweden have come to a different conclusion to Australia. In light of mobile phone number and health insurance portability being successfully established, the Indian government has announced that it will bring in savings account portability, although the details are not yet known to the public.57 Sweden has introduced a separate and unique number, called a “bankgiro number”, which allows customers to make and receive the equivalent of direct debits and credits to that number. Third parties need to know this customer number. Essentially, the unique customer number is linked to a customer’s bank account and if they 50 51 52 53 54 55 56 57

Intellect briefing note, The case for a central account portability system. Intellect briefing note, The case for a central account portability system. Intellect briefing note, The case for a central account portability system. Intellect briefing note, The case for a central account portability system. CRN, Government nixes bank account portability, 22 August 2011. Banking Services Switching Arrangements, Commonwealth of Australia, 2011. Banking Services Switching Arrangements, Commonwealth of Australia, 2011. Intellect briefing note, The case for a central account portability system.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1204 Parliamentary Commission on Banking Standards: Evidence

want to switch company they can decouple this unique number and attach it to a new account number provided by the new institution.58 How it Could Work The fact that, for example, Barclays allows customers to bank on their mobile phones shows that huge progress has been made technologically.59 Intellect outlines in detail how full account portability could work: “Account portability can be delivered through a Central Utility developed in two phases, that will consist of a central mandate facility, unique identifiers to differentiate individual consumers across the banking system and will be scalable to accommodate the mass migration of up to 30 million accounts in a short time frame. Each phase of the Central Utility will be built with the next in mind, so that the ability to expand it to fulfil these dual objectives, is not limited by design. The principle enabler facilitating the account portability is the centralised storage of payment mandate information (direct debit, standing order and recurring card transactions) and unique consumer identifiers that will be held in the Central Utility. Both account switching and mass account migration become a case of simply changing the specific target current account data (ie where the consumer holds their current account) rather than a process of re-establishing all of the mandates associated with a consumer’s account. Similarly, receivables directed to the consumer’s account (such as their salary, pension or benefit payment) will not require alteration, as they will be referencing the unique consumer identifier, rather than the actual consumer current account, and will therefore continue to function normally when the underlying target current account associated with the consumer’s unique identifier is switched to a new provider. In effect, all account information relating to a specific individual or business will ‘hang’ from a unique identifier—in essence a portable number that will be retained by that individual/business on an ongoing basis.”60 Conclusion Now is not the time for timidity and nor is it the time for false economies. Were the government to announce now that it expected full account portability within the next ten years, that would provide certainty in the market, banks could factor it in to their legacy and IT planning and we would be making a start along the road that the ICB and government alike suspect we may have to take eventually anyway. Full bank account portability would be good for the consumer and good for challenger banks. It would also be good for established banks—they should have nothing to fear from it being easier for customers to switch, as Stephen Hester of RBS has said. The appalling scenes we witnessed recently of a run on a bank would be a thing of the past and a sector which currently lies low in public opinion would be able to thrive, responsibly, as it has not done for some time. 16 September 2012

Letter from Erkki Liikanen On 22nd October 2012, the Parliamentary Commission on Banking Standards heard me in my role as Chair for the High Level Expert Group on reforming the structure of the EU Banking sector. As a continuation of the hearing, I hereby provide the Commission with some written evidence on the question “How to get more engagement from shareholders on how banks are run”. The High-level Expert Group did not put for suggestions that would directly increase shareholder engagement in how banks are run. The importance of shareholder engagement in eg the nominations committee was, however, highlighted. In particular, the High-level Expert Group proposed that more attention needs to be given to the ability of [...] boards to [...] monitor large and complex banks. Specifically, fit-andproper tests should be applied when evaluating the suitability of [...] board candidates. The High-level Expert Group did put forth suggestions that would increase shareholder engagement indirectly. The indirect impact of reducing complexity and increasing transparency as ways to facilitate shareholder engagement is not to be underestimated. First, the suggested mandatory separation of proprietary trading and other high risk trading activities will reduce the complexity of the banks thus facilitating monitoring by the shareholders. Second, the suggestion of the quality, comparability and transparency of risk disclosures should be improved by requiring detailed financial reporting for each legal entity and main business lines also improves transparency thus increasing the ability of shareholders to efficiently monitor banks. Moreover, the suggestion of the High-level Expert Group will have a significant impact on the incentives for 58 59 60

Intellect briefing note, The case for a central account portability system. http://www.barclays.co.uk/MobileBankingServices/MobileBanking/P1242561069586 Intellect briefing note, The case for a central account portability system.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1205

shareholder engagement by tackling the “too-big-too-fail” problem. Risk sensitivity is reintroduced in bank funding through the requirement that the deposit bank and trading entity are separately capitalised and funded. The High-level Expert Group acknowledged that shareholder engagement, and corporate governance in a broader sense, differ across banks with different ownership structure and legal form. Firstly, the lack of shareholder engagement is amplified if the share ownership is dispersed as the incentive to monitor is decreasing in the size of the shareholding. Secondly, while some institutional investors take a long-term perspective, others are known to focus more on short-term profits rather than the long-term prospect of the company in which they invest. Thirdly, the solution to improve shareholder engagement and strengthen corporate governance might not have the same impact in all banks as the legal form of eg cooperative banks and saving banks, without ownership in the traditional sense differ from one of the commercial banks. Finally, in addition to shareholder engagement, bank creditor engagement is also of great importance. The High-level Expert group acknowledged this by giving its support to the use of the bail-in instruments as a way to ensure creditor responsibility of losses; a concrete incentive to monitor how banks are run. 5 November 2012

Written evidence from Andrew Lilico 1.1 This document from Andrew Lilico responds to the call for written evidence from the Parliamentary Commission on Banking Standards (the “Tyrie Commission”). Drivers of Standards 1.2 In (a) (b) (c) (d) (e)

any industry, standards are maintained by a combination of the following elements: Competitive pressures—“customer power”. Ethical standards—“peer pressure”, both company peers and employee peers. Scrutiny by owners. Scrutiny by creditors. Regulatory oversight.

1.3 In the banking sector, there has always been significant regulatory oversight and long-established ethical norms for both firms and employees. We offer no detailed comment here on the perfection or even adequacy of oversight or norms, but note their presence. Any firm faces scrutiny from owners. We offer no detailed comment here on the adequacy or otherwise of corporate governance procedures. 1.4 The key point to note about the other standards-maintaining elements is that: (a) Any level of regulatory oversight sufficient, by itself, to maintain high standards in an industry as complex and multi-faceted as banking will almost inevitably involve such onerous intervention as to stifle the healthy functioning of the sector. It is simply a delusion to imagine that in a modern economy, in which banks are the main allocators of capital, regulatory supervision could ever be the main mechanism to maintain standards. Such a task would be similar in scale and complexity to the task of centrally planning an economy. It is not in any sense an exaggeration to assert—it is literally true—that if regulatory oversight and approval processes could manage modern banks efficiently, then Communism would be an attractive economic system. (b) Ethical standards operate most sustainably when they run broadly with the grain of incentives in a sector. If honest dealing and best endeavour are generally rewarded by market and government intervention processes, then it is much easier to maintain ethical norms promoting honesty and best endeavour. If, by contrast, the incentives as a whole in the system punish ethical behaviour, standards will, at best, fray over time, if not totally collapse. (c) The notion that owners do not attempt to look after their own property should, in general, be subject to great suspicion, regardless of the details of a specific case. 1.5 These high-level remarks noted, my focus hereafter will lie in two areas: (a) Competitive pressures. (b) Scrutiny by creditors. How Competition Maintains Standards 1.6 Competition maintains standards principally via consumer pressure. If a bank does not scrutinise the activities of its staff and those it deals with, in a competitive environment consumers would leave for other banks, for two reasons: (a) Poor internal scrutiny of standards will be interpreted by consumers as a signal that senior staff have relatively weak oversight of internal processes in general, with the consequence that a bank’s risk management is poor, so consumer investments are at risk;

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1206 Parliamentary Commission on Banking Standards: Evidence

(b) Consumers may object to dealing with firms they consider unethical. 1.7 Similar issues may arise in respect of other business parties—eg wholesale counterparties may also have risk-related or ethical concerns if dealing with a bank that has poor monitoring processes. Competition Requires Creditors to be Exposed to Risk of Loss 1.8 Healthy industries require the possibility of new firms entering. For new firms to have an opportunity to enter, it will typically be necessary for it to be possible for old firms to leave. 1.9 Preventing old firms from failing will create large barriers to entry for new players, in the following way. Suppose a new firm enters a market. In doing so, it will bear entry costs, and risks being unsuccessful in garnering investors and clients. But suppose it starts to succeed. Often its clients and investors will come at the expense of some established player—the old firm loses customers and investors to the new; that is a key form of competitive pressure. 1.10 Such losses might lead the old firm to fail. When it fails, many of its old customers and investors may shift over to the new firm—the new firm’s gamble on entry is vindicated. 1.11 If, however, failure of the old firm is prevented by government intervention and subsidy, the old firm will stop losing customers and clients to the new, as the subsidy makes it attractive for these parties to stay with the old firm. So the new firm never gets going properly. In many industries, the inability to eliminate rivals will be sufficient to deter entry—you won’t be a very successful cuckoo if you can’t push the other baby birds out of the nest. How Creditor Scrutiny Maintains Standards 1.12 If a small business borrows money (eg from a bank), the lender will often want a detailed business plan and regular update reports on the business. Lenders scrutinise the activities of borrowers, so as to ensure that those activities leave the loan likely to be repaid. Weak internal scrutiny procedures, publicity about unethical practices, excessive remuneration to individuals, and other indicators of risk might make loans unlikely in the first place and could trigger recall of loans already made. 1.13 If, on the other hand, governments guarantee loans to banks, creditors will not take the same interest in the risk management activities of banks, and so have limited, if any, interest in the banks’ standards. 1.14 Government guarantees of creditors thus destroy both the competitive pressure to maintain standards and the creditor scrutiny process—the two most important processes for limiting risk and thus driving ethical, accountable and transparent behaviour. The Creditors of Banks 1.15 A fractional reserve bank has two key classes of creditor: (a) Bondholders. (b) Depositors. 1.16 It is absolutely vital to the healthy functioning of banks, both in respect of their economic contribution and their ethical standards, that both these classes of creditor bear genuine and material risk of loss. In particular, it is a sine qua non of fractional reserve banking that depositors be exposed to genuine and material risk of loss. It is simply a delusion to imagine that there can be any regulatory or other fix in the banking sector that could achieve a healthy, competitive and ethical sector that left depositors totally insured from risk of loss. Deposit Insurance in Fractional Reserve Banks Leads to Bailouts 1.17 It should also be understood that, although reforms that expose bondholders to genuine risk of loss— such as depositor preference and bailins—are extremely welcome, they will be of necessity incomplete if depositors cannot also be exposed to genuine risk of loss. It is well established, both in theory and empirically, that bondholder bailouts are more common and more extensive, the more extensive is deposit insurance, and as a consequence financial stability is reduced, not increased, by deposit insurance.61 1.18 It should also be understood that deposit insurance does not work as it says on the tin. Depositors do not run on banks because they are afraid of losing the capital value of their deposits. Typical depositor losses in even Armageddon-type banking collapses, such as those in the US in the early 1930s, are less than 20% of capital values. Depositors have lost more than that in real terms since 2008 as a consequence of inflation, but have not withdrawn their deposits from banks. Depositors run on banks not because they fear losing their money, but because they fearing losing access to their money. Depositors hold cash deposits, rather than shares or other kinds of investment, precisely because they want them available; they want liquidity. If a bank fails, 61

In particular, see Demirgüç-Kunt, A. & Detragiache, E. (2005), “Does Deposit Insurance Increase Banking System Stability?— An Empirical Investigation”, Journal of Monetary Economics—http://www-wds.worldbank.org/external/default/ WDSContentServer/IW3P/IB/2000/01/06/000094946_99122006330270/additional/101501322_20041117140502.pdf

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1207

the key risk the depositor faces is being unable to access her funds for some time and therefore going broke herself or having to make sudden drastic reductions in consumption. 1.19 Deposit insurance works as an implicit promise by governments to keep banks functioning—to keep depositors liquid. That is why bailouts are much more common and extensive when deposit insurance is higher—because such bailouts are precisely what the government promises to do, in setting deposit insurance. Political Will isn’t Enough to Avoid Bailouts 1.20 It is naïve to imagine that bailouts or other consequences of deposit insurance, or indeed the implicit insuring of depositors regardless of the explicit rules, can be avoided simply by political will. When governments historically have allowed large banks to fail, imposing losses on depositors, in places such as Argentina, there has been a breakdown of social order that can lead to the personal safety of politicians becoming under threat. For example, in 2001 Argentine President Fernando de la Rua was forced to flee the Presidential palace in a helicopter to escape from mobs that had caused the deaths of 22 people. 1.21 Academics and think-tankers that urge politicians to be braver in not bailing out banks should bear in mind that no-one is going to stick their head on a pike if the banks fail, but that could happen to the politician. 1.22 To make no-bailout promises credible, it will be necessary to enlist public sympathy—the public should consider itself less enraged, in practice, when a bank is not bailed out than it believes it would have been if the bank had been bailed out. The Source of Public Sympathy for Bailouts 1.23 Many discussions about bank bailouts talk in abstractions about the flow of credit and the money supply. But in practice, the political aspect of bank bailouts is all about depositors. It is simply inconceivable that the British government would have devoted hundreds of billions of pounds to bailing out banks in service of some abstract credit mechanism. 1.24 The most important reason there is sympathy for bank bailouts is that there is a widespread public sentiment that there is no practical option but to keep money in banks. Tax and benefits authorities and pressurize payment via banks. If a family sells a house anticipating buying another in a few weeks, they simply want somewhere to store their money. It seems unfair to the public that money that they simply want to store in a bank should be subject to risk of loss. 1.25 A deposit in a fractional reserve bank is not a form of pure saving—it isn’t like putting money in a tin on the fridge, or in a child’s piggy bank. A deposit in a fractional reserve bank is an investment—a loan made to the bank. Yet such deposits are, to a material extent, used and regarded by the public not as investments but as savings. 1.26 To make it credible that fractional reserve deposits not be bailed out, it will be necessary to disentangle savings deposits from investment deposits. This can be done. Two Kinds of Deposit 1.27 Until the mid-1980s, the UK had two fundamentally different kinds of bank—two different kinds of deposits available. There were the fractional reserve banks—what we now think of as normal high street banks such as RBS and Lloyds. And there was another, fundamentally different kinds of deposit-taking institution: a savings bank—of which the last major one was the Trustee Savings Bank. 1.28 A savings bank did not take in deposits as loans to service lending on mortgages, personal loans, business loans, etc.. Under the Savings Bank Act of 1817, a “savings bank” was required to 100% back deposits with government bonds or reserves held at the Bank of England. 1.29 (Having introduced the concept of 100% backed banking, I emphasize immediately that I am not one of those that advocates requiring all banks to be 100% backed. In my view, fractional reserve banking can be efficient and effective and should not be abolished.) 1.30 So, until the mid-1980s there used to be two kinds of deposit available. One kind was fundamentally a form of savings—a deposit in a savings bank. The other was fundamentally an investment loan—a deposit in a fractional reserve bank. 1.31 Savings banks died out for a number of reasons—deposit insurance in fractional reserve banks was introduced by an EU directive in 1979; inflation reduced the value of savings deposits much more than fractional reserve deposits; and many other reasons. I do not believe it would be practical to bring savings banks back as separate institutions. My Proposal 1.32 What I do suggest is that every bank licensed to accept retail deposits should be forced by regulation to contain, legally nested and isolated within it, a savings bank. At every branch in every bank, someone approaching the bank seeking to deposit funds would always be invited, first, to deposit funds in “storage

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1208 Parliamentary Commission on Banking Standards: Evidence

deposits”—ie in 100% backed deposits in the savings bank. Such deposits would naturally pay very low interest (indeed, it would be necessary to regulate storage deposit interest rates to force banks to pay any interest at all on them). But they would be 100% backed by government bonds and hence it would be economically harmless for the government to guarantee such deposits, 100%, without limit (as opposed to the £85,000 threshold on fractional reserve deposit insurance today). 1.33 If a depositor preferred to take some risk, she could explicitly turn down insured storage deposits and instead put her money into “investment deposits” paying the fractional reserve deposit rate, but she would be told in terms that her money is an investment and would not be insured. 1.34 In my view, if everyone knew that anyone that deposited money in investment deposits (in the fractional reserve part of a bank) had explicitly turned down the opportunity to put their money into 100% insured, without limit, deposits, the public would feel very little sympathy for investment depositors making losses— much as there was little public sympathy for those that deposited money into IceSave. Then public sentiment could be politically enlisted against bailouts, even when the moment came, rather than in favour of them. Two cmplexities 1.35 I do not propose to detail all aspects of my scheme here.62 I do note two further points. Though fractional reserve deposits should not have their capital insured, they could have liquidity explicitly assured, via a scheme I detail in my paper Bank Creditors, Moral Hazard and Systemic Risk Regulation for a “deposit access fund”. Secondly, I have elsewhere proposed that one current account into which salary is paid could be insured to £10,000. I mention these points only to note that they can be addressed. They are tangential to my central thrust here. Summary and Conclusion — The most important drivers of standards are competitive pressures and creditor scrutiny. — Competition cannot function properly in the banking sector if banks cannot fail. — Creditors will not scrutinise standards properly if they are insured. — It is not adequate simply to remove insurance from bank bondholders. Bank depositors are the most important creditors of banks, and bondholders will tend to be bailed out if bank depositors are insured. — Removing deposit insurance is not a matter of regulatory declarations about insurance limits or about political will. It can only be achieved credibly if the public becomes disinclined to be sympathetic to the bailing out of depositors. — The public is sympathetic to the bailing out of depositors because some deposits are perceived as savings, not as investments. — The solution is to disentangle savings from investment deposits by having two explicit and legally isolated forms of deposit available in every bank—storage deposits for savings, 100% backed by government bonds and 100% insured without limit by the state; and investment deposits that are not insured at all. — The purpose of this change is primarily pedagogical. If the public feels that everyone putting their money into investment deposits must have been fully aware they were at risk of loss and had always turned down the opportunity to save in fully insured deposits, the public appetite to bail out investment depositors would vanish. — With government insurance of investment depositors removed, competition could function and creditors would scrutinise bank activities, driving up standards. 31 October 2012

Written evidence from Ian W Lindsey OBE 1. Background This paper has been prepared at the request of the Commission made during a meeting held on Monday 10 December 2012. The paper traces the transition of UK banks from being run by professional bankers to the current situation where most UK banks have boards of directors who are not professional bankers and who have put self interest ahead of the needs of customers and society as a whole. It is necessary to explain why our banks are no long managed by professional bankers but by amateurs who have lost the trust of society. This is covered in Paragraph 4 below. 62

Detail can be found in: http://www.policyexchange.org.uk/images/publications/incentivising%20boring%20banking%20-%20jun%2010.pdf http://www.policyexchange.org.uk/images/publications/ bank%20creditors%20moral%20hazard%20and%20systemic%20risk%20regulation%20-%20dec%2011.pdf and many other places.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1209

Banks tend to fail because of imprudent lending and investment decisions. So the next paragraph is devoted to lending and investment decisions. In this paragraph, the term lending is used alone but is intended to include investment. 2. Lending Principles When considering a request to borrow money and banker should ask the following questions: —

Who is borrowing the money and what is their pedigree?

—

What is the money required for?

—

How much is required?

—

Is it enough? A bank might be willing to lend £1m to a company for a project but not £2m. Nothing is worse than having advanced the initial amount than to discover later that more money is required which takes the bank outside its appetite for risk.

—

For how long will the facility be required?

—

What are the plans for repayment?

Only when these questions have been answered, can the bank take a decision on whether or not to lend. If the decision is to lend, the bank should then ask: —

What security can be provided for the facility? The availability of security should not impact upon the decision as to whether or not to lend but only upon the terms—interest rate and facility fee—of the facility.

Recently Government Ministers and would-be entrepreneurs have complained that for commercial loans to companies, banks insist upon directors’ personal guarantees secured by the directors’ personal assets. This has been normal banking practice for decades and is nothing new as it is a fundamental principle of lending that the customer should always have more to lose than the bank. Personal guarantees are a good method of ensuring that entrepreneurs are fully confident of their proposals. Why should bank depositors bear risks that entrepreneurs are unwilling to accept when it is the entrepreneurs who will benefit from success? Banks lend to companies for: —

working capital purposes

—

capital expenditure proposals

—

investment in newer or larger premises

—

purchase of plant and machinery

—

purchase of another business

Historically banks have never provided facilities to businesses other than for these purposes but there has been complaints from Government Ministers and would-be entrepreneurs that banks are unwilling to provide fixed capital funding for start-ups, that is funding to get a business idea transformed into an actual operation. Provision of such fixed capital funding has never been part of the role of banks as such funding should come from the promoters of the business. Government Ministers have unfairly criticised banks for not providing fixed capital lending but this criticism simply highlights the ignorance of the Ministers and their advisers. In a paragraph 4 below, reference is made as to how banks departed from these cardinal lending principles to lend against security, paying little regard as to how facilities would be repaid. In short they behaved like pawnbrokers. It should be noted that the FSA paid scant regard to the quality of lending preferring to concentrate on corporate governance and treating customers fairly. These are very important but not nearly as vital as the quality of lending. Historically banks never lent to aid tax avoidance but in Paragraph 5 below, pseudo lending is discussed. 3. The Differences Professional and Investment Bankers This paper makes frequent reference to Professional and Investment bankers so it is appropriate to outline the differences between them. Professional bankers are defined as individuals who have completed the examinations of either, the now defunct, Chartered Institute of Bankers (CIB) or the Chartered Banker Institute (CBI) and who have at least 20 years hands-on lending experience. Professional bankers take deposits from customers and on-lend these deposits to other customers at the bank’s own risk. If a borrowing customer fails to repay, the loss is that of the bank. A professional banker must always be able to repay its customers’ deposits on demand or at an agreed future date. It is vital that the professional banker retains the trust of depositors to be able to repay deposits otherwise the direct consequence is a ‘run on the bank’. If a bank is seen to be taking excessive lending or investment risks or becomes loss-making, then depositor trust is likely to be lost. Professional bankers are relationship bankers usually over a lifetime from childhood to retirement and beyond.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1210 Parliamentary Commission on Banking Standards: Evidence

It is vital that professional bankers are prudent lenders. The professional examinations give young bankers the theoretical knowledge but it takes years of actual lending experience to become a prudent lender. My first loan went bad; it was a salutary experience but a necessary one. Investment bankers are not really bankers at all. They are transaction ‘bankers’ and only do deals where a quick profit or loss can materialise. UBS and others bear testament to this. They do not foster long term relationships. Investment bankers rarely have completed the professional examinations of either the CIB or the CBI. Often they are members of the legal, accounting or actuarial professions while many have no qualifications at all. They tend to behave like estate agents in that they bring together buyers and sellers of assets or borrowers and lenders. Generally they do not lend or invest on their own account and so avoid credit or investment risks. They earn their fees on a transactional basis. It is pertinent to mention that HM Treasury had extensive dealings with investment bankers when the Government was privatising national assets; since then HM Treasury officials have behaved as investment bankers are professional bankers. This might explain the absence of professional bankers on the boards of either the FSA or UKFI. 4. From Professional to Amateur Bankers Until the early 1990s, the route to becoming a chief executive of a major bank was to be a good lender because banks which either lend or invest unwisely have a tendency to fail. Staff members were encouraged to become professionally qualified by studying for the examinations of the Chartered Institute of Bankers or its Scottish counterpart. Management status normally was denied those who failed to complete for their professional qualifications. The CEOs were home-grown and more often than not, the CEO would eventually become the Chairman, so there was always two experienced professionally qualified bankers heading each bank. It was a system that had worked well for decades as it ensured a breadth and depth of banking expertise at the top of the bank. However this was to change after the 1992 Cadbury Report on corporate governance and subsequent corporate governance guidelines, which dictated that good corporate governance should ensure there is a clear distinction between the roles of the Chairman and the CEO. These diktats discouraged the elevation of the CEO to that of Chairman because such individuals might have too much power. Some of the banks moved from the system whereby the CEO became Chairman to a system where a nonbanker became the Chairman. These individuals were known as ‘City Grandees’. Generally they had no banking experience whatsoever and even today, if questioned on a banker’s duties to his client, they probably could not provide an adequate answer. These individuals were deemed to have been successful in some other business sphere and this was the only experience they had to offer. Very often there was a cultural divide between these unqualified, inexperienced chairmen and the professionally qualified executives who managed the bank dayto-day. The new style chairmen appointed many of their ex-colleagues as non-executive directors (NEDs) who also lacked banking experience. HSBC has been the exception by almost routinely appointing its CEO as its chairman. While HSBC has not escaped poor lending and investment decisions, it has avoided the need to be rescued by the UK taxpayer or as in the case of Barclays, by a Middle Eastern government. When Gordon Brown was appointed Chancellor of the Exchequer in 1997 he took one good decision: giving independence to the Bank of England to set and implement monetary policy. He then made two disastrous decisions, firstly to take away banking regulation of banking from the Bank of England, creating the Financial Services Authority (FSA), and secondly by not appointing to FSA board any professionally qualified bankers. Its first chairman had just insurance experience. HM Treasury, which approves appointments to the FSA Board, does not appear to understand there is great difference between investment and professional bankers. HMT failed to ensure appointment to the FSA Board any professional bankers whatsoever with the result that the FSA was headed by a board of amateurs. From the outset, FSA board lacked the experience to regulate the UK banking system. The FSA, in a response to a Freedom of Information request, advised that it did not know how many professional bankers it employed because it never sought to employ professional bankers. By 1997, the scene had been set for disaster with the FSA headed by non-bankers and the boards of many banks headed by ‘City Grandees’ with little or no professional banking expertise. The ‘City Grandees’, having installed their family and friends as non-executive directors, set about removing experienced, professional bankers, who they saw as over cautious and risk adverse, with non-bankers who were seen as being more adventurous. The inexperienced FSA simply nodded through these appointees, routinely granting status rather than Control Function status rather than examining their relevant expertise. For example, an ex-actuary, James Crosby, was appointed CEO at HBOS followed by Andy Hornby, an exmarketing executive at the ASDA supermarket chain and chartered accountant Fred Goodwin at RBS. Recently, Crosby admitted to Commission that the demise of HBOS was the result of incompetence.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1211

In short, for over a decade, many banks moved away from the tried and tested formulae of only appointing banking professionals as executive directors and the FSA stood idly by allowing this to happen. The poor lending and investment decisions were taken by unqualified executives, which has been the prime cause of the crisis. Gordon Brown is ducking his responsibility for poor regulation of the UK banking sector by claiming that UK banks needed to be rescued because of the global banking crisis which started in the US. He is right in claiming that US banks had lent unwisely but there was no reason why RBS and HBOS should have become involved in the US toxic mortgage market other than the fact that both banks were run by amateurs and the FSA lacked appropriate banking expertise to adequately regulate these two banks. These amateurs broke the most fundamental rule of banking: namely that of ‘know your customer’. When RBS began investing in the US toxic mortgage market, Fred Goodwin and his team had no idea of the identity of the ultimate borrowers, preferring to rely on the ratings issued by the now-discredited rating agencies. No professional banker would have ignored guidance from the Bank of England whereas the FSA staff lacked the experience and confidence to regulate competently and issue appropriate guidance. The failure of the HM Treasury to understand there is a great difference between professional bankers and amateurs is highlighted by the appointment of Sir James Cosby as Deputy Chairman of the FSA upon his early retirement as the CEO of HBOS. He was the person who had presided over the reckless expansion HBOS lending before jumping ship and handing over to ex-Asda executive, Andy Hornby, who had the misfortune to be at the helm when the ship sank. The principles of lending were no longer adhered to with banks lending against security in both the personal and business sectors rather than the ability to repay. HBOS financed many property transactions and take-over deals which depended on being viable solely on the premise that property values continue to rise. Many banks provided 100% or more mortgages with scant regard as to the ability to repay. Residential property prices were driven up to such an extent that most homes are still beyond the means of first-time buyers. In the 1960s banks and building societies would only lend to three times the value of a single income or 2.5 times the joint incomes of a couple so as to ensure that repayments could be met. This prudence was discarded as amateurs gained control of our banks. 5. Should Retail Banking be Ring Fenced? It is my opinion that retail banking and investment banking should be completely separated. I believe banks such as Barclays and HSBC should be required to completely demerge their investment banking activities from their deposit taking activities. No holding company should be permitted to own both a deposit taking bank and an investment bank. Customers do not expect banks to use their deposits to finance investment banking activities which are inherently much more risky than normal lending activities. If an organisation wishes to indulge in investment banking activities, it should do so only using shareholder funds and not customer deposits. Deposit taking banking is quite simple and if managed by prudent professional bankers the risk of failure is not great whereas the breadth of investment banking activities and the risks thereto are very wide and not easily managed. If a deposit taking bank is linked via holding company to an investment bank, the FSA/PRA probably would not be a position to permit the investment banking arm to fail without causing a ‘run’ on the deposit taking arm. Barclays has argued that demerging investment and deposit banking will be costly and bring few benefits. I believe this view is incorrect and that Barclays does not wish to have to raise more expensive capital to fund its investment banking activities as deposit funding in much less costly. Barclays has argued it would be difficult to find NEDs with appropriate experience for deposit taking banks. In the words of the London Mayor, this is ‘utter tosh’. There are many individuals with the necessary skills and experience. Barclays and its recruitment consultants simply have not been looking in the right places. Should the Commission recommend ring-fencing of deposit banking, it will in effect be endorsing future tax-payer rescues of deposit taking banks when the investment banking arm fails. The Commission should recommend that the majority of directors of the boards of deposit taking banks should be professional bankers to ensure that lending activities are profitable, prudent and ethical. There is a need for directors who are not professional bankers to cover specialised areas such as finance, human resources and IT but they should be in a minority. For the avoidance of doubt, I do not believe investment bankers to have sufficient lending expertise to be trusted to run a deposit taking bank. History has shown that whenever an investment banker has run a deposit taking bank, disaster ensues. 6. Unethical Behaviour by Bank Directors Society is of the opinion that bank managements have behaved unethically for many years. There are many example of unethical behaviour such the PPI and LIBOR scandals which almost certainly were fraudulent. I

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1212 Parliamentary Commission on Banking Standards: Evidence

venture to suggest such behaviour would not have been tolerated by professional bankers. Professional bankers such a Sir Brian Pitman would not have countenanced doubtful tax avoidance schemes. I list below some unethical practices of our High Street banks on which the Commission might wish to recommend action: 6.1 Circumvention of the Remuneration Code Bank CEO’s and Board Members are cancelling their personal employment contracts with the bank and substituting management agreements via an off-shore company for their services with the Bank. By removing the contract to an off-shore entity the bank do not have to report earnings to the FSA. Many bank directors are now undertaking this approach. The banks are also using a complex web of Employee Benefit Trusts to disguise income and also circumventing the regulations. The Commission should recommend that all personnel holding FSA/PRA control function status should have all of their income and benefits paid via PAYE. 6.2 Pseudo Lending Schemes A pseudo loan that is advanced by a bank to a customer, where the customer has at no time free access to the money advanced by the bank, for which the customer has full liability to repay. The bank liability is mitigated by the fact that the bank is holding the money that it lent to the customer in a blocked deposit account in a 100% wholly owned subsidiary of the bank. Bank pseudo loan structures are designed to artificially engineer tax losses. Banks charge significant fees from the customers that wish to borrow money for the aggressive tax avoidance schemes with no risk to their balance sheets with the nil impact on the capital adequacy requirements. The diagram below illustrates how pseudo lending operates:

SIMPLIFIED PSEUDO LOAN STRUCTURE USED BY BANKERS TO FUND TAX AVOIDANCE SCHEMES Broker schemes

Investors

Bank provides 80% LTV pseudo loans

80% cash deposit / LOC as collateral for loans Offshore Subsidiary UK bank Blocked account

Investors Liability 80%

20% stake

UK bank parent

HMRC tax rebates

LLP Investors claim tax rebates

Fees

Offshore LLP’s Film R&D Music Software

Offshore Management Company Service Contract

It is clear that banks are engineering egregious tax avoidance loan structures in conjunction with the promoters of such schemes. The pseudo loans that the banks provide to support such schemes are not loans that are made in the usual course of legitimate commercial banking practice. Providing pseudo loans to customers for the purpose of tax avoidance schemes cannot be described as ethical, although they will have be authorised by a bank’s individual lending policy agreed by the Directors. It is believed that the Commission should recommend that: — Banks be prohibited from lending for tax avoidance — HMRC is tasked to tighten the law so that such schemes are illegal — The FSA/PRA develops appropriate expertise to identify pseudo lending — The FSA/PRA be given power to fine and ban bank directors who indulge in pseudo lending.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1213

It is believed that collective pseudo loans in the UK are in excess of £50bn. Very often, when a bank engages in Pseudo lending it also undertakes the activities described in Paragraphs 6.2 to 6.5 below: 6.3 Circumvention of the Conduct of Business Rules This happens where banks are offer complex tax avoidance schemes to their customers. In many cases KYC, AML Regulations, and customer classification regulations are ignored. The Commission should recommend that the FSA/PRA increases its expertise in this area to identify where the Rules are being abused. 6.4 Circumvention of the FSA Large Exposure Rules The FSA do not appear to understand the requirements of the Large Exposure regime and support the tax avoidance lending by agreeing to Large Exposures; many banks frequently have substantial exposures of their capital bases to a group of individuals but the FSA never enquires as to the purpose of the exposure nor asks to see documentary evidence supporting the Large Exposure application. The Commission should recommend that the FSA/PRA increases its expertise in this area to identify when the Rules are being abused. 6.5 Incorrect ‘classification’ of Intermediate Investors Complex derivative structures are used including options which customers do not understand. In the Schofield v HMRC case, Schofield was sold gilt option strips which exposed him to a £400 million liability with his bank. The customer was deemed never to have owned the Treasury Stock. Schofield was taken to Tribunal for claiming a £10m tax loss. Schofield told the Judge that he had no idea about the assets in which he had invested. The bank had classified him as an ‘Intermediate Investor’. Clearly he was not. In so doing the bank circumvented the Conduct of Business Rules for him and another 200 or so individuals who had similarly invested. The case was lost by Schofield. This is clearly an example of mis-selling by the bank and accountants. The Commission should recommend that the FSA/PRA increases its expertise in this area to detect when the Rules are being abused. 6.6 Bad & Doubtful Debts: Tax Relief Banks claim tax relief on loan losses but in recent years, aided by their auditors, have not always provided the documentation to support their claims. Evidence suggests that the amounts claimed so do reflect actual losses. The Commission should recommend that HMRC never grants tax relief on loan losses unless full audited documentation is produced for individual losses (above a de minimus level). Auditors should be required to produce to HMRC a certificate to confirm that they have reviewed each case claimed for and that in their opinion the loss has actually been incurred. HMRC and the FSA/PRA should have the power to commission Arrow Audits for bad debt loss claims. 7. Treating Customers Fairly (TCF). When the FSA should have been closely monitoring the quality of bank lending it devoted valuable resources to implementing a policy of TCF. Banks were required to regularly review management information relating to customer complaints and to ensure staff understood the concept of TCF. TCF conflicted with efforts of most banks to cross sell other services, in particular, PPI. There have been literally thousands of complaints about the mis-selling of PPI. Notwithstanding public statements that compensation will be paid where mis-selling has happened, there are still a record number of complaints being made to the Financial Ombudsman Service (FOS). Over 60% of the complaints against Lloyds Banking Group are being upheld compared with the best performing bank which has less than 10% of complaints against it being upheld. It is no coincidence that Lloyds is headed by an ex-investment banker and lacks any professional bankers on its Board or its Executive Committee. The FSA should have taken action to correct this situation but has failed to do so. The Commission should recommend that the FSA/FCA impose heavy fines on banks which consistently have more than 25% customer complaints upheld by the FOS and the FSA/PRA take action to rescind control function status from the CEO and Chairman of such a bank. There would be nothing more attention-grabbing to a Chairman or CEO than action such as this.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1214 Parliamentary Commission on Banking Standards: Evidence

8. Absentee Shareholders There has been much very fair criticism of the institutional shareholders not exercising sufficient influence over our quoted banks. Members of PIRC, the corporate governance consultants, have failed to do their duty as shareholders. UK Financial Investments, (UKFI), which now holds the largest stakes in both Lloyds & RBS and is owned by the HMG, will face similar criticism if it continues to sit on the side lines and watch events unfold. It claims to be an ‘engaged shareholder’ but given the fact its board lacks a single professional banker, its claim is rather hollow. It is difficult to criticise private shareholders who are unable to vote. Most privately owned shares are held via nominee companies which do not pass to shareholders the annual reports, details of Annual General Meetings, and proxy voting forms. Erstwhile Lloyds chairman, Victor Blank, claimed that the overwhelming majority of Lloyds shareholders who voted, supported the acquisition of HBOS. What he failed to mention was that nearly 50 percent of the shareholders eligible to vote did not actually vote, probably because they never received the voting papers. There is a strong case for the Business Secretary to amend the law to require companies to obtain a majority of all shareholders who are eligible to vote rather than a majority of those who do vote. This would give banks such as Lloyds more incentive to ensure that voting papers are distributed to all shareholders. While private shareholders have less influence, in terms of voting power, than institutional shareholders, it must be remembered that many private shareholders are customers of the banks in which the own shares and can bring much public pressure to bear on bank directors in a way that institutional shareholders have failed to do. The Commission should recommend to the Business Secretary a change in the law to require companies to obtain a majority of shareholders eligible to vote rather than those who actually do vote. 9. The Role and Responsibility of the Auditors The Big Four accountancy firms have introduced a culture within the banks of supporting tax avoidance schemes to the detriment of society as a whole. These schemes run into billions of pounds and a whole industry has developed over the past 15 years specialising in tax avoidance using the banks as a tool to support such nefarious schemes. Closing the tax avoidance activities of all the banks would increase UK tax revenues by billions of pounds, which could be spent on services which benefit the population at large. HBOS and RBS had massive Structured Finance Departments working on tax avoidance schemes. The schemes are so complex in nature but flimsy in substance. The Institute of Chartered Accountants has permitted some of it members to earn huge fees by promoting tax avoidance schemes. The Commission should recommend that the ICA reviews its ethics policy and introduces a robust enforcement regime. 10. The Role of Credit Rating Agencies HBOS and Royal Bank of Scotland, among others, invested in toxic US mortgage debt relying on incorrect ratings on the debt conferred by the major credit rating agencies. While these banks departed from the normal lending principles, as outlined in Paragraph 2, the ratings were seriously misleading, if not fraudulent. The Commission should recommend that credit rating agencies are brought into FSA/PRA regulation with directors and senior staff subject to similar Control Function approvals as for bank directors. These powers should reside to credit rating agencies not based in the UK. The Commission should recommend that banks, when investing in securitised debt, should not rely on credit rating agencies’ ratings but apply normal lending principles. 11. Banking Ethics, Integrity and Probity Ethics, integrity and probity are difficult to teach but they can be enforced by professional bodies. Many of the individuals who have been granted Control Function status by the FSA since its inception have lacked these qualities and this has been an important factor in the various scandals which have tainted banking in recent years. Until circa 2000 there were two professional banker institutes, the Chartered Institute of Bankers, which covered the UK other than Scotland and the Chartered Institute of Bankers in Scotland. These two Institutes provided banking education and examinations for young bankers. On completion of the examinations, individuals were granted Associate status. After several years practical experience, an Associate can apply for Fellowship.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1215

Both Institutes had power to confer Fellowship on individuals who had not completed the Associate examinations and frequently did so when a non-banker was appointed as a director of a bank. This was done primarily to ensure that the banks continued to lend support to the two Institutes by encouraging new recruits to become professional qualified. The banks also provided support by granting study leave and allowed for examinations to be conducted in bank premises after hours. It was usual for candidates from different banks to take their examinations in the branch of a competitor in the evening when the bank has closed. The Institutes had Local Centres where bankers from different banks would meet to hear lectures and discuss developments on banking law and practice. Both Institutes had power to terminate the membership of bankers who brought the profession into disrepute. Normally this was only exercised if a member was convicted of a serious criminal offence. In circa 2000 the Chartered Institute of Bankers (England & Wales) converted itself into the Institute of Financial Studies (IFS) to reflect the fact that banking had become much more complex than just deposit taking and lending. It, in effect, relegated its role to that of a commercial examining body. More recently the Chartered Institute of Bankers in Scotland was renamed the Chartered Banker Institute (CBI) .Many ‘homeless’ members of the erstwhile CIB have joined the CBI. The CBI provides the education and examinations for individuals to qualify as professional bankers as well requiring members to under CPD training. The CBI has created the Chartered Banker Professional Standards Board which has the objective of advancing professionalism in banking which is best described as ‘trust, integrity and probity’. It is not that trust, integrity and probity no longer exist in banking but they need to be seen to exist. I have noted the evidence given to the Commission by the CEO of Barclays and was surprised that he made the proposal for the creation of a new professional body for bankers as he appears to be total unaware of the existence of the CBI. Given that many Barclays’ staff members are members of the CBI this seems to be a very strange proposal. It might be that he is just ignorant of the CBI and hence his proposal to re-invent the wheel. The CBI has a major role to play in building trust, integrity and probity in banking. It could be enhanced if it was given statutory power to exclude from its membership anyone guilty of bringing banking into disrepute and the FSA/PRA adopts a policy of removing control function status from individuals so disciplined. The Commission should recommend the CBI be given statutory power to exclude from its membership individuals guilty of bringing the banking profession in to disrepute and then the FSA/FSA should automatically withdraw CF status from such individuals. Please note these views are made in a personal capacity as a Fellow of the Chartered Banker Institute. It does not necessarily reflect the views of the CIB Council. 12. Financial Services Authority (FSA) This submission makes several references to failures of the FSA to regulate the UK banking system in a competent and effective manner. After the collapse of several banks, its biggest ever failure was to fail to remove Control Function status from every director, both executive and non-executive, of every bank which needed to rescued by the taxpayer. The directors collectively are responsible for the failures and should have been held accountable and fined for their failure. It is no defence for NEDs to argue that they were unaware of the facts because if they were competent, they would have known. To date the FSA has taken action against only a handful of executives. The failure to take such action has made it more difficult to rebuild a culture of high ethics integrity and probity. There is nothing more attention-grabbing for a director than to know that he/she will be held personally responsible for regulatory failure. The Commission should recommend that the FSA/PRA takes disciplinary action against all directors who were in post at the time of the numerous bank and building society failures. 13. Summary This submission argues that there should be a complete separation of deposit-taking banking from investment banking and that deposit-taking banks should have boards populated with a majority of directors who a professional bankers as defined in Paragraph 3. Any activity where a bank takes a risk position on its own account, other than normal commercial lending, should be treated as an investment banking activity. It is accepted that bank profits may decline as a result of a complete separation of deposit taking and investment banking but so will be the risk of failure and taxpayer bailouts. The FSA/PRA should remove Control Function status from directors of banks who have been deemed by the Chartered Bankers Institute to have brought the banking profession in disrepute.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1216 Parliamentary Commission on Banking Standards: Evidence

The Chartered Bankers Institute should be given statutory authority to set and enforce professional standards within the banking profession. Investment banking should not be regarded as part of the profession and so excluded from the CBI remit. APPENDIX 1 Ian W Lindsey OBE BA Hons. MPhil FCIBS Profile Ian Lindsey qualified as an Associate of the Chartered Institute of Bankers in 1966. He read Banking & Economics at the University of Nottingham and was awarded a BA Hons.in 1971 and an MPhil in 1979 for research into competition between the UK banks. He was seconded to the Price Commission in 1967 as a Senior Principal for the Enquiry into Bank Charges. He returned to banking in 1979 and was appointed as an Executive Director of the Save & Prosper Group Limited in 1985 and Managing Director, Personal Banking of Flemings in 1988. He held these positions until 1996 and since then has been a non executive director of several banks. He was appointed to Council of the Chartered Institute of Bankers in 1986 serving as its Honorary Treasurer for several years. He was appointed as a Special Professor in Banking at the University of Nottingham Business School in 1995. 17 December 2012

Written evidence from Lloyds Banking Group Preface The global banking industry’s role in the financial crisis and the subsequent support provided by central banks and governments, together with historic remuneration structures have contributed to the mistrust that people now have in our industry. More recent issues such as mis-selling of PPI policies, SME derivatives, the alleged manipulation of LIBOR, money-laundering accusations and “rogue state” financing have only compounded the problem. Trust has broken down, not only in banks but also in bankers. A number of these ills were caused by an obsession with financial success and an over-riding fixation on short-term performance, driven by investors ratcheting up required returns, the “war for talent” driving up expected individual returns (ie pay and bonuses) and the regulators relying on the market. Customer outcomes and financial soundness arguably took second place. As a consequence, Boards and Executive Management in a significant number of banks, to a greater or lesser degree, failed. One of our principal challenges is to restore trust—the trust of our customers, shareholders, policymakers and regulators. Trust goes to the heart of what banking is about. Customers need to be able to trust their bank to look after their savings. They need to trust their bank to manage their financial transactions smoothly; trust that their bank will be diligent and not provide levels of credit or mortgage that are more than the customer can re-pay; and trust their bank to provide products that genuinely meet the customer’s needs and which the customer can understand. In commercial banking, sound businesses need to know that their bank will be with them through difficult as well as good times and will not suddenly change terms or withdraw support. At the start of this year, Lloyds Banking Group (“Lloyds”) set out a public target to make at least £12 billion of gross lending available to SMEs, since increased to £13 billion; in terms of net lending, Lloyds has increased lending by 4% whilst the market has reduced by the same amount. As an industry, we need to re-earn the trust of policy-makers and regulators too. Good legislation can provide the framework for safe and stable banks. Regulation can punish wrong-doing or negligence. However, regulation should be a back-stop not a substitute for trust. In the absence of that trust, banks do not function effectively, undermining the vital role they play in the economy. The introduction of ring-fencing has the potential, if carefully executed in the legislation, to help rebuild consumer trust in the banking sector and more clearly separate the different cultures of retail/commercial and investment banking. Investment banking has a different business model and culture as it is done deal by deal; retail and commercial banking is about the processes and procedures that see many thousands of individual transactions conducted daily to the satisfaction of the millions of customers who bank with them. The latter must be much more ordered and regimented to ensure that each of those thousands of transactions is conducted efficiently to rules and levels of risk that customers should be able to take for granted. Lloyds has focused hard on reducing customer complaints and their causes. Complaints have fallen by 42% over the last two years (excluding PPI). Banks are not faceless institutions. We are collections of people who make decisions and act as the ambassadors in our daily interaction with customers and other stakeholders. The tone and example needs to come from the top—having leaders with the highest integrity and values, who think and act for the long-term and with proper incentives.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1217

We know, having talked with our customers and other stakeholders, that it will only be through an unswerving determination to “do the right thing” and a fundamental commitment to anchor our business in activities which support the broader economy and contribute to prosperity, that we can address and rebuild that trust. We have to make things right, especially for legacy issues such as Payment Protection Insurance (PPI), where Lloyds was the first bank to break ranks and provide certainty for customers by offering compensation to those who were mis-sold. That was the right decision to rebuild trust, driven by a desire to embed a more customer-centric culture where we do the right things. Also part of our journey is a focus on a clearer and simpler range of products, our pledge to retain the number of branches and not to close a branch if it is the last one in a community. We want Lloyds and its individual businesses to be a source of pride for our employees. We can only do that through having the trust of our customers and the wider public. Commitment from all colleagues to personal integrity and professionalism is a key part of making Lloyds a trusted, contributing corporate member of society, and we are taking steps to reinforce this across all of our business. Throughout the bank, we are taking the necessary steps to ensure that colleagues are well trained, uphold the highest ethical standards in the way they behave and are appropriately incentivised. Restoring trust to the levels we want and expect will take time and effort—but we have to undertake it. In the absence of trust, banks do not function effectively, undermining the vital role they play in the economy. This is critical as the future of the banks and the economy are inextricably linked; there are no strong economies without healthy banks and healthy banks require sound and strong economies. Lloyds is different to other UK banks, being focused on UK retail and SME customers. Being a successful and responsible business, and the largest retail and commercial bank in the UK, means that we are able to benefit society and help Britain prosper. Parliamentary Commission On Banking Standards 1. To what extent are professional standards in UK banking absent or defective? Standards ultimately depend on the culture and values within which individuals work. With hindsight, it is clear that the culture of banking in recent years failed to consistently reinforce the right behaviours. While long term profitability should go hand in hand with dedication to customer service, in some areas of both investment and retail banking, the culture shifted too far towards pursuing short term profit at the expense of doing the right thing for customers. Trust has broken down, not only in the banks but in bankers. Fixing that requires a shift in the tone from the top—a shift in values and culture. Standards of integrity cannot really be regulated; rather they are set by individuals and businesses and are more evident in action than in words. Lloyds has recognised this and has set out to embed new values and culture throughout the organisation— we are enhancing the standards of integrity which our colleagues work to across our business. Across Lloyds, we are embedding enhanced standards of integrity, from the Board to the bank counter. These standards are built around new corporate values introduced in early 2012 (putting customers first; keeping things simple and making a difference together). Over the last 18 months, Lloyds has developed its Codes of Conduct with support from the Institute of Business Ethics—the Code of Business Responsibility and the Code of Personal Responsibility. These Codes, based on our corporate values, underpin the way we do business as a Group, set out the behaviours that we all want to be known for and set stakeholder expectations. The Codes are built around five pillars of responsible business and underpin our Ethics Policy: — We put customers at the heart of our business. — We aim to be a great company to work for. — We work responsibly with our external stakeholders. — We invest in communities to help them prosper and grow. — We work to continually reduce our environmental impact. We are also committed to high professional and accreditation standards as detailed below: (i) Professional Standards (externally codified criteria for professionals to follow during the course of doing business or providing a service, usually set by a regulator or a professional body) Individuals as well as banks are already regulated, which reinforces individual accountability: — The FSA’s regulation introduced an “approved persons” regime for particular roles, notably senior management (such as CEOs, Compliance Officers, Money Laundering Reporting Officers) and certain customer-facing roles. This regime requires approved persons to adhere to Seven Statements of Principle. Approval is subject to assessment of “fitness and propriety” by the FSA.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1218 Parliamentary Commission on Banking Standards: Evidence

—

The FSA’s Principles for Businesses set overarching requirements for all financial services firms, including requirements to conduct business with integrity, due skill, care and diligence.

Since 2001, the scope of the FSA’s regime and criteria for approval has been broadened, for example through the Retail Distribution Review (RDR) and the Mortgage Market Review (MMR). There is, increasingly, an ethical element incorporated in the FSA’s approach, which is welcomed. (ii) Accreditation Standards (passing examinations and technical skills training) Lloyds has a strong take-up of accreditation standards. The Retail Community Bank has launched the FSA recognised Certificate in Retail Conduct of Business (Cert RBCB), helping colleagues to become more expert in banking and customer service. Available to bank managers from June 2012, the offering is being extended to other colleagues shortly. The Wholesale business has achieved accreditation of its credit training through the Chartered Banker Institute. Group Operations has achieved similar accreditation for training it provides to colleagues. Depending on their specialism, employees may wish or need to affiliate with a professional body (eg ACCA) which has tailored standards that their members need to adhere. These often require attainment of particular level of competence, adherence to ethical probity and ongoing professional development. There is no single accreditation standard in UK banking. This is being addressed through the Chartered Banker Professional Standards Board and the introduction of the Foundation Standard for Professional Bankers, which is being implemented in banks, such as Lloyds, that have signed its Code of Professional Conduct. How does this compare to (a) other leading markets? Lloyds is primarily a retail and commercial bank. We focus on (and champion) UK customers and business. However, these issues may be present in other leading markets, but we would defer to those more expert on those markets to give a view. How does this compare to (b) other professions? Professions apply to areas of work where there are multiple individuals who stand or fall by their own reputation—like medicine or the law; thus there are guilds or professional bodies that ensure basic standards. Banking is a hybrid of corporate and professionals (including lawyers, finance, HR, auditors, accountants as well as client facing/relationship bankers), we look at standards that underpin the professions when considering the characteristics we want to underpin our activities—technical competence, continuous learning (or Continued Professional Development (CPD)), judgement, integrity and a commitment to maintain the stature and standing of the bank. How does this compare to (c) the historic experience of the UK and its place in global markets? The UK has enjoyed a strong reputation as a financial centre, driven by perceptions of high standards and regulation. London, for example, topped the Global Financial Centres Index in 2012. It is clear that appropriate regulation, high professional qualifications and standards of integrity drive sustainable, long term development. Regarding regulation, the FSA has implemented detailed conduct of business requirements on all authorised firms since 2001; expanded in 2009 with rules on retail deposit taking. This replaced voluntary arrangements (the Banking Code and the Business Banking Code) established by the British Bankers Association and others. The move to statutory regulation coincided with the implementation of the EU Payment Services Directive in the UK. The changes represented a sensible evolution from the selfregulatory regime. We would refer the Commission to the response of TheCityUK, which is better placed to comment on these more global issues. 2. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole? (a) retail consumers? The consequences of a perceived deterioration in professional standards and integrity have, for retail customers, led to a reduction in trust of the financial services industry generally, which could be detrimental for personal financial planning, eg, savings, pensions and investments. (a) wholesale consumers? Lloyds has limited investment banking, directed at serving the needs of retail and commercial customers. We distinguish between wholesale clients and commercial/retail customers. Wholesale clients generally have a deeper understanding of the role individual banks have played in the crisis and are better able to differentiate between financial institutions. Our Wholesale Division, for example, is focused on facilitating trade and commerce for UK businesses and for those non-UK businesses looking to invest in the UK. This focus is a

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1219

key differentiator—we have been winners of the CBI FD’s Awards as best commercial bank for eight years in a row. Lloyds Wholesale has also seen a relative improvement in independent rankings (eg FD Awards, Greenwich, etc). We recognise that challenges remain and monitor progress as an industry through the Edelman Trust Barometer and direct client feedback, which is also crucial for understanding customer needs. Many of the regulatory or business driven changes since 2008 have focused on Wholesale—eg balance sheet and cost of capital disciplines; ensuring that compensation and performance measures focus on longterm performance. There is clearly a balance—regulation needs to be fit for purpose whilst not being so constraining as to choke the provision of banking services to UK companies, or those non-UK companies wishing to invest here. If the regulation is not fit for purpose, then possible results could include an increase in unregulated lending, an increase in provision by differently regulated non-UK firms (eg a repeat of Iceland) and non-UK banks intercepting FDI (Foreign Direct Investment) into the UK, with a critical impact on the UK economy. (b) the economy as a whole? Banks which encountered severe difficulties or failed, shared some common characteristics from a precrisis era: — A focus on growth and returns rather than risk adjusted returns. — Limited experience of banking and credit. — A management structure in which risk was subordinated, rather than reporting to the Board or CEO. — A management style that encouraged complacency rather than rigorous challenge. In the pre-crisis boom, the poor risk management practices in some UK banks led to excessive lending, drove the price of credit to uneconomic levels and encouraged bank borrowers to take on dangerously high levels of debt. To fund the rapid growth in their lending, some banks relied excessively on borrowing from wholesale markets, often with a maturity mismatch between the funding raised in those markets and the credit extended to customers. The emphasis on growth also encouraged those banks to seek extra profit from proprietary trading in financial markets. Banks with weak risk management cultures became exposed to three types of risk; liquidity risk from the maturity mismatch between their assets and their liabilities; credit risk from the rapid growth in their lending; and market risk from the rapid growth of their proprietary trading business. In the crisis, the collapse of such banks (as credit and market losses mounted and wholesale funding markets dried up) together with the inability of bank investors and creditors to fully distinguish good banks from bad, caused a sudden stop in the availability of bank funding and capital with severe consequences for the economy. The main economic impact post-crisis has been more limited supply of bank capital and funding. 3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector? According to E&Y’s Global Consumer Banking Survey 2012 (based on 28,560 customers, across 35 countries), 87% of global customers are either satisfied or very satisfied with their main bank. Satisfaction is particularly strong in branch and internet banking. Our own research supports these conclusions. However, the twelve months to March 2012 shows a 65% decrease in UK customer confidence towards the UK banking industry, against a global decline of 40%. E&Y conclude that whilst mis-selling and alleged LIBOR manipulation has clearly contributed to this decline, pay is the main driver for dissatisfaction (cited by 80% of respondents). At the same time, customer expectations regarding integrity and service have rightly increased. 4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (a) the following general themes. 5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally? For the ease of reference, the comments below address both questions 4–5 for each sub-category of question identified. The answers to question 4 are shown as bullets (where appropriate); the answers to questions 5 are shown in a box below. (i) The culture of banking, including the incentivisation of risk-taking With regards to incentives, the following problems characterise the behaviours of the last decade across the industry: — A culture that placed too much emphasis on short term profit at the expense of delivering value to customers.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1220 Parliamentary Commission on Banking Standards: Evidence

— — — — — —

Incentives based on financial results with a focus on sales, without due consideration of risk, costs and important non-financial measures, notably customer satisfaction. Individuals regarded reward outcomes as dependent on individual performance rather than the performance of the organisation as a whole. Pressure from shareholders to increase share price by more than competitor group, and to generate quarter-by-quarter returns, encouraged greater risk-taking. The so-called “war for talent” led to generous employment terms and the potential to reward failure. Retention fears created ratchet effect on pay and bonus levels as companies sought to protect their franchise. Use of buy-outs and guaranteed bonuses encouraged movement between companies, exacerbating the above. Wide-ranging changes were implemented within the third Capital Requirements Directive (CRD III) and the FSA’s Remuneration Code. CRD III has been implemented since the beginning of 2011 (although the UK introduced the provisions early). There is also EBA Guidance on remuneration disclosure practices. The provisions of CRD III follow the FSB Principles for Sound Compensation Practice and apply to employees whose activities have a material impact on their employers’ risk profile, including senior management, risk takers, employees in control functions and employees in the same remuneration bracket as senior management and risk takers. CRD III requires banks to establish remuneration policies that are aligned with effective risk management and ensure that incentives promote the long-term interests of the institution to avoid the pursuit of short-term gain at the expense of long-term results. The rules discourage up-front cash bonuses based on expected performance and to strengthen the linkage between performance and payment through deferrals and potential claw back. Additional changes are being discussed as part of CRD IV due to be implemented shortly

(ii) The impact of globalisation on standards and culture Globalisation appears to have had an impact on the incentive structures of international and investment banks. (iii) Global regulatory arbitrage With regards to regulatory arbitrage, the following problems have been observed: — The scale of regulations (proposed and existing) facing banks is immense. While principles may be agreed at G20 level, implementation approaches can vary substantially across different jurisdictions, (UK, EU, US, etc). — Firms may seek opportunities for arbitrage, eg, for capital, between the banking and trading books and/or between the credit risk and securitisation frameworks. The Basel Committee has updated the rules to minimise/eliminate such opportunities. On an ongoing basis, the FSA and EBA (amongst others) identify these arbitrage opportunities and address them through approvals, peer group reviews, etc. Variations in country approaches in Europe are also addressed by the EBA and their binding technical standards; the EU Banking Union is likely to drive formal convergence across the Eurozone states. (iv) The impact of financial innovation on standards and culture Financial innovation is critical for retail customers. The introduction of ATMs, internet banking, mobile payments, telephony, free-if-in-credit accounts, loyalty credits, contactless payments, savers prize draw and mobile apps are some of the best examples of where innovation enables greater choice and competition across financial services. Some financial innovation has been less helpful. Some Collateralised Debt Obligations (CDOs) mis-priced risk ultimately to the detriment of all—customers, shareholders and the wider economy. (v) The impact of technological developments on standards and culture The interaction between banking standards and technology are most acute when things go wrong, as identified in the recent (and well publicised) UK bank system error and problems with Anti-Money Laundering (AML) payments. When it works well, we see technology, standards and culture working “hand in hand” to achieve the right environment for customers, banks and UK plc: — Telephone and Internet banking have made the provision of Banking Services a 24/7 activity. —

Significant growth in e-retailing in the UK underlines the acceptability of the internet within the UK to drive commerce. The industry, particularly in the Cards arena, has worked hard to support that growth through the development of capability and fraud management solutions to protect consumers and businesses.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1221

—

The proliferation of mobile/smart phones and tablet devices has a real impact on the ways our customers access products, services and advice. In the near future, more customers will access their accounts using mobile devices rather than desk top technology.

—

Such technology gives customers immediate and direct control of their products and accounts.

—

Social media plays an ever increasing role. Customers choose to communicate with us in different (and often) public ways. The communications between firms and customers will, as a result, continue to evolve.

—

Technology also facilitates new market entrants from non-banks. We support the development of global standards for payments—without them we would not have the security, functionality and inter-operability that we see today between banks. For example, we protect our customers by ensuring payments are made in a standardised way so that our filtering technology can undertake sanction and AML checks. The EU’s Single European Payments Area (for which the Payment Services Directive provided the legislative framework) is a key development in establishing cross-EU standards. We have also developed the Faster Payments system using state of the art technology along with existing standards that enables the speedier delivery of customer payments. Lloyds is currently enhancing existing systems or developing new technology that benefits both customers and the UK as a whole. This includes functionality to allow customers to switch accounts more easily, make mobile payments more simply and improve the interaction between consumers and e-retailers. Security is the main concern with mobile banking: 78% of young people responding to the E&Y Global Customer Banking Survey said they would make greater use of mobile banking if they had greater confidence in security. Cross-industry agreement on and compliance with standards, whether statutory or otherwise, is critical to meeting those customer and security expectations. Given this, we welcome the Government’s consultation on the future of regulation for UK payments.

(vi) Corporate structure, including the relationship between retail and investment banking —

IMF research shows that during the recent crisis, commercial banks were much less likely to get into trouble than investment banks or universal banks (which combine investment and commercial banking). This supports the UK proceeding with the recommendations of the ICB to insulate commercial from investment banking.

—

The investment banking divisions of universal banks have effectively been cross-subsidised by the commercial banking divisions of the same banks, both in terms of their cost of funding and the likelihood of state support.

Ring-fencing, as proposed in the Banking Reform White Paper (ICB), should help, if legislated correctly. It is important that the ring-fence allows firms to continue to provide those essential risk management products that are required by its customers, to ensure that those key contributors to the real economy are able to manage risk associated with currency, interest rates, etc. Ring-fencing is the best way to separate universal banks as it allows investors to consider if there are sufficient synergies remaining to keep both sides in the same Group or to take the decision to spin off the investment bank. The introduction of ring-fencing has the potential, if carefully executed in the legislation, to help rebuild consumer trust in the banking sector and more clearly separate the different cultures of retail/ commercial and investment banking. Investment banking, moving forward, needs to focus on activities which genuinely support the customer. Ring-fencing, as proposed in the Banking Reform White Paper (ICB), should help, if legislated correctly. It is important that the ring-fence allows firms to continue to provide those essential risk management products that are required by its customers, to ensure that those key contributors to the real economy are able to manage risk associated with currency, interest rates, etc. Ring-fencing is the best way to separate universal banks as it allows investors to consider if there are sufficient synergies remaining to keep both sides in the same Group or to take the decision to spin off the investment bank. The introduction of ring-fencing has the potential, if carefully executed in the legislation, to help rebuild consumer trust in the banking sector and more clearly separate the different cultures of retail/commercial and investment banking. Investment banking, moving forward, needs to focus on activities which genuinely support the customer. (vii) The level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects —

The level and effectiveness of competition in retail and wholesale banking markets (domestically and internationally) is not a cause of any alleged problems for professional standards in UK banking. On the contrary, the “virtuous circle” (by which consumers can access and assess products and services and then act by switching supplier if they are dissatisfied or a better offer is available) drives competition and helps maintain professional standards.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1222 Parliamentary Commission on Banking Standards: Evidence

—

The ICB broadly concluded that competition is effective in the mortgage, deposit, and credit card markets. Competition in the Personal Current Account (PCA) sector will be boosted by the Lloyds Verde divestment, by the new switching service and improvements in transparency for customers. We agree with this assessment; competing vigorously but fairly is a key component of our vision to be the best bank for customers. The banking sector is subject to extensive ongoing regulatory scrutiny (such as the OFT’s review of PCAs and proposed reviews of SME banking and payment systems, the European Commission’s reviews of bank accounts/payment systems and the Scottish Government’s development of a new banking strategy for Scotland). The FCA’s new competition remit will contribute further to this environment. Transparency requirements (currently being considered as part of the OFT’s PCA review and to be further developed by the FCA in the spring of 2013) will bolster the ability of the consumer to assess the performance of suppliers and to compare rival offerings. The new industry-wide, world-leading switching service, due for implementation in 2013, will significantly enhance a consumer’s ability to change supplier. Suppliers will recognise that they must behave according to the professional standards which consumers expect, or be punished by customers switching to rival suppliers. Promoting the virtuous circle of competition thus encourages banks to abide by high professional and ethical standards.

(viii) Taxation, including the differences in treatment of debt and equity The following perceptions exist around banking standards and tax: — Under-taxation: the perception of under-taxation is often repeated, based on the fact that financial services are VAT exempt. However, there is evidence that this exemption results in a higher cost for the sector (as Banks are able to reclaim only a small proportion of their VAT). In general, the exemption is beneficial to retail consumers (lower pricing), but not for suppliers. — Debt bias: deductibility is an established feature of the UK tax system. Recently, commentators have raised the concern that tax deductibility was a factor in some excessive debt levels in the run up to the crisis. The anecdotal evidence is that the overarching funding decisions of a bank are not driven by the tax treatment. — Structured finance: prior to 2008, the UK banking sector operated a large and sophisticated “structured finance” market, which generated transactions for banks and their customers that were “tax efficient” (at a very generalised level, “tax avoidance” transactions which generated tax benefits which did not reflect the underlying economics of the transaction but were, nonetheless, completely legal under the letter of the law). The scale of this activity and its impact on tax revenues was significant. In response to the perception of under-taxation, the UK government introduced the bank levy at £2.5 billion per annum to ensure that we pay a “fair share” and contribute to the cost of the crisis and to disincentivise short-term wholesale funding in favour of equity and deposit funding. With regards to Structured Finance, HMRC has been taking action for a number of years, primarily through the Tax Avoidance Disclosure rules and the Banking Code of Practice, (BCOP). BCOP requires a bank to take into account Parliament’s intentions rather than simply the strict words of the law itself and to engage with the tax authorities in an open and transparent way to discuss transactions prior to entering into them. The BCOP is not a substitute for good law but acting in accordance with it is important for Banks to demonstrate their commitment to acceptable behaviour with respect to tax. The need for banks to consider their wider group of stakeholders in their tax positions is reinforced by increasing reputational downside of any perceived tax abusive transaction and intense media coverage. A general anti-abuse rule is due to come into force from 2013. This will further reduce the effectiveness of more aggressive tax avoidance. Other themes not included above N/A and (b) weaknesses in the following somewhat more specific areas: (ix) The role of shareholders, and particularly institutional shareholders Shareholder behaviour “pre-crunch” focused on a drive for growth with emphasis placed on delivering potentially unsustainable returns, without recognition of the downside risks. This was a factor in creating a culture that arguably led to failure in the sector. In 2010, the UK Financial Reporting Council issued the UK Stewardship Code aimed at institutional investors holding voting rights in UK companies. Its principal aim is to make institutional

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1223

shareholders actively engage in corporate governance. The Code is on a statutory comply or explain basis under the Financial Services and Markets Act and the UK Listing Rules. The Kay Review of Equities Markets (June 2012) proposed the development of an investors’ forum to facilitate collective engagement and consultation with major long-term investors on board appointments. The EU is also looking at shareholder rights, and how shareholders are impacted (in extremis) under the EU crisis management framework. Lloyds has a close relationship with its main shareholders, including UKFI, which manages the Government’s 39% stake. There is a close dialogue on key issues, including remuneration and bonus policy. More broadly, Lloyds has the largest private shareholder base in the UK. (x) Creditor discipline and incentives There were a number of key lessons learnt across the financial services industry, many of which arise from poor quality lending: — Culture: strong Executive appetite for asset growth, over reliance on borrowers’ historic performance/track record and perceived robustness of certain sectors. Inappropriate methods of incentivisation of colleagues (credit and front line). Lack of independent control and authority in the decision making. Poor monitoring and control, and early warning signs missed or ignored. Credit Policy and Appetite seen as optional rather than rules. No additional control of out of policy decisions. — Business Assessment: insufficient understanding of underlying key business or sector drivers, with either a lack of supporting due diligence or inappropriate diligence undertaken, to verify key information or fill knowledge gaps. Inappropriate, or inadequate, sensitivity analysis. Too much lending against hope value or for speculative purposes, especially in Corporate Real Estate. No aggregation of connected counterparties leading to material single name/group concentrations. — Management Assessment: too often an overly positive view of management teams held, with a lack of suitable assessment tools available to determine whether such individuals or teams had the suitable skills sets, experience (especially change management, acquisition, integration or downturn/upturn), financial discipline or team cohesion. Particularly true of family businesses or where autocratic/ entrepreneur style of leadership were evident. Lack of effective use of professional due diligence or internal, independent resources. — Facility Structuring: heavily influenced by strong credit appetite at times, resulting in over leveraged/highly geared structures, with a greater reliance placed upon increases in underlying asset values (especially in Real Estate lending) as opposed to stress testing of viability. Some structuring controls (eg financial covenants, review periods/tenor lengths) either inappropriate for business/ sector or too generous headroom provided, resulting in ineffective early warnings. — Security: lack of appreciation of values of secured assets in stressed scenarios, with over-reliance placed on perceived realisable values; inappropriate security being looked to eg unsupported personal guarantees; some imperfections in the control of security processes; and a lack of consistency in documentation controls. Lloyds today has adopted a rigorous approach to risk management. Strengthened over the last two years, we manage these risks through a combination of the following (some of which apply more to wholesale rather than retail lending): — A Three Lines of Defence Model where the frontline customer facing business areas are the First Line of Defence and have responsibility for customer acquisition, developing lending propositions and monitoring of customer lending exposures. The Second Line of Defence, the Risk Division, is independent of the frontline and provides rigorous challenge and oversight. Additionally, Group Audit provides a Third Line of Defence to provide assurance on the implementation of Credit Policies and oversight by the second line. — A prudent approach to Credit Risk appetite agreed by the Board and cascaded down through Risk to the frontline customer facing Business Units. — A focus on cash flow. We do not lend against hope value nor do we lend for speculative purposes. We lend on the basis of supporting our chosen clients through the cycle and we look to at least two clear and ideally independent sources of repayment. — Holding senior debt on the balance sheet; we avoid subordinated debt and equity with only very limited and controlled exceptions permitted. — Requiring financial covenants for any business lending in excess of one year in tenure and all lending to corporate and commercial customers is reviewed and re-authorised at least annually. — Applying industry sector risk appetites with tightly defined policies for high risk sectors. — Lending to key participants in chosen industry sectors. We avoid single name concentration and excessive exposure to any one borrowing customer. This is supported by tight rules for aggregation of limits within connected customer groups. — Applying the same criteria to the provision of underwriting services as those that apply to lending on conventional terms.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1224 Parliamentary Commission on Banking Standards: Evidence

—

—

—

We identify, through early reviews and monitoring, those customers that might be experiencing difficulty so we can take early action to support those customers and, wherever possible, support their return to viability. Risk is independent; the Chief Risk Officer reports both to the Group Chief Executive and the Board Risk Committee. Risk plays a key part in overseeing the performance assessment of businesses within the Group and performance of key senior individuals to ensure that adherence to risk appetite and risk policies are a key determinant of their overall performance assessment and reward. Across the industry, staff that undertake Significant Influence Function (SIF) roles are regulated by the FSA, thereby reinforcing individual accountability.

(xi) Corporate governance, including the role of non-executive directors Sound governance arrangements have a role to play in restoring trust and confidence. The focus on governance has brought about positive changes but it is difficult to say whether this is due to the codes themselves or down to Directors learning the lessons for themselves. Bank Boards need to provide the leadership and, critically, ensure that they have overriding responsibility for financial soundness, customer treatments and standards/ethics. In this regard, it is important that the Board provides appropriate oversight of the “tone from the top”. Significant progress has been made in enhancing and refining corporate governance practices in recent years. These should now have time to become established. If there is an appetite for further change, we would highlight: — There is an opportunity to reduce the current proliferation of codes and standards by consolidating the various initiatives and removing duplication/overlapping requirements. — A greater emphasis on the collective responsibility of the Board, consistent with legal principles. — Greater clarity on the precise accountabilities of the Non-Executive and Executive Directors. (xii) The Compliance Function — Compliance plays a critical role in driving standards across the Group and acts, effectively, as the first line of defence for the regulatory authorities. — The Compliance teams need to be sufficiently resourced and managed to deliver against an ever increasing range of regulatory requirements and expectations, and needs senior visibility within a firm. — Compliance policies, first line reviews and escalation of issues through the risk committee to the Board are key aspects that drive control. (xiii) Internal audit and controls There are increased expectations around Group Audit’s role, both internally (various stakeholders and the Board) and externally (from regulators, shareholders and other third parties). Seniority and direct engagement in the key strategic and operational developments across the firm is vital. The Group Audit Director attends the Group Executive Committee, providing Audit with the opportunity to challenge and influence the Lloyds’s response to the key risks faced by it, for example the PPI remediation process. The Director has a direct line into the NED Chair of the Board’s Audit Committee. Group Audit fully complies with the Institute of Audit’s professional standards. (xiv) Remuneration incentives at all levels; recruitment and retention We believe that reward and incentives drive behaviour and influence an organisation’s culture. They are a vital influence on how people behave, whether they are front-line staff or senior management. In the recent past the structure of variable compensation packages across the retail banking industry has been characterised by an excessive emphasis on sales targets. This may, in some cases, have had a detrimental impact on behaviour which may, in part, have contributed to the problems the industry has experienced with mis-selling. Pay, as identified from the E&Y survey, is a key driver of customer dissatisfaction. Change has occurred or is underway. At the top, variable pay is increasingly linked to the long-term performance of the bank; it needs to be awarded in shares rather than in cash, to align the long-term interests of top management and the bank; it must be transparently linked with success and be capable of being clawed back where decisions taken by top management subsequently turn out to have damaged the bank’s performance or adversely affected its customers. Reward needs to be linked much more explicitly to customer-focused service, placing far greater emphasis on customer retention and long-term relationships with our customers, effective controls on risk and removal of the emphasis on sales targets. Underlying all of this, there needs to be a complementary set of values and a culture that permeate throughout the organisation, reinforcing the right behavioural standards.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1225

(xv) Arrangements for Whistleblowing The vast majority of our staff operate to exceptionally high standards of responsibility and probity. As with any business with 100,000 people, some colleagues may not at times meet those standards; we have a low tolerance for behaviours that do not conform to them. Lloyds operates a Whistleblowing line—this is an important business tool for highlighting inappropriate (or illegal) behaviour. All Whistleblowing notifications are treated seriously and investigated fully, with disciplinary action and/or engagement with law enforcement taken forward where appropriate. The Board receives regular reviews of the various cases and emerging themes. We have a relationship with Public Concern at Work (PCAW)—an independent UK charity—which undertakes an independent annual review, the results of which are used to confirm/improve current arrangements (eg as a result of their most recent review, steps are being taken to improve communication, awareness and out of hours access). The Commission should review the practices with regard to “Whistleblowing” in other jurisdictions to see whether additional safeguards are appropriate for the UK. We are keen to explore greater punitive action against individuals who knowingly break rules and greater encouragement for Whistleblowing to increase the likelihood of more people identifying any future wrongdoing. (xvi) External audit and accounting standards — The accounting standards are wide ranging and certain elements of them are perverse in terms of their implications and/or not aligned to regulatory approaches (eg the treatment of impairment on lending). As a consequence, the management reporting of many financial services companies, which supports key decision making, is different from statutory accounting. — Internal and external audit together with the relevant Board committees ensure appropriate standards and judgements are consistent with risk appetite and that these reinforce the culture of the organisation. — External audit must have high calibre personnel with breadth of experience. Accounting standards are complex—judgement is needed when implementing them. Existing development of standards (particularly in relation to financial instruments) is appropriate though accounting setters need to draw their deliberations to a conclusion to enable implementation. It is essential that changes enhance financial reporting and that their impact on regulatory capital is understood. The extent of financial disclosure has significantly expanded in recent years and needs to be considered to ensure it remains fit for the audience. Regulators should ensure that new requirements are value enhancing and not merely additive. Three way meetings between auditors, Audit Committee Chairman and regulator are especially useful—and have recently been established by the FSA. The proposal by the EU Commission to enforce rotation of auditors is undesirable; it is largely impractical due to the limit in the number of experienced auditors, the time taken to understand a bank/insurer in detail and the need to keep other firms free from all other engagements to ensure independence. Similar reasons argue against shared assignments. If further oversight or independence is required, this could be addressed by the Financial Reporting Council. (xvii) The regulatory and supervisory approach, culture and accountability — Some characterise the FSA’s prior regulatory approach as being light touch, where regulatory standards were based on principles that presumed an intelligent response on behalf of both firms and customers, and a risk-based approach to supervision which meant supervision was directed at the perceived areas of greatest risk. — It was possible, therefore, to miss emerging issues eg, the over-reliance on wholesale markets for funding and the consequential systemic risk. The new system being implemented in January 2013 splits the FSA into the macro-prudential focus of the FPC; the prudential focus of the PRA; and the conduct and markets focus of the FCA. We support the Government’s changes; after all, it is the banks that are ultimately liable through the Financial Services Compensation Scheme (FSCS) for bank failures (eg Bradford and Bingley, Dunfermline). (xviii) The corporate legal framework and general criminal law The corporate legal framework applicable to UK listed financial institutions (a combination of the Companies Act 2006, the Listing Rules, the Financial Services and Markets Act 2000 and the FSA handbook) is sufficiently robust to govern the behaviour of such financial institutions from a company law perspective. The changes implemented by the Companies Act 2006, in particular in relation to the codification of Directors duties, have been helpful. It is timely for the Commission to review the current powers available to regulators to punish wilful misbehaviour or recklessness.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1226 Parliamentary Commission on Banking Standards: Evidence

We note that the SFO has confirmed that existing legislation will suffice to bring criminal actions against banks and individuals in relation to alleged LIBOR manipulation. (xix) Other areas not included above There has recently been debate regarding the “free if in credit” banking model. Concerns have been raised that the model may create incentives for banks to mis-sell other products, because they are unable to recover the cost of providing current accounts when the product is free. This analysis ignores the various revenue streams available to suppliers of current accounts, such as interest earned on balances in the account, overdraft fee income and interchange fees on debit cards. We do not believe this drives mis-selling of other products to current account customers. The current arrangements are preferred by many of our PCA customers. 6. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice. Ultimately, re-establishing trust is about leadership (and individual leaders) setting culture rather than encouraging further regulatory change. A substantial amount of the required re-engineering has already been achieved (ICB, changes in UK regulatory capability and framework, Basel 3 etc, etc). The focus should be on implementing quickly and securely the programme that is already underway (we are currently progressing over 80 separate initiatives across Lloyds emanating from the EU, UK, US and elsewhere). We would welcome an enhanced role for the UK’s independent Regulatory Policy Committee in overseeing all new regulation proposed by the Prudential Regulatory Authority and Financial Conduct Authority. The Financial Services Bill provides an appropriate legislative vehicle to implement this. It would be helpful if the Commission examined the existing approach to professional standards. 7. What other matters should the Commission take into account? N/A 6 September 2012

Letter from António Horta-Osório, Group Chief Executive, Lloyds Banking Group I thought you might find it helpful if I set out my thoughts on the suggestion of a single, utility, banking platform, advanced most recently by Andy Haldane in the context of bank resolvability. There are both transition issues and underlying issues. Firstly, the transitional issues: if, as Britain did in the 1920s with the National Grid, a single banking platform had been built from scratch that might be a different matter. But that is not where we are. The UK’s banking infrastructure (in common with that in other countries) more closely resembles our telecommunications networks, with multiple different platforms, interconnected at key points to allow the necessary transactions to take place. In the case of banking payment exchange and settlement, debit payments, direct debits and standing orders etc. are on the utility network run for the banks by Vocalink; the CHAPS payment transfers are run by the bank of England. The operational challenge of getting from there to a single utility platform is very big. In the case of Lloyds, successfully merging the Lloyds TSB and Halifax Bank of Scotland platforms has taken three years, involved thousands of staff and very considerable cost. That is within one Group in common ownership. The collapse of the sale of the 314 RBS branches and associated infrastructure to Santander, driven by platform and IT incompatibilities, illustrates vividly the much greater difficulty of integrating platforms between different companies. That level of difficulty rises geometrically rather than arithmetically with the addition of extra platforms. There are at least six major platforms and dozens of smaller platforms in Britain’s banking system. As Lloyds has found, large-scale integration requires that the legacy platforms must be “frozen” while that integration process takes place. Bank customers, rightly, look to continuous process development and improvement to automated payments, transfers and settlements, both for speed and reduction in errors that such infrastructure improvements bring. Those improvements could not take place for the years it would take to develop and implement a single banking platform. Those are the transition issues. There are, I believe, three underlying issues with a single platform. The first is its impact on product and systems innovation to meet consumer needs. With a utility platform, all must move at the speed of the slowest.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1227

We have pressed hard in recent years for changes to benefit consumers such as electronic ISA transfers (and, indeed, the Account Re-Direct PCA switching system which comes in next year). The industry leaders can all join in to make it happen and competitive pressure forces the laggards to make the necessary investment to catch up. Energy Ministers, past and present, will tell you of their frustrations in trying to force through similar improvements in the energy markets, where the pace and scale of improvement is dictated by what is possible on the central National Grid or Transco platforms. In short, a single utility platform would act to favour incumbents and stifle competition and innovation. It would be like a return to the limited competition on the BT utility platform in the 1980s when there was no effective competing infrastructure and unstable and temporary competitors; whereas today we have mobile, cable, smart-phone and internet-based competition. Secondly, there is a global standardisation of payment systems and settlements. This is based broadly on the UK system: it allows for individual bank platforms but interconnection via a system of account numbers and geographically-based sort codes. This enables a global flow of payments and settlements across borders for trade finance. A single, national, utility platform would be at odds with this global system. It would add significantly to the complexity for all companies who import and export. It would also impact on the international competitiveness of the City where hundreds of banks, whether branched or subsidiarised here, participate in, or use the UK’s system on an agency basis; and the thousands of international banks who interconnect to the UK’s system. Thirdly, a single banking platform would set up a “single point of failure”. This does not matter too much for utility networks like National Grid, Transco or National Rail, where the failure can be geographically isolated. A banking network failure would inherently be nation-wide and would significantly increase systemic risk. We have seen the consequences if even one bank’s ATM or payments systems go off-line for as little as half an hour. We have seen recently one major bank whose overall systems went out of order for days or weeks. This was a major shock to millions of consumers. We simply cannot afford this nation-wide. I would be happy to discuss this with you when we next meet. You will understand that I believe that the costs, risks and long-term consequences significantly out-weigh the putative benefits. 21 November 2012

Written evidence from Lloyds Banking Group Executive Summary Various questions and concerns have recently been raised during the course of the Parliamentary Commission on Banking Standards (PCBS) in terms of improving competition and financial stability through changes to the UK payment systems. A couple of options—full sort code and account number portability (“portability”) and a common utility banking infrastructure (“bank utility”)—have been proposed as solutions to address these concerns. As we made clear in António Horta-Osório’s letter to Andrew Tyrie (dated 21 November 2012), whilst we are supportive of the principle that competition and financial stability can and should be improved, there has been an unhelpful level of confusion about and conflation of these solutions and the benefits they aspire to bring to the market. We are also concerned that the significant benefits of the world class switching service, to be launched in September this year, are being lost and undermined in this debate, which is a terrible shame especially for consumers. Therefore, we have undertaken further work to draw out the pros and cons of the various options being considered and the concerns they are trying to address. Some of what is being discussed poses significant risk, with concerning unintended consequences, which do not outweigh the benefits to UK consumers, businesses and society as a whole. Our views are based on real experience from the integration of LTSB and HBOS, the largest banking integration completed in the UK in the last 10 years, and our position as a major player in the industry, at the forefront of change. Moreover, we have developed an alternative solution which we believe merits consideration. We have shared this work with the PCBS’s expert Professor Dave Cliff. We believe the most effective, efficient and speedy solution is not in a bank utility and/or portability—but also realise that the new switching service alone is not a universal panacea. We propose a four part solution building on developments already in progress and on existing “proven” systems which can be delivered in parallel at a fraction of the cost, time and risk of other solutions: 1. The new fast, hassle free, guaranteed switching service with cost and risk born by the banks due September 2013. 2. The new mobile payments service with an account portability like identifier due in early 2014. 3. Following early investigation, we believe that mirror bank accounts could provide a workable solution to the current resolution and recovery issue. While a feasibility study would need to take place, in principle large banks could be required to have a separate mirror bank account for each consumer into which FSCS could be paid if a bank failed, enabling consumers to continue to transact and to give them time to switch to another bank if desired.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1228 Parliamentary Commission on Banking Standards: Evidence

4. A new requirement for Vocalink and the Payments Council to deliver a “Lite” payments infrastructure system to allow direct access for new entrants to the payments system. We do understand that this is a complex and wide ranging set of issues and we would support a sensible independent third party cost/benefit analysis of the different available options, paid for by the industry, to confirm our thinking.

There are a number of UK payment system and banking issues currently under the spotlight A number of stakeholders have suggested to the PCBS that competition and financial stability could be enhanced through changes to the UK payments system. Three key topics have been under the spotlight: 1. Making it easier for consumers to change bank quickly and risk-free. This could enhance the competitive dynamics in the market by encouraging consumers to seek better deals or service, incentivising banks to innovate and improve customer outcomes and encouraging new entrants into the market to challenge existing banks. 2. Aiding recovery and resolution by ensuring consumers and businesses are provided with continuity should a bank fail, and receive their FSCS pay out quickly. This addresses the notion that any bank is “too big to fail”, ensuring risks sit with the banks and shareholders and not taxpayers, reducing the risk of a run on a bank and minimising the impact on consumers if a bank fails. 3. Enhancing access to payment systems for small and new banks, reducing any perceived barriers to entry and ensuring a level playing field for challenger banks.

A pragmatic combination of four initiatives could address concerns efficiently and effectively As discussed in detail below, Lloyds Banking Group (LBG) believes that concerns with the payments system and banking infrastructure can be most sensibly addressed via a combination of four initiatives delivered in parallel which, at a fraction of the risk, complexity, disruption and cost of account portability or a utility infrastructure, will deliver improved consumer outcomes. —

The new account switching service, to be delivered in September this year, will deliver the account switching outcomes that have been called for. It will provide a fast, hassle free and guaranteed switching experience, where all the risk sits with the bank rather than the consumer. Critically, the new redirection element of the switching service will ensure all transactions are automatically routed to the new account, providing consumers with certainty and confidence that they can change banks safely.

—

The Payments Council recently announced a Mobile Payments solution that will enable consumers to make spontaneous payments using just a mobile phone number—introducing an account portability-like identifier. Consumers will no longer need to share their bank account details for spontaneous payments, meaning payments can continue unaffected and uninterrupted should a consumer switch bank.

—

While a feasibility study would need to take place, in principle we believe that Mirror Bank accounts could provide a workable solution to the current resolution and recovery issue. Large banks could be compelled to implement Mirror Bank structures to ensure large institutions can be resolved in the event of a bank failure, with minimal impact on consumers. Under Mirror Bank structures, banks would maintain a duplicate consumer account into which FSCS could be paid in the event of a bank failure. These mirror accounts would be held on existing infrastructure, segregated from the principle account and under a separate legal entity. This would enable quick and efficient electronic FSCS pay out, providing continuity of banking services to customers of the failed bank via the mirror bank and mirror accounts, and the option to switch to another bank if desired.

—

LBG also proposes that the Payments Council in conjunction with Vocalink be compelled to lead the development of a new Payments infrastructure “lite” which would allow smaller institutions and new entrant banks direct access to payment systems and networks without the same underlying complexity or cost base as the bigger banks.

A high level comparison of these options with bank utility and portability is summarised in the following table.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1229

Banking Utility Central Banking infrastructure used by all UK Banks to include customer and product data as well as Payments infrastructure and accounting processes. Involves migration by all Banks to common data standards and processes and buildings of a massive central infratsructure. Capability for all Sorting Codes and Account numbers to be portable with customers as they move between institutions. Will require addition of a new identifier structure and changes to the IBAN structure held internationally as well as payment systems and data stored by UK companies

Will impact every consumer and business in the UK

Bank level solution to hold “mirror” bank account for all FSCS eligible customers against a dormant sort code. Where relevant FSCS “pays in” to mirror account and all collateral from the old account still functions allowing continuity and then resolution in the event of a Bank failure

No impact on consumers and businesses until a bank fails

Limited as largely internal bank development

Industry level solution, utilising existing payments infrastructure to manage customer switching, notify billers and DD originators and to redirect all customers transactions from the old account to the new account for 13 months. Switches are guarenteed to complete in 7 days.

Impacts subset of consumers who choose to switch banks

Limited as largely internal bank development

Industry level solution utilising existing payments and banking infrastructure to delivery a portable customer proxy (mobile phone number) used to initiate and advise payments

Limited as largely internal bank development

By adding a new payments infrastructure “Lite” to the developments highlighted above, we believe that within four years and at a fraction of the risk, complexity, disruption and cost of a bank utility or portability, the same goals could be achieved by alternative means. A significant switching improvement will be delivered in September 2013 The switching service delivers what consumers really want In September this year a world class switching service will be delivered in the UK for retail customers, small businesses and charities. The switching service was designed using consumer research to deliver what consumers actually want—namely a way to change bank provider which is free, quick, simple, hassle free, guaranteed and with zero risk. Research has consistently shown that the specific process doesn’t matter to consumers as long as these objectives are met. We are concerned that the benefits of the new switching service are being lost and confused Some of the key features of the new switching service seem to have been forgotten or misquoted by a number of stakeholders. The service is free for the consumer, with costs paid for by the new bank. The cost per switch to the new bank will be £7 to £15 per switch (not £50 as referred to in recent oral evidence). This compares favourably with the current ToDaSSo switching process, especially considering the many additional facilities included in the new service and the opportunity it will present to banks to simplify and automate internal processes. The service is guaranteed, with all the risk sitting with the banks and not consumers. A critical element of this is the redirection facility, which automatically and seamlessly ensures that transactions (such as Direct Debits and Standing Orders) are routed to the new account. This redirection appears to have been overlooked by some commentators, but is one of the most important elements of the new switching service and provides consumers with assurance that payments will not go astray. The entire service is fast and hassle free. Consumers need only to speak to the new bank, and only a single instruction is required throughout the entire process. The new seven working day timeline provides clarity and trust, with consumers confident that from the eighth day they can start using the new account exactly where they left off as the account balance and all other payment details will have been transferred overnight to the new account. The switching service needs universal support to change consumer perception and behaviour The new service will be delivered in September this year, and will be launched with a substantial independent marketing campaign to raise awareness, funded by the industry. This is a rare opportunity to really change consumers perceptions of switching and enhance competition, which needs full universal support from all stakeholders rather than conflicting and confusing messages on account portability or bank utility platforms. The Independent Commission on Banking recommended that the benefits and outcomes of the new Switching Service should be reviewed in September 2015 having been given

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1230 Parliamentary Commission on Banking Standards: Evidence

time to bed down, and more recently the OFT reiterated this, recommending that the FCA or CMA review the success of this new switching solution at least 15 months after it is delivered before considering alternative solutions. We strongly endorse this position. Some have speculated that account portability might be a better solution to improve bank account switching Account portability isn’t as simple as it sounds Account portability, in simple terms, is a process that would enable consumers to retain their unique identifier (currently sort code and account number) if they choose to switch to another bank—removing any risk that payments (such as Direct Debits) would go astray. All consumers and businesses in the UK would need to be issued with some form of new unique identifier for every account they currently have, including not just current accounts (including personal and joint accounts), but also other types of account such as savings accounts, mortgages, etc. In practice, many consumers would have to have a number of unique identifiers, in many cases at least four (unlike mobile phones where most consumers only have one which they remember and attach a value to). While it is technically feasible to implement account portability, it would be incredibly complex. Fundamentally separate bank infrastructures and payment systems would remain, but everything would need to be re-engineered to decouple sort codes and account numbers from the systems used to (1) route, (2) settle, (3) post/apply and (4) account for transactions between different banks. On top of this, a new central routing table would be needed to link unique customer identities to the multiple existing identifiers (for example international account identifiers). Considering there are around 300 million separate accounts in the UK, and over 120 million transactions daily through these accounts, the new routing table would have a vital but risky role to play. The key consumer benefits from account portability are already being delivered by the new switching process Advocates of account portability believe that consumers would be more likely to switch if they retain their bank details, as there would be zero risk of direct debits and other regular payments failing. While consumer research does show that the risk of payments failing is currently a major concern for consumers, this is already being addressed as a priority by the new account switching service via the redirection facility which ensures that all transactions are routed to the new account. Supported by the switching guarantee, this means all the risk of switching sits with the bank and not consumers. Some advocates have also assumed that account portability would deliver near instant switching, however in practice portability would still require three to five days for accounts to be opened and collateral to be delivered. In comparison the new account switching process will take a guaranteed seven working days, providing consumers with clarity and trust in the timeline. We also believe there is potential for competitive forces to reduce this over time. Recent consumer surveys conducted by Which? and Quadrangle on account portability and the new switching service respectively have delivered similar results, demonstrating that consumers simply want an easier way to change banks and the specific process doesn’t actually concern them. Comparisons to the mobile phone portability process ignore key product and consumer behavioural differences Many commentators have drawn comparisons between mobile phone number portability and bank account switching. In practice, we believe these comparisons ignore significant differences between the products and consumer behaviour and are districting from the real issue at hand. Consumers attribute a value to mobile phone numbers, as generally most consumers only have one phone number (making it easy to remember) which is shared with a large number of parties including friends, family, work colleagues and businesses. Without mobile phone number portability, the process of notifying all parties of a change of number would be arduous. In comparison, the majority of consumers have more than one set of bank details (for example some consumers hold several current accounts and many also have savings accounts etc), and bank details are generally only shared with a very small number of parties—predominantly businesses—who are automatically notified of any switch under the new switching service. In fact, we believe the mobile phone portability process is inferior to the new bank account switching service. For example, unlike the new bank switching process, the mobile phone process involves consumers negotiating between the old and new provider (often subject to delays, errors and pressured retention sales), has no specific end-to-end switching timescale (leaving consumers carrying two phones and responsible for checking when the process has completed), often involves a loss of service for a period of time, and pay-as-you-go consumers forfeit any remaining credit balance when they switch. In conclusion, account portability risks being a dangerous and expensive “white elephant” All of the key consumer benefits that account portability would bring are already being delivered by the new switching service, which needs the full support of all stakeholders to avoid consumer confusion and the new

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1231

service being undermined before it is even launched. Comparisons with mobile phone switching are only confusing the situation, a better comparison would be property post codes which are interconnected to many other services and functions. While we do not dispute that account portability is technically feasible, the risks and costs involved would result in a negative consumer outcome. For example, during the implementation stage, which would take many years, innovation would be significant reduced as resources and expertise would inevitability be diverted to delivering portability. Existing systems would also be subject to a period of “lock down” to de-risk the implementation of such a fundamental change, again restricting innovation and discouraging new market entry. Consumers, businesses and international parties would also suffer direct disruption, as for example new collateral would likely need to be issued and Direct Debit originators would need to adapt to new identifiers replacing sort codes and account numbers. In practice it would be unlikely that all banks would be able to make the change at exactly the same time, resulting in a need for complicated conversion processes, with consumers and business confused as to what bank details are valid. Given all of this, we urge universal full support of the new switching service to give it the best possible chance of success. Only if it does not have the desired impact, after a bedding in period, should any consideration be given to portability or alternative solutions.

Going beyond portability, a utility core banking infrastructure has also been proposed Utility core banking infrastructure is an extreme solution Both the new account switching service and account portability are tools to facilitate consumers moving between banks, fundamentally based on existing bank and industry infrastructure. A utility banking infrastructure is quite different, it would effectively wipe the slate clean and replace most existing bank and industry infrastructures. Most simply, a bank utility is a single common core banking infrastructure which all banks access and use, with one accounting platform (holding customer and account information), one set of middleware (holding products and services) and one set of engines and gateways to manage transactions. Customer relationships would continue to be managed by individual bank channels (branches, internet, telephone, etc), but behind the scenes all the customer data and processing would be held and managed on the central utility infrastructure.

A bank utility could feasibly address concerns if the industry in the UK were starting with a blank piece of paper We do not doubt that a utility infrastructure would be worth considering if we were starting with a blank piece of paper. It certainly would address the key concerns that commentators have raised, namely making it easier to switch, aiding recovery and resolution and providing “plug-and-play” facilities for small and new entrants. The problem is that we are not starting with a blank piece of paper; the UK has one of the most advanced banking and payments infrastructures in the world, the envy of many countries, and to deliver a utility infrastructure now would be akin to flattening the whole of London to rebuild it as a more efficient gridbased Manhattan style city. Furthermore, we believe that a utility banking infrastructure would create a new set of issues.

Based on real LBG experience, implementing a utility banking infrastructure would be a long and immensely challenging process LBG is in a unique position to comment on such a significant banking infrastructure project having just last year delivered successfully the largest banking integration programme in the UK in the last ten years. LBG took three years to integrate LTSB and HBOS, which involved only a subset of the programme that would be required to build a bank utility infrastructure as we were migrating to a platform that was already in place and tried and tested. During this time, all developments on the legacy and target platforms had to be frozen to protect the delivery of integration. Implementing a utility banking platform would in effect be like multiplying the LBG integration many times over, migrating each existing banks data to a new single platform. Unlike the LBG integration, additional time would be required to specify, procure, build and test the new infrastructure in the first place. It would only be possible to migrate one bank at a time, making it is difficult to see what bank would go first (and risk being on an untested platform) or last (and risk being some years behind other competitors). As demonstrated in the diagram below, we estimate that it would take at least eight years for a utility infrastructure to be implemented (of which at least five years would be migrating data onto the new infrastructure).

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1232 Parliamentary Commission on Banking Standards: Evidence

12 Months Specify Requirements

6 Months Select Supplier

60 Months +

18 Months Build Test Harmonise

Run and Change

Migrate

Bank 1 • It took LBG 36 months to do a subset of this programme • LBG was migrating to an existing platform

Bank 2 Bank 3 Bank 4

• To protect the programme no change undertaken on target and legacy platform

Bank 5 Bank 6

• With the pace of technological innovation the infrastructure of new Utility Banking Platform is at risk of being obsolete before the last bank migrates to it.

Based on 10 banks migrating 3 months apart

Bank 7 Bank 8 Bank 9+

Change Freeze 8 years Each bank migration would pose huge consumer risks—35 billion pieces (equal to 2.5 petabytes) of data and £127 billion worth of balances were migrated when Halifax and Bank of Scotland moved to the LBG infrastructure. Leading up to the Halifax and Bank of Scotland migration, over 18 months of testing took place (c.250,000 test scenarios) with a total of eleven technical, business and full-scale migration dress rehearsals. The total aggregated cost of integrating LTSB and HBOS was £2 billion for a subset of the programme that would be necessary to create a banking utility. The implementation of a utility banking infrastructure would have a hugely detrimental impact on consumers and business, with innovation effectively frozen throughout the process, products and services potentially being changed or withdrawn to cope with the harmonisation that would be necessary to move to the new infrastructure, high risk of service interruptions, confusion and compatibility issues during the migration phase and likelihood of new collateral being issued. With the current pace of technological innovation the infrastructure would also be at risk of being obsolete before the last bank migrates to it, putting the UK years behind other countries. All of this would be going on in the context of other massive industry change, including the LBG and RBS divestments, FATCA, Dodd Frank, Ring Fencing, etc. A utility infrastructure could have a number of significant unintended consequences During the implementation phase, a mandatory “lockdown” would be required across the industry to ensure compatibility with the new utility infrastructure. This would in effect stifle innovation for up to a decade, in particular during a time when technological advancements are anticipated to have a major impact on UK banking. The implementation phase would also likely restrict any new market entry as new banks would likely want to wait until the new infrastructure is built rather than invest in a legacy system. Overall, competition would be seriously hampered. If implemented, we believe competition would continue to be restricted, rather than increased, by a utility infrastructure. Banks would be unable to develop and innovate beyond central infrastructure capability, and there would be a lack of incentive to collectively develop the infrastructure as there would be no competitive advantage to gain. Price would likely become the key differentiator between banks, with larger banks able to benefit from economies of scale and under-price smaller banks, leading to market consolidation. While a utility infrastructure would likely be able to permit “tick-box” instant switching, this could actually work against financial stability by making a run on a bank quicker and more likely. For example an inadvertent rumour could spark a run and the demise of a bank within hours as customers vote on line with their feet. All payment system users, not just banks, would need to update systems to accommodate new customer identifiers. Currently there are around 50,000 submitters of transactions, all of which would have to develop their own systems to cope with the change (and to manage during the transition when some banks have migrated and others haven’t). A utility infrastructure would represent a single point of failure, the size of which has never been seen before. Any system failure, such as the issues faced by some banks in 2012, either during migration or once fully implemented, would effect every consumer and business in the UK (and potentially internationally), potentially bringing the economy to its knees. The infrastructure would also present a substantial target for a terrorist or cyber attack, and as every bank would use the same infrastructure there would be an increased likelihood of a “rogue” employee gaining access and damaging the system for all.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1233

While this is by no means an exhaustive list of potential issues and unintended consequences, it demonstrates the seriousness of the risks posed by a utility infrastructure. In conclusion, a utility core banking infrastructure is technically feasible but the benefits are significant out weighed by the risks A bank utility infrastructure is technically feasible, and would address many of the banking payment system concerns noted previously. However in practice, a bank utility would be incredibly challenging to implement, with some kind of disruption to consumers and businesses inevitable. There is also a strong likelihood of the unintended consequences leading to worse consumer outcomes. We believe that this level of change and upheaval is unnecessary given other practical solutions which can also address the same goals at a fraction of the risk, time and cost. A pragmatic combination of four initiatives could instead address concerns efficiently and effectively We believe that developments which are already in progress allied to additional developments that could be built within current infrastructure with minimal risk and complexity represent the best way forward for the UK plc, consumers, businesses and competition. As discussed above, the new Switching Service will be implemented in September 2013 and it will make it quick, consistent and hassle free for consumers, small businesses and charities to switch banks. This will be backed by a comprehensive guarantee provided by all participating banks, ensuring risk sits with the bank and not the consumer. The new Mobile Payment solution announced recently will go live in April 2014 and will deliver portability like simplicity for making and receiving spontaneous payments using mobile phone numbers. With consumers confident that the new switching service will deal with redirecting all regular payments (such as Direct Debits for utility bills), and the new Mobile Payments solution effectively taking spontaneous payments (for example to friends and family) out of the equation when switching, there are no additional meaningful benefits from delivering account portability. In addition to these world leading and exciting developments, LBG proposes two further workable solutions: 1. While a feasibility study would need to take place, in principle we believe that Mirror Bank accounts could provide a workable solution to the current resolution and recovery issue. Large banks could be compelled to implement Mirror Bank structures to ensure large institutions can be resolved in the event of a bank failure, with minimal impact on consumers. Under Mirror Bank structures, banks would maintain a duplicate consumer account into which FSCS could be paid in the event of a bank failure. These mirror accounts would be held on existing infrastructure, segregated from the principle account and under a separate legal entity. This would enable quick and efficient electronic FSCS pay out, providing continuity of banking services to customers of the failed bank via the mirror bank and mirror accounts, and the option to switch to another bank if desired. 2. Payments Council and VocaLink should be compelled to initiate the design and build of a new Payments Infrastructure “Lite”. This development would provide small and new banks with access to UK payment systems, on a comparable basis to large established banks on a “plug and play” basis. This could encourage new entry and enhance competition. LBG would support an independent cost/benefit analysis to consider a utility infrastructure in comparison to our four initiative plan. This should be conducted imminently and be paid for by the industry. We believe that this would confirm our thinking that an approach that builds on established and proven infrastructure is the most effective and efficient approach to address the concerns of stakeholders. 31 January 2013

Written evidence from London First Introduction London First welcomes this parliamentary commission on banking standards. With the reputation of the banking industry severely damaged by recent events,1 and the expectation that this will not improve significantly in the near future, it is right that this essential part of the UK economy be scrutinised and the changes necessary to restore trust implemented.63 Our comments reflect the concerns of London’s diverse business community. London First is a business membership organisation representing over 200 businesses from a range of sectors, including finance, professional services, property, ICT, creative industries, hospitality, retail and education. Our mission is to 63

An August 2012 report by the consumer group ‘Which?’ found that 71% of UK consumers do not think banks have learnt lessons from the financial crisis (compared to 61% last year).

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1234 Parliamentary Commission on Banking Standards: Evidence

maintain London’s status as the best city in the world in which to do business. Restoring trust in our banking industry and ensuring the continued success of our world-leading financial services sector is a key part of this. Why we Need to Restore the Reputation of our Banking Sector Banks underpin our way of life Banking, combined with the wider financial services such as insurance, is core to our way of life. Banking, at a very basic level, leverages activity, enabling individuals and businesses to access funds above and beyond their savings: the ability of an economy to grow is dependent on the availability and price of capital (and the ability to offset certain risks through insurance and related products) and therefore the actions of the banks and the ability of this sector to provide competitive, secure funding streams is an essential driver of growth. Actions that result in a loss of liquidity to the market or dramatic and unanticipated increases in costs have lasting effects on the economy. Likewise policy responses which reduce the capacity for bank lending or increase the cost of lending beyond that justified by the risk will hinder growth. At a practical level, the banking system underpins our society by providing the infrastructure that enables individuals and businesses to manage their finances and interact with one another. The fact that many essential services—such as ATMs—are provided free at the point of use to most customers demonstrates the importance of ensuring that the sector remains economically viable. This is not to suggest that badly run banks should not be allowed to fail. So long as there are adequate measures in place to ensure that, in the event of a bank failure, retail customers’ deposits are protected, then banks should be subject to the same risks as any other commercial activity, with shareholders and creditors bearing any loss. Banks generate jobs, business and tax revenue As well as being a facilitator of business, banking is an important sector in its own right. The banking sector currently provides over 140,000 jobs in London and over 420,000 in the UK. In 2011, banks paid approximately £21 billion in direct corporation tax, income tax and national insurance64—equivalent to almost two-thirds of the annual cost of the UK’s education budget—as well as indirectly contributing through VAT (which banks are unable to reclaim), property and other taxes. However banking is only part of the financial services industry, an industry that provides the foundation for London’s global city status. The financial services sector as a whole provides over 335,000 jobs in London and contributes £52 billion in GVA.65 The economic benefit of London’s financial services cluster extends beyond its direct contribution as it supports a number of other world-leading clusters, most notably professional services. The growth of professional services over the past few years has been significant, and this sector now employs over 300,000 in London alone, yielding £17.7 billion to the Exchequer. Together the banking and professional services sectors employ over two million people in the UK and contribute £175 billion to the UK’s GVA,66 equivalent to over 13% of the UK’s total GVA.67 This cluster would be greatly diminished if London no longer housed a concentration of global banks. London’s financial services cluster supports London’s global city status A key factor in London’s global city status is its leading financial services sector. A diminution of this would threaten London’s global status which, in turn, would have a wider impact on the London economy. For example, London’s leisure industry is reliant in part on serving high-earning individuals, many of which are employees of the financial and professional services firms. If domestic demand is reduced this could, in turn, lead to a reduction in facilities which in turn would reduce the attractiveness of London to tourists and, indeed, to other businesses. Desired Outcome While trust clearly needs to be restored to the UK banking industry, the breakdown in trust in the sector has not been confined to this country.68 Certain aspects of the industry’s rehabilitation therefore needs to be driven by regulations developed at an international level (to ensure stability across this interconnected sector and prevent regulatory arbitrage) but, at a UK level, these need to be complemented by recommendations that support London’s continued position as a global financial centre of excellence and restore its reputation as a business environment built on integrity. As we discuss below, while a return to the days when ‘my word is my 64

65 66 67

68

House of Commons Library; Standard Note SN/EP/06193 “Financial Services: contribution to the UK economy”, 21 August 2012. TheCityUK. TheCityUK. “The Contribution of Financial and Professional Business Services to the City of London, Greater London and UK Economies”, Oxford Economics, February 2012. Global PR firm Edelman’s annual ‘Trust Barometer’ investigating popular attitudes towards Government, business and NGOs found that banks and financial services were the least trusted industry worldwide.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1235

bond’ was an acceptable alternative to a legal contract would be an unrealistic aim, a re-establishment of the ethos that underpinned that concept would bring both long-term stability and competitive advantage. The Problem Incidents that have come to light over recent years have highlighted problems affecting the stability of the banking system, such as the culture operating within some major banking institutions and the behaviour of certain individuals within some banks.69 While the majority of institutions and bankers played no role in the recent problems, the combination of these events has resulted in a wholesale loss of trust both in banks as institutions and in bankers as competent and trustworthy individuals. The extent of the damage caused by these banking scandals has not been confined to the banking industry but has damaged the reputation of the wider financial services sector and the international perception of the City of London. This wrongdoing must be seen to be dealt with—the perpetrators punished—and actions taken to ensure such behaviour is not repeated either at an individual or institutional level. However, in both acting against wrongdoers and attempting to mitigate future errors, it is important to recognise that we are dealing with a barrel containing some rotten apples rather than the Augean Stables. While the various banking problems have the common result of a loss of trust, the cause of each has been different. The credit crisis arose from a mis-pricing of risk, specifically sub-prime debt; product mis-selling, such as PPI, was encouraged through short-term incentives, aggressive sales targets and weak internal checks; and the Libor scandal appears (in part) to have arisen from senior level decisions on the manipulation of data to present an enhanced image of the institution. The problems have also affected different segments of the banking market. As with many industries, banking is not a homogeneous sector: different banks fulfil different roles in the economy, face different risks, pose different threats and operate in different competitive environments. By way of illustration, while attention has focused on a handful of market participants, the UK is home to some 318 authorised banks (of which 241 are foreign banks located in the UK—the vast majority in London)70 and most have had no involvement in any of the issues that have had an impact on the sector’s reputation. In developing recommendations, it is important to recognise the heterogeneous nature of the industry and ensure measures are targeted, proportionate and effective. Measures already in play Given the long-term nature of this problem (the reputation of the banking sector was severely damaged by the credit crisis five years ago and has not recovered since) there is already a wealth of regulation underway aimed at restoring the stability and trustworthiness of the sector.71 The fact that there are long lead times for much of this existing reform programme should not be mistaken for inactivity in this space, not least as the markets tend to require action much sooner than the regulatory timetable suggests (for example, increased capital requirements required under Basel III are already being expected and monitored by the markets). Alongside the regulations developed to deal with the stability of the banking system, measures are also in process to address concerns over customer protection, principally the Retail Distribution Review, which aims to ensure a resilient, effective and attractive retail investment market in which consumers can have confidence when planning their retirement and investments. We believe that in these areas, regulation already in place (or shortly to be implemented) should be given time to take effect and evaluated before any further measures are considered. However, a gap does still potentially exist regarding measures to ensure the ethical behaviour of bankers: putting the customers’ interests first and letting the profits follow good service. Potential Solutions Any recommendations for encouraging and supporting a culture of integrity in banking must recognise and support the positive contribution of the majority of the banking industry while dealing robustly with the rogue elements. Attempting to drive cultural change through prescriptive regulation is likely to be less effective and sustainable than measures that encourage each institution to find its own means of restoring the trust of its customers. Addressing the issue of culture on a principles basis which can be adopted to reflect the nature, risk and business activities of an institution avoids the risk of unintended and adverse consequences that would arise from a more prescriptive, industry-wide approach. That said, we should remember that the Financial Services Authority aspired to be a principles-based regulator, rather than one that relied on enforcement as its primary tool. As we move to a new regulatory 69

70 71

Stability of the banking system was brought in to doubt by the credit crisis; culture of banks brought in to question by the scale of the product mis-selling scandals; behaviour of individual (alongside culture) have been challenged through the Libor scandal and recent sanction-breaking trading activities. TheCityUK “Trends in UK Financial and Professional Services”, June 2011. 9 For example, MIFID II, Basel III, Solvency II.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1236 Parliamentary Commission on Banking Standards: Evidence

structure, it is reasonable to expect that a principles-based approach may still need to be supported by certain targeted regulation and a consistent approach to enforcement that visibly penalises (and therefore, should deter) rogue behaviour. Ensuring a set of principles-based recommendations are effectively enforced and monitored will be difficult. However, increased (and in some cases excessive) public and media scrutiny of this sector could assist in holding banks and bankers to account. A more ethos-driven culture should incorporate the following three themes: — Setting the tone from the top. — Increased personal responsibility. — Retail banks operating as service centres rather than shops. Setting the tone from the top The tone set by senior management is critical in defining the culture of an organisation. This has been recognised in other areas of legislation such as the anti-bribery law. Here, the Ministry of Justice issued official guidance for companies based on six principles, one of which is ‘top level commitment’, comprised of: internal and external communication of the commitment to zero tolerance to bribery, and top-level involvement in bribery prevention. Establishing a set of values at the top of the organisation whereby business activity is driven, and success measured, not solely on profits but also in terms of customer satisfaction should encourage a culture where serving the customers’ needs is prioritised with the belief that good service will yield returns. While values exert influence over attitudes, and attitudes influence behaviour, studies of corporate culture suggest that it requires more than just a statement of values by senior management to change the culture of an organisation.72 Ethics and compliance programmes need to translate into an ethical culture throughout the organisation. Research73 suggests that three actions were particularly important in creating an ethical culture: setting a good example; keeping promises and commitments; and supporting others in adhering to ethics standards. Making each tier of management accountable for ensuring that its actions reflect the firm’s values and subjecting each to peer review and independent assessment should encourage a positive culture to spread though the organisation. Increased personal responsibility Developing a culture of personal responsibility which extends to responsibility of management for those reporting into them would provide a useful internal check on behaviour. Evidence74 suggests that when companies have an ethos based on self-governance, in which everyone is guided by a set of core principles and values that inspire everyone to align around a company’s mission, employees are much more likely to blow the whistle and are more encouraged to put forward new ideas. Within such a culture, there must also be the mechanism for any employee to escalate an issue if it appears to breach the company’s ethos. Whether this is to an individual or, as in some firms, an independent ‘wise men’s’ committee will depend on each particular firm’s structure and style. Increasing the degree of self-governance within the culture of banking would support a more transparent and constructive employee relationship. Retail banks operating as service centres The traditional high street bank used to be a place where advice was trusted and bankers respected. Over the years this image has been eroded as banks have developed a more sales-based approach. This shift has been supported by the incentives provided and targets set for retail bankers. Customers once again need to feel that their needs are the priority and banks need to adopt an approach where good customer service is in itself the priority and profits are driven by successfully and appropriately meeting customers’ needs. This shift could increase the costs of retail banking which in turn would result in an increase in costs to consumers which would need to be justified by sufficient increases in consumer benefit. These three suggestions, alongside other ideas that have been mooted, need to be subject to full impact assessments prior to actions being taken. Banking is a subset of the wider financial services industry and the line between banking and other financial services institutions is often difficult to draw. Any regulations aimed at changing the culture of banking are likely to spill over to other financial services organisations and this should be factored into the impact assessments. 72 73 74

Economist article: The view from the top, and bottom, 24 September 2011. National Business Ethics Survey for the Ethics Resource Center “Ethics Related Actions” (2005). A report, “National Governance, Culture and Leadership Assessment” based on a survey of thousands of American employees, from every rung of the corporate ladder. 90% would blow the whistle compared with 25% in firms operating a “blind obedience” culture; over 90% of employees in self-governance firms agreed that good ideas are readily adopted by their company compared with 20% in blind-obedience firms.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1237

Conclusion Any new regulations or measures designed to restore trust in the banking industry must be considered in light of the regulatory change that is already in process. It is also important to acknowledge that the majority of banks and individual bankers have consistently operated with integrity and they should not be further burdened by measures that will yield no additional benefit to their clients. In identifying solutions, it is important to understand the problems that have caused the reputational damage, the drivers of these and the extent to which they are endemic to the industry or limited to a few individuals. In developing solutions, the unique nature of banking, its role in the wider economy and society, and its influence on growth must be taken into consideration. In implementing proposals, it must be clear how these will be targeted at the problems and how the risk of regulatory spread (across the financial services industry and beyond) will be prevented or managed. 28 August 2012

Written evidence from Angus MacLennan, Chairman, Advisory Board of the Institute of Risk Standards & Qualifications I write in my capacity as independent Chairman of the Advisory Board of the Institute of Risk Standards & Qualifications (iRSQ), as a concerned citizen with a strong interest in the subject of bankers’ behaviour and reputation, and as an experienced banking professional with 35 years “clean” track record in wholesale international banking. About iRSQ The iRSQ was created courtesy of the generosity and philanthropy of Moody’s Analytics, a subsidiary of Moody’s Corporation, and sister company of the rating agency. Under its corporate social responsibility umbrella, Moody’s Analytics provided a significant amount of funding to create a new global professional standard for bankers, in the wake of the global financial crisis. The iRSQ operates as an independent organisation, with an independent board (which I chair), and a governance infrastructure which ensures clear separation between the Institute and MA. In time, the intention has been that the Institute will operate completely independently of MA or any other sponsors. The iRSQ has developed a programme for bankers which takes as its core principles the lessons learnt from the financial sector crisis, and has been developed in close consultation with industry practitioners in the areas of risk and other key technical areas, together with other subject matter experts in the fields of culture, behaviour, governance and ethics. This programme was also created having analysed in detail the various existing offerings in the market in terms of banking and other financial sector qualifications, from both academic institutions and other professional bodies, and also paying close heed to the infrastructure, standards and competency requirements in other major professions such as accounting, law, engineering, medicine, etc. The focus of the iRSQ is to develop truly well rounded professionals, and a unique characteristic of the programme is that it goes way beyond proficiency in technical subjects (which represents only 45% of the content); instead it is grounded in the belief that a truly professional banker should be characterised by a robust all-round grasp of management and leadership capabilities which do not rely on models and processes alone, but which also incorporate the broader contexts in which risk, compensation and other decisions are taken, taking into account the human elements and market driven factors which affect banks’ market standing. The remaining 55% of the iRSQ programme focuses on these latter issues. The Way Forward Despite the fact that the Institute is a not-for-profit organisation, that it does not itself deliver any of the programme which has been developed (rather it “licenses” others to deliver relevant parts of the programme), and that it is truly governed with clear separation from Moody’s Analytics (rules concerning which are also imposed by OFQUAL which has accredited the iRSQ programme), it has been a hard sell in the past 18 months. This challenge in gaining adoption for the iRSQ programme has been due to a number of reasons, including the fact that many financial institutions have been focused on their very survival rather than issues such as their competence and professionalism, many have been in heavy cost-cutting mode and unwilling to look at new initiatives, and many have remained remarkably arrogant, stating that they are as close to perfection in terms of their capabilities and culture as exists in the financial world. I have presented the Institute programme to major banks, central banks, regulators and others, in Asia, the Middle East, and across a number of European countries. Whilst Asia as ever is eager to embrace enhanced qualifications for their market, and the Middle East has been quite welcoming, I regret to say that the greatest challenge has been to convince UK financial institutions to adopt the new programme, mostly down to the evident arrogance that their behavioural and cultural models are not broken and hence do not need fixed.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1238 Parliamentary Commission on Banking Standards: Evidence

The fact that it has been a hard sell however, is also down to a lack of confidence that the iRSQ is indeed truly independent of MA, and a number of what can be deemed competitor organisations to iRSQ have promulgated the notion that it is in fact a “front” for MA to gain greater business. My view therefore, based on having no particular bias in favour of iRSQ nor any alternative offering in the market, and having as a desire only that the banking market takes concrete and positive action to change and improve its reputation, is that the whole issue should be de-commercialised. That is, that an independent body be established, either to be newly created, or to reside within an existing body (eg, the Financial Services Skills Council, or indeed housed within part of the regulatory infrastructure), whose mandate is to introduce into the banking profession a new professional standard, focusing as much on culture and behaviour as it does on technical proficiency, and seeking to mirror the rules and regulations of the other professions as mentioned, wherever relevant comparisons can be drawn. Clearly, neither Government nor regulator can be seen to favour any one body over another, hence my recommendation is that this new body should be charged with the responsibility of taking the best from all the offerings in the market—including those of the IFS, Chartered Institute of Bankers, CISI, iRSQ, the Institute of Business Ethics, and Masters degrees in a number of business schools—and aggregating a best-in-class programme which combines the optimum elements of all, and embracing equivalent aspects of the other professions. Each body could then have a piece of delivering part of the programme, but the central independent body would remain truly independent and non-commercial. Funding for this central body should come from a levy on the major banks; after so many sizeable fines for failures, I do not believe that the major banks would have the front to object too loudly to support an initiative of this nature at the current time, and a level of £1 million per major bank in my view would be entirely feasible. The old adage as to why banks should pay for this is

If You Think Competence Costs, Maybe You Can Stick With Incompetence And See If It Ends Up Costing You More Whether it can be described as incompetence or failings in any other regard, there is no doubt that these huge costs incurred by banks, for the well known problems already in the public domain, or from massive losses from their risk-taking, or from hugely costly outcomes from their incentive and compensation structures, have left them reeling, and the public and other external stakeholders are rightly demanding some corrective actions. They will not refuse funding as envisaged here. No doubt an initiative of this nature needs to be international, indeed truly global ultimately, for it to become a true global professional standard for bankers, but the UK has the opportunity of taking a lead on the issue, and then seek to export it elsewhere. I know iRSQ would be willing to make available its work to date on this subject, including the details of the programme which has been developed, and I am sure other bodies would willingly participate also. I would also suggest that the iRSQ model, whereby the central body sets the standards, and vets the standards, is the one to follow, and hopefully the OFQUAL accreditation can be applied to the new programme, thereby giving it professional qualification status. I also believe that the iRSQ structure, which is modular and is designed to give a wide grounding in banking, culture and behaviour across whole banking organisations at the first level, and goes on to offering specialist electives for those who follow specific career paths within banking (eg, real estate lending, derivatives or currency trading, etc etc) at subsequent levels, is the right way forward. This modular approach also enables the lifting of any number of relevant modules into bespoke programmes for different audiences within banks, including board level and non executive director level. If the banking profession is to be properly professionalised, I am in no doubt that it needs a compulsory initiative from Government; despite all the protestations about lessons learnt and demonstrations of contrition from senior bankers, little has changed since pre-crisis, and the self-serving nature of the industry is such that the “market” will not voluntarily sort itself out. Turkeys do not vote for Christmas. I would be happy to make myself available for more detailed discussions on this paper at any time. 26 August 2012

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1239

Written evidence from Mira Makar Scope (a) professional standards; and (b) culture of the UK banking sector, taking account of (i) regulatory; and (ii) competition investigations, into the LIBOR rate-setting process; lessons to be learned about. (a) corporate governance, (b) transparency, and (c) conflicts of interest, and (d) their implications; (iii) for regulation and (iv) for Government policy; Evidence provided by Mira Makar MA FCA. Each point is backed by evidence, available to the Commission in live evidence. Court relief is backed by default judgment ie is not, “yet to be decided” (2005–2012). Relief for the abuses (damages) has yet to be assessed by the court. The witness thanks the Commission for the opportunity to contribute. 1. To what extent are professional standards in UK banking absent or defective? How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets? 1.1. Banking standards including the FSA business rules are universally ignored or are being actively diluted in effectiveness. In particular: 1.1.1. corporate lending happens on the say-so of City intermediaries, not by the proper authorisation by the relevant Board; purported debt (or client monies) is used to cover defaults and/or shift risk. Markets are not informed of the true position in regard third party financial dependence and basic compliance returns, for example in Companies House, can be circumvented by retaining documentation in draft form. This position has acutely worsened by the purported reduction of red tape, work that has regretfully been hijacked to, effectively, defeat the law. A simple, but financially devastating, example is that once a notifiable debenture is redeemed, there is no longer an obligation to make a return to Companies House, including with the date of the redemption, whereas until recently there was. This has the practical effect of circumventing the rights of a trustee in bankruptcy to set aside preferred transactions two years before the date of administration. This is because the public warning on the date of the redemption, and the two year clock starting to tick, is not public; 1.1.2. there is no due diligence carried out on RNS reporting and Companies House reporting. In particular, a failure on the AIM market can just disappear without trace, as Companies House reporting of matters such as lodging a prospectus is not required, and once an AIM company is de-listed, there is no automatic investigation on the failure, in particular of the auditor; 1.1.3. the move to “reduce red tape” is diluting the previous rigour of reporting (the above example is that of the redemption of a debenture which does not have to be reported in Companies House; if it is reported voluntarily, no date is required: therefore third parties get a distorted view of the debt and asset cover base); 1.1.4. investment banks (Sponsors/advisers/NOMADs) prioritize “their” interests over the market. They will operate a “split market” in order to avert resigning (which would bring reputational damage on grounds of “letting down the market”), whilst “protecting” their clients: the FSA will not in practice prosecute Companies Act breaches, for no good reason at all, or auditors who report without agreeing estimates to the underlying contracts, which, generally the auditor’s staff do not understand (banks in the hands of administrators find they have to pay bank staff premium amounts to teach the administrator’s staff); 1.1.5. mixing client monies and banks’ funds is prevalent, especially if something has gone wrong, that middle management do not want revealed to top management. Clients whose money is managed by intermediaries are particularly vulnerable, as are the estates of deceased clients. Auditors are able to avert liability by hiring lawyers and subjecting themselves to a “tribunal” and a paltry fine, as opposed to prosecution by BIS/SFO; 1.1.6. internal lawyers operate a “strangle hold” on the business and make decisions that ought to be made by the relevant managers, informed on the circumstances. The effect is that, if third parties wish to defraud a bank or use it to launder money/benefits, eg a bribe, they have no difficulty, they simply “wrapper” the

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1240 Parliamentary Commission on Banking Standards: Evidence

transaction in a form that “gets through” the internal lawyers on the nod. Banks are “geared up” for money laundering checks when new money comes in, but have no protection whatsoever if their customers are the victims of theft. SARs (Suspicious Activity Reports) go nowhere, and get buried, with no redress for victims. Banks state they have Complaints Procedures to give redress to victims but do not persue them, instead taking action against their customers and hiding behind internal and external lawyers. 1.1.7. “top down” management and bullying, are common, with wide spread “cover up” rather that “own up” and repair. Complaints departments are treated as the same as risk departments and, unless the point is trivial, are about warding off the victim and not addressing the problem; 1.2. FOS, the body for rectifying defaults, and compensating victims, does not assess with regard to Banking/ Insurance licensing rules or the FSA business rules as published on the FSA website. Therefore a victim/ witness has, in practice, no redress but, worse, believe they have. FOS staff are not licensed themselves and are therefore not properly capable of being supervised or meeting the purpose for which they were set up— ”you need to go to law to get redress” is a common response, as is “we have no obligation to report to the FSA [if we see something wrong]”, as well as “ we are not set up to establish the truth of a matter”. FOS do not refer breaches of the business rules to the FSA; and the FSA tell FOS to “hold the evidence ‘for now’ “, while the FSA call centre tells Joe Public that the breaches are reportable. Joe Public’s complaints to the FSA get logged; get frozen and then an outsourced supplier contacts Joe Public to ask whether Joe Public is happy with the Complaint handling. Behind the scenes both operate the same way, talking to others and eliciting evidence that supports inertia, that they refuse to provide to Joe Public. 1.3. There is no intrinsic value add in these edifices. There is however serious public damage in terms of public confidence, as the public, who are not stupid, know their time is being wasted and that massive spend, as the recently purported £22 million spend on IT by the FSA, is no more than a rear guard action to prop up crumbling self serving edifices. It is the case of the emperor with no clothes, with the fear, “if they go, what is left that one can point to for redress?” 1.4. The situation is the same for insurers; lawyers; auditors and accountants; all prioritize new product manufacture and sale and regard and operate a customer base as an income stream to be worked (“sweating the assets”); 1.5. The practice of “revolving doors” is endemic. Law enforcers, and those in a position to influence a decision to prosecute, have to take into account that the prosecution by them of those who may be a potential source of employment to them, will render the likelihood of such a move reduced, if not extinguished. A bank provides a disincentive for a law enforcer to prosecute on two accounts, first, the prospect of being “out walleted”; second, the prospect of loss of opportunity for employment for the staff of that law enforcer. This creates a culture of rewarding failure (omitting to prosecute) and complicity with dishonesty (those who ought properly to be prosecuted). In turn this creates poor morale amongst career civil servants and a defeatist attitude. 1.6. The UK market has, since at least circa 2005, gained a reputation for having taken de-regulation so far, that foreign capital is not safe: in particular debt financed balance sheets with no resilience and the absence of “checks and balances” cause the flight of capital. This is one step worse than new capital not coming in. 1.7. This problem is exacerbated by the approach of the “policemen”, the auditors. These have the approach that “banks are big boys” and that no duty is owed; relying on the fact that a bank will be “reluctant” to “pull”, causing reputational damage to itself. “Easy money” allows risk to be transferred to banks, with no one any the wiser, without the diligence, for instance, of a fund raising or public offer. 1.8. Ministers have received mis-briefings that there is something special about the capital markets and their audit. There is not. The principles of independence, specialist expertise and experience (rather than training on the job), agreeing estimates to underlying records, assessing the resilience of the balance sheet all refer to any audit regardless of whether a bank, retail, distributor or wholesale or not. 1.9. The U.K. is years behind other countries in policing (as opposed to so-called “self regulation”). The self regulation bubble has burst, delayed by the hopeless attempts to deny the depth of the effect of the 2008 burst, and that at that time, there was not the solid base from which to attempt to stabilize, let alone grow. The effect has been to give Ministers a problem, with no informed path to the repair. Worse, information flows have reflected vested interests, and have not been the result of prior consultation by those with the evidence of what it is like to be Joe Public, minding their own business, and possibly serving the UK public market as executive director, with explicit covenants to that market. 1.10. Those who have suffered are those whose pensions capital has been dissipated and for whom UK Plc directors can do nothing to provide compensation. The response of the law enforcers, as the FSA, was to jail executive directors, as they did in 2005 with the AIT directors, who had been bullied by their sponsor into pre close statements they could not properly make, and bullied into not resigning, whilst letting the sponsor off the hook. This event is an accurate reflection of FSA policy, as stated publicly: “we cannot take on the banks as they will outwallet us in the courts, we go for the small people”. The statement on money is wholly untrue, since the cost of timely prosecutions (ie not after the event) is trivial compared with the devastation of failing

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1241

to do it, leaving a wasteland in its wake and no entrepreneur inclined to add fighting the City and regulators in order to just stand still and keep out of prison. Credibility of the FSA successor will not be established in public eyes until there is proper examination of these events, as well as AIM crashes. This is a market that was explicitly set up to avert checks and balances, and the result of lobbying, under the banner of reduced red tape. 1.11. This lack of proper attention is manifest not just in the FSA, that is known to have regular compliance visits or even a permanent presence in the banks, but also the FRC. The FRC advertises promoting the interests of so-called “stakeholders”, which it lists on its web site. Notably they exclude the executive directors on whom UK Plc depends to function, and who are the people who are jailed when there is a prosecuted failure to maintain proper records, including those emanating from the supply chain (auditor, lawyer, sponsor/financial adviser), which the directors may or may not know about or even be able to control. 1.12. As concerning, is the little known fact that FRC audit inspections are carried out “after the event” and not live, while the audit itself is being carried out. This is a spectacular omission as compared with other inspections of labour at work; teachers; doctors; car mechanics; driving test instructors; each of whom must be a fully accredited, paid up, licensed and examined person, with the examiner already experienced in the same field. 1.13. The effect is that the FSA has a presence inside the banks monitoring live, but not doing what the FRC believes it is doing, but in fact after the event, when it is too late, and maybe with the right FRC people or maybe not, maybe doing the right thing and checking the licensing credentials and experience of those carrying out the audits or maybe not, and whether the auditors being inspected can accurately describe the end to end process of Suspicious Activity Reporting; or the modelling behind the manufacture of derivatives and hedge products and the interdependence of the balance sheets of the banks/insurers including internationally, taking the effect of international money markets into account. 1.14. There has been no quantative impact assessment carried out of the effect of the auditors licensing bodies having a policy of disciplining auditors on process and not substance, or even the effect of their investigation staff deluding themselves that process is capable of separation from substance. 1.15. Similarly there has been no quantified assessment of omitting to prosecute live crime in auditors defaults, but leaving it to “after the event”. By then the auditor/assurance purveyor has acted to, effectively, close the business in which there has been a default (or knowingly irreparably damaged it) and/or succeeded in turning the default into an insured event (as professional negligence); or hired a lawyer to turn the default into a disciplinary fine with no other come-back. 1.16. There has been no quantified assessment of spurious attempts by vendors to characterise assurance reporting (non audit) as something else and restricted in some way; no methodology for circumventing the blockage created by restricted covenants in Limited Liability Partnerships (LLPs) membership agreements, ceding control to internal lawyers, and separating knowledge in the heads of the defaulters from those mounting the defence; and a plethora of financing arrangements enabling pre emptive remedies, designed for protection, to be used in reverse to ward off fatal risks, including those in existence on the incorporation of LLPs. These devices are now routinely used including by risk shift from auditor to those audited, in exchange for an audit certification. 1.17. There has been no quantified assessment of the approach of enforcers that they will “do things better in the future”, burying their own defaults of the past, and in many cases “losing the papers”, and those knowledgeable moving on; choosing to move, or the work being disclosed as having been given to transient labour without trace. This is a common practice compounding the intrinsic problems, by depriving the enforcer from the build up of skill and expertise they would otherwise gain but which a transient third party is paid to acquire. 1.18. There has been no quantified assessment of the dilution of licensing by-laws requiring licensees to report financial and other defaults to the licensing bodies; those bodies hiring lawyers to deflect these obligations; and the by-laws themselves being relegated to statements of belief on public websites. A “statement of belief” is a state of affairs in existence in the head of the person who purports that belief, and is not a ready substitute, in the eyes of Joe Public at least, for omitting to take those mandatory steps that would precipitate prosecution. 1.19. There has been no quantified assessment of the prolongation of the agony before deferred prosecutions are finally buried; attempts at diving up the spoils of crime, to the perceived victims, together with the dogged determination of SFO directors consecutively to put the SFO above Parliament and the judiciary, including by attempts to replace class actions, by out of court actions by them, following prosecutions and making payments to victims; or even the SFO continuing to be led by those who have not succeeded whilst at HMRC and/or who believe that the SFO can be run without a CEO, and they can, with impunity, bury the previous CEO’s commitment to prosecuting to provide relief to victims of white collar crime; and/or who believe that returns required by them by court order to a dead-line can be ignored with similar impunity and no one, not even the court, will hold them to account.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1242 Parliamentary Commission on Banking Standards: Evidence

1.20. There has been no quantified assessment of unhappy mid ranking and senior staff in all walks who face the stark choice of keeping quiet and meeting family life style expectations, or moving job loaded with the burden of the knowledge, or knowing there is no job to move to, so they have to “put up and shut up”. The phenomena applies to partners in law firms; bankers told at 40 years of age that they are over priced, as what they do can be done by a 28 year old and there is no premium for experience; or call centre workers selling investment product knowing it is not in the interest of the public to buy, the equivalent of investment banks’ wealth managers promoting equity swaps with all the bundled risk that of the punter. This is now full circle from the days stock brokers kept the good opportunities for some and sold the rest to the retail public. At the time, a call to the DTI and from the DTI, would solve much; now there is a contractor who has no enduring obligation, or an answering machine and a response, “we only prosecute as the Insolvency Service” and in cases of fraudulent trading and/or administration. Plainly that cannot be regarded as either a timely or a sufficient response. 2. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole? 2.1. The Consumer Protection laws give front line protection by mandatory prosecutions, that, in themselves, facilitate civil relief: if an unprosecuted offender is fighting prosecution, the victim cannot practically secure civil relief. 2.2. The front line are: police; trading standards; SFO; FSA; DTI/BIS (DPP); OFT (as was); and any other body with prosecuting powers. Prosecution is mandatory and not discretionary, ie it cannot be prevented unilaterally by any of these bodies asserting “we prefer to focus on education and improvement”, “we believe XXX enforcer should run with this”, “we provide guidance where to go” and/or securing contrary evidence with a view to discrediting the victims and instead of focussing on the event, or otherwise creating a false account about which the victim knows nothing. If the front line fails, the victim will get no relief. Enforcers know this and hire externals to undertake Customer Satisfaction Surveys, and re-deploy front line enforcers, to give Customer Feedback and a steer to the next Complaints body, report to each other secretly, and the person responsible moves on. Victims die or become bankrupt or permanent disability or simply give up, in particular over periods of years. 2.3. Insurers have chosen to drop out of the picture, marketing instead litigation products in which they can secure up to 49% of the spoils of a transaction managed through the courts, off balance sheet, and secured on the capital assets of the victims. Those with an insurance policy, are met with a blockage of lawyers working for the insurers, to turn down claims and defend the insurer, when finally held to account in court on the six year dead line; the relief promoted by FOS, who say they can do nothing, but in fact assist the insurers by agreeing to accept “evidence” that is kept from the victims, until at least, FOS has turned the victims down. 2.4. Citizens Advice, the provision of which is a statutory obligation of local authorities, has now been turned into a purchasing exercise by local authorities, who choose not to recognise the obligation to provide this fall-back or back-stop service, substituting merely an exercise to “let a contract”. There is no quantified assessment of the calamity caused in the City of London, impacting Westminster also, by the Mayor and Commonality of the City (Corporation) of London pulling the plug on the Citizens Advice Bureau, losing in one fell swoop all its dedicated and underpaid staff, who assumed the problems of the victims and led them through the jungle they faced, and thereby dropping all the cases they were running with including over years, causing mayhem in their wake including in the courts. Court clerks say “we are not legally trained, we cannot tell you which form to fill in.” Personal Support Units (volunteers), where they exist, will help you find the form, but will not say whether it is the right one or not. 2.5. Trading Standards are disproportionately small compared to the prosecutions for licensing breaches they are required by law to prosecute; Corporation of London has a team of three and one part timer to deal with the whole of the City of London. This compares with the £22 million the FSA is reported on spending on IT alone, apart from the cost of its palatial accommodation that has not been earned, judging by what it has achieved, and now houses secretaries who are too busy to undertake what they perceive as menial work, as collect letters on market abuse from those attending the FSA to deliver to them, having incurred the cost and time to get there. 2.6. This builds a picture that it has now become wholly impossible to separate retail sales; wholesale sales; product manufacture; identify who licenses what and who is accountable for what and against which published standards. It shows that without: 2.6.1. impact assessment; 2.6.2. quantified data sourced and collated from at least the licensing bodies; 2.6.3. open recognition that law enforcers are separate bodies with infrastructures and operations that do not readily lend themselves to integration; 2.6.4. recognition that failures by local councils funded locally (police, trading standards, citizens advice etc), “micro” failures, cannot be repaired at a national macro level;

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1243

2.6.5. recognition that “regulators” cannot replace enforcers, are not competent to do so, and, in fact, act to circumvent the rule of law, the authority of Parliament and the operations of the court, fuelled by those identifying “tribunals” as a source of lucrative business, all parties emboldened by the limited liability partnership act. The effect is that fines are now regarded as a routine cost of business for an auditor, whereas this previously was the preserve of nomads and investment banks operating close to the wire; it follows that the creation of competitive and deflecting “tribunals”; enforcers being allowed to bury the past and promise better for the future, against more budget; and “deals” that effectively circumvent the courts, are approached that are doomed to failure and can never be either fair or be seen to be fair. This includes by those most vulnerable whose money and investments create and support the financial market, and who have seen their life’s savings, post war advancements in welfare and their grandchildren’s futures diluted or disappear, graphically as a vortex of water down a plughole, while the shift of capital towards those “working the system” to their own benefit forges on unabated, and youth are compelled to start adult life loaded with debt and worry for safeguarding their elders. This, in economics jargon, is called a market failure. 2.7. At a macro level, the position is a very simple one; in 2000 lobbying forces persuaded Parliament to create the Limited Liability Partnership Act 2000. This artificially attempted to incorporate (auditors, lawyers, others), limiting future liability, including on a “tax free” basis (colloquialism), whilst keeping out fatal and contingent liabilities that had not come home to roost. It sought in effect to protect individual partners/members from personal culpability and liability, creating a glaring mismatch with legal directors under the Companies Act, with personal liability, and whose every move, such as a decision to resign, provides an important signal to the market. It sought to convert uninsurable defaults to those matters that could be argued by a non party, without knowledge, to a default that was insured and arguable (“professional negligence”). It sought to allow trading in risk and audit certificates; and was permissive of incorporation after distribution of assets, and other devices, to “wipe the slate clean” and start over. It excluded for those incorporsting all forms of parity with those on whom it purported to report (sponsors reports, due diligence on launch, audit disclosures, fundraising diligence). It was permissive of secrecy over details of appropriations/remuneration/members agreements and no requirement for audit per se of the pre incorporation period. 2.8. Crucially these LLPs were allowed to audit those who had been compelled to go through the rigours of a public flotation that they themselves had not been through, requiring opening their books to auditor, sponsor, lawyer, initial investors and explaining the source of the goodwill they were putting to market and describe in whom it was vested; exposing insurance agreements; contract terms; CV’s of members; severance/retirement terms; members agreements; and committing to quarterly reporting with full accountability in law for members and senior staff. LLPs are allowed to merge (now cross border, effectively), without public diligence on the merger; members are allowed to move job, indemnified by those left for their defaults, no address for service of claim form certain that the likes of the SFO will not prosecute under the Bribery Act 2010 or POCA, as they are required by law and Ministry of Justice guidelines to do. 2.9. Financing products have flourished, manufactured by these players, uncurtailed alarmingly by having to get FSA licensing authority for these risk shift products. Instruments sold includes those involving the use of the courts pre-emptively, in reverse to that which the law intended, currently a civil abuse and not a crime, as the courts are always in “catch up” mode, requiring authorities to extend the existing law. They include those in which there are parallel activities outside the court and inside, with those inside used to secure leverage for those outside. 2.10. The result is that it makes no sense to approach these developments as a series of problems, rather there is a compelling approach to treat them as an intertwined and interdependent set, that must be accompanied by live experience/evidence which tests each of these processes to the point of exhaustion. It mandates eliciting evidence from those best placed to give it and not those purporting to represent others, in particular to the exclusion of the victims. It may require frank admission that to date there has been no enquiry into the adverse effect of lobbying, which, combined with revolving doors, raises the difficult and perplexing question of who it is who is governing. This market failure is the one space that the government uniquely occupies. The Commission will succeed as far as it can identify the first hand evidence and give voice to the evidence of those who otherwise are voiceless, including in spotting the next train predicted to crash, as, for example, the effect of liberization of litigation financing, without concurrent authorities on abuse starting to emerge, highlighting the measures banks resort to when caught out, including by interference in their customers civil reliefs in which they otherwise play no part. 3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector? 3.1. Simply, the public see the banks as thieves. Withdrawing free banking and personal bankers and using off shore call centres with access to private data says it all. If Joe Public had an alternative for banking, savings, insurance, local authority services, they would take it like a shot. If the staff of these places had an alternative, they may well do the same; anecdotal personal evidence shows the outflow where there is a choice.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1244 Parliamentary Commission on Banking Standards: Evidence

3.2. The public has written off the banks and properly resents have to pay to reward them for their unfettered addiction to greed and lack of stewardship or regard for whose money and risk it is, simply if X wants to speculate, the risk should be confined to X, with a health warning on the packet; unless the one way flow of private capital can be reversed and the public compensated, attempts to restore confidence are doomed to failure. The public have repeatedly been proved right, as shown by “kicking into the long grass” plans to separate different business areas and inertia in stopping revolving doors policy. Joe Public does not want a government ruled by the banks, but there is no one to listen, let alone hear. 3.3. Trivially simple steps are repeatedly over looked. For example BIS has it within its gift to ask any licensed person to assist it without pay beyond out of pockets, including steps to ensure parallel running of tasks with permanent staff, to retain the knowhow, so that BIS itself is a centre of forefront of thought, as respected as the Inland Revenue was thirty years ago. It does not do it. BIS can grovel (it would have to) and incentivise early retirees to come back and help it, this time treating them with the respect and accolade they deserve and taking the benefit of their evidence and experience. It does not do it. The cheque book can be taken from Buying Solutions and burned. It does not happen. Anyone hoping to move function with their tasks not completed and records capable of retrieval, could be invited not to start. It does not happen. A straw poll could be carried out of small to medium accountants (to, say, 50 staff) to assess the barriers to entry into the audit market, the effect of polarisation and the deskilling from the time audit requirements were eased. It does not happen. The result is that there is no fresh supply chain into the market, uncontaminated by the past. This coincides with barriers to entry for new solicitors and barristers, whilst existing legal businesses charge outrageous hourly rates for outdoor clerks, their secretaries and their taxis, previously known as the post room staff, and use advertising legal assistance to artificially inflate statistics (source: CAB), whilst attempting to “switch sell” to a customer paid service. 3.4. Sacred cows are capable of open challenge, as, for example, rolling the FRC into BIS, with staff mainstream civil servants, or asking licensing bodies to poll members before responding and to provide statistics routinely. Without such measures, what will happen has no preparation, courts are plastered with warnings that staff are protected by security from rudeness, aggression etc—nowhere does it say that victims of what some of them get up to are equally protected: the sadness, is that this is known, and aspects were reported to Cameron Scott on 24 May 2007, now on the FRC website. Cameron Scott has left the FRC having signalled BIS’s website for the prosecution of LLPs. Lawyers from the FRC say they destroyed his files and blame the service level agreement with the ISP for delays in restoring those records held electronically. 3.5. These points are not complex but are important as it is wholly unclear that there is much room to manoeuvre apart from a systematic analysis with real evidence and devoid of vested interests. 4. What caused any problems in banking standards identified in question 1? 4.1. Unfettered addiction to greed; the predictable and predicted (by the DTI staff) failure of self regulation; revolving doors; the impact of lobbying; consultations without evidence (eg from civil servants taking early retirement, executive directors, jailed directors, those who have chosen to leave the SFO; FRC etc, licensing bodies who have not provided statistical data, graduates and school leavers who cannot find work, those let down by their local authorities or made homeless by them and cannot fight back); the failed attempt to prop up the 2008 mini crash, that the man in the street could predict was going to fail; the lack of post event investigation; specific case examples on current re possessions; data on the impact of statutory obligations to provide a service being turned into a purchasing exercise by local and central government bodies; the effect of the LLP Act; the effect of liberalization of litigation financing; the effect of the plethora of unlicensed unregulated financial instruments with which the courts have not caught up; a demoralized public; fear of long term depression; inability to pay food electricity travel. The Commission requests that respondents consider (a) the following general themes: — the culture of banking, including the incentivisation of risk-taking; 4.2. It does not happen that traders who take risk have not got the tacit approval of their firm; the traders are merely the ones who can get caught out when it goes wrong. 4.3. There are moral and ethical issues of allowing scapegoats, and as many views will be expressed as people asked. The buck always stops with the man at the top and the auditor who failed to test the control environment or understand the transactions before him and was willing to sign off in the knowledge that the resilience of the balance sheet depended on the resilience of the other banks in the system: that is the same as an assurance report which says “we know it will crash, just a matter of when” and when caught out, saying it was a liquidity problem: plainly if the response to a hole is to pour money in, that is not going to work because the hole will never be plugged. Illiquidity is a feature of being insolvent; “solid” receiveables can be turned to cash, receiveables from those that cannot pay cannot—the auditor’s job is to know the difference and not to say that the interdependence of the banks means they cannot collapse. 4.4. These problems will never end until the audit certificate says what the auditor has done, rather than the current practice of not reporting on what he has not done; says who has done it; who was inspecting; and what licence the person held and what for. Banks are large with many silo and matrix structures, and most will

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1245

admit that no single person inside the bank will have an end to end view of transactions. The auditor by contrast must have the end to end view, and must report, that the bank survives only if the other banks do; if that is the case. The truth in fact may be that they do not know. —

the impact of globalisation on standards and culture;

4.5. Progress comes from abroad; Europe had auditors signing their own name years before the UK, the UK still hides the identity of the second partner on public company audits—if they cannot own up to who they are, how can the public have confidence that they exist or that do anything beyond signing off on an exceptions based risk report purged of those items purportedly disposed of? Australia required a statement of independence from its auditor; we do not. Canada requires assurance reporting to be backed by some forensic accreditation. We do not. 4.6. Financial statements have increasingly become unwieldy with literate and numerate reporters having to pay others to read them and the financial information buried beneath mountains of impenetrable notes and policies—this compares with the single question from fund managers, “is it going to fall over? How is the cash doing?” 4.7. VAT inspections, previously a key way untoward transactions were revealed, have lost their bite, since VAT merged with the Inland Revenue to become HMRC. Now returns are reviewed to see if they look like last time, rather than, what do they relate to? HMRC is self financing and this dilution in effectiveness means that problems are not detected as source by those in the best position to blow the whistle. 4.8. Global toxic products are as destabilizing as domestic ones; speculation in food prices on the global market is the same toxic effect as LIBOR rigging. The FSA has wrongly said it cannot prosecute such cases under FSMA 2000 because the default itself is not a “quoted security”. FSMA 2000 is about all the inputs that flow collectively to create asymmetric market information, without exclusions. For example the parallel in a public company is the information flowing into a company’s board: if a case of market abuse is being brought (knowingly/recklessly misleading including by omission etc), the case will examine the whole flow of information, not just the statement that was/was not made. Any “rigging” of a price or information flow is caught, that affects the public market or the price at which trades occur and the legislation had been described as the simplest around, with no effect because law enforcers choose not to enforce it; employ lawyers to find reasons not to; or choose not to enforce against the hand that feeds them (the case for the FSA whose staff wages are paid by levies on the banks etc). This leaves the banks (and insurers) in an unassailable position with the “policeman” committed to not upsetting the apple-cart, and heads of enforcement leaving in turn for lucrative posts in law firms and accountants. —

global regulatory arbitrage;

4.9. It is open to the FSA to not give permission for such transactions; the decision to set the FSA aside and create AIM, with the NOMAD the decision maker, was bound to fail, and has. This is because the NOMAD makes his money on public offering/fundraising/re purchases/M&A, and apart from seeing his clients safely out of the investment and not being seen to resign, or to blame when the bubble bursts in any one case, has no continuing concern save their own reputation. 4.10. Global regulatory arbitrage will go wrong if there is already something unsound; it will turn into a disaster if there is asymmetric information, ie the market is not fully informed. All disasters must be independently investigated and not by the licensing or regulatory body; the rush to enter deferred prosecution agreements or prosecute directors and not the city firms responsible creates an environment with no accountability and no opportunity to learn. “Arbitrage” is a loaded term; if the arbitrage is itself the product being sold (like tax mismatch products devoid of commercial risk), the product warranty on launch ought to spell out the risks, and be authorised by the FSA even if the float is on AIM and left to the NOMAD. It is a financial product and the public must be protected. It was predictable that the mere existence of AIM would at once create opportunistic public offerings that wrappered product outside FSA product vetting; on launches not vetted by the new issues team. Once that has finally failed, another more resilient equivalent will emerge, leaving all enforcers and the courts lagging behind by a factor of eight or more years. This delayed “catch up” together with the need to overcome the learning hurdle and a reticence to admit the extent of the failure, creates a “dragging” effect before repair, compounded by the eroded skill and experience base of the law enforcers. It has been left to the senior judiciary to complain that restructuring the police is a big problem for the courts: however this is like the little dutch boy putting his finger in the dyke to stop the torrent of water or bandaging the wrist of someone dying of suffocation. Ultimately unless the FSA/its successor is staffed by those with police prosecution experience, and independent from the levies, it can never have bite in stopping criminal activity or, indeed, in assuring ministers that the exercise is no more complex that prosecuting a hit and run, only fought in ways which are much more sinister. It can be proved by modelling that the impact of the above, other factors constant, is to lengthen the economic cycle making short term recovery instruments less effective, if not cosmetic. —

the impact of financial innovation on standards and culture;

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1246 Parliamentary Commission on Banking Standards: Evidence

4.11. Evidence is available from this witness to be provided live; briefly innovation has become synonymous with circumventing law and rules and those profiting effectively positioning themselves above Parliament and the courts. The applicable standard is a ruthless and callous addiction to greed unfettered by any licence or respect for fellow human beings; and without any thought of whose assets are being taken or used including against the rightful owner. Until there are regular prosecutions of those at the top, and LLPs routinely blacklisted in the courts, as those who issue a cheque to the courts that bounces, the rule “it is what you can get away with” and co-operation between players will always win. —

the impact of technological developments on standards and culture;

4.12. technology (beyond photocopying and scanning and email) has increased the gap between those who have and those who have not. Victims cannot access the courts for relief as case authorities, forms with guidance, transcriptions, bundles production etc are all expensive and beyond reach and the standard methodology in the court to “progress a case” rather than to “get it right”, together with penalising a loser for the fact of the loss whether procured honestly or dishonestly, transferring burden unfairly, means that there is less of a level playing field than previously, when clerks willingly explained what to do; 4.13. workflow products has destroyed the work of FOS, as multiple people handle an electronic file, none of who know the case or have any responsibility beyond filing. A proud announcement “we have cleared the backlog” merely means the file has been closed yet without regard to whether the claim was rightly and honestly resolved or not. This is mere manipulation of statistical data that helps no one, including FOS; 4.14. shared services in the courts guarantees that files from different courts are handled by clerks trained in just one, timescales are prolonged, and final judgments can remain unprocessed for 1.5 years, whilst non parties have a field day in deflecting antics and collateral attacks, enabled by those inside, not necessarily informed of the true and complete picture. So called orders are produced by clerks purportedly emanating from members of the judiciary whose authenticity is not assured and when challenged, are deflected. Properly every such incident must be investigated; in practice it does not happen. Technology per se cannot be to blame for documents, evidence, or so called orders that are not proper for one reason or another. —

corporate structure, including the relationship between retail and investment banking;

4.15. retail and investment banking should not be in the same group, nor should retail be vulnerable to collapse in the event of the failure of the investment bank (loans upward for example). 4.16. Progress up the management chain needs to be of those servicing the customers and not those “working the system” in practice there is evidence this can include by covering on financial crimes, theft, money laundering, mixing of client monies etc masked by internal lawyers, possibly hoping it will all go away, if delayed long enough, over months and years ie the victim is set up to be the problem. —

the level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects;

4.17. International operations have become impossible to navigate for retail customers, with foreign accounts dealt with separately; probate unwieldy and call centres neither where the money is not the customer and agents uninformed. Banks with overseas operations and who default block communications, sever relations, introduce strangers hire lawyers serially, alienate customers from money, investments and records, and go into courts to write off all trace of the account. This appears “run of the mill”. —

taxation, including the differences in treatment of debt and equity; and

4.18. Undisclosed debt and financial dependencies are a bigger issue than debt equity ratios; relaxation of rules for insurers, begs the question of what they were doing to need relief. Where the answer is “speculating”, more questions need to be asked. —

other themes not included above;

4.19. the responsibility of the auditor and their independence and (b) weaknesses in the following somewhat more specific areas: —

the role of shareholders, and particularly institutional shareholders;

4.20. Fund managers will make decisions based on management; if discord they will back the incumbents. These are governed by terms of the trusts they represent with limitations on what they can do beyond buy, sell, recommend etc. They do not like shocks and have no interest in non executives or regulators. —

creditor discipline and incentives;

4.21. Evidence is that creditors with a fatal or reputationally devastating claim will be the subject of wiping out tactics rather than paying their due and being held accountable. —

corporate governance, including

4.22. the term is a misnomer; it was previously simply risk management; —

the role of non-executive directors

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1247

4.23. non executives are directors as any director with personal liability set out in the Companies Act; few are prepared to assume the responsibility as they carry 90% of the risk, with 10% of the information. Non executives depend entirely on the executives, and attempts to split them, “as though” they were an overseeing function only, and not fully liable under the Companies Act, are misguided. The situation is different to say, Germany, where there is an executive board and a supervisory board. Non executives must have had at least five to ten years experience as an executive director in order to be credible and able to “punch their weight” in supporting the business. Retired audit partners are not credible as non executive directors and have neither the experience nor the credentials to serve. Regretfully, there are regular instances of partners retiring and after a period joining the board of those they audited. That simply cannot be right. Investors (fund managers) do not tend to object because they are more interested in the business and the executives, unless they wish to complain on pay for example or other issue dealt with by a non executive committee. —the compliance function 4.24. this depends on how it is being used; where the compliance team is used to ward off the FSA, it is meaningless, where to bring rigour, it is useful. Must be linked with the auditors to work best; if Joe Public complains to them, they will say “tell the business, we are back office.” —internal audit and controls 4.25. often bullied; not respected; a source of reliable data and analysis; can miss the point (eg in the courts where the internal auditors audit fee remission data to death, yet do nothing to audit the irregularities of those seeking to use the courts for relief the courts cannot give, and pay money to do it); —remuneration incentives at all levels; 4.26. Emotive but not the highest priority: earnings in LLPs are not disclosed and are much more damaging because the LLPS sign off on the audits and diligence reports of the banks; — recruitment and retention; 4.27. Only experience is that by 40 years of age bankers are out, it seems; — arrangements for whistle-blowing; 4.28. Harmful to the whistleblower usually. This cannot be properly considered without assessment of PIDA (public interest disclosure act), which does not set out to expose the wrongdoing, so the effect of stifling the (potential) whistleblower continues. Enough time has passed for Joe Public to realize that whistleblowers are not de-stabilisers, but those who have experienced wrong doing and have chosen to act to meet their obligations and protect others. Possibly the most valuable source of evidence to the Commission if it can be harnessed and voiced. — external audit and accounting standards; 4.29. Very low down the food chain; law firms in their scramble for the goodwill of the banks will not hold back on making their clients assets available to the banks without authorisation. — the regulatory and supervisory approach, culture and accountability; 4.30. Continues in silos and not co-ordinated; issues with loss of records; misuse of evidence; over reliance on contractors; early retirement and staff attrition. FRC over dependent on lawyers rather than accountants. 4.31. FSA lawyers pull the strings in the background and actively stop directors receiving the information and records that would enable them to prepare proper accounts and notify the markets; this strangle hold over the business by internal lawyers is manifest in the local authorities; FSA; BIS; SFO; FRC as well as the LLPs insurers and banks—these in turn appoint their own lawyers creating layer on layer on layer, that then gets laundered in the courts in contravention at least of POCA. Whole proceedings occur without the underlying point being defended ever emerging until after conclusion. All those in the process prioritize defending their own actions rather than admitting their own errors and correcting them. Senior civil servants in the courts refer to the reluctance of “the court” to admit its own errors, watch judiciary interfere in the orders of their seniors and refer to the state of the British justice system, in terms which are enlightening. — the corporate legal framework and general criminal law; and 4.32. In arrears, given the picture painted above. White collar crime in the civil courts is rife, affecting all courts. There are no published statistics. — other areas not included above. 4.33. Route for civil relief for victims, where there has not been a prosecution, and for all aspects of human rights arising (autonomy, privacy, family life, right to a fair trial, right not to be falsely imprisoned by being taken to court improperly or forced into servitude and working for no pay by improper proceedings). 4.34. Support for MPs constituency offices in plugging the gaps, now a chasm.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1248 Parliamentary Commission on Banking Standards: Evidence

5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally? 5.1. Stop the work to dilute the Companies Act immediately; 5.2. Investigate AIM failures and the role of the auditor/NOMAD; 5.3. Intervene in court cases (MoJ) where there is a principle to be established; 5.4. Accelerate steps to protect routine banking retail business; 5.5. Investigate the use of the courts post LLP Act plus the required steps to subject LLPs to the same rigour as a Plc; be ready to debar abusers from the courts; 5.6. Attempt to establish the extent of banks activities in mixing of client monies and other unauthorised transactions of the retail businesses and the risks they are exposed to from the intertwined capital structure with other (investment) business; investigate law firms selling off shore banking/trust arrangements and where sanctions are (ie offshore bank marketing via UK lawyer, does the FSA know?) 5.7. Elicit evidence on small accountants, barriers to entry and the new auditor supply chain; 5.8. Make recommendations on the importance of reviving respect for the civil service and the management of any essential suppliers (without pay), whilst lost experience from early retirements/not keeping up to speed with new instruments of risk shift/elimination, is rebuilt; 5.9. Establish supply chains of statistical/empirical data from licensing bodies and their licensees as well as others (the courts); 5.10. Openly recognise that the “system” depends on proper records being maintained by the executive director, the “lynch pin”, City firms (the rest) are the “suppliers” and that, further, the rest must be support not be players in their own right, ie independent, if there is to be rigour and prosperity and that there must be opportunity for new entrants and fresh uncontaminated blood, school leavers and graduates, as well as small firms not squeezed out. 6. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice. 6.1. No for the reasons given. Law enforcers cannot be funded from fines and levies of those they are required to hold to account. Statutory functions, as audit or legal notary/due diligence work cannot properly give the auditor take home pay that exceeds the civil service pay structure. Once these are out of line, greed takes over, with wholly predictable results including the massive shifts of capital we have witnessed. 7. What other matters should the Commission take into account? 7.1. First and foremost taking live evidence from those best to give it, unfiltered; 7.2. Second viewing the problem within the wider context and recognising interdependencies; 7.3. Third identifying real case facts that have not been prosecuted, and establishing why it went wrong; 7.4. Fourth holding enforcers to account on the back log and refusing to hear submissions on why it will all be better if more budget is released; 7.5. Fifth deciding where empirical data should be called for; 7.6. Sixth identifying quick wins and pushing ahead with those recommendations while the Commission is still live; 7.7. Seventh identifying supply side constraints and cases where intervention is the sole instrument for repair; reserve all posts to long term committed civil servants; 7.8. Eight, proactively intervene in the courts and develop the common law in particular in regard off balance sheet litigation funding, financial instruments such as pre emptive remedies used tactically in reverse and proceedings brought by non parties to secure relief the court cannot give at the expense of others. Tighten access to exclude lawyers and other intermediaries as far as possible. Check all financing contracts and identity of parties and non parties before allowing access (similar to the work of the Border Agency). Be ready to ban firms from access. Monitor so called “settlements” for evidence of bullying and coercion and remain open minded to the US model where out of court communications are made known to the court so unreasonable behaviour and unlawful leverage is fully exposed. 2 September 2012

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1249

Letter from Martin Wheatley, Managing Director, Financial Services Authority During my oral evidence on 27 February, you expressed some concern over the FCA’s strategic objective and whether it could act to the detriment of its operational objectives. You asked if a redrafting of the FCA’s objectives is required. In response, I said that I would be happy to provide you with my further thoughts once I had a chance to examine the issue in its legal context and consider all the necessary details. It may be helpful if I start by setting out some background as to the genesis of the FCA’s strategic objective. Given the breadth of the FCA’s regulatory responsibilities, the FCA’s three operational objectives have to cover a wide range of activity in the financial services industry. As a result, in drafting the legislation, we understand the Government believed it was necessary to bring the operational objectives together under one umbrella to give the FCA a clear steer as to what society expects of it. However, the Government recognised that while the strategic objective should steer the FCA as to the overall aim it is trying to achieve, the operational objectives should be the means by which the FCA discharged its responsibilities. The 2012 Act therefore provides that the FCA should, so far as possible, advance its operational objectives, and act compatibly with the strategic objective. As a result, there are no powers in the 2012 Act which are triggered off the strategic objective—instead those powers can be deployed where the FCA considers it necessary or desirable to do so for the purposes of advancing any of its operational objectives. At the time the Government was considering the content of the strategic objective the FSA made clear that it would be concerned were the FCA to end up with an objective it could never fulfil. However, we are satisfied that the strategic objective as it currently appears does not leave the FCA exposed in that way. We also think that, as a statement of the overall outcome society expects of the FCA, the strategic objective is a reasonably good fit to the operational objectives. Competition Objective I understand that you are also concerned about the scope of the FCA’s competition objective. As you know, the FSA has never had a specific objective in relation to competition. The 2012 Act, as it currently stands, simply requires the FSA to have regard to the need to avoid any adverse impact on competition arising out the exercise of its functions. This in effect amounts to a duty to pay competition the appropriate level of attention. As I understand your concern, it is that there may be circumstances, even with the benefit of the new competition objective, where the FCA may take action that could have an adverse impact on competition. Again, it may be helpful if I set out some background to the FCA’s competition remit. In addition to the competition objective, which the FCA may advance through the use of its powers, the FCA is also under a duty—when operating under the consumer protection and integrity objectives—to act in way which promotes effective competition for the benefit of consumers. This means that it must always consider how it might promote competition, even when it is not acting under the competition objective. However, the Government (rightly, in our view) recognised that there may be circumstances in which we need to hold our objectives in balance, particularly the need to protect consumers. An example of a potential situation in which this might occur can be found in the product intervention power, which as you may recall gives the FCA the power to ban products, or ban particular product features. The power can be deployed to advance either the consumer protection objective or the competition objective. However, when the FCA uses the power for consumer protection purposes, it is taking action which some would argue is inherently anti-competitive: requiring a product to be taken off the market entirely, or removing certain product features from circulation. We were concerned that a blanket duty to promote competition in all circumstances would be argued to act as a brake on the FCA’s ability to achieve the consumer protection outcomes which society rightly expects it to deliver. As a result, we think that the legislation has struck the right balance by giving the FCA a clear mandate to intervene to promote effective competition for the benefit of consumers, while recognising that there are some limited circumstances in which it will need to act to protect consumers in ways that could be argued by some as not promoting competition outcomes. In this respect we do not believe we are that different from many other sectoral regulators, such as Ofcom, who have to strike a balance between the promotion of competition and the achievement of other public policy objectives set by Parliament. We would be happy to discuss these issues further if it would assist. 15 March 2013

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1250 Parliamentary Commission on Banking Standards: Evidence

Written evidence from Professor David G Mayes, University of Auckland75 Incentives for more Prudent Bank Behaviour: Evidence from New Zealand 1. This note provides some evidence from experience in New Zealand with a rather different regime for improving prudential behaviour in banks to assist the Parliamentary Commission on Banking Standards in its deliberations over how beneficial changes might be made in the UK. 2. There have been no bank failures in the global financial crisis in New Zealand, nor has any bank behaved in a manner that has provided a serious threat to its own liability or that of the financial system. The obvious questions to ask are: Was that because of the regulatory system or despite it? Are their lessons that can be learned from this experience despite New Zealand’s unusual financial structure, with a banking system that is not only almost entirely foreign owned but owned by banks in a single country, Australia? Is this experience purely the result of the limited exposure of the New Zealand financial system to the economic downturn and the financial problems in other markets? Is it merely a tribute to the relatively strong but conventional supervisory regime that was introduced in Australia following the Wallis Review? 3. To pre-empt the discussion, the general conclusion is that there has been no test of how the New Zealand regime might have behaved had it been exposed to the opportunities and challenges that existed in the UK, US and elsewhere in Europe over the last decade but that a number of advantages and disadvantages in the regime have been revealed that provide important lessons for others. — Because New Zealand applies the concept of strict liability in cases related to disclosure documents by financial institutions, non-executive finance company directors have been successfully prosecuted for misleading disclosures even though they may not have aware of what had been was being done in the company. This gives a strong incentive to non-executive directors to ensure that they are fully aware of the activities of their companies. — The fact that the large majority of deposit taking finance companies in New Zealand failed during the first decade of this century suggests that the threat of custodial sentences is insufficient on its own to encourage prudence by directors. — Given the number of successful prosecutions as a result of the failures, including the conferral of custodial sentences, the incentives for prudence may now be much greater. Background 4. In the mid-1990s New Zealand undertook a careful review of experience round the world as it responded to the widespread concern, reflected in the Basel Committee’s work, that the prudential regulation of banks should be improved to increase the stability of the financial system as a whole and that of individual institutions within it. As a result of that review New Zealand introduced a new regime at the beginning of 1996, which was clearly different from that elsewhere in the OECD, being based on extensive disclosure, market discipline and harsh penalties for bank directors including civil liability in the event failures to disclose (set out in the Banking Supervision Handbook). 5. The regime had a second feature of relevance to the Commission as it treated those who wished to call themselves “banks” differently from other deposit-taking institutions who did not want use that name. Those institutions were subject to a light set of controls, also based on disclosure requirements, but with no special prudential regulation or concerns for any threat to the viability of the overall financial system. The main group of such non-bank deposit-taking institutions, finance companies, which formed only around 5% of the total deposit base “failed” in way or another, mainly before the global financial crisis. That regime was discredited, several of the directors have been successfully prosecuted, some are in prison at present, and the regime is being changed. However, there was no threat to the overall financial system. 6. There is one further aspect of the New Zealand arrangements worth highlighting at the outset. Unlike all the other OECD countries, New Zealand does not have deposit insurance, nor did it have it in the run up to the global financial crisis. It did introduce a temporary Crown Retail Deposit Guarantee Scheme in October 2008 (which was substantially reduced in 2010 and abolished in 2011) but this was largely disastrous, contributing to increasing the losses of the finance companies and hence to the taxpayer. The reasons for this, briefly mentioned below and set out in the Auditor-General’s Review of the scheme,76 are not germane to the Commission’s enquiry but the non-existence of deposit insurance is. 7. It is normally argued that while deposit insurance protects those who are not well-informed enough to assess the risks their banks are running and reduces the chances of a panic, it also increases the incentive for banks to take increased risk and to have weaker risk management. The New Zealand authorities have argued that by not having deposit insurance they have reduced this moral hazard and this helps contribute to the prudential behaviour of banks. 75

76

BNZ Professor of Finance, Department of Accounting and Finance. I was Chief Manager in the Reserve Bank of New Zealand when the new regulatory regime for banks was introduced in 1996 but my responsibility at the time was for monetary policy not banking supervision. The views expressed here are purely personal. Office of the Auditor-General, “The Treasury: Implementing and Managing the Crown Retail Deposit Guarantee Scheme”, Wellington, September 2011, available at: http://www.oag.govt.nz/2011/treasury.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1251

Forms of Incentive 8. It is normally argued that the best incentives for prudence exist when the directors of companies acting in their own self-interest have incentives that are well aligned with those of the principal stakeholders. In the present case the relevant stakeholders being the shareholders, depositors and the authorities acting on behalf of society at large. While the discussion is often restricted to remuneration, trying to ensure that contingent rewards reflect longer term share price performance, it applies more generally. The three stakeholder groups do not necessarily have compatible objectives and much of the problem is to achieve an appropriate balance. However, achieving this balance is not a problem unique to New Zealand. While recent emphasis has moved first in favour of depositors and more recently in favour of society at large, it is the shareholders who potentially have the potential for continuing control rather than simply setting boundaries for behaviour. 9. If incentives in a positive sense are insufficient then the normal response is to add a system of explicit penalties to back them up. Penalties have to be thoughtfully designed to be effective. It is usually not possible to provide anything much in the way of restitution from directors and with limited liability there is no means of repaying creditors and depositors in particular from shareholders. Custodial sentences are therefore normally needed to prevent directors from being able to protect their gains and avoid sharing in the losses in any material sense. 10. Beyond the positive and negative incentives there is the issue about what to do if the incentives fail. Penalties will not deter if the perpetrators do not believe that the penalties will be imposed or if they believe that they are unlikely to be found guilty or indeed will probably not be prosecuted. Such beliefs will remain contingent until there is a financial crisis or a generally applicable failure of an individual institution to which the other banks can relate. Since the intention of policy is to avoid both such events there is an inherent difficulty in obtaining a clear salutary message. 11. The New Zealand system does offer a rather greater incentive than many in this regard as it imposes strict liability on failures of disclosure. Thus it is not a defence for directors to say that they were unaware of problems that led to incorrect disclosures. Nor does the prosecution have to show that there was any deliberate attempt on the part of directors to mislead investors. The only requirement is to prove that the disclosures were erroneous, then the directors are liable. This places a substantial burden on non-executive directors to very clear about what the firm is doing and why. In general this is not an unreasonable burden on non-executive directors as they, like the executives, should be sufficiently conversant with the activities of the bank. 12. The problem that some such directors face is that they have been appointed to give respectability to a financial institution. They are well known public figures in whom the public has confidence. This is akin to using well known people, such as newsreaders, in advertising. The ordinary public assumes that such endorsement would only be offered if the personality had been convinced that the products and the risk management were of a very high quality. The practice is of course different as such publicity is a job, which is rewarded. The successful prosecution of directors after the failure of Nathans Finance, included two former ministers of justice. In passing judgement it was recorded that there was no suggestion that the two directors had been anything other than honest. They had simply not found out what the company was doing nor the true state of its affairs. They were thus in this sense negligent and hence liable. 13. There was a fear when the new supervisory regime was introduced in 1996 that the prospective penalties on non-executive directors would mean that no one would be willing to take on the job. In practice this was by no means true—existing directors were prepared to continue and there was no shortage of willing applicants to fill any vacancies. However, since there have been no bank failures it is difficult to decide whether nonexecutive directors simply believed that banks were well run or whether they felt that the scrutiny they would exercise as directors would be sufficient to avoid them every being caught out and endorsing incorrect dislosures. The Resolution Regime 14. Probably the most important incentive to prudent behaviour by directors lies in what will happen if the bank were to get into difficulty or be deemed by the authorities to have failed. If those involved can expect to lose their jobs and shareholders can be expect to be wiped out, along with some of the more junior creditors, there are considerable incentives for the members of all of these groups to try to avoid getting into such difficulties in the first place. 15. Right from the outset of the new regime in New Zealand, it was made clear that the special insolvency regime embodied in the 1989 Reserve Bank Act would be applied, whereby a statutory manager (the equivalent of a receiver) would be appointed in the event that a bank was thought unable to continue as an adequately capitalised and safe institution. Initially the resolution process was not fully spelled out but it was clear that this would involve the taking of control away from the directors and shareholders. In the resolution shareholders would either see their shares written down to zero or would receive only a small payment to cover the estimated residual value and the directors would lose their jobs in the takeover by the statutory manager under the control by the Reserve Bank.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1252 Parliamentary Commission on Banking Standards: Evidence

16. Over the succeeding years, the intention has become clearer, first with the development of the idea of “Bank Creditor Recapitalisation” and in 2011 with the exposition of “Open Bank Resolution” (OBR).77 Under this regime, any bank, whether of systemic importance or not and whether foreign-owned or not can be resolved within the trading day, so that it never closes for business. Furthermore, it is creditors’ funds, in increasing order of priority that are used to recapitalise the bank and not taxpayer funds. Although a government guarantee is likely to be required against any future losses while the bank continues to operate under statutory management. (The taxpayer would also be liable if the statutory manager failed to write down creditors sufficiently to enable the bank to be recapitalised and returned to private ownership.) 17. The key steps for making this plausible are: — all systemic banks must be locally incorporated and capitalised subsidiaries, with separate boards, so that the can legally be subject to statutory management; — all such subsidiaries must be capable of running themselves independent of their parents (and other key suppliers) within the trading day, so that they can be resolved in practice as well as in law; — it must be possible for the statutory manager to be able to value the bank adequately so that the creditors can be written down within the trading day sufficiently to restore capitalisation; — it must be practically possible to split all accounts or other claims on the bank into their active and continuing component and their written down and hence frozen component and that the continuing component can continue to be accessed by the end of the trading day. 18. If the four key steps listed above are not though plausible then shareholders and directors alike will have doubts about whether the regime will actually be applied and hence may be inclined to act less prudently. Even if all these practical concerns do seem to have been addressed in a manner that is credible for the directors, there is still the concern over whether this would be politically acceptable especially in a crisis. Since New Zealand does not have deposit insurance or depositor preference, depositors will have to be written down, possible substantially, to restore capitalisation. Such a writedown in the case of a large bank may be politically infeasible as these depositors are also electors. The Reserve Bank expects that there will be some de minimis limit below which deposits are not written down but if this carve out is large then the pressure on the remaining creditors will be that much harsher and their losses greater. 19. In any case at the height of the crisis in October 2008, New Zealand introduced a temporary Crown Retail Deposit Guarantee Scheme. Depositors, and directors could therefore be forgiven for believing that New Zealand had implicit deposit insurance and hence that troubled banks might be kept going despite the extensive rhetoric to the contrary beforehand. 20. Secondly, this pays no regard to the likely behaviour of the authorities in Australia, where the parent banks are incorporated. There, they do have both deposit insurance and domestic depositor preference. Is it going to appear plausible that depositors in the two countries should be treated so differently in the event of a failure? It is reasonable to suggest that some doubt will remain. 21. While the position in the UK is clearly different, the same principles apply. Is it really going to appear credible to bank directors that they will not be able to survive the realisation of substantial risks? Will living wills and funeral plans actually work? Will it be possible to get sufficient coordination among regulator across borders? None of these will generate an unequivocal response. The task is to make them more plausible as soon as possible. The Global Financial Crisis 22. New Zealand and particularly Australia were not very heavily affected by the global financial crisis. Australia did not even experience a recession in the sense of two consecutive quarters of falling GDP. While New Zealand did experience a recession and like many other countries discovered as a result that its fiscal policy stance was wrongly calibrated, resulting in large deficits that are not projected to disappear until 2015, it started from low indebtedness and has not had to reduce interest rates below 2.5% in order to maintain inflation in its 1–3% target band. As a result the main banks have not been seriously challenged, non-performing loans have not risen particularly strikingly and property prices have recovered from initial declines. With only limited increases in unemployment, it has therefore, fortunately, not been possible to find out empirically how well the banking system would hold up under the sorts of threats that have occurred in the US and Europe. 23. Similarly the main banks, whether in Australia or New Zealand did not participate in the sorts of derivative markets that have given the problems elsewhere. It is suggested by the Shadow Financial Regulatory Committee, among others that this was because there was not the same pressure on returns as elsewhere. Traditional banking business was doing well and there was no need for an aggressive search for higher yields by going into unfamiliar and higher risk areas. We therefore cannot infer that the banks in Australia and New Zealand would not have been equally aggressive if they had been faced by the same circumstances. 24. It is not possible to find some ready indicator which suggests that the behaviour of bankers in similar circumstances is some how different from those in the UK. Australian banks are modestly international and 77

The Reserve Bank has recently completed its impact assessment of the net benefit of OBR and concluded that despite noticeable costs for banks, these are small by comparison with the gains, which could exceed $1billion for a large bank.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1253

have operated in the UK and indeed Lloyds TSB used to own the National Bank of New Zealand, one of the five main banks, until the early part of the twenty-first century. However, the Australian Prudential Authority (APRA) has prided itself in the quality of its supervisory standards and would no doubt like to think that this was responsible in part for the prudence. 25. Nevertheless, APRA has also had its own problems and experienced some unfortunate failings in the insurance industry. One would therefore have to be rather cautious in attributing the prudence of the banks too firmly to the regulatory regime. Indeed, despite the fact that the regulatory regimes in New Zealand and Australia have been clearly different over the period, there has been no obvious difference in behaviour between the Australian and New Zealand parts of the banks. One might attribute that to a strong ethos that applies throughout the organisation. It has been common not just for Australians to run the New Zealand subsidiaries but for New Zealanders to run the entire banking group in Australia (the current and previous CEOs of Commonwealth Bank are New Zealanders). 26. While it is traditional for both countries to stress their own merits relative to their neighbours, it is clear that with their common heritage and single labour market they are more characterised by similarity than difference. Corporate governance standards are not particularly strong and to a large extent self-enforced rather than embodied in a strong legal framework. However, in the larger companies there has been a clear emphasis on transparency, aided by the importance of the disclosure regime. Smaller companies, as in other countries, can be less well governed and the representation of external shareholders can be weak. The performance of shareholders in New Zealand has been particularly criticised and it has only been with the setting up of the New Zealand Shareholders Association—purely through the actions of some small but vocal shareholders— that there has been any more widespread appreciation of shareholder rights and how these might be exercised. 27. A feature of governance which is clear in New Zealand, as elsewhere, is that while market discipline in theory should exercise considerable control over how directors behave it does not do so in practice. Not merely do shareholders tend to be relatively passive both in exercising their rights and simply in selling (and buying) their shares but the market for corporate control is relatively weak. In New Zealand this is assisted by a relatively weak financial press, which has not provided a widespread critical analysis of company performance. Pressure has been somewhat greater in Australia, in part simply because share ownership is much more widespread. New Zealand has a very low market capitalisation given the level of development and income per head of the country. (One reason for this is that the extent of foreign ownership in New Zealand is higher than in any other OECD country and hence the scope for local quotation is more limited.) Australia also has a strong compulsory superannuation scheme, which means that shareholdings tend to be rather more concentrated and hence more able to have influence of the companies in which those shares are held. 28. However, trying to differentiate New Zealand in this regard is not particularly helpful with the banks being Australian owned and hence the main pressure (or lack of it) for prudence coming through Australian markets. The Collapse of the Finance Company Sector 29. The collapse of the non-bank deposit taking sector in New Zealand, which started in May 2006, was almost complete by the time of the collapse of Lehman Brothers in September 2008.78 The New Zealand (and Australian) business cycle was in advance of that in the US by around 18 months. It is thus due largely to domestic economic conditions and to the realisation of domestic risks. Although there was some variety in the spread of finance companies lending business across consumer durables, cars, property and other finance, the ingredients of the collapse can be attributed to — greed and stupidity; — misaligned incentives; — governance failure and; — regulatory failure to use the words of Sheppard (2012).79 30. The sources of the failings are all too familiar. The institutions were not subject to prudential regulation as they were not thought, even jointly, to be of systemic importance as they covered less than 10% of total deposits. In so far as they were covered under the Securities Act of 1978, the Securities Commission had few powers to limit their actions, except through the power to compel them to withdraw the prospectuses they needed to raise/rollover funding. Aspects of good governance were not followed, although some of the worst offenders made strong claims to the contrary in their prospectuses.80 31. Finance companies were in the main owned by a limited number of individuals, who were also directors. While there were non-executive directors, the independence of many of them is debatable, and others were figureheads, associating well-known names with the company but not making any particularly extensive 78 79

80

46 companies collapsed before September 2008 and 11 afterwards leaving just 3 at the end of the period Sheppard, B. (2012). Fundamental Problems with the Governance of the Financial Sector, ch.2 in D G Mayes and G E Wood, Improving the Governance of the Financial Sector, Abingdon: Routledge. The specific case of Bridgecorp and the deposit taking finance company sector are set out clearly in Wilson, W., Rose, L. and Pinfold, F. Best Practice Corporate Governance? The Failure of Bridgecorp Finance Ltd., ch.4 in D G Mayes and G E Wood, Improving the Governance of the Financial Sector, Abingdon: Routledge.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1254 Parliamentary Commission on Banking Standards: Evidence

scrutiny of its affairs. Much of their funding came from fixed term deposits, which offered a margin over their bank equivalents. These appealed particularly to those in retirement or those saving for it—people whose appreciation of the risks involved would be likely to be limited. Some companies suffered from related party loans, to the extent in Bridgecorp that equity was negative. To cover the higher rates of interest finance companies had to take on higher interest paying and hence higher risk loans, with the need for larger margins increased by the salaries they paid themselves. 32. One of the most important failings of the light touch regime was the lack of a fit and proper person’s test for directors. This resulted in some people who had been involved in previous failures and poor governance being able to run up large losses for a further time. However, the sorts of test required are not simply that the potential directors should have an unsullied history and have demonstrated competence in running a company in the financial sector. For example, non-executive directors need to have the time, the inclination and the knowledge to have an impact. Strict liability provides a good but insufficient incentive. One of the difficulties is that “professional” directors with good reputations are likely to be “busy” and have several directorships, which reduces the chance of their being able to spend adequate time on the complex task of overseeing a bank. Compounding the Problems with a Poorly Designed Deposit Insurance Scheme 33. The introduction of temporary deposit insurance in October 2008 revealed a further side to imprudent behaviour by directors and the drawbacks of poorly designed rapid regulatory intervention in a crisis. New Zealand felt obliged to introduce a temporary scheme immediately when Australia announced that it was going to introduce deposit insurance (up to $1 million per depositor per bank) to avoid there being any lack of confidence in the financial system. The New Zealand scheme, which was voluntary, had a number of serious drawbacks, one of which was that admission to the scheme required agreement after investigation, which took well over three months in some cases. If there had really been any lack of confidence in the financial system this would not have halted the incentive for a run on weak institutions. However, the aspect which is of relevance in the present context is that they offered insurance for all deposits, not just those that existed at the time. Hence weak institutions could then offer insured deposits at a higher rate of interest than the banks offered. As a result new money flowed into the troubled companies. Rather than taking the opportunity to strengthen their businesses, the reaction was to increase lending to try to provide new revenue streams that would compensate for the non-performing loans already on the books. 34. The introduction of deposit insurance thus resulted in a major moral hazard. It contributed to a considerable extra burden on the taxpayer. The largest of the remaining deposit taking finance companies, South Canterbury Finance, was able to increase its deposit base by nearly 50%. When the company failed in 2010 the expected loss to the taxpayer, after recoveries, was greater than if the authorities had simply paid out all the existing depositors in full in October 2008 and not bothered to try to reclaim any funds from the company. (In part this was because of further failure in the design of the insurance scheme in respect of payouts. Not only was continuing interest payable to depositors encouraging an early payout but it was not possible to make such payouts without guaranteeing all creditors.) 35. The particular case of South Canterbury Finance is still before the courts and hence it is not as yet clear whether the actions of the directors in rapidly expanding the balance sheet and exposing the depositors (or rather the Crown which would succeed to their claims in the event of a default) was illegal in any respect, even though it was clearly imprudent. The guarantee should have encouraged an orderly retrenchment. However, this response is common and is one of the reasons why, in the US, under FDICIA, if banks start getting into difficulty a whole set of restraints are placed on their actions to limit their ability to impose further losses on the deposit insurance fund, even though that is funded by the industry and not the taxpayer. Professional Standards 36. Australia and New Zealand have jointly tried to develop professional standards in the finance industry voluntarily through Finsia (The Financial Services Institute of Australasia). This organisation offers courses, sets examinations and awards a series of titles for levels of experience and qualification. It also has journals, fosters links with the academic profession and seeks to lay on a continuing stream of events and advice that will keep its members well informed on the latest developments. This includes trying to encourage better regulation and governance and trying to increase financial literacy in the population at large. 37. While these developments are welcome and to be encouraged, there is no proper mechanism for ensuring the maintenance of good standards or the unfrocking of members for inappropriate actions. The recent requirements imposed by the authorities in New Zealand in requiring all financial advisors not simply to disclose their qualifications and degree of independence but to achieve one of two qualifications in order to be allowed to practice is clearly an important move to reduce some of the conflicts of interest and inappropriate motivation which existed in the past. 38. It is too early to judge whether these requirements, which have come into force over the last year, will make important differences for both the quality of advice and for the quality of decision-making by the clients who receive it. New Zealand has had its own small scandal related to miss-selling. This related to the sale of interest rate swaps to farmers towards the end of the period, in 2006, when interest rates had been rising. Purchasers were not properly informed of the costs they might bear if interest rates in the market actually fell.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1255

The advice provided by banks is covered by the act just in the same way as is that by independent advisors, so hopefully there will not be a repeat. At present it is not clear whether those selling the derivatives were simply ill-informed themselves about the implications of the product or whether they did not disclose all the aspects properly. Under strict liability the prime concern will be whether the disclosure was adequate, not over whether the banks knew about the downsides of their products. If the downside was not properly disclosed then the banks will be liable. Otherwise caveat emptor will apply. The Accumulated Lessons 39. The experience in New Zealand over the last decade offers a number of straightforward lessons for professional standards and culture of the banking industry in the UK and for corporate governance, transparency, conflicts of interest and their implications for regulation and public policy. A selection is listed below. (i) A lightly regulated sector is likely to lead to poor governance standards and poor risk management if the owners and directors can effectively protect themselves from the losses. (ii) The extent of such poor governance and risk management was sufficient to lead to the virtual elimination of the deposit-taking finance company sector in New Zealand, mostly in the two years before the global financial crisis took hold (iii) Strict liability and the successful prosecution of bank directors helps encourage better performance in the future but a period of successful growth and lack of prosecutions has led non-executive directors, in particular, to bear insufficient regard for what is occurring in their institutions and to place too much reliance on friends who were the executives. (iv) The disclosure regime introduced in New Zealand in 1996 has been highly successful in the sense that the registered banks have been prudently managed and have not got into difficulty during the global financial crisis. (v) The liability of directors, including the non-executives, for custodial sentences and for civil liability for losses may well have helped ensure a much closer attention to the business than is common in other companies. (vi) New Zealand and more particularly Australia, where all the largest banks are headquartered, was not severely challenged by the global financial crisis nor was there any significant involvement with subprime lending or any of the derivatives that turned out to have “toxic” properties. (vii) Margins on traditional business and hence profitability were good and hence there was no incentive to be imprudent. There is thus little that can be said about whether Australasian bankers would have succumbed in the same way as their northern hemisphere counterparts if they had been exposed to the same problems. (viii) The New Zealand authorities are firmly of the opinion that an important contribution to prudent behaviour by banks is a credible system for resolving problem banks of any size—that involves shareholders bearing the first loss, followed by creditors in order of priority and directors expecting to lose their jobs and be financial responsible for their errors. (ix) For such a scheme to work systemically important banks must be (a) locally incorporated and capitalised, (b) subject to intervention by the authorities at early stage when they no longer meet the conditions for registration, (c) able to run themselves independently within the trading day, (d) clearly enough structured that a summary assessment of the extent of the losses can be made within that day, and (e) able to divide claims into frozen and unfrozen accounts within the trading day. (x) Meeting these requirements implies very considerable prepositioning, not just in terms of bank structures and systems, but in having the skilled staff in both the banks and the regulator (resolution authority) who can perform the extremely rapid transformation should it be required (xi) While most of these precepts are translatable to the UK context, it is not clear whether larger banks can be dealt with in this manner, however, good the preparation under living wills, or whether EU rules will permit sufficient independence from parent companies to be required. (xii) Deposit insurance can offer serious moral hazards but a well structured explicit and compulsory scheme that is funded by the industry can avoid most of them (xiii) Don’t wait till a crisis to try out the crisis measures. 40. New Zealand remains vulnerable to external shocks. A substantial proportion of the financing of the banking system comes from overseas. At present, with positive short run interest rates, well ahead of the near zero values in the US, Europe and Japan, there is no difficulty in raising such finance. But the exchange rate has risen by more than 30% with respect to the major currencies and hence a shock is possible, despite measures by the Reserve Bank to improve liquidity management and reduce foreign funding exposure in the banks. At that point one might see a rather clearer picture of the extent to which Australasian banks have

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1256 Parliamentary Commission on Banking Standards: Evidence

managed to run an more prudent system and embrace a culture which is more responsible, less foolhardy and less aggressive than its northern hemisphere counterparts. 4 November 2012

Written evidence from Iain G Mitchell QC 1. Introduction: I am Iain Grant Mitchell QC, a member of the Murray Stable, Advocates Library, Parliament House, High Street, Edinburgh EH1 1RF and an Associate Member of Tanfield Chambers, 2–5 Warwick Court, London WC1R 5DJ. I am a Scottish QC and an English Barrister who is presently engaged in both advising and acting in a number of cases in which small businesses are seeking redress from various banks for alleged interest rate swap mis-selling. I acted for the Pursuers in the recent case of Grant Estates Ltd. v Royal Bank of Scotland plc [2012] CSOH 133. I am also a member of QA Legal, a grouping of lawyers and other professionals who are engaged in similar work. It will be appreciated that the details of individual cases are not matters which it would be appropriate for me to comment upon. I have, however, noticed a number of common issues in these cases which give me concern as to whether the regulatory regime is working as it ought to. I am particularly concerned that (as highlighted in the published judgement in Grant Estates) there are two areas where claimants may be prevented from bringing actions in court to seek compensation: first, the exclusion of claims brought by persons other than “private individuals” (as defined in the legislation) and, second, the effect of various standard-form exclusion clauses routinely inserted by the Banks into their terms of business. The more I see of the cases, the more I become concerned at regulatory lacunae in the system. I also have misgivings about the adequacy of the review scheme which has been adopted by the banks under pressure from the FSA. It is the purpose of this written evidence to set out these concerns and to suggest possible regulatory reforms which might address them. 2. The Regulatory Context: Registered financial institutions are under a legal obligation to follow the requirements of the FSA’s Conduct of Business Sourcebook Rules (“the COBS Rules”), which, in their present version, came into effect on 1st November, 2007 in order to give effect in UK law to the provisions of the Markets in Financial Instruments Directive (Directive 2004/39 EC as implemented by Directive 2006/73/EC) (here together referred to as “MiFID”). The provisions of the Rules are obligations which are owed to clients who fall within the protection afforded by the Rules. In particular, it is a fundamental requirement of MiFID and of rule 3.31 of the Rules that the bank should categorise the client as either a retail client or a professional client and should inform the client of that categorisation and the limitations of the protection afforded by that categorisation prior to undertaking any business on behalf of the client. The Rules place heavy obligations upon the bank in dealing with retail clients, including the general obligation under rule 2.1.1 of the Rules to act honestly, fairly and professionally and in accordance with the best interests of the client (the “client’s best interest rule”). Though the client’s best interest rule (as well also as the obligation to secure best execution) does not normally apply in the case of an execution-only contract, this is not true where the subject matter of the contract is a complex financial instrument as defined in the rules and MiFID. Although spokesmen for various Banks have from time to time suggested that an Interest Rate Swap Agreement (“IRSA”) (or at any rate a “vanilla” IRSA) is not a complex financial instrument, this is inaccurate. All IRSAs are classified under MiFID and the rules as complex financial instruments. In consequence, if, in selling an IRSA, a registered financial institution, such as a Bank, fails to follow the requirements of the rule it is in breach of the obligations owed to the client under the rules. 3. Actionability: (a) The Problem: Although a bank may have breached Rules, that breach is not necessarily actionable. Section 150 of the Financial Services and Markets Act 2000 (“FSMA”) provides: “(1) A contravention by an authorised person of a rule is actionable at the suit of a private person who suffers loss as a result of the contravention, subject to the defences and other incidents applying to actions for breach of statutory duty. ... (5) “Private person” has such meaning as may be prescribed.”

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1257

Such prescription is found in regulation 3 of the Financial Services and Markets Act 2000 (Rights of Action) Regulations 2001 (SI 2001 No 2256) (“the 2001 Regulations”), which provides: “3. (1) In these Regulations, “private person” means (a) any individual, unless he suffers the loss in question in the course of carrying on (i) any regulated activity; or (ii) any activity which would be a regulated activity apart from any exclusion by article 72 (overseas persons) or 72A (information society services) of the Regulated Activities Order; and (b) any person who is not an individual, unless he suffers the loss in question in the course of carrying on business of any kind”. The apparent effect of these provisions is to confer upon persons a right to sue for breaches of COBS, but to exclude from that conferral those persons who are not “individuals” (presumably intended as a synonym for natural persons) if they incur the losses in the course of business. What, however, is noteworthy is that the provisions do not purport to negate the existence of the relevant duties, only to restrict the extent to which a breach of such duties is actionable at the instance of anyone who is not a “private person.” In this regard, I note a remark made by Mr. Mark Garnier MP at an earlier session of the Commission’s hearings that “you can’t mis-sell to a corporate”, but, as is explained above, that is not accurate: a financial institution may breach a duty owed under the FSA Conduct of Business Rules—ie mis-sell—to a customer who is a non-natural person, but, although the institution will have breached a statutory duty owed to the customer, the effect of the regulations is that this breach may not be actionable. (b) Legislative History of section 150 and regulation 3: The legislative history of section 150 and regulation 3 is explained in the judgement of Mr Justice David Steel in Titan Steel Wheels Ltd v The Royal Bank of Scotland Plc [2010] EWHC 211 (Comm) (11 February 2010) at §§53 to 60. I reproduce the relevant section of this Judgement in Appendix A to this Evidence. In short, the present regulatory regime was originally designed to protect financial services firms from strategic lawsuits by competitors, but the language in which the regulations were (and remain) couched are far wider than is necessary to attain that objective, effectively blocking any court actions which may be brought by any company (no matter how small) which makes losses in the course of its business. Furthermore, attempts by the claimants in Titan Steel Wheels and Grant Estates Ltd. to narrow the effect of regulation 3 by urging that the test of “in the course of business” should be construed so as to mean integral to the business, were unsuccessful. As Lord Hodge stated in Grant Estates Ltd at §58: “If Parliament had intended the phrase to cover only transactions which were an integral part of the person’s business, that would have confined the restriction principally to such regulated activities. Instead, it appears to have cast the net more widely to prevent a competitor from using an associated company, which was engaged in other business activities, as the claimant in a strategic action. In that context the “integral part” test makes little sense”. There is a mismatch here with MiFID, which has client protection as one of its principal stated aims. However, MiFID does not in terms require breaches of its requirements to be actionable in the courts of the Member States, and there are certain member states which accord regulatory remedies instead. In these circumstances, as the judgement in Grant Estates illustrates, it is difficult to argue that the UK regulations fall to be “read down” (though that is an argument which might be revisited in a future suitable case). In consequence the courts have not seen a conflict between the UK regulations and MiFID. The result is that a regulatory regime which was promulgated two decades ago to protect the financial services industry from strategic claims is now employed in very different circumstances to protect the financial services industry from claims by retail clients, many of whom are small or micro-businesses with inexperienced directors who may have relied upon their bankers to do what was best for them: it is not that section 150 and regulation 3 are unfit for purpose; it is, rather that the purpose for which they are ideally suited is arguably no longer defensible or appropriate. (c) Regulatory Remedies: The effects of this might be have been mitigated if there had existed any satisfactory regulatory remedy, but in many cases there will be no such remedy. First, all regulated persons are subject to appropriate sanctions by the FSA, but that may not translate into recovery by a client of his losses incurred as a result of any misselling. Although section 382 of the 2000 Act provides for an application to be made to the Court by the Secretary of State or the FSA for a restitution order, this would appear to be a power which has rarely been exercised, and, in particular, has not been exercised in the context of alleged IRSA misselling. It may be that the Commission would wish to seek clarification from the FSA as whether and if so how frequently and in what circumstances this power has ever been exercised.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1258 Parliamentary Commission on Banking Standards: Evidence

Second, a claim may be made by a client to the Financial Services Ombudsman, such complaints may only be brought by “micro-buinesses” or individuals and, in any event the maximum compensation is limited to £150,000. In consequence, small business who, however, are not microbusinesses, will be unable to obtain compensation, and, further, even where compensation is ordered, it may well be substantially less than the losses made. Further, the criteria employed by the Ombudsman do not necessarily match the provisions of MiFID or the COBS rules. There is, of course, the scheme which has been devised by the Banks at the behest of the FSA (http://www.fsa.gov.uk/static/pubs/other/interest-rate-hedging-products.pdf). This scheme, however, contains a number of questionable features. First, the undertaking to pay compensation relates only to the most complicated kind of IRSAs, structured collars. The only promise in relation to the sale of other IRSAs is to have them reviewed by an “independent reviewer” to be appointed by each of the banks who have agreed to be bound by the scheme. Others have commented upon whether or not this is satisfactory. Second, the promise is made only to what are described as “non-sophisticated customers”. So-called “sophisticated customers” are not entitled to an independent review but instead have to take their chances with their Bank’s own internal complaints procedure. This scheme does not accord with the provisions of MiFID and the COBS rules and falls short of the protections afforded in MiFID and the rules. —

The rules give the widest protection to “retail clients” and narrower protection to “professional clients”. There is no class under the rules of “sophisticated customers”. The probability is that the banks will categorise a substantial number of retail clients as “sophisticated customers”, thereby cutting them out of the compensation scheme.

—

Under the rules, all IRSAs are “Complex Financial Products”. The undertaking narrows that down by guaranteeing compensation only for the most complicated of the various Complex Financial Products which Banks are accused of having mis-sold.

Third, there is no suggestion that any compensation will extend beyond the refunding of excess payments. In particular, there is no undertaking to provide compensation for consequential losses, such as, for example, where the excess charges might have restricted a businesses expansion, caused it to lose profits, or tipped it over the edge into insolvency. Furthermore, there is increasing anecdotal evidence that the compensation awarded under the scheme is being quantified in the difference between the cost of the mis-sold swap and a simpler form of swap, such as a vanilla swap, without any consideration as to whether a swap should have been sold at all. 4. Standard Terms: Given the difficulties posed by section 150 and regulation 3, a person who does not fall under the definition of a “private person” might choose to bring an action founded not in breach of statutory duty, but, rather, based in common law. Indeed, a “private person” may also wish to bring a common law claim. It is a common feature of many of the cases which I have seen that the clients believe themselves to have been given advice by their bank, and often the circumstances have disclosed that, to a greater or lesser degree, such advice indeed appears to have been given. The position of the Banks is consistently that their staff were not giving advice and were only salespeople. When such a statement is made it is often met with incredulity by the client, coupled with some such comment as “but I trusted the Bank to do what was right for me”. In these circumstances, a client will often seek to set up either a contract between the Bank and himself for the giving of advice and claim that the bank was in breach of contract by reason of having fallen short of the appropriate professional standard for the giving of advice, and/or will seek to found a claimed in negligence, claiming that the Bank gave advice intending that it would be relied upon. The Banks all tend to have standard form exclusion clauses contained within their terms of business. Such clauses would not give too much difficulty if they were restricted to limiting or excluding a Bank’s liability, since such clauses may not be able to pass the test of fairness and would be likely to be struck at in England by sections 2 and 3 and, in Scotland, by sections 16 and 17 of the Unfair Contract Terms Act 1977. However, the terms are usually couched in such a way that they exclude the existence of either a contract to advise, the very relationship of advisor and client and/or any entitlement to rely upon any advice given. Those clauses are not struck at by the 1977 Act, and will usually be effective. What makes this even more difficult for clients is that, although the standard form contracts would often have included warnings to the clients to take independent advice, at the time of the alleged mis-selling there were few if any independent advisors licensed by the FSA to give advice on complex financial instruments. there was nowhere for the client to turn for advice.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1259

It is clear that a substantial number of claims may be excluded by the effects of section 150 and regulation 3 and/or the Banks’ exclusion clauses. Furthermore, the regulatory alternatives and the Banks’ scheme are likely to be inadequate in many cases. These problems might be addressed, first, by amending section 150 and regulation 3, either by removing altogether the exclusion of actionability, or, if it were considered appropriate to protect Financial Services Providers from strategic lawsuits brought by their competitors, to seek to recast the regulation so as to target only that particular perceived mischief. Additionally (or alternatively), if the route of reform of section 150 and regulation 3 were not to be followed, then a high priority should be afforded to providing a suitable alternative administrative remedy so as to allow claims to be brought to the Ombudsman by any retail client, and removing the cap on compensation. So far as the exclusion clauses are concerned, the obvious approach would be merely to extend the scope of the Unfair Contract Terms Act to cover all clauses excluding the arising of a liability. However, this would affect all standard form contracts in any sector and would not be restricted to contracts in relation to financial advice. The position under German law is that there is a presumption that a bank stands in an advisory relationship to its customers. A less far-reaching amendment would be to enact a similar provision in the United Kingdom, together with a prohibition on contracting out from that presumption. 6. Conclusion I present this as my written evidence. Should the Commission wish me to expand upon it or respond to any queries which it may have, I should be pleased to attend to give oral evidence if required. APPENDIX EXTRACT FROM JUDGEMENT IN TITAN STEEL WHEELS LTD V ROYAL BANK OF SCOTLAND PLC 53. The first statutory provision furnishing a cause of action for breach of the regulatory regime was Sect. 62 of the Financial Services Act 1986 (“FSA”): “(1) Without prejudice to section 61 above, a contravention of—(a) any rules or regulations made under this Chapter; (b) any conditions imposed under section 50 above; (c) any requirements imposed by an order under section 58(3) above; (d) the duty imposed by section 59(6) above, shall be actionable at the suit of a person who suffers loss as a result of the contravention subject to the defences and other incidents applying to actions for breach of statutory duty…. 54. The 1986 Act represented a wide ranging overhaul of financial services’ regulation in the UK including the establishment of the Securities Investment Board. In order to give investment firms the opportunity of becoming familiar with the provisions of the Act, Sect. 62 was not brought into force for six months. 55. During this period the industry expressed concern that the open ended provision for claims by any investor might encourage strategic lawsuits brought for competitive advantage: see DTI Consultation Paper “Defining the Private Investor” September 1990. This concern led to the inclusion by virtue of Sect 193 of the Companies Act 1989 of a new Section 62A to the FSA: “62A.—(1) No action in respect of a contravention to which section 62 above applies shall lie at the suit of a person other than a private investor, except in such circumstances as may be specified by regulations made by the Secretary of State. (2) The meaning of the expression “private investor” for the purposes of subsection (1) shall be defined by regulations made by the Secretary of State. (3) Regulations under subsection (1) may make different provision with respect to different cases. (4) The Secretary of State shall, before making any regulations affecting the right to bring an action in respect of a contravention of any rules r regulations made by a person other than himself, consult that person.” 56. The Consultation Paper went on to annex a draft form of regulation defining “private investor” which in all material respects is the same as later adopted in the FSMA Regulation. In proposing the definition the DTI expressed a desire to avoid complexity and to introduce the definition as “brief and as clear as possible”. Having drawn attention to the fact that any contractual rights of action would remain unaffected, the paper went on (para 52): “This proposed definition is intended to have the following effects:

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:49] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1260 Parliamentary Commission on Banking Standards: Evidence

All individuals would retain their s62 rights for all purposes. Individuals who carry on investment business would lose their s62 rights only in relation to any action taken by them, or anything done to them, in the course of that investment business; All non-individuals would lose their s62 rights in relation to any form of business. Most charities and similar bodies do not carry on any form of business, and would therefore retain their s62 rights only in relation to any action taken by them, or anything done to them, in the course of that business.” 57. The draft regulations were in due course promulgated as the Financial Services Act 1986 (Restriction of Right of Action) Regulations 1991. The wording was in due course adopted in the 2001 Regulations in accord with the recommendation in a consultation paper issued by the Treasury dated December 2000. 58. Whether such consultation papers were strictly admissible or not, there is nothing in this material which gives substantive support for the proposition that the phrase “in the course of carrying on business of any kind” has the restricted meaning urged by Titan. But Titan relies in addition on observations made by ministers during the course of the passage of the Companies Act 1989 in Parliament which emphasised the exclusion of “professional investors”. 59. In the House of Commons, the Minister for the DTI said: “Part VIII makes a number of individual changes to the Financial Services Act 1986, the Insolvency Act 1985, the Policyholders Protection Act 1975 and the Building Societies Act 1986. Most of these changes are for clarification or tidying up purposes rather than being major policy departures. But I should refer briefly to clause 158 which removes the right of a professional investor to sue under section 62 of the Financial Services Act if he suffers loss as a result of a breach of the rules made under that Act. In considering experience of the working of the Act we have concluded that in respect of professionals—I emphasise professionals—the provision is inappropriate. I stress, however, that there is no change in the position for private investors, who will retain the additional safeguard provided by section 62.” 60. To similar effect, the Secretary of State for the DTI said in the House of Lords: “Finally, I come to Clause 132, which amends the Financial Services Act 1986 by removing the right of a professional investor to sue under Section 62 if he suffers loss as a result of a breach of the rules made under that Act. Section 62 provides valuable safeguards for private investors but it has been suggested that this provision risked contributing to an excessively litigious atmosphere between professional investment businesses. Such an atmosphere would hinder healthy competition and growth. The definition of “professional investor” is to be included in secondary legislation so that it can be adjusted if necessary in the light of experience and of any changes in the relevant rules.” 16 October 2012

Written evidence from NAPF 1. Executive Summary 1.1. The NAPF is the leading voice of workplace pensions in the UK. We speak for 1,300 pension schemes which collectively hold assets of £900 billion providing benefits to 16 million people. We represent over 400 providers of essential advice, products and services to the pensions industry. 1.2. Pension funds have a real and long-term interest in the issues being addressed by the Commission. Bank shares form a material part of most asset portfolios and funds are major consumers of wholesale banking services, from custody to stock market transactions to foreign exchange dealing. 1.3. Our members have been impacted by the failings in the standards of governance and lack of a positive culture within some of the world’s largest banks which have led to significant losses in shareholder value and thus a direct impact on pension funds. Episodes such as the manipulation of Libor and Euribor; the mis-selling of PPI to individuals and interest swap products to SMEs; the failure to prevent money laundering and unauthorised transactions involving customers’ money demonstrate why the NAPF believe improvements are needed. 1.4. Banks are heavily regulated institutions and while in some areas further regulatory intervention may be required—such as those proposed by the Independent Commission on Banking—it is not possible to legislate for a good culture. 1.5. What is most needed is greater independence and professionalism amongst those charged with overseeing banking operations, including, crucially, the non-executive directors. A good culture needs to stem from the board recognising its responsibilities to act in the long term interests of their shareholders and customers. As Lord Turner recently suggested reforming the banking culture has to start with the most senior levels of management asking searching questions of their own operations, ensuring they are truly delivering in their consumers’ interest.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1261

1.6. Recent reforms implemented following both the Turner and Walker reviews are only beginning to bed in, it is vital therefore to avoid responding in a manner which would be to the detriment of customers, shareholders and the broader economy. Instead the banking industry needs to act to restore and protect its reputation and recover the trust of its customers and shareholders. 2. The Culture in UK Banking 2.1. There has understandably been a significant focus over the past few years on the regulation of the banking sector, both in the UK and internationally. Recent events however, have highlighted that there is a limit to what regulation can achieve—it is not possible to regulate for good behaviour. 2.2. Recent disclosures have brought to light a worrying culture within many banks. While most incidents involved only a small number of individuals directly, it appears a larger number were often aware and the banks’ internal compliance functions failed to either spot or stop these activities. 2.3. It has been suggested that direct or indirect awareness or involvement in such activities stretched from trading floors, through compliance functions, audit functions and on up to the executives at the top of firms. It is the responsibility of the executives to set and live the culture, ethos and ethics of the firm which they are charged with running, to lead by example and instill this through their firm. 2.4. As with the outcry which followed 2008 and led to the wave of regulation aimed at the financial services industry, the justified recent public outcry at the behaviors of a minority in the banking industry has been the straw that has broken the camel’s back. The public, shareholders and regulators rightly expect the industry to put its house in order. 2.5. We believe that this behavioural change needs to primarily come from within the sector itself, although politicians, regulators, shareholders and the public should monitor this closely and make clear the expectations the industry should meet—this should include the ability to be able to hold to account those who stray, through the criminal courts if appropriate. 2.6. What is needed is to encourage compliance and individual responsibility at all levels in organisations to promote a healthy culture and foster trust-based relationships. It is for others to determine the best way to achieve this end; however, some have suggested that the industry may wish to consider a professional register and code of conduct with stringent robust sanctions. 3. The Role of Shareholders 3.1. The providers of equity capital, typically institutional investors, such as pension funds, have played a key role in supporting the return to health of many financial institutions in the recent past by providing the additional permanent capital required to reduce leverage and cover for losses incurred during the financial crisis. 3.2. By way of compensation for their provision of capital, investors have the right to engage with and seek to influence the strategic direction of the company in order to protect and hopefully increase the value of their investment. Shareholders, however, are not involved in the day-to-day operations of a firm; instead they rely on the board of directors to oversee and govern management and to make corporate decisions on their behalf. 3.3. To date, pension funds and their members have not been well served by the concentration in the financial sector on short term gains which have been made at the obvious expense of the longer term and at significant cost to shareholders. 3.4. This culture needs to be reversed and following the 2008 crisis there have been signs that this is becoming understood by those across the industry. The culture of these institutions is currently working against the interests of the providers of capital. It now requires those at the top of the industry to grasp the nettle. 3.5. Our members understand the risks posed by an individualist short-term culture. Pension funds and other institutional investors regularly engage with companies on routine and more serious matters and, in their meetings, the culture being set within the company from the top is a topic that is increasingly discussed. 3.6. Shareholders already have the ability to hold boards to account through the annual re-election of directors. This ultimate sanction can and should be utilised by shareholders where there is clear evidence of poor performance by the individual or the company and engagement has not resulted in a satisfactory response. 4. Corporate Governance vs Regulation 4.1. Corporate governance is about behaviours and how a company in any sector, not just financial services, is directed and controlled. Good governance is ultimately about the behaviours and culture within an organisation, whether it is effectively managed; decisions are sound and success sustainable. 4.2. The level of regulatory supervision of financial institutions prior to the crisis was widely accepted to have been inappropriately low. The Walker Review made a significant contribution in promoting increased corporate governance standards in financial institutions in the wake of the financial crisis. While it is still early days for the Walker Review recommendations, the early signs are positive.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1262 Parliamentary Commission on Banking Standards: Evidence

4.3. There are concerns however, that some of the other elements of the recent wave of regulatory reforms risk disempowering shareholders and making them less effective in holding boards to account 4.4. In banks, especially those that are Systemically Important Financial Institutions (SIFIs), it is clear that regulators have a role to play. But there needs to be a balance between the constraints of regulation and allowing boards to decide what is in shareholders’ best interests. Regulation may undermine the role played by shareholders who, as owners of companies and providers of risk capital, are best placed to hold boards to account. 4.5. In the context of the Commission’s inquiry, it is our view that prescriptive rules cannot guarantee good behaviour—this can only be encouraged, not prescribed. Increasing intrusiveness may be counterproductive— we give two examples below. 4.6. At present, the FSA approve individuals who perform controlled functions to ensure that the individuals concerned are “fit and proper”. This approval process by the regulator limits the scope for shareholders to engage in the nominations process. We therefore see merit in the FSA formally seeking investor views on the qualities of nominated directors, allowing shareholders to help shape the culture of those who represent their interests on the boards of banks. 4.7. There are also increasing requests for the FSA to attend board meetings, however, the FSA’s presence could in fact inhibit board discussion and discourage frank debate, thereby undermining board effectiveness. The recent events with Barclays for example raises questions about the regulator’s role if there are failings at a firm where the FSA has been an attendee at board meetings and had significant concerns about a firm which were not then shared with the firms’ shareholders. In such instances there should be disclosures from the company and the regulator of any pertinent points of concern which may impact on shareholder value; this could be facilitated through the Investors Forum recommended by Professor Kay in his recent report. 5. Remuneration 5.1. The situation is perhaps even more extreme with regards to remuneration, where the detailed prescription on pay structures and levels set by the FSA and other regulators mean that the role for shareholders risks being extremely limited. EU regulations are also following a similar pattern—with the Capital Requirements Directive IV (CRD IV) currently proposing to impose strict caps on bonuses. Some of the proposals under CRD IV take corporate governance issues outside the sphere of company law and into a banking compliance world. 5.2. We do firmly believe that there is a need for a fundamental rethink of executive pay structures to ensure better alignment between rewards to management and the interests of long-term investors such as pension funds. This is needed for remuneration structures of executives in all sectors—we do not support a separate prescriptive regime for executives in the financial sector. It is the case however, that the incentives provided by remuneration structures are perhaps more pertinent in institutions such as banks. 5.3. We believe that remuneration schemes are often not working sufficiently well to deliver their intended purposes. Often due to the best of intentions, complexity has built up which is now a barrier to understanding and motivation creating perverse behaviour. Moreover, remuneration may have been used as a short cut to the more difficult task of driving the right tone from the top and culture and alignment within companies. 5.4. Reforms on pay should therefore focus on simplicity and alignment both to companies’ ultimate owners via long-term share ownership as well as the culture and behaviour desired and expected by the board. 5.5. It is crucial that changes already introduced and those on the horizon are given time to embed. Changes in behaviour do take time and layering change upon change without due consideration of whether the initial changes have had the desired impact is likely to cause confusion, could lead to unintended consequences and risks shifting focus away from changing behaviours to a tick box approach. 6. Delivering a Better Culture 6.1. The board’s role in defining corporate culture is considerable. However, the primary responsibility lies with the executives, with the board’s role focussed on setting the values by which it intends to operate; its attitude to integrity, risk, safety and the environment; its culture; its value proposition to investors; and plans for development (ii) ensuring the heads of the organisation have the right cultural approach; and, (iii) holding management to account in respect of these issues. 6.2. The board should agree what the culture ought to be, and certainly can ensure that individuals with the wrong cultural approach are not at the top of the organisation, but shaping and delivering on that agreed culture is the responsibility of the executive team. The non-executive directors can critically assess their performance in delivering this—just as can the firms’ shareholders and regulators. 7. Remedies 7.1. Whilst the NAPF is supportive of regulation in circumstances where it is likely to add value, it is not always a means for achieving success. It is clear that culture change cannot be required by legislation, nor guaranteed by corporate governance structures. The cost of getting it wrong, not least in terms of serious

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1263

damage to corporate reputation, should be a significant incentive to financial institutions to think about what steps they need to take to get it right. 7.2. It is not for investors to prescribe a financial services firm’s culture. Their role is to ensure that the right people are appointed to the board which incentivises a culture that delivers the right outcomes—a role which is more difficult to perform in relation to banks due to the issues explained previously. 7.3. Remuneration structures have an important role to play in this and often the focus has been on increasing profit in the short-term, as opposed to return on assets and prudent management of leverage. There has been much progress on this and investors are becoming more proactive than was previously the case. 7.4. Executives and other industry leaders need to grasp the nettle and seek to change the culture of their industry. The industry needs a culture of responsible risk-taking in which sustainable shareholder value creation, including through the value of services provided to the entity’s clients, is the embedded objective of all, where reward can be high but only where performance justifies it, in which risk management systems are well-built and operate effectively, and where responsible employees can be confident that concerns they may have can be raised and addressed without career-limiting implications. 7.5. The risk is that rules will inevitably lead to formal, legal compliance with the letter rather than the spirit of the law or regulation. In turn this leads to behaviour that is focused on formal, defensive compliance (which easily drifts into a gaming of the system) rather than the sort of culture and approach that we seek. 7.6. Changes in culture and behaviours take time and recent amendments to the corporate governance framework introduced since the financial crisis should be given a period to embed before further regulatory action is taken. Any case for further change needs to consider whether measures already introduced have had the desired effect of changing behaviours. It is crucial that regulators do not further usurp the role of boards, or of shareholders, thereby threatening the chain of accountability. Instead the banking industry needs to act to restore and protect its reputation and recover the trust of its customers and shareholders. 30 August 2012

Written evidence from the Observatoire de la Finance This paper has been drawn up by an ad hoc working group at the Observatoire de la Finance, made up of three experts on the operation of financial markets, financial regulation and financial ethics: Andrew Cornford (expert on financial regulation, previously with UNCTAD); Paul H. Dembinski (executive director of the Observatoire, professor University of Fribourg) and François-Marie Monnet who has spend all his career in international financial industry (London, New York, Geneva). Different versions of this text have been circulated to a knowledgeable group of reviewers whose many illuminating comments are reflected in the final document, among others: Yves Burrus who has spend all his career in financial industry, Marc Chesney (Professor of Finance, University of Zurich), Tamar Frankel (Professor of Law, Boston University School of Law), Dominique Jacquet (Professor des Universités, Paris) and Alfredo Pastor (Professor of Economics, IESE Business School, Barcelona). The paper gives us an opportunity to highlight and flesh out some features of the Observatoire’s manifesto For finance that serves the common good (see appendix). I. Conclusion by way of an Introduction 1. London is not only the UK’s financial centre but has also been the main source of global financial practice for many decades. This model, which has relied on self-regulation, was given an added boost by the Big Bang, under the benign eye of the UK’s regulatory authorities and the Bank of England. The recent suspicion that the Bank of England may have allowed the calculation of one of the financial market’s key benchmarks to be manipulated is symptomatic of a malaise that is now challenging the basic premises of the model and the quantitative and qualitative changes within it. 2. UK banking standards in the traditional sense no longer appear to exist. The offshore standards and practices that now prevail are very different from the legendary professional standards of the UK’s banking tradition. “Old-fashioned” principle-based standards have made way for “rule books” that are thousands of pages long. This rule-based, procedural approach to professional standards, with its accompanying exams and certifications, is driven by legal concerns. At the same time, however, it has reduced the scope for sane judgment, ethical conduct and concern for the common good, while extending opportunities for litigation. This being the case, there seems little point in looking at the practices of individual traders and bank employees without first considering the inherent features that shape those practices at both macro and institutional level. Nor should we forget the special relationship between the UK and the US, and between the UK and the euro zone. 3. The Pandora’s box of financial distortion and malpractice is now open for all to see. For years, intellectuals (academics and journalists), financial practitioners and even central bankers warned of the self-accelerating, and potentially dangerous, process whereby offshore finance was drifting free of the onshore economy—but

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1264 Parliamentary Commission on Banking Standards: Evidence

their warnings fell on deaf ears. The prospects of gain, for governments, financial intermediaries and owners of offshore assets alike, were simply too high. The party went on “as long the music kept playing”. There was no conspiracy or deliberate plan. What made the offshore markets work so well, and continue to expand, was a mere convergence of interests. Yet the dark side of this convergence of interests, with its scant regard for the common good, is now plainly visible—and it poses a threat to the trust on which all financial systems depend. 4. Here at the Observatoire de la Finance (www.obsfin.ch) we are convinced that, when the prospects of gain are unusually high, it will not suffice to spell out the principles of the common good. Instead, these principles must not just be pursued, but also defended—and if necessary enforced. We are submitting these comments to you now because we believe the time has come for policymakers to act. The action they take must be comprehensive, and the European dimension must not be overlooked. If world finance is to remain stable and sustainable, the Pandora’s box of distortion and malpractice must be closed—and Her Majesty’s Government has a crucial part to play in this process. II. What made the London-based financial sector abandon traditional UK professional and ethical standards? 5. Offshore London-based banking as a substitute for the weak pound. London remains the centre of the world’s offshore financial markets. Yet many of the banks operating out of London are UK banks on paper only—in practice, their culture and organization are entirely global. The opportunity of developing offshore markets from London seems to have been seized on by the City’s financial sector in order to compensate for the collapsing role of sterling as a reserve currency from the 1950s onwards.81 The Euromarkets, which initially handled US dollars traded in Europe, beyond the direct control of the US monetary authorities, thus gradually developed in London as a convenient source of funding, at first for banks and later for any borrowers willing to accept the unregulated (or self-regulated) nature of the transactions involved. 6. The boundary between offshore and onshore finance. Despite its size, the City-based offshore financial sector (whether “Euromarkets” or “international finance”) has had little impact on the workings of the UK economy, the pound sterling or the UK’s domestic capital markets. Offshore markets have deliberately been left outside the scope of UK regulation, and hence have been unaffected by national monetary policies. 7. “Rollover” becomes standard practice. Banks operating in the Euromarkets were able to extend their commitments from maturities of less than one year (money-market instruments) to longer—even perpetual— maturities, while keeping their interest-rate commitments extremely flexible thanks to the “rollover” or “floating” rate-setting process. The result was a need to define this process more strictly in loan and bond documentation, which in turn fuelled the need for a benchmark interest rate. It took almost 20 years for the London Interbank Offered Rate (LIBOR) to be put in place, under the umbrella of the British Bankers’ Association. 8. However, LIBOR has never been a proper “market price”. Technically speaking, LIBOR was a benchmark used by professionals as a mere reference point. It only became a key feature of the “price-setting” process once it was used—and accepted—in documentation on loans and securities. What was forgotten, however, was that a market—in the received economic sense of the term—can only exist and operate if there is interaction between prices and volumes. In the case of LIBOR, banks were asked to report the rates at which they could borrow, but not the volumes they transacted. The FSA report mentions a Barclays employee being unsure how to report LIBOR rates on days when no actual LIBOR transactions were performed by his bank. Once the direct link between prices and volumes of transactions is severed—which is what happened with LIBOR— prices cease to be a “reality check” and instead become fleeting abstractions that can easily be inflated or deflated, and can lead to serious distortions if taken out of context. Imagine what would happen if the London Stock Exchange, or any other stock exchange, were to price its shares simply by polling market players as to their appropriate level—on similar lines to LIBOR! The fact that LIBOR was tolerated and never subjected to proper public scrutiny makes clear that the UK financial and monetary authorities deliberately left offshore markets only lightly regulated, with complete flexibility and—as has recently become apparent—lack of commitment on the part of the banks involved. 9. In theory, the only situation in which volumes do not matter is when demand is perfectly elastic, ie when any volume can be absorbed at any given price. By disregarding the volumes transacted, LIBOR helped bolster the illusion of infinite liquidity on financial markets—an illusion for which the world has been paying dearly ever since this liquidity evaporated in August 2007. 10. The increasing use of LIBOR as the benchmark for a variety of financial instruments, some of them designed for individual investors, went hand in hand with securitization. At the same time, it helped reduce the scope for truly long-term financial commitment, since artificial equivalents could be manufactured out of a series of shorter-term ones. As far as banks were concerned, what mattered was firm commitments on margins (and hence their contribution to profits) rather than interest rates—those risks were run by borrowers. Meanwhile, banking business models changed: off-balance-sheet assets were used so that risks could be transferred to third parties while maintaining margins on banks’ profit-and-loss accounts. The result was the creation of seemingly liquid short-term instruments that were actually tied to much less liquid longer-term instruments. The liquidity of the former was illusory, for the seeming maturity transformation between the 81

MacKenzie, Donald, “What’s in a Number?”, London Review of Books, Vol. 30, No. 18, 25 September 2008, pp. 11–12.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1265

underlying assets and the corresponding liabilities—neither of which now appeared on banks’ balance sheets— depended on the smooth functioning of “asset markets”. This ceased to apply once the financial crisis erupted. 11. LIBOR has become the crucial item of information for almost 550 trillion US dollars’ worth of assets (BIS figures) around the globe. Through the Interest Rate Swap (IRS) technique, LIBOR took on a significance that reflected both the banking sector’s control over a significant part of the securities market and the strong temptation to believe it had found the ultimate tool for valuing financial assets (in terms of profitability for banks, or quasi-banks, with access to the interbank market). The IRS technique created the illusion that there could be such a thing as a long-term LIBOR and that it could be expressed in relation to the short-term LIBOR—simply as a spread! The use of LIBOR as a price reference has since extended well beyond the realm of short-term interbank transactions, with potential for widespread distortion. 12. Many LIBOR assets are held by unsophisticated clients of financial institutions, as well as pension funds, insurance companies and so on. If, as it now appears, LIBOR has knowingly been set several basis points above the real interbank lending rate (the rate at which banks actually transact among themselves), the likely impact on such clients is immense. Borrowers may well have been paying too much, lenders earning too much and intermediaries enjoying too large margins—and this may have been going on for decades. Conversely, when the short-term interbank rate underwent a kind of “genetic mutation” to become the basis for mediumand long-term interest rates through its role in interest rate swaps, LIBOR arguably helped drive down the level of the “riskless” rate, ultimately fuelling the 2008 credit crisis. The alleged underreporting of LIBOR rates during the crisis years seems to confirm that it is no longer a meaningful price reference. 13. A new financial pact. As the Euromarkets developed and were organized beyond the reach of regulators, unprecedented opportunities arose for tax-avoidance and tax-evasion funds, given European governments’ increasing use of these markets. Matching up the needs of the various categories of players was simply a matter of financial technique, at which global practitioners soon became adept. From the mid-1970s onwards, a de facto informal pact on offshore finance thus gradually took shape, sheltering the sector from intrusive regulation. The tax revenues lost by governments through tax avoidance and evasion were shared out—in proportions that varied over time—among three groups of players: the avoiders and evaders themselves, borrowers (public and private) to whom cheap funds became available, derailing public finances in many investment-grade countries for decades to come, and (mainly London-based) intermediaries with their huge margins and commissions. As a result, excesses steadily built up in three areas: — excessive liquidity at artificially low interest rates, because risks were systematically underestimated; — excessive leverage in public and private finance; and — excessively large, complex and numerous financial institutions, some of which are today classified by the FSB as “global, systemically important financial institutions”—which means that they are “too big to fail” and “too complex to be regulated”. III. Bringing Back Professional and Ethical Standards 14. The marginal role of “UK professional standards” in today’s offshore banking. The question is to what extent there is now room for professional standards in UK banks, given that most of these banks do not have genuinely British counterparts and many of their employees are not UK citizens, or else have been moulded by the global financial culture rather than “old-fashioned” UK professional standards. A recent (2011) survey of ethical standards in the City by St. Paul’s Institute suggests that the “my word is my bond” culture no longer has many followers in London.82 The UK’s traditional professional standards appear to have been eroded by a financial culture that prides itself on having no roots and needing no supervision by political authorities (which would normally require market players to comply with rules designed to protect investors). Banks operating out of London—which are nominally “UK banks”—should be viewed in this light. Very little in the way of UK tradition (culture, regulation or supervision) has survived among London-based financial players, who mainly operate offshore. Another contributing factor is the constant concern of UK regulators and authorities to maintain London’s competitive lead as an international (“offshore”) banking centre and to avoid “regulatory arbitrage”. 15. One of the main issues that traditional UK banking standards were designed to deal with was conflict of interest. This arises whenever players are bound by several conflicting loyalties. The inevitable result is they misuse some of these loyalties in order to protect others. This definition of a conflict of interest is much broader than the one normally used in financial institutions’ codes of ethics. Thus defined, a conflict of interest is a fact of day-to-day economic and financial life. In order to deal wisely with such everyday situations, traditional professional standards deemed it essential to exercise sane judgement and make the necessary information available to all those with whom there were bonds of loyalty. In the case of offshore market dealings, every trader is in theory bound by a threefold loyalty: to his employer, to his client and to other market players. Each of these loyalties is, to a greater or lesser extent, enforced (and reinforced) by legislation, internal procedures, regulations and professional standards, and finally by ethical principles. In complex multifunctional financial institutions internal incentive schemes and promotion criteria often shift short-term profitability, the price of the firm’s shares and—indirectly—bonuses to the top of the list of loyalties at the expense of the two other 82

Value and Values: Perceptions of Ethics in the City Today, St. Paul’s Institute Report, October 2011, London, 24 pp.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1266 Parliamentary Commission on Banking Standards: Evidence

loyalties. There is no longer any room for sane judgement, and clients, markets as institutions and other market players become mere instruments in the hands of traders and other employees striving to meet personal and corporate targets. This suggests that professional standards cannot be analysed in isolation from the structural context typical of conflicts of interest in the financial sector as individual employees often find themselves trapped in conflicts of interest by their firm’s business model. In purely business terms such conflicts often translate into opportunities or synergies. For example, a salesperson may be instructed to develop a supposed relationship of trust with a client so that other divisions of the firm can sell the same client a range of lucrative products he does not actually need. Such conflicts of interest are built into the firm’s business model, and there is little the employee can do about it. 16. It is thus not only corporate culture that matters when assessing behaviour in the financial sector, but also business models, organizational arrangements and incentive schemes. Only when explicit and full account is taken of all these background elements do references to professional and ethical standards at individual level start to make sense. To lay the groundwork for fixing of what has gone wrong with professional standards, action must be taken at two levels: (1) at macro level, by providing a clear national framework for offshore financial activities, and (2) (even more important) internationally and at meso level, by auditing corporate organizations, cultures and incentive schemes. Only then can standards of behaviour, and the underlying values and principles, serve any useful purpose. 17. As we have seen, the detachment of offshore finance from the UK’s economic and social traditions and realities has been a top-down process. Once financial players detected the regulatory vacuum at international level, they devised products and organizations that could exploit it to the full. Through ad hoc internal incentive and remuneration schemes, recruitment procedures, promotion criteria and corporate culture, these organizations in turn attracted people who were only too willing to do their bidding. Such adaptations at the three interacting levels of reality (macro, meso and micro) were of course driven by the competitive market selection process. At all three levels, the emergence of a coherent (London-based) global offshore system was encouraged and supported by what at the time was seen as the science of market finance. This rapidly expanding field of expertise was viewed by many (including politicians, regulators and above all financial practitioners) as the purest expression of natural rationality—and at the same time yielded ample revenue for the UK exchequer. As the current crisis has unfolded, this paradigm is now looking increasingly questionable. Back then, however, such “scientific” policies as deregulation (culminating in the Big Bang) and refusal to interfere with “spontaneous’ market forces were entirely in keeping with the prevailing political tenets of the Thatcherite years, and with the economic interests of London and the UK. 18. The following preliminary steps are essential if the legendary professional standards of UK banking are to be revived: —

Regulation should be extended to the now unregulated offshore financial sector, which is where most LIBOR transactions take place.

—

Business structures and models should be made simpler and hence more transparent, enabling regulators to license only those banking models in which there are no inherent conflicts of interest.

—

Large banks should be broken up into smaller functional units. This step would presumably require an agreement among the G-20 to prevent regulatory arbitrage (ie firms moving to jurisdictions where large, complex financial institutions are still permitted).

—

Unlimited liability companies should be reinstated as required forms for certain kinds of activity.

—

Products offered directly or indirectly (via funds) to unsophisticated clients should be subject to regulatory vetting.

19. These steps concern the macro and meso level. Only when they have been implemented, or at least prepared for implementation, do actions and initiatives at micro (individual trader or bank employee) level have any chance of success. Possible ways of enhancing the role of professional and ethical standards would include: —

periodic auditing—as part of the licensing process—of corporate cultures and their links to internal incentive schemes. This should start with global, systemically important financial institutions and gradually be extended to all major players.

—

training in financial ethics as a prerequisite for all managerial appointments in the financial sector. Unlike the present system, which is based on rules and procedures, such training should be principle-based. Ethical standards are of particular importance in senior executive posts, given their exemplary role and their impact on corporate culture.

—

recognition of financial management as a profession in its own right, with its own internal disciplinary procedures, codes of ethics and penalties for non-compliance.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1267

APPENDIX (www.obsfin.ch) Manifesto of the Observatoire de la Finance (2009) For Finance That Serves the Common Good In March 2008 the Observatoire de la Finance published its manifesto entitled “For finance that serves the common good” based on its Report of 2007.83 Below is a second version of this manifesto that takes account of the many comments received over the past year and reflects what has become only too apparent during that year—namely, the widespread reluctance to see the crisis as anything but a mere cyclical upheaval, the helplessness of both the public and the private sector in the face of it, and the failure of purely technical measures to control it. Today we must regain control of the future before it is too late—reverse the financialization process and ensure that finance once again operates in the interests of human dignity and progress. The manifesto aims to alert men and women of good will to the danger that threatens our precious economic and political freedom because we have succumbed to the illusion that “greed is good”. Even if “greed” may appear to boost economic efficiency, it can only do so by profoundly undermining the very foundations of society: trust, respect and solidarity. The current crisis is not just economic or financial—it is system-wide. It is not simply a matter of the financial sector coming back into line with the “real” economy. The crisis is the outcome of years of unremitting pressure that has seriously weakened the material, social, intellectual and ethical foundations of the socioeconomic system based on political and economic freedom. If this systemic meltdown is not swiftly and correctly tackled, it may end up discrediting the market economy, whose primary vocation is to promote human dignity and happiness. Free societies never stand still; they are engaged in a constant, decentralized search for arrangements that are best suited to present needs. Today is no exception. Ever since the mid-1970s, finance has played an ever greater role not only in the economy, but also in the world views and aspirations of political, economic and social players. This rapid spread of financial practices and techniques, together with the attitudes and values they engender, has been termed “financialization”. Financialization has transformed both our economy and our society by increasingly organizing them around the pursuit of financial efficiency and a linear view of time that is peculiar to finance. Today’s crisis has brought this system close to breaking point, and there are some who see it as “the end of an era”. It is therefore vital not only to make a diagnosis but also to identify possible lines of action for the future. The Diagnosis Over the last thirty years most Western countries have based their promises of pensions and retirement benefits on savings invested in financial assets over long periods. The long-term viability of this arrangement now depends on the profitability of successive generations of financial instruments. A growing volume—in both absolute and relative terms—of the added value generated by the productive economy is therefore being channelled into returns on financial investment. This first brought pressure to bear on large quoted businesses, through the doctrine of “shareholder value”. These then passed the pressure on in three interconnected directions: to their staff around the world, under increasingly fierce managerial pressure to keep improving their performance; to consumers, under growing pressure to innovate as a result of ever more sophisticated marketing techniques; and to smaller businesses, suppliers and distributors in both the North and the South, which also found themselves under often unbearable pressure to perform. This pressure—which at first only affected the financial sector—thus spread to the rest of the economy and from there to the whole of our society, our culture and our everyday lives. The Western world now finds itself in the paradoxical situation that future financial performance requirements are compromising its present freedom and autonomy, including its political autonomy. The current crisis has shown this “radiant future” of promised performance to be as much of an illusion as the erstwhile communist utopia. Financialization has been greatly facilitated by the political appeal of deregulation and by the “laws”, “theorems” and so forth that Nobel prize-winners have put forward in support of financial rationality. The steamroller of the “efficiency ethos”, validated by supposedly scientific truths, has steadily crushed moral and ethical resistance. Today’s systemic meltdown has to be seen in this light. Financialization has led to the almost total triumph of transactions over relationships. Contemporary finance has prevailed because it has carried the pursuit of “capital gains”—the use of transactions to realize projected future returns with immediate effect—to extreme lengths. At the same time, the patience, loyalty, sustainability and trust on which relationships depend have been undermined, and distrust has become more widespread. For 83

Finance : Servant or Deceiver? Financialisation at the Crossroads, by Dembinski, Paul H.; in English by Palgrave, London, 2008, 200p ; Finance servante ou Finance trompeuse ? . Desclée de Brouwer, Paris, 2008 ;¿Finanzas que sirven o finanzas que engañan?, Ed. Piramide, Madrid, 2009 ; Finanse po zawale: od euforii finansowej ladu gospodarczego, Studio EMKA, Warszawa, 2011

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1268 Parliamentary Commission on Banking Standards: Evidence

a while this was concealed by the liquidity that was needed to perform the transactions, but in mid-2007 the less organized markets suddenly ran out of liquidity—and trust. The “efficiency ethos” has gradually worn down moral resistance and become the ultimate criterion of judgement. The extreme focus on efficiency has resulted in internal organizational procedures in which tasks and responsibilities are assigned so specifically that staff lose sight of what their work actually involves. This has led to widespread “ethical alienation”: staff no longer wonder, or care, whether their work is meaningful or justified. When separated from moral considerations, the “efficiency ethos” has led to increasingly crude manifestations of greed. This has created more scope for the selfishness that is inherent in human nature. Relationships of trust are all too often sacrificed to one partner’s wish to get out while the going is good. Such barefaced acts of betrayal or disloyalty risk destroying what is the essential mechanism in any free society or market economy, namely trust between people. The free market, based on players’ sense of responsibility, is making way for a “greed market” which will in turn require escalating controls, rules and procedures in both the public and the private sector. This will not only be very costly, but will make players even less willing to take responsibility for their actions. Possible Lines of Action This diagnosis suggests that the fundamental values of freedom of judgement, responsibility and solidarity— on which the common good depends, and without which a free and humane society cannot exist—are now under threat. This is not just a question of “capitalism with a moral face”. The economy must be put back in its proper place, which includes its place in relation to government. —

The reality, methods and morality of the world view behind contemporary economic and financial theories must be critically assessed. This may end up challenging the dogmatic focus on economic and financial efficiency and justifying renewed ethical and political concerns about the common good. Where appropriate, the results should quickly be made an integral part of economic, managerial and financial training courses. At the same time, they should lead to a redistribution of research and educational resources that will encourage a fundamental reform of economic thinking.

—

We need new incentives to develop long-term commitments in all areas of the economy and the financial sector, so that fewer relationships will be destroyed by untimely transactions in the interests of short-term gain. A new balance must be struck—in both qualitative and quantitative terms—between relationships and transactions, both of which are essential to society. Making transactions more “sticky” would also encourage relationships and efficient production rather than efficient allocation. This could lead to a rediscovery of the benefits of “shortening transaction chains”. This huge undertaking would have implications in many different fields: finance, taxation, employment, the environment, local development and so on.

—

We must introduce methods and resources that will allow us to break free from economic and financial timeframes and eventually loosen the stranglehold of actuarial forecasts and other constraints which excessive returns on capital have imposed on production and society. This will require great political courage and integrity, since the professional interests of financial intermediaries may be threatened.

—

The financial sector must be stabilized and restructured so that it can perform its two key functions on behalf of the economy and society, namely channelling savings and financing productive investment. This may make the sector a good deal less complex and lead to closer scrutiny of the economic and ethical justifications for certain kinds of remuneration.

—

The question of how to divide up the damage caused by the crisis must be swiftly dealt with. This needs to be done without preconceptions and with due regard for fairness, especially towards the poorest and weakest, as well as future generations. The full range of possible instruments, from taxation to money creation, will need to be looked at dispassionately. Consideration must be given to the question of how the damage should be divided up between the North and the South, taking account of complementarities as well as interdependencies between them.

—

There are now repeated calls for tighter regulation of the economy, and above all the financial sector. Reduction of the role of government to that of a mere ”night watchman” has allowed the world to be taken hostage by private interests. However, excessive trust in “minimum government” should not be replaced by its converse, a naïve faith in the omnipotence of government. The common good cannot be achieved by mere regulation, but only through daily efforts by private players who take their values and their responsibility to society equally seriously.

31 August 2012

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1269

Written evidence from the Office of Fair Trading The Office of Fair Trading 1. The Office of Fair Trading (OFT) is the UK’s consumer and competition authority. The OFT’s aim is to make markets work well for consumers. It performs this role by deploying a variety of tools including the enforcement of consumer and competition law and advice to policy makers where wider government policies affect competition and markets. Summary 2. This submission provides an outline of the OFT’s concerns regarding competition in retail banking and the actions it has taken, and is planning to take, to address these concerns. This relates primarily to the level and effectiveness of competition in retail banking and the effects of this (as set out in question 4 of the call for evidence) and actions that regulators and competition authorities can take to address the lack of competition in these markets (in response to questions 5 and 6). 3. The OFT’s response can be summarised as follows: —

the relationship between competition and standards in retail banking is complex, as is the case in many other sectors. Standards may suffer either where competition is weak with providers not losing customers when they fail to provide a high quality and well priced service, or where there is intense competition on a headline aspect of a service at the expense of other important aspects of the service. The latter may lead to low headline prices but an increase in less visible ancillary charges;

—

The OFT’s concerns in relation to competition in retail banking include: —

high levels of market concentration and problems for new entrants and smaller banks in competing effectively in the market;

—

low levels of transparency over the costs of using some financial services as well as real and perceived problems with switching providers, which limit the extent to which consumers are engaged with these services and can drive effective competition; and

—

concerns around the control of payment systems by banks and a consequent lack of focus on customer needs and innovation.

4. Over the past few years the retail banking sector has been subject to significant scrutiny by the UK’s competition authorities including the OFT. These interventions have led to a number of improvements.84 However, concerns about the functioning of competition in the retail banking sector remain and progress appears to have been slower than might have been expected, with a lack of consumer focus in much of the sector. 5. As a result of these concerns, the OFT launched a programme of work on retail banking in July 2012. This is designed to achieve a more competitive and consumer focused retail banking sector. 6. The programme of work will also help inform the OFT’s response to the Independent Commission on Banking (ICB). This recommended that the OFT consider making a market investigation reference to the Competition Commission by 2015 if it had not already done so and if sufficient improvements in the market have not been made by that time. Evidence About the Level of Competition in Banking Markets 7. Competition in the banking sector has not been effective for some years. The Cruickshank report on Competition in UK Banking85 highlighted concerns about a lack of effective competition in 2000, in particular that: —

the market was highly concentrated, especially for small and medium-sized enterprises (SME) banking;

—

customers perceived significant obstacles to switching current accounts and there was a lack of information provided to personal customers and SMEs; and

—

the banks were effectively in control of the money transmission service.

8. Since then there have been a number of reviews and interventions by competition authorities, consumer bodies, regulators and the Government. The OFT considers that these have brought benefits but progress has often been slow and incremental, and fundamental concerns remain about competition in these markets. This 84

85

For example, the OFT’s focus in its 2008 market study was on the charges for unarranged overdrafts and this focus continued during and after the OFT’s test case on whether unarranged overdraft charges could be assessed for fairness. The OFT’s progress update for the PCA market in March 2011 found reductions in 2010 relative to 2009 in both unpaid item charges and the revenues from consumers incurring unarranged overdraft charges from the largest banks in Great Britain (Personal current accounts in the UK—progress update, March 2011). Competition in UK Banking, a Report to the Chancellor of the Exchequer, Don Cruikshank, March 2000.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1270 Parliamentary Commission on Banking Standards: Evidence

was confirmed by the report of the Treasury Select Committee on competition and choice in retail banking in April 201186 and the Independent Commission on Banking (ICB) in September 2011.87 9. This submission addresses three themes identified in recent reviews and studies as well as two further indicators of concern with the retail banking sector: — concentration and barriers to entry: the level of competition in the sector and problems that new entrants and smaller banks face in competing effectively with larger established providers; — transparency and switching: low levels of transparency over the costs of using current accounts combined with both real and perceived problems with switching providers which limit the extent to which consumers can drive effective competition; — payment systems: concerns around control of payment systems by banks and a consequent lack of focus on customer needs and innovation; — customer complaints: the level of complaints from customers can provide an indicator of incentives to improve customer service and maintain high professional standards more widely; and — sales of linked products: levels of sales of linked products and the potential for miss-selling are indicators of concerns in relation to banking standards. Concentration and Barriers to Entry 10. The Cruickshank report found in 2000 that the retail banking market was highly concentrated, especially for SME banking, and the Competition Commission (CC) inquiry on the Lloyds TSB/Abbey National merger in 200188 found that the big four banks had a strong and entrenched position in the personal current accounts (PCA) market. 11. Most banking markets experienced little change in concentration between 2000 and 2008. The OFT’s market study of PCAs in 200889 found that overall the relative market shares of the four established banks (Lloyds TSB, RBSG, Barclays and HSBC Group) and the challenger banks (HBOS, Abbey, Nationwide and others) were almost unchanged between 1999 and 2007, although HBOS’s position had strengthened. 12. More recently and during the financial crisis however, concentration in the sector rose, with the merger between Lloyds TSB and HBOS in 2008 removing a challenger bank which had been a driver of competition in the market, and increasing the size of the existing market leader.90 This increased concentration in an already concentrated market. The ICB reported in 2011 that the largest four banks accounted for 77% of PCAs and 85% of SME current accounts.91 13. The OFT’s review of barriers to entry, expansion and exit in retail banking92 found that the greatest barriers to entry and expansion were the challenges faced by new and expanding providers in attracting personal and SME customers to switch their accounts. The difficulty of expanding market share can deter firms from entering these markets. 14. Switching rates are low in the PCA market and are only slightly higher for SME banking and savings accounts. Historically, switching was noticeably higher for mortgages and credit cards, although there has been a substantial fall in mortgage switching since 2008.93,94,95 15. The low propensity of customers to switch providers makes it difficult for new entrants to achieve the necessary scale required to recover fixed costs, in particular, the significant IT investment required to provide retail banking services.96 16. The OFT’s review also found evidence for the following barriers to entry:97 — some firms reported difficulties and uncertainties around the process of obtaining authorisation from the FSA to accept deposits and offer mortgages, which delayed entry and made it harder to raise capital; — it appeared that new capital requirements, along with liquidity standards, could have the potential to exacerbate differences between incumbents and new entrants, for example, by imposing higher fixed costs of compliance; 86 87 88 89 90

91 92 93 94 95 96

97

Competition and choice in Retail Banking, Treasury Select Committee, April 2011. Final Report Recommendations, Independent Commission on Banking, September 2011, p.16. Lloyds TSB Group Plc and Abbey National Plc: A report on the proposed merger, Competition Commission, July 2001, p.4. Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp.25–27. Anticipated acquisition by Lloyds TSB of HBOS plc Report to the Secretary of State for Business Enterprise and Regulatory Reform, Office of Fair Trading, October 2008, p.5. Final Report Recommendations, Independent Commission on Banking, September 2011, p.16. Review of barriers to entry, expansion and exit in retail banking, Office of Fair Trading, November 2010, pp.6, 10, 63. Review of barriers to entry, expansion and exit in retail banking, Office of Fair Trading, November 2010, pp.125–129, 135–6. Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp.31–2. Final Report Recommendations, Independent Commission on Banking, September 2011, p.180. This could account for up to two thirds of start-up costs, much of which would be likely to be sunk and not recoverable in the event of exit from the market. Review of barriers to entry, expansion and exit in retail banking, Office of Fair Trading, November 2010, pp. 7–9.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1271

— —

credit risk information about the smallest SMEs was limited, which could make it harder for new banks to lend to the smallest firms; and the ability of some firms to expand or, in some cases, maintain existing operations had been constrained by the lack of interbank lending from the financial crisis and recession.

17. If providers face significant difficulties in entering and competing in the market, they will be deterred from doing so and incumbent providers will not face the threat of new entrants challenging them for business. In addition, the low levels of switching in PCAs may indicate that competition between incumbent providers is limited with reduced incentives to innovate, increase their quality of service, reduce costs and price competitively in order to attract and retain customers. 18. Moreover low switching rates themselves can also represent a further barrier to expansion in other retail banking product markets (such as savings and credit products) because current accounts may act as a gateway for the sale of additional products.98 19. The effect of these competition problems on standards in retail banking is complex, as is the case in many other sectors. Standards may suffer either where competition is weak with significant barriers to entry with providers not losing customers and their revenues when they fail to provide a high quality and well priced service, or where there is intense competition on a headline aspect of a service at the expense of other important aspects of the service. The latter may lead to low headline prices but an increase in less visible ancillary charges. Competition in banking may be seen as weak and focused on certain areas with charges focused on other less visible areas of bank accounts. Transparency and Switching 20. Consumers’ decisions about whether to switch bank accounts are complex with a number of likely causes. The OFT will be exploring such issues and conducting some behavioural economics research on these issues as part of its programme of work on retail banking. 21. While there may be many reasons why consumers switch, we consider that the transparency of competing offers and the actual and perceived ease of switching are among the key determinants of consumers’ ability and willingness to change provider. These elements of transparency determine the degree of competitive constraint on providers to meet their customers’ needs in order to retain them. 22. The OFT’s market study on PCAs in 2008 found that it was difficult for consumers to compare accounts because of the lack of transparency of account costs. The two most significant costs for consumers are the least transparent—interest foregone (by holding money in a current account rather than in a higher rate in a savings account) and insufficient funds charges (where providers charge consumers for using either arranged or unarranged overdrafts). 23. The market study found that it was difficult for consumers to access the information they need in order to work out the cost of running their account and therefore to make comparisons across providers. It was particularly difficult for consumers to compare insufficient funds charges across banks because this requires a comparison of both the amount of the charges as well as how they are applied, which is complex and varies between provider.99 This study also noted that the quality of service is not easily observed by consumers before selecting a provider, again making an accurate comparison difficult. 24. The study also found that real and perceived difficulties with the switching process100 were also acting as a barrier to consumers switching provider. Consumers were particularly concerned about miss-directed payments and having to rectify any problems.101 25. The market study concluded that consumers’ lack of appetite for switching may generate little pressure on banks to raise the standard of their provision of banking services in order to retain customers, with implications for customers and the public’s view of the banking sector. It found that the overall picture is one of consumers who are not well informed, are relatively unengaged in the market for current accounts and are uninterested in switching.102 26. The CC’s investigation of the PCA market in Northern Ireland in 2007103 similarly found significant obstacles to searching and switching to alternative suppliers. It found a lack of clarity and a level of complexity in charging structures and practices that would be likely to impede searching and switching by customers. While some obstacles were perceived rather than real, these perceptions affected consumer behaviour, leading to a high level of customer indifference and a lack of searching and switching. 98

Review of barriers to entry, expansion and exit in retail banking, Office of Fair Trading, November 2010, p. 10 Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp. 89–90. 100 45 per cent were not very or not at all confident that it would go smoothly. 101 Such concerns are at least partly justified given that in the OFT's survey 28 per cent of those that had switched reported some kind of a problem. It was particularly significant that 33 per cent of switchers would be unlikely or very unlikely to recommend switching. Source: Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp.99–104, 107. 102 Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp. 85, 107–108. 103 Personal current account banking services in Northern Ireland market investigation, Competition Commission, May 2007, p.10. 99

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1272 Parliamentary Commission on Banking Standards: Evidence

27. The OFT notes that the Department for Business, Innovation and Skills has launched a consultation on its Midata proposals.104 If implemented, these may provide consumers with useful data on their use of bank accounts which may enable a more detailed comparison of the cost of these accounts and allow consumers to see the extent of benefits from switching provider. Payment systems 28. Some of the Cruickshank report’s concerns about payment systems also remain. Payment systems are still under the control of banks. Although it reversed its position in July 2011, the Payments Council’s decision to consider the abolition of cheques raised questions about the extent to which consumers’ views are reflected in its governance. There are also questions about the pace of innovation when it is organised collectively, reflected, for example, in the time it took to introduce Faster Payments. Some questions have also been raised about whether the need for access to payment systems creates a barrier to entry, although both the OFT105 and the ICB106 found limited evidence to support this view. 29. In July 2012, the Government consulted on options for reforming the regulation and governance of payment networks because they hadn’t responded effectively to the needs of consumers and in order to facilitate competition by permitting open access to participants on reasonable commercial terms.107 Customer Complaints 30. The OFT notes that levels of satisfaction and complaints in relation to retail banking, particularly when examined over time may be useful indicators of the level of dissatisfaction with banks, and can provide evidence of changes in incentives to maintain professional banking standards. Data from the Financial Ombudsman Service covering specific complaints on retail banking and credit products may be considered alongside evidence on levels of switching across the retail banking sector. Sales of Linked Products 31. This submission concentrates on the areas of retail banking in which the OFT has carried out most work and where it is seeking to undertake further work. However, there are other areas where the OFT has carried out less recent work, which may still be useful indicators of professional standards being below that which many might expect. 32. One example of this is the sale of payment protection insurance (PPI), where the OFT carried out work between 2005 and 2007.108 33. In June 2012, HSBC, Royal Bank of Scotland and Lloyds Banking Group agreed with the FSA to compensate some customers who were miss-sold PPI after the FSA found evidence of serious failings in the way PPI was sold to customers. Such widespread miss-selling may represent another indicator of a lack of incentives on banks to maintain high professional standards in their dealings with customers. Summary 34. These themes all indicate a lack of customer focus on the part of current account providers, which may be viewed as a diminution of standards of provision. Providers could be argued to be exploiting consumers’ particular behavioural biases together with their inability to access and assess information and hence to make effective decisions, rather than helping consumers find the most suitable account. The PCA market study found that banks profited from these factors by earning much of their revenues from less transparent sources, such as foregone interest and unarranged overdraft charges. In particular, the lack of visibility of insufficient funds charges and consumers’ inability to understand and control them meant that some banks appeared to see them as a way to generate additional revenue without affecting demand for their accounts.109 35. In 2008, the OFT expressed concerns around the merger between Lloyds TSB and HBOS. One concern expressed was that Lloyds’ greater share of the market, coupled with characteristics of the market, would encourage it to attach more weight to enhancing margins on current customers than to acquiring additional customers.110 104

Midata 2012 review and consultation, see: http://www.bis.gov.uk/Consultations/midata-review-and-consultation Review of barriers to entry, expansion and exit in retail banking, Office of Fair Trading, November 2010, p.9. 106 Final Report Recommendations, Independent Commission on Banking, September 2011, p.173. 107 Setting the strategy for UK payments, HM Treasury, July 2012. 108 In September 2005, Citizens Advice submitted a super complaint to the OFT regarding PPI, and in response to this the OFT carried out a market study from April 2006 and made a market investigation reference to the Competition Commission in February 2007. 109 Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp.2, 4–6. 110 Anticipated acquisition by Lloyds TSB of HBOS plc Report to the Secretary of State for Business Enterprise and Regulatory Reform, Office of Fair Trading, October 2008, pp.5–6. 105

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1273

Action Taken by the OFT to Address Competition Concerns 36. In October 2009 and following its 2008 market study, the OFT set out initiatives it had agreed with PCA providers and industry to make PCA costs more transparent and the switching process more reliable and trusted. 37. To improve transparency, so that consumers could more easily understand the costs of their accounts and compare with others, banks: — introduced annual summaries of the cost of their account for each customer, which will help them to focus on the value they are getting in a similar way to annual car or house insurance renewal quotes; — made charges prominent on monthly statements, so that consumers are more aware of the charges they pay; — provided average credit and debit balances, which will help consumers to estimate the potential benefits of switching bank; and — produced illustrative scenarios showing unarranged overdraft charges, giving consumers an idea of the costs for different patterns of use. 38. To improve the switching process, the following measures were introduced following work with Bacs, the payment processor: — steps to reduce problems that arise from transferring Direct Debits; — measures to reduce the impact on consumers of any problems with transferring Direct Debits; and — a new consumer guide and website as part of efforts to increase consumer awareness of the automatic switching process. 39. Following the OFT/FSA banking test case which examined whether unarranged overdraft charges could be examined in full for fairness, the OFT held discussions with PCA providers in relation to its concerns around unarranged overdrafts. As a result, in March 2010, the OFT noted that unarranged overdraft charges had changed in the following ways: — unpaid item charges, levied when a bank refuses to make a payment, fell from an average of around £34 in 2007 to around £17 in 2010; — per transaction paid item charges, levied when an unarranged overdraft is granted, fell from an average of around £30 in 2007 to around £22 in 2010; — the majority of PCA providers now use Faster Payments for standing orders and one off payments; and — commitments were secured from the banks to improve transparency for customers about their accounts as well as making it easier to switch accounts. 40. The OFT’s discussions led it to expect significant developments between 2010 and 2012, including: — greater ability for customers to opt out of being granted unarranged overdraft facilities and the charges associated with them; — more tools available for customers to control their balances and avoid going overdrawn; and — better treatment of customers who do go overdrawn and get into financial difficulty. 41. These improvements were supported by wider banking industry commitments, which were also announced in March 2010: — the development of minimum standards to apply when offering customers the ability to opt out of unarranged overdraft facilities; — the development by banks of best practice for customers in financial difficulty who incur unarranged overdraft charges; and — an industry working group to develop ways of giving consumers greater control and access to real-time information on their account. 42. New entrants in the market, including some big brand names, were also expected to stimulate further competition during that time. 43. The OFT committed to report back on the impact of these initiatives on the market during 2012. Further Actions for Regulators and Competition Authorities 44. The ICB made a number of recommendations aimed at increasing competition in the PCA market. These included a switching re-direction service, an enhanced competition role for the Financial Conduct Authority (FCA) and OFT to take steps to improve competition.111 111

Final Report Recommendations, Independent Commission on Banking, September 2011, p.17.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1274 Parliamentary Commission on Banking Standards: Evidence

45. The Government’s Consumer Credit and Personal Insolvency Review112 announced further initiatives to improve the transparency and control of unarranged overdraft charges for consumers. These included giving consumers the option to receive a text or email alert when their balance fell below a certain level, making them aware of a grace period when they can credit funds to put their account back within their overdraft limit and so avoid being charged and a small buffer zone within which unarranged overdraft charges would not be levied. The Role of Regulators 46. The OFT notes that it is important to ensure that regulatory processes do not act as a barrier to entry, preserving incumbents and restricting unduly the competitive constraints providers face, which may lead to a reduced focus on professional rigour and standards. The OFT considers that competition and financial stability are consistent, providing there is proper regulation to tackle excessive risk taking, but not overly to restrict competitive constraints that can discipline providers. The Prudential Regulatory Authority 47. The OFT has committed to providing support to the Prudential Regulation Authority in its review of the application of prudential requirements in order to ensure that new entrants and smaller banks are not disproportionately affected by, for example, requirements to hold proportionately more capital than major incumbents. Competition from outside the traditional banking model may also create challenges for the process of granting authorisation. It is important that regulators do not unduly constrain competition by taking the business model of incumbent and traditional banks as the starting point for the design of new rules in ways that could disadvantage new technologies and innovative providers. The Financial Conduct Authority 48. A key potential source of change in the banking sector in terms of regulation is the establishment of the FCA. It has a clear remit to place effective competition at the heart of its regulatory approach, expressed in terms of using its powers to make markets work well for consumers, so that competition is regarded as a key mechanism for achieving effective outcomes for consumers. 49. The FSA signalled a change in approach by the FCA: “The creation of the FCA provides an opportunity to develop a new approach to conduct regulation, addressing the problems which have beset UK retail financial services for 20 years.... A key task will be to ensure that the conduct of participants is compatible with fair and safe markets. The FCA will, therefore, focus more closely on wholesale conduct than the FSA. It will adopt a more issues and sector-based supervisory approach across the 24,500 firms which it will regulate for conduct and prudential purposes.”113 50. The OFT and FSA are developing a concordat to clarify the respective responsibilities of the OFT and the new FCA regarding competition. The OFT’s Programme of Work on Retail Banking 51. On 13 July 2012, the OFT launched a programme of work on retail banking with the objective of achieving a more competitive and consumer-focused sector. 52. The OFT considers that a well-functioning retail banking sector would have the following characteristics: — Barriers to entry and expansion would be lower — Consumers would be sufficiently engaged with their banking services to drive competition. — Consumers would have a broad choice of provider. — Competition would be driving providers to operate more efficiently and to innovate. — Providers would be more customer-focused—serving customers with products that are wellsuited to their needs and in a way that makes it easy for customers to make well-informed decisions about when and how they are used. 53. The first project in this programme of work is a review of the PCA market. The OFT committed in 2010 to a detailed review of the PCA market in 2012. 54. In seeking to establish how the market has evolved since the OFT’s market study in 2008, this review will look at whether the initiatives the OFT has agreed with the banks, and described above, have been successful at improving the switching process, increasing the transparency of PCA charges and allowing people to manage their accounts more effectively. 112

Consumer Credit and Personal Insolvency Review Formal Response on Consumer Credit, HM Treasury and Department for Business Innovation and Skills, November 2011. 113 The Financial Conduct Authority—Approach to regulation, FSA, June 2011.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1275

55. The programme of work will also involve the OFT considering the operation of payments systems and the SME banking market. It is also planning to consider in more detail at the way consumers make decisions and engage with retail banking services, including through the application of research on behavioural economics. 56. The OFT notes that there is scope for greater competition in this sector, with recent entry from Metro Bank and Virgin Money (through the acquisition of Northern Rock) and stimulus given to the market by means of the planned divestments from Lloyds Banking Group to the Co-op. More fundamentally, new technology may increase the scope for competition from outside the traditional banking model, for example from online or mobile innovation. However, whether these developments will generate increased competition will depend in part on whether consumers have sufficient information and are now more engaged with these services such that they can drive competition among providers. Effective competition would be expected to generate benefits including lower prices and higher standards and quality of service. 57. In the event that the OFT does not see real change from providers over the course of this programme of work, a more radical approach may be considered necessary. The ICB recommended that the OFT actively consider making a market investigation reference to the CC114 by 2015 if it had not already done so and if sufficient improvements in the market had not been made by that time.115 The OFT’s programme of work is aimed at informing its response to this recommendation, although a reference remains a possibility at any time if the legal test is met. 4 September 2012

Written evidence from the Oxford Centre for Mutual and Employee-owned Business, Kellogg College, University of Oxford Summary This submission argues that the relative lack of financial diversity within the UK financial services sector was a contributory factor behind the problems witnessed in banking over the past few years, and argues that a stronger presence of co-operative and mutual banks and financial institutions—a critical mass—would contribute towards greater systemic stability for the financial services sector and thereby for the economy as a whole. The submission argues that to achieve a healthier financial services sector in this way would require changes to the current regulatory system that resulted in regulators recognising properly the benefits that mutual organisations bring to the financial services sector—which includes reduced systemic risk, a focus on customer service, enhanced competition, and member engagement. The terms of reference of the Commission are to consider and report on: (a) professional standards and culture of the UK banking sector, taking account of regulatory and competition investigations into the LIBOR rate-setting process; and (b) lessons to be learned about corporate governance, transparency and conflicts of interest, and their implications for regulation and for Government policy; and to make recommendations for legislative and other action. The Commission would welcome responses to the following initial questions: 1. To what extent are professional standards in UK banking absent or defective? How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets? No comment 2. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole? No comment 3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector? The degree of public and consumer trust in banks has fallen in the course of and as a result of the banking crisis. The evidence—some of which is reported below—suggests that customer relationships with plc banks and insurers are typified by convenience and price, and also in some cases by a perception of intransigence, whilst with mutuals, customers habitually report that they feel they benefit from value, service and a sense of belonging. 114

The CC can take a detailed and fresh look at the market and has a range of behavioural and structural remedies at its disposal, up to and including requiring the break-up of incumbents. 115 Final Report Recommendations, Independent Commission on Banking, September 2011, p.18.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1276 Parliamentary Commission on Banking Standards: Evidence

Research commissioned by the Building Societies Association from GfK NOP found customer service to be better in mutuals than in other organisations, with satisfaction levels at mutuals higher than at plc banks on both savings and mortgages, and with significant differences in mutuals’ favour on questions regarding value for money, fairness, trust, support for customers getting into financial difficulties, and comments and feedback being taken seriously (BSA, 2010). This BSA-commissioned research has been repeated each year since 2007, and the above results have been found consistently, each year. The Association of British Insurers 2009–2010 Customer Impact Survey—which explores in depth the relationship a customer has with their company—found the score for the industry as a whole fell from 52% in 2008 to 51% in 2009 (ABI, 2010), but for mutual insurers the score in 2008 had been 57%, 1 and this rose to 58% in 2009. 2 Customers of mutual insurers and friendly societies were more likely than customers of plcs to believe that their company really cares about them and treats them fairly. 52% of mutual customers agreed or strongly agreed that the insurance industry has an excellent reputation, compared with 48% of customers of plcs. The key point is that building societies, mutual insurers, friendly societies, credit unions, and cooperative banks have an alternative business model from plcs, as they are required to serve the interests of their members rather than maximising financial returns to external shareholders. These organisations therefore have different incentives and will respond differently to new developments in the economy, thus reducing the risk of herd behaviour and hence producing a more stable and robust financial system. The different business models also provide competition to each other, of a qualitatively different type than is provided by just adding an additional firm with the same business model. Thus, firstly, the different business models have different behaviours and outcomes, and some may be more appropriate for some markets and functions and less so for others. That in itself is a reason for ensuring diversity of providers is not obstructed. Secondly, the different behaviours and reactions to events mean that a diversified financial system is more stable and robust, and less likely to create bubbles and crashes. Given the costs of the 2007–2008 credit crunch, this stability is worth a lot—including in financial terms. Thus, if there are opportunities to boost corporate diversity, then even if these might be expensive in the short run, such policies would likely pay dividends in the long term. Avoiding the costs of investing in diversity may prove to be a false economy—and an extremely expensive one at that. Thirdly, the greater degree of competitive pressure that will be produced by different business models competing against each other will tend to improve the service to customers over and above the improvement referred to in point one, of just greater choice. Corporate diversity promotes competition and drives further innovation and performance improvements. 4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (a) the following general themes: the culture of banking, including the incentivisation of risk-taking; the impact of globalisation on standards and culture; global regulatory arbitrage; the impact of financial innovation on standards and culture; the impact of technological developments on standards and culture; corporate structure, including the relationship between retail and investment banking; the level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects; taxation, including the differences in treatment of debt and equity; and other themes not included above; and (b) weaknesses in the following somewhat more specific areas: the role of shareholders, and particularly institutional shareholders; creditor discipline and incentives; corporate governance, including— the role of non-executive directors—the compliance function—internal audit and controls—remuneration incentives at all levels; recruitment and retention; arrangements for whistle-blowing; external audit and accounting standards; the regulatory and supervisory approach, culture and accountability; the corporate legal framework and general criminal law; and other areas not included above. A major reason for promoting corporate diversity within the financial services sector relates to the problem of systemic risk and instability.3 What one wants is a diversity of appetite for risk within the system. Mutuals will tend to have less appetite for risk than will shareholder-owned banks. The case of the Dunfermline Building Society is the exception that proves the rule: it failed not because of the weakness of the building society business model but on the contrary, because it was tempted away from that business model and was adopting policies and practices more appropriate to a shareholder-owned bank. Ayadi et al. (2009) found there to be a natural business model associated with different types of ownership structure, and that institutions which got into trouble were those that deviated from that natural business model associated with the particular ownership structure they had. That was certainly the case for Dunfermline. On appetite for risk, one of the features of a mutual and of many “stakeholder value” banks is that they cannot easily inject external capital, and this tends to limit their risk appetite, and that was precisely what Ayadi et al. (2009 and 2010) found to be the case, consistently, across Europe. The Dunfermline Building Society deviated away from the tolerance of risk associated with the inability to inject easily more external capital. This feature of mutuals limits their risk appetite and thus means that a financial services sector containing a critical mass of mutual organisations will have a spread not only of business models but also therefore of

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1277

appetites for risk. This is a positive feature and one that should be applauded and encouraged, to create a more stable and robust financial services sector. Ironically, the Regulator in practice takes the opposite view: this inability to inject easily more external capital is viewed as a weakness in mutuals. Similarly, the FSA is currently threatening to pursue a policy in relation to mutual capital for mutual insurers and friendly societies that could prove disastrous for the sector. 5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally? The Government should: (i) develop an effective set of measures to promote a greater degree of corporate diversity within the financial services sector; (ii) task the Bank of England with developing a measure of the degree of corporate diversity within the financial services sector, and for then tracking progress towards achieving the Coalition Government’s commitment to achieving a greater degree of corporate diversity within the financial services sector, including through the promotion of mutuals; and (iii) this measurement exercise should be repeated at regular intervals, with the information being made publicly available. 6. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice. Within the new regulatory framework, there needs to be a clear responsibility in the regulator’s charter to promote diversity of corporate ownership within the financial services sector. In the past, the objection to taking this step is that it would require legislation. But now there is going to be legislation in any case, and there is going to be a new regulator, so this is the moment to ensure that the regulator is given proper responsibility for fostering corporate diversity within the financial services sector, including through the promotion of mutuals. So, firstly, the regulator must have a responsibility and a requirement to demonstrate that they are taking the need to promote greater corporate diversity in the financial services sector into account. Secondly, the regulator needs to have somebody within the organisation who is at a senior level defined as a head of mutuals policy and who is therefore charged with demonstrating that regulation does not prevent mutual organisations from competing on an equal basis with nonmutual forms. (There is not anyone who has that particular remit currently and, therefore, there is no particular incentive for anyone in the organisation to think beyond the standard plc model.) Thirdly, regulation needs to be proportionate. Regulation and the demands it makes represents a powerful competitive advantage for large incumbent players because they can absorb that cost. The resource costs and the monetary costs impact more heavily on smaller players, constituting a barrier to entry—you have to comply with regulation before you have done your first deal—and it stops the smaller people thriving in a way that would provide meaningful competition to the big incumbents. On the whole that disadvantages mutuals, and it is certainly a barrier to greater corporate diversity within the financial services sector. Ironically, it actually favours the “Too Important to Fail” banks that are part of the problem. There is a precedent with the rules relating to credit unions which much more effectively enable new organisations to be developed, and this approach could and should be translated for other forms of mutual, to remove the barriers to entry and early survival. 7. What other matters should the Commission take into account? There is huge pressure from the regulatory environment, and from certain elements of the media, for mutuals to behave and measure themselves like non-mutuals, because that is how they get compared. There is little appreciation that a diversity of business models is precisely what is needed. Non-plcs should be encouraged to articulate why they are different, why they measure themselves differently, why their risk appetite is different, why their stakeholders are different, and why what success looks like is actually different. Firms with diverse ownership and business models are trying to do different things for different people with a different overall purpose. It is important to view the whole—diverse—financial services sector as both innovative and fluid, and this applies within the various business models as well as to the balance of market shares between such models. Thus, the mutual sector could transform its own models; we are not necessarily talking about a photograph of today’s mutual model. For example, one of the findings of Ayadi et al. (2010), which analysed the role of cooperative banks in Europe, is that the UK is the only one of the countries studied that did not have what they termed “central network institutions”—the collective. For example, Rabobank is not only a bank in its own right but it is also a confederation of 52 “little Rabobanks”. So, while one difficulty for non-plcs may be their

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1278 Parliamentary Commission on Banking Standards: Evidence

small size, there are models that can cope with that; the central network institutions enable their members to buy-in economies of scale from outside because they are too small to generate them inside—but the crucial difference between that and outsourcing is that the central network institution is actually owned by the members, and is an integral part of the business model. However, culture and tradition have tended to prevent such a model developing in the UK, and there would also be substantial difficulties combining legacy systems and co-ordinating the pooling of resources and procurement in order to benefit from cost reductions. Furthermore, such a model could be difficult to establish under current UK competition law. Nevertheless, it is important to stress that the mutual model is an evolving one, and there are a range of interesting success stories across Europe, and indeed in North America and elsewhere. The UK has a lot to learn from the experience of other European countries which clearly value the advantages of diversity in the financial sector. Likewise, the third element of the Butterfill Act enables—subject to the passage of appropriate secondary legislation—all types of mutual institution to merge with each other (apart from credit unions which are exempt from the legislation), yet secondary legislation has so far been enacted only to enable a building society to merge with an industrial and provident society. Other types of mutual-to-mutual mergers are still not possible. This is an anomaly that should be corrected. References Association of British Insurers (ABI) (2010), 2009–2010 Customer Impact Survey, ABI, London. Ayadi, Rym, Reinhard Schmidt, Santiago Carbo Valverde, Emrah Arbak and Francesco Fernandez (2009), Investigating Diversity in the Banking Sector in Europe: The Performance and Role of Savings Banks, Centre for European Policy Studies (CEPS), Brussels. Ayadi, Rym, D.T. Llewellyn, R.H. Schmidt, E. Arbak, and W.P. De Groen (2010), Diversity in European Banking: Why Does it Matter?, Centre for European Policy Studies (CEPS), Brussels. Building Societies Association (BSA) (2010), Customer service at mutuals is better than at banks, BSA, London. Ownership Commission (2012), Plurality, Stewardship and Engagement: The Report of the Ownership Commission, Mutuo, London. 11 September 2012

Letter from Adrian Kamellard, Chief Executive Officer, UK Payments Council I have been following the Parliamentary Commission on Banking Standards (PCBS) with great interest, particularly references to the new account switching service and account number portability. The Payments Council is responsible for managing the implementation of the new account switching service launching next year. As Chief Executive, I would like to assure you that the Payments Council is firmly committed to delivering and promoting the new service, to the benefit of consumers and the market. The Payments Council takes its role in addressing issues impacting the payment systems and their customers seriously. Working together with the industry, we believe we are usefully placed to consider the views and needs of payments users, all parts of the industry and the wider public interest. To ensure that the important questions on issues such as infrastructure are appropriately addressed, we are developing a new strategic document called the Payments Roadmap. The purpose of the Roadmap will be to examine the payments industry over a rolling two, five and ten year time horizon, providing a view of how the industry and its underpinning infrastructure should develop. It is a vehicle for systematically and comprehensively analysing fundamental UK payments issues, services and infrastructure to provide confidence for customers and the industry in future investments and decisions. It will involve widespread stakeholder engagement to ensure that the right issues are being addressed and prioritised. Seven Day Switching Guarantee The Payments Council is working with providers of current accounts, including those outside our membership, to implement a new account switching service in September 2013. This will enable customers to be able to switch their current accounts easily and quickly using a consistent service that will: — complete the switch in seven working days—a vast improvement on the current 18 to 30 day process—and allows the “switch” from the old bank to the new bank to take place on a date specified by the customer; — be free to use and be backed by a guarantee, so that the customer will not lose out in the event of any error in the process; — will transfer the customer’s existing payment arrangements from “old” to “new” account; — run a redirection service for 13 months to catch any stray payments; and

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1279

—

be managed by the new provider, so the customer has a single point of contact throughout the process.

The new service is designed to be hassle-free in order to address the major perceived barrier to switching. Qualitative research during the design stage found that the features of the service went a long way towards addressing concerns and barriers to switching, specifically: —

the seven day switching period is seen as a significant and welcome improvement, providing certainty and trust;

—

the guarantee feature was praised and felt to reduce risk when switching and give trust that the process would be managed effectively; and

—

the forwarding of transactions and a standardised service instilled confidence that the switch would be seamless and painless.

The service must also be accompanied by a high level of awareness. The Payments Council Board has committed to a multi-million pound communications campaign to promote the account switching service to raise awareness that it exists, build recognition of the service brand, and promote the service’s benefits. We recognise that this is key to its success. I am determined that confidence is instilled in the process from the outset. The service must be given the opportunity to deliver if we are to create a culture in which customers feel confident in switching accounts. The Payments Council and the wider payments industry, including key “challenger banks”, are committed to making it a success. Martin Wheatley of the Financial Conduct Authority has confirmed that the regulator will be looking at implementation to determine whether further interventions are needed, and the Independent Commission on Banking recommended that the service is assessed in 2015. I would urge the Commission to allow this checkpoint to be reached, rather than recommending alternatives before the service is in place. Account Number Portability A number of stakeholders have raised account number portability as an alternative option. A clear description of what is meant by account number portability would be required to fully assess its impact, as there are a number of different interpretations of the term. Studies into portability suggest that it would require the creation of a centralised system, which would involve replacement of the bank and branch system of numbering, a revamp of the entire existing payments infrastructure and changes to the systems of all financial institutions that interface with it. As the transition takes place, it would be important for updates to payments transactions to be implemented with synchronisation by central payment infrastructure, bank systems, and 50,000 direct submitters. A failure to execute flawlessly could have a serious impact on users of the payments system. There is limited prior experience to inform policy making, as no other country has full portability. In the Netherlands, a version was introduced in 1980—account numbers could be ported within the giro system covering approximately 50% of Dutch payment transactions. The system was discontinued in 1983 due to a lack of demand. More recently, the Australian Government conducted a detailed study into portability in 2011, which stated that “full account number portability is a deceptively simple concept”, concluding that it would “involve major costs which would ultimately be borne by payments system users, for relatively minor benefits”. Portability is sometimes referred to as the ability to retain an account number for life. With this in mind, it may be helpful to outline the likely changes to consumer experience this would bring. As existing account numbers are not necessarily unique, every customer would need to be given new banking credentials at the outset (even if they are not contemplating switching). For those who do switch, banks currently redirect Direct Debits and standing orders to the “new” account, so portability would not offer additional benefits for regular payments being made out of an account. Retention of an account number would remove the need for customers to advise payers of the new number, though credits will be automatically redirected for 13 months under the new switching guarantee. Under a system of account number retention, the customer would still be subject to the new institution’s account opening process (ID&V), and a new cheque book and debit card would need to be issued. The key change would be the ability to keep an account number through the switch in provider. I would like to close by emphasising how important it is that the concepts of portability, including any possible introduction of a central utility, are considered within a broader framework. This should address promoting competition, improving bank resolvability and providing continuity of payment services in a crisis, as well as ensuring the resilience and stability of the payment system—a fundamental building block of the UK and international economy. The Payments Council is focussed on delivering a world class switching guarantee for consumers now, but we are developing the Payments Roadmap as the analytical vehicle through which future debate about the infrastructure supporting the payments system can be thoroughly addressed. 30 November 2012

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1280 Parliamentary Commission on Banking Standards: Evidence

Written evidence from the Personal Finance Education Group (pfeg) Summary 1. It is always important, but in the current economic climate pfeg believes strongly that financial capability is crucial if future generations of adults are to make the right financial decisions for themselves, their families and the national economy. Prevention is better than cure. Financial education is a fundamental building block for life. pfeg believes that by educating children and young people to understand and manage their finances, we can build a generation of empowered consumers able to deal with financial challenges such as student debt, unemployment, pregnancy, negative housing equity and loss of income due to ill-health. A summary of our submission is as follows: — The banking industry has a crucial role to play in creating financially capable children and young people — Children and young people are currently active in the marketplace and need guidance to prevent them becoming irresponsible consumers as adults, the banking sector has a significant role to play in helping ensure that education — Following the key recommendations listed in Financial Education and the Curriculum116 financial education should be in the national curriculum and should be taught in every school through maths (financial literacy), and PSHE (financial capability) — The financial services levy should contribute to financial education in schools as many subscribers anticipate. — The Money Advice Service should have responsibility for coordinating the contribution that the banking industry makes to financial education in schools by: (i) Offering national leadership on a financial capability strategy which is internationally credible; advising the Department for Education on curriculum content, delivery, initial teacher training and continuing professional development (ii) Providing UK wide guidance, oversight and coordination of financial education programmes and resources administered by the banking industry aimed at children and young people in schools (iii) Providing grants and financial support to those organisations working directly to embed financial education in schools — pfeg believe there is an opportunity for the fines imposed on banking institutions to be put to good use to prevent the current situation from occurring again. We would ask that consideration is put towards a using a small percentage of the fines to pay for financial education in schools, and that this would be administered by the Department for Education. Introduction 2. pfeg (Personal Finance Education Group) welcomes the opportunity to submit evidence to the Banking Standards Commission. 3. pfeg is an independent charity helping teachers plan and teach personal finance relevant to students’ lives and needs. Our mission is to ensure that all 4–19 year olds can have financial education—giving them the skills, knowledge and confidence in money matters to thrive in our society. 4. pfeg provides free support, resources and expert consultancy to make learning about money easy. We know that each school or college is unique, and we provide a bespoke service which is accessed through our free advice line, website and face-to face sessions. We have worked with 151 local authorities, reaching 54% of primary and 88% of secondary schools in England. 5. pfeg also works with government, opinion formers and key bodies, campaigning for consistent, quality financial education for children and young people across the UK. We provide the secretariat for the All-Party Parliamentary Group on Financial Education for Young People. There are 250 cross-party members making it the largest active APPG. 6. pfeg is not affiliated to any one organisation and does not market or sell any financial products or services. Response 7. Two- thirds of people in the UK feel too confused to make the right choices about their money and more than a third say they don’t have the right skills to properly manage their cash.117 8. UK’s outstanding personal debt stood at £1.548 trillion at the end of March 2012. pfeg knows that children and young people are contributing to this. pfeg believes strongly that if we are to enable future generations to 116

Report by the All Party Parliamentary Group on Financial Education for Young People. December 2012 http://www.pfeg.org/ sites/default/files/Doc_downloads/APPG/Financial%20Education%20%26%20the%20curriculum%20-%20Final%20report%20%20APPG%20on%20fin%20ed%20for%20YP%20-%20Dec%2011.pdf 117 APPG on Financial Education for Young People, Financial Education and the Curriculum December 2011. p.4.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1281

manage their finances well all young people from 4—19 years must have access to high quality financial education in school. This education will ensure they can make informed choices and take responsibility for their own actions. Prevention is better than cure, being cheaper, effective and potentially less damaging. pfeg feels that the financial services industry has a crucial role to play and would like to see that role given greater priority across the sector. 9. Children and young people are making financial decisions themselves at a very early age. A Populus118 survey conducted for pfeg showed that one in five children has used their parents’ or older siblings’ credit or debit card to purchase items online; for those children who have purchased items online, 10 is the average age they begin doing so; and the average age at which children first have their own mobile phone is eight. Without education, these activities make children and young people extremely vulnerable. 10. EdComs Research119 also shows that as children get older, bad habits can start to show; over 75% of 7 to 11 year olds are saving their money but by the time they get to 17 over half of them are in debt to family and friends and over 26% see a credit card or overdraft as a way of extending their spending power. A YouGov survey in 2008 found 70% of 18–24 year olds were in debt120. 11. Young people don’t only get into debt, they worry about money. Nine in ten 14–18 year olds say they worry about money on a daily basis121. pfeg is concerned that financial worries will become an even bigger problem in the future. In 2009 the FSA made a significant correlation between anxiety or depression and a lack of financial capability122. 12. The UK is currently faced with high youth unemployment figures at 22.2%123. Research prior to the recession showed that 51% of teenagers would like to learn how to control their spending. In 2011, 90% of teenagers said they thought learning about money was important124. 13. The banking industry in the UK has a fundamental role to play in encouraging healthy financial habits from an early age, promoting a move away from the current ‘culture of debt’ and educating consumers about trusted providers of financial help and support when problems arise. 14. Many of the UKs leading high street banks now have financial education programmes that they take in to schools. pfeg welcomes their contribution and works alongside many of these providers to ensure that children and young people are receiving high quality, nonbiased education. 15. The All Party Parliamentary Group on Financial Education for Young People’s report entitled Financial Education and the Curriculum stated that ‘Outside organisations have the potential to boost the teaching of personal finance education in schools. However, schemes must be quality checked and it is clear that there is no capacity for it to be delivered universally by providers. A Quality Mark would ensure that teaching resources are linked into the current curriculum and that organisations do not market financial products or services.’125 16. pfeg’s own Quality Mark scheme, which currently kite-marks the majority of financial education resources for use in schools produced by high street banks was seen as best practice within the sphere. The programme could be developed to ensure that volunteers going in to schools from the banking sector were trained and assessed to ensure the highest quality education reaching young people. 17. In June 2012 the Money Advice Service announced it was to launch a voluntary Code of Practice for those providing financial education programmes and resources to young people. The research behind the Code of Practice highlights that there are currently no suitable and agreed Key Performance Indicators within evaluations of these programmes. KPIs are needed to ensure that these programmes result in the sustained behaviour change that the MAS have highlighted within their research. pfeg welcomed this announcement from the MAS and continue to work in collaboration with the MAS to develop honed behaviour change recommendations.126 18. pfeg would like to reiterate that whilst resources and volunteers from the banking sector play an important role in supporting the teaching of financial education it is essential that it is led by teachers and supported by a comprehensive and progressive curriculum. pfeg has responded to both the current National Curriculum and the Personal, Social, Health and Economic education (PSHEe) reviews recommending that financial education is a statutory element within both the mathematics and PSHEe programmes of study. 19. pfeg believe that the most sustainable way of ensuring the largest cohort of young people receive the financial education they need is to ensure that teachers have the knowledge and confidence they require to teach the topic. As the financial climate is constantly shifting their knowledge would need to be maintained by regular CPD. 118

Populus, Feb 2009 EdComs Research, January 2007 120 Ryanair services “Why do young people pay more?”, 2008 121 EdComs, January 2007 122 Financial Capability and Wellbeing, Evidence from the BHPS 2009 123 17 to 24 year olds FEdS Consultancy Briefing April 2012 124 RBS Group MoneySense research May 2012: 50,000 12–19 year olds 125 APPG on Financial Education for Young People, Financial Education and the Curriculum December 2011. p.28. 126 The Money Advice Service, June 2012 https://www.moneyadviceservice.org.uk/en/static/service-develops-financial-educationcode-of-practice 119

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1282 Parliamentary Commission on Banking Standards: Evidence

20. pfeg has established what we believe to be a comprehensive delivery ambition to ensure that financial education is taught in every school in the UK.127 There will obviously be some cost in recognising this ambition. pfeg has had many discussions with industry representatives whose organisations contribute to the financial services levy. They have reported to us that they are surprised to find that their funds are not being used for educating those under the age of 16. Regardless of how appropriate the model is the funds are not being used in the way that some of the subscribers anticipated. 30 January 2013

Written evidence from David John Pope Simple interest causes un-necessary inaccuracy in banking. Following the Commission’s initial response questions of 26 July 2012: Question 1. The accuracy in modern UK savings interest calculation is in line with Babylonian standard (1700BC) when un-advertised simple interest (Actual/365) is used instead of advertised compound interest (AER). Simple and compound growths at 6% are indistinguishable at five significant figure accuracy but modern home computers can offer over 30 significant figures. Question 2. The use of simple interest can lead to under-payment of interest to taxed savers and under-collection of tax revenue through TDSI for the same advertised AER. My personal worst example lost me £169.72 net (and HMRC one quarter of that) on a five year bond. Question 3. My personal trust in the banking system has been shattered by the lack of systemic improvement from my 130+ letters about simple interest since 2005 (50+ letters have yet to receive a reply). I was very disappointed when The FOS sided with one of my providers that deducted over 21% of an equivalent tax free saver’s interest from my three year account. This was a consequence of using un-advertised simple interest in an account advertised with AER (a measure of proper compound interest). HMRC also lost out. Question 4. The existence of simple interest in banking since 1803 is due to it not being banned when interest taxation at source was introduced. The Act of 1803 failed to define which interest was being taxed (simple or compound) despite previously published warnings about simple interest and the 1624 work of Henry Briggs that made the simple interest approximation to daily basis compound interest un-necessary. The persistence of simple interest may be due to lack of proficiency in maths in banking and the wider community, lack of a desire for achievable accuracy in senior banking management, the way that providers deliver simple interest without advertising it and HMRC’s failure to define which interest is being taxed. Question 5. Simple interest (Actual/365) must be banned from all banking. Division by 366 with a rate based on 365 days must be banned from all banking. It is unfortunate that APR suffers from this day count defect in both its statutory and EC definitions. It is unfortunate that trade body code for savings suffers from both defects. It is important that AER does not go the same way on day count as existing APR when (if) it becomes defined by statute (or EC). Question 6. The Financial Services Bill needs an amendment that bans simple interest and insists on proper compound interest throughout banking. My summary points: 1. The typical modern savings provider’s standard of accuracy in interest calculation is below what has been achievable since 1624. Note that I group banks and building societies together as “providers”. The BBA and BSA represent about 350 members in at least 50 countries but my experience is with UK savings interest. My providers (helpful and otherwise) will remain anonymous. 2. Compound interest is a smooth growth curve. Simple interest is a straight line. 3. Neither type of interest is defined or chosen by the government authority (HMRC) that tries to tax interest at source. 4. Providers have been free to choose which interest suits them for the purposes of taxing savings at source since 1803. 5. Providers prefer the traditional inaccurate and unfair approximation of simple interest to the achievable accuracy and fairness of proper compound interest. 6. APR is defined by statute and EC directive. AER is defined by trade bodies. Both APR and AER are measures of compound interest. 7. The joint BBA and BSA Code of Conduct for the Advertising of Interest Bearing Accounts (CCAIBA) defines Actual/365 without mentioning that: (a) Actual/365 is simple interest. (b) Actual/365 is an approximation to compound interest. 127

http://www.pfeg.org/about-us/our-delivery-ambition

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1283

8. 9.

10. 11.

12.

13.

14.

15. 16.

17.

18.

19.

20. 21. 22.

128

(c) Actual/365 is inappropriate for compounded (growth) accounts. (d) Taxation at source generally fails to deliver The Chancellor’s rate when averaged over the years of a growth account calculated by repeated Actual/365. Advertising AER (compound interest) but delivering interest based on un-advertised Actual/ 365 (simple interest) is mis-selling. Statutory APR, EC directive APR and trade body Actual/365 all encourage division by 366 in a leap year. Division by 366 in a leap year with a rate based on 365 days disadvantages the saver (and HMRC, if the saver is taxed). A majority of the providers of my “fixed rate” monthly income accounts pay me less per day during a leap year. The FSA’s BCOBS promotes CCAIBA without warning about Actual/365. Providers and their trade bodies have allowed: (a) Me to be unfairly treated by un-advertised simple interest. (b) HMRC’s income to be reduced by repeated simple interest. (c) The Chancellor’s 20% to be approximated by repeated simple interest. My failure to get systemic improvement in banking accuracy after over 130 letters (over 50 with no reply) since 2005 hints at a need for more mathematical ability in high places and indicates widespread lack of professional courtesy. Four providers have paid me more than their default calculations. This gives hope for the future but a more communicative industry would have responded to my criticisms by a group confession and a new-look promise to savers. The Financial Services Bill needs an amendment that will ban simple interest, insist on proper compound interest and provide a suite of equations for the calculation of proper compound interest. The overall result of the use of simple interest instead of proper compound interest is unfairness and avoidable inaccuracy in the banking and taxation systems. My general analysis provides my detailed findings on the problem of simple interest. It has been developed over several years, includes mathematical reminders, graphs and historical research and currently runs to 70 pages. I am sending a copy by post.128 The graph on the front page of my latest version (attached below) is one of several that are based on simulations of fixed rate accounts that are calculated by repeated simple interest and then analysed by proper compound interest. In this case, I compare outcome AER with advertised 5.00%AER. 7,400 different account timings, representing about 1% of all possible statement calculations up to around five years, are plotted. Proper compound interest is immune to intermediate timing variation. AER given to two decimal places in an advert (a BBA requirement) implies a tolerance of +/− 0.005%AER. Clearly this range is exceeded when repeated simple interest is used—even in tax free accounts. The Envelope of Inaccuracy is my name for the scatter of results due to simple interest, where proper compound interest would not have any scatter. Various versions of my analysis have been sent to 24 organisations (including government, providers, trade bodies and watchdogs) over the years of my quest for accuracy. Nobody has given me a detailed comment on my analysis document. Nobody has reported a fault. Perhaps nobody actually read it all through! The FOS found against me and for a provider that used un-advertised simple interest on my account (causing over £6 loss of revenue for HMRC). What hope is there for banking accuracy if even The FOS allows a provider to get away with un-advertised simple interest? Henry Briggs demonstrated daily basis compound interest for a rate based on 365 days to 14 figure accuracy in London in 1624. Simple interest is an un-necessary, un-fair embarrassment that has no rightful place in modern banking. The following example is an aid to understanding the problem of simple interest. Nobody has faulted this example. A graphical version is attached. (a) Consider a fixed rate growth account advertised at 5%AER for 3 years (that happen to be non-leap years, for ease of calculation). Two savers apply with £10,000 each. One saver is a tax payer the other is tax free. (b) Nobody would dispute that the tax free saver would expect a maturity of £10,000x(1+5/ 100)^3=£11,576.25. (c) The Chancellor expects providers to deduct 20% of interest at source through the TDSI scheme. A taxed saver would expect to receive 20% less interest than a tax free saver in the same product. £1,576.25 x 0.8=£1,261.00. Therefore a fair taxed maturity would be £11,261.00 with £315.25 being sent to HMRC.

Not printed in full. Page 1 printed as Ev

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1284 Parliamentary Commission on Banking Standards: Evidence

(d) However, in my experience, typical providers would use repeated simple interest as follows for the taxed saver: £10,000x(1+0.8x5/100)^3=£11,248.64 which is £12.36 less than the fair net maturity. (e) In 2005 I realised that such a calculation disadvantages the taxed saver**. (f) The typical provider’s method fails to achieve the Chancellor’s requirement when averaged over the life of the account. Compare the two savers’ interests: 100%x(£1,576.25-£1,248.64)/£1,576.25=20.784% by typical providers. 100%x(£1,576.25-£1,261.00)/£1,576.25=20.00% = Chancellors rate. (g) Closer inspection of the typical provider’s repeated simple interest process also reveals a shortfall of revenue to HMRC, despite the apparently higher than 20% of interest deduction rate. Year1: £10,000x5/100x0.8=£400.00 net interest, £10,000x5/100x0.2=£100.00 tax. Year2: £10,400x5/100x0.8=£416.00 net interest, £10,400x5/100x0.2=£104.00 tax. Year3: £10,816x5/100x0.8=£432.64 net interest, £10,816x5/100x0.2=£108.16 tax. Total net interest to saver=£1,248.64 Total tax to HMRC = £312.16 Proper tax would be 20% of the tax free saver’s interest = £1,576.25x0.2=£315.25 (h) In this case, the taxed saver loses £12.36 and HMRC loses £3.09. (i) The combined saver and HMRC loss of £15.45 is absorbed by the provider. ** My first reply from The BBA (in 2006) did not dispute this effect. After 19 letters to The BBA (the last 7 had no reply), 5 to The BSA and 10 to The FSA, simple interest still pollutes UK banking.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1285

An example showing some of the weakness of the repeated Actual/365 method—the graphical version.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1286 Parliamentary Commission on Banking Standards: Evidence

ANALYSIS OF INTEREST CALCULATIONS ON SAVINGS AUGUST 2012 17TH CENTURY TAX FREE INSIGHT EXTENDED TO INTEREST TAXED AT SOURCE AND LEAP YEARS

—

For an advertised fixed rate AER/Gross over consecutive arbitrary time steps “daysn” the outcome by: (1+Gross/100xdays1/365)x(1+Gross/100xdays2/365)x… [Repeated Actual/365] [Repeated simple interest] in general is not equal to: (1+Gross/100)^((days1+days2+…)/365) [Time value of money] [Compound interest, AER, APR, IRR, NPV...]

—

(From 1803) Taxation at source makes simple interest errors worse.

—

There is no mathematical need to prevent leap days from earning compound interest when a rate is based on 365 days.

In general: Repeated simple interest fails to be proper compound interest. Simple interest fails to deliver advertised AER. Repeated simple interest fails to deliver 20.00% tax at source. If this analysis is flawed then please tell me where. If it is not flawed, then traditional inaccuracy can be avoided by eradicating simple interest and by including leap days as interest earning days. 15 August 2012

Written evidence from Robert Pringle Robert Pringle is chairman and founder of Central Banking Publications and author of “The Money Trap: Escaping from the Grip of Global Finance”, a recent book on the global financial crisis. He has been deputy director of the Committee on Invisible Exports (a predecessor of TheCityUK), editor of The Banker, chief executive of the Group of 30, and a senior fellow of the World Institute for Economic Development of the United Nations University (WIDER). He has served as a consultant to private sector and official agencies in the UK and internationally on a wide variety of topics, including policies to support SMEs. The paper reflects the personal views of the author.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1287

Summary of the Paper Response to Question 1 on standards and culture — Recent history shows that the culture of UK banking has become one of “what you can get away with” rather than “what is right” for the client or the bank. Banks are widely perceived to operate mainly for the benefit of management. — The moral code that should support and complement the legal and regulatory codes is largely missing. Regulation cannot fill the moral deficit. — UK banking culture has been heavily influenced by the seeming success of the business model of US investment banks. That model failed in the financial crisis. — The existing approach to regulation failed comprehensively. Response to Question 2 on consequences for consumers and the economy — The scandals that have blotted the City’s reputation are not victimless crimes. Showing how customers are defrauded is often complex, and needs to be undertaken case by case. — The lack of trust on the part of professional market participants is if anything more damaging than the collapse of public trust. — The most serious consequence is that banks can no longer act as trusted intermediaries. Response to Question 3 on trust in banking — The effect has been severely damaging to the City of London’s domestic and international reputation. Response to Question 4 on causes of the problem — The main underlying conditions that gave rise to these problems have been policy-induced: pro-cyclical regulatory and monetary policies. However, this does not excuse the boards, shareholders and management of financial institutions from accountability for the failures of judgment that occurred in institutions during their watch. Response to Question 5 on remedial action — Further action is needed to change the structure of remuneration and in particular curb the bonus culture, at least in future ring-fenced banks. — Recent events suggest that structural reforms should go further than the government proposes following the recommendations of the Independent Commission on Banking, and that there should be a full separation of investment from deposit banking. Response to Question 6 on further remedial action — If banking is to be restored as a form of intermediation, regulation should be guided by a new set of principles: banks should be instructed to follow a few big, bold rules that the general public can understand and which bankers should interpret themselves. All other financial activities would be conducted by firms adopting a partnership form. — This approach can be successful only if buttressed by higher moral standards and integrity as well as tough external sanctions. Question 7 on Other Matters — The keynote of the new moral code should be the traditional one—put the interests of clients/customers/ consumers first at all times, in wholesale as well as retail markets. — The Bank, FCA and PRA should ensure that “heads roll” when a bank misbehaves or asks for public assistance. The City understands immediate, punitive action, and the authorities need to have discretion to take such action when appropriate even if they cannot prove the individual concerned was personally responsible. RESPONSES TO CALL FOR EVIDENCE Introduction The terms of reference of the Commission are to consider and report on: (a) professional standards and culture of the UK banking sector, taking account of regulatory and competition investigations into the LIBOR rate-setting process; (b) lessons to be learned about corporate governance, transparency and conflicts of interest, and their implications for regulation and for Government policy; and to make recommendations for legislative and other action.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1288 Parliamentary Commission on Banking Standards: Evidence

May I offer three introductory comments: Firstly, in my view, the most important initiatives that could be taken by the government to restore standards and a healthy financial system in the UK would be to support a broader reform of international money and finance. The financial crisis that erupted in August 2007 and that shows no signs of ending is above all an international crisis and the remedies also need to be international.129 Discontent with the behaviour of financial institutions is widespread. Many are now linking it with the lack of a proper international framework for money and banking. This interest is evident in different ways both in the US, where reform og the monetary system has become part of the Republican Party’s platform for the presidential election in November, and in the eurozone, where a radical restructuring of the banking system is recognised to be unavoidable. This is not to say that nothing worthwhile can be done at the national level. This submission offers observations in response to some of the specific questions raised by the Commission and indicates the direction in which, in my view, policy should move. Yet, if the underlying assumption of the Commission’s terms of reference is that raising standards in UK banking is important as a means to support growth and employment, rather than an end in itself, then what is needed above all is an international effort to develop stronger international rules for money and banking. Secondly, the terms of reference of the Commission are broad, and it is in the nature of my critique that my comments also range broadly—perhaps more broadly than most of the evidence that will be submitted. Given this, it has not been possible to go into as much detail as would be necessary to offer a full analysis of any of the questions. Thirdly, the central topic of inquiry—UK banking standards and culture—can be addressed and analysed at many levels. These include, for example, the following: — How people did or did not meet appropriate standards—what was the bad behaviour. — The structure of organisations in which bad behaviour took place. — The services that were being offered that were the context for poor behaviour. — The buyers of the services that were being offered, that were the context for poor behaviour (retail depositors, wholesale counterparties, corporate clients, other participants). — The period of time that is being reviewed. — How standards and culture in the period under review compares with those in previous periods. The Commission may find it helpful to distinguish carefully between these levels and time periods. The differing needs and perspectives of investors and capital markets, counterparties and end-users of financial products should also be born in mind. Answers to initial questions (The Commission’s questions are in italics; the responses follow its numbering) 1. To what extent are professional standards in UK banking absent or defective? The evidence that has come to light in the course of recent scandals shows that the culture has become one of “what you can get away with” rather than “what is right” for the client or the bank: or, “if it is not actually illegal it is OK”. The moral code that should support and complement the legal code is largely missing— possibly reflecting changing attitudes in society at large. Moreover, the more scandals come to light the more the suspicion grows that these are the tip of the iceberg. Hence the pressure to try to fill ethical gaps by ever more detailed regulations. Banks are widely perceived to operate mainly for the benefit of senior management—something that would have been so shocking as to be unbelievable to previous generations of bankers. This having been said, one could enter caveats. For example, professional standards as regards trading practices in specific market sectors may be, and so far as I know, are generally of a high level and well enforced (for instance the standards for good practice to promote orderly markets of the International Capital Markets Association). The bankers who initiated these markets—such as the international bond markets in the 1970s—and established trading standards, including ethical standards, were outstanding innovators. Such markets continue to provide key services to the UK and world economies. (This is only one example of the need to distinguish between the levels of analysis mentioned in my third introductory remark.) It is the use that top management of financial institutions have made of these markets where the loss of standards has been evident. This embraces lowering of standards in terms of due diligence, the conflicts of interest in large diversified groups, speculative proprietary trading, using customer deposits backed by public guarantee to leverage balance sheets and rates of return, as well as the bending of regulations, and willingness to take on massive speculative “bets”. There is one common strand: a failure fully to recognise—or, if recognised, to implement—the need for the interests of the client/user/customer to be treated as paramount at all times. This is both a moral failure and a 129

For reference, may I respectfully draw the Committee’s attention to my book, “The Money Trap: Escaping the Grip of Global Finance” (Palgrave Macmillan, 2012), which presents in detail the case for such a reform and outlines a reform programme. Copies have been presented through the proper channels to the Libraries of both Houses of Parliament.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1289

failure of corporate leadership, as it is the only sound foundation on which to build a successful business enterprise. How does this compare to other leading markets? It is sometimes said that this culture was imported from the US by the big investment banks, and while this may be an over-simplification certainly they exercised and have continued to exercise a great influence on it. They are still the financial firms most sought after by young graduates wishing to enter finance. From the early 1980s onwards, their increasingly dominant position was accompanied by a growth in the contribution of trading activities relative to fee-based services to profitability. Derivatives, properly used, were believed to offer new ways to manage risk; mathematical models seemed to offer a fool-proof way of measuring risk, with the great US investment banks leading the way. The investment banks’ business model and ethic seemed ideally suited to the emerging global financial market that followed the abolition of exchange controls in the UK and other developed countries. The difference between the remuneration they could offer and that available from other institutions rose rapidly, striking awe into the rising generation of financiers, and their pay practices were soon imitated. Some observers attribute this to the oligopolistic structure of the industry. In the US, their “Machiavellian” approach to business was traditionally balanced by harsh external discipline, where transgressors were regularly hauled before the courts, convicted and sent to jail. But such muscular discipline was not imported to Europe, which then became a playground. The seeming success of the investment bank model was imitated around the world, and shareholders began to expect and pressure bank managements to pursue much higher rates of return than had ever been achieved by commercial banks in the past. One element in a return to sanity must be shareholders’ acceptance in a deflationary environment that any positive stable return is a worthwhile investment. The spread of the investment bank ethic and business model was accompanied by a damaging decline in the diversity of forms of financial institutions. Almost all financial institutions looked the same, played the same games, took the same risks, because they almost all used the same risk model, ie VaR. The ideas of loyalty and long-term service to one’s employer and its culture were discarded. Teams of specialists were bought and sold like slaves or football stars. In London, the Bank of England lost its power to shock and awe the market, as large financial institutions acquired a global reach. Regulation increased, but these firms countered it by stepping up investment in lobbying and legal advice. Their alumni were soon to be found holding key policy-making roles throughout the world. Regulation suited the big firms. Regrettably, London has quite recently come to be seen as a polluter of world finance. This perception has developed largely since the outbreak of the crisis. This is partly because of US and euro area anti-City propaganda. But there is also an uncomfortable grain of truth in the accusation. Defences that institutions and centres with other traditions, such as the merchant banks in the City and the universal banks in continental Europe, had historically used to combat the inherent tendency of banking to crises were tested and either collapsed or were found wanting. These included both internal (moral) standards, and external discipline. The hollowness of the investment banks’ business model has been exposed in the financial crisis. It failed because of an absence of team work. Companies that enshrine bonus greed as their driving force are (as John Kay observes in his book “Obliquity”) unable to protect themselves from their own employees: individuals make fortunes (Bear Stearns, Lehmans) while the institutions collapse. Indeed, this species of institution has been saved from extinction only by a controversial extension of the central bank “umbrella” to the remaining two specimens, Goldman Sachs and Morgan Stanley, by the US Treasury in 2008. There was also a comprehensive failure of financial regulation. This points to the need for a rethink of the prevailing regulatory philosophy (see Response to Question 6 below). Other professions The aggressive, bonus-seeking culture of the trading room spread to other parts of the financial sector, then to the private sector more generally as well as recently the UK public sector. I cannot cite research on this, but one’s impression is that top professionals in many areas of national life expect outsize bonuses and excessive pay, while being protected from, or insuring themselves against, business risks, failure, or the costs of being sued. While not the only factor involved, this seems likely to have contributed to an upward spiral of rewards and growing social inequality. The historic experience of the UK and its place in global markets London was traditionally the freest and most diverse of all financial centres, and it had used that freedom to good effect in such innovations as the creation of the eurodollar and euro bond markets in the 1960s and 1970s, even while the UK maintained exchange controls. This relative freedom put a premium on internal, ethical,

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1290 Parliamentary Commission on Banking Standards: Evidence

norms of self-discipline and regulation. So London was perhaps particularly vulnerable to any weakening of such internal standards. There seems to be widespread agreement that in many respects standards declined from the 1970s—the contrast is sometimes drawn between the business style of merchant bankers (eg Sigmund Warburg) and stock brokers of the 1960s with that of the generation of bankers and their supine boards who came to run UK banks more recently. But here again it is important to distinguish between different levels of analysis and time periods. 2. What have been the consequences of the above for (a) consumers, both retail and wholesale? The scandals that have blotted the City’s reputation are not victimless crimes. Showing how customers are defrauded is often difficult and complex, and needs to be undertaken case by case. That should be a priority of the Financial Conduct Authority. (b) the economy as a whole? The economy has suffered in multiple ways: through the fall in the reputation of the City, a major sector and exporter, through mis-selling of financial products, through the way that excessive financial rewards have swollen the share of the nation’s skilled resources taken by the finance sector, through the costs of bank rescue operations and the recession and above all through the collapse of trust on the part of the public and market participants (including other banks). This has caused a drying up of liquidity and has crippled the banks’ ability to function normally. 3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector? Severely damaging to the City of London’s domestic and international reputation, leading to a general mistrust of finance. It is, however, worth reflecting that there is a general lack of trust in all authority. It is also worth remembering that the City has historically harboured many unsavoury characters and witnessed many shameful episodes—and recovered from them. Moreover, distrust of finance is a global phenomenon. This does not make the economic effects any less damaging. 4. What caused any problems in banking standards identified in question 1? The problems in UK banking standards should be viewed broadly in the context of the evolution of UK monetary and economic policies in a globalised world economy. In particular, UK monetary policy has become caught up in a business cycle where, every few years, pressure mounts on the central bank to pursue excessively expansionary policies. These surges of officially-supplied liquidity leave “money on the table”—to use bankers’ language, ie easy pickings for the private sector, and a perennial source of temptation to lenders and borrowers to build up excessive leverage. Thus, in my judgment, the main underlying causes of these problems have been the weakness of regulatory policy (reflecting the fact that finance is globally integrated, while policy remains essentially national), and the permissiveness of monetary policy. However, this does not excuse the boards, shareholders and management of financial institutions from the failures of judgment that occurred in institutions under their watch. One big problem was their narrow pursuit of maximising shareholder value—a pursuit that came close to destroying many companies. Some things can be done at the national level to improve the reputation of UK banking. The Commission requests that respondents consider (a) the following general themes: The culture of banking, including the incentivisation of risk-taking The structure of remuneration reflects and accentuates the lowering of standards, lack of discipline and readiness to take excessive risks. Events have shown that this structure is built on, and can survive only on the foundation of, the support of the public sector. This is an intolerable situation. Payment of bonuses has become an ingrained part of this dysfunctional culture and radical action is required (as discussed further in responses to Question 5). The impact of globalisation on standards and culture;global regulatory arbitrage Regulatory arbitrage is viewed as part of normal business practice. Under the existing culture, a bank management would be regarded by shareholders and boards as culpable if it did not take advantage of discrepancies between the regulatory rules, or in the strictness with which they are interpreted in different jurisdictions; this seems unavoidable. However, when it is used to threaten governments of specific jurisdictions that do not join in the race to the regulatory bottom it becomes a form of blackmail that a democracy must face down. The impact of financial innovation on standards and culture The influence is pervasive, and it could be argued is a necessary accompaniment of innovation. But if it occurs in the wrong environment (with too-big-to-fail institutions, ultra-low interest rates, and pro-cyclical

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1291

monetary policies as well as a lowering of fiduciary standards of top management) then of course standards and morality will suffer. The impact of technological developments on standards and culture; Corporate structure, including the relationship between retail and investment banking The ability of financial groups to undertake both kinds of banking under the same roof has resulted in investment banking culture becoming dominant in finance generally. The level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects This topic was well discussed in the Vickers report. Taxation, including the differences in treatment of debt and equit Equity finance should play a much larger role in financial intermediation. Risk-bearing and reward should be whenever possible tied together at the level of the individual, thus re-introducing a culture in which employees at all levels of a financial organisations are imbued with an awareness of risk. Policies that discriminate in favour of debt and against equity finance, such as the tax deductibility of interest, contributed to the build-up of excessive leverage and should be phased out, as the IMF has recommended. (b) weaknesses in the following somewhat more specific areas: (eg the role of shareholders, and particularly institutional shareholders) General comment: calling on boards of directors to exercise closer surveillance over management—demands for improvements in corporate governance of financial institutions generally—are common themes of inquiries of this type.130 But the executive can generally outwit the most dedicated of shareholders. I am not aware of evidence that calls for “more effective governance”, however numerous, have ever had any impact on behaviour. This applies, even more strongly, to “ethical” codes that routinely form part of an institution’s human relations and public relations. These can lead to ludicrous overkill—I understand that one institution’s “Code of Ethics” on personal trading, for example (just one of a multitude of policies employees are meant to follow) runs to 43 pages of tightly written legal language the sum effect of which is completely incomprehensible to the average employee. The whole lot could be replaced by the single sentence “Don’t take advantage of your position, don’t do anything you could not defend if it became public knowledge, always put our clients’ interests first and use your common sense”. 5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally General comment: If banking is to be restored as a useful, indeed leading, form of financial intermediation, bankers need to rediscover and extol the social purposes they fulfil, and keep the individualistic or profit-making objectives in their proper place. This means not only adopting the principle of putting the interests of the client/customer first but working out in detail the implications in everyday financial judgments and management styles. Some suggestions for what might be considered within the Commission’s terms of reference are mentioned in the answers to the following question. Structural changes also can help to promote a fresh vision of banking and its place in society. But the main point is that for most people it would be more interesting to work for a company that is visibly performing a valuable role for society, and has a passion for serving its customers and creatively meeting their needs, than one driven by individual or collective greed. Specific remedial action—remuneration structure Among specific steps that could be taken, as indicated in my answers to Question 4, I submit that further action is needed to change the structure of remuneration. Some measures have been taken at the EU and national level but these do not go far enough. Among steps that the Commission could consider recommending would be to bar banks that pay bonuses from eligibility for emergency lender of last resort assistance from the Bank of England. The pay structure is defended on the grounds that it allows overall costs to vary; an industry that has such volatile revenues needs to be able to respond to revenue downturns, it is said, by cutting its main expense, which are staff costs. If all banker pay were entirely fixed with no bonuses, the only other recourse would be redundancies, which, it may be argued, could be more damaging to the long term well-being and continuity of the industry. It might also make horizons even more short term. It could also be maintained that cutting off access to central bank liquidity provision would be misguided, on the grounds that it would not restrain bankers 130

For a summary of the views of financial sector leaders see a recent publication of the G30, “Towards Effective Governance of Financial Institutions”, at http://www.group30.org/images/PDF/TowardEffGov.pdf

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1292 Parliamentary Commission on Banking Standards: Evidence

in the good times—no bank ever thinks it is going to need to call on the Bank of England or runs its business on these lines—and may unnecessarily constrain the authorities if a bank does need to be rescued. On the other hand, there is a strong moral case for such action. First, individuals should not be able to buy private benefits at the cost of burdening the public with further, open-ended contingent liabilities. Secondly, nothing is more calculated to sow distrust between client and bank than the fact—whether or not the customer is aware of it at the time—that an employee stands to gain a bonus for selling a service or product to him or her. Thirdly, it is intolerable that one cohort of senior bankers should be allowed to privatise and pocket all the gains from the credit that previous generations of prudent bankers have built up for their bank, especially as their behaviour destroys the bank’s reputation and thus its capacity to fulfil its key intermediary functions in society. Fourth, bonuses encourage risk-taking and discourage cost containment as they are paid out of revenues rather than profits. Nothing has infuriated the public more or contributed more to the low esteem of finance than the bonus culture. This is often portrayed as “populist bank bashing”, and of course one should avoid a witch hunt, but in my view the public’s instinct is justified. The bonus culture is so ingrained that only public policy can effect a real change. 6. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice These questions clearly raise far-reaching, complex issues and in the following I limit myself to making a few general observations, mainly on financial regulation. Specific remedial action—structural separation As is evident from a submission I made with a colleague to the Independent Commission on Banking in 2010 proposing a form of ring-fencing, I have supported the recommendations of the Vickers Commission.131 However, I have come to the view that there is a growing case for a more fundamental restructuring, with a full legal separation of investment from commercial banking in the UK. This would assist bankers to rediscover and return with pride to serving their key functions in society. Yet even this would not be a panacea. The implications of the decline in trust The fundamental issue may be put very simply. All deposit banks require trust that the management of banks has the highest ethical standards. This is because of the “opacity” of banking—customers do not know what banks do with their money. It follows that if it proves impossible, given prevailing social attitudes, to re-introduce high ethical standards and social purpose into banking, as discussed above, then the focus should switch towards encouraging forms of non-bank finance that minimise the input of “trust” needed. For this reason, proposals for an equity-based financial system, where banks are replaced by unit trusts, made by Professor Laurence Kotlikoff, deserve fuller consideration that was given them by the Independent Commission on Banking.132 The international response has been to attempt to cover up this moral hole by extending regulation. Yet virtue cannot be legislated. Not only are measures to reform the institutional structure of regulation and its rules unable to bridge that moral gap. They do not in my view even mark an improvement on the pre-crisis regime. They are likely to contribute to the build-up of another crisis—as the former regulatory system is now seen to have done (despite the massive intellectual input that went into that earlier system). There are several reasons for this. The reforms are likely further to encourage homogenous, herd-like behaviour. Firms will adapt in similar ways to the regulations, thus raising the risks of a systemic crises if the regulators “bet” in the wrong way. Regulators will find it difficult to avoid becoming more and more involved in the effective management of the financial system and of individual institutions—eg expressing “guidance” or giving “direction” on desirable trends in lending, investment, capital, liquidity, and remuneration. Thus the regime represents another step in tightening official control over finance. Indeed, if it does not represent such a step, it will be seen as a toothless tiger. This may be an unavoidable and indeed logical implication of the effective assumption of intermediation risk by the State. With the banking system still “nursed” by central bank liquidity, taxpayer support and implicit 131

See Robert Pringle and Hugh Sandeman, “Comments on possible reform options: structural separability of deposit banking in the UK” 15 November, 2010 at http://bankingcommission.s3.amazonaws.com/wp-content/uploads/2011/01/Robert-Pringle-andHugh-Sandeman-Issues-Paper-Response.pdf 132 See in particular, “Financial ReFoRm—What’s Really needed?‡ Limited-Purpose Banking—Moving from “Trust Me” to “Show Me” Banking” By Christophe Chamley, Laurence J. Kotlikoff, and Herakles Polemarchakis American Economic Review: Papers & Proceedings 2012, 102(3): 1–10 http://dx.doi.org/10.1257/aer.102.3.1

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1293

guarantees, and with the key inter-bank market functioning poorly, the State is perhaps bound to have a greater influence on management decisions. But nobody should pretend this represents a return to normality. For example, the Interim Financial Policy Committee has already expressed sentiments to the effect that banks should raise capital ratios, set up a “temporary” capital “cushion”, restrain dividends and compensation, tackle risks promptly, while increasing lending to the real economy. Of course all these objectives should be achieved in way that avoids adding to financial fragility (see the record of the Interim Financial Policy Committee meeting held on 22 June 2012). How, bankers may ask, are we supposed to provide all these good things—why don’t the members of the FPC show us? How far, indeed, will the FPC go in enforcing its wishes—for example over bank pay? Every extension of the role of the state over the financial system diminishes the responsibility and autonomy of bank management. Yet the lesson of history seems to be that autonomy leads to reckless irresponsibility if it is not constrained by a moral code and credible external sanctions. Given the current direction of policy, the next financial crisis is likely to be blamed on the central bank and its associated organs—justly so, as they will have assumed responsibility for giving guidance/direction on all the main parameters that contribute to the build up of risk. This carries the risks not only of having adverse effects on its ability to conduct a stable monetary policy—one of the original reasons for separating the two functions—but also of substituting the judgment of officials for that of bankers over a wide range of the nation’s financial activity. The current trend in regulatory policy will reduce rather than foster diversity in the financial system. To the extent that regulators in other financial centres harmonise their approaches, diversity will be reduced globally, and the fragility of the global system further enhanced. The more complex the regulatory apparatus, the more it encourages size in banking, as only a large institution can cope with the flood of regulations, influence the interpretation of those regulations to its advantage and threaten regulatory agencies with unlimited spending on legal fees if a case should go to court. As a sector, banking is almost unique in modern capitalist societies in having high barriers to both entry and exit. It is tempting to believe that “judgment-based” regulation can fill the gap. Yet such an approach would further enhance the risks of an excessively cosy relationship developing between the shepherds and their flocks—regulators are already very close to the banks they oversee. Remedial actions—reform of regulation If banking is to be restored as a form of intermediation, regulation should be guided by a different set of principles: the search for ever-greater extension of the responsibilities of supervisors, and what is in my view likely to prove a vain search for effective counter-cyclical macro-prudential regulation, should be replaced by requiring banks to follow a few big, bold rules that the general public can understand and which bankers should interpret themselves. These would include limits on activities and a high, simple ratio of capital to deposits, buttressed by an aggressive competition policy to keep banks small so that failures can be more easily managed (and the threat of failure made credible). All other financial activities would be conducted by nonbanks, firms adopting a partnership form. Transgression would be followed by swift retribution. 7. What other matters should the Commission take into account? HMG should… — Extend areas of financial offences where criminal prosecutions could be brought. — Step up prosecutions for insider trading with custodial sentences. — Ensure that “heads roll” when a bank misbehaves or asks for public assistance; the widely-held and powerful City myth is that when a bank goes to the Bank of England for emergency lending, the Governor responds by saying “Thank you, Mr Chairman, we shall discuss that with your successor; goodbye”. That is the kind of action that the City understands and was sorely missed in the crisis—for example, when RBS failed (I doubt if many people took any notice of the results of the FSA’s laborious inquiry—a 352page report released three years later). — Give the appropriate authorities discretion to take such action when appropriate even if they cannot prove the individual(s) was/were personally responsible. — Make their expressed determination to end “too big to fail” credible in the markets, as the single most important step in restoring professional standards—and above all, the needed culture of riskconsciousness—at all levels of an institution. — Encourage the Financial Conduct Authority to have as its central focus an insistence that financial institutions put the interests of clients/customers/consumers first at all times. — Call for the head of the FCA to work closely with the Governor of the Bank to establish a new moral tone to UK banking.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1294 Parliamentary Commission on Banking Standards: Evidence

— Consider the possibility of conflicts between the objectives of different oversight bodies. Official allegations of law-breaking can destabilise confidence in a bank, and thus its funding—but this risk should not be allowed to hinder or postpone the need for disciplinary action including where appropriate prosecutions. — Affirm the public interest case in upholding the moral and legal codes and that this should trump the case for protecting any individual institution. — The latter risk underlines the need for the resolution authority to stand ready at all times to manage the failure of a bank without disrupting business or causing a more general panic. — Encourage the further development of forms of financial intermediation that could in the longer term offer substitutes for traditional deposit banking. Concluding Remark Lack of trust, low standards and the legacy of the financial crisis are preventing UK banks from fulfilling their key functions in society. They are in a state of torpor. New life can be breathed into them, however, if top management can effect a change of culture. Employees should follow an ethical code placing customers’ interests first. Given such a change, regulation could be radically simplified. 3 September 2012

Written evidence from Pro-Housing Alliance Introduction The Pro-Housing Alliance (PHA) is an alliance of organisations and individuals who believe that housing is a key determinant of health. Health inequalities cannot be addressed unless there is universal access to housing that is both truly affordable and healthy. It is a prerequisite for good public health, including mental health. The members of the Alliance are: Chartered Institute of Environmental Health, Team Homes, Care and Repair England, National Housing Forum, Professor Peter Ambrose, UKPHA, Ecorys, Housing Justice, C2O Future Planners, Camden Federation of Private Tenants, Zacchaeus 2000 Trust. Two recent reports, Recommendations for the Reform of UK Housing Policy and its accompanying report Housing Crisis in London, can be found on our website. http://www.prohousingalliance.com/resources/ The Banking Standards Inquiry’s Terms of Reference The terms of reference of the Inquiry are to consider and report on: (a) professional standards and culture of the UK banking sector, taking account of regulatory and competition investigations into the LIBOR rate-setting process; and (b) lessons to be learned about corporate governance, transparency and conflicts of interest, and their implications for regulation and for Government policy; and to make recommendations for legislative and other action. PHA Submission Summarizing the submission — A retrospective look at the consequences of the deregulation of lending, abolition of rent controls and allowing the free movement of capital in and out of the UK in the 1980’s shows that Parliament gave the impression that “anything goes” to make a profit. — We note that “stronger sanctions to tackle abuse of the system” are included in the initial discussion paper produced on 10 August 2012 by Martin Wheatley’s LIBOR review commissioned by the Cabinet. It is remarkable that such an inquiry is called for and that very severe sanctions for lying about an interest rate, which affects all citizens of the UK, had not already been put in place by Parliament long before the LIBOR crisis emerged. — The FSA Banking Conduct of Business Sourcebook (BCOBS) lays down clear guidance for the industry and the Handbook and the FSA Statement of Principles has clear definitions about “integrity and proper conduct”, the definition of “fit and proper persons”, standards of supervision to ensure stability in the sector, the adequate protection of clients’ assets and much else besides. — It is abundantly clear that the actual conduct of many individuals and banking organisations within the industry, not least in relation to LIBOR, has signally failed to live up to the standards laid down in these documents. — For the past twenty years and more we have had governments and others criticizing regulators for being “heavy handed” and anti-business when in most cases they are anything but. Whether in banking or dealing with the worst private landlords, enforcement of the legislation and use of powers to control bad practice has been minimal. In the long-term effective regulation is better for business, but we appear to be concerned only with the short-term.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1295

— The PHA believes that “professional standards and culture” must be interpreted to include the impact of the banking sector’s workings on the broader economy and society as well as the internal workings of companies and the conduct of their management and staff. — Several aspects of the changing lending practices following the 1980s finance sector deregulatory Acts were clearly less than providential, some were irresponsible and others fell well short of professional standards of conduct. — The huge release of house purchase credit, outstripping general inflation by a factor of four or more between 1980 and the mid 2000s, led to a severe mismatch between income growth and the growth in house prices and rents; this resulted in widespread housing unaffordability and greatly increased personal and household indebtedness which has very serious and costly implications for mental health. — The overall impact was to cause average house prices in the mid 2000s to be more than three times what they would have been without the disproportionate growth of mortgage lending. — Given the differential access to owner occupancy (about 70% can access ownership and 30% cannot) this in itself is likely to have had long-term regressive effects on wealth distribution. — The increased commitment to the servicing of mortgages has also had a range of other adverse social and economic impacts on households’ spending patterns, lifestyles and the work/life balance. — The application of very large sums of lending to the stimulation of property prices over the 1980 to 2005 period carried huge opportunity costs in terms of other productive uses to which anything up to £1,000bn of investment might have been put (for example in investment in the productive economy or in infrastructure). — It also led to a vast increase in housing benefit payments as rents increased in a housing market in short supply and this has had the knock-on effect of trapping more people into benefit dependency and complicating the transition into work. — The general public is now well aware of the adverse impacts of the mortgage lending boom and its aftermath (including the present dearth of bank lending); there is also general awareness of unprofessional and even criminal conduct in the banking sector; public trust in the banking system is therefore at a low ebb. — One way to begin to repair the damage might be to set up a banking Social Responsibility Commission to consider the range of social and economic impacts, including some set out in these responses, that flow from the operation and conduct of the sector. Responses to the Inquiry’s Specific Questions 1. To what extent are professional standards in UK banking absent or defective? How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets? Responses to 1(b): 1.1. “Professional standards” are a prerequisite for participation in other fields usually termed “professional”—eg medicine, law, accountancy, etc. 1.2. The term carries a number of implications including a high level of certification, strict internal regulation of competencies and conduct, a specific duty of care to the users of the skills of practitioners and arguably a general duty of consideration to society as a whole. 1.3. The same standards do not apply in banking and are widely perceived not to do so. 1.4. Part of the reason for this perception has been the changes in lending conduct and practices that followed the period of financial deregulation stemming from the passing of a succession of deregulatory Acts in the early to mid 1980s. Changes in mortgage lending practices over the ensuing decades have included: — A lengthening of average repayment terms. — An increase in the average loan to income multiple. — The taking into account of an increasing proportion of the household’s second earner’s income when calculating a loan. — The movement towards loans of 100% or more of the value of the property being purchased. — The gradual easing of income certification practices. — In some cases active encouragement to overstate incomes in order to permit a larger loan. 1.5. Some of these practices have marked a retreat from previously expected standards of responsible providential lending and some (for example the last two) have clearly fallen short of professional conduct. 1.6. In addition there has been the rapid introduction of complex and opaque financial products that have not been adequately explained to borrowers—some have subsequently been found to have been mis-sold and compensation has been paid.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1296 Parliamentary Commission on Banking Standards: Evidence

1.7. Some of these financial products have permitted the realization of profits in the form of bonuses before those profits have actually been made. 1.8. The use of the products referred to in 1.6 and 1.7 has been widely regarded as examples of unprofessional conduct and has been in apparent contravention of the BCOBS 2. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole? Responses to 2 (a): 2.1. The impact on indexed mortgage lending volumes of the changes in lending practices set out in 1.4 is shown in the 1980–2005 graph of mortgage lending (attached—also available in the Zacchaeus 2000 Trust Memorandum to the Prime Minister on Unaffordable Housing, published by Z2K in 2005).133 2.2. The effect on consumers of this massively increased indebtedness has been wide-ranging and profound. For example: — Mortgage repayments have increased as a proportion of incomes leading to reduced disposable income for other significant items such as heating, recreation, holidays and food all of which are significant to the preservation of health. — Heavy and unmanageable debt has been shown by a recent literature review (University of Brighton, forthcoming) to be deeply implicated in the increased incidence of mental ill-health which costs the country £105 billion per year.134 — Mortgage repayments have been spread over a longer timeframe, sometimes into retirement. — Increasingly the second earner in the household’s income has been taken into account in the loan calculation, obliging him or her to continue in full or part time work to continue to service the loan. — For many households this has forced both a juggling of work/life balance and a much greater dependence on paid childcare. — Two recent UNICEF reports have shown that the UK is at or near the bottom of the table of comparator EU countries in terms of exposure to risk and unhappiness in children. — Heavy loan repayment obligations have also significantly increased financial pressures (for help with housing costs) and time pressures (for help with childcare) on grandparents. — In extreme cases difficulties in making repayments, often due to changes of circumstances beyond the borrower’s control, have led to increased rates of repossessions. 2.3. It is intuitively evident that the steep increase in property values impact differentially on different groups in society. About 70% of the population has had access to the personal asset growth permitted by owneroccupancy and 30% has not. The tenure division has therefore worked to reinforce previously existing wealth inequalities. 2.4. Among the 70% who own, the more vulnerable and economically weaker groups, for example those whose parents have fewer capital resources or who have themselves built up less equity in property, are likely to be suffering far more from exposure to higher debt levels and higher repayments in relation to incomes. 2.5. If these suppositions are correct the much increased mortgage lending flow is in itself having long term wealth and income redistributional effects which contribute to the general inequalities in society; this is a matter of considerable significance and requires urgent consideration. Responses to 2 (b): 2.6. Table 1 of the Z2K Memorandum to the Prime Minister on Unaffordable Housing showed that the aggregate House Purchase Debt (HPD) outstanding as at 1980 was £53 billion (23% of GDP). 2.7. Were this to be updated to 2003 to match the rise in RPI and further adjusted to allow for the rise in the incidence of owner occupancy the HPD as at 2003 would have been £181 billion. 2.8. The actual HPD as at 2003 was £774 billion (72% of GDP)—this is an “excess” of £593 billion over the figure that might reasonably have been expected had lending grown consistent with the RPI, had it reflected owner occupancy growth and had it not seen the significant changes in lending practices listed in 2.2. 133 134

Available at http://z2k.org/wp-content/uploads/2011/11/Memorandum-to-the-Prime-Minister-on-Unaffordable-Housing.pdf Centre for Mental Health, In 2009/10 the total cost of mental ill health in England was £105.2 billion, including £21.3 billion in health and social care costs, £30.3 billion in lost economic output and £53.6 billion in human suffering. Costs of mental health problems, England, 009/10, http://www.centreformentalhealth.org.uk/pdfs/Economic_and_social_costs_2010.pdf £ billion % of total Health and social care 21.3 20.2 Output losses 30.3 28.8 Human costs 53.6 51.0 Total 105.2 100.0 The aggregate cost of mental health problems thus increased by 36% between 2002/03 and 2009/10, with a particularly large increase in the costs of health and social care (+70%) since.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1297

2.9. This “excess” HPD has subsequently been updated to 2006 when it was found to be of the order of £800 billion. It is highly likely that it now in the order of £1,000 billion. 2.10. There have been enormous opportunity costs relating to the application of these huge lending volumes to property purchase rather than to, for example, infrastructural, industrial R and D and similar uses in the productive economy. As approximate examples the cost of a significant upgrade to the rail network was put at £9 billion, a recent estimate of the cost of putting the housing stock in good order was £20 billion. The capital cost of a new hospital might be of the order of £0.25 billion. An estimate some years ago of renewing the entire water supply system in the USA was between £40–160 billion over 25 years. Pro rata to population the cost in the UK would be maybe one fifth of this. All these are insignificant compared to the sums loaned, effectively, to boost property values over a 25-year timespan. 2.11. Approximate calculations show that had mortgage lending volumes risen since 1980 consistent with RPI and owner occupancy growth, the average house value in 2011 would have been £61,000, not the actual £161,000. General private sector rent levels would have been commensurately lower since to a large extent they reflect capital values. Thus housing costs across the entire private sector would have been significantly more affordable. 2.12. In the years since the onset of the banking crisis (2007–08) there has been a dearth of mortgage (and other) lending as banks look to repair their balance sheet positions. This has been a major factor in prolonging the historically low output of new homes for sale and for the partial exclusion of first time buyers from the market. Both these effects have serious implications for the long-term health and balance of the housing market and for the viability of the house-building industry. 3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector? Responses to 3: 3.1. The lapses below professional standards of conduct identified in 1 and the consequences set out in 2 have seriously reduced public respect for the banking sector. 3.2. The general public have clearly perceived that the pre-emptive bonus-taking, the imposition of high charges and the public costs involved in the bail-outs have resulted directly from difficulties due to less than providential lending patterns and volumes over a period of at least three decades. 3.3. These bail-outs have led directly to the post-2007 crisis in public finances and the increasing regime of cuts across a wide range of public budgets. 3.4. These cuts again impact most heavily on the more vulnerable in society because they are the groups more dependent on public assistance programmes and publicly funded, as opposed to private, health and education systems. 3.5. As a consequence there is widespread unease and anger at these costs imposed on the public individually and collectively and a general loss of trust in the probity and social responsibility of the entire banking sector. 4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (a) the following general themes No responses from the PHA. 5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally? No responses from the PHA. 6. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice No responses from the PHA. 7. What other matters should the Inquiry take into account? Response to 7: 7.1. The Banking Standards Inquiry should take into account not only “standards of conduct” as strictly defined internally within the banking sector but also crucially standards of conduct as they have consequences for the wider economy and society.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1298 Parliamentary Commission on Banking Standards: Evidence

7.2. These consequences, some spelled out above, flow inevitably from the pattern and volume of lending carried out by the banking sector year on year. 7.3. Because of the central significance of money flows in the economy these lending patterns and volumes (or in some circumstances as at present the lack of them) have extremely important impacts on the long-term competitive success of the UK economy in relation to the world economy. 7.4. They also have extremely important effects on the internal distribution of wealth and income between different groups in society. 7.5. They are therefore powerful mechanisms in both the management of the economy and the shaping of the society; their regulation has been too weak over the past 30–40 years—stronger regulatory regimes are required that reflect more accurately the highly significant consequences of the conduct of the sector. 7.6. The Pro Housing Alliance feel that such is the importance of the banking sector to the health of both the economy and the society that there should be some mechanism to assess and monitor the impact of its workings on society as a whole—a banking Commission for Social Responsibility (CSR). This could be set up either: —

at corporate level by individual banks already known for taking an ethical stance (where a CSR might confer commercial or PR advantage);

—

at industry level by some appropriate umbrella organization; and

—

by the Bank of England or some combination of the regulatory authorities.

7.7. A banking Commission for Social Responsibility, while in no way undermining the prime duty of the individual bank or sector to maximize returns to the shareholders and to protect the interests of depositors, should keep under review many of the issues identified in this set of responses. In the view of the PHA this would have, among other benefits, that of beginning to rebuild public trust in, and respect for, the banking sector—currently at an extremely low ebb. CHANGES IN 5 KEY INDICATORS—1980 TO 2004* JULY 2012

* from the Zacchaeus 2000 Trust Memorandum to the Prime Minister on Unaffordable Housing, May 2005 (available at www.z2k.org). Note that over the period the total house purchase debt outstanding rose by a factor of about 18 (clearly involving much “sub-prime” lending) while the amount of housing stock for transaction in the market rose by only about 30%. This largely explains the damaging rise in house prices post-1996 (and the “blip” in the late 80s). The direct consequences of this lending explosion have been a bursting of the house price “bubble”, widespread difficulties in repayment for marginal borrowers and thus rising repossessions, increased forced

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1299

reliance on housing benefits, massive bad debts requiring transfers from bank reserves, some bank failures and the severe damage to public finances as a result of the cost (£150 billion?) of bank bail-outs. Even more important is the “opportunity cost” of this misplaced lending—seemingly quite undiscussed. The housing debt figure, had it risen since 1980 simply with inflation, would have been in the order of £200 billion in 2004. Instead it was around £800 billion. What benefits to the economy would have resulted had this “excess” £600 billion been applied not to inflating house prices (and rents) but to renewing our ageing infrastructure, modernising the rail network, investing in renewables, supporting R and D for our productive industries, building hospital and schools … the list goes on? The point is not what happened in the last 25 years, which cannot be re-run, but what regulatory regime can be put in place to prevent a recurrence of the cycle over the next 10–15 years! This is the structural issue— not bankers’ bonuses. How will the main parties respond to this challenge? 19 August 2012

Written evidence from Public Concern at Work 1. I make this short submission on behalf of Public Concern at Work (PCaW) in response to the call for evidence by the Parliamentary Commission on Banking Standards. PCaW is an independent charity set up in 1993 to provide advice to individuals on how to raise a concern about malpractice in the workplace. To date, we have advised over 13,000 whistleblowers. We were also closely involved in setting the scope and detail of the law that protects whistleblowers, the Public Interest Disclosure Act 1998 (PIDA). In addition, PCaW provides expert advice and support to organisations seeking to embed good practice whistleblowing arrangements. To this end we drafted and published in conjunction with the British Standard Institution (BSI) PAS 1998:2008 Whistleblowing Arrangements Code of Practice (CoP)135 which is step-by-step guide for all organisations. 2. Our submission relates specifically to 4b) and 5 of the call for evidence and will cover: (a) Statistics on the financial services sector, from our advice line. (b) Our forthcoming research into financial services. (c) An overview of best practice and current guidance for individuals and organisations in the financial services sector. (d) The framework for whistleblowers under PIDA, including current weaknesses and suggested amendments to PIDA. 3. Statistics from our advice line: Year 2006 2007 2008 2009 2010 2011 H1 2012

Financial services cases

Percentage of total cases to advice line

48 53 68 93 51 76 35

5% 6% 8% 9% 4% 5% 4%

4. While cases in financial services appear relatively static, this should be viewed in the context an overall increase in caseload: we have experienced a 30% rise in new cases in H1 2012 compared to H1 2011. We consider that some of this increase in cases is due to media stories in particular sectors, such as the Panorama expose of Winterbourne View Hospital in June 2011, which gave rise to a 63% increase in cases from the care sector.136 It is therefore somewhat surprising that the media coverage of the banking crisis has not resulted in a comparable increase in cases. That said, the increase in cases in the care sector was specifically related to a failure that could have been averted if whistleblowers were listened to and the Care Quality Commission, the regulator of health and social care, was criticised for its weak handling of whistleblowing and whistleblowers as a result. It has since made substantial moves to strengthen the system. This requires proper resourcing of a hotline and a specific focus on the issue. It remains to be seen whether a similar increase in cases will follow the LIBOR scandal, where we understand concerns had been raised about the abuse of the inter-bank interest rate setting process.137 135

Available for download here: http://www.pcaw.org.uk/bsi In H1 2011 we advised 96 whistleblowers in the care sector, in H1 2012 this increased to 156. 137 Paragraph 37, The Treasury Select Committee report into LIBOR on 18 August, 2012 following its inquiry into the Final Notice issued by the Financial Services Authority with respect to Barclays on 27 June, 2012. 136

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1300 Parliamentary Commission on Banking Standards: Evidence

Forthcoming Research—Qualitative Analysis 5. We are in the process of coding all cases we have received in the financial services over the last five years in order to “map out” the whistleblower’s journey to provide information on weaknesses in the system. This will include an analysis of the type of concerns individuals have, any barriers to raising a concern, to whom the concern was disclosed, how it was escalated, the response to the concern and the response to the individual. It will also include analysis of the seniority and profession of those raising a concern. We aim to complete this analysis in 2012 and are happy to share developments with the Commission as and when they are available. Best Practice Whistleblowing Arrangements in the Workplace 6. In order for the Commission to consider best practice guidance for whistleblowing in the workplace, we highlight the BSI CoP. This was published by BSI and drafted by PCaW in conjunction with a large and widely drawn working group. It is a guide for all organisations seeking to establish, review and audit their whistleblowing arrangements. We would recommend using the CoP to all organisations. 7. In 2002 we worked with the Financial Services Authority (FSA) before the launch of their whistleblowing hotline to develop guidance for individuals. There has been considerable change at the FSA since this time and while we are aware that the FSA continues to run a dedicated whistleblowing hotline, we are not clear that this has had any additional resource allocated since we last worked closely with them in 2002. 8. We have made numerous attempts, post the financial crisis, to approach key players in the banking sector. We sent a number of letters to major British banks in 2009 including RBS, Barclays and HSBC, offering support to ensure their arrangements met best practice. Though we have had a long running relationship in supporting Lloyds Banking Group, we have not been able to engage with any of the other major banks. 9. We are aware that the British Banking Association issued guidance on whistleblowing for their members in 2010, as we were asked for our comments on the framework of this guidance. However despite outlining a number of concerns about the guidance, we were not consulted any further and we do not know if these concerns were reflected in the final guidance as this is accessible to members only. We would be happy to provide commentary on the guidance if made available. Internal Arrangements—Policy, Practice and Review 10. We see a great number of whistleblowing policies through our work assisting and training organisations. Many policies are too legalistic, complicated, fail to give options outside line management, do not provide adequate (or any) assurances to the individual, place the duty of fidelity above all else, and contain contradictory and/or poor reassurances on confidentiality. 11. Getting the whistleblowing policy right is a crucial first step. The Committee on Standards in Public Life has informed and influenced practice on whistleblowing across and beyond the public sector. The Committee has recommended that good whistleblowing policies: (a) provide examples distinguishing whistleblowing from grievances; (b) give employees the option to raise a whistleblowing concern outside of line management; (c) provide access to an independent helpline offering confidential advice; (d) offer employees a right to confidentiality when raising their concern; (e) explain when and how a concern may safely be raised outside the organisation (eg with a regulator); and (f) provide that it is a disciplinary matter (a) to victimize a bona fide whistleblower, and (b) for someone to maliciously make a false allegation. 12. To be effective, the Committee has stated that it is important that those at the top of the organisation show leadership on this issue and ensure that the message that it is safe and accepted to raise a whistleblowing concern is promoted regularly. 13. A good policy will mean little if it is left to gather dust in a draw. A policy must be actively promoted and communicated, managers trained on their role and on how to handle concerns, arrangements reviewed regularly, trust and confidence of staff tested and arrangements refreshed. Buy-in at the top of the organisation is key and a good audit committee or board will want to know how the arrangements are working. The Institute of Chartered Accountants for England and Wales has devised a list of questions that a good audit committee might ask in order to sense check their arrangements:138 — Is there evidence that the board regularly considers whistleblowing procedures as part of its review of the system of internal control? — Are there issues or incidents which have otherwise come to the board’s attention which they would have expected to have been raised earlier under the company’s whistleblowing procedures? 138

Institute of Chartered Accountants in England and Wales (ICAEW) Guidance for Audit Committees: Whistleblowing arrangements (2004) www.icaew.com

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1301

—

Where appropriate, has the internal audit function performed any work that provides additional assurance on the effectiveness of the whistleblowing procedures?

—

Are there adequate procedures to track the actions taken in relation to concerns raised and to ensure appropriate follow up action has been taken to investigate and, if necessary, resolve problems indicated by whistleblowing?

—

Are there adequate procedures for retaining evidence in relation to each concern?

—

Have confidentiality issues been handled effectively?

—

Is there evidence of timely and constructive feedback?

—

Have any events come to the (audit) committee’s or the board’s attention that might indicate that a staff member has not been fairly treated as a result of their raising concerns?

—

Is a review of staff awareness of the procedures needed?

The Framework for Whistleblowers 14. PIDA protects the public by providing a remedy for individuals who are dismissed or suffer a detriment by any act or any deliberate failure to act by their employer for raising a genuine concern, whether it be a risk to the public, financial malpractice, or other wrongdoing. PIDA’s tiered disclosure regime promotes internal and regulatory disclosures, and encourages workplace accountability and self-regulation. Essentially, under PIDA, workers who act in good faith are given automatic protection for raising a matter internally. Protection is also readily available to individuals who make disclosures to prescribed regulators, such as the FSA or the Serious Fraud Office (SFO). In certain circumstances, wider disclosures, for example to an MP or the media, may also be protected. A number of additional tests apply when going wider, including: —

whether it is an exceptionally serious concern;

—

whether the matter has already been raised;

—

whether there is good reason to believe that the individual will be subject to a detriment by his employer if the matter were raised internally or with the appropriate regulator;

—

whether the disclosure was made for personal gain; and

—

whether the disclosure was reasonable given all the circumstances.

15. We are concerned that PIDA needs substantial strengthening in a number of areas. At present the Enterprise and Regulatory Reform Bill (HC), currently before Parliament, contains an amendment to PIDA that we do not consider will provide better protection against abuse of the law and will only further complicate protection for whistleblowers. Please see Annex A for our full briefing on this issue and suggested amendments. 16. There have been a number of suggestions that an ombudsman be created for whistleblowing (whether this should be in the financial sector or more generally is not clear) or that rewards should be offered to financial service whistleblowers, such as those offered by the Securities Exchange Commission in the US. While we see it worthwhile exploring both concepts, in the financial sector there are already four organisations prescribed under S43F of PIDA that are relevant to the banking sector—the FSA, the SFO, the Financial Reporting Council and the London Stock Exchange . The former two already have specific programmes for whistleblowers. It would seem more sensible to examine the arrangements presently in place and whether they require strengthening before the creation of a further organisation, unless this organisation was specifically set up to examine the handling of whistleblowing concerns by the above bodies. 17. As to rewards, the US have had the False Claims Act (FCA), in place for a number of years which allows whistleblowers to sue on behalf of the state if the Government has been defrauded. This provides that whistleblowers can receive between 15% and 30% of any monies recovered. This approach has been used in the Dodd-Frank Act, whereby whistleblowers who provide original information that leads to a successful enforcement action of at least £1,000,000 to the Securities and Exchange Commission (SEC) can receive between 10% an 30% of monetary sanctions collected. Recently the SEC released information that they had awarded the first individual under this scheme $50,000139. The percentage of the total sanction awarded to the whistleblower may be influenced by whether or not the matter had been raised internally. Additionally it is likely that a fine would be larger if a whistleblower had been ignored internally. It is not clear how many individuals pass on information that does not lead to a fine, nor the protections in place if their identity is deduced during any subsequent investigation, including those that do not lead to a successful prosecution of at least £1,000,0000. 18. If rewards are to be considered we would flag the following points which we would suggest require close scrutiny before proceeding with such a programme:

139

—

A rewards system should not be seen as a replacement for good legal protections for whistleblowers who raise information in good faith or the public interest.

—

A rewards system should not be seen as a replacement for development of good practice.

San Francisco Chronicle, 21 August 2012.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1302 Parliamentary Commission on Banking Standards: Evidence

—

— —

—

As with the provisions in the Dodd-Frank Act, consideration should be given as to how to encourage individuals to come forward at an early stage or there will be a risk that individuals will have an incentive to sit on information until it becomes “serious” enough to be eligible for reward, limiting the ability of organisations and regulators to detect malpractice early. Under PIDA internal disclosures are protected when an individual has “information which, in the reasonable belief of the worker making the disclosure, tends to show” one of the categories of wrongdoing. In layman’s terms, a genuine suspicion. Under PIDA, such rewards may come into conflict with requirement of all disclosures made under the act (bar those to a legal adviser under 43D) to be made in good faith. That consideration be given as to whether it is appropriate to have a separate system for the financial services. The clear example would be a nurse who raises serious concerns about patient safety. How would a reward to such an individual be calculated? We have provided advice to individuals in the US who have found it difficult to reconcile accusations that they blew the whistle for money, when ethical considerations have been their key motivation.

19. The current scandal creates an opportunity for the banking sector to revisit the issue of culture and how to ensure that this encourages individuals to raise concerns. For those working in the sector, where the criticism has been that many risky decisions have been made based on the profit motive alone, it is time to encourage and reward those who wish to act as good citizens in the workplace. There needs to be a clear move towards making it acceptable to have ethics and not only in circumstances where there is a monetary award if the concern is proved right. Ensuring that the question of ethics is included in the day to day decision making processes within the financial sector may prove more beneficial, particularly in deterring not just detecting malpractice, than any reward system and could perhaps be a consideration in appraisal or promotion programmes. Where appropriate this could impact on salary increases or bonuses. 20. We would be happy to provide further information to the Commission on any of the above and in relation to the analysis of our cases once the report has been finalised. Annex A BRIEFING ON ENTERPRISE AND REGULATORY REFORM BILL: Section 14 Disclosures not Protected unless Believed to be Made In the Public Interest Introduction DBIS have announced that they will be introducing a public interest test in the whistleblower protection law known as the Public Interest Disclosure Act (PIDA) in order to overcome a legal loophole whereby individuals are able to claim protection for raising concerns about their own personal employment contract. We are deeply concerned that they are doing so without thorough public consultation, the amendment suggested will not overcome the problem and will result in a field day for lawyers and that this is a missed opportunity for addressing problems which have arisen in the legal protection for whistleblowers. This loophole arose in an interim employment tribunal case, Parkins v Sodexho140, and has watered down the public interest purpose of PIDA. There have been concerns that PIDA is being abused by City Bankers who are using it to claim that raising concerns about their bonus payments are protected disclosures under PIDA141. This has led some to say that PIDA cases are being dominated by “pale stale males”. This affects the reputation of this key piece of legislation and is a far cry from the original purpose of the legislation and the Parliamentary debates for the first and second bills. DBIS are proposing to remove this loophole in the following way: Public interest test proposed by DBIS Enterprise and Regulatory Reform Bill 14. Disclosures not protected unless believed to be made in the public interest: In section 43B of the Employment Rights Act 1996 (disclosures qualifying for protection), in subsection (1), after “in the reasonable belief of the worker making the disclosure,” insert “is made in the public interest and”. The change would have the following effect: Employment Rights Act 1996 43B.—(1) In this Part a “qualifying disclosure” means any disclosure of information which, in the reasonable belief of the worker making the disclosure is made in the public interest and tends to show one or more of the following: (a) that a criminal offence has been committed, is being committed or is likely to be committed, (b) that a person has failed, is failing or is likely to fail to comply with any legal obligation to which he is subject, 140 141

[2001] UKEAT 1239_00_2206. A report in the Financial Times on 18 September 2007 quoted the city firm Nomura warning that "The whistleblowing legislation was designed to protect employees who, in good faith, raise legitimate concerns of wrongdoing in the workplace. Its growing use by white men as a litigation tactic when in dispute with the City employers, suggests the legislation is being abused".

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1303

(c) (d) (e) (f)

that a miscarriage of justice has occurred, is occurring or is likely to occur, that the health or safety of any individual has been, is being or is likely to be endangered, that the environment has been, is being or is likely to be damaged, or that information tending to show any matter falling within any one of the preceding paragraphs has been, is being or is likely to be deliberately concealed.

We agree that something has to be done to address this loophole but we find we cannot support the DBIS amendment on three grounds. 1. DBIS’s failure to consult First, DBIS propose including a public interest test in PIDA without considering the wider problems with the law and the need for a public consultation. The timing of an amendment to the law also does not seem prudent given the on-going Mid Staffordshire NHS Foundation and Leveson Inquiries, both of which will have important outcomes for the public interest and will likely have conclusions that will deal with whistleblowing. The failure to undertake a wider, comprehensive review, will be a “missed opportunity” to address some of the legal loopholes that exist which include a gaping hole in protection if workers are victimised by co-workers for raising a concern (no vicarious liability mechanisms), making sure all workers are adequately covered, clarifying protection for GPs, and ensuring that workers who raise concerns with all statutory bodies including the police and professional regulators are readily protected. We set out case studies and examples of these problems under the heading of “a missed opportunity” below. We also argue that DBIS need not act with such haste in rectifying the Parkins v Sodexho issue without full consultation with trades unions and employers, as in 2009/10 10% of final judgments or just 40 cases involved an individual raising a concern about their private employment rights142. Moreover according to 2011/12 employment tribunal statistics less than 1% of claims involve whistleblowing allowing an opportunity for full reflection on the state of whistleblower protection in the UK. 2. “Field day” for lawyers Secondly, we are concerned that the above amendment will not address the legal loophole (see our suggested amendment below) and will instead become a field day for lawyers who will spend time arguing whether or not something is in the public interest, increasing litigation, costing employers and the taxpayer more; all of which the Government has sought to address in recent consultations on employment law reforms. As it currently stands PIDA identifies broad categories of public interest issues- criminal offences, dangers to the environment, miscarriages of justice, health and safety concerns and breaches of legal obligations. The drafting suggested by DBIS is clumsy and nonsensical- the public interest test imposed will cut across all the categories of wrongdoing which means, for example, when raising a concern about a criminal offence an individual would have to show that it is in the public interest. It is common sense that issues that are criminal offences, dangers to the environment, miscarriages of justice and dangers to health and safety, are public interest issues and so should not be subject to an additional public interest test. The purpose of PIDA is to prevent disaster and to encourage workers to speak up when they have suspicions. Issues that at one point seem trivial may in fact be indicative of underlying problems in an organisation and could be the tip of the iceberg. A public interest test may have the unintended consequences of focussing on how big the disaster is or was likely to be, and mean less focus on reporting early suspicions. Issues such as missed medication may seem relatively minor compared to a multi-million pound fraud such as that in the high profile Olympus case143 but could be a matter of life and death. We suggest the amendment below, which would have the effect of dealing with the Parkins v Sodexho issue without imposing an additional barrier for the genuine whistleblower, as an alternative to the one presently suggested by DBIS: PCaW suggested amendment: 43B.—(1) In this Part a “qualifying disclosure” means any disclosure of information which, in the reasonable belief of the worker making the disclosure, tends to show one or more of the following: (a) that a criminal offence has been committed, is being committed or is likely to be committed, (b) that a person has failed, is failing or is likely to fail to comply with any legal obligation to which that person is subject (other than a private contractual obligation which is owed solely to that worker), (c) that a miscarriage of justice has occurred, is occurring or is likely to occur, (d) that the health or safety of any individual has been, is being or is likely to be endangered, (e) that the environment has been, is being or is likely to be damaged, or (f) that information tending to show any matter falling within any one of the preceding paragraphs has been, is being or is likely to be deliberately concealed. 142 143

Whistleblowing: Beyond the law, Oct 2011 http://www.pcaw.org.uk/files/PCAW_Review_beyondthelaw.pdf http://www.independent.co.uk/news/business/news/olympus-settles-claim-with-exboss-michael-woodford-7800965.html

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1304 Parliamentary Commission on Banking Standards: Evidence

3. A new barrier for honest whistleblowers Thirdly, the perception will be that this test is a barrier to individual whistleblowers. When this is added to the fact that PIDA is little known and often misunderstood, we believe that the legislation will be undermined by this approach. It will also add to the idea promulgated in the media that if you are whistleblower, you will be burned and that the law is too complicated to protect you. In sectors such as health and care, where whistleblowing can save lives and taxpayers’ money, and where gagging clauses and hierarchical professions and workplaces impose real obstacles for the individual, such an amendment will be seen as another obstacle. The honest and reasonable whistleblower, faced with an increasingly complex piece of legislation to navigate should they be poorly treated, may choose not to speak up. This is a rather damning position, nearly two decades on from the Bristol Royal Infirmary Inquiry when the whistleblower, Dr Stephen Bolsin,144 was forced to leave the UK to find work. Furthermore, Parliament when it passed PIDA did not place a public interest test in the legislation, choosing instead to define the categories of wrongdoing under which disclosures in the Public Interest Disclosure Act should fit. Good faith was seen as the appropriate safeguard. Dame Janet Smith in her report on the Shipman inquiry commented that perhaps good faith should be replaced by a public interest test. If the public interest test is to be considered at all, it really should be considered in conjunction with the test of good faith. Any attempt to add a public interest test requires wider consultation and should not be placed in the Act as an additional hurdle by the back door. “A Missed Opportunity” to Protect Whistleblowers The lack of consultation means that this will also be a missed opportunity to deal with some of the problems that have arisen since PIDA’s introduction over a decade ago. These problems include: 1. Vicarious Liability Loophole This loophole has arisen in the context of three nurses from Manchester who raised a concern about a colleague lying about his qualifications. The nurses raised their concern within the service and the Primary Care Trust. Their concern was upheld. However, the nurses were subject to bullying and harassment from coworkers. One of the nurses received a telephone call threatening her daughter and to burn down her home.145 The case proceeded as far as the Court of Appeal, which found that vicarious liability does not exist in PIDA, as it specifically does in discrimination law. Shortly after the publication of the judgment, Lord Howe, the Health Minister, agreed that this area needs to be reviewed.146 From the experience on our advice line, harassment and bullying by co-workers is not uncommon and for there to be no protection in this area is extremely problematic, as it means whistleblowers could be facing a cardboard shield in terms of the protection afforded by PIDA. It surely cannot be right that an employer can fail to do enough to protect a whistleblower from victimisation and yet altogether escape liability. To overcome this problem, we suggest transposing the existing tests from the Equality Act 2010 (sections 109–112 and section 40) into PIDA. This would also build a defence into the legislation for employers, as if they can show that they took reasonable steps to prevent the victimisation, they would not be liable. It is bad news for whistleblowers everywhere if whistleblowers who are bullied by fellow staff members are not protected. Another example of this is the case of Helene Donnelly, a nurse who gave evidence to the Mid Staffordshire Inquiry and spoke of the bullying she experienced by other staff. Surely no one would suggest she should not have got protection.147 2. Widening the scope of PIDA to cover all GPs, student nurses, doctors, health care professionals, volunteers, NEDs (including public appointments) and prospective job applicants Recent employment law cases and media stories have highlighted the difficulties of the above groups such as students on vocational placements in health and care settings, all GPs (see Anne Milton’s answer to a Parliamentary question which highlighted the complicated nature of the protection of GPs at present),148 volunteers, non-executive directors (the reluctance of Royal Bank of Scotland non-executives to question Fred Goodwin),149 public appointments (the case of Kay Sheldon- a board member of the Care Quality Commission),150 members of LLPs (covered by the Equality Act 2010), priests (covered by the Equality Act 2010) and foster carers. The lack of protection for job applicants was highlighted in an Employment Tribunal Appeal case, BP v Elstone,151 where an employee was protected from victimisation by his current employer, having raised a 144

http://news.bbc.co.uk/1/hi/health/532006.stm http://news.sky.com/home/video/15385116 146 http://www.independent.co.uk/news/uk/home-news/whistleblowers-not-protected-from-bullying-court-rules-6255015.html 147 http://www.nursingtimes.net/nursing-practice/clinical-specialisms/accident-and-emergency/whistleblowing-mid-staffs-nurse-tooscared-to-walk-to-car-after-shift/5036466.article 148 HC Deb, 9 March 2011, c66WS. 149 http://www.ft.com/cms/s/0/3776f564–02de-11de-b58b-000077b07658.html#axzz1tp9gA7M2 150 http://www.guardian.co.uk/society/2012/jan/24/kay-sheldon-whistleblower-care-quality-commission 151 [2010] IRLR 558, [2010] UKEAT 0141_09_3103. 145

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1305

concern with his previous employer. The tribunal commented that had the claimant been a job applicant he would not have been protected. On our advice line, discrimination at pre-employment stage is a worry for workers considering whether and how to raise a concern. It can be daunting for an individual who has raised a genuine concern about a danger, risk or malpractice in the workplace and has left the organisation, to know what to say about why they left their last job. This presents a very difficult dilemma for a whistleblower who has acted in the public interest and it is important to build some protection into the system so that whistleblowers are not fearful in such situations. In research that we have conducted for the Older People’s Commissioner for Wales, we found that the second most common negative response from an employer was refusing to provide a good reference. In order to overcome this problem we propose the definition of worker in section 43K of PIDA is extended to include: — Student nurses, doctors, healthcare professionals and social workers. — General Practitioners in the health service , regardless of their contractual arrangements. — Volunteers and interns. — Non-Executive Directors. — Public Appointments. — Members of LLPs. — Priests. — Foster carers. — Job applicants. — All categories covered in the Equality Act 2010. 3. Extending the categories of wrongdoing Gross waste, gross mismanagement and abuse of authority are not included in PIDA but are included in equivalent US legislation. At a time of austerity and the abolition of the Audit Commission, we suggest that these categories should be included, particularly as what may be deemed as a waste of money may not in fact be illegal but we would still hope that such concerns are raised. For example it could be a way to encourage workers to raise concerns about mass over-expenditure in public spending projects such as the waste of public money in the NHS IT system152. We suggest a public interest category would be useful to cover these types of wrongdoing which may not be covered by the other categories. This also ensures that PIDA evolves and covers serious ethical concerns that fall short of a breach of legal obligation. 4. Gagging clauses Little attention has been paid to the provision in PIDA section 43J which outlaws any contractual clause that prevents workers from raising a public interest concern. The cases of Dr Kim Holt and Great Ormond Street Hospital, and former inspectors at the Care Quality Commission153 giving evidence to the Mid Staffordshire Inquiry highlight the need for greater attention to be drawn to section 43J of PIDA and for there to be tougher enforcement. We recommend a positive requirement is placed on lawyers advising in the settlement of claims, that they advise claimants about their rights under the Public Interest Disclosure Act and that any such gagging clauses are void. 5. Disclosures to all statutory bodies are protected PIDA identifies a list of prescribed regulators and protection is relatively easy for individuals who raise concerns with them. Given that statutory bodies are changing we would suggest that the specific provision in PIDA dealing with this point (section 43F) be widened to cover a disclosure to a relevant statutory body whether or not it is prescribed. An amendment along these lines has been suggested by the DTI (as was) as it is administratively cumbersome to have to prescribe new regulators. The amendment includes not only regulators such as the HSE or FSA but also the relevant local authority enforcement authorities. Given that there are changes to the regulatory activities in financial services, it may be prudent to allow this change and to ensure protection can flow seamlessly. This also means that individuals who raise concerns with professional regulators such as the Nursing and Midwifery Council, General Medical Council and the Health Professions Council would be more easily protected. More importantly this would be a smart way to deal with international criticism from the OECD that disclosures to the police have to satisfy higher tests than disclosures to prescribed regulators. We recommend that the power to prescribe persons as this is something HMG may wish to use (eg in 1997/8 the Minister Ian McCartney MP suggested union officials might be prescribed at some point). 6. Tackling the good faith test Dame Janet Smith in the Shipman Inquiry stated that good faith was a barrier to whistleblowers. This is being borne out by recent reports in the Mid Staffordshire and Leveson Inquiries. 152 153

http://www.guardian.co.uk/society/2011/sep/22/nhs-it-project-abandoned http://www.telegraph.co.uk/health/healthnews/9170951/Health-regulator-gagged-own-staff-against-speaking-of-failures.html

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1306 Parliamentary Commission on Banking Standards: Evidence

We have proposed three options for addressing the good faith point. Option (i) is to remove the test altogether. Options (ii) and (iii) both clarify the purpose of PIDA protection is that wrongdoing can be addressed. Option (ii) follows the approach taken by the Court of Appeal in Street v Derbyshire UWC154 that (a) good faith means with the honest purpose of raising the concern so it can be addressed, but (b) that an ulterior predominant motive can negate good faith. Our suggested amendment clarifies this by stating that a predominant ulterior motive should only negate PIDA protection where it is malicious. This reflects the meaning the Government intended the term “in good faith” in PIDA should have, as confirmed by the DTI in its comments of 31 August 2001 on the report into the Bristol Royal Infirmary that “in good faith” in PIDA “simply means that the disclosure was made honestly, not maliciously.” In clarifying the honesty of purpose on the face of the Act, this amendment helps reduce the risk (increased by the abolition of the register of employment tribunal applications) that an employee might be tempted to make an internal disclosure to blackmail the employer by offering to keep the wrongdoing secret if he is given an undue benefit. While Option (iii) includes a public interest test which means that the worker would have to show that the predominant motive for raising their concern is in the public interest. If the legislation is to include a public interest test then it would be appropriate to consider this in conjunction with the good faith requirement in PIDA, rather than placing an additional hurdle on would be whistleblowers. To address this finely nuanced issue properly requires consultation and the current proposed amendment would need to be reversed. Where is the Bill? First reading The bill was published and first reading took place on 23 May 2012. Second Reading The bill received its Second Reading on 11 June 2012, where Katy Clark MP (Labour) spoke in favour of a public consultation and voiced concerns about the proposed public interest test. Shadow Secretary of State for Business Innovation and Skills Chuka Umunna also expressed concerns over the introduction of a public interest test. Committee Stage The Committee Stage of the bill started on 19 June 2012 with a number of scrutiny sessions where the Public Bill Committee heard evidence experts and interested parties. Our Chief Executive Cathy James gave evidence to the Committee. On 3 July 2012 Labour Shadow Minister Iain Murray proposed our amendment (see above). Unfortunately this was rejected. Early Day Motion Outside the consideration of the bill, Katy Clark MP has put forward an Early Day Motion (EDM). The EDM (359) calls for a public consultation and the wording is as follows: “That this House believes greater protection should be provided to whistleblowers in the workplace; is alarmed at the Court of Appeal’s decision in NHS Manchester v Fecitt & Ors which indicates that employees are no longer protected from harassment of co-workers; believes that this is just one of a number of issues, including the implementation of the Shipman Inquiry’s recommendations to remove the good faith test, and the use of gagging clauses which requires serious debate; believes that the changes put forward in the Enterprise and Regulatory Reform Bill will make it more difficult for individuals to rely on the Public Interest Disclosure Act and calls on the Government to hold a wider consultation on possible reforms to ensure a meaningful strengthening of the protection of whistleblowers”. 7 September 2012

Written evidence from the Question of Trust and the Financial Services Research Forum The Financial Services Research Forum (FSRF), based at the University of Nottingham, has been undertaking research on trust in UK Financial Services since 2003 and has been collecting data on the subject for some 8 years. The associated research has been undertaken by academic staff at the University of Nottingham and associated institutions. Since 2009, the work on trust has also been complemented with a series of studies on the related issue of fairness. Most recently, the FSRF has partnered with the Question of Trust (QoT) to explore further opportunities for the measurement and analysis of consumer trust. This partnership brings together the research base of FSRF with the industry-based, campaigning expertise of QoT to try to encourage greater industry focus on the need to engage with the types of business practice that have been identified as driving organisational trustworthiness and consumer trust. 154

[2004] EWCA Civ 964.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1307

Key questions posed by the Parliamentary Commission on Standards in banking are outlined below and accompanied by a summary response. A series of published and unpublished documents which are of relevance to the summary answers is provided at the end of this document. How can we measure trust in UK banks? (see Ennew and Sekhon (2007) for more detail) There have been many different approaches to measuring trust. Some of the more high profile measures adopt a relatively simplistic approach which asks customers directly whether they trust or not. Where the response requires a simple “yes” or “no”, the results can often provide appealing headlines but do not reflect the richness or complexity of the underlying construct. A more common approach (see for example, the Edelman Trust Barometer) asks directly about levels of trust but on a graded scale). Our approach is to try to recognise that trust is a complex construct, and to acknowledge the differences between trust (the consumer belief) and trustworthiness (the reputation of the organisation). We also recognise that trust may be cognitive (focused around dependability and reliability) and affective (focused around care and concern). Specifically, our current approach uses 6 questions to measure trust, of which 3 measure cognitive trust and three measure affective trust. The use of multiple items enhances the reliability and validity of the measurement. And the robustness of our approach to measurement has been statistically validated. How have levels of trust in UK banks changed over the past 5 years? We have two distinct sets of evidence. Both measure trust using scaled responses to multiple items—thus measures of trust are an aggregate of responses to a series of statements which are believed to reflect the underlying construct of trust. The statements themselves were developed drawing on existing literature and extensive scale development work. The first set of evidence comes from an annual telephone survey conducted from 2005 to 2009 which measures trust in the respondents own financial services provider (See Ennew 2009 for a summary). This suggests that levels of trust are remarkably stable over time, although there is variation across types of financial service provider with banks tending to receive some of the lowest trust ratings. It is worth noting that trust is an essential part of a relationship and some degree of trust is necessary for a financial services relationship to exist. Moreover as an underlying belief we would expect trust to display some durability—an established belief is not easily undermined. The second set of evidence comes from an internet survey conducted between late 2009 and the present. This used similar measurement to the surveys discussed above but sought to contrast trust in the respondents own provider with trust in the industry in general (see Ennew, 2011, 2012b). Again, the evidence points to a surprising level of stability in overall levels of trust. Trust in financial services providers in general is significantly lower than trust in the respondents own provider and banks are clearly amongst the lowest rated financial institutions. These surveys also draw attention to the idea of forced versus active trust. Forced trust reflects the idea that individuals may trust, not because of any positive assessment of their relationship with a financial services provider, but because they have no choice. This is contrasted with active trust which is a positive belief about the quality of the relationship with a financial services provider. The research points to an increase in the proportions of consumers who might be classed as “forced trustors”. Further analysis of the internet survey data was undertaken for the Question of Trust Campaign and particularly to develop a measure of trust which, in contrast to the FSRF measure, focused on consumer trust in the industry as a whole. This measure—the Money Trust Index—highlights the low levels of consumer trust across all sectors of the industry although banks do attract some of the poorest ratings. What are the key drivers of any changes in trust in UK banks that you have identified? (see Sekhon et al) Our research has focused on financial services providers generally rather than just banks. Our research suggests that consumer trust depends significantly on the extent to which providers project a reputation for trustworthiness. In turn, reputation for trustworthiness is dependent on aspects of business practice and specifically: Benevolence Integrity Ability/Expertise Shared values Communications

The extent to which an FSI demonstrates that it is concerned about the interests and needs of its customers. The extent to which an FSI is honest and consistent in what it does from a customer perspective. The extent to which an FSI is seen as having the necessary skills and ability to deliver its services from a customer perspective. The extent to which consumers believe that an FSI has values similar to their own. The extent to which an FSI communicates well/effectively from a customer perspective.

Failings in any or all of these areas (and there are many examples) will only serve to reduce trustworthiness and consumer trust.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1308 Parliamentary Commission on Banking Standards: Evidence

Why does trust in banks matter for the UK economy? Trust is fundamental to the effective operation of a market economy. In the specific context of financial services, intangibility, product complexity, and the long term nature of many products mean that customers face high levels of risk in making purchase decisions; they will often have difficulty in judging product performance and thus will need to trust financial services organisations to offer products of an appropriate type and quality. Consumers face risk in relation to most financial services, but the concern is perhaps greatest in relation to savings and investment products where the risks are associated with the poor performance of the product and a poor return. These outcomes could arise from the inadequacies of the product but could equally be due to misfortune—and consumers may struggle to distinguish between the two. Risk is inherent in the product but is compounded by consumer’s typically low levels of understanding and the impacts of uncontrollable factors. Associated with this element of risk is consumer vulnerability—since financial services can and do have a significant impact on the consumer’s well-being, a poor performing product can have a very significant impact on individual customers. Clearly then, financial services are of considerable importance but their risky nature makes consumers vulnerable to detriment. This is complicated by the fact that the functioning of financial markets means that in general, individuals need the services of a specialist intermediary to deal with their financial needs (notwithstanding the development of some peer-to-peer services). More significantly, product variety and complexity mean that the customer is dependent on a financial services organisation for advice and the more limited the customers understanding of financial services, the greater the dependence on a financial services provider or a financial adviser. In the absence of complete information, that relationship relies on a degree of trust to function effectively. Put simply, if consumers do not or cannot trust the intermediaries with who they have a relationship they may partially or wholly withdraw from the market. In a context in which individuals are expected to assume much greater responsibility for their own welfare, this could result in significant consumer detriment (inadequate protection against risks, inadequate savings for retirement) not to mention possible increased government expenditure to protect or support those who have inadequate financial provision for themselves or their families. Costing the direct financial consequences of lack of trust is difficult, but figures quoted in the Thoresen Report, for example, suggest that an estimated cost £15 billion is possible. Conversely, if enhanced levels of trust resulted in all UK households increasing savings by £1.50 per day, then the corresponding benefit would be in the region of £15 billion.

Relevant Publications Ennew, C T (2012b) Trust: Trends and Analysis—September 2012, Financial Services Research Forum, University of Nottingham (available at http://www.nottingham.ac.uk/business/forum/publications.aspx ) The Money Trust Index—A Report for the Question of Trust Campaign—July 2012, Financial Services Research Forum, University of Nottingham (available at http://www.nottingham.ac.uk/business/forum/ publications.aspx ) Devlin, J and Waite, N (2012) Fairness in Financial Services: Sector Analysis—July 2012, Financial Services Research Forum, University of Nottingham (available at http://www.nottingham.ac.uk/business/forum/ publications.aspx ) Sekhon, H, Ennew, CT, Kharouf, H and Devlin, J (2012) Modelling Trust and Trustworthiness: Influences and Implications, Unpublished Paper. Ennew, C T (2011) The Financial Services Trust Index, 2011-Q1, April 2011, Financial Services Research Forum, University of Nottingham (available at http://www.nottingham.ac.uk/business/forum/publications.aspx ) Ennew, C T (2009) The UK Financial Services Trust Index, 2009, Financial Services Research Forum, University of Nottingham (available at http://www.nottingham.ac.uk/business/forum/publications.aspx ) Ennew, C T and Sekhon (2007) The Trust Index, Consumer Policy Review, Mar/Apr, vol 17 (2) pp 62–68 01 October 2012

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1309

Written evidence from John N Reynolds OBE 1. Executive Summary 2. The major ethical failings in banking surround two issues: first, being prepared to ignore the duties of care to customers (and in some cases to deny that they exist), resulting in ethically unacceptably conflicts of interest; and second, a widespread tendency to subjugate truth to adherence to strict literal statements of fact which may nonetheless be actively misleading. 3. Banking, in order to protect its shareholders, customers and the taxpayers, requires both an external and internal impetus to require ethical behaviour, including proscribing both general and specific unethical practises. 4. Banks—and investment banks—need to reform their current inadequate codes of conduct to provide meaningful guidance to employees at all levels. 5. Background 6. This paper has been written by John N Reynolds, author of “Ethics in Investment Banking” (Palgrave Macmillan 2011, co-authored by Edmund Newell) and from 2006–2011 Chair of the Church of England Ethical Investment Advisory Group. I originally studied theology, including studying ethics, before commencing a career in investment banking. I am currently a director of a number of companies, and have recently been appointed a member of the Methodist Church Joint Advisory Committee on the Ethics of Investment (JACEI). I do not, at the time of writing, work for any bank or investment bank. I had a career of around 20 years in investment banking, and have worked for UK, European, Japanese and US institutions in various senior roles. As an investment banker, I have worked in four major areas: equity research, corporate finance, financial restructuring and principal investing. I have also been a client of investment banks, including the investment banking arms of universal banks. I do not, at the time of writing, work for any bank or investment bank. This paper is written in a personal capacity and represents the views of the author only. 7. This paper looks specifically at standards in investment banks and “universal” banks (integrating investment banking and commercial banking). It does not seek to comment specifically on retail banking. 8. Submission 9. An external requirement to behave ethically would enhance reforms to the banking and investment banking sectors to ultimately protect customers and taxpayers, reducing the scope for banks and investment banks to circumvent specific rules. 10. Professional standards in banking and investment banking are in general terms similar to those in business generally in the UK, but the impact of ethical lapses can be very significant, given the size of modern financial markets. This places an nous on the banking and investment banking sectors to behave with a heightened awareness of their ethical duties. 11. There has been increasing institutional pressure by banks to deliver high returns, a pressure which in a number of cases originates from the banks’ own institutional shareholders. Such pressure results in a management requirement on bankers to increase revenue and profit, and this can be at the expense of ethical standards and client care. Challenging such a mandate can be career limiting for a banker. 12. There is a clear dichotomy between the standards a bank espouses publicly (in its advertising) and the attributes looked for among employees (such as a desire to make money). Such a dichotomy is no different than that found in many areas of commerce, but is nonetheless unhealthy. 13. My personal experience of banks in the UK, over the course of the past 20 years, has been of strongly professional behaviour in most circumstances, in a prevailing environment where almost the only pressure on senior management is to deliver revenue growth. Bankers are aware of the need to behave professionally and ethically, but little thought is actually given to what is truly ethical or unethical, as opposed to what is legal or compliant. 14. There are two common failings which tend to undermine ethical standards, but which are commonplace and are not seen as unprofessional: first, being prepared to ignore any duty of care to clients; and second, preferring a reliance on strict factual accuracy over communication of the substance of a statement or situation. 15. The result of this would have been expected to reduce trust in the banking sector. However, as both a banker and a client of banks, banks do not seem to have suffered a loss in business from most categories of corporate clients. This is itself seems at first to be surprising. However, it can be explained by understanding the corporate clients do not tend to seek ethical behaviour in a banking relationship, so much as efficacious behaviour—the clients of a bank are typically looking for a “mercenary” rather than a “trusted advisor”. 16. The causes of the problems are complex, and relate primarily to: a general low level of ethics and understanding of ethics in business, not just in banking, often reflecting low prevailing ethical values in society. 17. In my own experience, the impact of the opening of the UK investment banking market led to a dramatic increase in technical standards, but a reduction in relationship-based banking. A major part of this has been the ability of US-based institutions to successfully develop businesses in the UK and Europe, directly resulting

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1310 Parliamentary Commission on Banking Standards: Evidence

in increased competition in certain areas. The US market is characterised by a more atomised market place, where corporations will shop around for suppliers of individual banking products, which in Europe are more likely to be sought from a single bank. 18. The business practices in the UK, the US and in major European markets vary considerably. However, this does not mean that underlying ethical standards are markedly different. Business practices reflect many facets of a country, including prevailing social values, and industry structures. I have worked extensively in the US, for example, and have not found ethical standards in business or society generally lower than in the UK. 19. The internal culture within investment banks, and the investment banking arms of universal banks, is often based on patronage by individual senior bankers. This results in loyalty required to be shown to individuals rather than the organisation in order to achieve promotion (and pay). There is relatively little attention paid to management training in investment banks, and this can have a clear impact on culture, and may explain in part the recurrence of internal cultural problems in the sector. This is important in an environment where an increasing proportion of both profits and senior management in universal banks appear to come from their investment banking arms. 20. The standards of investment banking seen recently in some emerging markets are significantly short of those tolerated in the anglo-saxon world, and are a cause for concern about the industry generally, giving the increasing percentage of fee income achieved from these markets. This can be seen for example in the standards of care taken in the initial public offerings (IPOs) of some companies in parts of Asia with poorly considered business cases. 21. The integration of lending and advisory activities can give rise to clear conflicts of interest, which the investment banking sector has been allowed by regulators and clients to embrace. I was told by a main board director of a major quoted bank some time ago that “conflicts of interest = revenue”, which from a commercial perspective is very accurate, but from an ethical perspective gives rise to a number of concerns. Banks are not alone in this approach, and there are apparent conflicts of interest in other professions as well. 22. An obvious example of conflicts of interest relates to advising a seller of a business at the same time as lending to a buyer. It has become almost commonplace for a bank to advise on the sale of a business while simultaneously advising on the financing for potential buyers. This can be done on a basis formally agreed with the seller, and as a service to the seller, through “stapled” financing (that is, a financing product available to any buyer), or alternatively by advising individual buyers. This latter practice creates a particular conflict of interest, as financing fees are typically a multiple of advisory fees. A number of recent court cases highlight the problems inherent in this approach. 23. The management of conflicts is possible without requiring the separation of commercial and investment banking, provided appropriate regulation is adopted. The current practice of banks, which in general terms is to disclose such conflicts, is not sufficient to genuinely ensure that there are no meaningful incentives to breach the duty of care to clients. 24. Improved governance and ethical behaviour is not, in my opinion, possible without clear regulations regarding conflicts of interest, and also without specific external requirements for Boards to have regards to ethics in general terms. 25. I have found advisory-only investment banks to have a greater regard for ethics and standards of conduct than universal banks. This may be because such firms are hired almost entirely on reputational values, rather than on the basis of their capital strength. However, a corollary to this is that the presence of an advisory function within a universal bank may provide internal pressure for higher standards of behaviour, and mitigate against a separation of investment banking from banking. 26. Major banks and investment banks publish a code of ethics or code of conduct to guide their employees. Having reviewed many of these, they are universally disappointing and in practical terms useless. In large part this is because they (i) primarily aim to protect shareholders, rather than customers, and (ii) signally fail to explain in any useful detail what “ethics” or “integrity” should mean in practice for an individual working in the company. Such codes need to set out practical guidance on how to deal with ethical questions, which at the moment they fail to do. In doing so, the ethical duties of the bank need to be clearly set out, as well as the ethical rights, and a process for dealing with a conflicts between ethical rights and duties clearly explained. 27. It is noteworthy that virtually no code of ethics in the banking sector addresses the question of whether there are any sectors or companies which it would be ethically wrong to have as clients, even though such a view is the starting point of investment policies for ethical investment funds. 28. The argument that codes of ethics cannot go into detail on business practices because of the range of activities within a major universal bank is to my mind specious. It would result in a code of ethics being a lengthier document, in the same way that an annual report for a large company is typically longer than for a smaller one. 29. It is not feasible to assume that in any bank of a meaningful size it would be possible for non-executive directors to routinely review decisions over whether business is conducted. It is however desirable that nonexecutive directors should not be appointed because of their ability to refer business to the bank or to simply add prestige to the bank (both of which happen frequently).

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1311

30. It is difficult, and in practice counter-productive, for individual banks to adopt markedly different ethical standards to the sector as a whole. This would not be the case if clients would choose their banks—or stop using them—based on positive ethical standards or on particular public malpractice in this area. 31. It would be of significant value to have an industry-wide banking or investment banking ethics-committee able to give clear guidance on ethical issues, and to take sanctions against firms which did not comply with such guidance. The UK investment banking industry already has a similar type of approach involving the takeover of quoted companies in the Takeover Panel, a model which could be extended to cover ethical questions. 32. The widespread development of derivative products such as Credit Default Swaps which can provide an incentive to reduce the value of an underlying business is a cause for concern. However, some form of sanction against parties actively seeking to inflict economic damage may have some benefits, although it is unclear how the line could be drawn between that the result of legitimate competition or accurate financial forecasting. Given the complexity of this area, a high level of transparency in such products would be the most obvious beneficial step, without risking creating wider economic inefficiency which in turn would damage parts of industry. 33. Restrictions in the ability to short-sell would undermine market efficiency, and are not supported from an ethical perspective, as the underlying process of short-selling is not specifically destructive. 34. Criminal law regarding banking products and markets is inconsistent. For example, there are differentiations between products traded on and off recognised markets—it can be legal to trade in bank debt of a company at the same time it is illegal to trade in the bonds of the same company. Rationalisation of this situation is urgently required. 35. The compliance function within banks and investment banks is frequently seen as a necessary evil, and compliance officers as on a less impressive career track than their colleagues in the “front-office”. Compliance tends to become a “tick-box” culture. I have been in compliance training sessions where I have been told that I am legally required to be present, but do not have to listen to the presentation. This is mainly the case because of the irrelevance of much of the information which it is mandatory to cover in such sessions. The overall approach to compliance needs to be changed in order for it to be effective at more than ensuring strict compliance with legislation without considering wider ethical issues. 36. Board of banks/investment banks need to understand the underpinning theories of ethics. My experience of banks, and of other major companies, is that their ethical thinking is typically utilitarian eg along the lines of “we’re not as bad as the others”. Alongside utilitarianism, an understanding of rights-based, duty-based and virtue ethics is important, together with the limitations of utilitarianism and the dangers of moral relativism. As part of this, it is important to understand that being legally compliant is not enough to satisfy ethical requirements on an organisation or on individuals within the organisation. 37. Boards of investment banks should require all employees with decision making or client facing roles to confirm in each reporting period that they have complied with their employer’s code of ethics (which should be comprehensively redrafted to focus on protecting the duty of care to clients as well as to shareholders). 38. Without a change in ethical standards within the banking and investment banking sector, which requires both an external and an internal impetus, I do not believe that reform of banking practices will be successful in protecting customers and reducing risk to both customers and the taxpayer. 39. Summary of Recommendations 40. There is a need for a pragmatic, pluralist approach to ethics in banking and investment banking, in which deontological and consequentialist principles go alongside cultivating virtuous behaviour in the workplace, but where deontological ethics take precedence in order to give clear guidelines about what is good, acceptable or unacceptable behaviour from an ethical point of view. 41. There would be a benefit in the creation of a banking/investment banking “ethics committee” on an industry-wide basis, modelled on the successful Takeover Panel, able to determine major ethical issues. This would resolve the current risk of commercial under-performance resulting from ethical decision by an individual institution. 42. Boards of banks/investment banks should be required to have regard to ethics. 43. In addition to a requirement for banks to train employees in compliance, there should be a requirement for training in ethics, so that bankers at all levels are able to judge if what they are being asked to do is in breach of their requirement to behave ethically. 44. Codes of conduct should be revised and should be required to clarify that when in conflict a firm’s duties to its stakeholders outweigh its own rights. Clear explanations of the practical meaning of terms such as “ethical” and integrity” should be given, eg through case-studies.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1312 Parliamentary Commission on Banking Standards: Evidence

45. The two specific problems highlighted above—conflicts of interest, and deliberate misrepresentation of facts—should be highlighted and addressed in codes of ethics and through either or both of legislation and regulation. 46. Legislation relating to trading practices and market behaviour which differentiates between on and offmarket and recognised and unrecognised exchanges should be rationalised to ensure that a consistent standard of behaviour is required in all circumstances. 22 August 2012

Written evidence from Mr Rippon Section A Bullet summary A.1 There is a very large number of prudential and integrity concerns about banks that need to be followed up. Some are listed in B.1 below. A.2 Concerns about imprudence and lack of integrity by banks, and concerns about the performance of regulators, require more statutory changes that are in the current Financial Services Bill and probably than are contemplated for the Banking Reform Bill; administrative action within the current and proposed legislative frameworks is not enough. A.3 The statute needs more detailed and demanding authorisation criteria/Threshold Conditions for banks, including on the integrity and the fit and proper criteria. Having more rigorous criteria on the face of the primary statute should help in the restoration of the UK’s reputation and help to deliver more effective regulation. A.4 The regulators should be required to report at least annually on their interpretation and application of the authorisation criteria, and on the principles that guide the regulators in the exercise of their powers, having regard to all the markets in which authorised firms operate. The FSA Handbook approach is not enough; and it is not sufficient to give the regulators discretion on whether to issue codes or statements covering such ground. A.5 The regulators need to take a more rigorous approach to the interpretation and application of the fit and proper person requirement; and take a tougher approach on banning and disqualifications. A.6 The scope for abuse in all financial and commodity markets needs examination before finally deciding how the FSMA market abuse provisions should be widened, although interim measures covering Libor and other benchmark rates seem desirable if the wider market study cannot be completed reasonably quickly. A secondary legislation route may be desirable to enable the authorities to keep up with market developments. A.7 The regulatory perimeter/the Regulated Activities Order needs to be kept under regular review; and the Treasury should report annually on their review on the adequacy of the perimeter and on the principles they follow in deciding the perimeter having regard to market/product developments, level playing fields and risks to consumers. A.8 The authorities should be required to report on conflicts between their various objectives that arise in practice and on the principles they follow in dealing with such conflicts. A.9 The regulators should be under an express statutory duty to supervise authorised firms (but with allowance for justified derogations— the onus being on the regulators to justify). A.10 There needs to be a review of the capacity of the Treasury to keep the adequacy of the regulatory legislation under review and to consider changes to associated secondary legislation. A.11 The adequacy of co-operation between criminal enforcement bodies and regulatory authorities needs review. Section B Main points (a) Deficiencies in banks’/financial firms’ conduct B.1 It seems beyond dispute that there have been many egregious examples of lapses by banks in their conduct whether in terms of prudence (hence the need for rescues of eg RBS, the Bank of Scotland, Dunfermline BS) or of integrity (eg mis-selling of swap and other structured products; negligent advice on pensions and savings products; a slack approach on suitability/know your customer; money laundering (London seems to have a bad reputation in this area); Libor (and possibly other benchmark rate?) misreporting; breaches of sanctions; mis-selling of guaranteed capital certain investment products; inadequate disclosure of information relevant to consumers’ credit assessments; inadequate or misleading information on FSCS cover; inadequate disclosure of charges and interest rate changes; inadequate disclosure of information relevant to customers’ investment/deposit decisions where there have been material adverse changes since the original transaction;

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1313

inadequate information on the implications of insolvency for investment or deposit products; failures to answer queries from customers/the public; inadequate response to complaints from the public/customers; mis-reporting to the authorities or failing to report material information—the list is not exhaustive). Lack of integrity in a bank’s conduct may have adverse prudential effects, eg reputational and confidence damage; fines; loss of authorisation. I note with concern the apparent lack of shock by the current regulators about the cumulative implications of the individual lapses; this may indicate a flawed regulatory culture. Such a flawed culture may have infected the culture of authorised institutions. B.2 The deficiencies relating to both prudence and integrity point to material concerns as to whether the responsible individuals, whether by commission or omission, are fit and proper persons to hold their positions or in some cases any position. In some cases of less major lapses in relation to integrity, it may perhaps not be warranted to conclude that the bank’s conduct overall was not conducted with integrity; but in such cases it may be difficult to avoid concluding that the senior management responsible for the lapse were not fit and proper. Recommendations (b) Administrative reforms are not enough B.3 It is not sufficient to rely on a more effective approach to regulation by the regulators whether within the framework of FSMA as it now is or as HMT currently proposes its amended form. The statutory requirements need to be more detailed and demanding, and greater transparency and accountability is needed for the regulators. (b) Market abuse B.4 There should be a study of whether all financial and commodity markets outside the scope of the FSMA market abuse provisions [eg the money markets] could be subject to abuse such that the FSMA provisions should be widened and tightened. B.5 In this connection, I welcome the recommendation of the Treasury Select Committee that: The Committee urges the Wheatley review to consider the case for amending the present law by widening the meaning of market abuse to include the manipulation, or attempted manipulation, of the LIBOR rate and other survey rates. They should also consider the case for widening the definition of the criminal offence in section 397 of FSMA to include a course of conduct which involves the intention or reckless manipulation of LIBOR and other survey rates. B.6 But there is a serious question as to whether the TSC’s recommendation goes wide enough and whether therefore the Wheatley review will have sufficient scope. Also, it is not enough to look at evidence of actual abuse; the scope for potential abuse also needs consideration, having regard to market developments. Closing the stable door after the horse has bolted is not satisfactory. It may be that secondary legislation here plus a vigilant approach by the authorities is the best approach, building on improved primary legislation and better oversight of the regulators. B.7 I raised with HMT in September 2011 the need to examine the adequacy of the width of the FSMA market abuse provisions and mentioned the earlier press reports [March 2011] of manipulation of Libor and Tibor (see C.1.2 below). HMT appeared to take no action then, which raises questions as to how well equipped HMT was and is to deal with such issues with sufficient sensitivity to the risks. B.8 Tightening/widening of the market abuse provisions should be complemented by a strengthened and widened statutory code on market conduct covering all relevant markets and with adequate detail ; such codes should be kept under be updated as necessary and cover developments in the relevant markets. B.9 There would need to be external scrutiny, by the TSC or otherwise, of the authorities’ approach to keeping the scope of market abuse provisions up to date. (c) Threshold conditions/authorisation criteria B.10 The FSMA Threshold Conditions (authorisation criteria) and in particular the FSA’s approach to the application of the fit and proper persons requirements for banks etc was too weak; and there is a good case for including in the primary statute an express, detailed and demanding integrity requirement plus amplified other authorisation criteria, eg on prudence , such as liquidity, bad debt provisions and capital on fitness and propriety (individuals and shareholder controllers), professional skills, adequate systems and controls, the “four eyes” requirement ( so that one individual does not dominate a firm unduly), non-executive directors and audit committees, and general catch-all provisions relating to the protection of depositors and other consumers— bearing in mind the better approach in the Banking Act 1987. The main implications of the criteria should be spelt out in the primary statute. This can also draw on material in the current FSA Handbook on fitness and propriety and other matters but with improvements. The specification of greater detail should be accompanied by “without prejudice to the generality” provisions, so that the regulators can take account of matters not given detailed reference in the legislation but falling within the more general, umbrella language.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1314 Parliamentary Commission on Banking Standards: Evidence

B.11 I noted to HMT in April 2011 the many concerns about the integrity of banks’ conduct. HMT appeared to take no action, I assume because they were content to rely on the FSA’s administrative actions. Again this raises questions on the capacity of HMT at the time to engage adequately on such issues, and what strengthening might be feasible. B.12 The regulator’s practical approach on “enforcing” the fit and proper persons requirements also needed to be toughened to achieve a more effective approach on deterring unsatisfactory conduct and disqualifying persons who have fallen materially short of the required standards . Better and more explicit requirements in the primary statute should help to reinforce higher standards and restore the UK’s reputation in this area. But the regulators should also be bolder. Fitness and properness provisions in the primary statute should expressly cover amongst other things compliance with legal and ethical standards, knowledge and skills, and diligence and the track records of the persons in relation to the prudence and integrity of the institutions with which they have been associated. The current FSMA is too weak in these areas; and it is not sufficient to rely on the Handbook’s provisions on fitness and propriety. B.13 A tougher approach on “fit and proper” and enforcement (disqualification/banning; removal orders; naming and shaming) by the new regulators may be easier to apply than criminal sanctions, though these appear to need to be tightened too. (d) Transparency on the interpretation and application of the Threshold Conditions; and on the principles underlying the exercise of the regulators’ discretions B.14 The primary statute should include a requirement that the regulators should produce an annual statement setting out their interpretation and application of the authorisation criteria as well as an account of the principles underlying the exercise of the regulators’ discretions in granting authorisation, withdrawing authorisation, restricting authorisation and exercising various regulatory powers (eg against persons deemed not fit and proper or where conduct lacks integrity). This should cover all relevant markets, retail and wholesale. The current FSA Handbook covers this ground inadequately and on some things apparently not at all. The statement should be updated annually but also ad hoc in the light of material developments. The provisions in FSMA on statements of principle and codes are not mandatory and do not go far enough. B.15 At present we seem to have inadequate information from the FSA as its approach on a concrete, detailed level to the interpretation and application of the Threshold Conditions and equally importantly to the principles which underpin the exercise of its discretions/powers when a Threshold Condition is no longer fulfilled or there is a concern about fitness and propriety or a threat to the interests of depositors or other consumers. It is not at all clear how often in practice the FSA’s intervention powers become exercisable and how often in relation to such cases powers are actually exercised as against by voluntary action/moral suasion. We need greater clarity in the PRA/FCA world. B.16 This point in B.14 has been raised earlier with HMT in 2011, but they seemed satisfied with FSMA’s provisions on these issues in its current state and took no action. Again there is cause to question HMT’s judgement; and the question again arises as to how HMT’s capacity can be strengthened. (e) Express statutory duty to supervise B.17 The regulators should have an express duty to supervise each authorised institution in the sense of keeping the fulfilment of the authorisation criteria and threats to the interests of consumers etc under regular review and of considering the exercise of intervention powers when their powers are exercisable or the seeking of remedial action by other means. (There was such a duty in section 1(1) of the Banking Act 1987,) This should help to ensure a tougher approach than the FSA took until the crisis. If there are cases where the regulators think appropriate only to authorise and not supervise an institution then the regulators should be required to justify their approach on particular categories of institution/business in published annual reports, taking account of risks to eg consumers and others. In other words, there needs to be greater transparency here. B.18 The regulators should also be required make it much clearer to the public the limitations of their supervision (including the lack of supervision) where the institution is a branch of an overseas-incorporated institution, distinguishing EEA incorporated firms from firms incorporated outside the EEA. Regulators should also require authorised institutions in the UK , whether EEA passported or otherwise, to make clear the limitations of the UK regulator’s supervision and also the limitations of any FSCS cover with respect to the product in question. (f) Non-executive directors and audit committees B.19 The authorities should consider whether the standards required by or under the statute of NEDs and audit committees are adequate; we need potentially “uncomfortable” NEDs of undoubted integrity who are prepared to perform a gadfly role and challenge any approaches of the management which may be imprudent or inconsistent with integrity or professional skills standards. This can be seen as related to “the four eyes” requirement and any governance provisions that can help to keep some control over very dominant individuals. It may be desirable to impose a statutory duty on NEDs to report concerns to the regulators if they conclude

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1315

that the management is not giving an adequate response. In such circumstances the NEDs may need some legal protection. (g) Duties of confidentiality and duties to report concerns B.20 The authorities should seek to ensure that duties of confidentiality do not hinder information flows between, for example, auditors and regulators or between criminal investigation or enforcement authorities and the regulators. There should be a presumptive duty for auditors to assist regulators; and probably a duty on both criminal investigators and regulators to assist each other in a proactive way. (The possible “reticence” of foreign criminal enforcement bodies and regulators in assisting their UK opposite numbers is an issue to be explored.) There also needs to be an alertness to the dangers of silo mentalities and practices in single bodies with a variety of functions and public policy objectives. (h) Conflicts of interest between the various public policy objectives of regulators and the central bank B.21 There should be an express requirement in FSMA or other legislation that the regulators (and the central bank) report, at least annually, on the conflicts themselves and on the principles guiding them in dealing with conflicts between their different public policy objectives. There is, for example, the potential for conflicts between some retail protection objectives and financial stability objectives; or between a sub-set of retail protection objectives; or between monetary stability objectives and consumer protection objectives; or between some objectives and any growth objectives. The conflicts may arise within a single authority or between several bodies. (i) The adequacy of (i) regulatory perimeter and (ii) scope of market abuse provisions B.22 The Treasury should report annually on the adequacy of the regulatory perimeter/the Regulated Activities Order and, in adequately detailed terms, on why particular products are within or outside the perimeter, having regard to consumer protection, FSCS cover, financial stability, level playing fields, different group structures for financial products, and product development as well as EU requirements. There are two “perimeters” to consider: one as regards requirements for authorisation and regulation (the Regulated Activities Order); and one for the market abuse provisions. (j) Appropriate legislation B.23 The most appropriate legislation for incorporating the points above would be the Financial Services and Markets Act (being amended by the Financial Services Bill) rather than the Banking Reform Bill. But it is not clear that the government’s timetable would permit this. On the face of it, one would expect the Banking Reform Bill to be primarily concerned with the follow through to the Vickers proposals. This said, there are a number of ways of skinning the cat. Section C Detail Market abuse C.1.1 I wrote to HMT last year (September 2011): 118: Market abuse “33. I assume that the authorities have considered whether there is any case for extending the scope of the market abuse provisions to other significant financial markets where there could be scope ‘abuse’ (in the sense of ordinary language). I am not in any sense pressing the case for extension. Doubtless the Treasury will have sounded out various market experts, although many players would of course hesitate to invite greater regulation. ( I am not clear how the present accusations about manipulation of eg Libor and Tibor fit into the FSMA framework.)” C.1.2 As noted there were press reports in 2011 on the possibility of investigations of Libor and Tibor manipulation, see Reuters report March 2011: LONDON/WASHINGTON, March 17 (Reuters)—Regulators are probing whether a handful of major banks manipulated a global benchmark interest rate to tart up their credit quality, a person familiar with the matter said on Thursday. Bank of America (BAC.N), Barclays (BARC.L), Citigroup (C.N), WestLB [WDLG.UL] and UBS (UBSN.VX) are the focus of the investigation by regulators in Britain, Japan and the United States, said the source, who asked not to be named. Swiss bank UBS had said on Tuesday it received subpoenas from Japanese and U.S. regulators regarding whether it made “improper attempts” to manipulate the London interbank offered rate, known as Libor.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1316 Parliamentary Commission on Banking Standards: Evidence

Investigators are probing whether banks understated Libor to reduce their borrowing costs and downplay investor panic during the financial crisis. Among the data examined are discrepancies between offered rates and some banks’ credit risks, as measured by credit-default swaps. I do not know if the Treasury considered my suggestion that the adequacy of the scope of the market abuse provisions should be examined or the possible implications of the March 2011 Reuters report- I could not second guess their approach as I have no detailed knowledge of the relevant markets, although I did flag that the Libor investigations, as reported in the press, pointed to one area where there could be a prima facie case for change. In the event the draftsman of the FSMA amendment bill did not seem to pick up the point. It now seems clearer that much greater consideration should be given to financial markets outside the scope of the current FSMA market abuse (or indeed insider dealing) legislation - such as the money markets and possibly the foreign exchange market, and not just benchmark rates; and I would suggest, as a lay outsider, that relevant experts should do some early work on the markets outside the current FSMA market abuse provisions - to identify them [not just the money markets], to analyse the scope of potential abuse (in the widest sense), the experience of any abuse (again in the widest sense) that has or may have occurred and to look at possible deterrents and regulation. It seems better to anticipate possible abuses and seek to prevent these, rather than wait until abuse occurs and then act by tightening legislation. Even if it were concluded that other markets do not need the extensions of the market abuse provisions, a study, up dated from time to time still seems desirable. C.1.3 Consideration should also be given to extending the scope of the criminal law in this area, with specific provisions for the particular financial markets. But it is important to realise that the burden of proof may be a major hurdle in some criminal cases, so that the potential for a regulatory response (with a less onerous burden of proof but still with adequate natural justice safeguards) may be a more appropriate and effective. C.1.4 It also seems necessary to have wider and more detailed codes, or a consolidated code, for a wider range of markets so that financial institutions and the public have a better understanding at a more concrete level of practical minimum standards and of what is unacceptable - and of “grey areas”, where doubtful behaviour should be avoided. There is need to have codes which have adequate detail and are not at an excessively high level of generality. C.1.5 I would repeat too that I do not think that the authorities should adopt a “closing stable door” approach and only seek to close regulatory gaps after a scandal has occurred. C.1.6 I have noted and welcome the recommendation of the Treasury Select Committee’s preliminary report which says: “199. The Committee urges the Wheatley review to consider the case for amending the present law by widening the meaning of market abuse to include the manipulation, or attempted manipulation, of the LIBOR rate and other survey rates. They should also consider the case for widening the definition of the criminal offence in section 397 of FSMA to include a course of conduct which involves the intention or reckless manipulation of LIBOR and other survey rates.” C.1.7 There is a question as to whether the scope of the Wheatley review is wide enough and whether it will look beyond “survey rates”. See my comments in the summary above. Integrity C.2.1 Last year I urged the Treasury to include an express requirement that banks conduct their business with integrity and professional skills ( as under the Banking Act 1987); and a requirement that the regulators set out in a published statement , updated at least annually, their approach to the interpretation and application of the integrity criterion. On 12 April 2011 in a letter to Mr Levendogˇlu of HMT I said, inter alia,: “I am concerned that the FSMA contains no express and prominent integrity requirement for banks; and I think that this is a great pity especially given the palpable lack of integrity in the conduct of some banks, including in advertising and in the promotion of some financial products, in general transparency, in answering questions, in dealing with complaints. The lack of integrity by the firms reflects too on the integrity on the responsible management. I note that the Banking Act 1987 included such a requirement in the minimum authorisation criteria; but that the Labour government decided to drop that - presumably given their preference for “light touch regulation” and their wish to boost the City. The FSMA threshold conditions do not include such an express requirement - the fit and proper requirement in FSMA and the FSA’s application of it seem to be feeble. I know that some City practitioners and some regulators are uneasy about ethical or moral requirements …. but their discomfort is not a good reason for not re-introducing a requirement of this kind.” C.2.2 I appreciate of course that the approved persons regime and the Threshold Conditions, plus the detail in the Handbook, provide some safeguards, but the track record provides only limited assurance and sometimes considerable cause for worry. Given the weaknesses in the current FSMA/FSA regime, I think that there is a good case for including in the primary statute a non-exhaustive definition of “integrity” to include compliance with legal and regulatory requirements, codes of practice, and recognised accounting and reporting standards with recognition that compliance with all this does not necessarily ensure integrity in conduct, so it would be a necessary but not a sufficient condition.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1317

C.2.3 I do not know the Treasury’s thinking on this; but I would strongly contend that the current Threshold Conditions and the regulators’ interpretation and application of them are not adequate or detailed enough. More detailed/better Threshold Conditions or minimum authorisation criteria in FSMA C.3.1 Against the background of the above and what I have heard so far on the Libor scandal, I have urged the Treasury to expand the Threshold Conditions to include the requirements as captured in eg the Banking Act 1987 minimum authorisation criteria. I noted earlier: “The judgments should have regard to something like the Banking Act 1987 authorisation criteria rather than the more general FSMA threshold conditions. The Banking Act criteria covered eg fit and proper persons; four eyes management; roles of NEDs/audit committees; adequate net assets and adequate liquidity taking account of all factors, including group and external threats; general prudent conduct taking account of eg business plans and adequacy of planning controls and new product preparations; adequate provisions for bad debts including possible bad debts; adequate accounting records; adequate systems and controls; carrying on business with integrity and professional skills; minimum net assets; and a sweep up provision. The FSA’s threshold conditions were vaguer and the specific statutory underpinning weaker.” C.3.2 The Banking Act 1987 criteria were: “Para 1: Fitness and properness The judgement relates to the particular position, thus requiring a particularised judgment taking account of all the relevant factors rather than a ‘clunking’ application of a rule. The judgment has to cover probity, competence, soundness of judgment, diligence, and likelihood of threats to the interests of depositors or potential depositors ‘in any way’. Para 2: Two individuals effectively directing the business Para 3: Composition of board of directors/role of NEDs Para 4–5: Business to be conducted in a prudent manner, including — adequate net assets etc including having regard to nature and scale of operations, interests of actual and potential depositors, risks from other group companies — adequate liquidity, including having regard to actual and contingent liabilities, maturity matching and stock of liquid assets, risks from other group companies — adequate provisions for bad debts, including possible bad debts — adequate accounting and other records ; adequate systems and controls for prudent conduct and fulfillment of duties under the BA — any other considerations relevant to general prudent conduct Para 5: carrying on business with integrity and professional skills Para 6: Minimum net assets C.3.3 I have also suggested to the Treasury that in addition to having a non-exhaustive definition of “integrity” as suggested C.2 above, the primary statute expands on the meaning of “professional skills” and “fit and proper person” [for directors, controllers, managers] requirement expressly covers knowledge, skills, probity, diligence, judgment, threats to the interests of depositors and investors (see below). Given Fred Goodwin’s record (and the record of other dominant individuals in other firms) more might be said about the “four eyes” requirement. C.3.4 Having all this set out in the new primary statute should help to restore the United Kingdom’s reputation in the financial sector, following the banking crises, the Libor, swaps mis-selling and other scandals, and set a more obvious and demanding standard for the regulators - if we also have effective regulators. We should learn the lessons of the FSA’s record under the current FSMA framework; and should not assume that possible recent administrative improvements should be sustained. A statement of principles on Threshold Conditions, authorisation, revocations, discretion on the use of powers etc C.4.1 And, as I have argued before, it is vital that such Threshold Conditions are complemented by a selfstanding statement by the regulators - annual and up dated ad hoc and put to Parliament - that explains in detail the regulators’ approach to the interpretation and application of each of the detailed criteria relevant to authorisation and details of the principles underlying and guiding the regulators’ approach to authorisation, the restriction of activities, the withdrawal of authorisation, the seeking of liquidation and administration orders, including the use of formal, statutory powers or the encouragement of “voluntary” action. C.4.2 As far as I can see, the FSA’s Handbook and other reports do not satisfactorily cover all the point in paragraph C.4.1 above. Requirements on the FSA on codes and statements seem inadequate, with too much discretion for the regulators. As it is, it is difficult for laymen and the “ordinary consumer” to understand the current regulators’ approach - for example, — how often do the regulators’ intervention and revocation powers become exercisable?

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1318 Parliamentary Commission on Banking Standards: Evidence

— — —

how often are they exercised when the powers are exercisable? how often do they seek remedial action without the use of statutory powers? what principles are applied here? how are conflicts of interest in public policy objectives dealt with? Or does the Treasury think that there should not be transparency about such matters or that current transparency is adequate - and if so why?

C.4.3 The statements that I have in mind would be in addition to the Handbook, although overlap with parts of it. But in any event the current Handbook’s approach is inadequate. Parliament should want to know such information. Fit and proper person requirement C.5.1 As an example, it seems to me evident that the FSA’s approach to the interpretation of the fit and proper person criterion has been inadequate - as admitted by Hector Sants, for many years the FSA did not seem to take account of competence, knowledge, experience, diligence, and apparently concentrated on a narrow view of probity [no criminal offence or formal disqualifications]. The Handbook now suggests that the FSA is taking a more rigorous approach, covering more of the key elements of fitness and propriety. But the history here points to the need for legislative strengthening as well. Also, the FSA seems also to have been feeble in taking action against individuals whom on any rigorous approach would not be considered fit and proper, especially when the relevant individuals were palpably in charge when the institution concerned was guilty of illegal or very dubious activities or bad breaches of rules or mis-selling or imprudence. C.5.2 On having an amplified fit and proper person requirement in the primary statute, it needs to be wholly clear which persons are covered by the requirement; and there seems to me a good case for defining the criterion in the statute to capture explicitly amongst other things probity/integrity, competence, knowledge, judgement, skills and diligence, threats to the interests of depositors, investors etc. Regulators ought to be able to apply this - by disqualifying persons from a particular position or “banning” them more widely - without the regulatory burdens for them or the regulated firms being disproportionally onerous, whilst still allowing sufficient scope for administrative law/natural justice protections. And Parliament ought to scrutinise the regulators’ application and “enforcement” of the fit and proper person requirement. We need to avoid the previous and possibly current limpness of the FSA. Conflicts of interest between the objectives of the Bank and two new regulatory bodies C.6.1 I must repeat my concerns, expressed to the Treasury earlier, that I am not at all convinced that the proposed FSMA amendments will impose satisfactory requirements on the central bank and the regulators to report annually and ad hoc on any material conflicts of interest between the bodies’ public policy objectives, as exemplified in particular cases and decisions, and on how the conflicts are settled and according to which principles. If there are no express provisions included in the legislation, how do they think that such transparency will be effectively delivered? My earlier letter to the Treasury gave examples of possible conflicts of interest. For example, what if action were taken in respect of mis-selling might well lead to adverse confidence effects and a run which damaged the interests of depositors? How would the PRA exercise its veto power over the FCA in such circumstances? (Many other examples could be given.) What would the regulators’ response be? I do not think that deliberate mis-reporting or the deliberate suppression of such information relevant to credit assessment can be tolerated - here surely the principle has to be Fiat justitia ruat caelum ? Should the statute recognise this? Also, how is Treasury policy here related to the authorities’ general policy on disclosure by banks on their financial condition and prospects, bearing in mind the tensions between the desire for transparency and caveat emptor on the one hand, and, on the other hand, the concern not to cause adverse confidence effects, such as bank runs, which might otherwise be avoided. The existence of depositor compensation arrangements does not wholly allow the authorities to square the circle, as it were, given the limitations of and gaps in the compensation scheme and in the Regulated Activities Order. Keeping the adequacy of the Regulated Activities Order/the regulatory perimeter under review C.7.1 I am disappointed that the draft FSMA amendment legislation does not impose any requirements on the authorities to report annually on their reviews on the adequacy of the RAO bearing in mind concerns about regulatory gaps, new financial products and product developments, and the lack of level playing fields. I would urge the Treasury to consider this, and in any event give their views on my case for transparency here. The Treasury’s own record to date on this seems to have been disappointing, with extreme reticence in explaining their policy thinking. I remained concerned that there are some lacunae here; and that lacunae could emerge in future, with the authorities behind the game. C.7.2 The argument for having a more rigorous and transparent process on the scope of the RAO also applies mutatis mutandis to the scope of the market abuse provisions. 23 August 2012

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1319

Written evidence from James Robertson 1. Introduction (1) My Credentials. A summary of these can be found in the Preface of my latest book, Future Money: Breakdown or Breakthrough?, published in April 2012 by Green Books.155 (2) Chapter 3 of that book (pages 97–121) is on “Managing the national money supply”. It begins with “Start with the right questions”, and ends with: “A simple thought should end this chapter. The obvious way to reduce our public and private debts is to stop having all our money created as debt. It’s a “no-brainer”. So why don’t we get them to stop it?”. (3) My suggestion to the Commission is in response to its terms of reference on “implications for regulations and Government policy”. It is certainly “a matter that the Commission should take into account”. 2. A Question the Commission Cannot Avoid (1) The number of people asking the question has grown steadily over the past ten years, and is now growing fast. It will soon reach the tipping point, at which it can no longer be ignored. It is: Why do our government and other countries’ governments continue to give commercial banks the privilege of creating the public money supply as profit-making debt at great cost to public wellbeing? Is there no alternative? (2) The Commission should not seem to be avoiding that question. By the time it reports, more people will be suspecting that how the money supply is now created and managed is a basic cause of the financial hardships that citizens of this country and others are now suffering. (3) What evidence is there for that? Here are three examples. (a) Positive Money—http://www.positivemoney.org.uk/ . This campaign has made astonishing progress since it started in May 2010. (b) The American Monetary Institute—http://www.monetary.org/. Founded in 1996, AMI is closely associated with the Monetary Reform Bill recently introduced in Congress. (c) In August 2012 the International Monetary Fund has published IMF Working Paper on “The Chicago Plan revisited” (WP/12/202). The following passages summarise its status and contents. This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Abstract At the height of the Great Depression a number of leading U.S. economists advanced a proposal for monetary reform that became known as the Chicago Plan. It envisaged the separation of the monetary and credit functions of the banking system, by requiring 100% reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this plan: (1) Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money. (2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt. (4) Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. We study these claims by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy. We find support for all four of Fisher’s claims. Furthermore, output gains approach 10 percent, and steady state inflation can drop to zero without posing problems for the conduct of monetary policy. In spite of the reservation about its status, this IMF working paper suggests that it is reasonable to question if the way we now create and manage the money supply should be changed. 3. A Possible Answer to the Question I am not suggesting that the Commission should necessarily recommend a change to the government. But it may be helpful to suggest what one might look like. Since the Chicago Plan in 1936, electronic storage and exchange of money make it possible to simplify the mechanics of achieving the equivalent to 100% reserve backing for bank deposits. A model for the change might be on the following lines. A basic reform would separate two functions now confused. 155

See http://www.jamesrobertson.com/futuremoney.htm, for more detail, favourable comments, how to download a free pdf text of the book, and how to purchase a copy from the publisher. (I am sending a copy to the Commission’s secretariat.)

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1320 Parliamentary Commission on Banking Standards: Evidence

(1) It would transfer to nationalised central banks like the Bank of England the responsibility for creating, not just banknotes and coins as now, but also the overwhelmingly large component of the supply of public money consisting of bank-account money mainly held and transmitted electronically. Having created the money, the central bank would give it to the government as public revenue to be spent into circulation on public purposes under standard democratic budgetary procedures. The central bank would not give or lend any of the money it creates to anyone other than the government. As at present in Britain, the central bank would be given its monetary objectives by the government and would answer to the government and parliament for its performance. Within those constraints it would have operational independence, as at present. (2) The reform would prohibit anyone else, including commercial banks, creating bank-account money out of thin air, just as forging metal coins and counterfeiting paper banknotes are criminal offences. Those two measures together would nationalise the national money supply, and also ease the denationalisation of any commercial banks that have had to be nationalised. They would also enable all licenced commercial banks to compete freely with one another other in an open profit-based market for borrowing and lending money already circulating after the central bank has created it and the government has spent it. Under the first measure a public agency would become responsible for efficiently creating and managing the public money supply in the public interest. Under the second, in addition to offering a more efficient market for exchanging money between lenders and borrowers, loss of the privilege of creating money to lend would bring commercial banks into line with ordinary private-sector businesses that don’t get given their main materials as a free gift. That would encourage banks to provide better services more efficiently to their customers, and make it easier for new entrants to join the payment services industry. 4. IN CONCLUSION My suggestion to the Commission, in the light of the above, is as follows. I hope your report to the government will find a way to mention that—as a consequence of the hardships to millions of people resulting from the banking crisis of 2007–08, the developments still arising from it and making things worse, and recent revelations of malpractice by the banks, more and more people are asking: Why do our government and other countries’ governments continue to give commercial banks the privilege of creating the public money supply as profit-making debt at great cost to public wellbeing? Is there no alternative? I am not in a position to advise how your Commission might want to present this to the government. But I feel that failure to mention it would soon be seen as a failure of responsible leadership. 25 August 2012

Letter on behalf of Dr Marcel Rohner from Kingsley Napley LLP Dr Marcel Rohner Dr Rohner read with considerable concern today remarks which are attributed to Mr Tyrie, in the Times. The relevant extract from the report is as follows: “Andrew Tyrie, the chairman of the commission, lamented the fact that some of the four were still holding senior jobs in the City and had not been struck off the Financial Services Authority’s approved persons register. “Since they’ve just acknowledged in front of us that they were ignorant and grossly incompetent...it strikes one that they shouldn’t be on an approved persons list”, he said” As the Commission will be well aware, Dr Rohner did not accept at the hearing yesterday any element of personal fault, in fact he specifically denied that he had been negligent. I can only assume that Mr Tyrie’s statement to the Times refers to his closing remarks. The uncorrected transcript states: “We have also heard about some appalling mistakes, which can only be described as gross negligence and incompetence. The best construction that many of us will place on that is that you were not only ignorant of what was going on but out of your depth. Do any of you want to challenge any of that? The video recording is clear in showing the Dr Rohner did not react at all to Mr Tyrie’s statement. There is no basis for any assumption that he accepted Mr Tyrie’s assertions.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1321

I am writing to make it clear that Dr Rohner does not accept that he was grossly incompetent, nor does he accept that he acknowledged this in front of the Commission. It is important that the Commission is aware of Dr Rohner’s position on this, since it seems likely that the Commission will wish to make some reference to this evidence session in its final report. 11 January

Written evidence from Dr Marcel Rohner Corporate Governance Thank you for the invitation to set out my views on structural governance issues based on my own experience. At the outset, it is important to note that my views regarding these issues are the result of several years of reflection on the time I spent as CEO of UBS AG, which happened to coincide almost completely with the global financial crisis that continues to reverberate today. I believe that the governance structure at the very top of a bank is of fundamental importance and should be specifically assessed with respect to its appropriateness in times of instability. During a crisis, it is particularly important to make decisions efficiently and expeditiously. A dual board structure, which we had at UBS and which is considered by many experts to be a state of the art governance structure, is in my view an inappropriate arrangement in such circumstances. In my experience, the supervisory board is held responsible for everything but does not run the bank operationally; the operational board is running the bank and needs to be able to make decisions without constantly deferring to the supervisory board. In such exceptional times, what is needed is a structure which facilitates considered and efficient decisionmaking. In my experience, this dual structure—particularly in circumstances where regulatory authorities, central banks and governments also wish to have input—can impede the decision-making process and ultimately impair the quality of the decisions reached. With respect to risk control, the dual board structure leads to a duplication of the committee structure as both boards typically run their risk committees. This results on one hand in duplication of work and on the other hand to a dilution of responsibility. As a solution, I envisage a single board composed of the key top executives of the institution, supplemented by a relatively small number of independent board members with a strong financial industry background. Those independent board members would represent the shareholders: they would assume responsibility for and execute the supervisory and control function by chairing the audit, risk and compensation committees. Whilst this is not very far removed from a dual board structure arrangement, it would in my view much more clearly delineate the operational responsibilities from the supervisory and control function. I hope that the Commission will find these observations to be of assistance. 28 January 2013

Written evidence from the Royal Bank of Scotland Group Summary — We recognise that consumers’ trust in banks has suffered greatly since the onset of the financial crisis. To a considerable extent, this loss of trust is linked to the weaknesses exposed in banks’ fundamental safety and soundness, and there has been considerable progress since the crisis in restoring banks’ financial strength. — It may prove more difficult to restore public trust that banks will put their customers first. We believe the Parliamentary Commission has an important role to play not just in raising standards across the industry but also in giving recognition to those areas where progress has in fact been made. — In 2009 RBS faced immediate issues of safety and soundness, and like other banks has prioritised action on this front. — This has resulted in one of the largest corporate restructurings ever undertaken, with a substantial reduction in the size of our balance sheet while at the same time increasing lending in our core UK retail and commercial businesses while protecting customers who are also our future. We have increased our Core Tier 1 capital ratio from 4% to over 10% and thoroughly restructured our funding position, with greatly reduced dependency on wholesale funding markets. — We have also taken a range of measures aimed at making the Group more customer-focused and to improve management. While we consider these measures to be important, we have no illusions about their ability to effect instant cultural change. — We believe that the delivery of real cultural change is more likely to be a consequence of having created a good company that serves its customers well than of having implemented a standalone programme of cultural change.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1322 Parliamentary Commission on Banking Standards: Evidence

—

We welcome the developing role of the Chartered Banker: Professional Standards Board. We would support giving the CB: PSB powers to maintain a register of accredited bankers and to strike off those who fall short of the required standards, subject to appropriate safeguards around due process.

1. To what extent are professional standards in UK banking absent or defective? How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets? 1.1 The level of professional standards in UK banking must, in the most general sense, be judged by our customers. As discussed below, the succession of scandals that has hit banking in recent years has ensured that their immediate judgment would not be positive. 1.2 We recognise that our customers are looking to us to improve our standards of professionalism and expertise so that we can deliver the levels of service they expect. This has not been easy. In many cases the training and professional qualifications we believe are necessary did not exist. We have had to develop a number of bespoke programmes to meet our requirements, as well as participating in industry-wide initiatives to raise standards. 1.3 RBS is a founding member of the Chartered Banker: Professional Standards Board (CB:PSB). It was established by the Chartered Banking Institute in October 2011 to enhance and sustain a strong culture of ethical and professional development across the UK banking industry. The CB: PSB will: — Outline the need, scope and application of professional standards. — Monitor and enforce professional standards. — Introduce an industry-wide ethical code of conduct. 1.4 Following consultation with all member banks, in July 2012 the CB: PSB published the Chartered Banker Code of Professional Conduct and a Foundation Standard setting out the values, attitudes and behaviours it expects of all UK banking professionals. RBS will ensure that the standards are implemented and/or integrated into existing standards and development programmes. 1.5 It is important to recognise, however, that requirements vary across the spectrum of banking, and the existing Code of Professional Conduct is more geared towards retail than wholesale banking. We are working towards a consistent goal of attaining professional standards across the Group. There is no one-size-fits-all provider of professional development and qualifications that currently meets our varied business needs. In the UK alone, we partner with over 40 different professional institutes for the provision of qualifications and development. 1.6 We also consider that formal professional standards are only one facet of the question. More important, in the longer run, is the range of basic management disciplines that ensure that a company puts its customers’ interests first and at the heart of everything it does. 1.7 We take very seriously the task of developing current and future managers across the organisation who will demonstrate this commitment to customers’ interests and have the competences, values and behaviours to ensure that our staff live up to this. This involves a strong commitment to recruiting and training a diverse workforce (we recruited 12,000 new employees in the UK last year, including 500 graduate recruits) and continuing emphasis on actively managing performance. 2. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole? 2.1 We recognise that consumers’ trust in banks has suffered greatly since the financial crisis. To a considerable extent, this loss of trust is linked to the weaknesses exposed in banks’ fundamental safety and soundness, and there has been considerable progress since the crisis in restoring banks’ financial strength. However, it may prove more difficult to restore public trust that banks will put their customers first. 2.2 While the most measurable consequences for the economy as a whole have stemmed from the direct impact of the 2007–08 financial crisis and the subsequent enduring difficulties in the eurozone, we consider that the current level of negative feeling towards banks and bankers is unhealthy and makes it more difficult to achieve acceptance of some of the difficult trade-offs inherent in balancing conflicting demands. 2.3 Banks are, in general, highly geared to the economies within which they operate. It is rare to find strong banks in weak economies. But it is also rare to find strong economies unless their banks are also strong. 3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector? 3.1 We recognise that consumers’ trust in banks has suffered greatly since the financial crisis. To a considerable extent, this loss of trust is linked to the weaknesses exposed in banks’ fundamental safety and soundness, and there has been considerable progress since the crisis in restoring banks’ financial strength. However, even once banks’ safety and soundness has been strengthened to a point where there it is no longer

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1323

the focus of public distrust, it may prove more difficult to restore public trust that banks will put their customers first. 3.2 One consequence of this loss of trust is that there is little expectation among the public, or among regulators, that banks will prove capable of improving their cultures in a way that places the customer’s interests above those of the bank. As a result, there will be little willingness to wait for results, even though delivering a better banking culture is more likely to be the product of a slow and sustained series of basic management improvements than of a single remedy. 3.3 Another consequence has been an expectation that many of the perceived problems in banking might be addressed if banks were to return to an idealised golden age in which every manager knew his customers personally and was empowered to make independent credit decisions on the basis of this personal knowledge without central office intervention. 3.4 In the mid-1950s, a time at which the independent branch manager is perceived to have flourished, “there were only about eight million bank accounts in the UK, equivalent to barely one third of the working, let alone the total adult, population.”156 All branches closed at 3pm, bank charges were levied entirely at the manager’s discretion, and credit was confined to overdrafts and short term credit (rarely beyond six months in tenor). While we have noted the widespread calls for a return to the practices of this era, we do not believe such a return would be in the interests of the vast majority of our customers. 4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (a) the following general themes: —

the culture of banking, including the incentivisation of risk-taking;

—

the impact of globalisation on standards and culture;

—

global regulatory arbitrage;

—

the impact of financial innovation on standards and culture;

—

the impact of technological developments on standards and culture;

—

corporate structure, including the relationship between retail and investment banking;

—

the level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects;

—

taxation, including the differences in treatment of debt and equity; and

—

other themes not included above;

—

and (b) weaknesses in the following somewhat more specific areas:

—

the role of shareholders, and particularly institutional shareholders;

—

creditor discipline and incentives;

—

corporate governance, including: —

the role of non-executive directors;

—

the compliance function;

—

internal audit and controls;

—

remuneration incentives at all levels;

—

recruitment and retention;

—

arrangements for whistle-blowing;

—

external audit and accounting standards;

—

the regulatory and supervisory approach, culture and accountability;

—

the corporate legal framework and general criminal law; and

—

other areas not included above.

4.1 We consider that most of the problems in banking standards can be related to a single basic issue: the failure to serve customers properly. While the vast majority of bank staff are squarely focused on doing a good job for their customers, it is clear that banks as a whole have not kept pace with some other industries in delivering the services and products their customers want. 4.2 In the decade preceding the financial crisis, the banking industry expanded too fast, with too much focus on income and profit, and too little on capital, risk and liquidity. This led to a regrettable tendency to promote products that delivered short-term income, rather than those that generated more sustainable benefits over time. Payment protection insurance is an example of this: PPI sales created income that could be booked at inception, rather than the slower income stream derived from the underlying loan. Sales were prioritised over service, and banks failed to balance their interests of their customers, their shareholders and their managers. 156

“Other People’s Money—the Revolution in High Street Banking”, David Lascelles, 2005.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1324 Parliamentary Commission on Banking Standards: Evidence

4.3 The persistence of a flat yield curve contributed to an inadequate appreciation of the real costs of term liquidity. As a result, banks were willing to take on longer term exposures than could be reconciled by the maturity profile of their funding. 4.4 Banks’ emphasis on growing income and profit had its counterpart in investors’ focus on growth. In some instances investors’ pressed for what were arguably unsustainable levels of return, creating pressure to increase leverage and take on additional risk. 4.5 Remuneration structures clearly played a role in encouraging some of these patterns of behaviour. Most banks have recognised this by instituting changes to the way they pay their staff, so that customer satisfaction and risk control, rather than just profit or income, determine pay levels. 4.6 We do not consider that the universal banking structure per se was detrimental to banking standards; as discussed in 4.2 above, misdirected sales occurred extensively in retail banking, as well as in wholesale banking. Nor was the universal banking model in itself more prone to instability. Over the period January 2007-February 2009 universal banks’ losses averaged 1.2% of average total assets, compared to 2.2% for narrow investment banks and 3.0% for narrow retail and commercial banks. 4.7 Ultimately, restoring basic management disciplines and embedding customer focus are the key to remedying the shortcomings that became apparent. 5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally? 5.1 The immediate priority of regulatory and legislative action in the wake of the financial crisis of 2007–08 was to address the issues financial stability exposed during the crisis, including weaknesses in capital, liquidity, risk management and resolvability. Similarly, individual banks needed to focus their immediate efforts on restoring their safety and soundness. 5.2 It may, to some extent, be viewed as a measure of the progress achieved in that regard that public attention is now focused more on questions of standards and culture, rather than simply of survival. 5.3 At RBS, that recovery process has involved one of the largest corporate restructurings ever undertaken. We have reduced the size of our balance sheet by £700 billion, while at the same time increasing lending in our core UK retail and commercial businesses, protecting customers who are also our future. We have increased our Core Tier 1 capital ratio from 4% to over 10% and thoroughly restructured our funding position, with greatly reduced dependency on wholesale funding markets. 5.4 The process of producing enduring improvements in standards and culture is more likely to be the product of a slow, deliberate and sustained march with many small steps, rather than one-off legislative or regulatory changes. Much of this essentially relates to basic management disciplines. 5.5 RBS has made it a priority to improve its customer focus, and has made a start on this. We have revised the Group’s statement of purpose, vision and values to give primacy to our customers’ interests. RBS’s Board is currently reviewing our code of conduct to make sure it reflects the values we aspire to and, as importantly, that it brings these values to life for our employees. 5.6 In response to feedback from SMEs for greater expertise levels, in June 2011, RBS launched an internal accreditation programme for relationship managers in Business and Commercial Banking. Every manager is required to complete modules in relationship management, risk, customer solutions and customer insight. RBS sees this programme as essential to developing our knowledge and skills so we can continue to help our customers realise their business ambitions. The programme is now externally accredited by the Chartered Banker Institute. To date, 3,700 corporate banking managers have been accredited. 5.7 The UK Retail division is working towards meeting the new regulatory requirements governing the professional standards of retail investment advisors by the end of this year. The objectives of the FSA Retail Distribution Review (RDR) are to establish minimum qualifications, raise standards of behaviour and secure the trust and confidence of the public. 5.8 Also in UK Retail, RBS has launched a Helpful Banker accreditation programme in collaboration with the Chartered Banker Institute. The programme includes induction, e-learning, assessment and requires the achievement of minimum standards. Colleagues who successfully complete the programme receive an externally recognised qualification—the Professional Banker Certificate, awarded by the Chartered Banker Institute. Since its launch earlier this year, over 300 colleagues have been accredited. Our aim is that 3,000 Retail bankers will complete the accreditation by the end of the year and a further 9,000 in 2013. 5.9 Remuneration in banks is an important and sensitive topic. Pay and incentive structures have a key role to play in supporting cultural change and appropriate risk behaviour. We have taken steps to overhaul these structures across RBS. It is, perhaps, fair to say that our focus initially was on reforming pay so as to achieve a better balance between employee and shareholder interest by, for example, paying bonuses in shares, not cash, and making awards subject to deferral and clawback so that performance could be evaluated over a longer term. Now our reform agenda has to go further so that pay also takes proper account of the customer interest.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1325

That means that pay awards must take account of customer satisfaction as well as risk-adjusted financial performance. 5.10 The new and enhanced process for individual accountability review assessments (which consider material risk management, control and general policy breach failures, accountability for those events and appropriate action against individuals) is operated across divisions and functions. The new accountability review assessments approach was sponsored and approved by Group Board Risk and Remuneration Committees. 5.11 The annual incentive pool is based on a balanced scorecard of measures including financial performance, risk, people and customer measures to better align shareholder and customer interests. Capital adequacy is also taken into account. 5.12 Within our UK Retail division we have replaced a pay structure based on sales incentives with one that rewards customer service and satisfaction. The scheme was introduced in January 2012 for branch and relationship employees linked to our Helpful Banking strategy. The scheme was introduced for employees providing telephone-based service in April 2012. 5.13 The new incentive schemes operating in the Retail division focus on retaining, growing and acquiring customer relationships based on great service and sales that are fully aligned to the customer’s needs and our strategy of becoming the UK’s most helpful bank. Payouts are determined on a mix of measures appropriate to each role with the most significant being Customer Service, Branch Contribution and Deposit Balance Growth. All participants must pass risk assessments and customer satisfaction hurdles and, in addition, all people managers need a minimum score in relation to feedback from their employees before they can participate. 5.14 We have recently completed an initial review of the scheme where we looked at financial analysis, customer and business outcomes as well as staff feedback. We are making some small changes to the scheme as a result. 5.15 Establishing good corporate governance is a key element of management and cultural change in the Group. In May 2011, the Board introduced a new Corporate Governance Policy to demonstrate that we are committed to the highest standards of governance, integrity and professionalism throughout the Group. The policy comprises ten principles and related guidance that apply across the Group and to all divisions and jurisdictions. The principles cover areas such as decision-making, individual and collective responsibility, identifying and managing risks, risk and reward and escalation and transparency. We want to ensure we have the right structures and systems in place so that sound business decisions are made and it is important to us that we demonstrate high standards of governance in all of our activities. 5.16 Since the crisis we have fully reviewed the Board size, role, composition and the experience and qualification of its members. As a result, the membership of the RBS Board has undergone sweeping change and a Senior Independent Director has been appointed to provide support to the Chairman and perform the function of intermediary for the non-executive directors where necessary. It is essential that directors have a sound understanding of the Group’s business so that the Board is able to provide input to help shape future strategy. This is achieved through site visits, in-depth board presentations and, for new directors, their induction programme. It is important to encourage a culture in the boardroom that facilitates debate and where non executive directors are able to provide constructive challenge to the executive team. RBS conducts an annual evaluation of the effectiveness of the Board and of the individual performance of each of the non-executive directors. 5.17 We also provide mechanisms for individual employees to challenge decisions and behaviours that they consider to be unethical or wrong. RBS has a comprehensive whistle-blowing policy. It is designed to ensure employees are able and feel comfortable to raise a whistle-blowing disclosure. Following an independent review conducted by KPMG in 2009, contacts have since January 2011 been managed externally by Global Compliance Services. 5.18 While we consider these measures to be important, we have no illusions about their ability to effect instant cultural change. We fully anticipate that it will take years to follow through on this programme and that the effects may not be immediately visible. Moreover, we believe that the delivery of real cultural change is more likely to be a consequence of having created a good company that serves its customers well than of having implemented a programme of cultural change. 5.19 It is also our belief that our success in placing customers at the heart of our business must be underpinned by investment in technology. We recognise that we have in the past underinvested in our systems, and that this has contributed to making it harder for our customers to do business with us, and harder for our staff to provide the kind of service they aim for. We are committed to remedying this, but it will take time to make up the past shortfall. Nor can this be a one-off investment; continuing efforts will be needed to maintain our technological capabilities.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1326 Parliamentary Commission on Banking Standards: Evidence

6. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice. 6.1 The extensive programme of prudential, macro-prudential, structural and regulatory changes that is under way has already done much to create a safer and more stable banking system, and we see further benefits as this programme is completed. This improvement in safety and soundness should of itself help rebuild customer confidence in banks. 6.2 In relation to professional standards in banking, we welcome the CB: PSB’s efforts to seek new, independent board members. We support efforts to develop a memorandum of understanding between the CB: PSB and the Financial Conduct Authority cementing its position as the instrument for setting and monitoring professional standards in banking. 6.3 We would also support giving the CB: PSB powers to maintain a register of accredited bankers and to strike off those who fall short of the required standards. We recognise that there is strong support from the public for bankers to be accredited, and RBS is already making progress towards the accreditation of customerfacing roles in the UK. Provided the standards expected are reasonable, the consequences of breaching those standards clear, and the processes of investigation, judgment and appeal fair, we do not believe that organisations or individuals should fear this approach. 7. What other matters should the Commission take into account? 7.1 We are seeking to rebuild an RBS that is stronger and safer than it was in the past. We recognise that the critical role our banking and payments services play in everyday life means that we must take full account of the wider social impact of our actions. 7.2 We recognise our obligation to be a positive force in the communities in which we operate, and have embraced this responsibility. This includes our pledge to maintain banking services wherever we are the last bank in town, as well as the financial education we provide to secondary students through our MoneySense programme. Acting as a responsible citizen also means working within both the letter and the spirit of the law and abiding by relevant codes of practice. 7.3 We consider that the work we are doing to ensure the sustainability of our business is an integral part of our overall recovery plan, contributing to the long-term performance of the company and its return to enduring profitability. 1 November 2012

Written evidence from Santander UK 1. Santander UK plc (“Santander UK”) welcomes the opportunity to present evidence to the Parliamentary Commission on Banking Standards. Introduction 2. Santander UK is mainly a retail and commercial bank: some 90% of profits after tax are derived from retail and commercial banking activities. Santander UK is a wholly owned subsidiary of Banco Santander S.A. (“Santander”). Santander UK is self-sufficient in capital, funding and liquidity and operates autonomously from its Spanish parent company. 3. Santander has invested more than £16 billion into the UK economy through the acquisitions of troubled financial institutions including Abbey National (c £9 billion, 2005), Alliance & Leicester (£2.3 billion, 2008), and Bradford & Bingley (£612 million) and a recent capital injection of £4.5 billion (2010) to further develop its business in the UK. 4. This makes Santander one of the largest inward investors in the UK economy. These investments are proof of Santander’s ongoing commitment to building a strong and stable retail and commercial banking sector in the UK, to retaining and creating jobs in the UK, and to supporting businesses and families in the UK to grow and prosper. 5. Santander UK is embedded in communities throughout the UK with some 25 million customers, 24,500 employees, 1,350 branches, and 1.6 million UK-based shareholders. 6. Santander UK is dedicated to earning and keeping the trust of its customers. Trust is the cornerstone of the Santander business model and the foundation of its corporate values. Santander UK is working to build a full-service, diversified retail bank around the needs and interests of its customers. Santander UK is also making a significant contribution to economic growth by focusing on growing its lending to small and medium-sized enterprises in the UK, which it did by 18% in the last year.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1327

7. Santander UK has maintained the strengths of its building society heritage in savings and mortgage products and is growing its presence in the current account market and SME banking. By doing so, Santander UK is bringing significant competition to the UK high street as the first serious challenger to the incumbent “Big Four”. 8. Santander UK’s balance sheet is one of the most UK-focused with an exposure of less than 0.5% of assets to eurozone periphery countries. More than 99% of customer assets are UK-related and 85% of its customer loans are prime residential mortgages to UK customers, with the balance being to UK businesses. 9. Unlike most global banks and many UK banks, neither the Santander Group nor Santander UK have ever needed state assistance. In contrast to many competitors, Santander’s prudential strength during and after the global financial crisis has allowed it to grow its retail and commercial banking businesses throughout the world. 10. As a UK-based retail and commercial bank, Santander UK will confine its evidence to commentary on issues relating to retail and commercial banking activities in the UK market only. Question 1: To what extent are professional standards in UK banking absent or defective? 11. High professional standards are essential to the proper functioning of the retail and commercial banking sector. 12. Over time, professional standards evolve to reflect new products, new risks and the changing expectations of consumers and society at large. With the benefit of hindsight, Santander UK would recognise that the evolution of professional standards in some parts of the retail and commercial banking sector may not have always kept pace with the rapid evolution of banking products and risks. At the same time, we would encourage the Commission to recognise that UK consumers have been generally well served by product and process innovation by banks and a significant widening of choice and access to banking products. 13. In recent years, professional standards have been called in to question in the wake of: — Prudential failures, eg the collapse of retail banks and former building societies in the UK. The incidence of prudential failure has varied across the retail and commercial banking sector. A number of retail and commercial banks, including Santander UK, avoided prudential failure altogether during the recent financial crisis. — Conduct failures, eg product mis-selling or “Treating Customers Fairly” (TCF) issues. The incidence and type of conduct failure have varied across the sector. Some instances have been to a greater or lesser extent common to most major UK retail and commercial banks, for example the mis-selling of Payment Protection Insurance (PPI), but other instances have been confined to individual institutions. 14. For this reason, Santander UK would encourage the Commission wherever possible to differentiate between institutions within the retail and commercial banking sector in order to reflect the diversity in incidence and type of prudential and conduct failures. Question 1a: How does this compare to (a) other leading markets? 15. The financial crisis was an international crisis. Prudential and conduct failures have occurred in retail and commercial banks in a number of countries around the world. Instances of prudential and conduct failure do not seem to have been correlated with a particular regulatory or supervisory model. Question 2: What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole? 16. Historically, consumers have been well served by retail and commercial banks in the UK. The UK’s high levels of owner-occupation, credit card use, mobile and internet banking, and pre-crisis availability of lending for both retail and corporate customers point to a financial services market that offers consumers high levels of choice and value. 93% of households in the UK have access to a bank account compared to a benchmark of 91% for OECD and non-OECD high-income countries.157 17. Conduct failures have a direct impact on consumers in terms of unsatisfactory TCF outcomes. Some indication of the severity of this impact is evident in the high levels of remediation set aside by the UK retail and commercial banking sector to cover conduct failures such as PPI mis-selling, for which total current provisions amount to approximately £9 billion. However, it is important to ensure that remediation levels are assessed in a consistent and unambiguous way in order to avoid encouraging the development of a compensation culture. 18. Conduct failures have also led to a considerable increase in conduct regulation, eg the Retail Distribution Review (RDR), an unintended consequence of which may be the removal of basic advice options as well as mass market investment advice as banks consider further reductions in their offerings. 19. It is difficult to separate the impact of prudential failures on consumers and the economy in the UK from the impact of the international financial crisis as a whole, of which the prudential failures mentioned above 157

The World Bank, Financial and Private Sector Development (June 2011).

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1328 Parliamentary Commission on Banking Standards: Evidence

were partly the product. The years preceding the financial crisis were characterised by macroeconomic imbalances, monetary expansion, an unsustainable credit boom, and asset price inflation. The total debt-toGDP ratio in the UK rose by 177 percentile points between 2000 and 2008.158 As one of the world’s more open economies and most important financial centres, the UK was particularly exposed to the impact of the financial crisis. The result has been economic downturn and significant deleveraging, not just by banks, but by consumers, businesses and the Government. 20. Deleveraging by the retail and commercial banking sector has been exacerbated by a significant increase in prudential regulation in response to prudential failures. This has constrained the capacity of banks to lend, which may have led to instances in which sound businesses have been unable to access the credit they need to realise growth and investment plans. Question 3: What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector? 21. The financial crisis has resulted in a significant loss of public trust in the retail and commercial banking sector. According to one recent survey, the public has an unfavourable opinion of the sector by a margin of 27%. 22. Conduct failings have compounded this loss of public trust. A recent Which? Report showed the extent to which trust in banks has deteriorated over recent years: 71% of respondents believed that general banking culture had not improved since the financial crisis. Santander UK recognises that it may take many years to regain this trust. 23. The loss of public trust is something we regret and it is a clear call-to-action for the retail and commercial banking sector. Retail and commercial banking is a public responsibility as well as a business. The services that banks provide are an integral part of every personal and corporate lifecycle. This sets retail and commercial banking apart, and makes bankers the “custodians of institutions of great public interest”.159 24. Santander UK believes that customer-oriented models of retail banking can help the sector to regain the public’s confidence. The survey cited above also showed that members of the public still have a positive opinion of their own retail bank by a margin of 38%. This suggests that, by focusing on serving the needs and interests of their customers, individual banks can begin to rebuild trust in the sector as a whole. Question 4: What caused any problems in banking standards identified in question 1? 25. As a retail and commercial bank focused exclusively on the UK, Santander UK proposes to confine its answer to consideration of the general themes and weaknesses that it believes to be most applicable to the UK retail and commercial banking sector. 26. With regard to the generic causes of prudential and conduct failures, Santander UK would echo the conclusions of the Turner Review in suggesting that the combination of a failure of supervision and a failure of corporate governance was the main the cause of prudential and conduct failure in the UK retail and commercial banking sector in the run up to and during the financial crisis. As the Turner Review stated: “improvements in the effectiveness of internal risk management and firm governance are also essential… There were many cases where internal risk management was ineffective and where boards failed adequately to identify and constrain excessive risk taking”.160 27. Santander UK has consistently supported recommendations to address weaknesses in corporate governance, specifically with respect to the prudential risk function and to Board oversight. Santander UK would echo the recommendations of the Walker Review that in future the risk functions within retail and commercial banks should be independent of executive management and have the authority within the corporate structure to challenge strategy or day-to-day decision-making. Non-Executive Directors should also be empowered to provide greater levels of oversight and challenge to executives who may be pursuing aggressive growth strategies. 28. With regard to some of the more specific causes of prudential and conduct failure, Santander UK would suggest that recent instances have indicated that certain additional areas of corporate governance could have been strengthened; that incentives and objectives could have been better balanced between targets and positive customer outcomes; and that front-line training and qualifications could have been improved. Features of the UK Market Structure 29. Over recent decades, the UK retail banking market has developed a number of features including a tendency to use cross-subsidies, high upfront discounts and complex charging structures. These features have been noted in a number of reports in recent years including the Government’s UK Mortgage Market: taking a long-term view (2004), with respect to the mortgage market, and the Treasury Select Committee’s report Competition and choice in retail banking (2011), with respect to personal current accounts. These tendencies have provided a context, and in some cases they may have acted as catalysts, for certain kinds of conduct 158

McKinsey Global Institute, Debt and Deleveraging: uneven progress on the path to growth, (January 2012), p 5. Lord Turner, “Banking at the cross-roads: where do we go from here?” Speech at Bloomberg, (FSA, 24 July 2012). 160 Financial Services Authority, The Turner Review: a regulatory response to the global banking crisis (FSA, 2009), p 92. 159

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1329

failure. For example, high upfront discounts and the proliferation of products with complex charging structures may have contributed to unsatisfactory TCF outcomes. Weaknesses in other Areas of Corporate Governance 30. We would suggest that recent conduct failures may in some cases have revealed a need to strengthen corporate governance and board effectiveness with regard to the risk function, audit and compliance controls, product approval processes, and professional cultures. (i) Risk management 31. In some cases, the definitions used of risk may have needed broadening in order to encompass the full range of conduct risks to which banks were subject. This might have avoided potential situations in which risk functions failed to identify or avert the full range of potential conduct failures. For example, the FSA noted in its report Banks’ management of high money-laundering risk situations (2011) that “at more than a quarter of banks visited, the risks they sought to mitigate were of limited relevance to anti-money laundering”.161 (ii) Control functions 32. Control functions like Compliance and Internal Audit may have required more resources in retail banks where conduct failures occurred. FSA enforcement and redress actions have identified instances in which Compliance and Internal Audit functions lacked the resources or authority to consider fully or report on risks, or in which Boards and executive committees failed to act on reports provided to them. For example, the FSA identified “a failure to respond to compliance concerns” in its Final Notice issued to the Norwich & Peterborough Building Society.162 (iii) Product Approval Processes 33. Product mis-selling and other TCF issues may have arisen as a result of, among other things, defective product approval processes. In some instances, new products may have been subject to insufficient levels of scrutiny or the approval process itself may have failed to take a sufficiently end-to-end view by not taking the sales process or the customer into consideration by testing customer outcomes. An example of this was highlighted in the FSA’s Final Notice over the sales process used in the distribution of Structured Capital At Risk Products.163 (iv) Professional culture 34. In some cases, professional cultures may have needed strengthening. Senior management may not have articulated or communicated the appropriate corporate values with sufficient clarity and a firm’s strategy may have needed to be more closely aligned with the interests of its customers. The FSA has in recent Final Notices drawn attention to these types of issues with regard to professional culture.164 Balancing Incentives and Objectives with Positive Consumer Outcomes 35. Incentive structures in some instances could have been linked to a more diverse set of objectives. For example, rewards might have been aligned with sales targets alone rather than a balanced set of performance indicators such as customer satisfaction, customer retention, service quality and risk. In some instances, this may have incentivised the sale of unsuitable products to customers. 36. In addition, one feature of the UK retail and commercial banking sector has been a high degree of focus on product lines. In order to achieve compliance on a product-by-product basis, retail banks have been required to employ staff specialising in single product lines. In some cases, this high degree of role specialisation may have created the incentive for specialised staff to sell specific product types to customers without sufficient regard to their overall needs. Training and Qualifications 37. We would accept that changes in the level of training and qualifications among employees in the retail and commercial banking sector may in part have contributed to instances of conduct failure. 38. Over recent decades, banking roles have become increasingly commoditised as a result of specialisation in individual product lines. This trend has been reflected in the growing specialisation of the types of qualification available from specialist providers. Over time, this may have resulted in fewer bank staff having the kinds of all-round banking knowledge that would enable them to serve customers’ needs in a comprehensive way. 161

Financial Services Authority, Banks’ management of high money-laundering risk situations, (FSA, 2011), p 4. Financial Services Authority, Final Notice, Norwich & Peterborough Building Society (15 April 2011). 163 Financial Services Authority, Final Notice, Lloyds TSB Bank Plc (24 September 2004). 164 See for example: Financial Services Authority, Final Notice, Bank of Scotland Plc (9 March 2012). 162

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1330 Parliamentary Commission on Banking Standards: Evidence

39. Furthermore, product specialisation has led to the development of an asymmetry between the level of qualifications required of regulated-product sales staff and the level expected of general sales staff. The result of this has been in some cases to change the overall types of responsibility held by branch managers and other front-line staff. In turn, this may have contributed to the demise of a traditional retail banking model in the UK based around generalist branch managers familiar with their customers’ overall financial situations. These trends may have played a part in driving instances of product mis-selling and other unsatisfactory TCF outcomes. Question 5: what can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally? 40. Since the onset of the financial crisis, significant efforts have been made by governments, regulators and banks, domestically and internationally, to identify and address weaknesses in the sector. Many of these efforts have resulted in substantial reforms that have already been or are in the process of being implemented. 41. Examples of reform at the legislative level in the UK include the Banking Reform Bill and the Financial Services Bill. At the European level, there are 61 separate measures regarding financial services in the legislative pipeline. In addition, UK regulators are in the process of implementing a number of reforms regarding corporate governance including the recommendations made in the Walker review and the Financial Reporting Council’s (FRC) review of the UK Corporate Governance Code. 42. These examples of recent legislative and regulatory reform at domestic and international levels will go a long a way to addressing the themes and weaknesses identified above. Many of these reforms have yet to be implemented and will, in any case, take time to settle. 43. In the view of Santander UK, the priority for the retail and commercial banking sector should be to ensure that current reforms are properly implemented. Furthermore, we would suggest that any remaining weaknesses can be addressed at the corporate level. 44. For this reason, we have in our answer below given examples of the steps that Santander UK has been taking to address potential weaknesses in its own corporate governance, incentives structures, and training regimes. We would suggest that these examples are evidence that the retail and commercial banking sector as a whole can address any remaining weaknesses of its own accord without the need for further regulatory and legislative action. Santander UK’s Approach to Potential Weaknesses Features of the UK market structure 45. In the view of Santander UK, the UK retail and commercial banking sector can and should of its own accord look to offer simple, transparent products that reward customer loyalty for the lifetime of the product. Furthermore, the UK retail and commercial banking sector can and should of its own accord take further steps to organise its business around customers rather than products. 46. Santander UK supported the recommendations of the Independent Commission on Banking (ICB) to improve competition in the retail banking market, specifically measures to increase transparency and improve the switching process. We supported the transparency initiatives announced by the OFT in 2009, and we implemented annual summaries to show the costs and benefits of current accounts to the customer and changes to monthly statements. We are working with the Government to deliver a new switching service by 2013. The service will be free for the customer and will guarantee that the switch will be in place within seven working days of opening the new account. (i) Simple, transparent products 47. Santander UK has acknowledged the need to move towards the provision of simple, transparent products. For this reason, for example, Santander UK has ceased to offer packaged accounts with opaque or complex charging structures. 48. Key milestones in our move to offer simple, transparent products were the launch of our 1|2|3 credit card in September 2011 and the launch of our 1|2|3 current account in March 2012. Our 1|2|3 products are transparent, simple to understand, and offer genuine benefits to our customers through cash-back and marketleading interest rates on the current account. In the first half of 2012, over 800,000 1|2|3 credit cards and current accounts were opened, 150,000 of which switched from other banks. 93% of customers report being satisfied with the account and 80% would recommend the product if asked. Moneywise.co.uk has called the 1|2|3 product the “market-leading current account”. In the view of Santander UK, these results demonstrate that banks can and should of their own accord seek to address the features of the market structure identified in paragraph 29. (ii) Customer centricity 49. Santander UK has taken a number of steps to organise its business around customers rather than products. We have undertaken a programme of customer segmentation, which has allowed us to gain a deeper

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1331

understanding of the needs of individual customers and ensure that we offer the right products to the right customers. For example, Santander UK’s latest offering to affluent customers—called Select—provides a personalised service to every customer via their own relationship manager, enabling them to solve their service problems via a single point of contact. In addition, we are implementing an integrated multi-channel experience—including telephone, Internet and branches—that enables all customers to access our products and services via the channel most convenient to them. 50. Santander UK would suggest that regulators also look to promote greater customer-centricity in the UK retail and commercial banking sector. We would not suggest that this is an area in which formal regulatory action is appropriate, but we would nonetheless welcome any steps on the part of regulators to facilitate greater customer centricity in banks. (iii) Customer service 51. Santander UK recognises that customer service is an area in which it needs to improve significantly. As a result, Santander UK has made improving customer service a top priority and taken a number of steps to address the issue including returning its call centres to the UK. These actions have resulted in a 29% reduction over the last six months in the gap between overall customer satisfaction with Santander UK and with peers, according to the Financial Research Survey (FRS). However, Santander UK still has a long way to go to reach its goal being one of the best UK banks for customer service. To address its issues with customer service, Santander UK will need in the short term to improve complaints handling and service quality and in the long term successfully implement the kinds of customer-centric structural reforms referred to in paragraph 49 above. Corporate Governance (i) Risk management 52. The Santander Group’s emphasis on prudent risk management has provided the model for Santander UK’s own risk management framework. The Santander Group model is characterised by the independence of the risk function from the business side of the bank; the involvement of the Board and senior management on a collective basis in decision-making; the diversification of risk across geographies, products and customers; and the high levels of expertise and the significant resources dedicated to the risk function. A particular hallmark of the Santander Group model is the Chief Risk Officer’s (CRO) membership of the Board. 53. Santander UK has taken steps to develop a fully-empowered, independent and holistic risk function by separating the Santander UK Board’s Audit and Risk Committee and by enabling the CRO to focus on strategic risk oversight rather than day-to-day risk management. In addition, we have created the position of Chief Risk Management Officer, who focuses on financial risks, and created a risk oversight unit to assist the CRO in advising the CEO and respective committees. Santander UK’s risk framework looks at financial and nonfinancial risks holistically to help minimise TCF issues and potential breakdown of controls. 54. That said, we would like to emphasise that a truly prudent bank is never complacent. Like every bank, Santander UK depends on the trust of its customers. Everything we do in terms of corporate governance is dedicated to ensuring that we avoid complacency and maintain the highest standards of prudent risk management. (ii) Control functions 55. Santander UK’s Internal Audit function working in conjunction with Compliance supports the Board Risk Committee by providing independent and objective opinions on the effectiveness and integrity of risk management arrangements. It does this via a systematic programme of risk-based audits of the controls established and operated by operational management and support functions and also those exercised by the risk oversight function. The Internal Audit function has the authority it needs to play an integral role in the business review process and to hold business divisions to account. Our effective control functions allow us to detect products that fall outside of our risk framework and respond proactively. One example of such early intervention resulted in an insurance product being withdrawn from sale shortly after launch due to advice quality metrics not being met. The product was only re-launched after an in-depth review and staff retraining to ensure that suitable and effective advice around this product could be delivered. (iii) Product approval processes 56. Santander UK has designed its product approval process to ensure that the potential defects identified in paragraph 33 are mitigated by establishing a Product Approval and Oversight Committee (PAOC), which is chaired by the Chief Financial Officer (CFO) and comprises senior representatives from all key functions in the organisation. The purpose of assembling such a diverse group is both to gain a holistic perspective on new products and to create an environment in which sufficient challenge exists. This ensures that PAOC’s duties in terms of product approval and continuous oversight are properly discharged with particular focus on guaranteeing that any new product or service sold achieves the right customer outcomes. PAOC considers the full spectrum of risks.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1332 Parliamentary Commission on Banking Standards: Evidence

(iv) Professional culture 57. In the view of Santander UK, the most important ingredient in fostering a strong professional culture is appropriate leadership from the top of the organisation combined with a clear corporate strategy. We believe that senior management should lead by example and regularly and consistently communicate key corporate values and the way in which these values relate to corporate strategy. 58. Santander UK’s senior leadership has consistently highlighted the importance of honesty and integrity at the product-design phase, giving customers appropriate advice, and putting the interests of customers before the interests of the bank. Communications are built around a clear aspiration: to make Santander UK the best bank for its people, its customers and its shareholders. The drive to transform Santander UK in to the customerfocused organisation referred to in paragraphs 49 has involved developing and communicating a new set of corporate values as well as leading the implementation of a number of operational initiatives Incentives 59. In the view of Santander UK, we have to consistently review the balance of incentives between targets and positive consumer outcomes such as customer satisfaction, customer retention and risk. 60. At Santander UK, we maintain our incentive schemes for branch staff in accordance with this aim. In order to be eligible for the branch incentive scheme, staff members must meet a minimum set of standards across a range of metrics including customer satisfaction, operational risk, advice quality and complaints handling. Once an individual qualifies, the scheme then rewards them according to their performance in terms of new business generation, customer retention, customer satisfaction, operational risk, advice quality and complaints handling. All schemes are geared to ensure reward is only issued when a balanced performance is achieved across all elements of the scheme. 61. Furthermore, Santander UK does not set minimum performance requirements for specific product areas. This approach ensures that Santander UK’s branch teams and advisors are able to meet business growth targets with the products that are most appropriate to the needs of each individual customer. 62. Santander UK would argue that regulators should continue to permit the retail and commercial banking sector to innovate with performance-related incentives. It is our view that the principle of performance-related incentives remains sound, and banks, like other industries, need the freedom to motivate, evaluate and manage the performance of their staff. Training and Qualifications 63. In the view of Santander UK, we have to continuously improve the training of front-line staff and support the development of professional standards certification regimes that embed ethical awareness, and establish mechanisms for monitoring and enforcing these standards. 64. The long-term goal of Santander UK is to align staff training and qualifications with the Santander Group model that supports highly-qualified, generalist staff in front-line roles that carry significant authority and responsibility. We recognise that the UK employment market is different to other markets in which the Santander Group operates with a relatively high staff turnover, particularly in key areas such as the South East. However, Santander UK continues to invest significant resources in staff training and will continue to look to raise the qualifications of front-line staff. 65. Santander UK is a founder member of the Chartered Banker Professional Standards Board (CB: PSB), a joint initiative under the auspices of the oldest banking institute in the world to develop a series of professional standards to support the ethical awareness, customer focus and competence of those working in the banking industry. Santander UK is currently working to implement the CB: PSB’s draft framework throughout the organisation. We believe that the Chartered Institute of Bankers in Scotland (CIOBS) and the IFS are suitable organisations to work with on the introduction of such industry-wide qualification regimes. We would support moves to extend the reach of these organisations and put their work on a more formal footing. Question 6: Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice 66. The changes already proposed by the government, regulators and the industry are substantial. In the UK, the Financial Services Bill will transform the regulatory framework for financial services, and the Government’s proposals for the Banking Reform Bill will lead to the most significant reform of the banking sector in decades. 67. The Walker Review has resulted in major changes to the FRC Corporate Governance Code and the FSA’s Approved Person Regime and the Kay Review is likely to result in further reforms to corporate governance for financial institutions in the UK.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1333

68. As explained above, at a European Union level, 61 separate pieces of EU legislation regarding financial services are currently going, or about to go, through the legislative process. A further five dossiers are planned for 2013 and there is an ongoing inquiry into the EU-wide structural reform of banking being led by the Liikanen Group. 69. These legislative and regulatory initiatives at domestic and international levels are in addition to the very significant and numerous internal changes that all banks in the retail and commercial sector have undertaken in the wake of the financial crisis. 70. Santander UK has supported all proposed legislative and regulatory initiatives that will help to create a stronger and more stable financial system. These numerous initiatives may help to restore public trust in the banking sector and may help to prevent the repetition of some of the major prudential failures and conduct failures seen in recent years. 71. In the view of Santander UK, the current challenge is to ensure that the many changes already proposed are implemented in such a way that they meet three tests: improve the strength and stability of the financial system; improve outcomes for consumers; and enable banks to play their full part in supporting economic growth. Despite current perceptions, we do not believe that it would be fair to suggest that the retail and commercial banking sector is still engaged in pre-financial-crisis “business as usual”. On the contrary, we would submit that the sector is undergoing the biggest bout of re-regulation and self-imposed corporate reform in decades. In the executive summary of its final report, the ICB stated that “together with other reforms in train, [the ICB’s reform package] would put the UK banking system of 2019 on an altogether different basis from that of 2007”.165 72. For these reasons, Santander UK would urge the Commission to assess the impact of the many legislative and regulatory changes already proposed or in the process of being implemented before proposing further reforms. Reforms should look to protect the customer but also recognise the need for a profitable retail and commercial banking sector and avoid undermining the ability of banks to attract investor capital and innovate on behalf of customers. It is a prudential necessity for banks to be profitable: banks must generate capital and maintain high levels of liquidity to satisfy regulators and to reassure depositors that their money is safe and maintain trust in the banking system as a whole. 3 September 2012

Letter from Sir Hector Sants In response to your request, I write to offer my thoughts on the issue of the design of an effective approach to conduct regulation of banks. These observations are made in a private capacity. General Background There is a fundamental difference between conduct and prudential regulation in respect of the feasible role of the regulator. Prudential Regulation In the case of prudential regulation the relevant authority can expect to achieve six outcomes: 1. Establish a set of regulatory rules primarily for capital, liquidity and resolvability. These rules should set the perimeter within which management can exercise their judgement. There are three principle outcomes to be achieved by the rules. Firstly, to significantly decrease the possibility that bad judgements by management will lead to the failure of the bank. Secondly, to ensure if it does fail that it can be resolved in a way which does not have systemic consequences for the economy. Thirdly, that any failure does not incur cost to the taxpayer. 2. Collect the right information from the banks which would enable the supervisor to make its own judgement as to the sustainability and resolvability of the bank. It is debatable however whether the supervisor should be resourced to check that the data is accurate and in particular whether the data on the quality of the individual loans is correct. I believe that a prudential supervisor should be resourced to achieve that goal. This resourcing can either come from specialists, employed directly by the regulator or by outsourcing to third parties, such as auditors, or a combination of the two. 3. Make an assessment of whether the bank has sufficient oversight mechanisms to enable the bank’s management to judge whether the prudential limits are at risk of being exceeded. 4. Ensure that the bank’s senior management have the right technical skills and necessary probity for the roles they are carrying out. 5. Deliver effective enforcement when its rules are broken. In particular, the regulator needs to have the necessary powers to both ban individuals from carrying out senior management roles for which they are not competent and to suspend them while investigations are pending. It 165

Independent Commission on Banking, Final Report Recommendations, (2011), p 18.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1334 Parliamentary Commission on Banking Standards: Evidence

should also have powers to attach conditionality to its authorisation of individuals. It is reasonable to give the prudential regulator powers to sanction banks through fines for failures to either maintain quality of data or have the right systems and controls. 6. Make a judgement as to whether the bank has the right culture to encourage individuals within the institution to comply with these rules. It would be reasonable for the supervisor to set rules to ensure that the individuals are incentivised by the bank itself to behave in the right way especially with regards to compensation. Conduct Regulation In the case of conduct regulation the feasible aims of a supervisor are more constrained. In particular it is not realistic to construct a conduct supervisor which could discover misconduct by individuals which is not visible to the firm, with any reliability. Discovering individual acts of wrong doing requires a forensic level of investigation for which it is not realistic to equip a regulator. This role should rest with the internal control mechanisms for the individual bank, namely management, compliance and audit. A conduct supervisor can however be expected to achieve the following seven outcomes: 1. Establish a set of regulatory rules which: (a) determine how markets and transactions between professional counterparties should be carried out; and (b) determine the rules which cover interaction with retail consumers. 2. Ensure that firms have appropriate oversight mechanisms in place to seek to ensure adherence with those rules. The testing of whether the oversight framework is in place can include periodic detailed assessment of particular oversight mechanisms, for example with regards to product suitability. However, as I mentioned above, it should not be set up with the goal of picking up individual acts of wrongdoing 3. Operate an effective redress mechanism which returns money promptly to consumers. 4. Operate an effective authorisation regime for key management roles which includes making judgements on competency and probity. 5. Operate an effective enforcement regime. My definition of an effective enforcement regime would be “one which ensures that when individuals are contemplating wilfully committing wrongdoing they believe there is a reasonable chance of them being caught and that the sanctions are severe enough to provide credible deterrence”. This was the substance of my speech in which I stated that individuals needed to be afraid of the regulator. 6. Operate a set of detection and analysis mechanisms which maximise the chances of detecting wrong doing once it has become reasonably prevalent in the system but prior to it becoming systemic. 7. Make a judgement as to whether the bank has the right culture to encourage individuals within the institution to comply with these rules. In particular, the supervisor should set rules which ensure that individuals are incentivised by the bank itself to behave in the right way, in particular the compensation structure needs to be correctly aligned. Specific Observations with Regard to Conduct Regulation I expand below on each of the seven points. 1. Regulatory Rules The central policy question in respect of rules is the degree of specificity which is required. This sits at the heart of the “principles versus rules” debate. Experience suggests a hybrid approach remains the only realistic solution. Superficially the concept of a simple set of rules such as “Treating Customers Fairly” appears desirable as it should be less bureaucratic to administer and would appear to avoid the opportunity for enforcement arbitrage. However, the fact is that any enforcement process ultimately gives the defendant recourse to the legal system. The absence of clarity creates the opportunity for the banks to resist sanction even when it is clear to the society that they have transgressed such as in the case of PPI. Consequently there has to be a mix of principles and detailed rules and the regulator has to seek the right balance between maximising enforcement success, giving clarity to firms, whilst minimising the administrative burden. 2. Conduct Supervision If the Financial Conduct Authority (FCA) is to be successful it is in the area of supervisory expectation that Parliament needs to be clearer. Currently the expectation of the media and Parliament is that any wrongdoing should be preventable by the supervisor. Thus, any wrongdoing by a firm is seen as a supervisory failure. This is an unachievable expectation which also creates unnecessary costs, regulatory burden and creates defensive behaviour by supervisors. It would be helpful if Parliament would make clear that it does not expect the

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1335

3.

4.

5.

6.

7.

regulator to discover wrongdoing before it has become visible in the marketplace not least because having the capability to do so would not pass a cost benefit test. The role of supervisors should be to detect wrongdoing once it is visible in the marketplace and also seek to ensure that firms have appropriate oversight mechanisms in place which themselves deter the wrongdoing. Redress Mechanisms The ability to deliver redress to consumers is an essential element of conduct regulation. The Ombudsman service has worked broadly well in relation to individual complaints, but there is clearly scope to give greater power to the regulator to achieve speedier mass redress. The current Finance Act has improved the regulator’s powers in respect of delivering mass redress, but more could be done. Authorisation Regime In relation to the authorisation regime, the supervisor needs powers to make it easier to make a judgement on technical competency. It also important that individuals recognise that they need to promote the right culture in the institution. The problem here is that this is a subjective judgement. Therefore, if this is an obligation on the regulator it lays it open to the risk it is being seen to misuse its powers. There is therefore an argument that this judgement should be made by the industry operating its own code of conduct and register. This would have to work in conjunction with the authorisation process. However, notwithstanding the reputational risk to the regulator, on balance I favour keeping all the judgements relating to authorisations with the regulator but in either case statutory backing would be beneficial. Finally, it would be helpful if authorisation of individuals could include conditions, albeit for a limited period of time. This would enable the regulator to formally identify actions which it requires members of management to carry out as a condition of maintaining their authorisation. Enforcement Regime In respect of ensuring an effective enforcement regime it could well be that fines need to rise again; even above the levels the changes made by the FSA in 2010 will have achieved. Furthermore, the regulator needs to be given additional powers. Firstly, to suspend individuals while their investigation is pending. Secondly, to enshrine in law that if an individual has been associated with a bank that either prudentially fails or commits an act of serious conduct wrongdoing, there is a presumption that the senior individual cannot hold a senior post again, unless they can demonstrate reasons to the contrary. In general I would not be in favour of imposing criminal sanctions for poor commercial decision making. It is however important that the Serious Fraud Office (SFO) is well resourced and effective and encouraged to use its powers in support of the regulator. The central point as I said earlier, is to ensure those who are contemplating wrongdoing are deterred by believing there is a reasonable probability of being sanctioned in a material way. This concept of fearing the regulator sits alongside the regulator being seen as respected and authoritative by those who are wishing to operate within the rules Detection Capability As has been discussed in the FCA document the detection mechanisms need to include much stronger analysis of business models, product suitability and, critically, complaints data by the regulator. This capability would supplement the existing obligations on regulated markets operators to provide the necessary data. This will require a significant investment by the FCA in terms of both people and technology. It will also require a change in culture, and in particular a greater willingness to listen to consumers. One particular innovation I would encourage would be to put much greater investment into encouraging consumers to contact the regulator directly with their concerns. This would require a vastly expanded call centre capability. Oversight of Culture As I made clear in previous speeches at the FSA I do not think the regulator should have responsibility for determining the culture within a particular bank, but it should make a judgement as to whether there is a culture in place which supports the regulator’s objectives. This would include making judgements on the effectiveness of Boards and the incentives, deterrence and oversight structures which individual firms have in place. Undoubtedly this would be a contentious area of focus as it is highly judgemental. Thus, some general obligation in statute requiring the regulator to make such a judgement would be helpful in giving it the necessary authority. In particular, the regulator should ensure that the banks have the following three elements in place: (a) A clear statement of purpose and values which places an obligation on employees to give consideration to the impact of their actions on society as whole. (b) An effective incentive regime which encourages individuals to see themselves as the custodian of their institution and which, in particular enables claw back for wrongdoing and does not reward high pressure selling.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1336 Parliamentary Commission on Banking Standards: Evidence

Further changes to the current compensation arrangement should include: — Making clear that any discretionary compensation is linked to compliance with the general statement of purpose. The specific changes below would assist in this aim. — For senior Executives extend the deferral period to five years. — As is being proposed, a clear ban on commission arrangements which encourage high pressure selling. — Clarity that fines should come out of the bonus pool. This would then encourage a greater ownership of good behaviour by everyone. One of the changes required is not just aiming to deter deliberate wrongdoing, but also to eliminate passive acceptance behaviour by everybody else. (c) A strong and independent compliance function which is tasked with ensuring adherence to the purpose and values statement, not just with regulatory rules. This would be encouraged by the setting up of a Board Committee to sit alongside the Risk and Audit Committee which would focus on operational conduct and behavioural risks, leaving the current Risk Committee to focus on balance sheet risk Summary In summary, the central point I wish to make is that the approach to prevention differs between prudential and conduct regulation. In prudential regulation the supervisor can make a forward looking judgement within the framework of the rules as to the likelihood of a firm achieving the regulators desired outcome and intervene if it thinks they are not going to be achieved. In the case of conduct regulation an inspection based regime is unlikely to reliably detect individual wrongdoing in firms. The focus of the regulator thus needs to be on ensuring the firms themselves take responsibility for achieving that goal. In pursuit of that goal the regulator needs to give greater emphasis to ensuring firms have the right culture and behaviour than has been done in the past. Ensuring firms have the right culture should be a statutory objective of the regulator. The historic approach has emphasised the need to ensure the right systems and controls are in place, this is still a valid approach, but it must be complimented by a focus on culture. Also in assessing controls, greater emphasis needs to be placed on ensuring that there is a strong and independent oversight function within the firm. This approach needs to be backed up by clearer enforcement powers which ensure individual accountability. It should however be recognised that whilst in this letter, I have emphasised the importance of culture, I am doing so because it has historically not been a focus of regulators. I continue to hold the view of the importance of also implementing the proposed proactive intervention strategy based on in depth market and business model analysis which has been laid out in recent FSA publications. I hope these observations are helpful and I would be happy to expand on any of them if you would find that of assistance. 20 January 2013

Letter from Clare Spottiswoode, former Director General of Ofgas and member of the Independent Commission on Banking I wanted to write to thank you for the opportunity to give evidence to the Commission and share my thoughts on vital matters such competition and innovation as the basis for regulation of the Banking industry, last month. If you recall, I mentioned that as a member of the Independent Commission on Banking, one thing I fought for the hardest was to ensure that we had an appropriate and compelling duty for the new Financial Conduct Authority (FCA) and Prudential Regulatory Authority (PRA), to promote effective competition. I would like to take this opportunity, in my personal capacity, to reiterate just how essential this duty is, and the importance of having competition at the forefront of any regulator’s mind and working culture. Such a duty will enable both the FCA and PRA to put consumers and fostering competition at the heart of their work. If the regulators have this duty, they can directly address matters before they are allowed to cause widespread detriment, such as was the case with the miss-selling of Payment Protection Insurance (PPI). PPI miss-selling is a classic example of an issue that should never have been allowed to get to the state that it did, and had the regulators been acting with “competition” embedded in their culture, they would have acted far sooner rather than sticking to an approach that is simply lots of (ineffective) rulemaking. Given that the “barrier to entry” is a competition duty and an integral solution to improving banking standards, the ICB recommended that the PRA worked with the Office of Fair Trading (OFT) to review all the prudential standards to ensure that there were no barriers to entry. Furthermore, we were conscious that the PRA should not become an organisation set up solely with objectives around the setting and monitoring of prudential standards. This is because it is essential to ensure

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1337

that both the PRA and FCA have regard to wider issues beyond prudential standards, and in doing so, do not stifle innovation. Having read the section on the PRA’s duties in the Financial Services Act 2012, I take comfort in the strong wording surrounding the need for the PRA to minimise any adverse effect on competition. In practice, I will be hoping to see this sentiment strongly embedded in the culture of the PRA, from the top down. If you would like to discuss any of the points I have raised in greater detail, or would like any further information, I would be delighted to hear from you. Once again, thank you for inviting me to give evidence to the Commission. 20 February 2013

Written evidence from Stonehaven 1.1 Historically, British institutions and their methods have been held in very high regard around the world; for instance in Egypt when a business meeting, or deal, is failing to progress sensibly there is a common saying that is used, which is, “let’s do this the English way”... meaning let us stop arguing and being emotional and tricky; and instead put fairness, openness and honesty in place as the means to achieve a mutually satisfactory transaction. RBS’s conduct in the SWAPS scandal has brought global mistrust of a leading British profession. What was seen globally as a centre of banking excellence must now rank amongst the more dishonest and risky places to do business. 1.2 Because all of the major British banks embarked upon the promotion of SWAPS to SMEs at about the same time and because hindsight has shown that all banks were already facing troubles as the peak of the boom approached, it has to be in peoples’ minds globally whether The Bank of England itself was a party to those banks’ behaviour in this regard. After all, Vince Cable has publicly used the term “we are in the equivalent of an economic war” to indicate the serious levels of crisis, so suggesting that extreme measures have been/ will be necessary. 2. Our Response to Question No. 2 2.1 All consumers are trapped in a market where SMEs have no profits to re-invest in either maintenance of quality and volume or improvement in products and services. 2.2 For all consumers, it is always the case that SME level of business is the lifeblood of continuity and growth. It is logical that those entrepreneurs, who are born to build proven businesses from scratch, are those that have in the past and can in the future become the nation’s leading conglomerates. Shooting stars die; even Marks & Spencer can fold if another Mr Marks and Mr Spencer cannot be recruited by them. How many major businesses have folder when the founder is no longer at the helm. Lady Thatcher saw that as a mantra and so championed small business in the nation’s best interests. 2.3 The economy is being held back because small business is being held back. History shows that Labour governments always have made the mistake of disregarding small business; and instead canoodling with big business, because big business fits the socialist dogma of dominance and control. The latter always fails. Success comes from freeing the vitality of the ‘new-born’ business. Nature does the job for us if we let it... it’s naturally so. 2.4 In effect, small business is what the government allowed (encouraged?) banks to target for their desperate survival as small businesses were the only ones who were modestly borrowed, by comparison to the banks and small businesses existed in sufficient numbers to equate to large cash sums in total; and small businesses tend not to be owned off-shore where cash that large off-shore companies own is inaccessible anyway. 2.5 The short-term need for huge cash rebuilding of banks’ balance sheets could only be met from a raid on small business but the medium and long term result of that manoeuvre is the stagnation and decline of the economy. 2.6 Some (New Labour and the Liberals) believe that investment in infrastructure will boost the economy (eg Boulder Dam and Thatcher’s motorways) but the problem is a different one this time; it is a problem of over regulation of and financial restriction and abasement (destruction) of small business like never before. It is a disease. 2.7 The disease (2.6 above) emanated from Europe (mainly France). Germany built its financial muscle in the 60’s and 70’s on the basis of cheap labour from Turkey (thus helping Turks); whilst others were striking and further empowering trade unions. So far, Germany has been able to stand back in amusement whilst further prospering during the mirage of the economic boom amongst its extravagant EU neighbours. Now, however, even Germany (the hardest working people in Europe) has to be fearful of contagion and, through Angela Merkel, have sought to hint at the facts by their reluctance to fund further unearned spending in other EU nations.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1338 Parliamentary Commission on Banking Standards: Evidence

2.8 Germany’s hint is... let small business get working. Stop milking small business just because it’s the only on-shore cow in the parlour. 3. Our Response to Question No. 3 3.1 Whilst a bank manager was once amongst the pillars of society and a trusted purveyor of good financial sense, with a heart that beat to the rhythms of control of risk of both his bank’s money and yours, that professional underwent a metamorphic change into something akin to a door-to-door salesman who had revenue and profit targets and bonuses linked to them... indeed his P45 is linked to them. 3.2 The public had become punch drunk with New Labour promises of Utopia whilst holding the belief that public spirited stalwarts of sense and reason such as the banks were their guardians of economic sense, fairness and prudence. The public is now punch drunk from the many shocks of being so wrong about the latter. 3.3 The public barely retains hope that the banking sector can, by itself or by the impositions of others, even begin to return to its previous trusted status. The public is in dire need of seeing some ‘honest visionary’ individual of great skill and drive, who can dispense and will administer the bitter pill of necessity. 3.4 The public sees leading bankers, including the governor of The Bank of England, looking shell-shocked and impotent. 3.5 The public can see the banks re-filling their coffers but that is all they can see. They need to see more. They are prepared to work for more themselves if they can only see how. The youngest of the working generation are beginning to see their role as being the new-blood saviours but they can’t see the opportunity. That is because there isn’t the opportunity whilst small businesses are being milked and any small business that they attempt has to wade through quagmires of regulation where meeting one regulation means you break another... thanks to New Labour and the misguided EU. Once, a young person would have seen the banks as the ‘X Factor’ critic who had the knowledge and power and the will to enable them to succeed with a combination of a good idea and proper own commitment. Now the banks are one of the crocodiles to wrestle with as they try to paddle their canoe. 3.6 The public expects the banking sector to pull together with the rest by making sacrifices in all areas; to demonstrate contrition and community conscious endeavour; to abandon its elitist bonuses and perks; to be at the heart of rebuilding the nation’s strength; to demonstrate true leadership in a crisis in their domain that has so seriously affected all. 4. Our response to Question No. 3 4.1 We, quite seriously, consider Tony Blair and New Labour to have been the root cause of the problems in banking standards identified in question no.1. Although Thatcherism brought about the merging of the banks’ high street operations with those banks’ financial markets and merchant banking operations, it was the naivety combined with the insincerity of Tony Blair’s New Labour that broke the chivalry in banking. 4.2 New Labour the worshippers of Murdoc’s Sun newspaper. New Labour the insulters of the public’s intelligence. New Labour the media savvy hypnotists. New Labour who proved you can get away with anything in government, including punching the face of a traditional, if naughty, egg-thrower. New Labour who never found weapons of mass destruction that could reach the UK in 45 minutes. New Labour ministers who had never had a job let alone run any business. New Labour who cavorted with Berlusconi and Gaddafi. Finally, and most significant, New Labour who convinced the populous (including bankers) that they had brought an end to boom & bust. If the latter isn’t a licence to run amok with finance and lending without fear of wrong then what is? 4.3 Respectfully, we say that the Commission’s terms of reference with regard to this question no.4 are missing the point by asking respondents to consider the general themes (a) and weaknesses in specific areas (b). 4.4 Simply failed ‘Leadership’ has been the cause through and through. 4.5 However, looking at those general themes (a) and weaknesses in specific areas (b):(a) ... (i) There is nothing wrong with incentivised risk taking; providing that delegation and monitoring go hand-in-hand. (ii) Globalisation likely may have had a role in bringing about a shift from responsible banking in UK banks and a severe lessening of bankers’ regard for the national (and nationals’) interests, reputation, standards and culture. (iii) Without any doubt the banks, especially US banks, had designed financial schemes and products that regulators failed to understand but still rubber-stamped anyway, eg packaged and distributed sub-prime mortgages. However, much sub-prime existed in the UK due to New Labour’s end of boom & bust pronouncement (see 4.2 above). (iv) With poorly regulated financial innovation it only have the same end as any other poorly regulated creativeness; in Africa you can see motor bikes repaired and rebuilt with wood frames,

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1339

cars overloaded beyond chassis strength, excess car/bus passengers with legs and arms hanging out of doors and windows. However, standards and culture in the UK have been in progressive decline for decades and that emanates from the civil service and its Unions. For example a solicitor acquaintance is married to a local government civil servant and told me of hearty household debates about events such as when the local government involved became concerned that staffs were leaving at 4pm every Friday when the office actually closed at 5pm. The Authority decided to change the time for office closing on a Friday to 4pm to stop wasting heat and light and to regularise the 4pm departures. The result was that staff ceased to return at 2pm on Fridays because it simply wasn’t worth coming into the office for just 2hrs! Even in the 1960’s the civil service was leading this decline; I was a young man working on a lorry delivering concrete blocks to building sites and at all the private developers sites we would carefully unload each individual block (by hand) and neatly stack them for use. One day we had to deliver to a council site and the site foreman instructed us to throw the blocks off of the lorry onto a mountain of broken blocks... of course, almost every block broke upon landing! I have a lifelong acquaintance that has had a career in teaching. Early in his career he told me the only way one can get rid of a bad teacher is to recommend them for promotion! The NHS sets an example of similar failure of public duty. Three quarters of NHS nurses are Agency nurses who get their work without commitment to the NHS as an employer... more non-commitment and lack of regard other than for self! Is that an example to bankers? I think not. (v) Technological developments should not have an impact on standards and culture but they do. The American style of email address using “Hi” promotes over relaxed attitude and attention to formality and both factual and ethical correctness. “Hi” may well not do so in the USA but in the UK it does because it seems childlike and non-committal. (vi) The main banks have become too big, too powerful and able to cooperate unhealthily if not even form cartels. Investment banking has allowed itself to pretend to be operating in the same way as a high street bank, ie as advisors to business borrowers. No other cutthroat sales operation is allowed to sell in such a way as to disguise its pitch as professional advice. (vii) SWAP scandal evidence suggests that the main UK banks have not effectively competed but, instead have shared ideas for duping customers. They may have competed in bidding to take over other banks as I am told that Barclays were second best bid for the Dutch bank ABN Amro. (viii) It is a concern that the banks have taken a lead in using offshore tax avoidance. Whereas that may be legal, is it ethical when duping SMEs with SWAPS when those SME’s are also usually taxed in the UK? (b) ... All of the specific areas listed as possible areas of weaknesses may be due closer attention but it will never overcome the underlying problem. Politicians, civil servants are setting the bad example; yet they are the legislators and regulators; get them acting correctly first and then they are able to tell others to do as they do and gain rightful respect in the process. Start there! To have a properly functioning team, business or country there has to be ‘leadership’ than can be respected; one that sets the example and thus merits compliance with its demands. There is more regulation than regulators can cope with. Cut regulations, champion enterprise and condemn (meaningfully so) political and regulator incompetence, weakness and mal-practice. The UK and its banks are suffering the EU contagion (see above). The example the UK needs can be found amongst its SME entrepreneurs. They get what they earn. They have commitment. They lead by example. They take measured risks and back that with all their personal worth. Free the SMEs, they have already proved they ‘can do’. Cease robbing them to oblivion. Make the banks repay the ‘borrowed’ SWAPS gains. The UK’s SME’s will, by peerless proven track record be the drivers of renewed UK growth. They will, themselves, regulate the banks by assurance of not permitting themselves to be bitten by the same dog twice. They will remind banks that banks are suppliers not customers. They will make the banks compete. The UK’s hope in the short, medium and long term is its SMEs. What we described here is what was done by a Labour government immediately after WW2... they set SMEs free. New labour shackled SMEs. Undo those shackles. Free the enslaved SMEs. That is all you need to do. It worked after WW2. It will work this time. Champion the SMEs. Lastly, I recently attended a ‘top 150 south-west companies’ seminar at Exeter university. The main speaker was the chairman of Flybe. A university official asked him what was most needed in terms of young recruits. The speaker announced that the university official would not like the answer. The speaker’s answer was, “Fewer university graduates who have never had any practical experience and more apprentices”. Immediately post WW2 apprenticeship was widespread and it was another feature that rebuilt Britain. In our industry all we see are ‘Oxbridge’ style reams of repetitive regulations that mean nothing at the ‘coal face’. One government department contradicts another (eg anti-scald measures) and apunch drunk disbelief asserts itself in the place of worker willing trainable.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1340 Parliamentary Commission on Banking Standards: Evidence

Getting Britain working means making the banks refund ill-gotten billions taken from honest and hardworking SMEs. The UK needs a return to growth. SMEs will do it—Its common sense. 2 September 2012

Written evidence from Raymond Sturmer Introduction An article in the September 2012 issue of “Governance and Compliance”, the magazine of the Institute of Chartered Secretaries and Administrators (ICSA), featured the setting up of the Commission and listed what expectations there are of it and that responses to a number of questions would be welcome. A copy of that article is attached in order to follow my responses.166 The writer is an Associate of the Institute of Bankers and a Fellow of ICSA and worked for 38 years in an international French bank in the City of London starting as a junior and attaining the status of general management. The experience embraced most areas of banking and included, for some time, frequent contact with the Bank of England and with many senior bankers from a wide range of banks as a result of being secretary of an association of international bankers. The experience included both corporate business and banking for wealthy individuals and stockbroking in a subsidiary of the French bank. Although retired, the writer has followed financial affairs quite closely through the media, including the professional magazines of the institutes mentioned. The responses (by reference to numerotation of the article) 1. There has been a deterioration in the standards of professionalism in London and the United Kingdom. Having been regarded as higher than those of many other countries, it is probable that standards are now no better and may be worse than in some. The UK had a very high reputation internationally for probity, skill and dynamism which manifested itself by attracting foreign banks from all over the world (over 500 at one time). The initial effect of this was to encourage a great and creative diversity of services and products which benefitted customers, the profitability of the banks and increased invisible exports enormously. However, almost inevitably some of the less ethical practices from some countries crept into the UK mindset. With the vast increase in competition more and more risky practices evolved and less and less care was taken over the analysis of the dangers. At the same time the creation of international giants of industry required the banks to make bigger and bigger loans and other transactions, sometimes in an effort to retain those customers or through fear of not being able to compete, especially against the largest US, Japanese and European banks. The ability of management to control the organisations in the way they had been able to earlier became more and more stretched. Indeed, I can recall thinking that some banks were so large that they were unsupervisable and that regulators would not be able to control them as envisaged. There was also a problem for supervision in that the former informal guidance from the Bank of England was challenged by more legalistic foreign banks and they were enabled to adopt practices and risks which the Bank would previously have been able to discourage, if not prevent. Banking Acts enshrined the powers of the Bank of England and subsequently the “Big Bang” instituted regulators governed by regulations, and in both cases the opportunity to challenge the regulator or to write business before the regulator had an opportunity—even if it could not object—to consider the impact of it became evident. The inauguration of hedge funds re-inforced the short-termism which was becoming a factor in the markets. They tended to trade in large amounts and began “investing” in companies with a view to a quick turnaround, having no interest in the long-term futures of their purchases or of the industry or of the UK’s interests. This was analogous to the “asset stripping” which became prevalent in the late 1960s and 1970s which was often centred around, and confined to, property values. The later version was mainly speculative. 2. The consequences for consumers, whether retail or wholesale have been: — Their interests have been largely ignored as witnessed by the unfolding of numerous scandals of mis-selling. — Products have been designed for the benefit/profitability of the institutions. — Institutions have furthered their own interests and profitability without regard to the interests of the consumer or the risks they have encouraged the consumers to take. — The introduction of call centres has distanced the consumer from the institutions (or vice versa) and has diluted the expertise which was formerly available to customers. Many bank branches do not have a manager with broad experience and many decisions are referred to regional centres to which customers do not have ready access. — Individual rewards have encouraged over-selling and caused bank staff to be oblivious to the consequences of their actions. 166

Not printed.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1341

—

Banks, encouraged by the financial press, have tempted consumers to seek increasing returns in unsuitable products, the customer having no appreciation of (or being able to appreciate) what risks are embedded.

—

Customers feeling disadvantaged and unenterprising unless they were taking “advice” from bank personnel or the press.

—

Conditions being applied to products and services which the average customer was unable to understand and the more onerous ones not being explained.

—

The media continually encouraging customers to seek out new opportunities and to switch providers and products so that there were ample occasions for confusion, for acquiring the wrong sort of product or service, and of customers not necessarily improving their positions as leap-frogging by providers would often leave them worse off with a new provider as their old one quickly overtook their new one.

—

Even supposedly “professional” customers turned out not to understand what they were doing and were certainly not enlightened by providers. Local authorities were caught in the lending to foreign banks; corporates were led into taking out hedges which cost fortunes; and investment managers bought into sub-prime packages which proved costly. Caveat emptor maybe, but today’s mores tend towards protections which did not exist in the past.

3. It is evident that banks have lost much trust and are seen as pariahs, not to say as dishonest. The public does not know to whom to turn for sound advice. This may not matter for the corporate and sophisticated customers but for the private customer he or she generally thought they would receive impartial advice. This idea is no longer believed. [ As an aside, so-called Independent Financial Advisers (IFAs) have a very mixed reputation and are themselves often guilty of over-selling and of encouraging customers to be economical with the truth when it comes to eg self-certification of salaries when applying for mortages. Many IFAs are not qualified to deal with the complex products and services on offer and which change overnight.] The recent revelations regarding LIBOR fixing, the PPI controversy and money laundering among the major banks have done nothing to inspire confidence. There is a widely held view that banks have been significant contributors to the economic woes of the last four years and that they have not accepted their culpability. The fact that they have received billions of pounds to support them grates with many when they compare the sufferings of the unemployed and those on low incomes, especially when compared with the excessive rewards of the senior executives of banks. It will take many years for this negative attitude to disappear. 4. Reasons for the problems are varied. Some are: —

The dissociation between the risk takers and the shareholders. That is to say that those taking the risks had no capital at stake. They earned large rewards without suffering the consequences of their errors. Shareholders, even institutional ones, would have little opportunity to see what was happening on a day-to-day basis, but belatedly have become more influential in respect of the rewards of executives. Perversely, there is sometimes a reluctance to hold down rewards as there can be an uplift factor for everyone if they are rising. Shareholders should expect the profits to be distributed fairly so that the capital is rewarded as it should be for the risks being taken, and generally better than for those taking the risks on the books. Dividends have been slashed or suspended while rewards for executives have continued at a generous level.

—

Peer pressure. It has been common for many years that if a “profitable” opportunity appears to arise all competitors will follow to benefit from the same product or service. Further, if one bank is seen to be making huge profits from an activity, the management and the shareholders of others will wish to participate as well and risks can be ignored, or at any rate overlooked, in the dash to make money.

—

The creation of highly technical products, very often not fully understood, has been a significant cause of problems. This has been exacerbated by mis-selling and ignoring counter-party risks.

—

The impossibility for directors and management to control operations and staff in organisations which are so vast, where markets are so fast moving and where innovation is rife. Pre-approval of the way a bank operates would be seen to be stifling innovation and dynamism so the oversight of much of what goes on is post facto and too late, or by the time the situation is fully understood the product/ service has burgeoned too much and sometimes the apparent profitability appears too attractive to call a halt. Internal audit work can be useful if those to whom it is submitted are prepared to act upon it even if it affects profitability.

—

The same is true for external auditors who try to have a “snap-shot” of the organisation and to make a judgment on whether the controls are adequate. There is little chance that they will detect major problems until they have occurred and the damage is done.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1342 Parliamentary Commission on Banking Standards: Evidence

—

—

—

—

—

Ratings agencies have created illusions of the standing of many banks and the risks attached to products. Doubtless their efforts are valiant and offer some insight into the risk of doing business with countries or banks or companies. However, the users of such ratings have often been blinded by those ratings and have suspended independent judgements, or in many cases lack the means to make independent appraisals. Many decisions have been taken on the basis of the rating given by these agencies, when the rating should only be a guide to which own judgement is added. Often the rating of the issuer, buyer or borrower is preferred over the risk of the product itself. Competition is certainly a factor, first because of peer pressure as mentioned above and, second because margins and profitability are so slim that they do not represent the true risk/reward ratio and banks do not build up sufficient reserves. The culture of the banks has declined over the last twenty or thirty years. Staff destined for promotion were expected, though less among the foreign banks who often benefited from employing qualified staff from the indigenous banks, to have climbed the ladder with a sound understanding of what banking was about and who would be expected to have obtained the qualifications offered by the Institute of Bankers which were generally of a technical nature rather than certificates in marketing. (I may be prejudiced here but the evidence of call centre staff who have a narrow range of knowledge has been obvious). The relationship between retail and investment is a factor to the extent that the latter tends to be fast moving, risk orientated and highly rewarded, creating a two-speed organisation. Further losses in the investment bank will be detrimental to the bank overall, although there are supposed to be risk weightings related to the quantum of capital available. But capital is not ring-fenced, so there is an argument for splitting the two activities, each having its own capital base. The difficulty for major corporate is that they want one-stop banking and an investment banking product or service may be used in association with its retail requirement, e.g hedging currency or foreign exchange risk. Almost instantaneous communication has been effective in the ability to trade quickly and anywhere in the world. On the other hand, and it is unlikely this will be reversed, decisions have to be made in an instant with little time for reflection and analysis. This may not be significant in respect of, say, foreign exchange transaction but may be more so when, say, legal opinion is needed and lawyers are under pressure to give fast advice, or when an assessment of a counter-party is necessary.

5. This is a difficult problem to resolve as the organisation of banks is so intertwined, the products so complex, the amounts of the risks being taken are so large, the multinational companies are so demanding and the controls are so problematic to put in place without hampering the innovation, the speed of responses required, and the service needed by the customers. It could be argued that the retail and investment sides of banks could be split off entirely, or that the investment banking side should be more highly capitalised (which would affect the profitability) or that banks should not deal in some retail products, eg domestic mortgages, but that would not necessarily have stopped packages of such products from being securitised and sold on. It could be that the seller of some products should be expected to retain some responsibility for the risk once they have been sold on—this might actually deter such activities. When syndicated loans were pre-eminent, the merchant banks and investment banks would try to pass off all the risks to the participants. This was sometimes successfully resisted, giving the “lead manager” an interest in ensuring that the risk was identified and covered as much as possible. 11 November 2012

Written evidence from Ian Taplin Submitted by Ian Taplin, ex Lloyds Bank Wealth and Private Bank (2005–2010) and Founding Member of Whistle blowers UK(WBUK). This submission relates to the call for evidence and testimony—specifically to 4b and 5. Part 1 will cover 4b “arrangements for whistle blowers”. (Part 2 will cover 5; which will submitted shortly.) Precis. “Arrangements for Whistle Blowers, and why more bank employees do not whistle blow within UK Banks?” — A. PUBLIC INTEREST DISCLOSURE ACT (PIDA)—as legislation is considered by banks and the regulator as voluntary and as an example of light touch regulation—easily ignored. — B. BANK STRUCTURES AND PROCESSES exist which actually discourage whistle blowers. — C. BANK BEHAVIOURS towards whistle blowers can include intimidation, obstruction, and deliberate confusing actions. — D. The EMPLOYMENT TRIBUNAL system does not serve the whistle blower making PIDA claims. — E. FSA; whistle blowers have little confidence in the FSA and confidence in the new PRA/FCA has already been undermined.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1343

—

F. WHISTLE BLOWING IS SELF HARMIMG; whistle blowers have their careers ruined, their financial security destroyed, and see their families suffer.

Preface 1. The PPI mis-selling episode has so far cost UK banks (and the other providers)—£12 billion and the claims volumes are not abating. Yet there is no public record of any banking employee raising concerns or whistleblowing on this activity. It is public record that the FSA warned the Industry of the regulators’ concerns about mis-selling in 2005; and yet the Banks only ceased their selling activities in 2010. 2. The Libor rate rigging, we are informed—was practised by the major UK Banks for many years and again there is no public record of disclosures made by whistle blowers in the public domain. On 27 July 2012, the Financial Times published an article by a former trader which stated that Libor manipulation had been common since at least 1991. 3. The questionable selling of interest rate swaps to small and medium sized businesses was only made public by the efforts and actions of the alleged victims; and not by any whistle blowing actions made in public by employees of the UK High Street Banks. It is estimated that between 40,000 and 60,000 businesses are affected. 4. Carol Sergeant, Chair of Public Concern at Work(PCAW), a Whistle Blowing Charity gave evidence to the Parliamentary Commission on Banking Standards, on 17 December 2012 and stated: “One of the reasons we (PCAW) are looking specifically at financial services is that that’s an area in which they’re probably hasn’t been sufficient whistleblowing.” With reference to the Public Interest Disclosure Act 1998, Ms Sergeant also states: “It is time for review—both of the legislation and how it is working.” “People have not been listened to. We need to find a way of not only encouraging people to speak out and making sure they are listened to.” Introduction 1. I have been working in Financial Services since 1992 and have experience of working in small, medium, and large regulated firms. I was registered with the Financial Services Authority (FSA) as an investment adviser and as an approved person. Previously I was in the book publishing business and also served in the British Army—as a Platoon Commander in the Light Infantry now the Rifles Regiment. 2. I worked at Lloyds TSB from 2005 to 2010 in the Private Bank and Wealth divisions as a regulated adviser providing advice to retail customers. In 2007, I started raising concerns, internally, about alleged misconduct and regulatory breaches. In 2009 and in 2010 I submitted 2 Formal Complaints relating to concerns of misconduct and regulatory breaches. In August 2010, I was dismissed for gross misconduct for, essentially, whistle blowing. (a) I did not seek to pursue PIDA Claims through an Employment Tribunal; as in my case such a process does not I propose serve the public interest and does not protect the LTSB customers; whom I allege have been victims of a new mis-selling episode—which the FSA are currently investigating. (b) As a result, I am claiming I am not subject to any non-disclosure agreements nor the confidentiality clauses in my employment contract with Lloyds Bank. (c) In 2011 and 2012, the FSA received two Formal Submissions of complaints concerning Lloyds Bank allegedly breaching regulatory law and Principles (Note 1). I have presented in person, two Formal Submissions to FSA Panels totalling over 5 hours of face to face discussions. My Formal Complaints have been acknowledged as legitimate and serious by the FSA. 3. I am also a founding member of Whistleblowers UK, (WBUK), which launched in 2012 as a self-help mutual organisation, run by Whistle Blowers as volunteers—for the protection and welfare of Whistle Blowers. The launch of WBUK has been widely reported in the mainstream media. http://www.whistleblowersuk.org/ (a) This Parliamentary Commission has published several submissions offered up by members of WBUK in December 2012.To date ,WBUK Banking members have yet to receive requests to provide oral evidence to assist the Commission. I, and other Banking Members of WBUK are grateful to the Commission for the opportunity for us to share our experiences; and to hopefully further assist the Commission by providing insights into the difficulties faced by Banking Whistle Blowers in the UK. (b) We welcome the Commission’s recognition the role Whistle Blowers have to play as explained by Lord Lawson-Chairing the Sub Committee e-panel on regulatory approach—on 17 December 2012;

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1344 Parliamentary Commission on Banking Standards: Evidence

With regard to Whistle blowing “is there anything else that can be done to enhance the risk management function within banks? I don’t think it should be the main bulwark, but it (whistle blowing) could be a useful additional one.” Andrew Love MP states: “We need Whistle Blowers to be effective if we are to find what is actually going on in some financial institutions.” A. Public Interest Disclosure Act (PIDA) Introduction; “the legislation is considered by banks and the regulator as voluntary and as an example of light touch regulation—easily ignored” 1. This legislation was enacted by Parliament to better protect whistle blowers from detrimental treatment by employees. Being a Private Members Bill (introduced by Richard Shepherd MP)—it was only passed into the Statute Book as a voluntary and not a compulsory duty upon employers. This was apparently because of the concerns of the extra costs which may be incurred due to the administrative burdens of compulsory compliance. 2. There exists other UK legislation which also can cover some aspects of whistle blowing—in Employment Law and in the UK Bribery Act 2010. In the Financial Services sector-there are further obligations under the “approved persons” regime of the Financial Services Authority (FSA). 3. There are, however, no statutory requirements in PIDA, for organisations to have a whistleblowing policy in place. However the government would expect public funded agencies to have such a policy in place; and such agencies are apparently assessed in their whistleblowing procedures -as part of their external audit. 4. Under the Combined Code of Corporate Governance, UK listed companies are obliged to have whistleblowing arrangements and are asked to explain if they do not have such arrangements in place. 5. Whilst it appears that FSA regulated firms have statutory obligations to ensure they have robust whistleblowing procedures in place, the FSA guidelines for the UK High Street Banks on whistleblowing appear to offer only encouragement. (a) Under the FSA guidelines SYSC 18.2.2; (1) Firms are encouraged to consider adopting appropriate procedures which will encourage workers with concerns. (2) For larger firms appropriate internal procedures may include; and (3) an assurance that where “protected disclosures have been made…” 6. So PIDA appears to be more voluntary and that even within a regulated sector the FSA seemingly only encourages rather than ensuring strict adherence .This is thus considered an example of light touch regulation. 7. There is no public record of any warnings or sanctions imposed by the FSA, upon UK Banks, for failing to have adequate Whistle Blowing processes in place. B. Bank Structures and Processes Introduction; “BANK STRUCTURES AND PROCESSES exist which actually discourage whistle blowers” 1. Staff Manuals (a) LTSB staff manuals detailed the procedures for making a Grievance complaint but there were no mention of whistleblowing or any guidance provided on the subject .Nor did the Staff Manual provide any reference to LTSB’s obligations as a regulated firm. (b) The LTSB definition of a grievance is: “A grievance is defined as a concern or complaint, actual or perceived, by an employee concerning misuse of company policies, procedures, processes or failures to honour contractual entitlements.” (c) In my own experience, it was seven months before LTSB alerted me to their Whistle Blowing procedures despite my Grievances being primarily concerned with alleged regulatory breaches. (d) Public Concern at Work (UK Whistle Blowing Charity) and BSI (British Standards Institution) state: “Whistleblowing is where an employee has a concern about danger or illegality that has a public interest aspect to it; usually because it affects others (eg customers, shareholders, or the public). A grievance or private complaint, is by contrast, a dispute about the employee’s own employment position and has no additional public interest dimension. Unless the organisation’s arrangements make this distinction, it cannot assume or expect that its employees will understand the difference and act accordingly.” (Note 2) (e) LTSB “bundled up” grievances and whistle blowing complaints. This “bundling up” of employment related grievances with regulatory based complaints within a Grievance Process can have serious ramifications for whistle blowers (WB). WBUK Banking Members consider this practice as seemingly deliberate.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1345

For example: (1) The WB concerns(which are regulatory based)—could be dealt with by the HR Department who have no proper remit to deal with regulatory based complaints as they have no qualifications as regulated personnel in the “approved persons” regime. It is Compliance personnel with the required approval and qualifications that should deal with regulatory based complaints. (2) HR departments can also appoint Line managers such as Sales Directors to conduct the Grievance meeting and subsequent investigation; even though it is the Compliance Staff that should supervise regulatory based complaints and any subsequent hearing and investigations. So the WB regulatory based complaint is dealt with by Sales and HR staff; and the direct contact with the appropriate Compliance Staff may be denied to the employee whistle blowing even though the Complaint is their responsibility. 2. The Line Management Dual Duties (a) The Management at LTSB Wealth doubled up on sales and compliance duties. So the sales consultants were supervised by a manager who had responsibilities for sales targets as well as the compliance requirements laid down by the FSA, the regulator. This structure of dual responsibility (of sales and compliance duties) extended up to the Managing Director of LTSB Wealth. There is an obvious conflict of interest inherent in such a structure as the incentives to achieve substantial monetary bonuses by reaching sales targets could well outweigh the absence of similar financial incentives to achieve compliance targets of “treating customers fairly”. Therefore there is a disincentive for management to listen to whistle blowers. Such a system acts as deterrence for the line management to assist the whistle blower and to protect them—even under “due duty of care” obligations lay down by Employment Law guidelines. 3. Incentives (a) The LTSB Incentives system during 2005–10 ensured that if a regulated sales consultant achieved a sale—then a complicated and extensive matrix of staff would benefit from such a sale. The crossselling opportunities of the LTSB Bancassurance model would only operate profitably if the referral system was working for maximising the sales prospects. Therefore, when I received a referral from a junior sales consultant who was based in a LTSB Branch, I was aware that many more LTSB staff depended on me to make a sale—for their own targets and performances were dependent upon me to achieve the sale. Most of the LTSB staff that was depending upon me to make the sale were non–regulated branch staff—and who often had no expertise to assess the suitability of a sale to a customer. So, if for any reason I decided that there was no scope to provide further advice to the customer and therefore I do not make a sale—I would be criticised by the non-regulated management that I had failed to make a sale. I calculated there were eight LTSB staff members who were depending on me to make the sale on LTSB branch referrals and whom would be awarded points as a direct result of a sale being achieved. A large capital sale of an investment of say £500,000 would make a substantial difference to the monthly targets of these dependent LTSB branch staff. (b) The Bancassurance Model is designed to exploit the vast customer base in retail banking. LTSB is first and foremost a retail bank and main source of profits is derived from the non-regulated activities of lending. The smaller regulated sales operations were totally dependent upon the retail bank ensuring a constant flow of customer referrals. The pressure is on the regulated sales consultants to make the sale to achieve his own targets and help the non-regulated retail staff achieve their own targets; and thus to be regarded more highly by the non-regulated powerful retail bank. (c) The nature of the interdependency of such a sales system and the wide distribution of awards from sales does not lend itself to an employee wanting to blow the whistle as the employee would be considered disloyal and would often feel disloyal themselves. Often these work colleagues have known each other for many years and have pursued their careers within the Bank together. This pressure, not to whistle blow, is immense. 4. The Issue of Leadership (a) This interdependency of sales of the Bancassurance Model reaches into the highest levels of the corporation; and the Executive Directors responsible for their respective Divisions were able to reap substantial rewards from the Bancassurance operation.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1346 Parliamentary Commission on Banking Standards: Evidence

(b) If the commercial considerations of the Bank were seemingly threatened by a troublesome whistleblower, experience has shown us, that Senior Level Executives will ignore the whistle blower and their own regulatory responsibilities- in order to accumulate more wealth. Even if such Senior Level Directors receive direct correspondence from a Whistle Blower (sent by registered mail) whom is appealing for assistance and leadership -because of obstruction or intimidation -the whistle blower will be ignored even though the Director has statutory obligations as a “approved person”. This is known as “wilful blindness”-and is a common phenomenon the whistle blower has to deal with. (c) Concerning PPI mis-selling, the FSA warned the Banks about the inappropriate selling of this contract in 2005 when the regulator assumed responsibilities for supervising insurance contracts. Despite the introduction of regulatory supervision and repeated FSA warnings, the UK High Street Banks persisted on selling the PPI contract through to 2010. This was in defiance of the FSA whom were evidently considered to be light weight regulators. (d) The various Banking leaderships were thus openly ignoring the regulators. Substantial financial rewards were paid out to Executive Board Directors partly made up of the high margins generated by the selling of the PPI scheme; a clear example of senior level misconduct and self-enrichment. (e) This Senior Level self-enrichment through open and public defiance of the regulators has undermined the workforces’ own confidence in the integrity of the Bank they committed to work for—since school or University; and upon which they have become totally dependent to reach their own personal and career goals. (f) Thus the rank and file employee, whom having no leadership example in the ethics of how to properly treat customers and how to be a partner in a good business model—becomes hardened to the rights or wrongs of abusing the trust of the customer .The employee can become cynical as to standards the leadership claim to be upholding in the Bank’s own published “Code of Conduct”. So in this vacuum of any quality leadership and example—there is no public record of a Bank employee whistle blowing on the PPI mis-selling scandal, the LIBOR rate rigging, and the sale of Interest Rate Swaps. 5. No Formal Training (a) The FSA Principles and Guidelines use key words or phrases such as fairness, transparency, or acting in the clients “best interest” and “treating customers fairly.” (Note 3) These Regulatory Principles and Guidelines have had little meaning to staff when they have been so heavily targeted to sell an Insurance Contract such as the PPI product. So given the Financial Services and Markets Act 2000 relies upon basic principles of how to conduct business—being adhered to; then it follows that regulated staff should be trained on how the FSA Principles apply to actual behaviours when dealing with customers. (b) Regulated Staff are well trained on the risks of money laundering activities and banking fraud through the retail networks—yet many would hard pressed to answer how the FSA Principles apply to their everyday activities. (c) Nor is there any formal training on the Whistle Blowing Legislation and how PIDA is embedded in FSA Guidelines. (d) I would also suggest few regulated staff would realise that the FSA guidelines expect a bank to ensure a direct discreet channel to Compliance Staff is available which can bypass the usual line management structures. C. Bank Behaviours Introduction; “BANK BEHAVIOURS towards whistle blowers can include intimidation, obstruction, and deliberate confusing actions” 1. Based upon the research available and indeed the experiences described in the media in the UK and indeed by members of Whistle blowers UK there is seemingly a pattern of behaviour which is displayed by Large Corporates when dealing with whistle blowers. 2. The US based Government Accountability Project (GAP)—the US Whistle Blowing Charity—has published the “Corporate Whistle Blowers Survival Guide”; written by GAP Legal Director Tom Devine and former GAP Investigator Tarek Maassarani. http://www.whistleblower.org/action-center/know-your-rights-campaign/banking-industry/corporatewhistleblowers-survival-guide The guide describes the “Malek Manual”, which according to GAP may be used as an HR Manual on how Corporations should treat whistle blowers. For example:

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1347

(a) Ignore the whistle blower and then isolate them by ensuring the whistle blower goes on sick leave limiting the potential collateral damage. (b) Ensure his workmates are informed the whistle blower is on sick leave dealing with his health problems and instructing them not to contact the whistle blower. (c) Refusing to deal with the Whistle blowers complaints until cleared fit for work by his doctor; whilst simultaneously taking steps to make the whistle blower redundant. (d) Promising investigations but refusing to commit to informing the whistle blower the results of the investigations. (e) Multiple investigations are promised as the whistle blower escalates his complaint through the corporate hierarchy. In my own case there were five new investigations into my two regulatory based complaints. (f) Confuse the whistle blower by: (1) Not disclosing the wider management structure and the direct lines of reporting. (2) Not disclosing the identities of key legal and compliance staff with whom the whistle blower should have access to. (3) Being selective in answering queries and ignoring substantial elements of a regulatory based complaint which has the effect of delaying matters and building up volumes of correspondence; which can wear down the employee whom is suffering from stress. (4) Claims by Senior Executives they have not been given certain key evidence and therefore cannot comment. (5) Compliance Staff refusing to discuss issues such as WB intimidation—as intimidation is an employment matter and therefore not a compliance concern. (6) HR refusals to accept whistle blower complaints against Senior Directors have any validity; and failing to explain why Senior Directors are protected from employee complaints. (g) Using subtle and not so subtle intimidation and obstruction: (1) In correspondence with the WB -constantly referring to the WB as being on sick leave and therefore being unwell might affect the validity and legitimacy of his concerns. (2) Using threats of disciplinary action if WB refuses to follow the HR processes if the WB lawfully complains that access to Compliance Staff is being blocked by HR and his own line management. (h) Senior Executive Board Level Directors standard policy of refusal to reply to registered mail sent by the Whistle Blowers trying to bypass obstruction. (i) Making oral offers of a settlement then denying any offer has been made when asked to put such offers in writing. (j) Dismissing the whistle blower for gross misconduct forcing the whistle blower into an Employment Tribunal—or the court system which invariably is stacked against the whistle blower. D. Employment Tribunals Introduction; “The EMPLOYMENT TRIBUNAL system does not serve the whistle blower making PIDA claims.” Public Concern at Work 2011. (Note 4) 1. If a whistle blower decides to pursue claims for wrongful dismissal there are concerns that the current ET system does not serve whistle blowers making PIDA claims. (a) The removal of legal aid often forces the whistle blower to use lawyers on a “no win no fee basis”. The conditionality of using legal advice in this way can mean the retained lawyer has more interest in advising a settlement than encouraging the whistle blower to insist on a formal hearing in the public interest. (b) Therefore there is pressure to settle and agree to a non-disclosure agreement which does not serve the public interest element in the whistle blowing action. PCAW report that over 75% of PIDA Claims are settled before an ET Hearing—which means we have no information as to what caused the whistle blower to act. (c) Therefore the public interest element to the whistle blowers action are lost and the problems which seem to been identified within a corporation are buried-to the detriment of the public interest. Cathy James CEO of Public Concern at Work wrote in 2012: “There is an increasing urgent need for greater transparency in claims brought (through the ET system) under the Public Interest Disclosure Act.” “Public interest information is likely to be buried in settlements.” (Note 5)

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1348 Parliamentary Commission on Banking Standards: Evidence

2. PCAW and WBUK are campaigning for greater transparency in Employment Tribunals as there is scant information available. The ET system is underfunded and scattered across the UK with no central mechanisms to capture key data. PCAW and WBUK are calling for a central online database with details of ET judgements to ascertain the public interest elements which may affect the public welfare. 3. Regulators such as the FSA/FCA should be expected to liaise with the ET to ensure information on judgements which concern regulated activities and public interest matters—are shared with them. The FSA/ FCA thus have a key role in capturing ET information. E. The Financial Services Authority (FSA) Introduction; “whistle blowers have little confidence in the FSA and confidence in the new PRA/FCA has already been undermined” 1. The FSA is being replaced with two new regulators—the Prudential Regulatory Authority and the Financial Conduct Authority. The FSA is being replaced because of the regulator’s failures to properly regulate and supervise the banking sector. There are many reasons for this failure but light touch regulation must be considered a major factor; and the FSA’s own behaviour towards whistle blowers seems to suggest that the light touch regulation effect has also determined how whistle blowers have been dealt with. WBUK Banking members can relate that when complaints are submitted to the FSA-they never receive any further correspondence other than a brief curt acknowledgment. 2. On the subject of WB being offered settlements and agree to non-disclosure agreements -the FSA wrote in 2011: “The FSA is well aware that regulated firms will often offer to compromise claims to former employees rather than contest a claim through the tribunal system or the courts. There seems to us to be nothing inherently wrong in this. Indeed, the courts themselves actively encourage the early settlement of claims. We are also aware that, as part of a settlement, firms will usually include a confidentiality obligation in an agreement with the former employee. We also see nothing inherently wrong in this.” (Note 6) There is no public record of the FSA requesting the reasons behind WB blowing the whistle whom then reach settlements with employers—despite the FSA writing in 2011: “The (regulated) firms understand that the confidentiality obligation does not prevent the FSA from being able to obtain information from the former employee, where they have information which is relevant to the carrying out of our regulatory functions.” (Note 6). We question how can the FSA seek to retrieve such public interest information when they have no willingness or indeed formal processes to obtain such information? 3. S43J of PIDA expressly states that any clause that seeks to gag an individual from making a protected disclosure is void and unenforceable but there is no public record of the FSA enforcing this principle to obtain information from regulated firms to protect the public interest. 4. WBUK are aware that should a former employer seek to disclose sensitive information in the public domain and break any non-disclosure agreement he could only do so—and avoid the corporate backlash—with an overwhelming public and media interest at that time—as in the case of Paul Moore and HBOS. There are few examples of whistle blowers breaking such non-disclosure agreements in the banking sector. 5. When a whistle blower contacts the FSA and submits his concerns the FSA will advise the Whistle blower: “For legal and policy reasons, we will not be able to let you know the outcome of our inquiries or to give you progress reports. Should you have any further information at a later date we would like to direct you to our dedicated whistleblowing team within the FSA who can assist you.” (Note 7) (a) Unless the FSA moves to enforcement action against the regulated firm, the WB complaint disappears into a black hole. (b) WBUK members can supply evidence that having presented robust evidence of regulatory misconduct to the FSA they are then ignored and subsequent efforts to re-engage with the FSA are disregarded. 6. There is thus a contradiction inherent in such regulatory methodology in dealing with approved persons whom are whistleblowing. The FSA insists that approved persons should adhere to the FSA Principles and report any concerns of regulatory breaches; yet the FSA refuse to disclose any details of their investigations. How can a regulated person therefore fulfil his own statutory responsibilities to ensure the customer’s interests are being protected when the FSA refuse to share any information with the regulated individual whom is whistle blowing?

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1349

7. Whistle Blowers have no confidence in the FSA and the wider public’s confidence has been undermined in the regulator’s failure to supervise the Banking Sector. (a) Recent statements by Andrew Bailey, the new head of the Prudential Regulatory Authority whereby he publicly stated that UK High Street Banks are too big to prosecute; and such statements have already begun to undermine the fragile confidence in the new regulator—set up precisely correct the failures of the FSA—which it is replacing. “Mr Bailey told The Daily Telegraph that some banks had grown too large to prosecute. ‘It would be a very destabilising issue. It’s another version of too important to fail,’ he said”. (14 December 2012) http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/9743839/Banks-are-too-bigto-prosecute-says-FSAs-Andrew-Bailey.html. 8. We know of many examples of UK High Street Banks sacking employees for whistle blowing yet the FSA has failed to properly assist WB, even when their WB actions taken are to precisely fulfil their own regulatory duties as “approved persons”. BBC Newsnight reported on 11 September 2012: “Newsnight can reveal that not a single UK-based bank has ever been punished for firing a whistle blower within its ranks—even though these individuals are protected in law since the Public Interest Disclosure Act 1998 came into force. When Newsnight approached the FSA for a response it said it would not comment on individual cases, but acknowledged that no bank had ever been sanctioned in such circumstances.” http://www.bbc.co.uk/news/business-19545849 F. Whistle Blowing is Self-Harmimg Introduction; “whistle blowers have their careers ruined, their financial security destroyed, and see their families suffer” 1. Well known UK Banking Whistle Blower Paul Moore, ex HBOS, is unable to find similar work—from which he was fired—for internally whistle blowing .He was a Senior Group Risk Officer at HBOS and was fired for properly reporting that the HBOS sales culture was an emerging risk to the business. Paul Moore’s reported income in 2012 was £15,000. 2. Martin Woods, ex Wachovia Bank Money Laundering Officer, was forced to leave the London branch when he reported Wachovia processing Mexican drug cartel money; crimes for which Wachovia paid $160 million in fines. In 2012, when applying for a similar position at Coutts Bank (whereby he disclosed his experience at Wachovia)—he was offered a position by Coutts Bank—but Coutts then withdrew the job offer having second thoughts. Martin, an ex-Metropolitan Police Officer-has at last secured work for which he is trained. 3. There are many other examples of WBUK Banking members whose careers have been severely affected or destroyed, their financial security ruined and their family life put under immense strains—for voicing their concerns through their whistle blowing actions—acting as they were, in good faith in the public interest and for the public’s welfare. 4. WBUK believe it is time to recognise that properly protecting legitimate whistle blowers, whom act in good faith is vital, within a democracy, and genuine whistle blowing is as effective as regulation. Notes and References 1. FSA Principles. http://fsahandbook.info/FSA/html/handbook/PRIN/2/1 2. PAS 1998–2008; Whistleblowing arrangements—Code of Practice. Published by the British Standards Institute with Public Concern at Work 2008. 3. FSA Guidelines “Treating customers fairly”. http://www.fsa.gov.uk/doing/regulated/tcf 4. “Whistle Blowing; beyond the law .The Biennial review.”—published by Public Concern at Work; Oct 2011. (Page 10) 5. As in Note 4; Cathy James CEO PCAW; (Page 3). 6. Statement written in a letter to the author sent by FSA Lloyds Bank Relationship Manager; June 2011. 7. Statement written in an e-mail sent to the author by FSA Lloyds Bank Conduct Manager Oct 2012. 11 January 2013

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1350 Parliamentary Commission on Banking Standards: Evidence

Written evidence from Ian Taplin Preamble 1. Submitted by Ian Taplin, ex Lloyds Bank Wealth and Private Bank (2005–10) and Founding Member of Whistle blowers UK (WBUK); Banking Member. 2. Part 2 of this Submission relates to the call for evidence and testimony—specifically to Item 5. — Item 5; “What policy measures may be considered” to: (a) “Strengthen whistle blowing protection for whistle blowers acting in the public interest within retail banks”. (b) “How to make whistle blowing easier within retail banks”. 3. Part 1 submitted on 14 January 2013 covered 4b—“arrangements for whistle blowers.” (Part 3 on the subject of mis-selling to be submitted shortly) 4. Chairman of the Parliamentary Commission on Banking Standards: “We aim to produce some practical proposals for improved standards and culture, contributing to rebuilding trust in the banks and restoring pride among their employees, the majority of whose reputations have been wrongly impugned. Only when confidence in the industry recovers will it be able to play its full role in generating economic growth.” Andrew Tyrie MP. (Note 1) Summary Précis — Banking Whistle Blowers remain unprotected because the UK legislation PIDA 1998 and FSMA 2000-have conflicts of interests. — Public Interest Disclosure Act 1998 (PIDA) needs strengthening: — Abandon Government’s insertion of “public interest test” amendment in the Enterprise and Regulatory Reform Bill. — Embed vicarious liability within PIDA. — Consider financial incentives/compensation for whistle blowers and their supportive organisations. — Reinforce PIDA non-disclosure agreements as null and void. — Consider Registration as a simple no cost solution. — Consider an Ombudsman. — Financial Services and Markets Act 2000(FSMA 2000), and Financial Services Authority (FSA) Regulators. — FSA statutory objectives’ have conflicting obligations which directly impact upon whistle blowers. — The need to clarify mis-selling and fraud. — FSA regulators are inexperienced, insufficiently remunerated and vulnerable to the “revolving door” syndrome. — The UK has allowed regulatory capture and such apparent regulatory seizure deters whistle blowers. — Banking Conduct — CEO’s can be perversely incentivised to be hostile to whistle blowers. — Widen claw back provisions. — Whistle Blower Organisations connected to Banking. — Whistle Blowers UK is a voluntary self-help group with very modest independent funding. — Public Concern at Work is funded by corporations such as Lloyds Bank and NHS agencies. — Consider funding whistle blowers organisations from fines imposed on Banks. — The evidence suggests that the public is strongly supportive of whistle blowers in the UK. Part A—Conflicts of Interest Introduction; Whistle Blowers remain unprotected because of UK legislation which has conflicts of interests 1. Any whistle blowing action involves three core participants: — The whistle blower—whom is a person and is a voter and whom seeks protection to be provided by society. — The corporate organisation—a corporate non person with no vote whom seeks protection to be provided by society.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1351

—

The society, whose citizens by consent form a democracy to seek to provide protection for its own mutual well-being.

2. The word “whistle blower” was first used by Ralph Nader whom described the legitimacy of the whistle blower acting because “the public interest outweighs the organisation’s interest.” (a) The “organisation’s interest” may defend itself against whistle blowing actions as described by General Motors Chairman James Roche -whom warned against Ralph Nader’s whistle blowing in 1971. (b) “Some critics are now busy eroding another support of free enterprise—the loyalty of a management team, with its unifying values of cooperative work. Some of the enemies of business now encourage an employee to be disloyal to the enterprise. They want to create suspicion and disharmony, and pry into the proprietary interests of the business. However this is labelled-industrial espionage, whistle blowing, or professional responsibility—it is another tactic for spreading disunity and creating conflict” (Note 2) (c) The third core participant is the society in which the whistle blowing action is taking place. The society—(whose citizens by consent form a democracy to seek to provide protection for its own mutual well-being)—and its own democratic robustness will reflect the rules and law within the society, and will determine the extent to which legitimate dissent is not only tolerated but encouraged. 3. These three core participants in the whistle blowing action are acting to defend their perceived respective interests and may or not share these interests with the two other participants. (a) For example the whistle blower as a person may be strongly protected and defended by the society—whose democratic robustness is of a high quality—which upholds the rights of the whistle blowing individual whom is the voter—such as in Norway. (b) In 2010 the Tavistock Institute commissioned Norwegian Academics Marit Skivenes and Sissel Trygstad to study why Norway appeared to have effective whistle blowers protection in their public sector: “A very high proportion of employees blow the whistle when they experience misconduct, and the majority of these people receive positive reactions. Furthermore, a majority of the whistleblowers report that the conduct that led them to blow the whistle improved. These positive findings are different from those reported in international research displaying that whistleblowing is difficult, often results in retaliation and is rarely effective.” (Note 3) (c) However in a society whereby corporate interests are seemingly stronger—such as in the US or UK (as compared with Norway)—the lack of whistle blower protection is a reflection of a society whose democracy is of a less robust nature; and reflects the extent to which the society enables non-voting corporate interests to hold and use power. (d) This three core party characteristic of the whistle blowing action can therefore expose conflicts of interest between whistle blowers, whom are citizens and voters, and corporate organisations whom are non- persons and do not vote ;and in such conflicts can reveal where the real power lies within a society. (e) However given the nature of our society, we, the voting citizens form corporate organisations to provide us with employment and sustenance-and to deliver governance, schools, hospitals, defence and welfare—to survive and protect our own immediate families and communities -with a collective mutual will. (f) So the corporate organisation which the citizens and voters have themselves created, also seeks protection to survive and safeguard its corporate organisational interests. The voting citizens themselves created the corporate organisations, and within the society they work in the corporate organisations, they receive income and receive protection from the corporate organisations—for their own survival. They may invest their capital in the corporate organisations and own a portion through shared capital (shares) and by the prosperity of the corporate organisation receive income when retired through a pension. (g) So society organising a democracy to govern itself must ensure the protection of the voting citizen’s interests and must also protect the corporate organisations which have been created by the voting citizens themselves to enable the society to survive, self-govern and prosper. In this way the society must properly align these interests and then ensure a workable balance between these interests in order to exercise the collective will. (h) Why therefore are there inherent conflicts of interest existing today when all three core participants should in theory be functioning together in a balanced fashion with a collective will? Because for a variety of reasons our democratic society has become unbalanced and the three core participant’s interests which should be aligned—have become mis-aligned. (i) Hector Sants the former CEO of the regulator—the Financial Services Authority (FSA)— described that the mis-aligned “balance of power” was the reason why Lloyds Bank resisted

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1352 Parliamentary Commission on Banking Standards: Evidence

the FSA for 4 years in refusing to cease its predatory selling activities of PPI to the UK citizenry. When discussing the failure of the FSA to supervise the UK Banking sector, in his oral evidence—he stated that the FSA simply did not have sufficient legal powers to stop banking abuses. (See Note 4) (j) If one reviews the evidence given to the Commission by Helen Weir (ex-Retail Director Lloyds Bank), Phil Loney (ex-Insurance Director Lloyds Bank) and Carol Sergeant (ex-Chief Risk Officer Lloyds Bank) on 11 January 2013; it is evident and clear that these Senior Bankers believed that they had sufficient corporate organisational power to resist society’s regulators— the FSA—because society’s laws were seemingly not robust enough to enable the regulator to overcome such corporate power. (k) So Mr Sants was claiming that society (through our democracy) had failed to provide sufficient protection through law to safeguard the interest of its own voting citizens and had failed to ensure a proper alignment and workable balance with the corporate organisations—which are the banks. As Mr Sants has suggested—the “balance of power” had been allowed to become mis-aligned which has created conflicts of interest within society—and which society has itself become more unbalanced resulting in society creating laws which reflect these imbalances and conflicts of interests. (l) But the society through government did not appear to act to rebalance and re-align the three core participant’s interests—and did not seek to resolve these conflicts of interests. (m) The two key rules created by society relating to the banking sector and whistle blowing issues are examples of law which reflects these conflicts of interest and exacerbates the imbalances and mis-alignments—already present within the society—when these rules were created: —

Public Interest Disclosure Act 1998.

—

Financial Services And Markets Act 2000.

Part B—Public Interest Disclosure Act 1998 (PIDA) Introduction; Public Interest Disclosure Act 1998 (PIDA) needs strengthening. “The legislation is considered by banks and the regulator as voluntary and as an example of light touch regulation—easily ignored” 1. The FSA only encourage Banks adopt processes to encourage whistle blowers-and there is no legislation which compels Banks to comply with PIDA. As Part I of this submission sets out—the FSA guidelines on banks ensuring whistle blowers’ protections—are not obligations. The FSA have admitted that they have never sanctioned a Bank who has dismissed a legitimate whistle blower. (See Note 5) 2. PIDA is a compromise brokered by society through Parliament in an attempt to seek to balance the interests of the citizen voter-whom is the whistle blower, and the interest of the corporate organisations. PIDA 1998 was enacted as legislation via a Private Members Bill and the Labour Government insisted that PIDA only provide rights and not obligations upon the whistle blowers and corporations. Therefore PIDA does not protect whistle blowers as it is not an obligation placed upon corporate organisations. (a) A right is a voluntary action within law with no compulsion—whereas an obligation is a legal requirement—by which non-compliance of any legal requirement may trigger a legal sanction. (b) PIDA was only allowed to become UK law because the Government yielded to lobbying from corporate organisations—which ensured that the interests of the corporate organisations were safeguarded within the legislation. (c) The corporate organisation succeeded in ensuring that if a whistle blower had good reasons to raise concerns—that he would be expected-in the first instance report his concerns use the internal processes made available to him-by the corporate organisation. (d) The result of this PIDA requirement is that the whistle blower has been encouraged to report internally without adequate protection from PIDA—and thus exposes himself to the corporate organisation’s power to protect its own interests which may be threatened by the revelations being reported by the whistle blower. The corporation will, as a natural response, seek to deal with any threat—which often means acting in a deliberate and managed fashion—to discredit the whistle blower whom threatens their own interests—which are often commercial interests. (e) Therefore PIDA is counter-productive and reflects the power of the large corporate organisation—being more powerful than the citizen voter whom is the single person and whistle blower. (g) PIDA is an example of weak legislation created by society whose good intentions have been compromised by powerful corporations whom use such power to lobby legislators; and thus society itself allows imbalances and mis-alignments to be reflected in legislation.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1353

(g) Therefore whilst PIDA is somehow considered by some—as an example of effective legislation—WBUK contend that it does not protect whistle blowers and is aligned more in favour of the corporate organisation-and we believe it should be reviewed. 3. The absence of effective whistle blowers in the Financial services sector demonstrates that PIDA is not functioning properly. Both Paul Moore and Martin Woods, prominent UK Banking whistle blowers are on record to claim that PIDA was not effective in protecting them—which must deter would be whistle blowers. 4. Yet this Government is seemingly working not to strengthen whistle blowers protection through PIDA— but is acting to weaken whistle blowers protection. The Enterprise and Regulatory Reform Bill has been introduced in Parliament which seeks to “cut red tape” and reduce onerous regulations on businesses—which may impede economic growth. But an amendment attached to the Bill is dangerous to the welfare of current and would be legitimate whistle blowers. 5. Remedies and solutions: (a) The Enterprise and Regulatory Reform Bill (ERRB) ERRB is an attempt by this Government to reduce “red tape” and regulations which are imposed upon industry for a variety of reasons. (1) Whilst this is a laudable mission to free up resources for growth and job creation—there is a dangerous amendment within ERRB which seeks to place additional burdens on legitimate whistle blowers and as a result—will weaken whistle blowers protection. So this government is not seeking to strengthen whistle blowers protection—it seeks to weaken it. (2) Currently the whistle blowers in seeking protected disclosures through PIDA must generally prove he is acting in good faith; whilst the proposed amendment contained in the ERRB seeks to insert a “public interest test.” This insertion of a “public interest test” by the amendment by which a whistle blower must prove is served by his actions—if written into the legislation—will discourage whistle blowers by creating further hurdles. Why? (a) How many different definitions of what is the “public interest” will be declared by corporations, lawyers and judges? How will these myriad definitions be interpreted in the whistle blowing processes within corporations and within the Employment Tribunals System; whereby a whistle blower is seeking redress for unfair dismissal by a corporate organisation through a PIDA claim? The legal and intellectual “debatefest” will only serve the legal profession and will intimidate a would be whistle blower-whom will be vulnerable to varying interpretations and varied advice offered up by the legal profession. (b) How will regulators when considering their own legal guidelines in their supervisory duties, interpret the public interest test when approached by a whistle blower whom is acting in the “public interest”? What exactly is the “public interest?” — Does the regulator the FSA/FCA in interpreting PIDA in the “public interest”, apply more weight to the whistle blower whom is alleging widespread mis-selling and seeks to protect the welfare of the citizen consumer? — Or does the regulator the FSA/FCA , in the “public interest”, apply more weight to the corporate organisation whose activities of widespread mis-selling when subject to regulatory enforcement actions and fined—would suffer destabilising sanctions which damage confidence in the integrity UK Banking industry-and thus weaken the UK economy? (3) Public Concern at Work-UK’s Whistle Blowing Charity state: “If the legislation is to include a public interest test then it would be appropriate to consider this in conjunction with the good faith requirement in PIDA, rather than placing an additional hurdle on would be whistle-blowers. To address this finely nuanced issue properly requires consultation and the current proposed amendment would need to be reversed”. (Note 6) WBUK share PCAW’s view that the insertion of the “public interest” test amendment in the Enterprise and Regulatory Reform Bill should be abandoned. The “good faith test” within PIDA should remain unimpeded. (b) Vicarious Liability. (1) The majority of WBUK members report experiences of their employers tolerating instances of colleagues intimidating, bullying, and victimising the whistle blower; and

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1354 Parliamentary Commission on Banking Standards: Evidence

such behaviours are often seemingly standard practices carried out by the Senior Directors, themselves, within the corporations-including Banks. (2) Public Concern at Work state: “It surely cannot be right that an employer can fail to do enough to protect a whistleblower from victimisation and yet altogether escape liability. To overcome this problem, we suggest transposing the existing tests from the Equality Act 2010 (sections 109–112 and section 40) into PIDA. This would also build a defence into the legislation for employers, as if they can show that they took reasonable steps to prevent the victimisation, they would not be liable.” (Note 7) WBUK support this statement. Employers that tolerate victimisation bullying, threats and intimidation of whistle blowers must be made liable through a strengthened PIDA. (c) Financial incentives or compensation to whistle blowers and their supportive organisations. (1) At WBUK we have recorded that legitimate UK Banking Whistle Blowers, have in many cases—faced severe financial hardships and the destruction of their careers—which in some cases has led to family break ups, severe mental health problems and even suicide. Yet PIDA has failed to protect these publicly minded citizens. So it is not unreasonable for society to consider a system which will underwrite the risks, taken by the whistle blower, whom is a person and voter—taken in the event that the whistle blower is proven correct in his allegations. (2) In the US—the disincentive to whistle blow because of the risks to the welfare of whistle blowers—is now recognised. The False Claims Act 2010—enables Whistle Blowers to sue on behalf of the state if any Government Department has been defrauded—and can receive between 15%–30% of any fines/levies received. Union Bank of Switzerland whistle blower, Bradley Birkenfield, received $104 million for assisting the US regulators identify US residents unlawfully avoiding US taxes in offshore jurisdictions. (3) Within the US Financial Services Industry, the Dodd Frank Act 2010—provides for the situation, whereby whistle blowers who provide information that leads to a successful enforcement action of at least $1,000,000 to the SEC—will be compensated for the risks undertaken in their whistle blowing. The US regulator has recently announced that the first whistle blower has been awarded $50,000. (4) Andrew Tyrie, Chairman of the Commission, stated in late 2012—that he had asked Martin Wheatley, who will head the new Financial Conduct Authority from April 2013, to examine “what incentivisation can you provide to whistleblowing without moral hazard?” (5) Clearly the risks to a whistle blower’s own financial security, own career and personal life—should be recognized by society whose interests and welfare, the legitimate whistle blower is seeking to protect—by acting in good faith. It is not unreasonable to suggest that the underwriting of such risks by society—should be enabled by any subsequent fine imposed by the regulators—upon the corporation whose mis conduct threatens the society’s welfare. (6) The mechanisms put in place should not claim to “reward” a person (who has risked his career and personal and family life happiness)-but to “compensate” him for the risks he has taken for the public welfare and for the benefit of the society. The risks taken and the impacts upon his own career and well-being should be reflected within the compensation. To offer compensation therefore reflects the personal risks undertaken whereas a reward might incentivise non-legitimate whistle blowers seeking to extract financial rewards acting against corporations for nefarious motives. There are obvious potential pitfalls to a fair compensation scheme which must ensure the whistle blower is acting in good faith. (7) Also the destination of the monies extracted and levied against the corporation should more fairly reflect the needs of society in protecting the whistle blower. (a) It follows that a percentage of all fines levied should be awarded by society to legitimate whistle blowing organisations that participate and contribute to this society—whose work, mostly undertaken by volunteers—seeks to protect legitimate whistle blowers. Thus society is enabling a more level playing field in relation to countering the power of non-voting powerful corporations such as banking institutions; whom have deep pockets. (See below Part 6 “Whistle Blowers Organisations”). (b) Thus the Prime Minister’s initiative of there being a Big Society and his encouragement of citizens whom follow his political leadership within society—is surely an endorsement of Whistle Blowers organisations such as WBUK; and WBUK

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1355

should be encouraged to claim a percentage of future levies to help in their Big Society endeavours. (d) Non-Disclosure Agreements (1) Non-Disclosure agreements; also known as gagging clauses are, in theory, non-enforceable under Section 43J PIDA. In reality internal whistle blowers, whom sign a non-disclosure agreement do not generally break such agreements, as their own career prospects would be affected, as employers would question the trustworthiness of the whistle blower—as a future employee. Whistle Blowers may also fear a powerful corporate backlash which can be intimidating. (2) At WBUK we have discreet Banking Members who chose not to disclose their membership of WBUK and chose not to divulge their reasons for their internal whistleblowing actions and who have signed non-disclosure agreements. Some of these Members were in senior positions of responsibility within Banking and Finance institutions and signed non—disclosure agreements for “self-preservation”. Usually the Corporation for whom they had worked -will supply references which make no indication as to the real reason why the whistle blower is leaving the firm. (3) If the whistle blower accepts offers of settlement (with a non-disclosure agreement)—soon after his whistleblowing actions he may be spared the expected corporate intimidation, threats, and bullying—and he may be able to find suitable work in a reasonable time frame. Conversely, the more the whistle blower insists the corporation acts to comply with the rule of law—the more the corporation will appear to break the law in dealing with the whistle blower in a hostile manner. (4) So in many cases, for example, WBUK Banking members have shared their own experiences within Whistle Blowers UK—that when they have reported their concerns (about possible corporate mis-conduct) to the relevant person within their organisation— they feel exposed and vulnerable. Some will admit they chose not to disclose their concerns in the public domain via the media—as they would be effectively self-harming. (a) Despite the fact that the information they claim to hold about possible corporate mis-conduct should be in the public domain for the public’s welfare—some WBUK members do not share this sensitive information in the public domain—in order to protect themselves, their careers, their families and their hopes of a future life of happiness and security. (5) Therefore the corporations ignore PIDA, which clearly states non-disclosure agreements are null and void (through Section 43J PIDA);and such corporate failures of recognition of the rule of law—towards the rules of society—reflect the imbalances within society and fails to protect the whistle blower (the person voter). (6) Therefore PIDA should be revisited in this respect and enabled to give the clear and unambiguous message written in the text of the legislation—that non-disclosure agreements agreed with whistle blowers acting in good faith are unenforceable-should the whistle blower act to put relevant information in the public domain for the welfare of society. (e) Registration as a simple no cost solution. (1) There should be a mechanism to register a legitimate whistle blowing action when the whistle blower starts a formal action within the bank acting in good faith. This should have the effect of “insuring” the whistle-blower and may prevent corporate intimidation, threats, bullying, and dismissing whistle blowers—unlawfully. (2) There is no mechanism for a legitimate whistle blower to be recognised as legitimate when voicing concerns, whilst still working within an organisation. Therefore he can be exposed to corporate intimidation, isolation, and threats when he uses the internal processes made available to him as encouraged by PIDA. But at this stage when he is most exposed to corporate abuse of intimidation—he remains unprotected and he has no legal status as a legitimate whistle blower. (3) PIDA only properly applies when the whistle blower invokes the principles of “protected disclosures” when dismissed or when leaving the firm he works for. He cannot use PIDA when still working as there is no device or process which is embedded within legislationand corporations have evidently shown they ignore any supposed protections—which PIDA aspires to. (a) The Whistle Blower may be a member of a Trades Union; at Lloyds Bank, for example, the Trade Union—LTU—would advise the whistle blower to follow the “grievance processes” set up by the bank .This advice does not protect the whistleblower whom suffers exposure and corporate intimidation. (b) He may be advised that Lloyds Bank have a whistle blowing hotline operated by Public Concern at Work—whom are paid by Lloyds Bank to provide whistleblowing

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1356 Parliamentary Commission on Banking Standards: Evidence

advice ; but only when still employed at Lloyds and not when dismissed.(See later Section F—Whistle Blowers Organisation). (c) Yet despite the existence of these agencies whose purpose is to protect the whistle blower—WBUK Lloyds Bank members have explained to Whistle Blowers UK that they felt there was inadequate protection for themselves and were vulnerable to corporate pressures; but such members were properly fulfilling their statutory obligations-as regulated approved persons—in reporting their concerns of possible corporate mis-conduct—which is required of them by law. (4) Corporate intimidation can continue after the whistle blower leaves employment whether dismissed, made redundant artificially, or who resigns through severe stress. This corporate intimidation can extend up to and through the Employment Tribunal system. (5) So whistle blowers at Lloyds Bank, for example, remain completely exposed when making formal whistle blowing complaints—even though there are several agencies in existence which are meant to protect the whistle blower when in employment. So at Lloyds Bank we have the Bank’s own staff manuals and grievance processes, the law in PIDA, the trades union LTU, PCAW’s hotline (for which PCAW receive an income) and the regulators—the FSA. Yet despite this impressive agency array of would be protections—Whistle Blowers remain unprotected and dangerously exposed to corporate intimidation, threats and their apparent freedoms to ruin lives and careers. (6) There is no commercial advantage for a corporation and regulated firm to recognise the employee voicing his concerns as a legitimate whistle blower—as such recognition implies a possible corporate failure to comply with the regulatory law; and such failure implies a risk to the commercial interests of the firm. (7) If, however, by law or regulation the corporation was compelled to recognise the legitimacy of the whistle blower then PIDA would apply when the employee was still employed and not after the dismissal of the employee. Therefore the recognition of the legitimacy of the whistle blower through an act of registration would invoke further protection afforded the employee—such as due duty of care under Employment Law and Discrimination legislation to prevent vicarious risks of corporate intimidation and bullying. (8) How would such a registration system work? (a) This would apply to any regulated activities within the banking sector and those activities which are supervised by the regulator the FSA/FCA. (b) The act of registration is not a device to investigate the alleged breaches which have triggered the whistle blowing actions; this is the job of regulators. The act of registration is a recognition that the whistle blower is claiming to act in good faith within PIDA 1998 and is should be afforded protection whilst employed. (c) Who can execute and record an act of registration? —

Trades Unions on behalf of a member.

—

WBUK on behalf of a member.

—

PCAW on behalf of a client.

—

Any other body representing whistle blowers within regulated activities.

—

The whistle blower through a simple act of registering with a notary of oaths-such as a Private Practice solicitor or a solicitor at the Citizens Advice Bureau.

(d) The registration system merely records the act of registration as a legal event; and thus the act of registration itself would be recorded only at a registrar as a matter of record. The registry can be kept at the regulator, or an Ombudsman (see Section 5d— Ombudsman); and copied to the corporation’s HR and Legal and Compliance Directors. The act of registration which is a simple letter or document is enacted by the whistle blower and his property and he may use the document in the public domain if he so wishes. (e) Therefore such a simple system should enhance protection for the whistle blower whom is still employed and such protection is extended should the whistle blower be forced to leave employment—as a result of his whistle blowing actions. The employer would thus be discouraged from behaviours which are described as examples of vicarious actions—such as bullying, intimidation, threats, and may be discouraged from dismissing the whistle blower for gross misconduct.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1357

(f) Therefore in any subsequent legal proceedings or actions the validity of the registration would be tested and if found to be with substance, the corporation’s own conduct would also are examined. If the corporation accepted the whistle blower’s registration as valid at the time of registration—and displaying good conduct—then any subsequent sanctions which may be imposed would reflect this good conduct as “best practice”. (g) Conversely if the corporation did not recognise the whistle blowers registration as valid and then the regulator vindicates the whistle blower, it follows any sanctions imposed upon the corporations should reflect this failure. (9) What are the advantages of a registration system? (a) It costs nothing. (b) It uses existing legislation and encourages the corporation and the whistle blower to act to comply with the law. Existing legislation exists to support a registration system .The Financial Services and Markets Act 2000 is legislation based upon the standard of principle based legislation-the FSA Principles. For example the FSA acting on the application of these Principles can issue guidelines which have legal substance—such as the FSA Guidelines “Treating customer fairly regime”. So using the Principle based legislation, the FSA/FCA are already empowered to ensure Corporate compliance with the Principles and so should be further encouraged by new guidelines such as “Treating employee whistle blowers fairly”. Part of this regime would ensure that legitimate whistle blower complaints were handled by the Bank and were treated as regulatory based complaints and not as grievances—as described in Part 1. Public Concern at Work (UK Whistle Blowing Charity) and BSI (British Standards Institution) state: “Whistleblowing is where an employee has a concern about danger or illegality that has a public interest aspect to it; usually because it affects others (eg customers, shareholders, or the public). A grievance or private complaint, is by contrast, a dispute about the employee’s own employment position and has no additional public interest dimension.” Within the approved person regime—the FSA/FCA can also embed the “Treating employee whistle blowers fairly” Regime. Part of this regime would be the FSA/ FCA encouraging banks to comply with the aforementioned Registration system. (c) This simple adjustment of a no cost registration which can use existing legislation which will go some way to protect the whistle blower whom is acting for the benefit of society—in good faith. (d) Ombudsman. (1) If this commission is minded to consider more robust remedies which imply more regulation within the Banking Sector then a proportion of the fines levied—can be redirected to setting up a Whistle Blowing Ombudsman whom could also act as the Registrar of the Banking Whistle Blower registering a whistle blowing action. This WB ombudsman would be funded by levies raised by fines and would therefore should not be an additional cost met by UK Taxpayers. (2) Consideration could be given to enable the Ombudsman to have: (a) Powers in the regulated banking sector only. (b) Extend the remit to all activities within the Financial Services Sector. (c) Across all industries and public agencies including the NHS and Care Sectors. (3) The Ombudsman would ensure ,for example, PIDA was properly applied and would, I suggest be effective in monitoring “black listing” within industries (such as the construction industry)—or monitoring whistle blowers reporting being victims of implied discrimination by potential employers—when applying for work (as in the case of Martin Woods the Wachovia Bank Whistle Blower—see Note 8). (4) The case for a Whistle Blowing Ombudsman to protect whistle blowers may be reinforced by the proposition that large UK High Streets Banks whom enjoy implicit taxpayers subsidies and thus such subsidies -need to be insured by an Ombudsman service. Also the Commission’s discussions around the wider responsibilities Bankers have to society, by the nature of their financial support of society—when such wider societal responsibilities should be represented by a Whistle Blowing Ombudsman.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1358 Parliamentary Commission on Banking Standards: Evidence

Part C—FSMA 2000, and the FSA Regulators Introduction; FSA statutory objectives’ have conflicting obligations which directly impact upon whistle blowers 1. In this section I am referring to the Financial Services and Markets Act 2000 (FSMA 2000) and how it applies to the regulator—the Financial Services Authority (FSA) and the statutory objectives. (I have no experience in matters relating to the other banking/finance related regulators—the Serious Fraud Office, the London Stock Exchange or the Financial Reporting Council) 2. Hector Sants, former CEO of the FSA stated to the Commission on 10 January 2013 that the FSA tried for four years to get the banks to cease selling unsuitable PPI products; and the banks resisted because they had sufficient power to choose to fight the FSA. Mr Sants said the FSA did not have sufficient powers to intervene more proactively and the failure of the FSA over PPI—was a reflection on the “balance of power”. Mr Sants, also said implied that “it was extremely difficult” to target Senior Directors whose own conduct appeared to be the cause of the banking abuses. (Note 9) 3. FSMA 2000 and its conflicting Statutory Objectives Mr Sants, when he describes “balance of power” and insufficient powers—may be referring to the conflicting statutory objectives of FSMA 2000 which also directly impact upon whistle blowers. (a) These conflicts, which I will attempt to explain, may provide some enlightenment as to why the FSA has failed, as a regulator, in its supervision of the UK Banking Sector. The FSA statutory objectives are: — Market confidence—maintaining confidence in the UK financial system; — Financial stability—contributing to the protection and enhancement of stability of the UK financial system; — Consumer protection—securing the appropriate degree of protection for consumers; and — The reduction of financial crime—reducing the extent to which it is possible for a regulated business to be used for a purpose connected with financial crime. (b) There are inherent conflicts between: (1) Maintaining confidence in the UK financial system and securing the appropriate degree of protection for consumers. (2) Contributing to the protection and enhancement of the stability of the UK financial systemand securing the appropriate degree of protection for consumers. These conflicts of interest directly impact upon whistle blowers whom are still seemingly ignored by the FSA or are treated in an apparent dismissive manner. (c) Why? (1) There is a regulatory reluctance to describe or classify mis-selling as fraud—whereby it is proven that the known cases of so called mis-selling is a form of fraud. Fraud is deceitfulness or false misrepresentation—or a deception intended to benefit the deceiver. Fraud requires a deliberate wrongdoing. It requires somebody actually knowing that they are doing something wrong and misleading somebody. PPI was not a case of mis-selling by an implied mistake or a mis-judgement; PPI selling was an organised deliberate exercise in non-transparent misleading deceptive selling activities-which is fraud. (2) The FSA has powers under Section 397 as does the SFO as described in their Handbooks (Note 10). (3) The FSA refuses to classify the PPI activities as fraud ;and such a refusal is because the FSA are seemingly acting to fulfil their statutory objectives to maintain “market confidence” and “financial stability” over their statutory objective of providing “consumers protection.” Or the FSA as a society agent is protecting the interest of corporate organisations over and above the citizens whom are the voters and are the whistle blowers; whom are the victims of mis-selling or fraudulent selling activities. (4) Or to put this another way, the FSA statutory objectives of “market confidence” and “financial stability” seem to mean the large UK Banks “are too big to prosecute” which is how Andrew Bailey described the current situation as Managing Director, Prudential Business Unit FSA and Head of the incumbent PRA. (See note 11)

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1359

Mr Bailey’s public admittance of UK Banks being “too big to prosecute” is confirmation of dangerous imbalances existing which distorts a true and functioning balance of power within a functioning society. Mr Bailey wrote to Theresa May MP on 30 January 2013: “In the interview (given to the Daily Telegraph 14 December 2013—Note 11)—I said that legal action against a major financial institution raised very difficult questions, and it would be a destabilising issue. I compared it to the ‘too big to fail’ issue that exist with the major banks, who could not fail without taxpayers support, and the major financial stability implications.” “The purpose of my remarks was to highlight the issue and the prudential concerns that it raises. I do not believe that this is an acceptable position, and believe that it is important that the regulatory authorities examine the issue and potential solutions so that wrong-doing can be appropriately punished.” (See note 11a) (5) Returning to the former CEO of the FSA whereby Hector Sants informs the Commission the FSA do not have sufficient powers to properly supervise errant banking behaviour—I would suggest that he refers to the conflicting nature of the FSMA 2000 statutory objectives. (6) Therefore when whistle blowers acting with evidence and in good faith, report to the FSA that there has been allegedly substantial fraud or widespread “mis-selling” and the FSA fail to properly respond—despite the evidence being robust—whistle blowers conclude with good reason the FSA are protecting corporations over and above the whistle blower and the UK citizen whom is the consumer; which is otherwise known as regulatory capture. “Regulatory capture occurs when a regulatory agency, created to act in the public interest, instead advances the commercial or special concerns of interest groups that dominate the industry or sector it is charged with regulating. Regulatory capture is a form of government failure, as it can act as an encouragement for firms to produce negative externalities. The agencies are called ‘captured agencies’.” (Note 12) Therefore the FSA statutory objectives are inherently conflicting—with the balance of power confirmed in favour of the corporate organisations. 4. The FSA Regulators. (a) Carol Sergeant, when in her role as the Chief Risk Officer at the Lloyds Banking Group (2004–11) gave oral evidence to the Commission on 17 December 2012—describing that she recalled having meetings with inexperienced more junior regulators and Ms Sergeant implied such FSA staff were “out of their depth”. (b) In my own experience in 5 hours of presenting my concerns on LBG regulatory conduct to FSA Panels, I have the impression that certain key regulators did not fully understand how LTSB operated their regulated sales teams (from 2005–10); and why such a system presented wider risks of mis-selling; when set against the FSA Principles of fairness transparency and the “Treating customers fairly” Regime. (c) Such regulators whom have important responsibilities—such as protecting millions of consumers, are I suggest, not properly qualified and many such regulators have no experience in how UK High St Banks in reality operate their regulated sales teams, on the ground, in their branch networks. (d) Therefore it follows the FSA/FCA should be attracting the experienced personnel whom want to commit to the public service ethos and whom also may resist the “revolving” door opportunities (see below). If whistle blowers are to begin to have confidence in regulators we have to have confidence in the staff—which we do not. (e) The remedy is to attract the top talent which means ensuring the pay reflects the responsibilities and is set at an appropriate rate; which can resist more lucrative offers of working in the Commercial Banking Sector. 5. Revolving Doors. (a) In principle there seems to be some benefits to society, when senior level and experienced individuals move from regulators to industry or into political life. However given the public’s concerns about the banking failures and past and newly emerging abuses—the revolving door phenomenon is encouraging the public perception that institutional elites are working amongst themselves to protect senior bankers from proper scrutiny and in some cases possible prosecution. The only institutional agencies who are attempting more effective scrutiny of Senior Bankers’ and Senior Regulators’ Conduct—are the Treasury Select Committee and the Parliamentary Commission on Banking Standards-both chaired by Andrew Tyrie MP.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1360 Parliamentary Commission on Banking Standards: Evidence

(b) There are multiple examples of the revolving doors syndrome, but below I detail two such examples which undermine whistle blowers confidence in UK institutions: — Carol Sergeant CBE; MS Sergeant whom has given oral evidence on two occasions to the Commission was the FSA Head of Enforcement when she was recruited by Lloyds Bank in 2004 to be their Chief Risk Officer. (2004–11) Ms Sergeant, whilst at Lloyds Bank resisted the FSA efforts to rein in—Lloyds Bank— selling PPI. Ms Sergeant is also Chair of Trustees at Public Concern at Work-UK’s only Whistle Blower charity. Ms Sergeant is also co-opted to Chair an advisory Treasury Committee on Banking Products. — Sir Hector Sants joined the FSA from a career in Banking in 2004 and was appointed CEO of the FSA in 2007. He resigned from the regulator in June 2012. He announced that he was to be Barclays Banks Chief Risk Officer from early 2013. He was awarded a Knighthood in the New Year’s Honours List 2013. When asked by the Commission why the FSA failed to properly supervise banking conduct—on his watch-Sir Hector maintains the FSA were never given sufficient statutory powers. There is no record of Mr Sants when at the FSA—asking for more statutory powers to tackle banking abuses. (c) There is a justified perception that the revolving doors syndrome undermines the application of the rule of law in the UK. Whistle Blowers have suffered broken lives because of UK institutional failures—and have a justified perception of a “lucrative institutional merry go round” whereby game keepers turn poachers and vice versa; and still in 2013 nothing has changed. 6. FSA/FCA role in PIDA and Employment Tribunals. (a) The FSA has admitted to the BBC that they have never sanctioned a Bank who dismiss whistle blowers acting in good faith. (Note 12) (b) The FSA refuse to comment on whether the regulator has investigated non-disclosure agreements following PIDA claims—whereby such settlements have been agreed between an approved person and a regulated firm. (Note 13) (c) The FSA/FCA should be reminded that through existing legislation via FSMA 2000 that one of their Statutory Objectives is protecting the UK consumer and it is incumbent upon the FSA to enquire as to the nature of non-disclosure agreements following PIDA claims. (d) Therefore Employment Tribunals(ET) when dealing with PIDA claims must be funded to capture the key data which relates to potential risks to the UK consumer being buried through settlements which have non-disclosure agreements. The FSA must be encouraged to understand the inherent risks being undiscovered and still yet potentially destabilising-through the ET not capturing key data relating to public interest matters on banking conduct. The solution is to ensure the ET system provides the key data on PIDA settlements—to the regulators as explained in Part 1. Part D—Banking Conduct and Whistle-Blowing 1. Whistle- blowers in the UK, past and present believe that the current leaderships in the UK banking sector view whistle blowers as hostile. In reality UK Whistle Blowers have been found to be loyal to the firm in which they work or used to work and, acted as they did as whistle blowers to protect the integrity of the firm and the welfare of the customers. 2. CEO’s of Lloyds Bank ,for example ( and the Chairmen and their Boards) have no incentive to protect whistle blowers within Lloyds and no incentive to co-operate willingly with regulators; whom may be acting on whistle blowing evidence. 3. The current Lloyds Bank CEO’s own remuneration and reputation is based upon performance indicators such as share price and profitability and a reduction in customer complaints. The achievement of reaching a certain share price might trigger an additional bonus allowing the UK Government to offload the taxpayers 40% share of the bank—without loss and ideally achieving a taxpayer’s gain. (a) Or to phrase this statement in another way Senor Horta Osorio as CEO of LBG is being incentivised in a perverse fashion to ignore, then intimidate and then discredit legitimate whistle blowers. (b) If a whistle blower comes forward with new allegations relating to widespread mis-selling in LTSB for example—which are not connected to PPI or Interest Swaps-the CEO is thus encouraged through these perverse incentives to treat the whistle blower as a threat to his remuneration and reputation; so far from being “customer focused” as he claims in his oral evidence to the Commission (on 4 February 2013)—he is acting against the interest of the customer whom the whistle blower is acting to protect—in good faith. 4. Therefore the Commission should consider that where a whistle blower has formally alerted the leadership of a Bank and the FSA—and is subsequently proven correct is his allegations—all extra financial rewards the

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1361

CEO of the Bank receives on reaching his targets—should be clawed back in totality. This would also apply to the Chairman and his Board. 5. In addition there should be an application of a “wilful blindness test”, when leaderships being in receipt of information passed to them by whistle blowers—fail to act. (a) Therefore the aforementioned Registration system described in section Part B (PIDA) would assist in this respect to counter the impact of perverse CEO incentives and ensure that the temptation to plead ignorance is properly exposed as wilful blindness. US Judge Lake has defined wilful blindness in the trial of Jeffrey Skilling and Kenneth Lay CEO and Chairman of Enron: “You may find a defendant had knowledge of a fact if you find that the defendant deliberately closed his eyes to what would otherwise have been obvious to him. Knowledge can be inferred if the defendant deliberately blinded himself to the existence of a fact.” (Note 15) In UK law the use of terms such as connivance, conscious avoidance, or deliberate indifference may be tested when CEO’s plead ignorance concerning whistle blowers actions and their subsequent treatment by the corporation. Part E—Whistle-Blowers Organisations 1. This is the written statement of a WBUK banking member when recently asked to introduce himself to the group: “My health deteriorated as I was consistently lied to, victimised, threatened, bullied and harassed. An application was made to the Employment Tribunal, claiming amongst other things detriment and victimisation having made a protected disclosure. At the Employment Tribunal hearing my health had deteriorated to such an extent because of the threats and intimidation I was hustled into signing a compromise agreement terminating my employment. I was ‘isolated’ and ‘shot as a messenger’ I now face an uncertain future my career having been destroyed for doing what I was legally obliged to do. PIDA legislation has provided no protection.” 2. There are now, I believe, two main UK Whistle Blowing organisations, of any substance and size which concern themselves with internal (or employee) Banking whistle blowing issues; these are Whistle Blowers UK (WBUK) and Public Concern at Work (PCAW). (a) WBUK is a voluntary self-help mutual organisation run by whistle blowers for the protection and welfare of whistle blowers. WBUK is independently funded and will never accept any corporate donations of self-interest. (b) PCAW is a registered charity staffed with paid professionals funded by corporate organisations such as Lloyds Bank and NHS agencies. These organisations share some common aims but are quite different. 3. Whistle Blowers UK (WBUK) (a) WBUK has, in a short time, become a significant organisation with a substantial national membership of UK whistle blowers past and present from across industry sectors. Our membership is drawn from retail banking, investment banking, insurance, pensions, the NHS, Care, the Police, Military and defence, aerospace, the travel sector, social services, other public agencies and small businesses. (b) Our support network of advocates whom volunteer their own time includes Academics, University staff, trained counsellors, Mental health specialists, lawyers, and selected supportive journalists whom properly investigate whistle blowers stories. (c) WBUK is best described as an umbrella group which has close contacts with other voluntary organisations such as Patients First and Compassion in Care. Our membership includes prominent whistle blowers whose brave actions have exposed institutional corruption, abuse, and corporate misconduct in the UK, the Republic of Ireland, Saudi Arabia, South Africa and Canada. (d) Our first inaugural conference was held in March 2012 and subsequent conferences have attracted more member whistle blowers. We formally launched in December 2012 attracting over 70 attendees—some who travelled from abroad. (e) The largest membership is drawn from the health and care sectors and the Banking and finance sectors. (f) Our primary mission is to protect the welfare and well-being of whistle blowers past present and in the future-as a mutual self-help organisation. Our secondary mission is to engage in the political process and lobby power to create more effective protection for whistle blowers within the UK; which as we have explained—is sadly lacking in our society and democracy.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1362 Parliamentary Commission on Banking Standards: Evidence

(g) WBUK is independent and we were awarded a small Foundation Grant in 2012—and we have applied for further Foundation Grants for 2013. We are working to emulate the Government Accountability Project which has grown to become an effective whistle blowing advocacy organisation in the US. 4. Public Concern at Work (PCAW). (a) WBUK and PCAW share some common objectives in working to assist whistle blowers and to lobby to improve whistle blowers protection through effective legislation. (b) Public Concern at Work—which is UK’s only dedicated whistle blowing charity, is the primary collator of relevant data on Banking whistle blowing actions in relation to PIDA claims in the Employment Tribunal System. (c) PCAW also engage in the political process and lobbies to stiffen whistle blowers protection. (d) PCAW are however primarily dependent on contracts from industry and the public sector and is therefore restricted on any claim to be truly independent. For example one of their main customers is the Lloyds Banking Group. (e) The staffs at PCAW are lawyers or legally trained executives with support staff (whereas the Members of WBUK are whistle-blowers past and present). (f) PCAW’s Chair of Trustees is Carol Sergeant whom from 2004–10 was the Lloyds Bank Chief Risk Officer -the most senior Compliance Director within the Lloyds Banking Group. She was therefore responsible for ensuring LBG were complying with legislation and regulations such as FSMA Act 2000; the FSA Principles and the Treating Customers Fairly Regime. At LBG she was also responsible for applying PIDA to the bank processes to protect whistle blowers. Carol Sergeant was asked to give evidence to the PCOBS on two occasions. (g) WBUK Banking members have expressed concern about the influence that Lloyds Bank Directors past and present seem to have at PCAW. There is no public record of any LBG whistle-blowing re PPI. Lloyds Bank UK’s largest retail Bank are directly funding PCAW and is PCAW’s largest corporate customer. (h) PCAW which has qualified staff and does valuable work on whistle blowing issues deserves a more appropriate funding model which guarantees independence from corporate influence. 5. Funding requirements. (a) Given then scale of the fines imposed on Banks by the FSA we propose that PCAW and WBUK should both be encouraged to apply for a percentage of the fines levied against the banks by the FSA—so be fully funded and independent. (b) Such funding would enable society to address the imbalances and misalignments within society, which as I have argued in this paper are currently loaded in favour of powerful corporations whom have no vote in our democracy. Without society’s support whistle blowers whom act in good faith will be continually exposed to over powerful corporations in an atmosphere of an Orwellian world not so far removed from “1984”. Part F—The Public Perception 1. In November 2012 Greenwich University and a Market Research agency ComRes published a report based on a survey of 2000 UK citizens. The main findings were; (a) 53% said that they were concerned that too much publicly relevant information is kept secret by organisations. (b) 81% stated that whistle-blowers deserve our support when reporting allegations of mis-conduct. (c) 75% of those questioned stated they would feel they should report an abuse or wrong doing despite the risks—implying UK citizens would like to do the right thing. (d) Less than half of those surveyed were confident that the management would protect whistle blowers, “If we want to encourage people towards internal reporting, we’ll need to make those involved feel safer”; announced research leader Wim Vandekerckhove from the Work and Employment Relations Unit at the University of Greenwich. (See note 16) Acknowledgements The author would like to acknowledge the encouragement and guidance provided by: 1. Whistle Blowers UK. 2. Parliamentary Commission on Banking Standards. 3. National University of Ireland, Galway. 4. Cambridge University. 5. City of London University.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1363

6. Public Concern at Work Notes 1. Andrew Tyrie; MP, Chairman of the Parliamentary Commission on Banking Standards; author of article published in the Financial Times 27 January 2012—“Electricfying the ring fence.” 2. Wim Vanderkerckhove and Eva E Tsahorida 2010; Journal of Business Ethics; “Risky rescues and the duty to blow the whistle.” University of Greenwich Business School and RMIT University Melbourne Australia. 3. Marit Skivenes and Sissel C Trygstad; Human relations and Tavistock Institute 2010; “When whistle blowing works.” (University of Bergen, Norway and FAFO—Institute for Labour and Social Research in Oslo-Norway.) 4. Hector Sants; oral evidence to Parliamentary Commission on Banking Standards 9 January 2013. 5. BBC Newsnight reported on 11 September 2012: “Newsnight can reveal that not a single UK-based bank has ever been punished for firing a whistle blower within its ranks—even though these individuals are protected in law since the Public Interest Disclosure Act 1998 came into force. When Newsnight approached the FSA for a response it said it would not comment on individual cases, but acknowledged that no bank had ever been sanctioned in such circumstances.” 6. Francesca West and Shonali Routray, August 2012; Public Concern at Work; Submission to Parliamentary Commission on Banking Standards. 7. As above in Note 6. 8. Martin Woods whistle/a649245

http://citywire.co.uk/wealth-manager/court-sides-with-coutts-over-expert-who-blew-the-

9. As in Note 4. 10. FSA: (a) Section 397; FSA; http://www.legislation.gov.uk/ukpga/2000/8/section/397 (b) SFO Handbook guidance. http://www.sfo.gov.uk/media/99198/financial_services_offences_sfo_operational_handbook_ topic.pdf 11. Recent statements by Andrew Bailey, the new head of the Prudential Regulatory Authority whereby he publicly stated that UK High Street Banks are too big to prosecute; and such statements have already begun to undermine the fragile confidence in the new regulator—set up precisely correct the failures of the FSA— which it is replacing. “Mr Bailey told The Daily Telegraph that some banks had grown too large to prosecute. ‘It would be a very destabilising issue. It’s another version of too important to fail,’ he said”. (14 December 2012). http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/9743839/Banks-are-too-big-toprosecute-says-FSAs-Andrew-Bailey.html. 11a. Letter sent by Andrew Bailey ,Managing Director Prudential Business Unit FSA-to Theresa May MP acting for the author in her Maidenhead Constituency duties; 30 January 2013. 12. As in Note 5. 13. Regulatory capture http://en.wikipedia.org/wiki/Regulatory_capture 14. Correspondence sent to the author by Senior Legal Counsel FSA; 18 January 2013—available on request. 15. Margeret Heffernan; Willful Blindness 2011; Walker Publishing Company. 16. Risky Rescues and the Duty to blow the Whistle 2010; Journal of Business Ethics by Wim Vandekerckhove—Greenwich University Business School, UK; and Eva E Tsahuridu; RMIT University, Melbourne University, Australia. 8 February 2013

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1364 Parliamentary Commission on Banking Standards: Evidence

Written evidence from TheCityUK Summary — The UK’s future prosperity depends on driving growth by investing in innovation and creating new jobs, and maintaining improvements in living standards even as our society ages. A strong financial and professional services sector enjoying confidence and trust is key to these goals. — It is crucial that firms and individuals adhere to the highest standards at all times, not just because this is right in itself, but also because of the impact a reputation for honesty and fair dealing has on the standing of the sector in overseas markets. — There have undoubtedly been failures of management control and the sector is committed to learning the lessons of past mistakes. Alongside the seriousness of the crisis and of recent failings, it is also important to acknowledge that many organisations, and their thousands of employees, continue to serve their customers in an ethical and conscientious manner. — The question of ascribing recent scandals to individual misconduct, misaligned incentives, cultural problems or institutional issues is a complex one. What is certain is that good governance, appropriate incentivisation, and professional standards can foster ethical conduct and long-term value in organisations. A number of important legislative and regulatory initiatives are underway. The Parliamentary Commission is well placed to consider this wide-ranging programme of regulatory reform holistically and to suggest areas where additional reform is required so that the financial services sector may move forward in making changes and rebuilding its reputation. Introduction 1. TheCityUK is a national membership organisation representing the UK’s financial and related professional services sector. Our members are drawn from across the banking, insurance, asset management, exchange and other financial and related professional services sectors. Our purpose is to promote and explain the role and value of the sector in society and the economy, and to promote the sector abroad. TheCityUK’s members are committed to: — Restoring public and policymaker confidence in the financial services sector. — Fully implementing the regulatory reform programme that is underway, alongside necessary cultural changes. — Demonstrating the crucial contribution of financial and related professional services to economic growth, the lives of people in Britain and the UK’s place in the world. 2. We are committed to these objectives because we believe them vital not just to the sector but to the success, sustainability and long-term growth prospects of the UK economy. 3. We welcome the establishment of the Parliamentary Commission on Banking Standards. As you are aware, a number of important legislative and regulatory initiatives are underway, as well as independent reviews. The Parliamentary Commission is well placed to consider this wide-ranging programme of regulatory reform holistically and to suggest areas where additional reform is required so that the financial services sector may move forward in making changes and rebuilding its reputation. 4. The sustainability of the UK’s position as the pre-eminent global financial services centre is grounded in the integrity of its financial markets and probity of market participants. Indeed, in measuring UK competitiveness, TheCityUK aggregates Transparency International’s Corruption Perceptions Index alongside other metrics.167 5. It is crucial that firms and individuals adhere to the highest standards at all times, not just because this is right in itself, but also because of the impact a reputation for honesty and fair dealing has on the standing of the sector in overseas markets. Poor conduct at any one firm can affect the perception of the whole sector across the country. It is in the interests of banks, the wider financial services community and the UK economy to address this damage as financial services cannot be sustainably successful without confidence and trust. Implementing Change and Rebuilding Trust 6. Trust in the financial services sector is low following the financial crisis and other failures. Some people question the sector’s value and express concerns over its role. There is no quick fix in rebuilding trust. Achieving sustained, demonstrable change requires long-term partnership between governments, regulators and financial firms. 7. The question of ascribing recent scandals to individual misconduct, misaligned incentives, cultural problems or institutional issues is a complex one. What is certain is that good governance, appropriate incentivisation, and professional standards can foster ethical conduct and long-term value in organisations. There have undoubtedly been failures of management control and the sector is committed to learning the lessons of past mistakes. Those firms needing to change must demonstrate the changes that they have made in recent years and how they will continue to embed them in their organisations. 167

See http://www.thecityuk.com/research/our-work/reports-list/uk-competitiveness-tracker-august-2012/

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1365

8. With respect to individual misconduct, breaches of law, regulations and company policy must be dealt with swiftly and with due regard to their seriousness. If an individual’s misconduct can be attributed in whole or in part to the culture or the incentive arrangements of their organisation, this must be addressed urgently by boards and shareholders, and changes implemented as necessary. It is incumbent on firms to maintain remuneration policies that incentivise the right behaviours and rule out rewards for failure. The FSA’s strict new regulatory code for remuneration has been designed to ensure this outcome. The regulator also has responsibilities for deterring and sanctioning individual misconduct and it is important for this regime to be robust and well-enforced. 9. Alongside the seriousness of the crisis and of recent failings, it is also important to acknowledge that many organisations, and their thousands of employees, continue to serve their customers in an ethical and conscientious manner.

A Vital Role in our Future Prosperity and Well-being 10. This Parliamentary Commission matters because financial services matter. The UK’s future prosperity depends on driving growth by investing in innovation and creating new jobs, and maintaining improvements in living standards even as our society ages. A strong financial and professional services sector enjoying confidence and trust is key to these goals. Businesses large and small need financial and professional services to help them to invest and to grow. Financial intermediation—and in particular the process of maturity transformation, through which short-term deposits are channelled to finance longer-term investment—is essential to the modern economy. 11. The total amount of loans made available by major banks to UK businesses totalled £214.9 billion in 2011, including £74.9 billion lent to SMEs. Besides bank lending to businesses, financial institutions provide a variety of other services, from alternative types of financing to investment management to risk management. For example: —

UK companies have raised a total of £307bn in issues of shares and private equity since 2005, allowing them to invest in creating jobs, training and developing people.

—

Private equity funds managed in the UK currently back around 3,800 companies, employing around 1.2m people across the world, of which 515,000 in the UK.

—

The UK general insurance industry in 2010 paid out £60m a day in claims including motor, property, accident and health care.

12. The sector represents a truly country-wide asset: from local high street branches through to the offices and operations of the world’s largest financial institutions. Financial and professional services firms employ just over two million people across the UK directly, more than two-thirds of them outside London, and many more indirectly. There are more than 130 parliamentary constituencies where 3,000 or more people are employed in financial and related professional services. 13. Alongside sectors like advanced manufacturing, pharmaceuticals, digital and creative industries, the financial and professional services sector represents one of the UK’s greatest business assets. For example: —

The London insurance market is the world’s leading international insurance market, enabling businesses to obtain multi-million pound protection for personal, physical, financial and political risk.

—

Overseas companies invested £33bn in the UK financial services sector between 2008 and 2010, more Foreign Direct Investment than in any other sector.

—

The UK is the leading Western centre for Islamic finance.

14. UK financial and related professional services have a worldwide reputation, from the largest developed economies to emerging markets which are powering global growth. Many third countries look to the UK for help as they seek to develop their financial markets and TheCityUK is working in partnership with a number of jurisdictions, including Moscow, Dubai and Toronto. 15. Financial and related professional services generate approximately 14% of GDP and contributed a £55bn trade surplus in 2011. While the domestic financial sector contributes 5.9% of UK GDP, a further 2.9% of GDP is generated in net exports of financial services, making financial services the biggest contributor to UK’s current account by some margin (see below).

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1366 Parliamentary Commission on Banking Standards: Evidence

The Future Framework for Financial Services 16. The ability to take on, manage and intermediate risk is a critical function of banks. While there can be no such thing as an entirely risk-free financial sector, the effective management of risk is at the core of financial services. It is important that financial institutions continue to be able to take well-managed risks. A substantial programme of regulatory reform has been undertaken in the wake of the financial crisis with the aim of improving systemic stability and addressing the causes of the crisis and other inadequacies in the financial regulatory system. 17. The leaders of financial institutions are committed to implementing this programme of reform. The ramifications of misconduct in a sector with fiduciary duties, access to leverage and/or information asymmetries in relation to customers can be grave. While senior executives are ultimately accountable for the conduct of their staff, making this accountability meaningful poses a genuine challenge in organisations as large and varied as modern financial institutions. The effectiveness of governance structures and processes ought to be assessed in the face of this challenge. 18. High standards, including robust and effective regulation, are an asset to the UK’s financial sector. Within the regulatory reform agenda are initiatives covering prudential requirements and financial stability, harmonisation across the European Single Market, supervision, accounting and corporate governance, and consumer protection. Across this matrix are differentiated levels of legislative or policymaking initiative, including international (eg G20 Financial Stability Board, Bank for International Settlements’ Basel Committee on Banking Supervision), the European Commission, UK Parliament and regulators. For example, a framework for prudential requirements for banks was set at the international level in the Basel III accords, which are currently being legislated for by the European Union as Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD), the former which will be directly applicable and the latter which will be transposed into national law by Treasury regulations and FSA Handbook, as provided for under the Financial Services and Markets Act 2000. Appended to this submission is the regulatory landscape produced by TheCityUK in partnership with the City of London Corporation. 19. In particular areas it may indeed be desirable for regulation to be initiated at a national level, though this will not always be the case. In particular, it is vital that new initiatives or legislative solutions take account of the existing reform programme which is already underway at the national, European Union and international level. TheCityUK is currently undertaking research considering the impact of various factors on UK

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1367

competitiveness in financial services and will share this work with the Parliamentary Commission when it is completed. 20. Much of the regulatory reform agenda is either in the course of being implemented or not yet at the point of implementation, and the Parliamentary Commission should consider how its recommendations work with the grain of this broad-based range of activity. 21. Banking is highly interconnected with other industries within the financial services sector, which in turn is indispensible to individuals and businesses across the UK. Recommendations emanating from the Parliamentary Commission could have far-reaching implications for the banking industry, the wider financial services sector and the economy at large. It is important that any recommendations are well-researched, impact-assessed and targeted at the policy issues they seek to address, avoiding unintended consequences and spill-over effects where possible. TheCityUK would be happy to support the Parliamentary Commission in this regard or to provide further evidence as required. APPENDIX ILLUSTRATIVE VIEW OF CROSS SECTORAL NATIONAL, EUROPEAN & INTERNATIONAL REGULATORY LANDSCAPE

A - Financial Stability & Reducing Systemic Risk Regulation promoting stabilising effects, and reducing systemic risk

Macro-economic Levers/ESRB

PIPELINE STAGE 1. Emerging issue or review of policy and existing regulation

PIPELINE STAGE 2.

Banking Union/European Resolution Scheme

Risk-free status of Sovereign Debt

Tax Arbitrage

B - Transparent, Safe & Competitive Single Market promoting economic growth

C - Financial Supervision, Corporate Governance, Audit & Accounting

Regulation promoting Single Market for financial services as a driver of economic growth

New structures to Improve supervision of financial institutions; institutional governance arrangements supporting this

Payment Systems

Liikanen Group on structure of EU banking

Debt Valuation Adjustments (IAS 39)

Trading Book Review

Competition Authorities

Banking Union/ECB Supervision

Emerging Markets / Capital Flow

Super-equivalence/ Single Rule Book

Commodities

International Reg Convergence

Long term financing of the economy

Islamic Financial Instruments

Collective Redress

Client Assets

Payment Services Directive

Action Plan for SMEs

Covered bonds

Financial Crime

Financial Markets Infrastructure

Corporate Tax

Securities Law Directive

Crisis Management

PIPELINE STAGE 4.

Recovery & Resolution Procedures

Financial Transaction Tax Innovative Financial Instruments

Harmonising Insolvency Regimes

Post-trade issues

MiFlD II / MiFIR

Cross-border debt recovery

Executive Compensation

MAD II/MAR

European Venture Capital Funds

Transparency Directive

European Social Entrepreneurship Funds

Insurance Supervision

Statutory Audit

PRIPs

Fees & Levies

Insurance Mediation Directive

Financial Services Bill : FPC, PRA, FCA responsibilities

Solvency II

Non-EEA immigration cap

Common European Reporting

AIFM Directive

Prospectus Directive

Financial Sector Sanctions

Financial Conglomerates Directive

Offshore RMB Centre

Short Selling / CDS

Dodd-Frank Act: Regulators

Internal Governance Guidelines

FATCA

Financial Reporting

Bank Levy

LEGEND

INTERNATIONAL POLICY ISSUE

EU POLICY ISSUE

US POLICY ISSUE

EU Contract Law

Pension Reform

Insurance Guarantee Schemes Data Protection

UCITS V

Credit Rating Agencies III

EMIR

UCITS and Money Market Funds IORPs

CRD IV

Dodd-Frank Act: Banks / Corporates

2012/08/23

Corporate Governance & Company Law

Third Country Access

Formal Legislative Proposal/ Market Standards issued

Consumer Credit

Retail Banking Package

White Paper on Banking Reform

Green paper / White paper/consultation phase

Mortgage Market Review

Extra-territoriality

Shadow Banking/Alternatives to Bank Finance

PIPELINE STAGE 3.

De facto standards agreed; legislation in place; secondary legislation in preparation

Review of ESA Powers

Regulation promoting and protecting consumer interests

Variable annuities

Intent aired by authorities (speech / high level paper drafted by regulator)

PIPELINE STAGE 5.

Eurozone/Single Market boundary

Banking Union/Deposit Insurance Scheme

D - Consumer Protection

Investor Compensation Schemes Directive Retail Distribution Review

Mortgage Credit Directive Dodd-Frank Act: Consumers

Deposit Guarantee Schemes

Global Accounting Standards UK POLICY ISSUE

24 August 2012

Written evidence from TUC Summary — The TUC very much welcomes this opportunity to submit evidence to the Parliamentary Commission on Banking Standards. — The TUC believes that a stable and profitable banking sector is an essential part of a productive and healthy UK economy. — High professional standards are an important component of a successful banking sector, but achieving them will be contingent upon significant change in the structures, governance and regulation of the banking industry, not simply upon further accreditation and training. — While the TUC welcomes the Commission’s investigations, we also believe that the problems with the UK’s banking sector go beyond the areas the Commission is focusing on. — We would like to see further investigation into how to rebalance the UK economy away from an overreliance upon the financial services sector, and how to ensure that the banking sector works to better support the real economy. This would include consideration of the need for the introduction of a British Investment Bank.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1368 Parliamentary Commission on Banking Standards: Evidence

— The consequences of the recent financial crisis have been severe for households and businesses across the UK. We continue to face the worst economic crisis since the 1930s, our economy remains 4% below its pre-crisis peak and while 2.5 million people remain unemployed a further two million are either in involuntary part-time or temporary work. Our over reliance upon finance placed us at greater risk during the global recession, heightened regional inequalities and has squeezed growth in other sectors. — Public trust in banking is low, as is public confidence in the ability of Government to secure improvements in banking culture and practice. This risks exacerbating a lack of faith in trust around wider banking products such as pensions, which could have serious long-term impacts for the UK’s wider social and economic health if not addressed. — Problems in banking culture can be traced back to wider problems in the UK’s system of corporate governance. The TUC would like to see amendments to the Companies Act to make directors’ primary duty the promotion of the long-term success of the company, rather than the prioritisation of shareholders’ interests as at present. — The TUC further believes that the Commission should consider the benefits that a two-tier board approach, as opposed to a unitary board system, could offer. A key attribute of two-tier boards is that employees and in some cases shareholders generally have either direct representation or nomination rights on boards. The interests of employees are well-correlated with the long-term interests of the bank, and the TUC believes that having employees represented on UK banks’ boards could help boards to prioritise the longterm interests of the bank in decision making, rather than being distracted by short-term financial engineering, as occurred in the run-up to the financial crisis. — Corporate governance in the UK places shareholders in an overly privileged position. Particularly given the growing prevalence of short-term shareholding, and the growth in the proportions of shares owned by alternative asset managers, it is far from clear why companies should be required to prioritise the promotion of shareholder over other interests, or why shareholders should have the ultimate say over how companies should be run. The TUC believes that governance rights and responsibilities should be dependent upon holding shares in a company for a minimum of two years. — Decision making in financial institutions could also be improved by better ensuring that those responsible for both executive and non-executive board functions have sufficient time to carry out their responsibilities effectively, and ensuring that there is greater diversity on boards. A first step towards this would be for all Non-Executive Director (NED) positions to be publicly advertised. — The TUC believes that quarterly reporting is a symptom of short-termism, as well as exacerbating it. We believe that further consideration should therefore be given to the introduction of requirements for company reporting on long-term performance as well as to the removal of quarterly reporting requirements. — It is vital that excessive levels of remuneration within the banking industry are addressed. Extremely high rewards continue to be paid to directors and senior executives, rewarding failures and incentivising the types of risk which led to the financial crisis. The TUC does not support the emphasis upon performancerelated remuneration and bonuses. There is convincing evidence that performance-related pay does not achieve its stated aim, and we believe there should be a greater focus on annual salary payments. Where performance related deals continue to exist, we are supportive of calls that bonuses should be subject to “claw-back” in the event of trades or deals turning bad. — We would also like to see shareholders taking a much tougher approach to remuneration than they do at present. But on its own this is unlikely to be sufficient to bring about significant change. We therefore believe the banking workforce should be represented on remuneration committees as a means to bring a fresh perspective to discussions on pay setting and to curb directors’ pay. — We also support wider measures to curb remuneration, including ensuring that remuneration consultants only report to the remuneration committee (and not the executive directors) and requiring mandatory disclosure of the number of people within each firm whose total remuneration exceeds £1 million (preferably in pay bands). — Further, we recommend that pay and bonuses above £250,000 per annum (around ten times the level of average pay in the UK) should be considered profit and therefore paid out from profits available for distribution rather than being accounted for as a general expense. This would mean that the available pool for such high rewards would be subject to corporation tax as part of the banks’ normal taxable profits, in recognition of the risk that short term risk taking and rewards have proven to have to wider economy. — Although the problems in the finance sector were caused by those at the top of the industry, it is frontline banking staff who are paying the price through redundancies, restructuring and pay cuts. These staff are also affected by a sales driven culture which incentivises retail banking staff to sell unnecessary and risky products to SMEs and households, and which needs reform. — The TUC has long held concerns about the impact of the tax deductibility of interest payments on corporate debt with evidence suggesting that this encourages highly-leveraged private equity buyouts by providing a very cheap means to borrow large sums of money. Amending the tax rules so that taxdeductibility on debt would not apply to debt used to buy up other companies is an approach that merits further investigation. We further believe that the Government should review the current arrangements for tax relief for work-related training, and would support greater priority being given to accredited training.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1369

— The TUC welcomes the introduction of the Government’s new regulatory regime for the banking sector. We agree that the previous system of financial regulation had key weaknesses, and welcome the decision to provide the Bank of England with the responsibility, authority and tools to monitor the financial system as a whole. Matters concerning systemic risk should be monitored by regulators rather than shareholders. — There is evidence that the lack of personal liability has encouraged excessive risk taking at financial institutions in the past. The TUC recommends that the Commission look into ways of either changing the ownership and control models of bank ownership or piercing the veil of shareholders of banks (increasing their personal liabilities for the banks’ practices) that benefit from the implicit guarantee of the taxpayer so that shareholders are required to bear a fair proportion of this risk. — The TUC supports in principle the Government’s proposal to introduce a “rebuttable presumption” that the director of a failed bank is not suitable to be approved by the regulator to hold a position as a senior executive in a bank and also to introduce criminal sanctions for serious misconduct in the management of a bank. The TUC also endorses in principle the European Commission’s proposal to introduction a Regulation and a Directive with the cumulative effect of making manipulation of benchmarks, of the kind features in the recent LIBOR scandal, a criminal offence. — Overall, wider corporate governance reform, legislative and regulatory reform are all required. Only a complete package of policy aimed at creating a banking system that takes a more long-term approach to servicing the real economy will have a chance of success. — Only time will tell whether the new Financial Policy Committee (FPC), and the two new regulators, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) will be effective, and it will be vital that in their early days of operation they are given both time to establish themselves and that on an ongoing basis all necessary resources are made available to them. — The TUC has welcomed the ICB’s report as a good start to the process of addressing the fundamental problems facing the UK banking sector and believes it should be implemented in full, as quickly as possible. But we also believe that the mandate given to the ICB was limited and specific. the ICB did not examine four key issues facing the UK economy: the low level of fixed investment in the UK economy; limited access to credit for small and medium sized enterprises; ongoing sectoral imbalances with the UK economy; and unmet need for finance to enable green growth. Determining how banking reform can enable these wider challenges to be addressed will be key to our future economic success. Introduction 1.1 The TUC very much welcomes this opportunity to submit evidence to the Parliamentary Commission on Banking Standards (the “Commission”). The TUC represents over six million workers in 54 unions, including approximately 200,000 workers in the banking sector. Our members are also consumers of financial services and, along with the entire UK population, are still living with the consequences of the 2007 credit crunch and ensuing financial crisis of 2008, created in part by the poor professional standards and culture of the UK banking sector. 1.2 The TUC believes that a stable and profitable UK banking sector is an essential part of a productive and healthy UK economy. To achieve this, the UK banking sector needs to foster a culture where decision-making is focused on strategies for long-term institutional success; where long-term and trusting relationships are developed with both the banking workforce and with wider stakeholders; where employees are encouraged to contribute ideas and to report problems without fear of reprisal; and where high standards of ethical behaviour are at the sector’s heart. 1.3 Professional standards are an important component of a desirable corporate culture within all businesses, but are particularly important in the banking sector because of the imbalance in information and knowledge between customers (from consumers to investment grade borrowers) and those within the industry. The complexity of financial services adds further weight to the case for high professional standards. 1.4 But the TUC does not feel that “professional standards” should be interpreted so narrowly as to refer only to the entry route and continuing professional development of those within the banking industry. It is also vital to look at the wider picture and examine the structures, governance and regulation of the industry, and the extent to which these have permitted lax professional standards to take hold. The TUC will address some of these concerns throughout our response. 1.5 More broadly, while the TUC welcomes the establishment of the Commission we are concerned that the focus of its enquiry is limited to the specific issue of the UK banking sector’s internal professional standards and culture, and to the corporate governance and regulatory levels which could facilitate change, rather than to the wider reforms which may be necessary to ensure the banking sector plays a productive role in the wider economy. In our view the scale of financial sector reform that is necessary is far larger than the terms of the Commission’s remit accept and a wider investigation is therefore necessary to examine and recommend improvements to the economic and social utility of the UK banking sector. 1.6 Specific attention should be paid to the fact that the sector constitutes a disproportionately large portion of the UK’s GDP, and to investigating ways of reforming banks and supporting growth in such a manner that the rate of growth in the real economy becomes faster than that of financial services, so as to address this

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1370 Parliamentary Commission on Banking Standards: Evidence

imbalance. The more unbalanced an economy is the more vulnerable it is to economic shocks. The UK, by 2008, was too dependent on the financial sector both as a driver of growth and as a source of tax revenues. The growth of the sector was accompanied by rising household debt, leaving household balance sheets equally vulnerable. A more broadly based economy, with varied growth drivers, would have been better able to cope with a downturn. 1.7 The UK financial services sector has also caused wider problems. The geographical dominance of the City and Canary Wharf in the financial services sector has contributed to regional economic imbalances. Investment in the UK economy as a ratio of GDP remains low; small and medium sized enterprises continue to struggle to obtain the credit they need to operate and grow; and “green” investments remain undercapitalised. Put simply the banking sector is not working to support the real economy in the way that it needs to if we are to secure strong and sustainable future growth, and far more work needs to be done to determine how this can be changed and what role new institutions (including a British Investment Bank) could play in facilitating it. As part of this there is a need to examine overseas banking sectors, to assess the extent to which other countries have strong financial sectors that support their real economies much more effectively than is the case in the UK. 1.8 The TUC would also like to see further recognition of the important role that trade unions have the potential to play both in improving the stability and profitability of the UK banking sector and in helping to deliver the culture change that is now so evidently required in banking practice. Both through representing the workforce through existing structures, and through playing a more active part in corporate governance mechanisms (as we discuss below), unions have the potential to act as an important check to the cultures and practices that led us towards the biggest financial crash since the 1920s. 1.9 Finally, the TUC does not accept the argument that the increasingly global nature of the economy prevents the UK government or the UK banking industry from taking action to improve the sector’s culture and reputation. On the contrary, the UK banking sector remains a key global player and is in the enviable position of being able to lead by example. Given the severe question marks over the stability and security of the UK banking industry and the fact that many others around the world share those questions, it is imperative that the UK government leads with serious and substantial reforms to the UK banking industry to ensure its standing in this incredibly competitive global market is maintained. To what extent are professional standards in UK banking absent or defective? How does this compare to … (b) other professions …? 1.10 The entry level qualifications and training required to enter into the UK banking sector are not as rigorous as those required to enter into other UK professions. Bankers, for example, do not require a license to practice in the same way as is the case in many other fields. Given the significant impacts that the activities of the banking sector have for the wider economy, and the failures in professional standards that contributed to the crash, the TUC believes that the case for the introduction of appropriate entry requirements and ongoing professional licensing within the industry should now be examined with urgency. 1.11 However, as stated above, it is also our strongly held view that limited training and a lack of professional accreditation are not the key driver of poor professional standards, which we feel are primarily a result of wider failures in the structures, governance and regulation of the banking industry. 1.12 What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole? 1.13 What have been the consequences of any problems identified in question 1 for public trust in, and expectations of, the banking sector? 1.14 The TUC has long argued that the financial crisis was not just caused by errors of judgement taken by a few people investing in securitised US sub-prime mortgages. As this submission will go on to demonstrate, our view is that the crash resulted from a persistent focus on generating high levels of distributable profits from short-term risk taking—a strategy which has caused untold immediate damage to the real economy as well as exacerbating the UK’s long-run trend of low levels of investment compared to other developed nations. 1.15 The recession of 2008/09 and the subsequent double dip recession of 2011/12 comprise the UK’s worst economic crisis since the 1930s. The depth of the initial recession and the weakness of the recovery are both unheard of since the 1870s. Four years on from the initial crash the UK economy is still 4% below its precrisis peak and, on current forecasts, it will not regain its pre-crisis level until 2015. In other words the financial crisis has effectively led to a lost decade of growth. 1.16 The implications for living standards and jobs have been severe. Although, by headline results, the labour market has performed relatively well (given the large fall in output) unemployment rose to levels not seen since the mid 1990s, long term unemployment has risen to twenty year highs and the UK is experiencing record high youth unemployment. In addition to the 2.5 million people currently unemployed, there are another two million either working part-time when they want a full time job or on a temporary contract when they want a permanent position.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1371

1.17 The financial crisis has had a major impact on living standards. Real wages have been falling for two years and are expected to fall for at least another year. Median wage earners, those in the middle, are not expected to achieve their 2003 standard of living until sometime around 2015/16. Real household disposable income fell in 2009, 2010 and 2011. This is an unprecedented fall in living standards. 1.18 In addition the financial crisis, and the resulting tight credit conditions, have had a major adverse impact on business investment. Investment remains around 20% below its 2008 level which may well lead to slower growth in the medium term due to a smaller capital stock than would otherwise have been the case. 1.19 The TUC’s recent economic report (a copy of which is attached at Appendix 1) shows that the contribution of the financial sector to the UK economy rose rapidly in the 2000s and that the share of financial services in GDP is also higher in the UK than in many other major economies. If the UK had been less dependent on the financial, and related, sectors it would have been much better placed to weather the global crisis of 2008. Rather than the deficit leaping from 3% of GDP to around 12%, it would have grown more in line with that of other major economies (generally to around 5–6% of GDP). The recovery would also have been stronger as our economy would have been less reliant upon credit, and would have been broader based, facilitating faster expansion. Not only was the recession that began in Q1 of 2008 triggered as a direct result of the credit crunch, but the OBR has acknowledged that the primary reason why the UK’s fiscal deficit opened up so widely in 2008/09 was a rapid collapse in tax revenues from property and finance. The current squeeze on public finances can be traced directly back to our over dependence on financial services prior to the crash. 1.20 This imbalance causes a heightened risk to the UK economy due to a lack of diversification (as the credit crunch itself demonstrated). It has also led to regional inequality in the UK as the majority of the revenue that flows to and through the financial sector flows through institutions based not just in London, but in much smaller localities (namely the City and Canary Wharf). With the banking sector also consuming much of the UK’s skills and resources, this too leads to lower growth in other sectors negating the positive contribution that the banking sector makes to the real economy both in terms of revenue from taxation and in terms of the financial products and services it supplies. 1.21 The TUC believes that there is little doubt that public trust and expectations of the banking sector is at an all time low from the days when journalists lauded the integrity of Labour Party leader John Smith MP by comparing him to a Scottish banker; a comparison that would be deemed an insult not 20 years later: —

A survey168published by the consumer pressure group Which? on the fifth anniversary of the credit crunch shows that;

—

84% of people think that the banks have not done enough to prevent another credit crunch—an increase from 76% in September 2011;

—

71% think the banking culture hasn’t got any better since the start of the credit crunch;

—

50% think that the Government’s handling of the banking industry has also got worse; and

—

80% think there is a deeper problem with the culture in banks than just a few individuals making bad decisions.

1.22 Recent research undertaken by GQRR169 showed that 45% of respondents believe “greed and recklessness amongst bankers on Wall Street and in London” is the factor most responsible for our deteriorating public finances, with 43% blaming “the failure of governments to properly regulate banks and financial institutions”. Public confidence appears to have been significantly affected by an accurate analysis of the role that the financial sector played in creating our current recession. But worryingly, public confidence in the ability of Government to implement measures to change the banking industry is also low, with the Which? survey showing that only 26% of respondents were confident that the Commission “will lead to positive improvements in UK banks”. 1.23 The TUC is very concerned about this lack of public trust in and low expectations of the UK banking sector. Not only is finance the oil that greases the wheels of the real economy, it also provides the means for the public to provide security for their futures and to obtain the liquidity that they need to live a modern lifestyle. If public trust in the UK banking sector remains at a low, that lack of faith will pollute the trust around wider financial products including pensions, and this could have very serious and negative long term consequences for the UK’s social and economic health in the decades to come. 1.24 The TUC believes that whilst financial services must and will remain a key part of the UK economy, at present the UK is too dependent on the financial sector and that it is vital to secure stronger growth in other sectors in order to rebalance the UK economy and ensure long-term growth for the benefit of all. This is also a vital step if public trust is to be rebuilt: because the public view the UK banking sector as toxic, and have seen the significant risks such a large financial sector can bring. Rebalancing the economy so that the financial sector is not as dominant as is currently the case (therefore reducing the systemic risks such a position creates) is key to restoring trust in the UK banking sector. 168 169

http://www.which.co.uk/news/2012/08/banks-fail-to-learn-lessons—new-which-survey-292882/ http://gqrr.com/index.php?ID=2779

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1372 Parliamentary Commission on Banking Standards: Evidence

What caused any problems in banking standards identified in question 1? 1.25 What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally? Corporate Governance 1.26 The TUC believes that more regulation is not a substitute for effective corporate governance; the two should complement each other. Corporate governance is about ensuring appropriate structures, procedures, cultures, incentives and supervision to promote effective decision making. Regulation is about setting out legal minimum standards which are enforced by the state rather than by shareholders. 1.27 The TUC believes that the broad aims of corporate governance are consistent across all sectors including the banking sector. At the broadest level, corporate governance aims to provide: — appropriate structures and procedures for effective board-level decision making that reflects directors’ legal duties under section 172 of the Companies Act (but see our suggestion for reform of this below); and — a monitoring and supervisory function sufficient to ensure that decisions are questioned and challenged where appropriate. Breaking these two broad aims down further, corporate governance should seek to achieve: — effective long-term strategic leadership of the company; — good succession planning; — a corporate structure where stakeholder interests (including those of shareholders, employees, suppliers and local communities) and environmental impacts effectively taken into account in decision-making; — positive, long-term stakeholder relationships based on trust; — vigilant risk-management; — an appropriate degree of transparency and integrity in reporting; — board recruitment that is managed to ensure the board constitutes the range of skills, knowledge, experience and backgrounds necessary to facilitate an appropriate degree of challenge and input into decision-making and strategic direction; and — an effective remuneration policy. 1.28 While these aims are consistent across sectors, their implementation will inevitably vary across different industries. In the context of systemically important financial institutions we recognise the critical importance of risk management and ensuring that risks to the organisation and its stakeholders (including investors) as well as risks to the wider economic system are managed effectively with a high degree of scrutiny. 1.29 We do not believe that the Independent Commission on Banking’s (ICB) report will necessarily have a direct impact on corporate governance in these institutions, as according to our understanding, the same board would still be responsible for the separate retail and investment parts of the bank. 1.30 But this does not mean that such changes are not necessary, and the TUC believes that corporate governance reform could act to significantly strengthen the governance of the UK banking sector. 1.31 Corporate governance systems also have potential to significantly impact upon banking cultures. The Companies Act 2006 codified some but not all of directors’ duties for the first time in the UK. In Section 172, directors are required to act in good faith “to promote the success of the company for the benefit of its members as a whole”, and in doing so are required to have regard to the long-term implications of decisions, employee interests, customer, supplier and community relationships and environmental impacts. Documentation from the Company Law Review, whose recommendations formed the basis of the Companies Act 2006, and Parliamentary exchanges that took place as the Bill passed through Parliament, both show that one aim of the new duties was to ensure that directors were encouraged to balance short-term aims with long-term strategies. 1.32 The thinking behind Section 172 of the Companies Act is that in the long-term the interests of shareholders and other stakeholder groups—and indeed, the company itself—will converge. Section 172 was designed to ensure that directors took what could be called the “high road” to success, based on investing in R&D and training, developing long-term, committed relationships with employees, suppliers and customers and managing environmental impacts responsibly, rather than the “low-road”, based on low-skill, low wage employment, low investment levels and a short-term approach to financial returns. The idea that shareholder relationships will generally be long-term is critical to the basis of this analysis. 1.33 The changing nature of share ownership in the UK (as highlighted below) including the short term nature of such ownership, poses a significant challenge to the assumptions behind directors’ duties as set out in Section 172. In particular, growth of alternative asset managers and the increasing use of share trading as an investment strategy across all investor groups cuts right across the basis of Section 172 of the Companies Act, with major implications for corporate governance and company performance. Directors are required to “act fairly between the different members of the company”, but (again, as discussed below) it is not possible

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1373

to do this if some shareholders have bet on the bank’s share price falling and will therefore benefit from the company doing badly. 1.34 Based on union experiences of representing the interests of employees employed by banks, the TUC does not believe that the new directors’ duties have had any significant impact on company prioritisation and decision making. This experience is backed up by research; a recent Association of Chartered Certificate Accountants (ACCA) study found that interviewees from the corporate sector believed that directors’ duties amounted to maximising share price in the short-term.170 What directors’ duties require of directors in reality is almost irrelevant if this is how directors interpret them. 1.35 In our view section 172 should be amended to make directors’ primary duty the promotion of the longterm success of the company, rather than t shareholders’ interests as at present. Serving the interests of shareholders and the different stakeholder groups included in Section 172 should be secondary to this central aim. In so doing, they should be required to deliver sustainable returns to shareholders, promote the interests of employees, suppliers and customers, and have regard to community, environmental and reputational impacts. This would have the effect of rebalancing the interests of shareholders and others stakeholders, but all their interests would be secondary to those of long-term success of the company. This would be closer to the original intention of how the new directors’ duties set out in the Companies Act 2006 would operate. A possible formulation would be: “The directors of the company are required to act in good faith to promote the long-term success of the company, and in so doing, should have regard to the need to: — deliver fair and sustainable returns to investors; — promote the interests of the company’s employees; — foster the company’s relationships with suppliers, customers, local communities and others, and — take a responsible approach to the impact of the company’s operations on the environment”. 1.36 The TUC also believes that a two-tier board system, as opposed to a unitary board system, could offer important benefits, some of which are particularly relevant in the context of the financial sector. The separation of the executive and the supervisory functions in a two-tier board structure make the supervisory function much more explicit. It is also much harder for non-executives to be “out-gunned” by the executives, because the executives are generally in a minority on the supervisory board (in the German system, for example, the only executive member of the supervisory board is the Chief Executive). Some may suggest that this separation of structures can slow down decision making, but we would argue that making the right decisions is much more important than making decisions quickly. If the decision-making process at RBS over buying ABM Amro could have been slowed down, it is highly likely that this disastrous purchase would not have gone ahead, and RBS would not have needed such high levels of Government support to avoid collapse. 1.37 A key attribute of two-tier boards is that employees and in some cases shareholders generally have either direct representation or nomination rights on boards. The interests of employees are well-correlated with the long-term interests of the bank, and the TUC believes that having employees represented on UK banks’ boards could help boards to prioritise the long-term interests of the bank in decision making, rather than being distracted by short-term financial engineering, as occurred in the run-up to the financial crisis. Employees also bring with them in-depth knowledge of how the bank operates in practice and are well-placed to contribute to the need to foster positive stakeholder relationships, as set out in section 172 of the Companies Act. The TUC believes that the Commission should consider the benefits that this approach could bring. Shareholder Primacy and Short-term Shareholding 1.38 Under the UK’s corporate governance system, shareholders have a privileged position. Shareholders are entitled to elect annually directors at company AGMs; vote on remuneration reports (although the vote is currently only “advisory”); vote on shareholder and other resolutions at AGMs; and convene Emergency General Meetings. Directors are required to serve shareholder interests (although please see our recommendations for reform in the paragraphs below). 1.39 This system is based on an assumption that there is a convergence of interests between shareholders and the company (and its other stakeholders). However, this convergence of interests only holds in practice if shareholders are committed to investing in the bank on a long-term basis and their prime financial interest in the company is the ability to receive dividend payments over time. If, however, an investor is a short-term share trader whose prime financial interest in the company is to sell their shares at a higher price than they bought them, their interest will be in short-term strategies to raise the share price, rather than long-term strategies to invest in organic growth. In this case, their interests will not coincide with those of company stakeholders such as customers, nor, very significantly, with those of the company itself. If the investor is shorting the stock, their interests will be diametrically opposed to those of the company and its other stakeholders, including long-term shareholders, as they will stand to gain if the bank’s share price falls. 1.40 In addition, increasing proportions of shares are owned by alternative investment managers with short time horizons and investment practices based on share trading rather than long-term share ownership. While 170

David Collison et al, Shareholder Primacy in UK Corporate Law: An Exploration of the Rationale and Evidence, ACCA Research Report 125, 2011.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1374 Parliamentary Commission on Banking Standards: Evidence

the proportion of shares owned by alternative investment managers across the stock market as a whole remains fairly low, the ability of alternative investment managers to buy and sell large numbers of shares in a particular company over a short period of time magnifies their influence in the market. In addition, seeking to increase the value of a portfolio by buying and selling shares at an advantageous time has also become an important part of portfolio management among traditional so-called “long-term” institutional investors. 1.41 One of the key barriers to more effective engagement between investors and companies (be it banks and their shareholders or banks and the companies in which they hold/manage shares in) is the dispersion of shares. Share ownership patterns have changed rapidly over recent decades. In the 1960s, the majority of shares in UK companies were owned by individuals, many of whom took a reasonable level of interest in the companies whose shares they owned. By the 1980s, the majority of shares were owned by UK institutional investors such as pension funds and insurance companies. Today, this has changed again, and recent figures from the Investment Managers’ Association suggest that pension funds and insurance companies now hold around 13% of UK equities each, with an additional 14% held by other UK institutional investors171. ONS figures show that at the end of 2008, 41.5% of UK-listed shares were owned by investors from outside the UK, and individuals held just over ten%, the lowest percentage since the survey started in 1963172. 1.42 These changes have great significance for the quality of engagement between shareholders and companies (including banks). It will clearly be harder for overseas investors to develop the kind of engaged relationships with UK companies and banks that are envisaged by the UK’s corporate governance system. Language, culture, proximity and availability of information all make engagement much more straightforward within a national context in comparison with engaging with companies abroad. This is reflected in responses to the TUC’s Fund Manager Voting Survey: in the 2011 Survey, 21 respondents said they voted all their UK shares, while just ten voted all their overseas shares, although a further seven indicated that they voted the large majority, or a large proportion of their overseas holdings173. The UK’s corporate governance system was not designed on the basis that the largest single share ownership block would be investors from outside the UK. 1.43 In contrast to individuals who tend to own shares in a limited number of companies whose progress they follow closely, institutional investors generally own shares in hundreds or even thousands of companies. Just as an increasing proportion of UK shares are held by investors from outside the UK, an increasing proportion of equity holdings of UK institutional investors are global, rather than UK equities. The sheer number of companies whose shares they hold poses major practical challenges to the ability of institutional investors to carry out corporate governance effectively. If institutional investors are to engage effectively on an informed and consistent basis with all the companies whose shares they own, this would require a very significant deployment of resources, considerably above the levels that most currently devote to engagement. 1.44 As Sir David Walker pointed out in his report on UK bank governance, competition between institutional investors and the fact that the gains generated by effective engagement are enjoyed by investors, across the board rather than flowing directly to the investors who have carried out the engagement, further reduces the incentives for institutional investors to devote sufficient resources to enable them to engage effectively with all the companies whose shares they hold. 1.45 It should be remembered that one of the most significant errors in the run-up to the financial crisis— the RBS takeover of ABM Amro—was voted on by RBS shareholders and overwhelmingly approved. It is also the case that shareholders were generally supportive of the approach of RBS, HBOS and Northern Rock in the pre-financial crisis period, despite the major risks that each was running up. Indeed, Lloyds, which (until its takeover of HBOS) was less highly leveraged and less exposed to risky assets than some of the other banks, had come under pressure from some shareholders for not making sufficient use of leverage and being “boring” in its approach. Shareholder involvement is not a panacea, and as John Kay’s recent Review into Equity Markets and Long-Term Decision Making has illustrated, shareholders can at times put pressure on boards to generate short-term results at the expense of strategies for long-term, sustainable success. 1.46 In this scenario, it is far from clear why it is shareholders whose interests companies should be required to promote, nor why it is shareholders who should have the ultimate say over how companies are run. In addition to our proposals to reform directors’ duties (set out at paragraphs below), the TUC believes that governance rights and responsibilities, including voting rights, should be restricted to long-term shareholders, and proposes that all voting rights in UK companies should be dependent on holding shares in the company for a minimum of two years. We believe that these reforms would greatly improve the quality of corporate governance of the banking and finance sectors. 1.47 The TUC further believes that excessive share trading activity is taking place at the expense of longterm investment gains and that addressing this issue will be key to improving UK investment rates and returns. As Dr Paul Woolley has argued, heavy trading has come at a high cost to long-term investors, and pension funds are having their assets exchanged and traded on average 25 times over their lifetime, even though in the long-term this drains pension funds of 30% of their value174. The TUC believes that the Government should initiate work on proposals to cap share turnover, looking at proposals to be adopted by pension funds and 171

IMA, Asset Management in the UK 2009—2010, July 2010. Available at http://www.statistics.gov.uk/cci/nugget.asp?id=107 173 TUC Fund Manager Voting Survey 2011. 174 The Future of Finance: the LSE Report, Paul Woolley, Sept 2010. 172

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1375

other long-term investors as well as the role that Government and regulators can play in encouraging longterm shareholding. Non-Executive Directors 1.48 It has been recognised in the UK since the Cadbury Report of the 1990s that non-executive directors have an important monitoring function in relation to executive directors on UK boards. One of the factors that contributed to poor decision-making in financial companies in the run-up to the financial crisis was the domination of boards by powerful chief executives who were subject to insufficient challenge from other board members. In some cases, the chief executive had had considerable influence over nomination procedures, thus weakening the capacity of the board for effective challenge. 1.49 The TUC believes that it is essential that all those responsible for both executive and non-executive functions have sufficient time to carry out their responsibilities effectively. This principle must be given very careful consideration when determining the number of board roles that any one individual carries out. 1.50 In addition, the TUC believes that there is a strong case for greater diversity of board members. The tendency of banks to appoint non-executive directors (NEDs) who are executive directors of other companies or institutions within the banking sector means that board members are generally drawn from a very narrow pool of people with similar backgrounds and experience. This can contribute to the problem of “group think” on boards. 1.51 The TUC strongly supports the appointment to banks’ boards of NEDs who are drawn from a wider range of backgrounds, and believes that this would make a valuable contribution to improving the effectiveness of boards. A first step towards this would be for all NED positions to be publicly advertised, rather than often using head-hunting firms as is currently the case. Drawing NEDs from a wider range of backgrounds would also help address the issue of whether executive directors have time to carry out additional non-executive director roles effectively. Long-Term Reporting 1.52 Quarterly reporting is often said to promote short-term decision making of both company boards and investors. For example, Rathbone Unit Trust Management Income fund manager Carl Stick, commenting on the average holding period for stocks in the UK and US falling from 10 years in the 1940s to nine months in 2010, said “much of my industry is only interested in taking a bet on the next two quarters of news reporting [from companies], which is absolutely crazy. We are all turning to quarterly reporting, that is why the industry is so short term”.175 1.53 The TUC is sympathetic to the argument that if information is being produced for investors on a quarterly basis it is hard to see how this can fail to encourage both boards and investors to focus on the shortterm. However, the TUC believes that quarterly reporting is also a symptom of short-termism, as well as contributing to the problem. We believe that this is exacerbated by a lack of long-term information on company performance which could act to counter-balance the short-term information made available to investors. We would recommend that the Commission investigates the introduction of requirements for company reporting on long-term performance and recognises the importance of the Kay Review’s recent assessment that the obligation to produce quarterly reports may have an adverse effect on the behaviour of companies and shareholders. 1.54 There is considerable evidence that directors of publicly traded companies, including banks, do feel under pressure to maintain their company’s share price. This can lead them to undertake short-term strategies to boost their share price even when this will not be conducive to long-term company performance. For example, Andy Haldane in Patience and Finance argues that there is “strong evidence of high and sticky dividend payout ratios, almost irrespective of profits. Moreover, dividends appear to be becoming stickier over time”.176 Remuneration 1.55 The TUC believes it is particularly important that excessive executive remuneration in the banking industry is addressed. While significant damage to the rest of the economy has been caused by mistakes made within this sector, extremely high levels of reward continue to be paid to directors and senior executives in the industry, rewarding failures and incentivising the types of risk which led to the financial crisis. 1.56 The compensation to revenue ratio for the banking sector is remarkably high with historically investment banks setting aside an eye watering 45–65% of their net revenue to pay staff long before the taxman and shareholders receive any revenue. Although there have been some lower examples in recent years payments for the highest paid individuals remain astronomical. 1.57 The TUC does not support the current emphasis on performance-related remuneration and bonuses. There is ample evidence that performance-related pay has not been effective in rewarding good performance, 175 176

Investment Week, February 2010. http://www.bankofengland.co.uk/publications/Documents/speeches/2010/speech445.pdf

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1376 Parliamentary Commission on Banking Standards: Evidence

as noted by the BIS Discussion Paper on executive remuneration launched in September 2011. There is also convincing academic evidence that performance-related pay does not generate higher levels of motivation or performance177. We believe that there should be a greater focus on annual salary, with performance-related pay limited to a much smaller proportion of total remuneration than is currently the case.178 1.58 Where performance related pay/bonuses do exist, we are supportive of calls that bonus payments should be subject to “claw-back” in the event of trades or deals turning bad. The current structure of much remuneration in the financial sector means that individuals face a different risk/reward trade-off from that of the institutions they work for. They are personally financially rewarded when a trade or deal works and face little or no personal financial liability if the trade/deal does wrong. This misalignment of incentives can lead to excessive risk taking. 1.59 Some have argued that a stronger alignment of individual risk/reward trade-offs with institutional risk reward trade-offs would lead to banks and other financial institutions not taking “enough risks” and ultimately to slower economic growth. This is unlikely to be the case, and in fact an argument can be made that if banks engaged in less high risk/high reward behaviour they would be able to deploy more of their balance sheet in “traditional” activities (such as retail and commercial banking) which are often more supportive of sustained growth. 1.60 The TUC would like to see banking shareholders taking a much tougher approach to remuneration than they do at present and in particular making much greater use of their powers to reject remuneration reports; a copy of the TUC Response to the BIS Consultation on Executive Pay Shareholder Voting Rights is attached at Appendix 2. Investors have had an advisory vote on company remuneration reports since 2003. Between 2003 and the end of 2011, just 18 remuneration reports had been defeated at company AGMs out of the thousands of votes that have taken place over that time. While the recent increase of investor activism, particularly in the banking sector on remuneration, is both welcome and long overdue, it should be remembered that this year to date there have been just four remuneration report defeats. Whether what we are currently witnessing is a permanent trend towards greater shareholder activism on pay or just a blip is too early to say. 1.61 But, for the reasons we discuss in detail above, simply encouraging shareholders to take a more active approach to policing bankers’ remuneration will be insufficient to bring about significant change. The TUC therefore believes that more significant changes are needed to engage wider stakeholders in corporate governance and that as a start the banking workforce should be represented on remuneration committees, an approach we believe would bring significant benefits:

177

—

Workers and their representatives would bring a fresh perspective and common sense approach to discussions on remuneration, in contrast to the current culture that presides on remuneration committees.

—

The Government has acknowledged the importance of taking into account both company pay differentials and consulting with employees about directors’ pay. The best way to ensure that these issues are considered properly in decision making is for the workforce to be represented on remuneration committees.

—

The interests of the workforce are inextricably linked to the long-term success of their bank; they are therefore well placed to contribute to discussions on an appropriate remuneration strategy to serve the long-term interests of the business.

—

Including worker representatives on remuneration committees would engender a higher degree of buy-in from employees on pay arrangements at their bank. This should contribute to employee engagement, which is shown to be linked to higher business productivity and performance.

—

Research has shown that workforce representation does help to curb directors’ remuneration. One study showed that, among the largest 600 European companies, the presence of board level worker representation is correlated with lower CEO pay and a lower probability of stock option plans. A second study showed that, within large German companies, stronger worker representation on the board led to lower CEO pay and less use of stock-based remuneration.179

See, for example, The False Promise of Pay for Performance: Embracing a Positive Model of the Company Executive, James McConvill, 2005; The Upside of Irrationality: The Unexpected Benefits of Defying Logic at Work and at Home, Dan Ariely, 2010; Not Just for the Money: Economic Theory of Motivation, Bruno Frey, 1997; The Hidden Costs of Reward: New Perspectives on the Psychology of Human Motivation, Mark R. Lepper & David Greene, 1979. 178 For more discussion on this, please see TUC, Treasury Committee Inquiry into corporate governance in systemically important financial institutions, November 2011(a copy of which is attached as Appendix 2). 179 Board Level Employee Representation, Executive Remuneration And Firm Performance In Large European Companies, Sigurt Vitols, March 2010; and Arbeitspapier 163, Beteiligung der Arbeitnehmervertreter in Aufsichtsratsausschüssen, Auswirkungen auf Unternehmensperformanz und Vorstandsvergütung, Studie im Auftrag der Hans-Böckler-Stiftung, Sigurt Vitols 2008; both available from the TUC.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1377

—

There is clear academic evidence that high wage disparities within companies harm productivity and company performance.180 Combined with evidence (cited above) that workforce representation on remuneration committees is associated with lower rates of CEO pay, this makes a strong case for the inclusion of workforce representatives on remuneration committees.

1.62 For further information on our analysis on remuneration, a copy of the TUC paper “Worker Representation on Remuneration Committees: Why do we need it and how would it work in practice?” is attached at Appendix 3. 1.63 The TUC believes that remuneration consultants have played a significant role in designing increasingly complicated remuneration structures that have paid out excessive amounts for mediocre and at times poor performance. The TUC is very concerned about the conflicts of interests that are created when remuneration consultants are also carrying out other work banks, and believes that this should be prohibited. It is also important that remuneration consultants are appointed by and report to the remuneration committee only and not to the executive directors. 1.64 The TUC would also support mandatory disclosure of the number of people within each firm whose total remuneration exceeds £1 million, preferably in bands of £1 million to £2 million, £2 million to £3 million and so on. Taxation of Bonuses 1.65 Given the significant risk that high levels of bonuses and their incentivisation of short term risk taking and rewards have proven to have to the economy, the TUC recommends that this risk should be internalised to the banking sector. The TUC therefore recommends that pay and bonuses above £250,000 per annum (around ten times the level of average pay in the UK) should be considered profit and therefore paid out from profits available for distribution rather than being accounted for as a general expense of the bank. This would mean that the available pool for such high rewards would be subject to corporation tax as part of the normal taxable profits of the bank. Recruitment and Retention 1.66 Across the UK, finance sector workers continue to fear for their jobs. Although the problems in the financial sector were caused by those at the top of the industry, it is frontline bank staff who are paying the price through redundancies, restructurings and pay cuts and freezes. This is leading to a decline in morale and hence service quality in the area of banking that most of the public interact with. Many thousands of jobs in financial services have been lost in the last four years. 1.67 It is also vital to remember that the vast majority of bank employees do not work in investment banking divisions, but in high street branch networks. And there is growing evidence here that staff are under increasing pressure. Just as performance related pay affects behaviour at the higher end of the banking pay scale, it also causes distortions at the bottom end. A sales driven culture with sales targets and performance related pay linked to indicators such as product sales incentivises retail banking staff to sell unnecessary and risky products to households and SMEs and needs significant reform. 1.68 An online survey on stress, carried out by Unite in March 2012 within a major UK bank received almost 8,000 responses in just one week. Results showed that 85% of respondents said that they felt stressed by their work; 77% said that they suffered from symptoms caused by stress including anxiety attacks and depression, 78% agreed or strongly agreed that they faced “unremitting pressures to perform well” and 56% agreed or strongly agreed that there was a failure by the bank to recognise their achievements. Respondents were also asked about their experiences of stress in relation to a number of issues. 74% agreed or strongly agreed that unrealistic targets were a cause of stress and 65% identified uncertainty about their future as causing stress. Stress and its effects are clearly an issue for employees in the banking sector and from other communications Unite has received this is reflected across other parts of the industry. Tax Deductibility of Interest Payments on Corporate Debt 1.69 The TUC has long held concerns about the impact of the tax deductibility of interest payments on corporate debt with evidence suggesting that this encourages highly-leveraged private equity buyouts by providing a very cheap means to borrow large sums of money. 1.70 The financial crisis illustrated the fact that high levels of leverage create substantial risk throughout the economy, and especially within the financial sector. The number of voices drawing attention to the undesirable consequences of the tax deductibility of interest payments on corporate debt has increased considerably in the aftermath of the crisis. Both Nigel Lawson and Andy Haldane have called for reforms to address the anomalous 180

See, for example, Pedro Martins, Dispersion in Wage Premiums and Firm Performance, Centre for Globalisation Research Working Paper No. 8 April 2008; Olubunmi Faleye, Ebru Reis, Anand Venkateswaran, The Effect of Executive-Employee Pay Disparity on Labor Productivity, EFMA, Jan 2010; and Douglas M. Cowherd and David I. Levine, Product Quality and Pay Equity Between Lower-Level Employees and Top Management: An Investigation of Distributive Justice Theory, Administrative Science Quarterly, Vol. 37, No. 2, Special Issue: Process and Outcome: Perspectives on the Distribution of Rewards in Organizations June 1992.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1378 Parliamentary Commission on Banking Standards: Evidence

tax treatment of debt and equity, with Haldane arguing either for a normal return on equity to be made tax deductible or the tax deductibility of debt to be withdrawn.181 1.71 We believe that there is a fundamental difference between debt used to fund organic growth through investment in research and development, innovation and training and debt used to buy up other companies. The TUC believes that reflecting this distinction in the tax rules so that tax-deductibility on debt would not apply to debt used to buy up other companies is an approach that merits further investigation. The size of debt relative to company turnover could be used as a possible proxy to distinguish between debt to fund organic growth and debt to fund takeovers. Tax Deductibility for Training 1.72 The TUC is concerned about the quality of training in banks. The TUC has for some time called for companies to be required to set out a short summary of their training provision in their annual reports and for this to be more tightly linked to how tax relief on training is applied. The TUC believes that the Government should review the current arrangements for tax relief for work-related training, and would support greater priority being given to accredited training. Regulatory Framework and Culture 1.73 The TUC welcomes the introduction of the Government’s new regulatory regime for the banking sector. We agree that the previous system of financial regulation had key weaknesses, and welcome the decision to provide the Bank of England with the responsibility, authority and tools to monitor the financial system as a whole. 1.74 The TUC believes that there is an important distinction between the role of shareholders and regulators in relation to systemically important financial institutions. We believe that matters concerning systemic risk should be monitored by regulators rather than shareholders. This is in part because we do not believe that shareholder oversight is sufficiently effective to take on this critical responsibility as illustrated above. 1.75 It is particularly important that systemic risk is addressed by regulatory requirements and that law enforcement agencies are responsible for the enforcement of measures in this area. It is not viable to leave the monitoring of systemic risk to individual financial institutions and their shareholders, as there may be times when the short-term interests of an individual financial organisation and the interests of the financial system as a whole diverge. In addition, it is essential that systemic risk is addressed on a systemic basis, by an organisation that is responsible for supervising the system as a whole. It is not realistic to leave this broader responsibility to shareholders of individual institutions, although clearly the latter should still seek to be vigilant against systemically-risky behaviour at individual organisations so far as is practicable. Corporate and Criminal Legal Framework 1.76 There is evidence that the lack of personal liability has encouraged excessive risk taking at financial institutions in the past. The current Executive Director for Financial Stability at the bank of England has gone much further than the Chairman of the FSA and questioned the whole notion of limited liability in respect to banks182. In 2009 it was noted that Hoare’s Bank, which is still structured as a traditional partnership with the owners bearing the risk, had weathered the crisis (and previous crises) much better than limited liability banks183. 1.77 In particular, as has been demonstrated above with respect to Lloyds (see paragraph 4.10) the fact that increased gearing in turn increased the potential pool of assets from which profit and therefore dividends can be derived has led to shareholders criticising directors for not permitting riskier and riskier gearing. The downside for such shareholders is always limited to the amount of capital invested because of the corporate veil. However, because of the implicit guarantee provided by the taxpayer to the banking sector the wider public may be facing a higher risk. 1.78 The Bank of England184 has already argued that this implicit guarantee gives the banks that benefit a competitive advantage over those that do not. It also of itself increases a bank’s incentive to take risk (thereby leading to a vicious circle of high gearing leading to growth leading to an implicit guarantee which in turn encourages further gearing increases) and also leads to the disproportionate growth of the finance sector compared to the other sectors of the real economy. The quantum of this implicit guarantee to the taxpayer is almost impossible to quantify with values being put at between £6 billion to over £100 billion. 1.79 The increases in equity capital held by banks required by Basel III185 will not be sufficient to negate this risk. The TUC therefore recommends that the Commission look into ways of either changing the ownership 181

http://www.bankofengland.co.uk/publications/Documents/speeches/2011/speech525.pdf 11 Andrew Haldane, “The Doom Loop”, LRB, February 2012. http://www.lrb.co.uk/v34/n04/andrew-haldane/the-doom-loop 183 South Sea Bubble Survivor Says Dismantle RBS, Lloyds, Bloomberg, March 2009. http://www.bloomberg.com/apps/news?pid= newsarchive&sid=aANXHOD12Q2A&refer=news 184 “The implicit subsidy of banks”, Bank of England Financial Stability Paper No. 15—May 2012 http://www.bankofengland.co.uk/ publications/Documents/fsr/fs_paper15.pdf 185 Duncan/Nicola—Insert reference to Government response to Vickers? 182

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1379

and control models of bank ownership or piercing the veil of shareholders of banks (increasing their personal liabilities for the bank’s practices) that benefit from the implicit guarantee of the taxpayer so that shareholders are required to bear a fair proportion of this risk eg by requiring shareholder to be liable for an additional fixed level of reserve capital in the event of the bank’s stress or bankruptcy. Criminal Sanctions 1.80 The TUC supports in principle the Government’s proposal to introduce a “rebuttable presumption” that the director of a failed bank is not suitable to be approved by the regulator to hold a position as a senior executive in a bank and also to introduce criminal sanctions for serious misconduct in the management of a bank. 1.81 The TUC also endorses in principle the European Commission’s proposal to introduction a Regulation and a Directive with the cumulative effect of making manipulation of benchmarks, of the kind features in the recent LIBOR scandal, a criminal offence. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? 1.82 Overall, the TUC believes that that wider corporate governance reform, legislative and regulatory reform are all required. Only a complete package of policy aimed at creating a banking system that takes a more long-term approach to servicing the real economy will have a chance of success. Piecemeal reforms, especially if watered down will be unlikely to succeed. As argued above, whilst the international context matters, this should not be used as an excuse for not taking tough action domestically. 1.83 Only time will tell whether the new Financial Policy Committee (FPC), and the two new regulators, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) will be effective, and it will be vital that in their early days of operation they are given both time to establish themselves and that on an ongoing basis all necessary resources are made available to them. In particular managing the transition from the Financial Services Authority (FSA) to the new regulators will be complex, and it will be imperative that a prolonged transition does not lead to reductions in regulatory capacity. 1.84 These new institutions will have an important role to play in determining the appropriate regulatory regime for the different swaps, derivatives, pension funds, bonds and other complex instruments available on the markets. While some financial products do not pose much of a systemic threat, ambiguity remains over how dangerous some products might be. It will be vital to its success that this new regulatory infrastructure is able to better identify where these challenges may lie, and act to prevent the proliferation of financial products that could undermine the wider stability of the banking system. 1.85 It is not the TUC’s view that this change in regulation will be detrimental to the industry. An example of heavy product regulation in a successful UK industry is that of the regulation of pharmaceuticals. Not only does the pharmaceutical product itself have to undergo rigorous regulatory approval before it can be offered to the public, but approval is also required with respect to who prescribes it or sells it and of course to whom. Notwithstanding this regulation, the pharmaceutical industry in the UK is the envy of the world. 1.86 The TUC has also welcomed the Independent Commission on Banking’s (ICB’s) report as a good start to the process of addressing the fundamental problems facing the UK banking sector and believes it should be implemented in full, as quickly as possible. Similarly the TUC believes that even after the Commission reports, there will still be further work to do on examining the questions of what needs to be changed in the UK banking sector so that it fulfils its social utility in full. 1.87 But we also believe that wider change is still required within the banking sector, and that the mandate given to the ICB was limited and specific. As a result its proposals focused on financial stability and did not fully consider how banks could better support business and how credit flows could be unlocked and boosted. In particular, the ICB did not examine four key issues facing the UK economy: the low level of fixed investment in the UK economy; limited access to credit for small and medium sized enterprises; ongoing sectoral imbalances with the UK economy; and unmet need for finance to enable green growth. A copy of the TUC discussion paper “Banking After Vickers” which addresses this lack of mandate can be found attached at Appendix 4. Appendices (available upon request) Appendix 1: TUC Economic Report. Appendix 2: TUC Response to the BIS Consultation on Executive Pay Shareholder Voting Rights. Appendix 3: TUC paper “Worker Representation on Remuneration Committees: Why do we need it and how would it work in practice?” Appendix 4: TUC discussion paper “Banking After Vickers”. 3 September 2012

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1380 Parliamentary Commission on Banking Standards: Evidence

Written evidence from the Bank of England Concentration in Banking Services and Stability 1. The concentration in the UK banking industry in the run up to the crisis was unhealthy for financial stability.186 A bank’s abrupt closure has a bigger impact on current and prospective customers, and so on the economy, where there are few or no competitors to move into the space left behind. Remedies exist, but will come slowly given the current degree of concentration. Concentration and the Effects of Bank Failure 2. The UK’s economic recovery has probably been impeded by some of the banks worst hit by the crisis being those previously most important to business lending: the businesses making up Lloyds Banking Group and Royal Bank of Scotland Group accounted for over 40% of the stock of lending to UK firms at end-2007. 3. Also, there were more banks and building societies active in the UK mortgage market. Many failed, and were closed, taken over or merged.187 Together those lenders accounted for almost 20% of the stock of mortgage lending at end-2007. 4. The costs of bank failure in the UK have been felt through credit conditions rather than a breakdown of the payments system. That is partly because deposit insurance ensures some continuity in the provision of deposit and payments services. Up to a £85,000 limit, depositors are guaranteed by the Financial Services Compensation Scheme, with payout in most cases now assured within seven days.188 Alternatively, under the Special Resolution Regime created by the 2009 Banking Act, another bank can assume the insured deposit liabilities of a failed bank. In that case, depositors find themselves banking with a different bank but services are maintained. 5. There are no corresponding guarantees on the lending side. Small and medium-sized companies, without access to the capital markets and with bespoke borrowing requirements, may find it slow or difficult to arrange new credit facilities elsewhere—as might some households. Nevertheless, resolution regimes can sometimes help to preserve lending capacity, depending on the type of resolution strategy employed and the particular circumstances of the case: (1) If a failed bank goes into Liquidation and Payout, the insured deposits are covered by the FSCS but all the assets go into administration. The lending business is, therefore, closed unless it can be sold out of administration to another bank (or other purchaser). Where loan portfolios go in to run-off or during the transitional period whilst a sale is being arranged, households and companies have to look elsewhere to refinance or renew existing loans and facilities. (2) If, instead, the resolution authority sells the deposit book to another bank under a so-called Purchase and Assumption resolution, there are the same two broad possibilities for the loan book. Either the whole or part of the loan book might be sold to the bank buying the deposit book or to another buyer, or it goes into administration and run off. In the first case, services are maintained, albeit perhaps after a delay; the loan-market share of the buyer is increased. In the second case, customers need to find new lenders. (3) A third resolution strategy is bail-in, involving recapitalising and restructuring a failing bank through writing off the equity, writing down sufficient debt to absorb losses, and converting part of the residual debt to equity. In that case, any sound business lines, including lending, can be sustained.189 6. Effective resolution can, therefore, reduce the consequences for the economy of bank failure in a concentrated industry; and some, such a bail-in, avoid increasing industry concentrations. 7. Another possible approach is to try to make a virtue of industry concentration. For example, some countries—for example, Australia and Canada190—are sometimes characterised as shielding their main domestic commercial banks from competition, so that domestic banking remains sufficiently profitable to reduce the temptation to launch out into risky variants of international wholesale banking. This strategy implicitly accepts concentrations, and seeks to reduce the probability of failure rather than to reduce the consequences for the economy of failure nevertheless occurring. 186

See, for example, Tucker, P M W (2012), “Property Booms, Stability and Policy”. Amongst banks, Alliance & Leicester, Bradford & Bingley and Northern Rock no longer exist in their previous form. Amongst building societies, Barnsley, Britannia, Catholic, Chelsea, Chesham, Cheshire, Dumfermline, Norwich & Peterborough, Scarborough and Stroud & Swindon have all merged with other societies or closed since the crisis began. 188 See Financial Services Compensation Scheme, Protecting your money, which states that “in most cases for deposits, FSCS aims to pay compensation within seven days of a bank, building society or credit union failing. [The FSCS] will pay any remaining claims, which are likely to be more complex, within 20 working days”. 189 One type of resolution strategy employing bailin was described in Resolving Globally Active, Systemically Important, Financial Institutions, a joint paper by the Federal Deposit Insurance and the Bank of England 190 See, for example, IMF (2012), Global Financial Stability Report, October 2012 187

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1381

Other Possible Responses: Reducing Concentrations 8. Another approach would be to seek to reduce concentrations, and so to reduce the costs of failure. That can be attempted in a variety of ways. 9. One approach, which has been used elsewhere, is to prevent concentrations via an explicit cap on the market share that banks can accumulate through acquisitions. For example, the United States bans acquisitions that would result in a bank controlling more than 10% of the country’s insured deposits. (The rule does not prevent banks from crossing the 10% line organically.) The same broad approach could, in principle, be related to a bank’s share of loan markets, or to GDP etc. 10. In a recent discussion of size limits of this broad kind, Governor Tarullo of the US Federal Reserve Board concluded that, given the paucity of empirical work on economies of scale and scope in banking, policymakers are not in a position to decide what a sensible size limit might be.191 11. A different approach would be to reduce barriers to entry, including by streamlining the process through which new banks can be set up and reducing the financial requirements on new banks. At the Commission’s hearing in November,192 Paul Tucker said that the prudential supervisor can authorise banks more readily if there are lower barriers to exit. In other words, good resolution regimes can be used to help reduce barriers to entry. As described above, with rapid payout by the deposit insurer for smaller banks and a resolution regime to transfer or recapitalise the banking business of larger deposit-takers, the impact of the failure of a new bank on the financial system becomes more manageable. Where the prospective costs of failure are manageable, the board of the Prudential Regulation Authority (PRA) should feel comfortable in ensuring that line supervisors are less cautious about granting licences to new banks. Even so, a minimum solvency standard at the point of entry is warranted to avoid an excessive incidence of bank failure—not least because of the cost to surviving banks. The Bank/PRA plans to adopt this broad approach. 14 January 2013 Written evidence from Paul and Nikki Turner193 1. This submission is from Paul and Nikki Turner and our view is that of people who: a) have been victims of systemic bank fraud; b) have experienced firsthand the unethical way in which a major bank has attempted to conceal fraudulent behaviour in their organisation to the detriment of clients and shareholders; c) have experienced firsthand how the regulatory system in the UK has been manipulated by banks to the detriment of the consumer; d) have had to investigate a massive fraud ourselves because no authority that should have looked into the matter, did; e) have adduced evidence which confirms the corruption endemic in the banking sector, is not confined to banks. 2. Surprisingly perhaps, we would call many bankers and ex-bankers we have met, friends. So our submission is not an attack—but rather an informed “layman’s” view of how key, influential people in the banking industry and other “supporting” sectors, have corrupted the system to the detriment of a society which also includes the majority of people in the banking and other sectors. 3. It is clear to us from the evidence we have scrutinised, to address the issue of “Banking Standards”, the Commission must also look into all the related services which have facilitated the demise of “Banking Standards” because of the business and rewards they derive from the banking sector. 4. Accountancy Firms, Law Firms, Insolvency Practitioners and, sadly, the Judicial system (both criminal and civil), have all become complicit in enabling banks and other financial service providers to continue with practices which have caused the complete loss of faith and trust in the sector. They too have become victims of greed and, in doing so and like the banking sector, they have lost their integrity. It may be a bitter pill for the Commission to swallow but sadly, corruption is endemic at all levels and across the whole of these sectors. You have a huge mountain to climb and very little time in which to achieve the goals you have set. We hope you are steadfast in your aims. To what extent are professional standards in UK banking absent or defective? How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets? 5. In light of the myriad of scandals being exposed across the UK Banking sector, we would ask if the Commission itself considers the Banking sector has any “professional standards”? As part of our own investigation, we have read all the voluntary Codes of Conduct for Banks and the Statutory Principles and Regulations of the regulators. In our experience, the Codes are not adhered to at all and the FSA Principles are repeatedly and deliberately breached with little or no penalty for doing so. There simply are no “professional 191

See, for example, Tarullo, D (2012), “Industry structure and systemic risk regulation” The point had also been set out in an earlier speech. See Tucker, P M W (2012), “Competition, the pressure for returns, and stability”. 193 The Commission redacted part of this submission for reasons of sub-judice. Paul and Nikki Turner requested that this be made clear. 192

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1382 Parliamentary Commission on Banking Standards: Evidence

standards” for the “too big to fail” banks. There is only the banks’ conduct which flies in the face of every professional standard. 6. In our opinion, whatever good intent the FSA may have is automatically crippled by its key remit of “market confidence”. While “consumer protection” and “reduction of financial crime” may suggest the FSA require Firms to adhere to ethical, professional standards, “market confidence” overrides any other consideration and effectively gives bankers free rein to behave however they want to. 7. It is a fact the banking sector is not only “too big to fail” it is also “too big to regulate”. 8. Between them, the part state owned banks (RBS and LBG) employ approximately 250,000 people and have approximately 60 million customers worldwide. Any scandal likely to cause even a minimal percentage of those customers to move to other banks or, worse still, to remove their money from the big banks, is not considered to be “in the public interest”. Anything likely to destabilise any of the big banks is considered to be potentially dangerous to Government and this includes any forceful action by the FSA. “Market confidence” means the FSA or its successor has its hands tied as a regulator but it gives the banks grounds to act without regard to any standards in the way it does business. 9. The Notice explicitly laid out the serious breaches of FSA Principles and of FSMA 2000 by HBOS. And then what happened? No fine was imposed and an FSA officer told us some executives of HBOS may, in the future, be banned from holding positions in the sector. But, as those same people have already walked away from the failed Bank with their substantial earnings and pensions intact, we would question how such a penalty really reflects the enormous damage the Bank has done? 10. Most importantly we would ask why the Regulator would need the Bank’s permission to publish its findings over and above it being provided for in FSMA 2000? It suggests a bank is able to dictate what the regulator can do—a situation we believe we have observed happening repeatedly. 11. To the general public, the situation between the FSA and the banks has long been seen as a case of the tail wagging the dog. It is the job of the FSA to make sure professional standards are upheld but, in our experience, the “revolving door” scenario between banks and their regulator combined with the necessity not to “rock the boat” because of “market confidence”, has led to the untenable situation we now have. 12. And this “revolving door” situation is, we suggest, another way in which banks manipulate regulation and authority. One example is a Director of Lloyds Banking Group who was simultaneously the Chairman of an influential media Group which owns financial publications and the Deputy Chairman of the FRC. He was also, for a short time, the Chairman of UKFI. Are these not a “conflict of interest”? 13. We ask how this “many hats” scenario, which has a very small number of the same people in key positions, can be allowed to continue? Or how this will raise standards? A lot of these people were in these senior positions running up to the so called “Credit Crunch”. Changing titles does not change attitudes. We have all noted standards in banking have not improved. It seems those involved have only worked harder to conceal what has happened in the misguided belief it protects “market confidence”. 14. We do not know how this compares to other markets. We do believe it is logical to compare banking to other “professions” because the real comparison and the real problem is between “Corporate” behaviour and “non Corporate” behaviour. Across the board and with few exceptions, professional standards have declined as “globalism”, the “sales culture”—which is entirely focused on “profit”—and consequently greed, has replaced any consideration for ethics, professionalism and, sadly, even society. 15. A worrying aspect of the immoral culture pervading professional standards in banking and business, is the control of business, especially the thousands of SMEs who are its backbone, has been handed to the banks on a plate in the same way feudal barons were handed land, title and workers. A mere handful of people (78 we believe) run our 5 biggest banks and dictate policy for millions of ordinary people. These few people do not seem to have contact with the public—nor, it also seems, any desire to communicate. 16. It is common practice for all these agencies not to have contact with the public even when the public have information that would assist the agencies to fulfil their role. UKFI, the BBA and the FSA, are failing to protect the integrity of the financial sector by covering up its failings—wilful blindness? 17. Senior bankers, often referred to as “Masters of the Universe”, perhaps understandably have no concept of how disastrously their decisions, invariably based on a need to “increase profit” above all else, impact on ordinary people, as they live in a parallel universe completely cocooned from everyday hardship. 18. The “hands off” attitude of the regulators, BBA or even the organisation charged with protecting the public’s interest in banks, does nothing at all to challenge underperforming professional standards which have disastrous consequences even for people working in banks. 19. We recently attended a meeting at the FSA as independent witnesses for a friend who is a whistle blower. This person gave the FSA substantial detail of how the culture of “profit above all else” meant that when working as an IFA for a major bank (which in itself is an oxymoron) he was expected to a) deliberately miss sell financial products and b) segment and penalise less wealthy customers b y imposing the highest charges to the “poorest” customers.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1383

20. When he raised these irregularities with his boss and pointed out it is in breach of the FSA Principles, he lost his job. The practice continues and it appears anyone challenging it, risks the same treatment. 21. Therefore, not only is a high street bank deliberately breaching FSA Principles, few people inside the bank can report such wrong doing without losing their livelihood. 22. The only prevailing standard in banking appears to be “money is our God—how we get it, who we get it from and who we damage in the process, doesn’t matter.” What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole? 23. The most damaging consequence to the consumer has been that while, on the one hand, we have all now seen detailed evidence of systemic fraud by the major banks, on the other hand we are all still entirely subject to a system we now know is corrupt and in complete denial. 24. As we know from our experience, any member of the public who identifies crime in the financial sector cannot expect the authorities to take the appropriate action. What we have now is a situation where the banks say black is white and the lack of proper oversight combined with a Government policy that has no appetite to punish financial crime, means black is indeed white. 25. We give the following example of how banking is now detrimental to people at all levels of life: 26. On Tuesday 14 August, we attempted to help a 19 year old family friend with a banking problem. 27. In the first instance, we tried to get through to his local branch. We got through to India and the Philippines but it took over an hour to get through to a local branch. 28. The lad in question works as a builder and gets paid erratically depending on completion of jobs. Some weeks ago, concerned he would miss a DD payment, he asked his branch for a temporary OD of £200.00. The branch manager would not grant it. He did however increase the lad’s banking costs by persuading him he should have a “silver account” instead of a regular account. 29. The DD was returned and he was charged £20.00. The £8.00 for the silver account went through even although there were no funds. The Bank wrote to him saying he would be charged £5.00 per day if he was OD. However, these amounts were not shown on his online statement and consequently he could not see the true amount by which he had actually gone OD. 30. In no time at all, the charge for the silver account caused a £50.00 OD but this would not show on the account for a further month. The Bank wrote again to say he would be charged £10.00 per day for going OD. The lad, who was paying money into his account, was unable to ascertain whether or not he remained OD. Thus our call. 31. When we finally did get through to a Cambridge branch (still not his branch), the person we spoke to explained the lad’s account had been moved to collections because he had gone OD—which is why we had been put through to India. Cambridge branches could not deal with the account. 32. It was explained that, at present, they were charging him £10.00 per day for being OD. They could charge for a maximum of eight days per month + a £5.00 monthly charge. As this doesn’t show on the account until the next month, an account that appeared to be in credit, was hiding a debt of £85.00. 33. A simple calculation would show the Commission that, going OD by £30.00 with this major high street bank could, over the course of a year, become a debt of £1,050.00 + any interest also accrued. 34. The Commission might think the lad should simply not have gone OD. But, in this instance, the lad had taken the responsible action of talking to his bank and asking for a £200.00 OD facility to mitigate the erratic nature of getting paid in the building trade. The requested facility would have incurred minimum charges and kept his account within its agreed facility. 35. The OD facility was not granted and this entitled the Bank to charge the customer up to £85.00 per month. Multiply this amount by a few thousand customers and what you have is a license to print money. The bank want to have these circumstances as they make far more money alleging imprudence than allowing the customer a minimal OD to allow for the vagaries of getting paid on time, exacerbated in these times of “austerity” caused by the banks in the first place. 36. In a lot of cases, it is the knock effect of the way banks are in so much control now of peoples’ money, which has caused and continues to cause havoc and which is the root cause of the problem. 37. The effect a lack of professional standards by banks has had on SMEs has been even more catastrophic than for personal accounts. Without considering the effect of frauds like the one originating at HBOS Reading, it is a fact many banks impose third party consultants on SMEs with crippling effect and the banks claim this is best (and normal) practice. 38. In recent years, banks’ “sales culture” has made life untenable for business owners. Much is made of the banks lack of lending in the press but as big a problem is the conduct of banks where they do lend to

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1384 Parliamentary Commission on Banking Standards: Evidence

businesses. Over and above the now well publicised Interest Rates Swaps scandal and the Libor rigging, banks frequently impose additional, unnecessary and inflated charges on SMEs. 39. These exorbitant charges combined with penalty interest rates if an SME exceeds its limit, is effectively causing a “sub prime” for SMEs. We would draw the Committees attention to the BBC article on this link http://www.bbc.co.uk/news/business-16002022 entitled “UK banks charging as much as 800,000% on overdrafts”. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector? 40. There is no trust left. Most people now expect bad treatment from banks and most people get it. This is not because everyone working in a bank intends to treat customers badly but most people working in banks are not in a position to challenge the policies they must follow, because of losing their jobs. 41. A bigger but related problem is the distrust people now have for authority and Government. Repeatedly we are being told there is no Law to prosecute bankers when the Law is very clear on matters of fraud, theft, corruption and money laundering. Deliberate miss selling is, after all, a fraudulent activity. 42. These crimes are exposed on a daily basis and we repeatedly see shareholders penalised for banking crimes with huge fines to the banks. We never see any individual held to account for the crimes shareholders and the public pay for. 43. A frequent debate amongst the many people we know who are fighting for change and reform in the banking world is: Are bankers exempt from the Law because of Government policy? 44. This article on Ian Fraser’s blog site by Rowan Boswell Davis, suggests such an agreement was put in place in the 1980’s http://www.ianfraser.org/has-the-uk-rediscovered-its-long-lost-appetite-for- prosecutingwhite-collar-crime/ 45. It states: After the “Blue Arrow” case, a friend of mine in the SFO told me that the message had come down from on high that there would never again be any similar kind of prosecution of any City institution or its senior executives. The reason the “Blue Arrow” affair proved so terrifying for the managerial classes and senior financiers was that it demonstrated that ordinary juries could understand the ramifications of complex fraud cases, and that they could convict. 46. Evidence we have seen regarding the exclusion of bankers from specific (and recent) criminal actions, suggests there still is an agreement to keep bankers and influential executives exempt from prosecution. 47. Similarly, we repeatedly see major banks breach FSMA 2000 and the FSA Principles For Business. With the exception of small IFAs, we rarely see any individual brought to book. And where they are, it is usually just a case of stopping them from holding authorised positions. 48. In our opinion, the FSA and various Committees tasked with looking at irregularities in bankers conduct, have little idea how badly this conduct and the apparent inability of any authority to curtail it, adversely effects not only most of the population but also the overall morale of the Country. 49. There is no doubt banks and the financial sector have not simply caused austerity for the masses, they have authored a situation most usuall y associated with dictatorships. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (a) the following general themes: The culture of banking, including the incentivisation of risk-taking 50. It is only through talking to bankers, we realised how badly incentivisation has promoted a risk culture. 51. An IFA we have spoken with on many occasions, gave us the following example: 52. An elderly person sells their property (which they may have bought years earlier) and moves into a nursing home. The sale results in a large deposit to their bank account. That person’s bank manager will immediately inform the bank’s IFA of the increase in funds. Again we point out the incongruity of an Independent Financial Advisor working for a bank. 53. The IFA will contact the client and suggest various ways the money should be invested. The IFA can only offer the bank’s own products to the client unless the client is in the top wealth bracket. 54. Interestingly, the less money the client has, the higher fees and percentage they will pay for this service. 55. Also, the less money they have, the fewer investment options they will be offered and there is a structure of what a bank will offer its clients based on what wealth bracket the client falls under. 56. If the client agrees to the investment products, a specialist IFA will then visit. 57. Additionally, the client will be offered what will be called a specialist bank account (complete with elegant packaging) on the grounds they are entitled to this because of their new status.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1385

58. These specialist accounts attract charges for all sorts of things the elderly client does not necessarily need, like mobile phone insurance, travel insurance, breakdown insurance and many other things. 59. Because the riskier products produce higher fees and returns for the bank, often elderly clients who have no need to risk money for greater returns and simply want to ensure their money is safe, end up with financial products that can equally result in them losing substantial amounts of their savings. 60. Many bank staff and IFAs are aware of this situation. But everyone, including; the original bank manager reporting the client’s increase in funds; that manager’s boss; all the IFAs involved; and the new manager of the specialist account, will all get a bonus based on this elderly person’s deposit and investments. The client trusts the bank but the bank usurps that trust and covers the action by denying any liability in the T&C, on the basis the client should not solely rely upon their “advice”. 61. By breaking the chain, the IFA jeopardises not only their own bonus but those of all their colleagues. 62. While the debate about top bankers’ bonuses continues on a regular basis, we had never considered, prior to the advice from our friend, how bonuses run right through the banking sector and are used to ensure compliance with policy—even where that policy is seriously flawed. 63. The IFA mentioned above has reported his serious allegations of deliberate mistreatment of customers, to the FSA and we attended a meeting at the FSA as independent witnesses for him. 64. At that meeting the FSA confirmed that, even if they do take action on his allegations, he will not be informed because Section 348 of FSMA prohibits them from disclosing information. 65. We hope the Commission finds that statement as worrying as we and others do. The impact of globalisation on standards and culture 66. Perhaps the only thing that has done more damage to societies globally than the financial sector, is globalisation itself. It has undoubtedly damaged the motivation of the many who aspire to creating a fair society, because the many have seen the exploitation of their good intentions, for the profit of the few. 67. Banks and multi national corporations have, together, heavily impacted standards and culture because they are global and their aims are at odds with that of societies worldwide. 68. We all consider ourselves as individuals no matter what part of the globe we live in. Yet globalisation takes little if any account of the individual apart from rewarding their work in global institutions. The practices utilised in one part of the globe may not be suitable for use in another but there seems little account taken of these fundamental differences despite the advertising suggesting the contrary. When decisions are made for reasons that are out with the individual’s scope and requirements, they would probably have a negative impact but this will not be a consideration in a global sense. 69. Given the banks heavy involvement with global business and the rewards it receives from that involvement, it has had a negative impact on both standards and culture as it is perceived the individual is of less consequence and worth than a global business and makes less profit for the bank. 70. For years England was referred to as “a nation of shop keepers”. Looking at our high streets now, we are clearly a nation of shop keepers without shops. 71. It is obvious a High Street butcher, that may have been in existence for years but suddenly it has three supermarkets with free parking within a two mile radius, will struggle to compete with supermarket prices and will probably be forced out of business. 72. It is also obvious banks prefer to support and deal with big business rather than 10 high street butchers because the margins for dealing with big business are better and, by comparison, involve less work than the high street butchers. Big, multi national business is therefore more profitable to the banks. 73. In our business (we were in the music business and not the bank investigation business) we have seen the demise of the independent record shop as major supermarkets and global chains were increasingly given preferential treatment and controlled “dealer prices” (PPD). A “free market”? 74. Apply this to food, clothing, music, cups, saucers and even kitchen sinks, we would ask how anyone making policy, including the banks, could ever believe our High Streets could survive. 75. The knock on effect is supermarkets and global chains competing against each other are permanently on the look out for the cheapest product—regardless of where it comes from or if it is “ethically” produced. 76. Therefore, British farmers are receiving less in revenue for milk than it costs to produce it; British fashion, while possibly still designed here, is manufactured in China or India; British industry (what’s left of it) struggles to compete in global markets and is relatively ignored in our own market, etc, etc. 77. Additionally, the morale of the people working for multi billion pound companies where they are simply another tiny cog in an enormous wheel, is reflected in the level of customer service we now expect and therefore get in the UK.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1386 Parliamentary Commission on Banking Standards: Evidence

78. You do not need to be brain of Britain to realise bright people, whether or not they have been to University, will not be happy or inspired stacking shelves in a supermarket or stocking rails in a shop. 79. None of this is a consideration for banks as their sights are set in the short term and solely on their balance sheet. The culture is for profit today and make it wherever you can in the world. 80. The work conditions in many of our well known global chains are not good. Relatively inexperienced and ill prepared people are given key positions on the shop floor—they do not know how to treat or encourage their staff—they are paid minimum wages—their breaks are minimal and short. Often the regime they work under is a culture of fear, a culture where the bully thrives—very much like shop floor level of the banks. Very little consideration is given to individual circumstance, so a junior employee arriving ten minutes late for work because a bus was cancelled, is likely to be chastised, financially penalized and even expected to stay late and miss their transport home. 81. Meanwhile they too read in the papers how people who have been responsible for destroying our economy, continue to be paid millions of pounds. Or how traders who have lost millions of pounds of other people’s money, can spend thousands of pounds on “a bottle of Bolly”. They too want some of that. Global regulatory arbitrage 82. As we have no direct experience, we cannot comment on global regulatory arbitrage. The impact of financial innovation on standards and culture 83. Innovation implies we have moved forward. While undoubtedly the advent of online banking and debit cards is something everyone now accepts as “the norm” but is a fairly recent innovation, the majority of innovations appear to have been much less positive for the consumer. 84. We would ask the Committee to read the following article which demonstrates how “interest rate swaps” have ruined the life of one small business owner. http://in.reuters.com/article/2012/08/22/uk- banks-insuranceidINDEE87L06P20120822 85. We suggest Mr Colin Jones experience can be multiplied many thousands of times with regard to IRSA and, combined with LIBOR rigging (so that first the banks rig the rates and then insist customers buy costly insurance the banks know will cause them loss), there can be no doubt banks intended to use such products to steal thousands upon thousands of pounds from their customers. 86. The many and varied financial products consumers have been encouraged to buy to their detriment have been catastrophic whether on a personal level with PPI, on a business level with IRSA or on a national level with the continual rolling over of toxic debt that was packaged up as triple A rated product. 87. Any culture where bankers or their lawyers deliberately and repeatedly invent toxic or flawed products they know will damage the consumer while increasing bank profits, is inherently immoral. 88. Even when an innovation is designed and promoted to aid the consumer, it is usurped to make money. 89. The promotion of the Direct Debit system to help the consumer is probably the best example given it is now common place that consumers pay a penalty if they don’t pay their bills using Direct Debit and the banks will usually not accept an instruction from the account holder to stop an amount being debited. 90. If this is the innovation of the banking industry, we would be better walking backwards. The impact of technological developments on standards and culture 91. While no one would sensibly deny the advantages of technological development or the fact the British have always been at the forefront of it (albeit it seems it is now developed oversees and benefits other economies), we cannot help but wonder if technology is now being used by banks as an excuse for inefficiency and negligence or even something more sinister, like a cash crisis or worse? 92. Like many people, we have been against the demise of the cheque book and the check guarantee card. 93. As seen recently when technical problems denied many RBS customers access to funds for a prolonged period, we are asked to rely on well functioning technology in banking when it isn’t always in place. 94. A darker suggestion (but not entirely unreasonable) is that banks experiencing cash flow difficulties can, at any time, close their ATM machines or their clients’ ability to use debit cards, blaming technology. 95. Even major power cuts can now have a seriously damaging consequence for consumers as credit and debit card terminals become impotent. 96. We believe Government should ensure an alternative scenario exists for the consumer where technology in the banking sector fails. The easiest way to ensure this safety valve is in place, is to simply re- introduce the cheque book and guarantee card.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1387

97. Therefore we would say that while technology in general is good, an over reliance on it with no plausible back up, is dangerous. An over reliance on its veracity, is also very dangerous as technology almost always relies on human input. This can lead to either innocent mistakes being made which cause the customers problems or, more worryingly, deliberate and fraudulent entries to cover up criminality. 98. While banks will say this costs them money, we would say it is time banks took a cut in profits (and bankers took a cut in remuneration), if it will benefit society overall. Corporate structure, including the relationship between retail and investment banking 99. We cannot comment on the relationship between retail and investment banking except to say that, like many ordinary people watching the recent banking catastrophes, the combination of the two banking sectors seems akin to sending a compulsive gambler to Las Vegas with someone else’s savings. The level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects 100. We have insufficient knowledge of the competition in both retail and wholesale markets anywhere. Other themes not included above 101. We have genuine concerns regarding the limited remedy or redress available to SMEs and individuals who fall victim to banking irregularities or malpractice caused by defective professional standards. 102. We ask the Committee to consider the appalling situation whereby a business, that may have been damaged to the tune of millions, only has two remedies—both invariably futile. 103. An SME can take an action in the Civil Courts—and we can assure the Committee this route is invariably disastrous. Banks, some of which only exist thanks to tax payers’ money, will spend huge amounts in legal fees to fight such cases. 104. The Civil Courts are a) not affordable to SMEs and b) not a level playing field. 105. While there are law firms who will work on CFAs or even Pro Bono, experience has shown that, with the best will in the world, you get what you pay for with the legal profession. 106. A CFA client invariably must play second fiddle to paying clients and it is a fact most of the top law firms form part of the banks’ panels of law firms. 107. In our view the legal profession (like the banking profession) is long overdue for reform. We can assure the Commission, what happened in the Reading fraud could not have occurred without the complicity of lawyers. However, this is a matter we cannot expand upon until Operation Hornet is finished. 108. Suffice it to say, the Civil Courts are rarely an option for SMEs to challenge major financial institutions and we have repeatedly seen good cases thwarted by top lawyers and barristers using legal trickery and the wealth of the banks, to manipulate Justice. The Internal Complaints procedures are a joke. 109. The only alternative for an SME is the Financial Ombudsman Service and, with no disrespect to individual officers of the FOS, the term “Chocolate teapot” is one frequently used by both individuals and company officers in relation to the FOS. 110. The process is long and, even if the Ombudsman finds for an SME, the maximum award is £150,000. 111. And even in such a clear cut case, when we first reported our matter to the FOS we were asked for relatively little evidence or explanation while the Bank was asked for a full defence and the FOS was even unwilling to consider all our allegations. We still have not got a definitive response and, until the involvement of the police and the FSA, we feel the Ombudsman had a definite bias towards the Bank. 112. The inability of SMEs to challenge banks successfully or at all is a situation much exploited by the banks. And their knowledge of this inequitable situation promotes the unhealthy contempt with which banks continue to treat their business customers. 113. Contrary to the FSA Principles of Business, bank employees right to the top of the executive chain, feel able to deal with serious complaint or irregularity by adopting the 3D scenario. “Delay, deny, dilute”. 114. Over the last five years and given the seriousness of the HBOS Reading situation, we have corresponded with the most senior executives of HBOS, Bank of Scotland and Lloyds Banking Group. This includes both past and present CEO’s and Chairmen of all 3 Banks. 115. They have all, without fail, ultimately resorted to responses saying “we do not intend to correspond further”. The last letter informing us of this position was on 26 June 2012, from Lloyds Banking Group. We have met with victims of other bank scandals who have been treated similarly. 116. While we do not ask the Commission to consider our particular circumstances, we do ask: how can a situation exist in a democracy whereby victims of financial crime have little or no redress because, to get

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1388 Parliamentary Commission on Banking Standards: Evidence

Justice against such wealthy opponents, is unaffordable and; how can it be permissible for banks to exploit this further by blatantly breaching FSA Principles and their own Codes of Conduct which clearly state they must treat people or businesses, both fairly and reasonably? 117. This contempt combined with the disappointing lack of appetite from any authority (except TVP) to apply the Law of the land to financial institutions or their employees, is a major contributory reason why no one should expect a change in policy or conduct from the banking industry, in the near future. 118. In our opinion, banks have been given such overwhelming powers, they not only control the economy but have also taken control of the judicial system. If this power is not given back to the democratic process, we believe the banks will continue to cripple our society until the situation is irreversible. Weaknesses in the following somewhat more specific areas: The role of shareholders, and particularly institutional shareholders 119. We believe the role of the institutional shareholder has been a significant, contributory factor in allowing the professional standards of banks to decline and almost disappear. They have a vested interest in not rocking the boat. It is even the case some major global investors often practice business with the same lack of adherence to social and ethical rules, as banks. It is only recently that institutional shareholders have appeared to take a position against the boards of banks whereas individual shareholders have always seen their role as holding the board to account on matters including standards. Creditor discipline and incentives 120. Given the amount of “toxic assets” revealed by the 2008 crash and the inability for professionals to be able to understand the true “creditor” involved in those assets because of the number of times the same asset would have appeared to underpin the multiple risks involved, it would take years and a voluminous tome to provide a constructive opinion. 121. It is the new business models the banks have freely used since at least the late 90’s which are fundamentally flawed and far too complicated for even the banks’ auditors to comprehend. Corporate governance, including; the role of non-executive directors 122. Over the past five years we have come to ask if such a thing as corporate governance in some banks even exists? One would assume corporate governance requires the board of the banks to ensure compliance with the Law, the Regulator, the FSA Principles and the various codes of practice. 123. Overall in the banking sector, the working model of boards has been seen to fail dismally. Just recently Bob Diamond has confirmed just how negligent or “uninformed” the Board of Barclays was with regard to the very serious issue of Libor rigging. And that is just one bank that has been exposed so far. 124. Amongst the many questions posed about the credit crunch and the demise of various banks, some have asked if non executives in banks have done effective jobs and concluded they have not. Lord Stevenson made the point on many occasions in the past, that you cannot expect the best performance from nonexecutives unless they are well remunerated. 125. These days most bank non exec’s are paid (for a few days work a month) more than most people make in a few years. For example, we randomly looked at the 2011 remuneration for the non executives at Barclays Bank and the lowest paid received £98,000. 126. When making his point about suitable remuneration, we believe Lord Stevenson overlooked the obvious problem—the fact many non executives are on multiple boards. 127. Many are also simultaneously executive directors or chairman of other companies while acting as non executives of banks. 128. Therefore we would ask the Commission to consider whether the obvious lack of attention by non executives of banks running up to the credit crunch was, as Lord Stevenson has implied, because poor remuneration leads to a lack of good candidates for the job or is it because too many non executives are on so many other boards, they simply do not have the time to do any one job effectively? 129. We would ask; given how important the banking system is to the economic stability of the Country, is it reasonable that non executives of banks are sometimes able to dedicate a very limited amount of time because they have so many other commitments? 130. Also, is it reasonable that some executive directors of banks are simultaneously holding multiple directorships? For example, a former CEO of a major bank has held 147 directorships from 2000. Another former CEO in 2006 held at least 11 including while also holding a position at the FSA. 131. We suggest that, as long as banks choose their executive and non executive directors from an elite circle of individuals who, between them, hold hundreds of well paid executive jobs, the likelihood of promoting good corporate governance in banks for the well being of the economy, is unlikely.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1389

The compliance function 132. As stated above, we believe the banks have simply become too big for meaningful oversight and regulation and recent events clearly identify the compliance function in banks has just had lip service paid to it because it is detrimental to their business models and the pursuit of profit at any cost. 133. We believe the reason for this lack of compliance is simple—if you get caught, you pay a fine and the fine is unlikely to exceed the amount of profit made by not complying in the first instance. 134. The evidence of this has never been more obvious or available than recently, when most major banks in the UK have been accused of potentially criminal conduct and serious regulatory breaches. 135. For breaching their compliance functions, some banks have been fined millions of pounds which, realistically, is only a penalty on the banks’ shareholders. 136. In a few cases, senior executives have resigned from their posts but it is hard for the general public, many of whom have lost their jobs, savings or even homes as a result of the credit crunch and banking failures, to understand how anyone resigning with substantial wealth and a six figure pension gained from presiding over these catastrophes, is actually being penalised? 137. The Regulator and Government ministers have repeatedly said there is no Law under which bankers can be prosecuted and this is why no individuals have received a custodial sentence for their conduct. 138. We find this hard to accept as the Law is very clear on matters of fraud, theft, money laundering and corruption. Until the Law is applied to the financial sector, we think it highly likely our banks will remain rife with corruption aimed at “making a quick buck”, ignoring compliance functions. 139. Why would banks stop abusing the Law if they are told the Law does not apply to them? Why would they be concerned about the lack of compliance when, as in the case of Bank of Scotland, the Regulator has identified serious breaches of FSMA 2000 but has little, if any, ability to penalise the Bank or the individuals responsible for the breaches other than publishing a report which, in the first instance, required the permission of the Bank before it could be released? 140. This is very clearly an aspect of oversight that does not work and cannot work as it is presently open to maximum abuse and minimum, if any, consequences. Internal audit and controls 141. In the last two years, it would appear the FSA has become much less cavalier in its acceptance of the banks’ submissions. However, realistically and unless the FSA is able to examine every internal bank audit with a fine tooth comb, there is no conclusive way for the Regulator to ensure the “Control issues” reported are any more than well worded documents masking the true events occurring inside the banks. 142. We ask how, across the board, internal audits and controls (and the resultant control issues reported to the Regulator) have failed to alert the FSA to any of the scandals that have recently been exposed, as many of these date back years and should, had the correct information been made available to the Regulator, been identified earlier? 143. Given internal audits should be reflected in the annual audit, we believe the sector has been presenting creative accountancy to the “enth” degree. Sadly the public are now paying the price for this creativity. 144. We also believe banks have traded heavily on the historical reputation, wherein the bank manager was seen as a pillar of society, to impart any information they choose in the belief it will go unchallenged. We assume this belief prompted Government to employ bankers on a regular basis and why the CEO of the “basket case” bank, was invited to become deputy Chairman of the FSA and the “Mortgage Tsar”. 145. Our experience shows that, in one major bank at least, the misinformation disseminated from internal audits and controls far exceeds any correct information. Otherwise, how could the loss of billions of pounds from HBOS have gone undetected for so long? 146. This kind of “creative accounting” inside a bank does, we suggest, continue to mislead both shareholders and external auditors as to the true state of the bank balance sheets and it lays the ground for yet another banking disaster when the true figures will probably and yet again, affect the public purse. Remuneration incentives at all levels 147. As mentioned above, we had no idea the remuneration package which includes the bonuses for all bank staff, worked as a form of pyramid system. 148. The entire Country knows and objects to the sometimes ludicrous bonuses senior bankers are given while their banks make continual losses. We believe few know this bonus scheme works right through the banking sector and is a way of suppressing any objection to unethical behaviour. 149. As people from the music industry, we note bankers sometimes complain that musicians often make phenomenal amounts of money which no one appears to object to. Similarly footballers.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1390 Parliamentary Commission on Banking Standards: Evidence

150. There is a definite difference of opinion here between the two authors of this document with regard to the footballers, as one of the authors cannot see how kicking a ball into a net, necessitates millions of pounds in remuneration. 151. However, the dissenter can see very well the difference between football and banking. There is no doubt some footballers are talented and they generate huge amounts of money because fans watch their talent. 152. Similarly, a popular musician or singer (especially those who write their own music) generate huge revenues for their label and even for the economy. We don’t know if the calculation has ever been done into how much of the income of the Beatles, the Stones or Elton John, has generated in revenue for the Country. But one thing is for sure, that revenue is generated from the talent of these individuals and therefore it is only right the lion’s share of that income should go to them. 153. As far as we know, Bankers don’t write songs or paint pictures; they’re not sportsmen; they’re not brilliant academics or scientists who discover life saving solutions. They deal entirely with other people’s money and it would be hard for anyone to say their ability to manage money has shown talent, forethought or anything other than a talent to create money to feather their own nests with the profits they have created and mismanaged from the talent and savings of others. 154. The fact the people in charge of the banking industry who have failed with vigour to protect and grow the assets of their customers and therefore the economy of the Country, continue to demand and get excessive reward for failure and the fact successive Governments continue to allow this, is an anathema that will surely go down in history. Recruitment and retention 155. It would be wrong for us to comment on this aspect as we do not work in the banking sector. We again urge the Commission to look at the “revolving door” scenario and ask you to consider whether this is at all beneficial for the most important sector in the Country with regard to the stability and growth of the UK economy. Should the sector be allowed to continue to act as “an old boys club”? 156. Many people might say the City is akin to “The Green Mile” whereby what happens in the City, stays in the City. This lack of transparency could not, we suggest, be maintained without the careful recruitment selection of like minded people who are all happy to play the game for their own personal gain. 157. In our opinion it is time the banks opened their doors to “new blood”, definitely at non executive level. Arrangements for whistle-blowing 158. Over the last few years we have been in regular contact with Paul Moore, the well known HBOS whistleblower and many other whistleblowers. In the whistle blowing community, we are seen as “external” whistleblowers. 159. Recently we have become members of a new organisation dedicated to the support of whistleblowers and, talking to many of them who are part of that group, we can confirm there are currently no effective strategies in place to protect whistleblowers from the extreme consequences that result when individuals attempt to expose wrong doing across any corporate or public sector. It is called “Whistleblowers UK”. 160. Paul Moore’s evidence is widely published and he has also given it to the Treasury Select Committee. We believe Mr Moore has now been exonerated but, remarkably, no one has been seriously challenged or penalised for ignoring his concerns in 2004–05. Neither has any official body looked at the reasons why whistle blowing remains to be seen as a negative action rather than a positive remedy to corruption. We are now in 2012 and little has changed for whistleblowers. They face the same isolation, discrimination and trauma Mr Moore faced in 2005. 161. In the banking industry, blowing the whistle is often seen as an attack on colleagues who may face loss of remuneration if one of their team exposes wrong doing. Again this is down to the fear based, pyramid bonus scheme. And whatever the official policy is on reporting wrongdoing, internal whistleblowers in banks would say the unofficial policy was and is, “blow the whistle at your own risk”. 162. Clearly this situation is wrong. We conclude there should be a dedicated agency charged with protecting legitimate whistleblowers, which has the powers to both protect and investigate their allegations or direct them to the relevant authority for investigation. Where appropriate and where allegations are proven, whistleblowers should be remunerated for their public service. 163. Some of the most effective whistle blowing we have seen is in the health sector, where individuals have witnessed serious mistreatment of patients and the elderly. It should be the same for the banking sector. No one knows what is going on in a bank better than the people who work there and reports of malpractice should be welcomed and not punished. If legitimate challenge continues to meet with such alarming condemnation, we can only expect such misconduct to continue unabated.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1391

164. Many bankers and ex bankers we have spoken to have confirmed they were well aware of the miss selling of PPI for years. Many of them attempted to report it. Some of them had to make the choice of losing their job or turning a blind eye. 165. We hope the Commission will consider support for legitimate whistleblowers and even consider a similar model as the one used in the US, which appears to be an effective way of insuring irregularities and malpractice in banking are dealt with and not buried. External audit and accounting standards 166. Never does the phrase “you scratch my back, I’ll scratch yours” comes into play more meaningfully than in the unwholesome relationship between banks and their external auditors. We would say the same applies to the very unhealthy relationship between banks and administrators, receivers and liquidators. 167. The cosy relationship between the Big 4 auditors and the Big 4 banks is, without any doubt, a risk to the economy of this Country. Never was this better evidenced than at the hearing of the Economic Affairs Committee on 23 November 2010 of senior executives of PwC, KPMG, Deloitte and Ernst & Young. 168. We ask the Commission to consider the transcript of that hearing from Q263 to Q267 inclusive, wherein the auditors confirmed the big banks’ accounts were prepared on a “going concern” basis based on the auditors’ view the banks would be bailed out. 169. In reply to Lord Lawson of Blaby, Mr Powell of Deloitte said (in Q263, final paragraph): (a) “All four of the people here had detailed discussions, instigated by the Big Four, with Lord Myners because of the circumstances we were in. It was recognised that the banks would only be going concerns if there was support forthcoming. The management of the banks, first of all, who make the initial decision as to whether they conclude they are still a going concern, had to take into account all circumstances, including the likely availability of support, in concluding that they were a going concern. We had to take into account all the available evidence in reaching that conclusion. I think it was a proper and appropriate act from the four firms to seek to understand the likelihood of support being forthcoming and I can only say that had we concluded—and I assume had management of the banks concluded—that there was not going to be support, then a different audit opinion would have been given.” 170. Not surprisingly, Lord Lawson of Blaby responded to say (In Q264): (a) “I find that absolutely astonishing..... Absolutely astonishing. It seems to me that you’re saying that you noticed that they were on very thin ice but you were completely relaxed about it because you knew that there would be support; in other words the taxpayer would support them, so there was no problem. That’s what it seems to me you just said.” 171. What is surprising is that nothing has changed. The Big Four Banks and their “enablers”, the Big Four Auditors, are able to continue with “business as usual.” It is unbelievable to us and others that no further action was taken and no public inquiry into the conduct of the auditors in relation to the credit crunch and the need for taxpayer bailouts, ensued after that hearing of 23 November 2011. 172. An additional burden on society by this cartel approach to auditing and banking, is the appalling insistence by the banks that, at every possible opportunity, their accountancy “chums” must also be imposed on businesses as consultants. 173. The astronomical fees charged by these firms—where the client (business) has absolutely no option but to accept a) their appointment and b) the cost—is no less than an example of legalised “Mafia” conduct. 174. We give the example of the shameful demise of Farepak, where every attempt the Directors of EHR made to find a solvent solution and save the Christmas money of 133,000 low income people, caused HBOS and other third parties to involve the Big 4 accountancy firms. The fees for this (charged to EHR) amounted to over £2 million and we would say, this merry go round of banks and their external audit partners, whether for accountancy, consultancy or for administration/liquidation purposes, is a license to print money and destroy business. We mention Farepak in more detail below. The regulatory and supervisory approach, culture and accountability 175. We have attended the FSA on many occasions. It is housed in a large building and employs thousands. 176. Like many others and with no disrespect to those working for it, we ask—what is the point? 177. In our opinion, the supervisory division is absolutely not able to exercise any control over the banks and instead, takes the role of the banks’ puppets. 178. The enforcement side of the FSA, which has enormous powers on the one hand, is handcuffed by FSMA 2000 which forces the FSA to proceed always as a slow, lumbering giant. 179. We do not have any issue with any individual at the FSA and, if anything, we were concerned by the very quick exit of Hector Sants who, we believe, had fully come to terms with the level of immorality and

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1392 Parliamentary Commission on Banking Standards: Evidence

criminality in the banking sector. However, we are not at all optimistic the successor of the FSA will fare any better than the present organisation. 180. We believe the problem lies in FSMA 2000 which enables banks to manipulate both the regulator and the Law. Until FSMA is challenged, we ask again, what is the point of the FSA which, it cannot be denied, failed to identify any of the major irregularities in our banking system. 181. In our opinion, the probable appointment of Mr Griffith-Jones as head of the new regulator, is another blatant example of the “revolving door” scenario and is a perfect case of putting a fox in charge of looking after the chickens. The corporate legal framework and general criminal law 182. We have already stated above we are concerned there may be a Government directive that exempts bankers from the criminal justice system. And this is evidenced by the legal advice the banks adhere to. 183. In our opinion this approach stems from a genuine concern in the banks, of contagion. Recently we have seen evidence suggesting bankers guilty of criminality have been excluded from prosecution. Aside from the very worrying fact this has been able to happen, is the more worrying issue of why? 184. We note Mr Bob Diamond in the LIBOR rigging case against Barclays, like Mr Murdoch in the News International case, opted for the negligence scenario. He did not know what was going on in his own Bank. While this has resulted in Mr Diamond resigning and may have damaged his reputation, he cannot be criminally prosecuted for “negligence”. Had he taken any other approach, he may well have been prosecuted and found guilty of either being complicit in a crime or perverting the course of justice. 185. It is this last proposition we believe has resulted in serious manipulation of the justice system and is a proposition that has bank legal teams working day and night to maintain a very unhealthy scenario. For example; in a case where a senior manager lends billions of pounds to specific clients when his actual discretion to lend without higher authorisation, is limited to, say, £2 million, it is reasonable to suppose his superiors have sanctioned the larger loans and will know their purpose. If it later transpires there has been irregularities or criminality either in making the loans or the use of the money loaned (eg money laundering), is it reasonable to pretend senior management were not complicit? 186. If senior management insist they did not know what was happening but are then informed in detail of criminality but take no action except to conceal the matter, is it not the case they are guilty of perverting the course of justice? 187. We suggest, wherever criminality occurs in a bank or is perpetrated by its employees but reveals systemic failures of governance, is when (and by any means whatsoever) criminal prosecution is avoided. At all costs, senior management of our big banks must not be seen to have endorsed any potentially scandalous situation, as the result of such a scenario could be detrimental to “market confidence” and consequently, detrimental to the economy. 188. We have not been able to get any answers from any official body as to how a banker, “intimately involved” in a serious crime, was excluded from the criminal prosecution. The question is posed on an almost daily basis across the media or the social media networks of “why are no bankers going to jail?” We seriously believe the answer is contagion but that argument is wearing very thin and holds no water. 189. As a consequence of the above, we now have a situation whereby banks will spend millions of pounds to fight legal battles rather than admit and address the criminality that has occurred in their business. Other areas not included above 190. It seems to us, not only are “Professional Standards” so poor as to be non existent at the moment, any person opening a bank account, whether personally of for a business, is seriously at risk. The public have to rely on the FSA Principles for Business, the Banking Code of Conduct, the banks’ own Codes of Conduct, because these are the only criteria we have to judge the conduct we should expect from banks. 191. As things stand, we rely on these statements while the banking sector overall, simply ignores them. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally? 192. In our opinion, it is still not too late to remedy the weaknesses that are so evident in the banking sector. 193. What we need is for the authorities to stop pussy footing around bankers and do their jobs. 194. The handcuffs must be taken off the FSA or its successor and we suggest the only way to do so, is a complete revision of FSMA 2000 which currently and despite its intended use, is being used to protect the banks from the public and not the public from the banks.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1393

195. The banks themselves must be made to take serious and effective action where they identify irregularities. For example, even now and in the face of an FSA Section 168 Investigation and a two year + police investigation, LBG, like HBOS before them, have taken no action against the people who caused the Bank to lose billions of pounds. Nor has the FSA. 196. Unless we want to continue with our present, unwholesome scenario, we believe the “cartel” situation where a handful of banks use shareholder and public money to employ a handful of accountancy firms and a handful of legal firms, have complete control over the financial status of the whole of the UK. 197. If banks are “too big to fail” then surely they must be smaller and new banks must be more readily introduced to promote healthy competition? 198. If Globalisation is becoming a danger to society and while big banks are only interested in global, corporate companies which generate big profits and therefore big bonuses, it would make sense for the Government to stop pouring millions of pounds into our badly run banking institutions and create a bank specifically to fund SMEs. 199. In January 2009, Mr Cameron told Jeff Randall Live on Sky News: “I think that we need to look at the behaviour of banks and bankers and, where people have behaved inappropriately, that needs to be identified and if anyone has behaved criminally, in my view, there is a role for the criminal law and I don’t understand why in this country the regulatory authorities seem to be doing so little to investigate it, whereas in America they’re doing quite a lot.” 200. Such brave words seem to have evaporated when the Coalition got into power and we have watched as additional billions have been channelled into banks to supposedly help the economy when, in fact, it has simply increased the banks’ balance sheets but caused yet more austerity for the country. We are not at all revolutionary by nature but everything we have experienced over the last nine years convinces us the banking sector has caused an “unjust society”. 201. We do not believe the Government, the authorities or the Commission, have any idea how angry the British people are about the demise of our economy at the hands of a few bankers. 202. We believe now is the time our Government and our judicial system “does what it says on the tin” and puts Justice and the protection of society before the interests of a small elite who have been allowed to mug this country for at least the last 10 years. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice 203. In a word, NO. We have seen endless reviews, Commissions and Committees examining what went wrong leading up to the 2008 Credit Crunch. None of them has provided any effective, remedial action. 204. Without doubt, the only thing that will restore public faith in the banking sector or in our Government, is for the Government and the authorities to make it absolutely clear: We have the Law in this Country. Everyone is subject to it and that does includes bankers. 205. We do not agree with the witch hunt, “hang bankers from lamp posts” strategy but we believe 100% some bankers have committed some heinous crimes in recent years and have got off Scot free. In some cases they have walked away with millions of pounds of shareholder and taxpayers’ money when they should have gone to jail. 206. The arrogant “let them eat cake” approach banks seem to have toward the taxpayers who bailed them out is, we suggest, causing a very hot pot to reach boiling point. We have a situation where banks and senior bankers are completely contemptuous of the public. This is evident via their policies. But we also have a situation where the public are completely contemptuous of bankers. It is not a good situation. 207. To quote Lord Stevenson of Coddenham “We’ve jolly well got to stop bad people doing the modern day equivalent of bank robbery.” We would agree with his Lordship but we would suggest the first stop is to curtail such conduct in the banks themselves. When that happens, we can then build a better society. What other matters should the Commission take into account? 208. We think we’ve probably said enough already although, due to our probably unique experience over the last five years, we undoubtedly could say a whole lot more, but that would involve jeopardising the criminal investigation we have fought so hard to ensure happened.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1394 Parliamentary Commission on Banking Standards: Evidence

209. We thank the Commission for reading this submission and would be happy to attend in person should the Commission feel that is appropriate. 28 August 2012

Letter from Andrea Orcel, Chief Executive Officer, UBS Investment Bank I wanted to write and thank you for the opportunity to appear before the Parliamentary Commission on Banking Standards Joint Committee on Wednesday last week. The Commission’s recommendations will be a very valuable contribution to the reform of our industry. As I said to you at the hearing, the new senior management team are very focused on completing the turnaround at UBS. We are simplifying the investment bank to focus on client-driven activity. We have radically reformed incentive structures and improved systems and controls to enhance management oversight. Underpinning all of this however is the rebuilding of a culture of self-adherence to the highest ethical standards. Establishing professional values that engender the right behaviour is a top management priority. While we have made progress, there is more to be done. I hope that I was able to provide some useful insight into what the team have experienced in our initial months at UBS. I am at your disposal for further conversations in public or private if I can be of any further assistance to you or the Commission. 18 January 2013

Written evidence from Unite the Union This response is submitted by Unite the Union. Unite is the UK’s largest trade union with 1.5 million members across the private and public sectors. The union’s members work in a range of industries including financial services, manufacturing, print, media, construction, transport, local government, education, health and not for profit sectors. Unite is the largest trade union in the finance sector representing some 130,000 workers in all grades and all occupations, not only in the major English and Scottish banks, but also in investment banks, the Bank of England, insurance companies, building societies, finance houses and business services companies. Executive Summary — Unite has reservations that opting for a parliamentary inquiry over a Leveson style judicial inquiry is unlikely to address the cultural and ethical failings evident in the sector or lead to the delivery of root and branch reform of the financial services industry; — Unite would wish to see remuneration systems overhauled; — Unite has called for the publication of a report on pay ratios between executive directors and employees as part of company annual financial accounts. — There are fundamental failings in the Boardrooms of banks in the UK with those in positions of influence displaying a staggering lack of competence and an innate inability to accept responsibility; Unite supports: — The introduction of a National Investment Bank to increase lending to SMEs, stimulate growth and focus investment on infrastructure projects; — Changes to legislation that would enable the future prosecution of individuals identified in any failure in corporate responsibility; — The complete separation of retail and investment banking at the earliest opportunity; — Greater democratic control of the banks and financial institutions. The sector has proven that in recent years it is incapable of acting in the public interest and operates primarily to reward shareholders and a select group of individuals. Introduction 1. While Unite welcomes the opportunity to respond to this call for evidence we do however have reservations that opting for a parliamentary inquiry over a more formal Leveson style judicial inquiry is unlikely to address the cultural and ethical failings evident in the sector or will lead to the delivery of root and branch reform required in the financial services industry. 2. Unite is in a unique position to provide an insight into the banking system from the position of the workforce. This gives access to the workings of the organisation which are not biased or tainted by the greed

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1395

and excessive personal reward evident at the very top of many organisations across the sector but by a real ambition by the workforce, through their union, to change things. 3. Unite has responded to numerous consultations to the FSA, H.M. Treasury as well as Independent and parliamentary committees and yet has rarely been asked to elaborate, expand or clarify on any of the points made in our submissions. The issue of unfair pay systems, concerns over whistle blowing and corporate governance, and the potential for mis-selling have all been raised in previous Unite submissions as far back as 2007, (see links below)194 often before they were highlighted as areas of concern by these bodies. 4. Many of these issues related to cultural and ethical concerns. However, the sector and other “interested” parties were apparently uninterested in such issues at the time. 5. The bailout of the banks and the significant impact this has had on every taxpayer in the UK has forced government and regulators to listen more carefully to those who raised concerns over such issues in the past and who aim to act in the wider public interest ie consumer groups, faith groups and trade unions. Unite therefore has a few key concerns which it wishes to bring to the attention of the Commission. 6. Unite has recently produced a document—A Finance Sector for the Real Economy 195 which lays out Unite’s vision for the finance sector going forward. Unite believes that it is vital that the outcome of the financial crisis is a reformed banking and finance sector which supports a long-term outlook that meet the needs of society and the real economy. This should include: — Stronger regulation, including the involvement of trade unions, as well as independent and academic experts. — The introduction of a Financial Transaction Tax (or Robin Hood Tax) on speculative trading to help repay the damage caused by the financial crisis and curb the most risky transactions. — Fair and transparent pay systems for all workers, including employee representation on remuneration committees. — Employment security and an end to the jobs cull in the sector and the rush to outsource and offshore. — A reassessment of performance management systems with greater emphasis given to service rather than sales and delivering fairness for both customers and employees. Pay Systems 7. There have been discussions taking place at many levels regarding tackling remuneration packages and other methods of reward. However, so far this appears to be limited to a review of the pay packages of high level and executive directors. Unite would wish to see remuneration systems overhauled. 8. The systems need to be changed but so too does the way pay is distributed. Pay distribution across the sector is unfair with those at the top earning upwards of 90 times the basic pay of those at the bottom. Unite has called for the publication of a report on pay ratios between directors and employees as part of company annual financial accounts. 9. The performance based remunerations system presently rewards target driven sales which can lead to inappropriate selling and pressures on the workforce to deliver unachievable levels of sales. 10. Unite conducted a survey within one high street bank in early 2012. The survey received over 10,500 responses: an unprecedented response level on a single issue: — 85% of respondents reported that they felt stressed at work; — 77% agreed that they generally suffer from symptoms caused by stress in the workplace including headaches, depression and anxiety attacks; and — 54% agreed or strongly agreed that they had an unfair pay system. 11. Asked what they thought were the major causes of stress at work responses included: “Too many privileges for higher levels and not enough credit to lower levels who keep the bank running on a daily basis”. “Targets are not realistic and we are not rewarded fairly for the things we are achieving.” “Too much work with not enough time to do it, resulting often in unpaid overtime.” “Constantly feel worried about my job as everything is being “looked at”! and trying to juggle all the balls with not enough hours in the day to do everything.” “We have not learnt from all the mis-selling in the past!!! Recent changes to the system etc have not been fully implemented.” 194

http://www.epolitix.com/fileadmin/epolitix/stakeholders/FSA_Approved_Persons.pdf http://www.dodsdata.com/Resources/epolitix/Forum%20Microsites/Amicus-Unite/ FSA%20Retail%20Distribution%20Review%20final%20submission%2007.pdf http://www.dodsdata.com/Resources/epolitix/Forum%20Microsites/Amicus-Unite/HMT%20BoE%20financial%20stability_ final.pdf 195 http://www.unitetheunion.org/pdf/Job%204823%20Finance%20Sector%20for%20the%20Real%20Economy.pdf

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1396 Parliamentary Commission on Banking Standards: Evidence

12. When asked what could be done to reduce stress some of the responses included: “Set achievable targets with responsible budgets.” “Make targets more realistic and provide a culture that is driven by customer’s needs rather than sales pressures.” “Be more realistic and remember we are people, not machines.” “Give us back some pride in what we do and who we are”. “Improve on “trust” culture so colleagues not afraid to speak up.” “Talk to us”. 13. Unite is working with the company to address some of the issues raised in this survey. However it is clear that a wider issue which is evident across the sector is that the workforce believes that they should not be pressurised into selling products and services based solely upon profitability but on appropriateness and need, and certainly not through coercion or confusion. 14. The finance sector also has the largest gender pay gap across all industrial sectors of the economy. According to a 2009 report by the EHRC the pay gap between men and women working in the finance sector based upon mean full time annual gross earning is 55% compared with 28% in the economy as a whole. 196 Professional Standards 15. With regards to the issue of professional standards and the impact of this on public trust and expectations, Unite has witnessed conveniently selective memory recall by some individuals giving evidence to the Treasury Select Committee over the past few years, and who were also apparently unaware where their own responsibilities lay. 16. During his appearance before the Treasury Select Committee Bob Diamond, former CEO of Barclays, described ethics, integrity and values as “important”. However John Thurso, MP suggested that “taking all incidents…it is possible to conclude there was a culture of unethical behaviour within Barclays”. His assumptions are well founded. Some of the incidents he refers to include: — Barclays has set aside £1.3 billion for mis-selling PPI. — Potential £450 million pay out for mis-selling financial products to small businesses. — Blatant tax avoidance systems which it has been reported could have cost the Treasury as much as £500 million. — LIBOR fixing involved basically illegally fixing the inter bank borrowing rate. A practise overseen by Jerry Del Missier, former chief operating officer of Barclays, who has gone on to receive a £8.75 million exit package from Barclays. 17. These were not honest mistakes but show unethical behaviour and market abuse on a massive scale which reflects negatively on Unite members and the wider workforce in Barclays Bank. 18. Unite would also argue that it was not just a few bad apples in the trading room floors of the banks that went unnoticed, but fundamental failing in the boardroom with those in positions of influence displaying a staggering lack of competence and an innate inability to accept responsibility. 19. According to the British Social Attitudes Survey published in December 2010 people’s views about banks have been transformed by the banking crisis. In 1983, 90% believed banks were well run—far above the figure for a variety of other institutions including the police and the BBC. By 2010 just 19% believed banks are well run. 20. Coupled with this was the government bailout of the banking sector which has led the country to borrow the largest amount since records began. This increased debt has led to austerity measures which have had a dramatic impact on living standards for households across the UK. 21. The national debt is now around 65% of GDP, the highest level in UK post-war history; in 2011 unemployment reached its highest peak in 17 years with 2.7 million people unemployed. According to the Council of Mortgage Lenders, 2009 saw a peak in home repossessions with around 13,000 homes being repossessed. In 2011 around 160,000 people were in mortgage arrears. We also witnessed the highest level of personal and business bankruptcy in a decade; and youth unemployment at 22.2%. 22. To add insult to injury banks have awarded excessive bonuses, provided rewards for failure and guilt edged exits to those responsible for many of the decisions which have had such a negative impact on the sector and the economy. These payouts have infuriated our members and the rest of society. Quite clearly, we are not all in this together. 23. Professional ethical standards are vital to bring much needed shot of credibility back to the banking sector. This must be supported by robust penalties for misconduct or inappropriate behaviour, up to and including criminal prosecution. 196

EHRC Financial Services Inquiry—Sex discrimination and the gender pay gap, September 2009

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1397

24. In 2009 the FSA introduced changes to increase penalties and fines levied at individuals and companies who fail to reach acceptable standards of behaviour. While the fines on the banks are substantial,197 in most cases they are affordable and therefore Unite would deem such fines to be inappropriate alternatives to criminal prosecution. It is therefore not clear that such fines are a credible deterrent. 25. At the 2012 Unite policy conference delegates agreed to campaign for changes to legislation that would enable the future prosecution of individuals identified in any failure in corporate responsibility. 26. The sector has a long way to go to rebuild confidence and trust and Unite believes that we cannot allow dishonest and reckless behaviour to become the standard by which the UK finance sector conducts itself. Interests and Influence 27. The banks exert significant influence over the country’s elite networks and this is coupled with extremely successful lobbying by interest groups of the present government, which itself has also derived a significant proportion of its funding from the City. According to a recent report by the Bureau of Investigative Journalism,198 funding of the Conservative party from the City rose from 25% in 2005 to make up 50.8% of the party’s total funding in 2011. 28. The report goes on to highlight that the influence is also embedded in the very system set up to bring change to the sector with Martin Taylor, former Chief Executive of Barclays Bank on the Board of the Independent Commission on Banking. 29. The relationship between the City, government and the UK’s elite networks must shift in order that the public can regain trust in the financial system and the sector must show that it is willing to act in the wider interests of society. SMEs 30. Despite enormous taxpayers bailouts and huge sums made available through Quantitative Easing to increase lending to small business, the banks have resolutely stalled on acting in the public interest. 31. It is clear from figures from the Federation of Small Business that banks are continuing to limit lending to small businesses, making funds available on unfavourable terms thereby limiting take-up while claiming they are meeting demand. 32. Banks are trying to redress the situation, but for some it is too late. According to the latest quarterly survey from the Federation of Small Business, 4 in10 small businesses applying for credit are being refused.199 33. The most recent initiative introduced by the Government to reinvigorate lending to business is Funding for Lending. It is too early to say whether this new initiative will stimulate lending where other initiatives have failed. However, there are already those who have criticised the scheme as unlikely to attract new lenders who have already been refused credit on other terms. 34. Critics have suggested that the scheme appears to favour those able to put down substantial deposits as security or existing borrowers seeking more favourable interest rates, rather than, for example, first time buyers with small deposits. 35. The inability of SMEs and entrepreneurs to access or increase funding at this time is one reason why Unite supports the introduction of a National Investment Bank. Such a body would act to increase lending to SMEs, stimulate growth and focus investment on infrastructure projects, such as a house construction programme and supporting a joined-up manufacturing strategy. Vickers Review 36. The recommendations of the Independent Commission on Banking for a ring fencing of the constituent parts before 2019 is not only inadequate it is potentially damaging to the long term stability of the sector and the economy. Unite policy is for the complete separation of retail and investment banking at the earliest opportunity. The Vickers Review also completely failed to consider the impact of remuneration and performance based pay systems (although admittedly, this was not in its terms of reference). 37. Unite also supports greater democratic control of the banks and financial institutions. The sector has proven that in recent years it is incapable of acting in the public interest and operates primarily to reward shareholders and a select group of individuals. It does not act to serve the interests of real economy and yet it is a vital component in the functioning of society. 38. The finance sector needs to change and through the introduction of robust regulation together with fairer and more transparent pay systems which are built around moral and ethical values which reflect the needs of society it is possible to do so. 197

FSA fines table: Santander £1.5 million Feb 2012, Coutts £8.7 million March 2012, Barclays £59.5 million June 2012, HSBC £10.5 million December 2011. 198 http://www.thebureauinvestigates.com/2012/07/09/revealed-the-93m-city-lobby-machine/ 199 http://www.fsb.org.uk/News.aspx?loc=general&rec=7750

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1398 Parliamentary Commission on Banking Standards: Evidence

39. Workers in the sector want to work for successful and responsible organisations, and to deliver a professional service for a decent wage, but they also want to feel valued, be rewarded for their work and to be treated fairly and with dignity and respect. 20 August 2012

Written evidence from the Universities Superannuation Scheme Summary Urgent action is required to address perverse incentives hard-wired into our accounting and audit system that encourage excessive risk-taking by bank executives. On accounting standards, we propose that: — Prudence should be restored as an overarching accounting principle in the UK, to ensure consistency with UK Company Law. — The EU’s approval process for adopting IFRS is strengthened to ensure the standards are consistent with existing legal requirements for prudence, “true and fair view” and capital maintenance. — Amendments are made to the proposed EU Accounting Directive to strengthen the emphasis on prudence, clarify the link between accounts and requirements for capital maintenance, and emphasise the concept of “substance over form”. On the audit system, we propose that: — Audit Committees are made more transparent. Specifically, the critical areas of debate between the auditor and company, how these were resolved, and what steps are being taken to protect auditor independence should be disclosed to investors. — Audit Committees ensure audit firm rotation at regular intervals, with an upper tenure of 15 years. — Audit Committees limit non-audit fees to less than 50% of audit fees. 1. Introduction 1.1 The Universities Superannuation Scheme (USS) is the second largest pension fund in the UK. As at August 2012, the value of the Fund was circa £34 billion. We have a large exposure to UK banks, and—given the long term nature of our liabilities—a strong interest in ensuring long term sustainable returns from the sector. We also believe that achieving a fundamental shift in the investment horizons and risk-taking culture at banks is vital to broader macro-economic stability, which drives returns throughout our portfolio. 1.2 The Parliamentary Commission is touching on numerous issues that have played a role in the financial crisis. Whilst we believe many different factors are important (from faulty executive remuneration schemes to inadequate regulatory oversight), we focus in this submission on two topics that we feel have received inadequate attention: the accounting and auditing systems. 1.3 We believe the current accounting and audit systems in the UK are contributing to short-termism and excessive risk-taking in the banking sector (as well as other sectors). We believe, in particular, that: — The adoption of IFRS in the EU in 2005 has fuelled incentives to take on excessive risks in the banking sector, leaving shareholders and taxpayers to pick up the tab when boom turned to bust; and — The audit system in the UK fails to provide the necessary check on banking executives’ behaviour, in large part due to the lack of transparency and accountability to shareholders. 1.4 Our submission is relevant to your questions 4 to 6. 2. Banking Culture is Driven by Improper Incentives 2.1 We believe improper incentives in the banking sector have contributed to excessive risk-taking. Company executives’ performance is measured to a large extent by reference to banks’ audited accounting numbers. Remuneration, moreover, is often directly tied to these numbers. Accounting and auditing standards, thus, play a vital role in determining how executives behave. 2.2 Accounts, consequently, also have a direct impact on how shareholder capital is used, and whether it is protected. In short, accounts—and the external audits that provide a key stamp of approval—are a vital input to our corporate governance system. 2.3 It is our view that failures in both the accounting standards and audit system have played an important role in the excessive build up of risk in the banking sector prior to the financial crisis. Below we set out our concerns, and reference related submissions and Position Papers on these topics.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1399

3. IFRS has Encouraged Risk-Taking200 Legal context 3.1 Accounting standards in the UK (and EU) have been seriously weakened with the adoption of IFRS in 2005, and—specifically—with the move by the International Accounting Standards Board (IASB) to replace “prudence” with “neutrality” as the guiding principle underpinning accounting. This shift in accounting was a key part of the IASB’s convergence project with the US accounting standards, ie US GAAP. 3.2 Prudence has been at the heart of the UK system of accounts for generations. It is hard-wired into our Company Law and underpins our system of corporate governance, which relies on financial reports as a basis for holding management to account for their use of capital. In Company Law accounts must provide a “true and fair view” and be “prudent”. Accounts provide the basis for company directors to determine whether a company is a “going concern” and ensure they do not make distributions out of capital.201 These are fundamental protections offered to providers of capital, and underpin confidence in the equity markets. 3.3 Prudence also lies at the heart of EU Company Law and system of corporate governance. In 2005, the EU’s “IAS Regulation” came into force requiring companies listed in EU securities markets to use IFRSs (as adopted by the EU) in their consolidated financial statements.202 The Regulation explicitly reinforces the requirement that all standards adopted by the EU must comply with “true and fair view” and all relevant EC Directives.203 3.4 And yet, fundamental changes to IFRS—including the replacement of “prudence” by “neutrality” as a guiding accounting principle—do not appear to have been picked up as contrary to EU or UK Company Law. This has led to the application of accounting standards that have a high risk of diverging from the true and fair view, and producing profit numbers that are not “distributable” (see the ICAEW in its 02/2010 Guidance on Distributable Profits which takes 167 pages to try to reconcile the two).204 3.5 Notwithstanding the legal questions, the move away from prudence to neutrality has led to greater incentives for risk-taking in banks. We provide two examples below. Loan loss provisioning encourages risk-taking 3.6 IFRS replaced the UK GAAP’s “expected loan loss provisioning” with “incurred loan loss provisioning”. 3.7 Under UK GAAP (prior to convergence with IFRS), accounts were expected to hold loans at no more than realisable value, meaning that it was necessary to estimate “likely” loan losses/defaults on different pools of loans dependent on their level of recovery risk. That was achieved by “general provisions” for bad debts. The riskier the pool of loans, the higher the provision. Decisions about appropriate provisioning were audited. This approach was considered prudent, and it was aligned with key accounting principle of “accruals” and “matching” (ie recognising revenue as it is earned, not necessarily paid, and matching it with the associated costs). 3.8 Under IFRS, however, an incurred loan loss provisioning approach was adopted, which required that only actual defaults be recognised as a cost of the loan. No estimations for future losses were permitted. The intention was to tackle management manipulation of provisions to smooth earnings. However, in tackling what was is in effect a problem of implementation and audit (management manipulation of accounts) by changing the standards, we are left with a standard that is not prudent, and does not comply with accruals and matching principles. 3.9 The incurred loan loss provisioning approach feeds through to bank executive incentives for risk-taking. In boom years, where accounts do not provision for future likely loan losses, banks will earn the highest “profit” on the riskiest (and highest margin) loans. Banks with the riskiest loan books, and who grow these most quickly, will see profits rise faster than competitors. Executives will also likely see their bonuses rise commensurately. 3.10 As the banks’ equity increases, moreover, banks are able to extend their lending even further, thereby fuelling the boom. When the economy turns, of course, the process goes into reverse. Banks with few provisions for bad debts then have to recognise large losses. In effect, under IFRS the profits for banks’ loan books are all front-ended, and the losses come through all at once in a downturn. 200

Please also refer to the investor group’s Position Paper (7 August) on this topic, which is attached. The Companies Act 2006 requires accounts provide a “true and fair” view (Part 15, Ch 4), and ensure capital maintenance (solvency) to protect creditors (Part 23, Sections 830–837). A “prudent” accounting framework is required under The Large and Medium Sized Companies and Groups (Accounts & Reports) Regulations 2008 (Part 2). The same requirement exists in European Company Law (2nd, 4th and 7th EC Directives). 202 Although the EU Regulation only requires IFRS is used for Group accounts, the UK went further and requires IFRS for banks’ subsidiaries. Indeed the UK’s Accounting Standards Board appears to have been moving away from prudence even earlier than required by EU regulations. 203 See Paragraph 9, Regulation 1606/2002. 204 Please refer to LAPFF, “UK and Irish Banks Capital losses—Post Mortem”, Dec 2011 to gain a sense of the scale of the problem for UK banks. 201

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1400 Parliamentary Commission on Banking Standards: Evidence

3.11 What is particularly damaging is how the accounting standard feeds through to incentives for risktaking, which accentuates the boom and bust, with enormous costs for macro-economic stability.205 Excessive use of mark to market (MTM) encourages risk-taking 3.12 Under IFRS, the use of MTM (and mark to model) for valuing trading and available for sale assets has been significantly expanded. This is particularly evident with respect to accounting for financial instruments (IAS39 until 2009–10, and now IFRS 9 and 13). Market prices are viewed to be “neutral”, and the best way to value banks’ assets. However, the approach faces two critical flaws. 3.13 First, markets are rarely perfect, and the prices at any one time may be biased for a number of reasons. This is particularly true in illiquid and volatile markets. Indeed, in such markets the sale of the assets held by banks to realise the value quoted on the balance sheet may itself lead to a price drop. In other words, the prices quoted on the balance sheet would not be realisable in practice. Balance sheet valuations are then, as the CEO of RBS remarked during the crisis, “Alice in Wonderland numbers” (Preliminary Announcement, February 2012). Depending on the day that you value the assets, you might come up with very different numbers. Where there is no acceptable market price according to IFRS rules, then companies can “mark to model”, which introduces enormous scope for subjectivity and manipulation. 3.14 Moreover, using MTM so extensively (under UK GAAP a more restricted and considered use of MTM was permitted for the most liquid assets—see the British Bankers’ Association SORP) fails to meet the prudence test. The profits which flow through the Profit and Loss account as a result of revaluation of assets (which are not in fact sold) are viewed as “real profits” and may be used as a basis for determining distributions. However, if these profits turn out not to have been real (eg are reversed when markets turn) and were never realised (ie never actually converted into cash), the distributions (which were made in cash) may have been made out of capital. This is, of course, not permitted under Company Law. Furthermore, the unrealised profits then feed into the company’s equity, which is in turn used as a basis to ascertain a company’s “going concern” status. 3.15 The extensive use of MTM also feed executives’ incentives for risk-taking. In an upward moving market, the more assets banks hold in their trading books, the more “paper profits” they will make, and the higher their bonus payments. As with incurred loan loss provisioning, the higher profits feed the banks equity base (and Tier 1 capital), off which they are able to buy more of these trading assets thereby pushing up the prices. The more risky assets, of course, will tend to generate the highest returns. In a downturn, the process reverses. In short, MTM is pro-cyclical. 3.16 The examples above highlight why we believe the move to IFRS, and specifically the move to neutrality as a guiding principle in accounting, has led to excessive incentives for risk-taking in banks. It is vital that this matter is looked at in greater detail and action taken. Recommendations 3.17 There are important openings right now to address the weaknesses with IFRS. We recommend the actions outlined below. Recommendations

205

—

Restore prudence as an overarching accounting principle in the UK. The UK should explore what steps might be taken to restore prudence in UK accounting, to ensure consistency with UK Company Law. This may require a supplementary process of reviewing standards before they are rolled out in the UK.

—

Strengthen the EU’s approval process for adopting IFRS to ensure the standards are consistent with existing legal requirements for prudence, “true and fair view” and capital maintenance. The UK should use its vote and voice in this approval process to achieve this goal.

—

Amendments are made to the proposed EU Accounting Directive to strengthen the emphasis on prudence, clarify the link between accounts and requirements for capital maintenance, and emphasise the concept of “substance over form”. The proposed Accounting Directive is currently being debated in the European Parliament. City of London MEP Syed Kamal’s proposed amendments to clarify the link between prudent accounts and capital maintenance requirements. These were dropped from the most recent compromise version from parliament.206 In addition, the EC’s proposed Article 5(h) emphasising “substance” over form as a “General Financial Reporting Principle” has also been dropped.207 The UK government should seek to have these reinstated.

While the problem with incurred loan loss provisioning has been recognised by the IASB, and is currently being reviewed, early indications of a replacement model do not address the core weakness: the failure to adequately and prudently provision for expected future loan losses. 206 Proposed amendments are found in Recital 6, Recital 31, Article 4, 7(5), and 7(6) in the attached document “Amendments 101–26”, Draft Report by K. Lehne, 9 May 2012. 207 Please see Article 5(h) in the proposed Accounting Directive, and Parliament’s compromise version (6 July 2012).

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1401

4. Audits have Failed to Provide a Robust Check on Executives 4.1 Audits are undertaken for directors on behalf of shareholders to provide an independent and robust check on accounting numbers. The audit, therefore, reassures providers of capital that the accounts can be trusted. The audit plays a critical role in maintaining investor confidence in equity markets. 4.2 It is our view, however, that the audit system currently suffers from a number of structural flaws that undermine auditor independence. This problem was highlighted by the House of Lords’ Economics Affairs Committee inquiry into audit in 2010–11, and has been taken up by the UK Competition Commission in its ongoing investigation into large audit market. Concerns over the failure of auditors have also resulted in proposed reforms by the European Commission (EC) in 2011, which are currently being debated by the European Parliament. 4.3 USS has contributed to both the UK and EU policy debates, and led a coalition of long term investors in drawing up a Position Paper on audit.208 These papers set out evidence that illustrates the failure of the audit to deliver demonstrably independent verification of accounts; the underlying causes for these failures; and what we feel needs to be done to tackle these problems. We attach the relevant submissions for your information.

Recommendations 4.4 Our key proposals for action are summarised below. We hope these will be taken on board also by the UKCC and EU as proposed reforms are explored. —

Audit Committees should be more transparent. Shareholders need to know, in particular, the critical areas of debate between the auditor and company, how these were resolved, and what steps are being taken to protect auditor independence.

—

Audit Committees should ensure audit firm rotation at regular intervals, with an upper tenure of 15 years. Firm rotation should ensure there is a regular challenge to past assumptions and offer independent due diligence on the previous auditor. Firm rotation should fundamentally shift power back to shareholders as the ultimate client.

—

Audit Committees should limit non-audit services provided by the auditor to 50% of audit fees. Auditors seeking to win non-audit contracts with their audit clients are conflicted. No doubt, there should be flexibility for companies to appoint the best possible service provider, but shareholders also need reassurance that the integrity of the audit is paramount. Where the ratio rises above the 50% threshold, it must be brought back down.

5. Conclusion 5.1 The financial crisis resulted from numerous failures at several levels. Banking executives behaviour, and the culture of risk-taking, is nonetheless a vital piece in the jigsaw. Understanding what has driven executives decision-making and, in particular, their often imprudent risk-taking is of utmost importance. 5.2 We believe that to date regulators have failed to appreciate the integral role of accounting standards and the audit system. Our submission, therefore, focuses on these two topics. 5.3 Importantly, we believe there are important openings right now to address the failures we identify, and have made specific recommendations for what steps should be taken.

6. Attachments209 —

“Concerns with IFRS—A long term investor position paper”, 30 July 2012.

—

“Audit—a long term investor position paper on proposed EU reforms”, 7 August 2012.

—

USS submission to UKCC, 9 May 2012.

—

“Amendments 101–26”, Draft Report by K. Lehne, 9 May 2012.

—

Parliament’s compromise version (6 July 2012).

6 September 2012 208 209

Please see attached Position Paper “Audit—a long term investor position paper on proposed EU reforms”, 7 August 2012. Not printed. Available on request.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1402 Parliamentary Commission on Banking Standards: Evidence

Written evidence from the Centre for Research on Socio-Cultural Change Executive Summary210 — “Culture” is commonly invoked as the ideal cause of recent banking catastrophes. But this neglects the obvious question: what sustains and animates a practically defective and morally deficient culture? — We argue that it exists in more material conditions: in particular, culture can only be understood in the context of the kind of business models which governed banking, especially investment banking, before the great crisis, and which still govern banking practices. The Libor scandal is therefore important not only for itself; it is symptomatic of a wider crisis of the banking system. — It follows that reform cannot be fully effective if it relies on trying to change the hearts and minds of bankers, nor on a more closely controlled and centralised system of regulation, nor on a reform of Libor itself. What is required is fundamental reform of banking institutions and practices to transform the banking business model. — We use recent scandals involving Barclays and HSBC to illustrate our arguments but contend that these two giant banks are by no means unique. — We show that under existing business models, banks have become loosely controlled federations of money making franchises in which the pursuit of reward by senior executives has overridden both the interests of shareholders and the wider social obligations to which banks, like all businesses, should be subject. — We show that reform cannot be achieved by bankers, boards and regulators acting alone, nor by moral injunctions to behave better. Effective reform to change the business model requires the use of the authority and legitimacy which only the democratic state possesses. This makes the recommendations of the Commission especially important. Since banking, and the wider City, have in recent years come to exercise a disproportionate influence over the executive, parties and Parliament, radical recommendations will demand courage from the Commission. — We conclude with eleven recommendations which are designed to reshape banking practices, to rebuild a socially responsible business model and to reshape the world taken for granted of bankers. These include separating investment from retail banking, creating a more diversified banking industry, and opening up the world of banking and finance to more democratic influences. When Definitions Matter “Culture is one of the two or three most complicated words in the English language” Raymond Williams, 1983 1. In his first public apology for Libor fixing, Bob Diamond said “I am sorry that some people acted in a manner not consistent with our culture and values.”211 That apology set the register for the establishment’s account of what has gone wrong with banking in Britain—as we document below, the assumption is that banking has a cultural problem and we all know what culture means. But invoking “culture” is not enough, especially when a complicated and contestable word is being used in an unexamined manner. 2. Definitions do matter. Our argument in this submission is that the thoughtless and unexamined invocation of a common-sense ideational concept of culture by practical men has encouraged misconceptions about the nature of the moral and political crisis caused by finance in London. And the problem needs reframing using a material definition of culture before effective reform can be introduced. (i) Ideational culture and the expressive model vs. material culture and the performative model 3. Bob Diamond’s choice of words are an example of a “practical” man using a common sense concept of culture and a model of how the world works: he implies that banking culture is some kind of ideational motive or value which is (or should be) expressed in behaviour. These tropes about ideational culture expressed in behaviour, recur in most of the subsequent discussion by politicians and regulators who, like Mervyn King, wanted to have “a change in the culture of the banking industry.”212 Thus David Cameron argued: “The most important thing people want to see is a really concrete set of actions that will help change the culture. You don’t change culture by changing laws and changing regulations alone.” 213 4. This definition of culture and the expressive model of behaviour was then carried over into the terms of reference of Barclays’ own internal inquiry into rate fixing. It also carried over into the external Parliamentary 210

Correspondence to: [email protected] or [email protected] authors of this submission are affiliates of the ESRC funded Centre for Research on Socio-Cultural Change at the University of Manchester and the Open University. We gratefully acknowledge the financial support of the Economic and Social Research Council but the views and positions in this submission are of course those of the authors, who have for several years worked together as a collective on financial crisis and economic reform. This submission is freshly prepared, presents new evidence and develops previous arguments but draws on many years of collaborative work, most notably a book by E. Engelen et al. After the Great Complacence: Financial Crisis and the Politics of Reform (Oxford University Press, 2011). 211 Statement by Barclays issued 27th June 2012 http://www.newsroom.barclays.com/Press-releases/Barclays-Bank-PLC-Settlementwith-Authorities-901.aspx 212 BoE governor urges reform of Libor, Financial Times, 29 June 2012, http://www.ft.com/cms/s/0/7a76a74a-c1d2–11e1-b76a00144feabdc0.html 213 ‘Ministers to order Libor bank rate review’, BBC News, 30 June 2012, http://www.bbc.co.uk/news/uk-politics-18640916

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1403

Commission on “professional standards and culture of the banking sector” which was announced after the government had set itself against a broad ranging, Leveson-style inquiry into the banks and persuaded the parliamentary opposition to accept a far more narrow, technical and depoliticized inquiry into what went wrong with the practice of setting the Libor.214 5. Here is the Barclays press release which announced that Anthony Salz is to conduct an independent review of Barclays’ culture which will conclude by next April. “The global review will assess the bank’s current values, principles and standards of operation and determine to what extent those need to change; test how well current decision-making processes incorporate the bank’s values, standards and principles and outline any changes required; and determine whether or not the appropriate training, development, incentives and disciplinary processes are in place”.215 6. In the case of the Parliamentary Commission, the standard definitions and model structure is used as the framework for the (leading) questions which the inquiry sets those seeking to make written submissions. The Commission’s questions are about culture and standards in ways which are orthodox but have the unfortunate effect of reinforcing its narrow terms of reference in two key respects. 7. First, the Commission’s questions suppose ideational culture and the expressive model. They start from the assumption that there is a problem about “professional standards in UK banking”, and standards in common usage are of course always about behaviour and outcome. The first possible cause of the standards problem in their question 4 is the “culture of banking” understood implicitly as the stuff of ideas and values. 8. Second, standards and culture have a material and external frame but this is defined very narrowly in terms of what upsets culture/standards. Thus question 4 brackets culture with the “incentivisation of risk taking” (by individual agents?). The sectoral conditions of upset are exogenous developments like “financial innovation” or “technological developments”. The firm level conditions of upset include the activity mix of retail with investment banking, the level of competition and weaknesses of control apparatus (primarily corporate governance via shareholders, directors, audit and regulation) 9. The Parliamentary Commission’s framing of the problem does no more than mirror the self-knowledge of bankers like Bob Diamond and the common sense of politicians and regulators. But this shared ideational concept of culture and the expressive model of how the world works are both confused in ways which prevent us identifying what has to change if we are to have better, more socially responsible banking. The ideational notion of “culture” is misleading because it implies that some kind of cultural cleansing is possible. This could involve sacking or mentally reprogramming the most irresponsible individuals who personify the “bad culture” of greed. This would then allow the ambient “good culture” of corporate responsibility to flourish. Like giddy, overexcited children who knock things over at parties, it is assumed bankers can be taught to calm down and behave by giving them a stern talking to by a non-executive director (NED) or a lecturer in business ethics. And this follows in the lineage of one of the most popular framings of the financial crisis as the result of out of control greed amongst key individuals. 10. Against all this, our submission makes a counter argument as follows: (a) Culture is not an ideal or value in the hearts and minds of men who can be cleansed or reprogrammed. Culture is something material that is embedded in organisational structures and the specifics of the business activity which define everyday norms about what is permissible and how employees can avoid getting into trouble. (b) In banking, the structures and specifics are sui generis because household name banks (like Barclays or HSBC) are not unitary organisations but loose federations of money making franchises; in the case of PLC banks, the federations are driven by the pursuit of shareholder value and bonuses in a kind of joint enterprise between shareholders and senior investment bankers which defines the business model. (c) Tighter regulation and governance will deliver few benefits unless such controls prioritise reform of the investment banking business model. A shift in the investment and retail business model is the absolutely critical precondition of any meaningful change in behaviour. (d) Reform of the banking business model raises issues of control which are beyond the domain of corporate governance for shareholders, or of banking regulation narrowly considered as a matter for the Bank of England. This is because non-executive directors or regulators lack the political authority to spoil a profitable business model in a world where private and social interests diverge and the interests of elite investment bankers are defended by the Westminster political classes. 11. The submission which makes these points is organised in a straightforward way. The next two sections propose a material definition of culture by considering evidence about organisational behaviours that has emerged from recent official inquiries into Barclays and HSBC. The argument then turns to examine the Barclays business model before a final section turns to consider the political difficulties of reform. 214 215

‘Ministers to order Libor bank review’, BBC News, 30 June 2012, http://www.bbc.co.uk/news/uk-politics-18640916 ‘Anthony Salz to lead independent business practices review’ at http://www.newsroom.barclays.com/Press-releases/AnthonySalz-to-lead-independent-business-practices-review-915.aspx

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1404 Parliamentary Commission on Banking Standards: Evidence

(ii) Banks as unitary organisations vs. loose federations 12. In a now notorious public lecture for the BBC Today programme, Bob Diamond said “Culture is difficult to define … but for me the evidence of culture is how people behave when no-one is watching.” Here again he takes an entirely orthodox position on ideational culture and assumes the expressive model. Within this frame, in the special case when nobody is watching, internal values will of course directly determine behaviour.216 But this leaves out a key feature of institutional life: organisational design and controls structure routine performance whether or not anybody is watching. This material culture position is supported by the evidence of senior bankers when questioned about investment bank rate fixing by the UK Treasury Committee and about money laundering in a US Senate hearing. We are already indebted to the work of anthropologists like Joris Luyendijk and Karen Ho who have described the processes of selection, acculturation and precarious attachment which produce a dangerously conformist mentality inside banking firms where employees operate within silos. But the recent public testimony by senior bankers In London or New York suggests that the (loose) internal organisation of giant banks makes them unfit for purpose. 13. Let’s begin with some generalities which should be familiar to anyone who has done an introductory course in organisation studies. A firm is a space of bureaucratic coordination which requires internal hierarchy and division of labour that implies expectations and rules about what can and cannot be done at different levels, and runs partly on active instructions and permissions from top to bottom. Any organisation then requires individual and group initiative because rules and instructions cannot be complete, so improvisation is required. But such improvisation operates within procedural limits so that, for example, authorisation of expenditure or breach of standard procedure usually requires some kind of signing off and a paper trail. 14. All this is a mixed blessing. The firm or any other large organisation is for bureaucratic reasons typically an inflexible, unreflective economic and social actor with a limited capacity to respond to how things have gone wrong, or indeed to recognise that things have gone wrong or will go wrong. Consider BP’s succession of accidents and environmental disasters after the Browne-led mergers had created a much larger firm where operating control was a major unresolved problem; or, worse still, think about how a disastrous combination of hierarchy and institutional baronies encouraged the Catholic Church to cover up child abuse in many jurisdictions. 15. But the investment bank illustrates two different problems which make investment banks like Barclays or retail banks like HSBC positively frightening, not just poorly controlled like BP or unintentionally vicious like the Catholic Church. On the basis of testimony in London and New York, the present day investment bank is a thoroughly informal organisation where many things, including gross rule breaking at middling levels, can go on without formal authorisation. 16. On Monday 16 July 2012, Jerry del Missier, the recently departed chief operating officer of Barclays appeared before the Treasury Select Committee and gave an account of how Barclays came to “lowball” its Libor submissions in the aftermath of the phone call of 29th October 2008 between Paul Tucker of the Bank of England and Bob Diamond at Barclays, which led Diamond to produce an email note. There was, to put it neutrally, a misunderstanding at this point about whether the Bank was instructing Barclays to lowball (because of the public interest in making Barclays look sounder than it was). 17. The interesting point is that, along the internal chain of command at Barclays, all the instructions were verbal and the instructions were accepted without demur, even though the instruction was for Barclays to do something irregular at the (second hand reported) invitation of the Bank of England. The internal chain in Barclays Capital ran from Bob Diamond (who took Tucker’s call) to Jerry del Missier as co-head of investment banking, and then to Mark Dearlove as head of the money market desk. “Yes it was” an instruction said del Missier in his July testimony when he claimed he had “passed on the instruction as I received it”. And how did Del Missier receive it? The Financial Times reported: “in a phone conversation the day before he received the email note” from Diamond which did no more than report another phone conversation with Tucker. Diamond did prepare a “file note” which went to the CEO of Barclays as well as del Missier; but neither asked for an internal meeting or any kind of confirmation of what the Bank of England wanted. 18. Let’s pause here. Barclays is clearly not an organisation of the staid, formal kind which most civil servants or academics will be familiar with. Let us hypothetically suppose the nearly unthinkable. Some senior authority outside our University (for whatever reason) wants to adjust the academic grades on our degree programmes so as to deliver more good honours degrees. That would require written orders down the chain, then a series of committee meetings so that all those affected could discuss any concerns about issues of authority and implementation. And the committee chairs would be expected to have a written instruction from an external point of origin after, for example, the university’s academic registrar had forwarded an authoritative outsider’s direct and explicit email instruction to fix the grades with some supporting reasons. (Our university registrar’s recall of the sense of a phone call would not be any basis for action). 19. Such bureaucratic safeguards are more elaborate in public sector organisations which spend taxpayers’ money and must identify the public interest. But they would be familiar to most managers in private sector companies. Consider, for example, another hypothetical example of a car company instructed (by authority, for whatever reasons) to falsify CO2 emissions of a new model. In this industry (which we have previously 216

‘Shaming the banks into better ways’, Editorial, Financial Times, 29 June 2012, http://www.ft.com/cms/s/0/6dc5b9a2c117–11e1–853f-00144feabdc0.html.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1405

researched) it is routine to tune car engines, by varying injection and ignition timing, which reduces “drivability” but gets test cycle emissions below key thresholds that will affect sales or taxation. But no individual or group in a major car company would return a false test result without written authority and extensive internal committee discussion. 20. The difference of practice here is not public vs. private but banking vs. the rest. The investment banker’s counter argument is that formal bureaucratic safeguards are quaintly inappropriate in the fast moving world of banking where the principle has to be “just do it” because there is no time for all this procedural stuff which still regrettably clutters up the hierarchical public sector and manufacturing companies. But that raises a serious question. What protects economy and society if the investment bank (as organisation) does without the bureaucratic safeguards which in other organisations protect us from compounded misunderstandings and active malpractice? Because, in this world of informality, orders are passed on without question as junior bankers at desks will simply follow verbal orders from their seniors while (on the testimony of Diamond and others) senior bankers may have a very limited knowledge of what is informally going on at the lower levels. 21. Just as amazing in terms of informality was Mr Tucker’s explanation, as regulator from the other end of the phone line, about why the Bank of England had no recording of his conversation with Bob Diamond. According to Tucker, no record was kept of many phone calls within the Bank of England because the press of crisis made this impossible. One might have expected that the press of crisis, which was forcing numerous commitments out of public institutions like the Bank, would precisely have made imperative an accurate, permanent recording of communications. But just as the banks were captives of a “just do it” mentality, the central bank was, and remains, captive of its historic relationship with markets, which pictures the Bank as an informal and informed regulator better able to do the job than “inflexible” bureaucrats in Whitehall. 22. The back stop social protection is then supposed to be supplied internally by a bank’s internal compliance department which enforces standards and polices wrong doing. But, the ineffectiveness of such arrangements was dramatized when senior HSBC executives appeared before a US Senate hearing in July to explain how and why HSBC had, despite repeated US regulatory censure and internal whistle blowing, continued to allow drug proceeds from Mexico to be laundered through the bank and allowed terrorist financiers to obtain US dollars. 23. The central institution in this story is HSBC’s largest US affiliate: HSBC Bank USA (or HBUS) is key because it provides HSBC’s overseas clients with access to dollar markets and the US financial system, which is important because the dollar’s role as leading trade currency makes it a prime target for launderers. Between 2007 and 2008, HSBC’s Mexican affiliate, HBMX, shipped $7 billion in physical US dollars to HBUS, more than any other Mexican bank, even one twice HBMX’s size. According to the senate Chair’s report: “HBMX operates in a high risk country battling drug cartels; it has had high-risk clients such as casas de cambios; and it has offered high risk products such as US dollar accounts in the Cayman Islands, a jurisdiction known for secrecy and money laundering. HBMX also has a long history of severe AML deficiencies. Add all that up and the US bank should have treated HBMX, the Mexican affiliate, as a high risk account for AML purposes. But it didn’t. Instead, HBUS treated HBMX as such a low risk client bank that it didn’t even monitor their account activity for suspicious transactions. In addition, for three years from mid-2006 to mid-2009, HBUS conducted no monitoring of a banknotes account used by HBMX to physically deposit billions of US dollars from clients, even though large cash transactions are inherently risky and Mexican drug cartels launder US dollars from illegal drug sales. Because our tough AML laws in the United States have made it hard for drug cartels to find a US bank willing to accept huge unexplained deposits of cash, they now smuggle US dollars across the border into Mexico and look for a Mexican bank or casa de cambio willing to take the cash. Some of those casas de cambios had accounts at HBMX. HBMX, in turn, took all the physical dollars it got and transported them by armoured car or aircraft back across the border to HBUS for deposit into its U.S. banknotes account, completing the laundering cycle.” 24. In addition to the cross border movement of physical notes, it was also found that HSBC affiliates in Europe and the Middle East circumvented filters set up by the US Treasury Department’s Office of Foreign Assets Control (OFAC) to prevent the funding of terrorist organisations: references to Iran in $19bn worth of US dollar transactions between Iranian entities and HBUS or other US affiliates were stripped out of or omitted from paperwork in 85% of cases, in full knowledge of HSBC’s Chief Compliance Officer and other senior executives in London. There were similar allegations of negligence and cover-ups made regarding HSBC’s ties with the suspect Al Rajhi Bank; clearing travellers cheques for suspicious Russian used car business via a Japanese bank; and offering accounts to “bearer share” corporations, which due to their anonymity are prime vehicles for money laundering and other illicit activity. 25. Why was the internal compliance department so completely ineffectual and why did senior London management fail to engage with the funny business coming out of Mexico? The short answer is that HSBC was less a bureaucratic organisation and more a loose federation of franchises organised on an ask-no-questions basis. The senate report makes it clear that HSBC Group HQ in London instructed its affiliates to assume that every other HSBC affiliate met the group’s AML standards and so should be provided with correspondent banking services. HBUS merely followed this instruction, ignoring more stringent US law which requires due diligence reviews before any US account can be opened for a foreign bank. David Bagley, HSBC’s chief compliance officer since 2002, admitted to the US Senate that his position lacked any power. As the FT

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1406 Parliamentary Commission on Banking Standards: Evidence

reported, on his own testimony, David Bagley did not control compliance in national affiliates like Mexico because his job was only “to set policy and to escalate issues that were reported to him”. 26. Bagley’s testimony was front page news partly because of his resignation from the job on the day he testified. But, the largely unreported parallel Senate testimony of Paul Thurston, HSBC chief executive for retail banking and wealth management, was even more devastating; not least because it described an absence of control and rules in retail banking where customers and regulators would quite reasonably expect them. The key exchange was with Senator Levin: Sen. Levin: Why did these things fester for so many years at this bank [HSBC Mexico]? This isn’t something discovered in hindsight, this is something that people knew was going on at that bank. Why was it allowed to continue? Thurston: The business model was complicated and decentralized. It was very difficult for the center to get controls. 27. The difficulty of central control was separately explained by Thurston: “It became apparent that decision-making processes concerning anti money laundering were not satisfactory [at HSBC Mexico]. Over time, it also became clear that this was not only a question of process and technology, but that the underlying business model needed to be examined. Branch managers operated as local franchise owners, with considerable autonomy and a focus on business development, reinforced by an incentive compensation scheme which rewarded new accounts and growth, not quality controls.” 28. Banks and banking are defined in most dictionaries in terms of business conducted and services offered so that retail banks take deposits and make loans, investment banks advise on merger and engage in prop trading. In organisational terms, after last July’s testimony by Barclays and HSBC execs, it might be fairer to describe a bank as a loose federation of money making franchises (with always troubling and sometimes dire economic and social consequences) (iii) The boundaries of the firm 29. The bank as a federation of money making franchises is a troubling idea and even more disturbing is the consequence that some senior franchisees will not only be working for the bank but working for themselves, and with franchisees in other firms. In this case, the firm would have no definite boundaries of the kind presupposed in most studies of bureaucratic organisations. If this seems far-fetched and fanciful, consider the terms in which the Financial Services Authority (FSA) indicted Barclays for libor manipulation. The staid FSA prose is startling because it reveals collusion by bank employees in one firm to benefit traders operating in another firm. Paragraph 8 of the FSA proceedings reports that: “Barclays acted inappropriately and breached Principle 5 on numerous occasions between January 2005 and July 2008 by making US dollar LIBOR and EURIBOR submissions which took into account requests made by its interest rate derivatives traders (“Derivatives Traders”). At times these included requests made on behalf of derivatives traders at other banks. The Derivatives Traders were motivated by profit and sought to benefit Barclays’ trading positions.” (our emphasis added) 30. Thus, employees from Barclays were willing to manipulate their own institution’s reported borrowing rates, (with uncertain effects for their employer), to benefit a trader at a competitor. This observation of collusion is important because it indicates that the boundaries of the firm are fluid and permeable as working structures involve building and maintaining interpersonal networks across firms which allow employees in one firm to work for the benefit of employees in another firm who needs a profitable trade 31. This collusion relates to activity specifics in investment banking when the presence or absence of profit on a particular trade, or at the firm aggregate, relies on the quality of the numerical inputs and valuation models used when assigning a price to often complex derivative assets on the balance sheet. Banks are conversion centres: they turn assets into income streams and income streams into bonuses. When derivatives traders ask someone on the cash desk of another bank to fix LIBOR, this affects the value of an asset which then flatters the return on that trade. Strictly it produces, not profit, but the appearance of profit which is good enough for an employee who wants to book a positive return. 32. Of course Barclays no longer uses LIBOR to price many of its interest rate products. The game moves on. It now uses much more complex calculations to value its assets. On its valuation of collateralised interest rates it uses: “Overnight Index Swap (OIS) rates…to reflect the impact of cheapest to deliver collateral on discounting curves, where counterparty CSA (Credit Support Annex) agreements specify the right of the counterparty to choose the currency of collateral posted”. And on interest rate derivatives: “Interest rate derivatives cash flows are valued using interest rate yield curves whereby observable market data is used to construct the term structure of forward rates. This is then used to project and discount future cash flows based on the parameters of the trade. Instruments and optionality are valued using a volatility surface constructed from market observable inputs. Exotic interest rates derivatives are valued

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1407

using industry standard and bespoke models based on observable market parameters which are determined separately for each parameter and underlying instrument. Where unobservable a parameter will be set with reference to an observable proxy. Inflation forward curves and interest rate yield curves are extrapolated beyond observable tenors”. 217 What does that mean? 33. When assets are priced using inputs of uncertain verity which are run through models of great complexity, several games can be played, sometimes simultaneously. Such convoluted calculations are often designed to avoid writing down the value of assets and thereby deliver the impression of solvency. But, more generally, the financial sector has become acutely aware of the signalling power of active numbers reported to elicit an effect in the future, rather than passive numbers designed to faithfully depict an image of the present. Thus LIBOR is not the rate at which unsecured funds are accessed, LIBOR is the signal to investors that everything is under control, or that a trade has been particularly profitable. 34. So what is the purpose of the firm under such circumstances of intra-firm signalling and extra firm collusion? This is all very different from classical “theory of the firm” literature, where signalling is not envisaged and firm boundaries are rigid. The reason for rigid boundaries is different in various traditions: firms with boundaries exist to minimise transaction costs in the Coasian perspective, firms exist to manage agency problems in the Jensen and Meckling perspective, or firms exist to protect and coordinate certain skills and competences in the Teece et al perspective. But, in different ways, all of these theories presume that the firm “contains” activity on some rational basis and in doing so performs some functional purpose for the broader economic good. As a corollary the firm has interests which management employees should defend. 35. None of this adequately explains collusion and signalling in investment banking. This behaviour suggests that the bounded firm and its interests are no longer primary because its elite workforce has captured the institution so that the purpose of the firm is to serve the elite. The outcome is akin to what Akerlof and Romer described as “looting”, which involves maximising individual rewards at the expense of the institution when accounting is poor, regulation is lax and there are few penalties for abuse. In looting, managers take from the trading profits and the institution is left with the liability.218 36. A large complex investment bank is an ideal site for looting activities as the firm institutionalises opportunities for insiderism, when it is one way or another on both sides of many trades either in its own right or when acting for clients. Put another way, the bank is a machine for generating asymmetric information from which private gains are made as strategies of position, disguise and deception within and beyond the firm are incentivised. 37. Many politicians and regulators find it difficult to conceive of banks as organisations that institutionalise inside trading opportunities. For most of the 1990s and 2000s, regulators were absorbed by discussions about market efficiencies, financial innovations that improved intermediation and capital allocation, new whizz-bang models that distributed risk and the need for light touch regulation to liberate the sector. They then failed to register that modern banking is particularly prone to looting, because of the opportunities for insiderism in large complex institutions and because the looting can go on as long as the institution remains solvent, which is a long time when there is a state bailout guarantee. 38. The result is banks as towers of assets built on the quicksand of confidence with opportunities for manipulating profits, sometimes by collusion between insiders and outsiders across firm boundaries. In this case, the most fundamental institution of the capitalist world, the public limited company, is being arbitraged in the interests of an elite workforce inside and outside the firm. (iv) The business model (and the madness of Barclays) 39. At this point in the argument we turn to analysing the banking business model of large, complex financial institutions. This is relevant for several reasons. To begin with, we have observed that irresponsible dysfunctional behaviour is related to a series of organisational characteristics inside banks (excessive informality, loose federal structures, and permeable boundaries around the firm). All this could be very easily understood as a kind of disorganisation, ie informality is the absence of the principles which properly structure other kinds of organisations. Instead, we would wish to argue that the characteristics represent an active kind of misorganisation, ie informality and permeability are the organisational corollary of a business model where the firm has been captured by senior employees. 40. Put directly, the weakness of the organisation and the discretion of individual investment bankers is what we would expect given the bank business model which primarily supports looting by employees (and in doing so puts shareholders second and the public interest nowhere). We concentrate on the post-crisis present day because all discussion of pre-2008 irresponsibility is met with arguments that, of course, much has changed. As we shall see, not enough has changed. At this point, we turn also to financial numbers from bank report and accounts where we will use Barclays most recent accounts for illustrative purposes. It should be said that standards PLC accounts are not very informative if we are trying to figure out what is going on inside large, 217 218

Barclays Annual Report & Accounts, year ending 2011, p234 G. Akerlof and P. Romer. Looting: the economic underworld of banking for profit. Washington: Brookings Papers on Economic Activity. Washington: 1993.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1408 Parliamentary Commission on Banking Standards: Evidence

complex, financial institutions. But, we would argue that the aggregate accounting numbers on large, complex banks strongly suggest that senior investment bankers are behaving irresponsibly in claiming trading assets which generate feeble returns but underwrite their continued high pay (and that is a kind of looting at the expense of private shareholders and the public interest). Analysis of accounts at company level is important because it shows that language about looting by senior employees is not exaggerated and we are not constructing an overly dark view of banking from a few anecdotes. 41. We chose Barclays as the illustration for several reasons. To begin with, Barclays is now widely considered to be the classic example of a bank with a cultural problem. Barclays was the first major bank to admit collusive Libor rate fixing and there clearly was a breakdown of trust between its now departed senior management and the FSA which was unnerved by successive instances of rule bending and merely formal compliance. While all this is true, it misses the crucial point that Barclays was and is not so much a bank with a bad culture as a bank with a mad business model which is performed in all kinds of dysfunctional ways that won’t be stopped by simply getting rid of Bob Diamond and his senior staff. And, worse still, on our preliminary calculations, the key numbers and ratios in other banks are not massively different from those in Barclays, which is fairly representative of large complex financial institutions that generally share not a bad culture but a mad business model. 42. But what is the business model of Barclays and the other large complex banks? It has three elements, disclosed, undisclosed and absent. (a) The first, disclosed element is the public commitment to shareholder value, especially in the form of declared return on equity (ROE) targets which by 2012 are now about getting back to the good old days of 15% or higher ROE achieved (through leverage) in 2008. (b) The second, undisclosed element is maintaining the pre-conditions of looting by senior and high paid employees. The key precondition is retaining a large pile of assets in the investment banking division; and this is crucial because senior employees are paid according to turnover under some variant of “comp ratio” system ie on an understanding that the total pay bill will account for some fixed proportion of net turnover after expenses. (c) The third absent element is any safeguard for the public interests in a sector where the private and social interests in preventing accidents do not coincide and where the public is one way or another on the hook for bank bail outs, liquidity injections and guarantees if and when the assets turn into liabilities or markets freeze. So before 2008 there was no limit on levering returns for shareholders though that would dump liabilities on the public in the ensuing down turn; and, after 2008, there has been no limit on piling up low return assets which benefit nobody except senior employees. 43. Let us now see how this plays, beginning with the public, disclosed business model element. “Diamond vows to try harder as Barclays disappoints” was how the Financial Times of the 10th February 2012 reported Bob Diamond’s presentation of Barclays disappointing financial results for 2011. The CEO admitted that the bank had made an “unacceptable” 6.6% ROE. “I am not satisfied with these returns. I care about this a lot … it is important to shareholders. We have a lot more to do”. At the same time Bob Diamond reiterated his commitment to his target of 13% and insisted that “if it wasn’t for the external factors we could still do it (and) we’ll make steady progress next year”. 44. Any calculation of ROE confirms Diamond’s point that shareholders have not done well from the Barclays business model since the financial crisis began. ROE can be calculated in several different ways using slightly different numerators and denominators; while time series calculations of Barclays ROE are complicated by the bank’s acquisition of substantial parts of Lehman’s business after the crisis of autumn 20008. Table 1 presents our own calculations of aggregate company-wide ROE and table 2 presents the slightly different calculations made by Barclays which break ROE down by line of business. Table 1 BARCLAYS PLC RETURNS ON SHAREHOLDER EQUITY AND ASSETS

2007 2008 2009 2010 2011

Return on average shareholder equity %

Return on average total assets

Return on average total assets

Total shareholder equity

Pre-tax profit (continuing operations)

%

%

£m

£m

14.5 12.1 6.5 6.8 5.7

0.4 0.3 0.2 0.3 0.2

0.4 0.3 0.2 0.3 0.2

31,821 43,574 58,699 62,641 65,170

6,254 5,094 4,559 6,079 5,974

Source: Barclays 20-F. Notes: Shareholder equity includes capital injection -note the underlying profit has not collapsed. Total shareholder equity is not the same as average shareholder equity.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1409

45. On our calculations, Barclays current company-wide return on shareholder capital of around 6% is well below the 15% level achieved before the crisis in 2008. Barclays own calculations, based on allocating equity capital to business lines, are even more interesting because they suggest that ROE in investment banking is currently well below the level achieved in the bank’s quality retail businesses. The company’s calculations of ROE by line of business present two different measures (adjusted or statutory) and we prefer adjusted because it excludes various exceptional items. On this basis, according to Barclays own calculations, return on equity is higher in UK retail and Barclaycard which can both hit 15% whereas the investment banking division Barclays Capital does no better than 10%. Table 2 BARCLAYS PLC RETURN ON AVERAGE SHAREHOLDER EQUITY (AS PUBLISHED IN BARCLAYS 20-F) Return on average shareholder equity (ADJUSTED) %

Return on average shareholder equity (STATUTORY) %

14.9 –6.0 10.0 17.4 10.4 1.3 10.9 24.1 –2.9 6.6

10.6 –21.8 10.0 6.8 10.4 –1.4 10.9 3.3 5.8

UK retail Europe retail Africa retail Barclaycard Barclays Capital Barclays Corporate Barclays Wealth Investment Management Head Office Group Source: Barclays 20-F.

Adjusted performance measures exclude the impact of own credit gains, gains on debt buy-backs, loss on disposal of a portion of the Group’s strategic investment in BlackRock, Inc., impairment of investment in BlackRock, Inc., provision for PPI redress, goodwill impairment and loss/gain on acquisitions and disposals. The adjusted return on average equity and the adjusted return on average tangible equity represent adjusted profit after tax and non-controlling interests (set out on pages 274 to 276) divided by average equity and average tangible equity, excluding the cumulative impact of own credit gains of £2,708m (2010: 391m gain, 2009: £1,820m loss) recognised in Head Office and Other Operations. 46. This first calculation of return on equity by line of business, encourages us to dig deeper and consider Barclays sources of income and return on assets in different business lines. As Andrew Haldane has emphasised, banking before 2008 was often about leverage which boosted ROE but trashed return on assets (ROA). The question is rather different and even simpler by 2012. Where’s the ROA on the large pile of assets held within the investment banking division? And, if these assets are low return in term of ROA profitability, what ‘s the rationale for this allocation which only clearly benefits senior investment bankers whose pay effectively relates to turnover and volume. 47. The starting point in this analysis has to be the observation that trading (which was central to investment banking profitability for fifteen years before the crisis) is not and has not been an engine of profit for Barclays because it does not generate a large proportion of the bank’s income. As table 3 shows, the percentage of Barclays’ income derived from trading in 2011 stands no higher than 23%, while the interest income (mainly) derived from old fashioned banking intermediation between depositors and borrowers is substantially higher at some 37%. This is not a recent post-crisis development because in 2007 the percentage of income derived from investment is lower and intermediation accounts for no less than 41% of Barclays income. Table 3 BARCLAYS PLC INCOME BY TYPE, 2007 AND 2011 2011 £m Interest income Fees and commissions Trading Investment Insurance Gain on buy backs Other Total

12,201 8,622 7,660 2,305 1,076 1,130 39 33,033

% 36.9 26.1 23.2 7.0 3.3 3.4 0.1 100.0

2007 £m 9,610 7,708 3,759 1,216 1,011 188 23,492

% 40.9 32.8 16.0 5.2 4.3 0.0 0.8 100.0

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1410 Parliamentary Commission on Banking Standards: Evidence

Source: Barclays 20-F. Notes: Excludes write-offs. 48. Of course, such classifications tell us about what Barclays does and also about how it chooses to represent its activities. A further one quarter to one third of Barclays’ income appears under the heading of fees and commissions, which arise from retail and investment banking. It may be that Barclays is, like JP Morgan, now increasingly wily about reclassifying its trading activities under other headings because US regulators disapprove of own account prop trading. But the proportion of Barclays income derived from fees and commissions has fallen in recent years and the supposition must be that retail (before and after 2008) has generated a bigger lump of profit than investment banking. 49. Both traditional retail and post-1990 investment bank trading are asset intensive and (as and when things go wrong) the asset pile will generate huge liabilities for the taxpayer. It is not possible to be precise about what proportions of Barclays’ assets and liabilities arise from retail and investment banking but the pile is huge and a substantial proportion of the total arises from investment banking activity. Table 4 summarises relevant sections of the 2011 accounts which show a bloated balance sheet and huge credit risk. In 2011, Barclays credit risk is £1,795 trillion ie this one bank has a credit risk larger than nominal British GDP of £1,500 trillion. And nearly half of that is in derivatives and off-balance sheet liabilities, driven by investment banking that is generating paper whose future realisable value is often uncertain. Meanwhile, old fashioned loans account for no more than one quarter of the bank’s credit risk. Table 4 BARCLAYS PLC CREDIT RISK SPLIT BY CATEGORY TOTAL AND GEOGRAPHIC SPREAD, 2011 TOTAL 2011 £m %

Derivatives Loans (w/s and h/l) Repos Trading portfolio Off balance sheet Other Total exposure of which net exposure

538,964 431,934

UK £m Share of total %

£m

Other Share of total %

32.3 51.1

173,863 90,444

32.3 20.9

153,629 63,457

28.5 14.7

37,609 57,218

7.0 13.2

22,701 15,162

14.8 12.2

32,926 23,381

21.4 18.7

80,124 68,835

52.1 55.2

17,914 17,360

11.7 13.9

16.3 104,576

35.8

35,663

12.2

126,977

43.4

25,076

8.6

254,011 14.1 69,708 1,795,604 100.0 606,825

27.4 33.8

89,636 445,913

35.3 24.8

57,574 550,596

22.7 30.7

37,093 192,270

14.6 10.7

153,665 124,738 292,292

30.0 173,863 24.1 220,815

Geographic Region Europe Americas £m Share £m Share of of total total % %

8.6 6.9

794,700

Source: Barclays 20-F. Note: Net exposure relates to exposure with no net counterparty. Abbreviations w/s refers to wholesale and h/ l refers to home loans. 50. No doubt, Barclays’ management would argue that the relevant measure of credit risk is net risk, which at £794 trilion is still roughly half the size of British GDP. But that net calculation assumes that all Barclays counterparties would or could pay up when things go wrong. And the reliability of this calculation depends on the quality of Barclays internal risk models, and whether there is a systemic crisis where the illiquid and insolvent can’t pay. As we argued some months ago, in a separate publication, the euro zone crisis is a banking crisis about long chain interconnections through bank lending and derivatives from South to North Europe; against this background it is unwise to assume that currently sound counterparties in Northern Europe would pay up in crisis because they are likely to have problems about liquidity and solvency arising from Southern exposures which (in areas like derivatives) are completely unknown to outside parties. Barclays’ pile of assets is not in the interests of shareholders and may cost the British taxpayer dear in a further round of bank re-capitalisations. 51. The accounting evidence is not conclusive but it is strongly suggestive of the second undisclosed element in the business model. The big pile of low return assets in investment banking is an indicator of firm capture and looting by senior executives because it is likely to inflate their salaries through the connection to turnover (which represents nothing more than a promise of profit for shareholders). How else do we understand the

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1411

accounting numbers? If we make the comparison with retail, investment banking makes a modest contribution to the bank’s total profitability and trails in its ability to generate ROE. At the same time investment banking requires a large pile of assets to make this contribution (which incurs massive potential liabilities). Whose purpose does the BarCap investment business serve if it needs to ramp assets to generate a modest return? Is it not paradoxical that those senior employees who are paid most within Barclays investment banking division are unable to turn a higher profit on the assets they manage? If banks are making some contribution to efficient capital allocation, why are the highest paid the worst performers in terms of allocative results. Are they not looting the company? 52. The third, absent, element in the business model is any consideration of the social interest. While private shareholders do get modest returns, the citizen who back stops the risk when it all goes wrong gets almost nothing out of an investment bank like Barclays—either directly in the form of taxes paid or indirectly in the form of banking products which are fit for purpose or in the form of loans that support the productive economy. British citizens could and should ask Barclays management, what have you done for us lately? 53. If we look at Barclays profits or pay, the totals run into billions. This machine for enriching elite investment bankers paid out 46% of BarCap turnover in comp last year when the whole bank’s headline ( adjusted” profit was more than £5billion. But tax payments can be measured in hundreds of millions because Barclays is a corporation built on tax avoidance. The risks to the tax payer are not offset by corporation tax because Barclays has used losses to minimise its payments; a parliamentary question in early 2011 forced disclosure that Barclays paid just £113 million in UK corporation tax in 2009. Again, this is not matter of standard private sector practice because there is clearly a line between Barclays’ aggressive tax avoidance and the practice of socially responsible private PLCs (like supermarkets, Tesco and Sainsbury) which pay around 25% of profits in taxation. 54. Ordinary bank customers are equally right to be aggrieved about a sector which has repeatedly sold retail products which are not fit for purpose as it has admitted in successive scandals about mis-selling of endowment mortgages, personal pensions and payment protection where Barclays alone has now made £1.3 bilion provision against claims of mis-selling.. This serial misbehaviour is what happens when the demand for shareholder value returns intersects with confusion pricing and selling to retail customers. Retail delivers 15% returns on equity because the high street retail business model is to cover free current accounts and expensive high street branches with aggressive cross selling, where fines and claims are an acceptable cost of business 55. Nor is there indirect social benefit through loans for the productive economy. Barclays’ pile of assets continues to do very little for the UK’s productive economy because of the continuing bias in its lending patterns. As table 5 shows, more than 60% of Barclays company-wide lending and of Barclays UK lending is to other financials and for house mortgages, and the sums advanced to other financials and on mortgages have increased sharply since 2007. If we consider loans to manufacturing, retail and wholesale distribution sectors, they account for no more than 7.2% of the UK loan book in 2011 and these loans are in relative and in nominal terms sharply down on 2007 levels (see also figures 1 and 2). The company’s explanation is that there is not much demand for loans to the productive economy and that may be true. But that does not explain Barclays’ business model which involves an investment banking commitment to low-return assets in the hope of higher ROE, with the taxpayer footing the bill when it all goes wrong.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1412 Parliamentary Commission on Banking Standards: Evidence

Table 5 BARCLAYS PLC LENDING TO UK CUSTOMERS, 2007 AND 2011 (NOMINAL DATA AS REPORTED BY BARCLAYS DURING THE FINANCIAL YEAR)

2007 £m Finance Manufacturing Construction Property Energy and water Wholesale and retail business Other business Home loans Cards and other personal loans Other Net lending Of which: Total non-finance business (excl. property)

%

2011 £m

%

Nominal increase/ decrease 2007–2011 %

21,131 9,388 3,542 10,203 2,203 13,800

11.1 4.9 1.9 5.4 1.2 7.2

27,725 6,185 3,391 16,230 1,599 10,308

12.0 2.7 1.5 7.0 0.7 4.5

31.2 -34.1 -4.3 59.1 -27.4 -25.3

22,705 71,755 26,810

11.9 37.7 14.1

16,473 112,260 27,409

7.1 48.7 11.9

-27.4 56.4 2.2

8,810 190,347

4.6 100.0

8,856 230,436

3.8 100.0

0.5 21.1

51,638

27.1

37,956

16.5

-26.5

Source: Barclays PLC annual reports. Note: Non-finance business is manufacturing, construction, energy and water, wholesale and retail business, other business. Figure 1 BARCLAYS PLC UK LENDING 2007 AND 2011 SPLIT BY SECTOR

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1413

Figure 2 BARCLAYS PLC UK LENDING TO THE NON-FINANCIAL SECTOR, 2007 AND 2011

56. The problem of “banking culture” is thus materially embedded in the bank’s business model so that the madness of Barclays is mandated by the model which supports the socially dysfunctional behaviours that concern us. And, in turn, reform is complicated because the business model is not so much technically misregulated as politically sponsored by elites. (v) (Political) authority to spoil the business model 57. In focusing on Barclays we are not suggesting that they are a “bad apple” in the system. We have focused on that bank because it epitomises the wider systemic problem. The “cultural” problems of banking arise from the very character of the business models which now dominate investment and retail banking. This means that reform is no easy matter because effective reform demands changes in more than firm level governance, attitudes, and in regulatory practices. Therefore, addressing the problem of the business model is beyond the authority, or the will, of bankers and their regulators. Reform of the investment banking business model depends on the exercise of the political authority which democratic legitimacy confers on legislators. Thus the political courage shown by this Parliamentary Commission will be critical to the future. Change demands an act of courage on the scale of the great Glass-Steagall reforms in the United States in the 1930s, reforms which stabilised the American banking system for a generation. One issue for members of the Commission is whether they have the political courage of legislators like Senator Carter Glass and Representative Henry Steagall. 58. They will need this courage because the obstacles to reform do not just lie in the structure of banks; they also lie in the institutions of democratic government—in the executive, in the parties and indeed in Parliament. The Libor scandal provided opportunities for the kind of adversarial blame shifting for which the House of Commons has now become a byword. The finances of the parties also provide plenty of opportunities for adversarial exchanges. It has been well documented, for instance, that under David Cameron the proportion of Conservative Party funding derived from the City rose by 25% in five years to make up 50.8% of the Party’s total—27% of this came from hedge funds and private equity. And, in a kind of parallel to the contrition of bankers, front benchers of both main parties have acknowledged that they got too close to the City in recent years. 219 59. But the problem of political authority over the City goes beyond a matter of individual contrition, and this explains why there are such great obstacles to the exercise of democratic authority for the purpose of fundamental reform. The City has acquired a uniquely powerful position in British society and radical reform will involve confronting that power. The observation that the financial markets, and the interests embodied in them, are powerful in shaping economic policy in the UK is hardly novel. But the striking development of 219

‘Tory Party funding from City doubles under Cameron’, The Bureau of Investigative Journalism, 8 February, 2011, http://www.thebureauinvestigates.com/2011/02/08/city-financing-of-the-conservative-party-doubles-under-cameron/ , ‘Hedge funds, financiers and private equity make up 27% of Tory funding’, The Bureau of Investigative Journalism, 30 September 2011, http://www.thebureauinvestigates.com/2011/09/30/hedge-funds-financiers-and-private-equity-tycoons-make-up-27-of-toryfunding/

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1414 Parliamentary Commission on Banking Standards: Evidence

recent decades has been the reconfiguration of the institutional mechanisms that convert this economic muscle into influence over policy. Three active forces are at work: the reorganisation and professionalization of the lobbying capacities of London finance; the changing institutional configuration within the core executive, notably the way this has affected the capacity of financial interests to make their voices heard at the heart of government; and the changing relationship between democratic actors, especially the major political parties, and City interests. 60. For much of the twentieth century the City was barely recognisable as a “lobby”; its considerable influence over policy depended on social and cultural integration with governing elites, and on the Bank of England as a mediator between City interests and the core executive. The development of more open and transparent systems of interest representation, and the growing relative autonomy of the Bank of England from City interests, made this informal regime of representation increasingly anachronistic. The financial elite responded with professionalization and more formal organisation of its lobbying operations. Aeron Davis has documented the rapid growth of professional financial PR and lobbying services in the City in recent years. Under Angela Knight, a Treasury Minister in the Major governments of 1990–7, the British Bankers Association was revitalised as a lobbying operation: it had originally been revived to speak as the voice of British banking in Brussels, but now acquired a prominent role in domestic lobbying. 61. A second big change has involved the role of the Corporation of the City of London. Until near the end of the 20th century it was largely a body with narrow local government and social functions. Now it has been reorganised into a systematic lobby for London finance. A key change occurred in 2002, when the constitution of the Corporation was reformed: it had hitherto escaped every reforming measure in local government since the original Municipal Corporation Act of 1835. The City of London Ward Elections (2002) does something unique in British local government. The business vote in all other local government systems of the UK had finally been abolished in 1969. The Act of 2002 not only retained the business vote in the City, but greatly expanded the range of the business franchise, so that business vote now actually outnumbers the residential vote in the City. The Corporation has applied its considerable historical endowments to building up its advocacy and economic intelligence capacities: it was the Corporation, for example, which provided much of the research work for the Bischoff Report. 62. Within the Executive the powerful role of City interests is well illustrated by the case of United Kingdom Financial Investments (UKFI) which, as members of the Commission will well know, is the vehicle for managing the huge tranche of the banking system acquired in the rescue operation after 2007. UKFI was from the beginning defined by its founding chief executive (John Kingman, then a senior Treasury official) as an “arm’s length” institution: that is, an institution operating at arm’s length from the democratic state. Its relations with the “city state” were very different—and much closer. Its successive chairmen have been City grandees, and its senior executives have been drawn overwhelmingly from the financial elite. Moreover, its operating strategy has been defined in a familiar, pre-crisis language of the maximisation of shareholder value: it sees itself as promoting any practices in the banks—including the highly contentious bonus system—that will allow it eventually to dispose of its holdings on terms which maximise return to the taxpayers as shareholders. 63. The nexus between the core executive and the elite of the city state has been in turn strengthened by the third force: the rise of a financial nexus between the leading parties and City interests. The figures cited above about the Conservative Party’s present reliance on City money are the common material of adversarial party exchanges. But they are only significant because they illustrate a deeper set of problems: both major parties in office are magnets for City money; and in office both welcome the money because the financially independent mass party which flourished a generation ago is now a thing of the past. 64. Pinto-Duschinsky’s landmark study of party finance shows that in the golden age of the mass party the Conservatives, contrary to many myths, raised most of their income through membership dues and fund raising activities at local level.220 . The bulk of income came from the constituency parties—large in the age of the mass party—and highly effective fund raising operations. There were some obvious and unsurprising social and geographical biases in constituency party strength. But in the age of the mass party—at its post war peak the Conservative Party had 2.8 million members—both membership and fund raising had a wide base: the Party had large, wealthy constituency organisations in Scotland and the north of England. It thus had deep social roots, and funding sources, outside the metropolitan centre. These roots have now withered: there are presently about 200,000 individual members, most of them elderly; Labour has about 170,000. (At its peak there were more Young Conservatives than there are now members of the whole Party). These withered social roots have also had an important financial consequence: the Party in the country is no longer a significant source of income. 65. Moreover, increasing transparency about donations—beginning with the 1967 Companies Act and culminating in the regulatory regime now run by the Electoral Commission—has made large corporations hesitant to donate. The Party has to rely heavily on rich individual backers. A large proportion of this money comes from the working rich created by the financial services revolution—high net worth individuals who have the means to make significant donations, and who as individuals do not feel constrained by the delicacies that hem in major corporations. 220

M. Pinto-Duschinsky, British Political Finance, 1830–1980. Washington: American Enterprise Institute.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1415

66. We stress that in using illustrations from the Conservative Party we are not seeking to make a partisan point. Were the problem confined to the Conservatives, the problem would be easily amenable to solution by means of democratic electoral competition. But all the major parties have suffered a catastrophic decay of their non-metropolitan roots. The result is not only financial dependence, but a kind of intellectual dependence. It helps explain the enchantment with the City as the source of dynamism in the economy, and the obsession with “light touch” regulation which united both front benches for many years. And since the institutional decay which gave rise to this state of affairs still exists, changing the mindset which produced the moral and financial catastrophe in British investment banking is going to be extremely difficult. Hence the need for conspicuous courage on the part of the Commission when it produces its report. (vi) Recommendations 67. If the political will and authority exists, it is possible to make recommendations that will change the economic practices and business models that now dominate the banking industry and thereby transform culture and behaviour which depend on material support and encouragement. Indeed, the good news is that, if the political will can be summoned, the reform policies already advocated by radical critics of banking could be deployed purposively to spoil the business model. We will below summarise some major recommendations and in each case end by explaining how it spoils the business model. If the political will does not exist, then we will get governance reform at firm level and (maybe) some kind of macro prudential regulation which will not change bank behaviour and outcomes for the taxpayer. 68. The first recommendations are about segregating and shrinking the investment banking sector and forcing a change in the business model by limiting senior management ability to loot. 69. i. Segregate investment banking (by completely separating retail and investment banks) so as to remove the possibility of cross subsidy from retail and expose the risk and returns characteristics of investment banking. After the Libor scandal, the Vickers proposal to establish ring-fences or “Chinese walls” between retail and investment divisions looks less adequate than ever. Allowing the two activities to remain together serves nobody bar the bank executives who benefit from opacity and cross subsidy. A growing number of people— most recently Lord Myners and Lord Lamont—are now calling for a complete split, and this stands as the most simple and most politically attainable of the banking reforms proposed. Here is where the Commission could, through structural reform recommendations, most clearly emulate the courage of Senator Glass and Representative Steagall’s original foundation of banking probity and stability in the American New Deal. 70. ii. Assert the public interest by announcing the policy objective of a smaller investment banking sector. Contrary to the PR story repeatedly told by the City, the social contribution of investment banking to the UK economy is, in light of the risks it creates, either negligible or negative—an observation documented in our own research publications, and made with particular force in the reflections on the crisis by Andrew Haldane and Adair Turner. Bank assets worth several times the value of UK GDP represent a threat to the UK taxpayer which should not be sustained into the future. Since these risks were exposed by the 2008 crash, proposals for how to minimise them have revolved around either strengthening regulators or making the regulation more complex. Most notably, the Coalition has given the Bank of England responsibility for the FSA’s supervisory duties, under the assumption that a greater concentration of regulatory power will create greater levels of efficiency in spotting and acting upon systemic risks as compared to the previous tripartite system. However, the size, complexity and opacity of the modern banking system—particularly its shadow and offshore aspects—have made modern finance near ungovernable. Given the pace of financial innovation, new pieces of regulation are likely to act only as inputs to an on-going process of bricolage or opportunistic improvisation—just as the increase in Basel II capital requirements led to an expansion of banks’ off balance sheet activities. 71. iii. Re-engineer pay so as to limit high pay for investment bankers and break the link between pay and turnover. That the working rich of the banking sector are encouraged to misbehave by their incentive structures has become accepted as common sense. And yet widespread public anger has been misdirected because, while the form of bonuses has been changed, little has been done to restrict the size of those bonuses, and nothing has been done about pay and its connection to turnover. Even the timid reforms proffered in 2009/ 10, concerned with deferring payment or reducing the proportion given in cash, have been circumvented. Government cannot rely simply on episodes such as the “shareholder spring”. It must use its authority to intervene for the public good. The most simple and effective action would be a large tax on firms’ compensation funds. More significant and less acknowledged than bonuses (as a form of pay) are the use of compensation ratios (to determine the size of the pay pot) so that senior investment bankers expect a share of net revenues. This form of pay is one of the main drivers of the “looting” which we earlier analysed. Restricting compensation ratios by taxing the compensation (pay) fund is therefore an obvious step to both re-engineer incentives and reduce the size of investment banking. 72. iv. Levy a financial transactions tax because that is a way of discouraging long transaction chains (with the booking of profit on day one) which are part of the socially pointless churn and clip central to the present business model. The object of reform should be to diminish socially useless speculative activity and leave behind a smaller but more effective system which acts as the servant of industry and wider society rather than the master. This would be best achieved not by shutting down trading operations directly but by frustrating the modus operandi. A variety of measures can be brought to bear to reduce the volume of financial transactions

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1416 Parliamentary Commission on Banking Standards: Evidence

taking place, but most immediately feasible would be a financial transactions tax—for which there is already substantial public support. 73. v. Restrict the use of secrecy jurisdictions. As authors like Nicholas Shaxson have demonstrated, secrecy jurisdictions are not so much an adjunct to the modern financial system as an integral part of it, enabling banks to dodge taxation and keep their most risky activities hidden from regulators .221 In the aftermath of the 2008 crash, world leaders led by Barack Obama produced a flurry of promises to clampdown on the banks’ use of secrecy jurisdictions. So far little has been done. The City of London and its offshoots in the British island protectorates remains the most significant secrecy jurisdiction in the world, and pressure for change should begin in the UK. 74. vi. End ultra-loose monetary policy which sustains an on-going bank welfare regime (now perniciously combined with tight fiscal policy that harms the real economy). The Bank of England’s provision of abundant liquidity for the banking system, through more than £300 billion of quantitative easing plus unprecedented low interest rates, is effectively bank welfare because it provides cheap feedstock for speculative activity like carry trades, and thereby diminishes the impetus for more serious reforms. Tight fiscal policy meanwhile has sucked demand out of the economy and thereby lowered the appeal for the banks of productive lending. The government needs to create more accommodating macro-economic conditions as a context for banking reform but with strict controls on property lending which was the Achilles heel of deregulated finance under Thatcher and Blair. 75. Changes of ownership in themselves achieve nothing if the business model stays the same, but will deliver much if combined with an attack on existing business models. This leads to our second series of recommendations which concern ownership 76. vii. Compel new non PLC ownership models in banking that remove the illusions of shareholder value which have been used to legitimate ramping assets in wholesale and incentivised mis-selling on the high street (at the same time as it prevents us from coming to terms with how we manage a low return and high investment economy). The high returns targets demanded by PLC shareholders and continual stock market pressures provide an incentive for banks to engage in risky or corrupt practices and provide cover for looting by managers (which is always legitimated as in the interests of shareholders). Given retail banking’s role as a public utility and the experience of repeated mis-selling, PLC ownership should be restricted in retail banking, with moves towards mutual ownership and regionalisation encouraged in order to ensure that banks serve the interests of their customers first and also pay attention to the general good. 77. viii. Break up too-big-to-fail-banks. The high level of concentration in retail banking creates institutions that are, to use the popular phrase which emerged in 2008, too-big-to-fail. We achieve nothing just by breaking up the banks and creating a larger number of smaller institutions with the same business model. But we do need smaller banks with new business models. We agree with the Governor of the Bank of England that if a bank is too big to fail, it is simply too big. One implication is that retail oligopolies need to be broken up. Another is that this breakup might be arranged along regional lines, as a public policy measure to counteract the metropolitan bias of the wider economy. 78. ix. Make the nationalised banks behave like public banks which exemplify a new engagement with the public economy. The taxpayer has ploughed enormous sums of money into rescuing the banking system. Northern Rock, RBS and Lloyds TSB, have received direct bailouts, but all banks have benefited from other forms of public subsidy, in particular Quantitative Easing (QE) and deposit guarantees. Public support has not, however translated into banks acting in the public interest. The taxpayers’ stake in the part-nationalised banks has been managed with “arms-length” technocratic detachment by UKFI, which has ensured minimal disruption to the banks’ existing priorities and practices and sought a return to business as usual as quickly as possible (even if, in the case of Northern Rock/Virgin Money, it means that the taxpayers have taken a substantial loss on their investment). Generously low Project Merlin lending targets were barely reached by the major banks, and there is a need for more targeted, socially useful investment to help stimulate the UK economy. The public stake in RBS should be used to transform the institution into a state-backed industrial bank, and the other major banks should have non-voluntary targets for productive lending set by government. 79. Overall, we should recognise that more and better governance (within the existing PLC framework of NEDs drawn from the officer class) will achieve very little. A diversity of corporate forms should broaden the range of civil society interests represented. But the approach to reform needs to be much more political, as the next recommendation outlines, and the first priority should be to limit the influence of London finance over the political system which has so far prevented serious reform. 80. x. Democratise finance. The crisis of the banks is a crisis of politics and the democratic disconnects which allow finance to work against the common good. The re-democratisation of finance will require many measures. First a number of overtly political measures are needed. These include: greater transparency and restrictions around lobbying to avoid the capture of regulators and politicians; the transformation of the City of London into a public organisation, instead of being an anomalous territorial-state preserve of finance; reforms to the funding of political parties in the hope that they can rebuild themselves with a mass membership of citizens rather than reflecting the concerns of a small elite of wealthy backers. These political interventions 221

N. Shaxson, Treasure Islands: tax havens and the men who stole the world. London: Bodley Head 2011.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1417

need to be paralleled with measures that will reduce the ability of special interests to capture knowledge and expertise, since it is only with the democratisation of knowledge that it will become possible to scrutinise the operations of finance and render these accountable. Once again the potential list of interventions is long. It might start by handing greater power to Select Committees (already one of the more significant locations of financial scrutiny), for instance by introducing expert cross-examiners (as has been so effective in the extra parliamentary Leveson inquiry); by creating independent institutions and locations for cross-examining the operation of systemically significant financial institutions, supported by expert counsel, but also by an informed but heterogeneous membership drawn from sectors other than finance; by extending the freedom of information act to cover systemically important financial institutions; and by creating appropriately funded public research institutions with the remit to produce pluralist and dissenting forms of expertise and knowledge about finance. 81. When all this has been done, there would still be a residual problem of culture in banking As Bob Diamond and others show, when bankers respond to criticism, they simply do not get it, cannot take responsibility for their actions and are full of excuses. It is not easy to deal with these forms of denial and the response needs to be inventive. 82. xi. Complicate affiliations. The need to re-engineer incentives returns us to the issue of culture. A dose of fear might help—by which we mean fear of penalties. While institutional changes to regulation are not a magic bullet for reform, we do need better resourced and more adversarial public regulators. Conversely, as well as a dose of fear, the right kinds of rewards would help. Present incentives tend to work in terms of an individual calculus, whereas it is the very culture of individualism that needs to be undone. Our suggestion, then, is that we need mechanisms for complicating affiliations so that those in power are bound to people unlike themselves. National Service worked this way. (No, we are not recommending a return to National Service, but it is notable that the one-nation Toryism of, say, a Harold Macmillan was born in the trenches). Certain kinds of collectivities (think of the NHS) work in this way for those—most of the population of the UK—who use them. Our argument, then, is that alongside the macro-politics we also need micro-structural interventions to complicate the affiliations of people such as traders. Here is one modest suggestion: that people in elite positions should spend two weeks a year working on the shop-floor, or its equivalent. (If we were after long-term affiliations, then it would be the same shop floor, year after year.) Or (this is done in some companies) they should donate substantial amounts of time to working within an NGO or a voluntary association. This is just a sample of small suggestions. The larger point is that we need many small-scale forms of structural reengineering if we are to create new mechanisms for weaving complicating social affiliations. 23 August 2012

Written evidence from Virgin Money Summary 1. We support the full professionalisation of banking, with training and CPD that would support proper understanding of banking risks, a professional code of conduct that would guide bankers to make decisions that are responsible, and a fair and transparent process leading to sanctions for breaches of the code. We regard the full professionalisation of banking as an important but not in itself a sufficient step to restore trust in banking. 2. The Chartered Banker Code of Professional Conduct is consistent with the format which we consider appropriate, in that it contains a short set of principles that are easy to understand and remember, and that can be applied to situations as they arise. The code of conduct can be supported by professional standards as required. 3. In addition to the introduction of the full professionalisation of banking, we believe that measures to improve standards in banking, and trust in banking, should address conflicts of interest arising from trading activities, high concentration and limited diversity in retail banking, high remuneration apparently regardless of performance, and methods of assessing banks’ risks and minimum capital requirements which reduce trust between banks and their regulator. 4. We believe that personal and business customers are entitled to a better deal from their banks, as a result of the introduction of standards and cultures such that customers can trust their banks and have confidence in their products and services, and as a result of greater competition between banks in ways that benefit personal and business customers. 5. Various surveys have shown that trust in banking is low. To restore trust in banking, we believe that two key issues are the introduction of a professional code of conduct with simple principles, and the separation of retail banking and investment banking. 6. There appears to be need for some regulatory parameters for bonuses and total remuneration (at least in ring-fenced banks), supported by shareholder oversight. For shareholder discipline to be effective, we suggest that banks should be required to give information about their bonus schemes and bonus payments, and about their total risk exposures and changes in their risk exposures. We believe that “manipulation” to enhance bonuses should be liable to sanctions under the professional code of conduct.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1418 Parliamentary Commission on Banking Standards: Evidence

7. In the context of the globalisation of banking, the Chartered Banker Code of Professional Conduct sets out principles that form a common code for all chartered bankers, whatever their background. 8. The extent of regulatory arbitrage suggests that banks’ regulatory capital requirements should be determined on a basis that is standardised and straightforward, with as little scope for manipulation as possible. This would support financial stability, and would create a more level playing field between large incumbents, smaller banks and new entrants. 9. In retail banking, we welcome the introduction of simple financial products, which set good standards, support trust in banks and encourage greater competition. We encourage the FCA to examine cross-subsidies, both within products and between products, and introductory offers, since these practices can inhibit competition and limit incentives for efficiency and innovation in ways that benefit consumers. 10. We believe that shortcomings in standards in risk management in some banks, made possible by the use of powerful technology, should be addressed by the use of a standardised approach rather than of banks’ own internal risk models, by disclosures about the full extent of banks’ risks and regulatory capital requirements, and by the inclusion of an executive summary in banks’ risk reports. 11. Retail banking and investment banking are different businesses. Retail banking is about long-term customer relationships, investment banking is about short-term transactional activities. The cultures in retail banking and investment banking are quite different. The fundamental differences between retail banking and investment banking are reflected in the different accounting treatment of loans in the banking book and assets in the trading book. We believe that there is a strong case for the full separation of retail banking and investment banking. 12. In retail banking, particularly in personal current accounts and in SME banking, concentration is high, and diversity is limited. We believe that, to improve competition in retail banking, the key issue is to encourage wider provision of personal current accounts by a greater diversity of providers, including smaller banks and new entrants with different business models, and that, to achieve this, it is necessary to give consumers confidence that switching current accounts will be easy and reliable, and to provide consumers with greater transparency about the cost of their current accounts. We therefore support the ICB’s recommendations to improve switching and transparency, and hope that they can be in place by the end of 2013. If it is thought that further measures are required at this stage, to improve competition by reducing concentration and increasing diversity, and to improve financial stability by diluting the “too big to fail” problem, we suggest that consideration be given to further divestments, access to infrastructure, and free-if-in-credit banking. We suggest that simple financial products should be extended to personal current accounts and basic bank accounts. More broadly, to improve competition in retail banking, we suggest that the FCA should state how product regulation will improve competition as well as protect consumers, and should ensure that competition is not trumped by financial stability. 13. While it is desirable that banks should not have leverage ratios as high as in 2008, we are not sure to what extent changing the corporate tax deductibility of debt interest would encourage banks to maintain low gearing in any future “bubbles”. 14. To support more effective market discipline by shareholders, we suggest that banks should be required to make greater disclosures, including about their risks and regulatory capital requirements, risk factors associated with intended acquisitions, and bonus schemes and bonus payments. We suggest that UKFI might take a lead in setting standards for the expected behaviour of shareholders, for example by establishing shareholder forums as suggested in the Kay Review. 15. We support the additional market discipline on banks that is likely to arise from the ICB’s recommendations that unsecured debt should be capable of being bailed in and that insured deposits should be preferred. 16. Stronger challenge by non-executive directors may be achieved by limiting executive positions on bank boards (possibly just to the CEO and finance director), by encouraging greater diversity of non-executives on bank boards (possibly advertising for at least some positions) and by Lord Turner’s proposal that there should be automatic bans on the directors of failing banks. Given that the compliance function and internal audit may not identify some major risks, and may be reluctant to escalate concerns, we suggest that consideration be given to the appointment in large banks at a senior level of a risk strategy executive, whose role would be to identify major risks and discuss them with the executive management team and board. To strengthen governance on remuneration, we suggest that consideration be given to the composition of the remuneration committee, to the role and responsibilities of its chairperson, and to the need for independence of any advisers on remuneration. 17. The full professionalisation of banking, with exams and CPD, a code of conduct and sanctions for breaching the code, would make it easier for banks to assess candidates for recruitment, and would make it easier for people moving from one bank to another to maintain the required standards and behaviour. 18. It is desirable that the view is communicated that whistle-blowing about legitimate concerns is responsible rather than disloyal, that the routes available to whistle-blowers, for advice and for raising concerns,

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1419

are made clear, and that as much protection as possible is given to whistle-blowers, possibly including financial compensation for adverse consequences. 19. To support confidence in banks’ reported results, we believe that there should be dialogue between auditors and the regulator, that the published report of audit committees should detail significant financial reporting issues, and that consideration should be given to the gradation of accounts by auditors. We support the proposal to change the accounting basis for loans on the banking book back to expected loss accounting. We believe that the different accounting standards for loans on the banking book and assets on the trading book, with the possibilities of capital arbitrage and of pro-cyclical impact, support the case for the full separation of retail banking and investment banking. 20. We believe that it is important for banks and their regulator to be open with each other, and to be able to trust each other. We suggest that the use of a standardised approach to assess banks’ regulatory capital requirements (along the lines suggested by Barclays Equity Research) would support trust by reducing “RWA optimisation”, would support financial stability, and would create a more level playing field between large banks, smaller banks and new entrants. We believe that differentiation between large banks, including in the assessment of the capital surcharge for large banks, and of any capital “add-ons” (possibly including an element for the quality and openness of communications), would incentivise low risks and high standards. We believe that greater disclosure about banks’ risks and regulatory capital requirements, by both banks and their regulator, is desirable, to support more effective market discipline by shareholders. 21. We believe that, to restore trust in banking, public concern about the lack of sanctions on individuals needs to be addressed. We think that this should be done by ensuring that the law is appropriate, that the automatic incentives based approach is applied to directors of banks, and that employees who break the professional code of conduct (which we think should be mandatory) should be liable to sanctions, up to expulsion from the banking profession. 1. To what extent are professional standards in UK banking absent or defective? 22. Three behavioural shortcomings were evident in the period leading up to the banking crisis, and subsequently: — Some bankers did not understand their risks properly, for example in complex securities with subprime exposures, or the limitations of their risk models in extreme conditions. — Some bankers made judgements that were not responsible, in serving their customers and in managing their risks. — Banking regulators have found it difficult to sanction bankers (at least so far) for allowing banks to fail, or for behavioural shortcomings such as LIBOR manipulation. 23. We believe that the full professionalisation of banking would enable each of these three issues to be addressed, through professional exams and CPD, a professional code of conduct, and sanctions by the professional body for breaches of the professional code. We regard the full professionalisation of banking as an important but not in itself sufficient step to restore trust in banking. 24. In June 2010, the Future of Banking Commission recommended the professionalisation of banking in the UK, with compulsory formal training, including in ethical behaviour, the development of a “Good Financial Practice Code”, and the introduction of a “new professional standards body along the lines of the General Medical Council, or the Legal Services Board”.222 Virgin Money echoed this view in its response to the ICB Issues Paper,223 and was disappointed that the ICB did not consider and make recommendations on this issue— presumably because the ICB understood that behaviours and bonuses did not fall within its remit.224 25. At that time, the professional body in Scotland for bankers was known as the Chartered Institute of Bankers in Scotland (CIOBS), which is now known as the Chartered Banker Institute. The equivalent body in England had transformed itself into IFS School of Finance. We strongly supported the initiative led by CIOBS and a number of banks to support professionalism in banking on a voluntary basis. We supported the establishment in December 2010 of the Chartered Banker Professional Standards Board (CB:PSB), its launch in October 2011 of the Chartered Banker Code of Professional Conduct which “sets out the values, attitudes and behaviours expected of all banking professionals”,225 and its development of the Foundation Standard for Professional Bankers, which was published in July 2012.226 26. Building on what the Chartered Banker Institute has already achieved, we think that consideration should be given to: — whether professionalism should remain voluntary, or be made mandatory. 222

The Future of Banking Commission Report, June 2010, pages 76 and 77. "A professional body should be set up for bankers, involving the introduction of professional exams and a professional code of practice, with processes and penalties for breaches of the code", Virgin Money response to ICB Issues Paper, page 17. 224 "I think there is a very important set of public policy issues around remuneration, around bonuses and around governance. I think those issues are very relevant to our remit, but I think they are not within our remit and I think there is a danger for us as a Commission of spreading too wide and too thin", Sir John Vickers, Treasury Committee, 24 May 2011. 225 Foundation Standards for Professional Bankers, Chartered Banker Professional Standards Board, July 2012, page 2. 226 Foundation Standards for Professional Bankers, Chartered Banker Professional Standards Board, July 2012. 223

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1420 Parliamentary Commission on Banking Standards: Evidence

—

— — — — —

whether the professional code of conduct should apply to all employees of ring-fenced banks, not excluding specific groups such as senior executives or dealers in bank treasuries. We realise that it may be difficult to apply UK standards to the UK operations of global investment banks without international agreement to do so. whether the professional standards board should have an independent chairperson, and a number of lay members. how quickly the Chartered Banker Institute can complete its Advanced Standard, for experienced and senior bankers, and its Intermediate Standard, for specialist roles. whether the Chartered Banker Institute should have power to investigate possible breaches of the code of conduct, working with the FCA. whether a whistleblowing route should be open to the Chartered Banker Institute, working with the FSA and subsequently the PRA. how the professional code of conduct and professional standards should relate to the conduct requirements of the FCA. We think that they should complement each other.

Conclusion 27. We support the full professionalisation of banking, with training and CPD that would support proper understanding of banking risks, a professional code of conduct that would guide bankers to make decisions that are responsible, and a fair and transparent process leading to sanctions for breaches of the code. We regard the full professionalisation of banking as an important but not in itself a sufficient step to restore trust in banking. How does this compare to (b) other professions? 28. In connection with the Lord Mayor’s Initiative on Restoring Trust in the City, Cass Business School carried out an analysis of 48 codes of conduct applicable to people working in the City.227 This analysis considered employers’ codes, professional codes, regulators’ codes and other codes. We agree with its assessment of codes. 29. “Similar topics appear in many of the codes, with some patterns in which topics tend to appear in employers’, professional or regulators’ codes. 45 out of 48 codes, including all the employers’ and regulators’ codes, use words related to ‘ethics’, ‘honesty’ or ‘integrity’. 34 mention ‘ethics’ or ‘ethical’ explicitly, while only one uses the word ‘moral’. 38 out of 48 codes discuss ‘conflicts of interest’, ‘bias’, or the need to be ‘impartial’, including all the employers’ codes, 16 of 18 professional codes and 3 of 4 regulators’ codes. 29 codes discuss matters which lead to ‘penalties’, ‘punishment’, ‘discipline’, ‘termination’, ‘suspension’ or ‘expulsion’”. 30. “Perhaps the most obvious variation in how the codes are written is length. [...] Among the codes analysed, the longest codes are from the Solicitors Regulation Authority, which runs to about 16,000 words, and JPMorgan, with almost 13,000 words. At the other end of the scale, the Declaration of Freeman, sworn to gain the Freedom of the City of London, is only 114 words, and the Code of Professional Conduct of the Chartered Bankers Institute (CBI) contains a statement of nine principles in less than 200 words. The Actuaries’ Code gives five principles, each with explanatory paragraphs, in about 850 words”. 31. “The codes’ length relates to other issues of style, as the shorter codes tend to give general principles, while longer codes set out more detailed rules for particular circumstances. Longer codes tend to be written in the style of legal contracts, while shorter codes typically try to provide a memorable set of positive maxims”. Conclusion 32. The Chartered Banker Code of Professional Conduct is consistent with the format which we consider appropriate, in that it contains a short set of principles that are easy to understand and remember, and that can be applied to situations as they arise. The code of conduct can be supported by professional standards as required. How does this compare to (c) the historic experience of the UK and its place in global markets? 33. While it is important not to view behaviour in the City before Big Bang through rose-tinted spectacles, various factors encouraged good behaviour. The Stock Exchange code “My word is my bond” set a standard for the City as a whole. Members of the Stock Exchange who failed to uphold its standards could be expelled. Financial services businesses were smaller, and it was easier to know what employees at all levels were doing in relation to both customer relationships and risk management. Proprietary trading was strongly discouraged by the unlimited liability structure of partnerships and by the limited capital of merchant banks. 34. Twenty years after Big Bang, media articles commented that the changes had caused some problems, but that they had enabled the City to maintain a leading position in banking and investment banking.228 Now, 227 228

Codes of Conduct in the City of London, Cass Business School. “London insiders remember Big Bang”, BBC, October 2006.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1421

after the banking crisis, and after another five years, there is greater concern about behavioural problems. Since Big Bang, five key issues seem to have led to declining standards, and to declining trust in banking: 35. Firstly, at the time of Big Bang, there were good reasons for ending the system of fixed commissions charged by stockbrokers. However, the introduction of dual capacity sales and trading, and the acquisition of brokers and jobbers by banks, led to a fundamental conflict of interest between making profits for the bank (and bonuses for employees) and supporting its customers.229 The resulting behaviour has contributed to a breakdown in trust between banks with trading activities and their customers. 36. Secondly, over the 25 years since Big Bang, there has been a remarkable consolidation in banking in the UK, leading to the concentration of retail banking in the hands of five large universal banking groups. This consolidation has led to a significant change in the mindset and behaviour of the managements of these large groups. Smaller banks had to be ever mindful of the possibility that they might be taken over, and this encouraged them to work with their customers, employees and shareholders to deliver sustainable organic growth to justify their independence, and to avoid unnecessary risks which could lead to them “getting into play”. Larger banking groups were “too big to buy” before they became “too big to fail”: the fact that they could not be taken over made them more inclined to take risks in trading or other activities, and to achieve growth by making acquisitions (where their size gave them advantages which enabled them to offer higher prices than other bidders). 37. Thirdly, during the years ahead of the banking crisis, the prevailing view was that the benign economic conditions would continue, and banks were under pressure from their shareholders to continue to increase their profits, even if that meant taking on higher risks, and to return capital through increased dividends and share buy-backs, even if that meant lower capital ratios. The process of increasing leverage, followed by decreasing leverage, is of course typical of “bubbles”,230 but it was made worse this time by the availability of complex securities with sub-prime exposures, and by the failure of the risk models that were used (including the Gaussian copula)231 to anticipate the extent of the losses which arose. 38. Fourthly, for whatever reasons, over the years ahead of the banking crisis, the remuneration of the CEOs and senior executives of large banks increased dramatically, to levels that do not seem justifiable to ordinary people, and has remained high since the banking crisis, despite the poor performance of some banks, and despite the pressures on household incomes in general. Excessive remuneration and the associated lifestyle may have contributed to an apparent lack of awareness and of humility in some senior bankers, exacerbating the lack of public trust in bankers. 39. Fifthly, a further problem is the approach to risk management used by large banks. Under Basel I, the assessment of regulatory capital was relatively simple, although approximate, and many banks also calculated their economic capital—the amount of capital which they judged necessary to cover their risks. Under Basel II, banks qualifying for advanced treatment have used their internal risk models to assess their regulatory capital, and this has led some banks to flex their risk models to reduce their risk-weighted assets (RWAs) and their regulatory capital requirements—as is evident in the FSA’s letter to Barclays dated 10 April 2012.232 More general use of “RWA optimisation” was discussed by the Bank of England in its December 2011 Financial Stability Report.233 This behaviour seems to have contributed to a breakdown in trust between some banks and their regulators. 40. Unfortunately, behavioural problems, and declining trust, have not been limited to investment banks, or to the investment banking arms of universal banks. Some retail banks have mis-sold payment protection insurance (PPI) and interest rate swaps to their personal and business customers, and have offered products with complex and at times opaque pricing. In managing their risks, the converted banks, Northern Rock, Bradford & Bingley and Alliance & Leicester, all experienced problems in the banking crisis. The reasons for these disappointing outcomes in retail banking could include some or all of the following: — The “casino banking” culture may have spread to other parts of large universal banks, and then been carried across to other retail banks.

229

—

It has been difficult for retail banks to compete effectively and grow their customer base without matching the pricing of their peers in areas such as “free” banking on current accounts, low introductory rates on credit cards and mortgages and high introductory bonuses on deposits. And, for a number of years, it was difficult for banks to match market-leading rates on personal loans without expectations of cross-selling payment protection insurance.

—

Ahead of the banking crisis, it was difficult for banks to match the financial performance of their peers without accepting similar levels of risk, for example in buying complex securities with subprime exposures.234

See for example “The Brandeis problem” in Can a return to Glass-Steagall provide financial stability in the US financial system?, Jan Kregel, 2010. This Time is Different: Eight Centuries of Financial Folly, Carmen M. Reinhart and Kenneth S. Rogoff, 2009. 231 “The Formula That Killed Wall Street”? The Gaussian Copula and the Material Cultures of Modelling, Donald MacKenzie and Taylor Spears, University of Edinburgh, June 2012. 232 Letter to Chairman, Barclays Bank PLC, Financial Services Authority, April 2012. 233 Financial Stability Report, Bank of England, December 2011, pages 39 and 40. 234 "As long as the music is playing, you”ve got to get up and dance. We”re still dancing", Chuck Prince, Citigroup, July 2007. 230

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1422 Parliamentary Commission on Banking Standards: Evidence

Conclusion 41. In addition to the introduction of the full professionalisation of banking, we believe that measures to improve standards in banking, and trust in banking, should address conflicts of interest arising from trading activities, high concentration and limited diversity in retail banking, high remuneration apparently regardless of performance, and methods of assessing banks’ risks and minimum capital requirements which reduce trust between banks and their regulator. 2. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole? Consumers, both retail and wholesale 42. Ahead of the banking crisis, as a result of weak competition among the effective oligopoly of five large banks, there was a transfer of value from consumers, and from non-bank companies, to banks (although some of this is now being paid back in compensation for PPI and interest rate swap mis-selling). In preparing for our response to the ICB Issues Paper, we were surprised by the strength of opinion that weak competition is good for financial stability because it supports high profits.235 However, weak competition did not prevent the banking crisis, in which tax-payers had to support banks, and as a result of which both consumers and nonbank companies faced difficult economic conditions. For the banking sector as a whole, as for dealers’ bonuses, there has, regrettably, been a “heads we win, tails you lose” outcome at the expense of consumers and nonbank companies. 43. The possibility of further bail-outs by tax-payers has been greatly reduced by the much higher equity capital ratios that are now required, by the ICB’s recommendation that unsecured debt should be capable of being bailed-in, and by the establishment of recovery and resolution plans.236 Over recent years, financial stability has, understandably, taken precedent over competition in retail banking, most notably in allowing the acquisition of HBOS by Lloyds TSB to go ahead despite the OFT’s objections.237 We believe that it is now time to give a better deal to consumers and non-bank companies by encouraging greater competition, by implementing the ICB’s recommendations and by considering what other actions are, or may be, necessary to address the high concentration and limited diversity in retail banking. The economy as a whole 44. History will probably describe the banking crisis of 2008 as the inevitable result of a “big bubble”. Ahead of the crisis, house prices and mortgage borrowing expanded strongly, and the gearing of banks rose sharply. It was thought that this time would be different, because of the expectation that benign economic conditions would continue, and because of the view that risk could be reduced through packaging and distribution. “Bubbles” are not unusual.238 But this “bubble” and “bust” were made worse this time by the availability of complex securities with sub-prime exposures, by the failure of the risk models that were used (including the Gaussian copula)239 to anticipate the extent of the losses that arose, and by the additional risk taken on by some banks where dealers were incentivised by high personal bonuses. 45. We regard the establishment of the FPC, with appropriate powers of direction and of recommendation, as an important improvement, which is likely to give early warning of emerging risks, and to limit the recurrence of “bubbles” in future. To enable banks to regain public trust and confidence, and support economic growth, we believe that some cultural issues need to be addressed, and, while regretting its need, we are pleased that the Parliamentary Commission on Banking Standards had been established to look at these issues. Conclusion 46. We believe that personal and business customers are entitled to a better deal from their banks, as a result of the introduction of standards and cultures such that customers can trust their banks and have confidence in their products and services, and as a result of greater competition between banks in ways that benefit personal and business customers. 3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector? 47. Media articles have commented on various polls pointing to low public trust in banks since the banking crisis, especially after the disclosure of LIBOR manipulation. For example: “Nearly two-thirds of banking customers no longer trust their lender to look after their money, a poll has revealed. As public outrage over the unfolding banking crisis grows, a YouGov poll commissioned by the Sunday Times showed 60% of people 235

"There are arguments that competition between banks can be bad for stability. One such argument is that competition, by reducing profitability, encourages greater risk taking, to the detriment of stability", Issues Paper, Independent Commission on Banking, September 2010, paragraph 3.17. 236 “New crisis management measures to avoid future bank bail-outs”, European Commission press release, June 2012. 237 Anticipated acquisition by Lloyds TSB of HBOS, Office of Fair Trading, October 2008. 238 This Time is Different: Eight Centuries of Financial Folly, Carmen M. Reinhart and Kenneth S. Rogoff, 2009. 239 “The Formula That Killed Wall Street”, The Gaussian Copula and the Material Cultures of Modelling, Donald MacKenzie and Taylor Spears, University of Edinburgh, 2012.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1423

losing faith in their bank. Some 49% believe the high-street banks to be dishonest while 45% think of them as incompetent, the poll revealed. And just 1% of respondents believe that senior executives of the biggest banks have improved their behaviour since the financial crisis began”.240 48. Commenting on public trust in banks at the launch of the Kay Review, Professor John Kay said, “A recent poll for ITN showed that only 10% of the population trusted bankers—less even than journalists and politicians. But restoring trust is not something you achieve by lecturing people about how honest you are. Trust and confidence is something that is earned or forfeited by behaviour, and the reason trust has gone is that the objective basis for trust has gone. The central issues for this review arise from the replacement of a financial services culture based on relationships by one based around transactions and trading”. 241 Professor Kay’s comments, which we endorse, support the case for introducing a code of conduct with simple principles which bankers can understand and remember, and can “live and breathe”. They also support the case for separation of relationship banking and transactional banking. 49. Public antipathy towards large banks has, unfortunately, persisted for some years. We are concerned that it may damage the perception of all banks (including smaller banks and new entrants), perpetuate low trust in banks, and restrict economic growth. 50. A disappointing aspect of a recent poll by Which? was the finding of low public expectations that things will get better: “Nearly three-quarters—71%—of people surveyed by Which? do not think banks have learnt their lesson from the financial crisis, up from 61% in September last year. Consumers have low expectations of a parliamentary inquiry into banking ethics, with only 26% confident that it will lead to positive change among the UK’s lenders”. We do not share this pessimism. We believe that the questions raised by the Parliamentary Commission, which we have found both interesting to consider and challenging to answer, get to the heart of the matter, and that, by addressing these questions, the Parliamentary Commission can make a real difference to UK banking in ways that are good for consumers and for the economy as a whole. Conclusion 51. Various surveys have shown that trust in banking is low. To restore trust in banking, we believe that two key issues are the introduction of a professional code of conduct with simple principles, and the separation of retail banking and investment banking. 4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (a) the following general themes The culture of banking, including the incentivisation of risk-taking 52. Much has been written about the extent to which the lure of large bonuses led to short-termism and to a “heads we win, tails you lose” culture. It does seem that expectations of high bonuses led to some investment banks, and the investment banking arms of some universal banks, taking on high financial risks, most notably in securities with sub-prime exposures which became seen as “toxic”. Equivalent problems were not evident in all parts of banking, but, even in retail banking, targets for bonuses may have encouraged mis-selling of PPI and of interest rate swaps. It may be that the investment banking culture contaminated parts of retail banking. However, whether in investment banking or in retail banking, the targets for bonuses were set by management teams, which themselves were under pressure from shareholders to continue to increase profits. 53. We do not believe that issues relating to bonuses and total remuneration should be addressed only by regulation. We believe that excessive remuneration reflects weak market discipline by shareholders. There appears to be need for some regulatory parameters for bonuses and total remuneration (at least in ring-fenced banks), supported by shareholder oversight. For shareholder discipline to be effective, we suggest that banks should be required to give information about their employee bonus schemes and about bonus payments, for senior executives, investment banking employees and retail banking employees. In parallel, we suggest that there should be greater transparency about their risk exposures and about material changes in their risk exposures, in a written statement that can easily be understood by shareholders. 54. The desire to achieve financial targets set for bonuses may have encouraged some bankers to engage in LIBOR manipulation, to increase profits, and in “RWA optimisation”, to reduce risk-weighted assets and regulatory capital requirements, and increase returns on capital. We suggest that “manipulation” should be addressed through a professional code of conduct, and that a disciplinary body should be able to impose sanctions for breaching the code. Conclusion 55. There appears to be need for some regulatory parameters for bonuses and total remuneration (at least in ring-fenced banks), supported by shareholder oversight. For shareholder discipline to be effective, we suggest that banks should be required to give information about their bonus schemes and bonus payments, and about their total risk exposures and changes in their risk exposures. We believe that “manipulation” to enhance bonuses should be liable to sanctions under the professional code of conduct. 240 241

“Public trust in banks "obliterated" over scandal”, The Independent, July 2012. Professor John Kay, Speech at Kay Review Launch, July 2012.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1424 Parliamentary Commission on Banking Standards: Evidence

The impact of globalisation on standards and culture 56. The globalisation of banking has brought people with outstanding talent to the City, and this has enhanced the role of London as a leading centre of international and investment banking. However, globalisation can present some challenges in standards and culture: — In a global bank, it is more difficult to control risks effectively across all locations, as was seen recently in the losses suffered by JP Morgan in its Chief Investment Office in London. — In a global bank, there is likely to be a degree of matrix management, and this can easily lead to tension, or even conflict, between mangers with product responsibilities globally and others with geographic responsibilities for all products. — With people from different geographic and cultural backgrounds, there may not be a shared intuitive response to issues as they arise. This may lead to reliance on the rules as stated—or even to the view that, if something is not specifically prohibited in the rules, it is permitted. Conclusion 57. In the context of the globalisation of banking, the Chartered Banker Code of Professional Conduct sets out principles that form a common code for all chartered bankers, whatever their background. Global regulatory arbitrage; 58. One of the strongest reasons for introducing full professionalism in banking, including a professional code of conduct that guides bankers to make judgements that are responsible, is that regulation has not been sufficient, or sufficiently effective. Banks (which typically have greater resources than regulators) have been adept at “gaming the system”, getting round the rules and exploiting loopholes in them.242 For example, banks got round Basel I by securitisation, and got round Basel II by holding assets (including risky assets) in offbalance sheet vehicles. 59. Regulatory arbitrage practices revealed in the FSA’s letter dated 10 April 2012 to Barclays include Barclays’ desire to move assets from its trading book to its banking book and its proposed extension of model approaches, both of which were intended to reduce Barclays’ risk-weighted assets and its regulatory capital requirements.243 More generally, the December 2011 Financial Stability Report observed that some (un-named) banks had been engaging in “RWA optimisation”, flexing their risk models to reduce their risk-weighted assets, to achieve the higher minimum equity capital requirement (of 9% by June 2012) set by the European Banking Authority (EBA), without having to raise new equity capital.244 60. RWA optimisation has led to two different problems: — There is declining trust in banks’ assessment of their risks, and greater uncertainty as to whether their capital is adequate. In his opening remarks on the December 2011 Financial Stability Report, Sir Mervyn King said, “The Committee recognises that concerns about the opacity of the internal risk weights used by banks in calculating regulatory capital ratios can undermine confidence in those measures”. 245 A recent poll by Barclays Equity Research showed that the confidence of most investors in RWAs had gone down, and that most investors thought that model discretion should be removed. Barclays’ conclusion was that, “To restore confidence in the actual output (ie the resulting RWAs) in the face of growing scepticism of models in general following the financial crisis, we believe that the best route for the Basel Committee to follow would be to abandon (or perhaps suspend) the entire IRB [internal ratings-based] approach”.246 — Large banks, using the internal models-based approach and engaging in RWA optimisation, can gain “unfair” advantage over smaller banks and new entrants which largely use the standardised approach. In a recent paper on market risk, the Basel Committee commented that, “the potential for very large differences between standardised and internal models-based capital requirements for a given portfolio is a major level playing field concern”.247 The approach proposed by Barclays would support financial stability by increasing the regulatory capital requirements of banks that have engaged in “RWA optimisation”, and would create a more level playing field between large incumbents, smaller banks and new entrants. 61. An additional problem is that regulators may have had reasons to accept a degree of manipulation, to support financial stability. The EBA seems to have tacitly accepted RWA optimisation, because of its desire to present a positive message that European banks are strong enough to withstand possible losses arising from problems in peripheral Eurozone countries. Earlier in 2011, when announcing the initial results of its 2011 EUwide stress test, the EBA seemed to take an overly-positive view of possible write-downs on the Government debt of peripheral Eurozone countries, particularly Greece, justifying this view on the technical basis that, “The 242

See for example Don”t Be Fooled Again: Lessons in the Good, Bad and Unpredictable Behaviour of Global Finance, Meyrick Chapman, 2010, Chapter 8. 243 Letter to Chairman, Barclays Bank PLC, Financial Services Authority, April 2012. 244 Financial Stability Report, Bank of England, December 2011, pages 39 and 40. 245 Financial Stability Report Press Conference, Opening Remarks by the Governor, December 2011. 246 Bye Bye Basel?, Barclays Equity Research, May 2012, page 1 and page 13. 247 Fundamental review of the trading book, Basel Committee on Banking Supervision, May 2012, page 4.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1425

reality is that shocks to sovereign bonds only impact the regulatory capital position via the trading book. The regulatory treatment of holdings in the banking book means that the impact of short term price shocks is limited”.248 In April 2012, the EBA postponed its 2012 EU-wide stress tests, leading to speculation that the EBA was concerned that the results might not be sufficiently positive.249 62. The scope for regulatory arbitrage is increased by differences in accounting, risk management and other regulations between different geographic areas. The threats by some UK banks to move to other areas, with less onerous regulatory requirements, may or may not have been empty threats, but they add to public disenchantment with big banks and to an impression that some banks seem to think that they are “above the law”.250 Conclusion 63. The extent of regulatory arbitrage suggests that banks’ regulatory capital requirements should be determined on a basis that is standardised and straightforward, with as little scope for manipulation as possible. This would support financial stability, and would create a more level playing field between large incumbents, smaller banks and new entrants. The impact of financial innovation on standards and culture 64. In retail banking, it is remarkable how little innovation there has been over recent decades, at least in the sense of developing new products that offer sustainable benefits for consumers. The management team of Virgin Money is proud to have been involved in developing and launching (in 1997) The One Account, which offers significant benefits in convenience and flexibility for customers for whom this product is appropriate. 65. Many of the “innovations” which have occurred in retail banking have centred around pricing (for example, low introductory rates on credit cards and on mortgages, and high introductory rates on deposits) and bundling (for example, packaged current accounts with “free” insurance). These reflect questionable standards and cultures, in that the complexity and opaque pricing of such products makes it difficult for consumers to compare offers from different providers. 66. In product markets where such “innovations” have become prevalent, it is difficult for providers which aspire to high standards and cultures to maintain their values and compete effectively. For example, new entrants to credit cards are effectively forced to match the low introductory rates that are widely available. A similar challenge faces new entrants to deposit savings. 67. A different problem exists in the core retail banking product of personal current accounts, where there has been no real innovation, other than the introduction of packaged current accounts and the addition of phone and Internet banking. The widespread availability of “free” banking (with cross subsidies between groups of customers and between retail banking products) means that it is not possible for new entrants to develop lowcost models and offer simpler products at lower prices,251 in the way that Direct Line and others did successfully in motor insurance, bringing benefits to consumers and transforming the market. 68. We welcome and strongly support the introduction of simple financial products, which should set good product standards and encourage banks to offer products that can be trusted, with appropriate features and with fair and transparent pricing. We are disappointed that this encouraging development did not happen as a result of competition between incumbent banks and new entrants, but that it required intervention, in this case by HM Treasury.252 We suspect that intervention may be necessary to address some other market practices which inhibit competition, since it is not clear that there is a market solution where new entrants can set high standards, win substantial business and force change in the market as a whole. 69. In investment banking, there was, over the decade ahead of the banking crisis, substantial innovation, particularly in the securities, such as CDOs and CDSs, that became seen as toxic. A general theme was the development of complex products with opaque pricing. If banks distributed these products, it was difficult for customers to assess fair pricing; if banks retained these products on their trading books, there was scope for “manipulation” in marking them to model (rather than to market), using banks’ own internal models. Conclusion 70. In retail banking, we welcome the introduction of simple financial products, which set good standards, support trust in banks and encourage greater competition. We encourage the FCA to examine cross-subsidies, both within products and between products, and introductory offers, since these practices can inhibit competition and limit incentives for efficiency and innovation in ways that benefit consumers. 248

Questions and Answers, EU-wide stress testing, European Banking Authority, 2011. Minutes, 6th meeting of the Banking Stakeholder Group, 20 April 2012, European Banking Authority, June 2012. 250 See for example “Banks threaten to leave London over measures to prevent another bailout”, Guardian, April 2012. 251 "across the market as a whole, there has been little incentive for innovation or efficiency", Competition in the financial services sector, Speech by Clive Maxwell, June 2012. 252 Simple financial products: a consultation, HM Treasury, December 2010. 249

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1426 Parliamentary Commission on Banking Standards: Evidence

The impact of technological developments on standards and culture 71. In retail banking, technological developments have brought clear benefits for consumers, for example in the convenience of phone and Internet banking for checking balances and making payments 24 hours a day 7 days a week, and for getting information about retail banking products. The availability of comparison websites has made it easier for consumers to compare the pricing and features of competing products, and to purchase the product they select. We welcome HM Treasury’s proposal that simple financial products should be available online, including through comparison websites. 72. In risk management, banks have been able to use technology to build comprehensive data warehouses and complicated risk models (even for the securities that became seen as toxic), to quantify their total riskweighted assets. However, several behavioural problems have arisen in some banks: — The availability of the risk models seems to have given a false sense of security that banks’ risks were being measured accurately and measured properly. — Sight was lost of the underlying risk exposures, and relationships between them, and of the limitations of the risk models, particularly in extreme conditions. — Powerful technology has allowed the manipulation of large volumes of data, and has been used to “play the game” rather than “run the business” in the “optimisation” of risk-weighted assets. Conclusion 73. We believe that shortcomings in standards in risk management in some banks, made possible by the use of powerful technology, should be addressed by the use of a standardised approach rather than of banks’ own internal risk models, by disclosures about the full extent of banks’ risks and regulatory capital requirements, and by the inclusion of an executive summary in banks’ risk reports. Corporate structure, including the relationship between retail and investment banking 74. Although there can, at least in theory, be benefits from cross-selling, cost savings and diversification between retail banking and investment banking within a universal bank, these benefits may be more than offset by cultural problems that can arise: — Trading activities can easily lead to fundamental conflicts of interest between making profit for the bank (and bonuses for employees) and supporting its customers.253 — The transactional nature of investment banking does not sit well with the relationship nature of retail banking; nor does the short-term nature of market risk sit well with the long-term nature of credit risk. — The accounting treatment of assets in the trading book (which are expected to be short-term) is different from the accounting treatment of loans in the banking book (which are expected to be long-term). — Investment banking is essentially about global markets, while retail banking is essentially domestic, even if it supports customers with international activities. — The senior management of universal banks may not be equally capable in both areas. — Within a universal bank, investment banking can easily attract more attention, and investment, than less glamorous retail banking. SME banking is particularly liable to become a somewhat unloved area. 75. Within universal banks, subsidiarisation should go some way to increase focus on retail banking, improve its governance and the transparency of its performance, and support greater competition. But subsidiarisation may not address the cultural problems set out above. As Sir George Mathewson has said, “This then seems to point to a natural division of a banking group into a commercial bank (not merely a retail bank) and a trading bank (investment bank), where the commercial bank includes the vast majority of the functions of our large banks (nearly 100% in the case of Lloyds). I should say that, during my career in banking, I perceived that the introduction of the individualistic culture of investment banking to the corporate culture of commercial banking was always problematic”.254 76. More recently, Andrew Haldane said, “restoring trust in our banking system is an urgent priority”. He suggested that this will require, among other things, “a reconfiguration of the structure of banking so that in future basic banking services are no longer contaminated by investment banking services”.255 Jayne-Anne Gadhia has expressed similar sentiments, in response to questions on this topic in a recent media interview.256 77. We note and support comments made by Lord Lawson that, “in order to recreate the culture of prudence in core banking, there should be a complete separation between retail banking and investment banking. I am delighted that, thanks to the Vickers commission, the Government are going halfway towards that by creating 253

See for example “The Brandeis problem” in Can a return to Glass-Steagall provide financial stability in the US financial system?, Jan Kregel, 2010 254 Sir George Mathewson, Article in the Financial Times, September 2011. 255 “We are not "risk nutters" stifling the recovery”, Article by Andrew Haldane, Bank of England, July 2012. 256 “Interview: Virgin Money boss calls for radical action to end banking scandals”, Jeff Prestridge, This is Money, July 2012.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1427

the ring-fence. However, I do not believe that a ring-fence will be impermeable or wholly effective. Bankers are very clever, or most of them are, and they will find ways round it. We are also talking about culture, and the prudent culture of retail banking and the adventurous culture of investment banking are two diametrically opposed cultures. With the bets will in the world, it is difficult to see how we can have two quite different and opposed cultures within the same corporate entity. There should be a complete separation, not just the ring-fence”. 257 Conclusion 78. Retail banking and investment banking are different businesses. Retail banking is about long-term customer relationships, investment banking is about short-term transactional activities. The cultures in retail banking and investment banking are quite different. The fundamental differences between retail banking and investment banking are reflected in the different accounting treatment of loans in the banking book and assets in the trading book. We believe that there is a strong case for the full separation of retail banking and investment banking. The level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects 79. As has been recognised in reviews by the OFT, the Treasury Committee and the ICB, there is not adequate competition in UK personal and SME banking,258 and there are significant barriers to entry and expansion.259 These reviews have recognised the centrality of personal current accounts, which enable banks to establish long-term relationships with their customers, and provide information about them, and can act as a “gateway” product to other retail banking products.260 Personal current accounts can also act as a step towards SME banking. 80. In personal current accounts, concentration is high, and diversity is limited. As a result of the consolidation in banking, including in particular the acquisition of HBOS by Lloyds TSB (despite the OFT’s objections)261 at the height of the banking crisis in 2008, there is now an effective oligopoly of five large banks with combined market shares of about 80% in personal current accounts262 and almost 90% in SME banking services.263 As well as high concentration, there is limited diversity: to many consumers, the five large banks seem very similar to each other. In our submission to the ICB, we recognised that Nationwide has been very successful in growing personal current accounts, from about 2% in the mid-1990s to about 7% in 2010. Nationwide is clearly different: it is a retail-only mutual building society. But the benefits of diversity are not limited to mutuals: diversity is also enhanced by “non-banks” such as Virgin and Tesco, which have strong consumer brands whose value they wish to protect. In this context, we note and welcome the intentions of Marks & Spencer and Asda to increase their activities in banking. 81. In personal current accounts, switching is low, whether because of consumer inertia, possibly influenced by limited choice and the sense that “all banks are the same”, or because of concerns that switching may be problematic, or because, with the prevalence of “free” banking, there is not a clear economic incentive to switch provider. 82. We therefore believe that, to improve competition in retail banking, the key issue is to encourage wider provision of personal current accounts by a greater diversity of providers, including smaller banks and new entrants with different business models, and that, to achieve this, it is necessary to give consumers confidence that switching current accounts will be easy and reliable, and to provide consumer with greater transparency about the cost of their current accounts.264 Switching 83. The ICB suggested that a current account redirection service should be established, by September 2013, to “smooth the process of switching current accounts”. We are happy to support this recommendation, which has been endorsed in the Banking Reform white paper. However, we are not sure that it will be sufficient to overcome consumers’ inertia, and their concerns that switching may be difficult. In our submission to the ICB, we expressed a preference for full account number portability, and suggested that, “banks should be required to introduce current account portability, to address the perception (and, too often, the reality) that PCA switching will be problematic”. We noted that Sir Donald Cruickshank had pressed for mobile telephone 257

Lord Lawson, Grand Committee debate on “Auditors: Market Concentration and their Role”, House of Lords, March 2012. "More than a decade on from the Cruikshank report, we still have a banking sector where competition is manifestly not working well for consumers. This is not just the OFT’s view—the ICB and the TSC also reached the same conclusion", Competition in UK Banking, Speech by John Fingleton, February 2012. 259 Review of barriers to entry, expansion and exit in retail banking, Office of Fair Trading, November 2010. 260 Competition and choice in retail banking, Treasury Committee, April 2011, page 85, paragraph 9. 261 Anticipated acquisition by Lloyds TSB of HBOS, Office of Fair Trading, October 2008. 262 Interim Report, Independent Commission on Banking, April 2011, page 121, Table 5.2. 263 Interim Report, Independent Commission on Banking, April 2011, page 121, Table 5.2. 264 "Banks must be far more transparent about their fees and charges so that people can clearly see what they already pay", “The true cost of “free” banking”, Which? press release, August 2012. 258

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1428 Parliamentary Commission on Banking Standards: Evidence

number portability, despite industry protestations, and we suggested that switching current accounts should be at least as easy as switching mobile phone operators.265 Transparency 84. The ICB suggested that annual statements to current account customers should include estimates of interest foregone. We are happy to support this proposal, with statements including estimates of interest foregone along the lines illustrated to the Treasury Committee by Lloyds. We are not sure how well consumers understand the concept of interest foregone, or how strong an economic incentive for switching an estimate of interest foregone will provide, especially when interest rates are so low, but we regard transparency about interest foregone as an important step foreword, and were disappointed by the apparent lack of urgency on this matter in the Banking Reform white paper, which states that, “As a first step, the OFT will host a roundtable in October 2012 to gather views on the proposal from all relevant stakeholders”.266 85. In normal circumstances, we would be happy to allow time for the measures on switching and transparency to be implemented, and for interested parties to assess their effectiveness, before considering the possible need for further measures to improve competition such as those suggested by the ICB: full portability of current accounts and a review of retail banking by the Competition Commission. However, in current circumstances, it seems important that any necessary actions are taken within a reasonable period to improve standards in banking, to give consumers a better deal and to restore trust in banking. We believe that this should be done as far as possible by encouragement of greater competition in ways that brings benefits for consumers (as well as by the professionalisation of banking, and the separation of retail banking and investment banking), rather than by more and more regulation. If it is thought that further measures are required at this stage, to improve competition by reducing concentration and increasing diversity, and to improve financial stability by diluting the “too big to fail” problem, we suggest that consideration might be given to the following possible actions. Further divestments 86. One way to reduce the size, and power, of the large retail banks, and to create more challenger banks, would be to split up some of the large banks, or at least require them to make further divestments. In our submission to the ICB, we supported the TSC’s view that the ICB should give consideration to further divestments over and above the RBS and LBG divestments required by the EU, and we supported Andrea Leadsom’s suggestion that parcels of branches should be sold to groups, outside the big five banks, which would add to competition.267 We did not agree with the ICB’s view that a challenger bank has to have a large share of at least 6% of personal current accounts to be an effective challenger, and we pointed out that Nationwide had been very successful in growing its share of personal current accounts from about 2% in the mid-1990s to about 7% in 2010.268 87. Although a requirement for further divestments seems a straightforward way to reduce market concentration and create greater diversity, we are not now sure that it is practical. According to media reports, the sale of branches by RBS to Santander has been delayed by technology problems,269 while Lloyds has found it difficult to get a buyer for its divestment and is reported to have reduced its price.270 It has recently been suggested that the big five banks might be required to sell branches to create two new challenger banks.271 However, the creation of new banks through combinations of branches of the large banks would be operationally and culturally challenging, and it would probably take some time before such new banks could become effective challenger banks. Access to infrastructure 88. As an alternative to requiring further divestments, to reduce concentration and increase diversity in personal current accounts, we suggest that consideration might be given to allowing new entrants and smaller banks to provide personal current accounts (and, subsequently, SME banking services) by “piggy-backing” on the established infrastructure of the large banks. This approach would be comparable to allowing telecom companies to gain access to British Telecom’s infrastructure, to create competition to the privatised 265

"Number portability, which you all enjoy now in telecoms, was something that I drove through in the 1990s, first on the fixed line and then mobile. In each case the estimates of the cost were huge. You could get an engineer sitting in front of a body like this demonstrating how expensive it was going to be. However, if you drive it through, that same engineer is delighted to have the challenge and the costs are trivial. The engineers get at it, they are legitimised to get at the issue and in today’s world they should be able to deliver it very easily. I would go further: they should be able to deliver it in ways that are cost saving for the bank, as well as service improving for us", Sir Donald Cruickshank, Treasury Committee, Competition and choice in the banking sector, March 2011, HC 612-iii, Question 130. 266 Banking reform: delivering stability and supporting a sustainable economy, HM Treasury and BIS, June 2012, page 54, paragraph 4.24. 267 “What can Government do to compensate taxpayers for the pain caused by the banks?”, Andrea Leadsom, conservativehome, May 2011. 268 Virgin Money response to ICB Interim Report, page 4, paragraph 16. 269 “RBS suffers blow over branches deal”, Financial Times, June 2012. 270 “Co-operative Group set to approve deal on Lloyds branches”, Financial Times, July 2012. 271 “Miliband set to up the ante on big banks”, Financial Times, July 2012.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1429

monopoly,272 rather than breaking up British Telecom, as happened with AT&T in the United States through the creation of the “baby Bells”. Variants on this alternative to divestments include transferring current accounts infrastructure and payments systems to a not-for-profit organisation which would operate as a regulated utility, and encouraging specialist firms such as FDR and TSYS to offer current account processing and other services in the way that they currently offer credit card services. Free-if-in-credit-banking 89. “Free” banking is not free, because of insufficient funds charges and interest foregone (of which many consumers have been relatively unaware), and fees for withdrawing cash and using debit cards abroad. 90. We welcome the recent debate on free-if-in-credit banking. This has raised a number of important issues relating to the “free” banking model: — Firstly, strong barriers to entry. John Fingleton observed that, “it may be difficult for entrants to attract customers from their existing provider if those customers perceive that their banking is free, or to use a different charging model when the ‘free if in credit’ model prevails across the sector”.273 Clive Maxwell subsequently said that, “it isn’t just numbers of competitors that matter—identities can have an impact too, with ‘outsiders’ typically playing a key role in shaking up established patterns of competition—this is certainly what we have seen in other types of market”.274 — Secondly, cross-subsidies between current account customer groups and between retail banking products, and risks of mis-selling, as happened with PPI. Lord Turner said that “It is not a sound basis for a long-term trust-based relationship between a competitive banking system and its customers”.275 — Thirdly, the lack of an obvious market mechanism leading to an outcome that is better for consumers. Andrew Bailey observed that, “it is hard for the industry as a whole to break out without appearing to collude. So it may require intervention in the public interest, not least because it is a way to encourage greater competition”.276 — Fourthly, the comment by Which? that, “The suggestion that banks should increase charges to avoid more scandals defies logic and is a slap in the face for consumers who are being hard hit by one of the worst financial crises in recent times”.277 The end of “free” banking would not be popular, unless there were clear offsetting benefits. 91. We therefore believe that it is important for the OFT, in its market study of personal current accounts, to consider competition in a broad sense, including the impact of cross-subsidies between current account customer groups and between retail banking products on competition in ways that are good for consumers, and which support good standards in banking and trust in banking. We suggest that the OFT should come to a view as to whether it is appropriate to make a reference to the Competition Commission at this stage. Simple financial products 92. An intervention that might act as a catalyst for better standards and greater competition, and for addressing “free” banking cross subsidies between customer groups and products, would be the introduction, as soon as practical, of simple financial products for personal current accounts and for basic bank accounts. Consistent with the general approach to simple financial products, this would set industry-wide standards for products that could be kitemarked (and, by comparison, for other product variants), but would allow banks to determine their own pricing, and continue to offer whatever product variants they wish to offer. Product regulation 93. In our submission to the FSA about the Mortgage Market Review, while strongly supporting the overall objective of improving consumer protection, we expressed concern that some of the current proposals could limit consumer choice and restrict competition. We are pleased that the FCA has been given the responsibility to promote competition, as well as to protect consumers, and we suggest that, in product regulation such as the MMR, the FCA should be required to state how its proposals will enhance competition in retail banking, as well as how they will protect consumers. Financial stability versus competition 94. Over recent years there has, understandably, been greater focus on financial stability than on competition, most notably in allowing Lloyds TSB to acquire HBOS, at the peak of the banking crisis in 2008, despite the OFT’s objections and without a review by the Competition Commission. Subsequently, the sale of RBS branches to Santander was a lost opportunity to create a new challenger bank, and greater diversity. 272

Monopoly and Competition in British Telecoms, John Harper, 1997. Competition in UK Banking, Speech by John Fingleton, February 2012. 274 Competition in the UK financial services sector, Clive Maxwell, June 2012. 275 Banking at the cross-roads: Where do we go from here? Speech by Lord Turner, July 2012. 276 The future of UK banking—challenges ahead for promoting a stable sector, Speech by Andrew Bailey, May 2012. 277 The true cost of “free” banking, Which? press release, August 2012. 273

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1430 Parliamentary Commission on Banking Standards: Evidence

95. While financial stability obviously remains very important, especially against the background of the ongoing eurozone crisis, the level and quality of banks’ capital is now much higher than it was before the banking crisis, and effective recovery and resolution plans should now be in place.278 We believe that it is now appropriate to encourage greater competition in personal and small business banking. Conclusion 96. In retail banking, particularly in personal current accounts and in SME banking, concentration is high, and diversity is limited. We believe that, to improve competition in retail banking, the key issue is to encourage wider provision of personal current accounts by a greater diversity of providers, including smaller banks and new entrants with different business models, and that, to achieve this, it is necessary to give consumers confidence that switching current accounts will be easy and reliable, and to provide consumers with greater transparency about the cost of their current accounts. We therefore support the ICB’s recommendations to improve switching and transparency, and hope that they can be in place by the end of 2013. If it is thought that further measures are required at this stage, to improve competition by reducing concentration and increasing diversity, and to improve financial stability by diluting the “too big to fail” problem, we suggest that consideration be given to further divestments, access to infrastructure, and free-if-in-credit banking. We suggest that simple financial products should be extended to personal current accounts and basic bank accounts. More broadly, to improve competition in retail banking, we suggest that the FCA should state how product regulation will improve competition as well as protect consumers, and should ensure that competition is not trumped by financial stability. Taxation, including the differences in treatment of debt and equity 97. A critical problem in the banking crisis was that, although banks had total capital ratios that seemed reasonable by historic standards, the levels of the equity capital ratios of the banks that failed were not sufficient to absorb the losses that arose. According to the ICB interim report, the median leverage of UK banks increased from about 20 times in 2000 to almost 50 times in 2008.279 Commenting on the high gearing of banks, Sir John Vickers said that, “Senior debt has generally been poor at absorbing losses (but junior debt less so). Equity is good at it, but (privately) somewhat more expensive, in part because of unintended consequences of the general corporate tax system”.280 98. There appears to be a case for considering whether tax relief on debt interest contributed to the high gearing of banks in 2008, and whether changes to the tax system should be made to encourage lower gearing of banks. However, consideration of other sectors suggests that tax incentives were not the principal reason for the high and increasing leverage of banks: —

The gearing of the personal sector increased markedly over the decade ahead of the banking crisis, principally as a result of mortgage borrowing, even though individuals no longer got tax relief on mortgage interest payments.

—

The gearing of the non-bank corporate sector (where non-banks, like banks, qualify for tax relief on debt interest) did not increase markedly over the decade ahead of the banking crisis.

99. Reasons for the high and increasing gearing of banks up to 2008 included: —

Firstly, in the mid-2000s, strong pressure from shareholders to return capital through higher dividends and share buy-backs;

—

Secondly, a willingness by banks to accept higher leverage because of the widespread view that benign economic conditions would continue; and

—

Thirdly, as the mood changed, recognition by banks that raising equity capital would be expensive, and difficult.

Conclusion 100. While it is desirable that banks should not have leverage ratios as high as in 2008, we are not sure to what extent changing the corporate tax deductibility of debt interest would encourage banks to maintain low gearing in any future “bubbles”. 4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (b) weaknesses in the following somewhat more specific areas: 278

“New crisis management measures to avoid future bank bail-outs”, European Commission press release, June 2012. Interim Report, Independent Commission on Banking, page 18. 280 “How to regulate the capital and corporate structures of banks”, Speech by Sir John Vickers, Independent Commission on Banking, January 2011. 279

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1431

The role of shareholders, and particularly institutional shareholders 101. Ahead of the banking crisis, it seems that there was a lack of challenge to banks by institutional shareholders on matters such as higher risk and higher leverage,281 acquisitions such as ABN Amro and HBOS, and remuneration including bonuses. Reasons for this lack of challenge, ahead of the banking crisis, may have included the short-termism of capital markets,282 and their bias towards optimism, especially in “bubbles”.283 As warning signs of sub-prime losses emerged, following HSBC’s profit warning in 2007, further reasons may have included the fact that many UK funds are indexed or quasi-indexed, the reluctance of fund managers to engage284 and practical difficulties faced by institutional investors wishing to challenge banks,285 and the reluctance of banks to disclose information about their sub-prime exposures until forced to do so by falling share prices towards the end of 2007. 102. As a general approach to addressing these issues, we prefer ways that incentivise shareholders to apply market discipline to banks, rather than more regulation. We support the view expressed by Professor John Kay, when introducing the Kay Report, that, “The approach we favour is one which favours giving people incentives to do the right thing, rather than presenting rules to prevent them doing the wrong thing in a situation where commercial incentives encourage them to do the wrong thing. It is an approach which emphasises structure and incentives, rather than prescriptive rules”.286 However, we believe that there may be need for some regulation, such as disclosure requirements, to support the incentivisation of effective market discipline by shareholders. 103. It is clearly hard to address the short-termism of markets and their bias towards optimism. However, the FPC will now monitor emerging risks, will increase awareness of such risks, and will have powers to limit “bubbles”. In addition to the initial macroprudential toolkit proposed for the FPC, we suggest that it should have powers to require banks to make disclosures, in the way that it might have required banks to make discloses about the extent and nature of their sub-prime exposures after the HSBC profit warning in early 2007. We recognise that the criteria set by HM Treasury for FPC powers of direction may have to be amended to allow for this.287 104. Index funds, and institutional funds with approximately indexed weightings, are less worried that share prices might fall, since this will not affect their performance relative to the index. It is not clear how the managers of index funds could be incentivised to be concerned about the possibility of falling prices. It is therefore desirable to encourage diversity of fund managers, including hedge funds and other funds interested in absolute rather than relative returns. Short-selling by hedge funds contributed to pressure on some banks, in the autumn of 2007, to disclose their sub-prime exposures, and, in the autumn of 2008, to admit their need for equity capital. 105. In relation to engagement between investors and banks, the Walker Review found shortcomings on both sides. An opportunity exists for UKFI to take a lead in setting standards for the expected behaviour of shareholders through its interaction with RBS and Lloyds. For example, UKFI might establish shareholder forums, as suggested in the Kay Review.288 106. Among the options available, we believe that requirements for greater disclosures are the most straightforward, and probably effective, way to empower shareholders and incentivise them to discipline banks, either by engaging with them or by selling shares in them. The financial performance of banks, and trust in them, was damaged by higher risk and leverage, acquisitions and remuneration. Taking each of these in turn: 281

"Before the recent crisis phase there appears to have been a widespread acquiescence by institutional investors and the market in the gearing up of the balance sheets of banks (as also of many other companies) as a means of boosting returns on equity”. , A review of corporate governance in UK banks and other financial industry entities—Final recommendations, November 2011, page 71. 282 "Our evidence suggests short-termism is both statistically and economically significant in capital markets”. , The Short Long, Speech by Andrew Haldane, Bank of England, May 2011. 283 "This was not necessarily irrational from the standpoint of the immediate interests of shareholders who, in the leveraged liability business of a bank, receive all of the potential upside whereas their downside is limited to their equity stake, however much the bank loses overall in a catastrophe”. , A review of corporate governance in UK banks and other financial industry entities— Final recommendations, November 2011, page 71. 284 "But despite potential benefits, reservations about increased engagement initiative that are frequently mentioned include [...] the scale of the senior resource commitment on the part of fund managers required for effective dialogue and the unwillingness of many or most end investors to the cost of such effort and the free-rider benefit that may be generated for those who do not contribute to the engagement process", A review of corporate governance in UK banks and other financial industry entities— Final recommendations, November 2011, page 73. 285 "On the side of boards, inhibiting factors in relation to such engagement have typically included [...] a degree of hubris or complacency about the board’s strategy which makes a chairman or CEO reluctant to spend time on challenge from one or more institutional shareholders whose interests may not necessarily coincide with those of other shareholders", A review of corporate governance in UK banks and other financial industry entities—Final recommendations, November 2011, page 71. 286 Professor John Kay, Speech at Kay Review Launch, July 2012. 287 "In addition, the Committee agreed that powers of Direction over disclosure requirements would be desirable but that it could be difficult to meet the test set by HM Treasury in its February 2011 Consultation Document that powers of Direction should be specific”. , Financial Policy Committee statement from its policy meeting, 16 March 2012. 288 "Two central recommendations in our report are that [...] and that we should encourage large institutional investors to act collectively and establish a forum to facilitate such collective engagement”. , Professor John Kay, Speech at Kay Review Launch, July 2012.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1432 Parliamentary Commission on Banking Standards: Evidence

—

—

—

We suggest that banks should be required to disclose information about all their risks (not just their Pillar 1 risks) and regulatory capital requirements for these risks, and the results of their stress tests. We suggest that banks’ risk reports should include an executive summary covering material risk exposures, changes in their risk exposures and changes in the risk environment. We suggest that banks, or their regulator, should disclose their Individual Capital Guidance, including the amount of any capital “add-ons”. For acquisitions requiring shareholder approval, we suggest that consideration be given to requiring banks to include in their document for shareholders an assessment of risk factors associated with the acquisition, as might be done for an IPO. We suggest that banks should be required to make disclosures about bonus schemes and bonus payments, for senior executives, investment banking employees and retail banking employees.

Conclusion 107. To support more effective market discipline by shareholders, we suggest that banks should be required to make greater disclosures, including about their risks and regulatory capital requirements, risk factors associated with intended acquisitions, and bonus schemes and bonus payments. We suggest that UKFI might take a lead in setting standards for the expected behaviour of shareholders, for example by establishing shareholder forums as suggested in the Kay Review. Creditor discipline and incentives 108. We hope that greater transparency by banks and by their regulators, and leadership by UKFI, will support more effective market discipline by shareholders. In addition, we support the additional market discipline on banks that is likely to arise from the ICB’s recommendations, which are endorsed in the Banking Reform white paper, that unsecured debt should be capable of being bailed in, and that insured deposits should be preferred. 109. For these additional sources of discipline on banks to be effective, we suggest that: — It should be made clear to relevant categories of bond holders that their bonds will be bailed-in instead of, or at least before, any bail-out by taxpayers, despite what happened in 2008, and despite the reluctance of the European Central Bank to force bondholders in failed banks to accept writedowns before 2018.289 — It should be made clear to depositors that deposits above £85,000 with a bank are not guaranteed, despite the possible perception, based on what happened in 2008, that all retail deposits are implicitly guaranteed. However, in making this clear, care should be taken to avoid shrinking the pool of deposits by encouraging depositors to move to national savings or gilts, or to deposits in banks of countries where all retail deposits are preferred or implicitly guaranteed. Conclusion 110. We support the additional market discipline on banks that is likely to arise from the ICB’s recommendations that unsecured debt should be capable of being bailed in and that insured deposits should be preferred. Corporate governance, including The role of non-executive directors 111. Ahead of the banking crisis, it seems that the boards of some banks did not challenge management sufficiently on matters such as higher risk exposures, the adequacy of capital and liquidity, acquisitions, and remuneration. 112. One reason for the lack of challenge appears to have been the practical difficulties for non-executive directors in challenging strong and forceful chief executives. We support the Treasury Committee’s suggestion that, “The Parliamentary Commission on Banking Standards’ examination of the corporate governance of systemically important financial institutions should consider how to mitigate the risk that the leadership style of a chief executive may permit a lack effective challenge or to the firm committing strategic mistakes”. 290 In this context, we note that, after the banking crisis, Sir Richard Greenbury was reported as saying that, “There was ‘a good chance’ that a two-tier board would have prevented the collapse of RBS challenging and curbing the actions of Fred Goodwin”.291 We are not sure that a two-tier board would be better overall for UK banks, but we support the concept that executives on the board should be limited to the chief executive and the finance director. 113. More generally, it seems desirable to ensure that there is challenge and debate at board meetings, and to ensure that desire for collegiate culture among board members does not lead to dissenters going along with 289

“ECB shows signs of bailout flexibility”, Financial Times, July 2012. Fixing LIBOR: some preliminary findings, Treasury Committee, August 2012, page 111, paragraph 32. 291 “Unitary or two-tier”, Paul Gibson, September 2009. 290

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1433

the majority “for the sake of peace”. It seems desirable to achieve greater diversity on bank boards (but preferably not through quotas): this may imply that consideration should be given to advertising for nonexecutive board positions (as in the public sector) to allow access by some candidates not on the lists of HR firms (which may be limited by a requirement that candidates already have experience on other boards). Low challenge resulting from an overly-collegiate board culture would be addressed by Lord Turner’s proposal for automatic bans on the directors of failing banks, “unless they could positively demonstrate that they were active in identifying, arguing against and seeking to rectify the causes of failure”.292

The compliance function Internal audit and controls 114. It is likely that people who choose to work in these areas have good standards, and wish to ensure that their bank complies with the regulations, and does not do things which, while not illegal, might damage the banks’ reputation. But the power of these functions may be limited. They may not be invited to comment on major corporate initiatives such as, before the banking crisis, investments in securities such as CDOs and CDSs, or acquisitions such as ABN AMRO and HBOS. And, even in activities where they are involved, they may be reluctant to escalate issues, and concerns, either within their bank or to the regulator, in case they suffer the same consequences as whistle-blowers, becoming out of favour and possibly losing their jobs. While it would be unwise to generalise from Barclays, the preliminary findings on LIBOR says that, “It is important to state that Barclays’ internal compliance department was told three times about concerns over LIBOR fixing during the period under consideration and it appears that these warnings were not passed to senior management within the bank”.293 115. There is therefore a case for establishing in banks (or at least in large ring-fenced banks) a senior position for a person who has strong technical skills and a track record of good judgement, and who is bound by professional standards, who would have a duty to raise any concerns with the executive management team and with the board, with whom the bank would have to learn to live, and who could not be dismissed, or encouraged to leave or to retire, as a result of carrying out his duty to identify and escalate major risk issues. This senior position could be established in either of two ways: —

It could be a “risk strategy executive” who would not oversee the banks’ risk management activities, but who, with appropriate seniority and authority would be free to consider strategic risks (such as, in 2007, sub-prime lending, and, currently, risks that could result form the eurozone crisis) and would discuss the areas of perceived risk on a regular basis with the executive management team and with the board.

—

It could be a “public protagonist” as suggested by Matthew Hancock and Nadhim Zahawi: “To strengthen the effective power of shareholders, a public protagonist would have the authority to convene special shareholder meetings on behalf of the public, and publicly test a course of action contemplated by the management. The management would of course remain under their obligation to shareholders, but shareholders would now hear both sides of any argument. Faced with this challenge, and with their monopoly of the supply of information to shareholders broken, a culture of challenge would be strengthened, and the senior executive would consider their options more carefully”.294

Remuneration incentives at all levels 116. It is clearly a matter of public concern that executive remuneration (in banks and more generally) has expanded rapidly over recent years, while average remuneration has grown only modestly. The 2011 BIS discussion paper on executive remuneration showed that, “between 1998 and 2010, the median total remuneration of FTSE100 CEOs increased from £1 million to over £4 million, and that the year-on-year increases were not impacted by fluctuations in the FTSE100 Index”.295 The BIS paper also showed that, while base salary has increased, most of the growth in CEO remuneration has come in the form of bonuses, deferred bonuses and LTIPs.296 To support market discipline by shareholders, we believe that there is need for greater transparency about executive bonus schemes and bonus payments, and about the total remuneration of senior executives. We also suggest that consideration should be given to the role and responsibilities of the chairperson of the remuneration committee (and whether there should be any external representation on this committee), and that firms giving advice on executive remuneration should have no other business relationship with the bank. We suggest that banks should be required to make disclosures about bonus schemes and bonus payments, for senior executives, investment banking employees and retail banking employees. 292

The failure of the Royal Bank of Scotland, Financial Services Authority, December 2011, page 9. Fixing LIBOR: some preliminary findings, Treasury Committee, August 2012, page 105, paragraph 4. 294 Masters of Nothing: How the crash will happen again unless we understand human nature, Matthew Hancock & Nadhim Zahawi, 2011, page 227. 295 Executive remuneration discussion paper, BIS, September 2011, Figure 3. 296 Executive remuneration discussion paper, BIS, September 2011, Figure 2. 293

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1434 Parliamentary Commission on Banking Standards: Evidence

Conclusion 117. Stronger challenge by non-executive directors may be achieved by limiting executive positions on bank boards (possibly just to the CEO and finance director), by encouraging greater diversity of non-executives on bank boards (possibly advertising for at least some positions) and by Lord Turner’s proposal that there should be automatic bans on the directors of failing banks. Given that the compliance function and internal audit may not identify some major risks, and may be reluctant to escalate concerns, we suggest that consideration be given to the appointment in large banks at a senior level of a risk strategy executive, whose role would be to identify major risks and discuss them with the executive management team and board. To strengthen governance on remuneration, we suggest that consideration be given to the composition of the remuneration committee, to the role and responsibilities of its chairperson, and to the need for independence of any advisers on remuneration. recruitment and retention 118. An important social change over the last fifty years is that many people change jobs, possibly several times, during their career, rather than stay with the company they join from school or university. Greater job mobility is good for people who wish broader career experience and opportunities. For employers, it brings a broad range of skills and experience. However, employers may have to spend a lot of time on recruitment, while recent recruits may take some time to understand how things work at their new employer. 119. The full professionalisation of banking would help in both areas: — It would be easier to for banks assess candidates for recruitment on the basis of their performance in the professional exams and in their CPD, and it would be possible to check whether they had been subject to any sanctions by the profession. — It would be easier for people moving from one bank, whether at a junior or at a senior level, to maintain the required standards and behaviour. Conclusion 120. The full professionalisation of banking, with exams and CPD, a code of conduct and sanctions for breaching the code, would make it easier for banks to assess candidates for recruitment, and would make it easier for people moving from one bank to another to maintain the required standards and behaviour. Arrangements for whistle-blowing 121. In the acquisition by banks of the securities that became seen as “toxic” and in LIBOR manipulation, common themes were that only small numbers of employees within large organisations were responsible for the actions,297 and that senior management did not seem to know what was going on at the time. 122. In the smaller banks and partnership businesses that existed before Big Bang, it was easier to know what was going on, lines of communication were shorter, and upward communication of problems and potential problems was often encouraged, because of concerns that financial or reputational damage might cause a bank to falter and be taken over, or that a partnership business might lose the confidence of its customers and fail. 123. However, within large organisations, the upward flow of information may well be less effective than the downward flow. One reason is that senior management have to establish formal processes for downwards communications, but may be too busy for, or less interested in, upward communications. Another reason is that middle management may be reluctant to pass on “bad news” about problems or potential problems in their areas of responsibility. There is therefore a case for establishing arrangements for “whistle-blowing” as Social Partnership Forum and Public Concern at Work did for the National Health Service.298 Concerns 124. A problem with whistle-blowing is that, if it is to be useful for preventing problems arising rather than subsequently for allocating blame, it is desirable that concerns should be raised at an early stage. However, as Matthew Hancock and Nadhim Zahawi described in their book, people raising concerns at an early stage may be labelled “fools in the corner”, and may be ignored.299 125. For many whistle-blowers, the consequences of whistle-blowing have been bad. Research carried out in Australia showed that the consequences of whistle-blowing were uniformly negative. Among 35 cases of whistle-blowing considered in the analysis, 29 had experienced victimisation immediately after their first internal complaint. Eight of the 35 were dismissed, ten were demoted and a further ten resigned or took early retirement because of ill health. These people found it difficult to get another job, and suffered vary large 297

“This attempted manipulation of LIBOR should not be dismissed as being only the behaviour of a small group of rogue traders”, Fixing LIBOR: some preliminary findings, Treasury Committee, August 2012, page 106, paragraph 7. How to implement and review whistleblowing arrangements in your organisation, Social Partnership Forum and Public Concern at Work, 2010, page 17. 299 "In the play, the loyal court fool repeatedly warns Lear of impending catastrophe. First he’s laughed at, then ignored”. , Matthew Hancock and Nadhim Zahawi, Masters of Nothing: How the crash will happen again unless we understand human nature, 2011. 298

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1435

reductions in income. Among wider consequences, 29 of the 35 reported symptoms of stress, 15 were recommended long-term treatment with drugs which they had not been prescribed before, and 17 considered suicide.300 These cases may or may not be typical of financial services, but other case studies support concerns about the possible consequences for whistle-blowers.301 Possible approaches 126. A possible approach is to establish anonymous whistle-blowing hotlines in banks. However, these could be mis-used by people with grievances, and expressions of concern that are anonymous may not be taken seriously, as was the conclusion of a US study of whistle-blowing to audit committee members.302 The NHS paper on whistle-blowing arrangements recommended that concerns should be raised openly.303 However, there could be value in a confidential whistle-blowing advice service, for employees to discuss whether, or how, they should raise their concerns. 127. To encourage whistle-blowing in an open manner, it is desirable to encourage the view that whistleblowing is not disloyal, but that it is responsible, to protect the bank and the reputation of the banking profession.304 The most obvious route is for people to raise concerns, as early as possible, with their immediate superior. If people are concerned about the possible consequences, an alternative route would be for people to raise their concern with the regulator. However, it is likely that many bankers are not aware of any duty to report concerns to the regulator, or how to do so. In any case, reporting concerns to the regulator might be seen by the bank as more disloyal, and might lead to more serious consequences for the whistle-blower. 128. An alternative route would be for people to approach the banking professional body. A code for whistleblowing could be communicated along with the professional code of conduct, and people would probably find this route easier because they would already have some contact with the professional body. This route might be particularly useful for employees who feel that expressions of concern to their bank are not being taken seriously, for senior executives who are afraid of the consequences of expressing their concerns to their CEO or chairman, and for early-stage concerns based more on intuition than on hard evidence. If considering this route, consideration might be given to established processes for whistle-blowing in other professions,305 how the regulator would be informed and possibly involved, and what protection could be given to the whistleblower and to the professional body. 129. In the event of a whistle-blower, who had expressed legitimate concern, being victimised, the banking profession could give support, and might be able to prevent him or her being dismissed. But it could probably not stop the whistle-blower being “encouraged to leave”. Given the extensive evidence of serious and longterm consequences for whistle-blowers, there is a case for considering whether they should receive financial compensation, either (as can happen in the US) as a percentage of any fine levied by the bank’s regulator, or as an amount agreed with the bank by some appropriate body, probably including representatives of the profession and of the regulator. Conclusion 130. It is desirable that the view is communicated that whistle-blowing about legitimate concerns is responsible rather than disloyal, that the routes available to whistle-blowers, for advice and for raising concerns, are made clear, and that as much protection as possible is given to whistle-blowers, possibly including financial compensation for adverse consequences. External audit and accounting standards External audit 131. It is a matter of concern that auditors signed off the accounts of UK banks at the end of 2007, and in the middle of 2008, without reservations, shortly before some banks had to raise equity capital from investors (RBS and Barclays) or from tax-payers (RBS and Lloyds), or experienced difficulties and had to be taken over or nationalised (Bradford & Bingley, Alliance & Leicester and Northern Rock). Concern about the failure of auditors to give warning of the banking crisis, and broader concern about the effective oligopoly of four large accounting firms, were expressed clearly in the opening paragraphs of the House of Lords report on auditors: “Identification of the shortcomings of the large-firm audit market is easy enough. It is clearly an oligopoly with all the attendant concerns about competition, choice, quality and conflict of interest. It gave no warning 300

“"Whistleblowing": a health issue”, KJ Lennane, British Medical Journal, September 1993. See for example “For a Whistle-Blower No Good Deed Goes Unpunished”, New York University Stern Executive MBA, June 2011. 302 “Anonymous Whistle-Blowing Systems Are Often Dysfunctional”, University of New Hampshire, March 2010. 303 How to implement and review whistle-blowing arrangements in your organisation, Social Partnership Forum and Public Concern at Work, 2010, page 11. 304 "Both reviews [the review of Barclays” business practices being carried out by Anthony and Salz, and the Parliamentary Commission on Banking Standards] should recognise that encouraging whistle-blowers is an important tool in the battle to clean up banking and indeed corporate life in general. But change will have to overcome widespread prejudice against whistle-blowers and the deep scepticism of business leaders”. , David Wighton, The Times, August 2012. 305 See for example Whistle-blowing: A guide for actuaries, and Whistle-blowing: A guide for employers of actuaries, The Actuarial Profession. 301

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1436 Parliamentary Commission on Banking Standards: Evidence

of the banking crisis. The narrowness of the assurance it offers is much criticised. [...] Yet investors, regulators and commentators regard rigorous and reliable external audit as an essential underpinning of business and the capital markets which finance it, in Britain and elsewhere. The assurance offered by audit is especially needed in the case of banks, with their attendant risks and where loss of confidence can imperil the financial system”.306 132. We await the outcome of the Competition Commission’s investigation audit services.307 We believe that there is a case for requiring auditors to be re-appointed, or even rotated, every five years, and possibly for prohibiting audit firms cross-selling some consultancy services. But, in the context of restoring trust in banking, we believe that the most important issue is whether, and how, auditors can indicate any concerns they have about banks’ reported accounts. We support the recommendation of the House of Lords Select Committee on Economic Affairs that there should be “two-way dialogue between auditors and supervisors about the financial health of banks”.308 However, while the qualification of a bank’s accounts might be a “nuclear” option that could undermine confidence in the bank,309 it seems desirable to learn lessons from risk management, where market discipline by shareholders has been constrained by the disclosure of less information to shareholders and to the regulator. So we suggest that consideration should be given to the Committee’s suggestion that, “the published report of the audit committee should detail significant financial reporting issues raised during the course of the audit”,310 and to Lord Lawson’s suggestion that, “It may be worth considering a gradation, rather in the way the rating agencies grade financial instruments, starting with AAA and going down to wherever they eventually go. It would be possible for the auditors to grade the accounts, and there could be a requirement for them to do so”.311 Accounting standards 133. We have concerns about three aspects of the IFRS accounting regulations: — Whether intended or not, they removed the need for judgement, for example in loan loss provisions and in the valuation of trading assets. While this may reduce the scope for “manipulation” in some respects, it encourages a “tick-box compliance” mindset, by banks and their auditors, that is not consistent with HM Treasury’s intended approach to financial regulation, based on proper risk analysis and judgement”.312 — The IFRS accounting regulations increased the pro-cyclicality of banks’ reported results. Two reasons for this impact were the use of incurred loss accounting rather than expected loss accounting for loans on the banking book, and mark-to-market (or mark-to-model) adjustments for assets on the trading book. We support the proposal to change the accounting basis for loans on the banking book back to expected loss accounting. For assets on the trading book, we believe that mark-to-market adjustments are appropriate, although their reliability can be limited by thin trading in markets, or by the opacity of banks’ internal model. — The IFRS accounting regulations maintained the distinction between the banking book and the trading book, with different accounting regulations. This allows “manipulation” by switching assets from the trading book to the trading book (or, at times, in the opposite direction) to reduce riskweighted assets and regulatory capital requirements.313 Although the BCBS has proposed two alternative boundary definitions, the ability to trust banks’ reported accounts may be reduced by this form of arbitrage. 134. Our conclusion is that the different accounting treatments for long-term bank loans and short-term trading assets, the possibility of capital arbitrage between the trading book and the banking book, and the procyclicality of mark-to-market accounting for trading book positions, support the case for the separation of retail banking and investment banking. Conclusion 135. To support confidence in banks’ reported results, we believe that there should be dialogue between auditors and the regulator, that the published report of audit committees should detail significant financial reporting issues, and that consideration should be given to the gradation of accounts by auditors. We support the proposal to change the accounting basis for loans on the banking book back to expected loss accounting. 306

Auditors: Market concentration and their role, House of Lords, March 2011, Abstract. Issues statement, Audit Market Investigation, Competition Commission, December 2011. 308 Auditors: Market concentration and their role, House of Lords, March 2011, Abstract. 309 "Under the present system the accounts are either qualified or they are not", Lord Lawson, Grand Committee debate on “Auditors: Market Concentration and their Role”, March 2012. 310 Auditors: Market concentration and their role, House of Lords, March 2011, page 17, paragraph 4. 311 Lord Lawson, Grand Committee debate on “Auditors: Market Concentration and their Role”, March 2012. 312 "The Committee heard that IFRS were more rules-based than previous national standards and leave less scope for the auditor to exercise prudent judgement and as necessary to override a box-ticking approach in order to reach a true and fair view of a given financial statement”. , Auditors: Market concentration and their role, House of Lords, March 2011, Abstract. 313 "Coupled with large differences in capital requirements against similar types of risk either side of the boundary, the capital framework proved susceptible to arbitrage. For example, prior to the crisis, it was advantageous for banks to classify an increasing number of instruments as “held with trading intent” (even if there was no evidence of regular trading of these instruments) in order to benefit from lower trading book capital requirements. During the crisis the opposite movement of positions from the trading book to the banking book was evident at times in some jurisdictions”. , Fundamental review of the trading book, Basel Committee on Banking Supervision, May 2012. 307

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1437

We believe that the different accounting standards for loans on the banking book and assets on the trading book, with the possibilities of capital arbitrage and of pro-cyclical impact, support the case for the full separation of retail banking and investment banking. The regulatory and supervisory approach, culture and accountability 136. We believe that the objective should be “better” regulation, that builds trust between banks and their regulator, that encourages good standards and open behaviour (including when problems arise),314 and that requires banks to hold adequate capital and liquidity, but not so much as to restrict their ability to support economic activity and economic growth. Different 137. We believe that it is important for banks and their regulator to be open with each other, and to be able to trust each other. RWA optimisation practices revealed in the FSA’s letter to Barclays dated 10 April 2012315 do not support trust; neither do the repeated statements that “banks should be very afraid of the FSA”.316 The establishment of greater trust between banks and their regulator should make it easier to implement HM Treasury’s intended approach to regulation, focusing on proper risk analysis and judgement rather than tickbox compliance.317 138. Given the limitations of banks internal risk models (particularly if based on value-at-risk methodologies),318 and the extent of “RWA optimisation” that has taken place,319 we suggest that the UK authorities should support the recent proposal by Barclays Equity Research that banks should assess their risks and their regulatory capital requirement for these risks on the basis of a standardised model,320 with as little scope for manipulation as possible. We suggest that banks should be required also to form an honest assessment of their “economic capital” requirements—the amount of capital which they think that they need to cover their risks, using whatever methodology they wish to use. The suggested approach would limit “RWA optimisation” practices, would support financial stability,321 by increasing the regulatory capital requirements of banks that had engaged in “RWA optimisation”, would create a more level playing field between large banks, smaller banks and new entrants, and would underline the fact that estimates of capital requirements represent different points on a distribution of possible outcomes. 139. We consider it appropriate that the regulator should continue to apply, within the supervisory review process, capital “add-ons” to banks’ regulatory capital requirements for their risks, to allow for matters about which they are concerned. In exercising their judgement about the size of any such capital “add-ons”, we suggest that the regulator might take account of the quality and openness of banks’ communications about their risks. However, to encourage good standards and open behaviour, we consider it important that the regulator should hold out the prospect that the amount of capital “add-ons” can be reduced if and when the areas of concern are addressed. Differentiation 140. We believe that there should be differentiation between the capital requirements for the large banks that pose systemic risk, to incentivise low risks and high standards, as well as to disincentivise high risks and low standards. A key opportunity for differentiation is in the Individual Capital Guidance given to banks by the regulator, including any capital “add-ons” (possibly including an element for the quality and openness of communications). A further opportunity is in the capital surcharge for large systemically-important banks: although the ICB has suggested that the size of this surcharge should be determined by the ratio of banks’ RWAs to UK GDP,322 we suggest that the basis proposed by the BCBS and the FSB, which takes account of five factors including size, interconnectedness and complexity,323 seems more likely to create differentiation between the large banks, and to incentivise behaviour that could lead to the capital surcharge being reduced. And, as HM Treasury pointed out, there is merit in adopting a common approach internationally. Transparency 141. For market discipline by shareholders to incentivise good standards and low risk, there has to be adequate transparency about banks’ risks. Ahead of the banking crisis, limited transparency by banks and their 314

“Firms must be encouraged also to report to the regulator instances they find of their own misconduct”, Fixing LIBOR: some preliminary findings, Treasury Committee, August 2012, page 105, paragraph 6. 315 Letter to Chairman, Barclays Bank PLC, Financial Services Authority, April 2012. 316 See for example “Hector Sants fright talk was badly judged”, Money Marketing, March 2012. 317 A new approach to financial regulation: judgment, focus and stability, HM Treasury, July 2010, paragraph 1.7. 318 "A number of weaknesses have been identified with using value-at-risk (VaR) for determining regulatory capital requirements, including its inability to capture “tail risk”", Fundamental review of the trading book, Basel Committee on Banking Supervision, May 2012. 319 Financial Stability Report and Press Conference, Opening Remarks by the Governor, December 2011. 320 Bye Bye Basel?, Barclays Equity Research, May 2012, page 13. 321 Bye Bye Basel?, Barclays Equity Research, May 2012. 322 Final Report, Independent Commission on Banking. 323 The Government response to the Independent Commission on Banking, HM Treasury, December 2011, page 40, Box 3.A.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1438 Parliamentary Commission on Banking Standards: Evidence

regulator meant that shareholders effectively had to rely on the regulator for supervision of banks’ risks and risk management. We believe that there should be more comprehensive risk disclosures by banks, and by their regulator. 142. Risk disclosures by banks, required under Pillar 3 of the Basel regulations, contain many schedules, but the information is limited to Pillar 1 risks.324 The disclosures do not include Pillar 2 risks, or the results of stress tests carried out by banks. We suggest that banks should be required to disclose information about all their risks and the full extent of their regulatory capital requirements, and about the results of their stress tests.325 In addition to this information, we suggest that banks should be required to include, at the beginning of their Risk Report, an executive summary which covers material risk exposures, changes in risk exposures and changes in the risk environment, and which is written in such a way that it is easy to understand. Under Solvency II, insurers will be required to provide a “short and easily understandable executive summary”.326 143. We believe that there is also a case for disclosure, either by banks or by their regulator, of the amount of their Individual Capital Guidance, including any capital “add-ons”. As we understand it, under Solvency II, the equivalent information for insurers will have to be disclosed,327 at least after a transitional period. 144. In addition to this regular reporting, we suggest that the FPC should have powers to require banks to make disclosures, in the way that it might have required banks to make disclosures about the extent and nature of their sub-prime exposures after the HSBC profit warning in early 2007, and that, if necessary, the criteria set by HM Treasury for FPC powers of direction should be amended to allow for this.328 145. We recognise that there has been some reluctance to require full disclosure by banks about their risks (especially in respect of liquidity risk) because of fear of “spooking the market”.329 However, information about perceptions of the riskiness of individual banks is already available in ratings given by credit rating agencies, bond yields, spreads on credit default swaps and margins charged by clearing houses such as LCH Clearnet. Also, equity capital ratios are now much higher than they were in 2008, and effective recovery and resolution plans are now in place. Conclusion 146. We believe that it is important for banks and their regulator to be open with each other, and to be able to trust each other. We suggest that the use of a standardised approach to assess banks’ regulatory capital requirements (along the lines suggested by Barclays Equity Research) would support trust by reducing “RWA optimisation”, would support financial stability, and would create a more level playing field between large banks, smaller banks and new entrants. We believe that differentiation between large banks, including in the assessment of the capital surcharge for large banks, and of any capital “add-ons” (possibly including an element for the quality and openness of communications), would incentivise low risks and high standards. We believe that greater disclosure about banks’ risks and regulatory capital requirements, by both banks and their regulator, is desirable, to support more effective market discipline by shareholders. The corporate legal framework and general criminal law 147. There is public disquiet that action has not been taken against directors of banks that were failing and had to be bailed out (apparently because, although they exercised poor judgement, they did not break any laws),330 or against people who engaged in LIBOR manipulation (despite the fine levied on Barclays and the fines expected to be levied on other banks).331 The failure to take action against individuals adds to public 324

See for example Pillar 3 Disclosure 2011, RBS Group. "Indeed, market participants have generally placed more value on the disclosure accompanying US and European stress tests than the quantitative results themselves", Instruments of macroprudential policy, Bank of England, December 2011. 326 "Executive Summary: 3.91. In order to assist readers of the SFCR, a short and easily understandable executive summary aimed specifically at policyholders should be provided. 3.92. The executive summary should also highlight clearly any material changes that have occurred in the undertaking’s or the group’s business written, risk profile, solvency position or system of governance since the last reporting period. This information should provide the reader with a brief summary of the contents of the SFCR”. CEIOPS” Advice for Level 2 Implementing Measures on Solvency II: Supervisory Reporting and Public Disclosure Requirements (former Consultation Paper 58). 327 "The disclosure of the Solvency Capital Requirement referred to in point (e) (ii) of paragraph 1 shall show separately the amount calculated in accordance with Chapter VI, Section 4, Subsections 2 and 3 and any capital add-on imposed in accordance with Article 37 or the impact of the specific parameters the insurance or reinsurance undertaking is required to use in accordance with Article 110, together with concise information on its justification by the supervisory authority concerned", Directive 2009/ 138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) (recast). 328 "In addition, the Committee agreed that powers of Direction over disclosure requirements would be desirable but that it could be difficult to meet the test set by HM Treasury in its February 2011 Consultation Document that powers of Direction should be specific”. , Financial Policy Committee statement from its policy meeting, 16 March 2012. 329 "It is sometimes argued that enhanced disclosure may reveal information that triggers an adverse market reaction. This risk is likely to be particularly acute for liquidity risks, given the potential for funding to dry up rapidly", Instruments of macroprudential policy, Bank of England, December 2011. 330 The Failure of the Royal Bank of Scotland, Financial Services Authority, December 2011, page 7. 331 “The Committee was surprised that neither the FSA nor the SFO saw fit to initiate a criminal investigation until after the FSA had imposed a financial penalty on Barclays”, Fixing LIBOR: some preliminary findings, Treasury Committee, August 2012, page 115, paragraph 48. 325

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1439

concern that directors and senior executives of large banks seem to be “above the law”.332 It is not clear that fines, such as those which have been imposed on some banks, have a significant impact on standards and culture in banking. Even large fines may be regarded as “a cost of doing business”.333 148. Public antipathy towards large banks has, unfortunately, persisted for some years. We are concerned that it may damage the perception of all banks (including smaller banks and new entrants), perpetuate low trust in banks, and restrict economic growth. In connection with the objective of restoring good standards and trust in banking, we believe that the public concern about lack of sanctions on individuals needs to be addressed, but in a controlled and responsible manner, rather than through periodic outbreaks of “banker-bashing”.334 149. There does seem to be a strong case for a comprehensive review of the legal framework and criminal law applicable to banking, and more generally to white collar crime, to ensure that the laws are appropriate and adequate. However, a properly-considered review of the legal framework is likely to take some time. In the meantime, we believe that two actions, which could be taken within a relatively short period, would have a positive impact on standards and culture in banking, and would go some way to addressing public concerns: —

The first recommended action is to establish arrangements for sanctioning the directors and senior executives of banks that are failing and have to be bailed out. Of the two possible ways to achieve this put forward by Lord Turner in his Foreword to the FSA’s report on the failure of RBS, we prefer the automatic incentives based approach, with the stated option of, “Establishing rules which would automatically ban senior executives and directors of failing banks from future positions of responsibility in financial services unless they could positively demonstrate that they were active in identifying, arguing against and seeking to rectify the causes of failure”.335 The possibility of automatic bans would address one of the main areas of public concern, and the suggested approach would encourage individual board members and senior executives to raise their concerns, rather than just go along with things, and so would reduce the likelihood of failures (and so of the need to impose bans).

—

The second recommended action is to strengthen the ability of the professional body to apply sanctions for breaches of the professional code of conduct (even if no laws are broken), by making the code of conduct mandatory within the full professionalisation of banking, and by giving the professional body power to investigate possible breaches, working with the FCA.

Conclusion 150. We believe that, to restore trust in banking, public concern about the lack of sanctions on individuals needs to be addressed. We think that this should be done by ensuring that the law is appropriate, that the automatic incentives based approach is applied to directors of banks, and that employees who break the professional code of conduct (which we think should be mandatory) should be liable to sanctions, up to expulsion from the banking profession. 31 August 2012

Written evidence from VocaLink Summary — VocaLink operates at the heart of the UK payments system. — It is vital for UK competitiveness that the banking industry finds a governance structure which enables the common infrastructure to be developed more flexibly and quickly, with a view to enabling new entrants to join the market. — A coherent blueprint for future growth and development in the banking sector needs to emerge from the various strands of regulatory review currently taking place. — The pace of change in retail banking has been slow. This is because banks have focused more on investment banking; consumer demand has been for the improvement of existing services rather than for innovation, and retail banking appears to be commoditised; and banks themselves have placed more emphasis on cross-selling to existing customers than seeking new ones. — In any case, customers have not found it easy to switch their account from one bank to another. — When change is contemplated, it often takes a long time to agree and to implement. 332

"But where are the criminal charges? […] As an attorney who used to work on enforcement with the U.S. Treasury told Lake, “This is absolutely indefensible. When someone other than bank officials willingly, knowingly, repeatedly does this kind of conduct, they go to jail”. " Banks: Too big to prosecute?, CNN, August 2012. 333 "But given the huge size of these banks, do these fines simply amount to a relatively small cost of doing business?", Is Flogging Bankers an Option?, Wharton, July 2012. 334 "We recommend that the Wheatley review examine whether there is a legislative gap between the responsibility of the FSA and the SFO to initiate a criminal investigation in the case of serious fraud committed in relation to the financial markets", Fixing LIBOR: some preliminary findings, Treasury Committee, August 2012, page 115, paragraph 49. 335 The Failure of the Royal Bank of Scotland, Financial Services Authority, December 2011, page 9.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1440 Parliamentary Commission on Banking Standards: Evidence

— Proposals for reform include: the way in which the agency bank model works in relation to new services such as Faster Payments; a pre-funding model to counter the disincentive effects of the collateralised losssharing agreement on participation in the Faster Payments Scheme; and the introduction of different classes of membership to facilitate the involvement of new entrants. Introduction 1. VocaLink welcomes this opportunity to contribute to the deliberations of the Parliamentary Commission on Banking Standards. This submission focuses primarily on how to inject more competition into retail banking (4(a) of the Commission’s Terms of Reference). 2. VocaLink is a specialist provider of payments services to banks and the wider financial community, with unique experience and capabilities. VocaLink processes domestic and international automated payments, supports clearing and settlement, and provides ATM switching for around 60,000 ATMs. In 2006, VocaLink replaced a 30-year-old payment system with a robust, innovative platform. VocaLink’s real-time payments platform went live in 2008 and is the central infrastructure for the UK Faster Payments Service. Building on all of this, VocaLink is now poised to deliver an international Immediate Payments solution, and is working with the UK payments industry to deliver the Mobile Payments Common Infrastructure Platform. 3. VocaLink’s role, at the heart of the UK’s payments sector, is to provide the central, common platform on which banks and building societies can base their differentiated consumer propositions. This platform has proved its worth over the past forty years in terms of operational security and resilience, and it is important to consider how this infrastructure can best be leveraged to enhance the banking sector and in particular to foster growth and competition. VocaLink’s contention, broadly, is that it is vital for UK competitiveness that the banking industry finds a governance structure which enables the common infrastructure to be developed more flexibly and quickly, with a view to enabling new entrants to join the market, bringing with them innovative products and ways of working which will benefit consumers and the UK economy. Conversely, allowing the governance of the infrastructure to stagnate would render nugatory any other measures taken to promote competition in high-street banking. 4. As the provider of infrastructure, rather than being involved in providing commercial services to consumers or in the financial markets, VocaLink is not directly concerned with many aspects of this Commission’s Terms of Reference, nor with many of the other developments in financial services regulation and legislation which are currently in progress, with the exception of the Treasury Review of Future Payments, on which a consultation is currently taking place. However, from a VocaLink perspective, many of these developments—including the Financial Services Bill currently before Parliament, the Banking Reform Bill expected later this year or early next, the OFT inquiry into current accounts and the work of this Commission— are inextricably interlinked. It would benefit everyone, including the banking sector which VocaLink serves and the payments sector of which it is a significant and integral part, if the complementary nature of these different developments could be borne in mind, so that what emerges from this period of considerable (and undoubtedly necessary) change and upheaval in the UK financial services industry forms a coherent blueprint for future growth and development. Competition in Retail Banking 5. On the face of it, customers’ experience of retail banking has changed considerably over the past thirty or forty years. Mostly this has been linked to technological change—for example, the introduction of online banking, the easy availability of cash through ATMs and the decreasing use of cheques and cash in the face of the switch to debit and credit cards. But on the other hand, comparing change in retail banking with the overall pace of change in technology, or, closer to home, with the speed of developments in the investment banking sector, it is clear that retail banking has practically stood still. Retail banking has essentially responded, often quite slowly, to change elsewhere, but its own internal development has been largely frozen. 6. It might be argued that the pace and scale of change in the investment banking sector has in part led to some of the problems which beset the industry today. But retail banking is at the other end of the spectrum. The Big Four may (just about) have become the Big Five, but they continue between them to control around 90% of the volume of transactions. 7. In VocaLink’s view, the slowness of the sector to embrace new entrants and accordingly to innovate in product development has come about not through any deliberate intent but for four main reasons. First, the attention of the banking sector in the world of unified investment and retail banks has been on the more glamorous and (potentially) profitable arena of investment banking; retail banking has to some extent become the poor cousin. Secondly, in a sense, consumers have not known what they might be missing and therefore consumer pressure has tended to focus on elements of the existing set-up which are felt not to be working in consumers’ best interests: account charges are one obvious example, the availability of free-to-use ATMs has been another. In this context, it is also worth bearing in mind that as an industry retail banking has to serve a very large customer base, many of whom have a small “c” conservative view of how banks and banking should operate. The furore over the proposal to phase out cheques was one graphic illustration of this. Thirdly, the lack of innovation in banking has become self-reinforcing: as all bank accounts seem pretty similar, there is a view that retail banking services have become commoditised, and differentiation has tended therefore to focus

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1441

on relatively minor aspects of service rather than offering anything fundamentally different or innovative. Finally, banks have focused strongly on selling other products and services beyond traditional current accounts to their account-holders, rather than competing for new business. 8. This sense of inertia in the marketplace has been reinforced by the perceived difficulty for consumers of changing their bank. With the introduction of easier account switching next year, this situation should improve. But in VocaLink’s view, there will not be really significant change in the retail banking market unless the governance structures of the industry are seriously overhauled. For the reasons set out above, the market has been slow to change and innovate. This has meant that the structures in place forty or more years ago, when the Big Four emerged from the period of banking consolidation, have remained largely intact. The banking sector retains some of the attributes of a gentlemen’s club: change, if it occurs, is slow; decisions are by consensus and taken at the pace of the slowest; the membership list is maintained by the existing leading members; and the committee is made up of busy people who all have other jobs to do. 9. When change is agreed, it tends to take too long to implement and to roll out to all those who might benefit from it. Faster Payments, for example, which VocaLink operates, is proving very successful and volumes are growing rapidly. But in truth it took a long time for the industry to decide to proceed with it, and even now it is not as accessible as a scheme as it should be to some of the smaller players (who have to be sponsored by an existing member in order to participate—indirectly—in it). What could have been a revolution in the payments sector has instead been replaced by incremental growth at a pace moderated by the controlling interests. 10. The introduction of a mobile interbank payments infrastructure has been another case in point. It has taken so long to get off the launch pad that individual banks are now producing their own solutions, which brings with it the risks of lower interoperability, higher industry costs and an overall disbenefit to UK plc. The specification for the mobile payments infrastructure is still not fully determined. At one level, this may appear to be an example of the banks competing with each other to innovate; but in fact it is a symptom of failure, because without a common platform only the big players will be able to compete in this market. Recommendations for Reform 11. Access to the central payments infrastructure is one area that should be considered for reform. Whilst the agency bank model (in which a member agrees to act as an agent for a non-member) works well for Bacs, after four years operation there is still extremely limited agency access to Faster Payments services directly. This may be due in part to the technical complexity of building or purchasing a gateway and then integrating this to the bank’s back office systems, which has led to VocaLink developing a managed service access to Faster Payments. However, we believe that technical considerations are a secondary concern. 12. One disincentive to any bank considering membership of the Faster Payments Scheme is the way that banks fund their participation. The system works on the basis of “Deferred net settlement” with three settlement points a day. Between these settlement points, banks will be either in credit or debit to the system. To ensure that the system is protected from the failure of a member, each member bank is set a “Net Sender Cap” (NSC), ie a debit position to the system that cannot be exceeded. The system is protected by a collateralised losssharing agreement, to be called on in the case of the failure of a member bank. The loss collateral is funded by members pro rata to the size of their own cap. Thus all members are obliged to provide security collateral, and asked for more if the largest member increases its volumes through the service. We believe a more open and equitable route would be to remove the loss-sharing agreement and require each member to pre-fund their settlement accounts. They would then only be able to operate if the sum of their settlement pre-funding, plus inbound transactions less outbound transactions, is greater than zero (ie in credit). Such an arrangement would be more transparent to operate and, without unnecessary contractual agreements and collateralisation, simpler to sign up to and administer. 13. Further consideration should be given to the “rules of the club” that govern membership of the scheme. These rules exist for a reason but a consequence is that smaller players and new entrants find them overly onerous; we believe that additional classes of membership, conferring access rights but with fewer obligations, would encourage wider participation, promote competition and stimulate innovation. 24 August 2012

Written evidence from Paul Volcker (a) History, culture, and social value of innovations in banking 1. The internal culture of the dominant international banks has changed radically in recent decades. That change is related to the increased emphasis on trading activity, highly complex financial engineering, and the related spread of aggressive compensation practices. In practice, the traditional commercial banking emphasis on “customer” relationships, with the implication of fiduciary responsibility, has given way to impersonal “counter-party” transactions, with the implication of caveat emptor.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1442 Parliamentary Commission on Banking Standards: Evidence

2. While richly rewarded, the economic and social value of much of the trading and innovative financial engineering is questionable, and in fact has contributed to volatility and risk. (b) The need for structural reform 1. Traditional commercial banks provided essential public services: safe depositary; lending to businesses (particularly small and medium-sized business); a reliable and efficient payments system, and home buyers. Recognizing that role, banks have long been supported by central bank liquidity facilities, various forms of deposit insurance, and emergency assistance. These protective facilities in effect reduce perceived risks to creditors and lower bank financing costs, constituting a significant public subsidy. The sense that creditors, and even stockholders, of the large publicly-protected commercial banks will be protected in time of crisis may encourage excessive risk taking. 2. The recent and continuing crisis has led to intense and useful efforts to raise bank capital and liquidity standards internationally. Experience suggests that, however important capital standards may be, regulated institutions, market developments, and political pressures may reduce the effectiveness of risk-based standards over time, particularly as they are (and must be) subject to supervisory judgment rather than imposed by explicit and rigid statutory language. (c) These considerations point to the importance of structural reform of banks 1. Risk-based capital standards need to be supplemented by a clear restriction on leverage of the entire banking organization (including off-balance sheet liabilities). 2. More speculative, proprietary actions of banking organizations need to be prohibited (as in the “Volcker Rule”), or walled off from the socially and economically essential activities of commercial banking organizations (as in the Vickers and Liikanen proposals). 3. Whichever broad approach is adopted, questions of practical implementation will arise. “Borderline” issues will be intensely lobbied. Strong statutory language will be necessary to assure regulatory authority and to support supervisory judgment. 4. There is a critical need for adequate “resolution authority” to deal with large (“systemically important”) failing financial institutions. Superseding existing bankruptcy procedures, prompt government intervention and financial and interim financial support will be needed to maintain market continuity, while forcing management change and stockholder loss and placing unsecured creditors at risk. Contingency planning in preparing socalled “living wills” is common ground internationally. Specific approaches will need to be coordinated internationally, particularly with the US and the UK in the lead. (d) Vickers, Liikanen, Volcker—and the ghost of Glass-Steagall 1. These reform proposals call for a particular form of structural change to help deal with critically important cultural issues as well as specific risks. 2. They have in common a statutory separation of certain trading activities from the core banking functions. — In the case of Vickers and Liikanen, all trading activities (proprietary and “market-making”) and certain lending activities related to “wholesale” and investment banking functions, would be confined to a separate subsidiary of a banking organization. Transactions with an “independent” commercial bank subsidiary strictly would be limited, inevitably with certain exceptions. This approach appears close to the former Glass-Steagall restrictions in the U.S. The fact that those restrictions broke down over time in the face of financial innovations and complacency may provide a cautionary lesson. — In the case of Volcker, the restriction is confined to proprietary trading and sponsorship of equity and hedge funds (apart from limited, defined exceptions). Complete legal and organizational separation of those activities from the commercial banking organizations is required. Underwriting, prime brokerage, securitization, lending to all businesses (as well as other widely practiced functions such as investment management) would remain with the commercial banking organization. In essence, the distinction (now embodied in law) in Dodd/ Frank legislation is between customer-related business and strictly proprietary or speculative trading. 3. Each of these approaches requires careful regulatory definitions and supervisory oversight to maintain the separation of functions. In practice, identifying the precise line between market-making and proprietary trading has been questioned. Based on the American experience, the concept that different subsidiaries of a single commercial banking organization can maintain total independence either in practice or in public perception is difficult to sustain. (e) Other areas of “unfinished reform” — Money market mutual funds—particularly important in the US.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1443

—

The nature of bank capital, including the usefulness of contingent debt instruments.

—

Credit rating agencies.

—

Common accounting standards.

17 October 2012

Written evidence from Sir David Walker Thank you for your letter dated 17 October 2012 requesting supplementary evidence on two points further to my hearing with the Commission on 12 September. My responses to the two specific questions you pose are as follows: 1. I still believe that a time commitment of 30–36 days per annum for non-executive directors to be broadly right. This assumes a non-executive director is a member of at least one committee whilst the time commitment for the chairs of board committees such as Risk, Audit and Remuneration would be significantly higher. However, it is important that Board members are prepared to devote such time as is necessary to ensure they carry out their duties effectively. For example, Barclays directors devoted significant additional time over the summer in response to the situation facing the bank, frequently at relatively short notice. It is also important that serving chief executives are not effectively prevented from serving as non-executive directors on bank boards and I would not expect such individuals to commit to a time commitment of 30–36 days. However, the minimum time commitment for such individuals in my view would be 20 days and I would expect the average time commitment of the non-executive directors as a whole to be in the 30–36 day range. 2. In my short response to the Commission, I explained that “… the principal accountability of the board is to the shareholder; but the shareholder’s interest is in sustainable performance, which will not be achieved if it is a quick buck and is inattentive to reputation.” To expand on that point, any board, in setting the risk appetite for an organisation, should have in mind the obligations that must be adhered to under its fiduciary and statutory obligations. However, a board must also have in mind the social externalities of the environment in which that business operates, particularly societal and economic. A board must ensure the right return for shareholders, but that cannot be set in a vacuum. That applies even more so to banks, which are, perhaps, different to other companies in that they must be particularly attentive to the wider social externalities I have touched on. It is, however, important that banks can earn returns on equity above the cost of equity if they are to be viable private sector enterprises. 24 October 2012

Written evidence from Which? Executive Summary 1. The financial crisis has had a devastating impact on consumers and their trust and confidence in the banking sector. However, it has also exposed the fact that even before the financial crisis many aspects of the banking market were not working in the best interests of consumers or the economy as a whole. 2. Low levels of professional standards within the banking sector have led to problems such as excessive risk-taking, Payment Protection Insurance (PPI) mis-selling and LIBOR manipulation. Consumers have paid a heavy price for the low level of professional standards in the banking sector through the bank-bail outs, economic uncertainty and higher prices for banking services. The Level of Professional Standards in the Banking Sector and their Impact on Consumers 3. Unlike other sectors, bankers do not have to abide by a code of conduct and face weak sanctions for failing to maintain high levels of professional standards. Even those banks which claimed to aspire to high levels of professional standards seem to have done little to promote and embed those standards within their organisations. 4. The prevailing culture within most parts of our high-street banks is based on sales rather than serving customers effectively. Overly complex and expensive products are designed, and frontline staff are given strong incentives to sell—rewarded with bonuses if they hit sales targets and threatened with dismissal if they do not. Despite the introduction of “Treating Customers Fairly” parts of the banking sector still suffers from a tickbox approach to professional standards which sees regulation as the only guide to acceptable behaviour. 5. Low levels of professional standards in the banking sector have damaged consumers’ trust in the industry. Consumers have much lower levels of trust in bankers and think they are less likely to face sanctions than other professions such as doctors, engineers, lawyers and accountants. Only 29% of consumers believe that bankers who breach industry codes of conduct would be removed from the profession compared to 78% who think Doctors would.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1444 Parliamentary Commission on Banking Standards: Evidence

The Causes of these Low Levels of Professional Standards 6. More than in any other sector, banks can give the appearance of short-term success by taking extra risk. Over the course of many years, a culture developed which focused on expanding risk without due regard for the long-term sustainability of the sector or of individual banks. Those at the highest levels within some banks set a tone that encouraged banks to game regulations and risk metrics or to comply with the letter but not the spirit of the requirements. This culture failed to investigate concerns about poor behaviour and ignored problems of mis-selling and poor products until they were widespread. 7. The integration of highly leveraged investment banking and retail banking played a part in spreading this culture throughout large banking institutions. State aid, Government guarantees and bail-outs have meant that taxpayers subsidised banks with low levels of professional standards. This has distorted competition by strengthening the position of the largest banks—regardless of whether they were well run or their level of professional standards. The lack of effective competition means that consumers find it difficult to influence banks by taking their business elsewhere and fed a prevailing consumer sentiment that switching is not worthwhile because all the banks are the same. 8. Regulators failed to be proactive when poor conduct emerged or to impose sufficient sanctions on companies or individuals responsible. The culture of the regulator itself, a lack of transparency, and external pressure from commentators and politicians encouraged this weak approach. 9. Banks and regulators failed to ensure that individuals within their institutions were given the right incentives to uphold high standards. Incentive schemes for staff at all levels encouraged mis-selling and excessive risk, rather than focusing on customer service and maintaining high standards. 10. There was also a failure of checks and balances. Boards, non-executive directors and shareholders failed to exercise control within their institutions or indeed actively encouraged or rewarded behaviour which could promote low levels of banking professional standards. Objectives of Reform 11. Consumers depend on the banking system to meet their own financial objectives and fulfil their aspirations. Banking is an essential utility for all consumers. Regardless of wealth, we all need to access financial services in order to go about our daily business. At present the changes proposed as part of the various reform efforts will only go some of the way towards achieving the improvements that are necessary. Restoring trust by improving the level of professional standards in the banking sector will require significant reform to the structure, regulation and culture of the banking sector. Structural reform Ring-fencing of essential retail-banking services with strong independent governance: Which? wants to see full and robust implementation of the Vickers ring-fencing proposals to make sure that if a poorly run bank fails it doesn’t have a damaging effect on its customers or the economy. Ring-fencing is required to limit the scope of Government guarantees and to tackle the conflicts of interest which exist in large complex banking groups. It will reduce moral hazard and, by helping to impose a credible threat of failure, will reduce the extent of taxpayer subsidies for low levels of banking standards. Ring-fencing should also limit the spread of a damaging investment banking culture to the retail bank by ensuring an independent board, independent chairs of board committees and prohibiting the sale of complex derivatives and structured products designed by the associated investment bank. Some have called for the Government to go further and break up the banks into investment and retail entities. Our concern would be that to be effective this would require international agreement, which, even if forthcoming would be slow, meanwhile taxpayers would continue to be exposed. Introducing depositor preference and a clearly understandable deposit protection scheme: This will help protect the deposits of retail customers whilst ensuring that those who lend to banks through the wholesale markets have stronger incentives to monitor and constrain the behaviour of banks with low professional standards. Strengthening Competition and Regulation 12. More competition is essential to ensure that banks which have low levels of professional standards are subject to market discipline. Effective competition should ensure that well run banks which treat their customers fairly are able to thrive whilst banks with low levels of professional standards lose customers and are allowed to fail. Effective competition would also encourage banks to compete for customers by offering better value products and improved levels of customer service. Regulators need to do more to promote effective competition and take strong and robust action against any bank with low levels of professional standards. Refer the banks to the Competition Commission: The Competition Commission is the only body with the power to restructure major banking groups to enhance competition. We should recall that in 2001, the CC rejected a merger between Lloyds and Abbey on competition grounds which would have created a banking group similar in market power to Lloyds after it has completed its divestment.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1445

Consumer protection and prudential regulators should be given a clear mandate to promote competition: To provide stronger incentives for high professional standards consumer protection regulators should promote transparency and the ability of consumers to switch products. Prudential regulators should not discriminate against new entrants and focus on ensuring that market discipline can operate so badly run banks are able to fail without catastrophic consequences for their customers or the economy. Easier switching for consumers: Portable bank account numbers should be introduced to make it easier for people to switch banks and they should be able to download their usage data to enable them to make one-click comparisons of current accounts Strong, open and proactive conduct regulation: The new Financial Conduct Authority should take early action to tackle low levels of banking professional standards, hold individuals and banks to account for poor practice and use regulatory transparency to shine a light on the performance of individual banks and its concerns about their culture. Stronger collective redress powers: There should be new legislation to ensure that collective action can be taken on behalf of consumers who have lost out from corrupt banking practices or mis-selling. Culture and Corporate Governance 13. Which? believes that changing the culture of the banking sector has been a neglected part of the reform agenda although it formed a significant part of our own Future of Banking Commission report in 2010. Bankers should seek to create a culture that focuses on the long-term creation of value for shareholders by putting the customer at the heart of their business and recognise their critical role in society at large, along with other professionals such as doctors, lawyers and accountants. This will require a dramatic change of tone and strong action amongst the leadership and management of our largest banks. To be effective this new culture must be embedded at all levels within the banks and staff given the proper incentives to maintain high levels of professional standards. This must involve a totally different approach from Boards, non-executive directors and shareholders. New professional standards: There is an urgent need for a redefinition of acceptable practice in banking that we believe should be based on a new Good Financial Practice Code. This Code should have similar status amongst the banking profession as codes of conduct have in the medical and other professions. This Code should be devised and enforced by a new professional standards body along the lines of the General Medical Council or the Legal Services Board. Staff training: Senior managers must practice what they preach and ensure that all staff understand their obligations. To help achieve this, all employees of British banks should receive formal compulsory training in the Good Financial Practice Code. This should include expected ethical behaviour including how to resolve conflicts of interest. Embedding and enforcing professional standards: Individual banks should take more responsibility for ensuring that all bankers meet these higher professional standards. This should include an annual report from the Board on concerns raised internally and what action has been taken. Non-executive directors need to take greater responsibility for measuring the culture of the bank and reporting back to shareholders. Remuneration: Remuneration incentives throughout banks, from senior executives should be reformed to prioritise meeting the needs of customers over simply making sales. These schemes should be longer-term in nature with proper clawback of bonuses for inappropriate behaviour. Individual accountability: Senior management must take greater responsibility for their decisions, including signing off individual products and remuneration schemes. It must be made clear to them that when doing so it is their responsibility to maintain high professional standards and they should be subject to serious consequences in cases where they do not uphold these responsibilities. Stronger criminal sanctions: In the most serious cases it is important that stronger criminal sanctions are available to the authorities. Introduction 14. Which? is a consumer champion. We work to make things better for consumers. Our advice helps them make informed decisions. Our campaigns make people’s lives fairer, simpler and safer. Our services and products put consumers’ needs first to bring them better value. 15. Which? established and supported the Future of Banking Commission, chaired by Rt Hon David Davis MP. In addition to taking evidence from senior regulators, banking executives and academics, the Future of Banking Commission included the Which? big banking debate—an event attended by 300 members of the public and a process that allowed consumers to make their own submissions through the Which? website. The report was published on 13 June 2010 and made a series of recommendations for changes to the structure, regulation, governance and culture of the banking industry.336 We have sent copies of this report to all members of the Parliamentary Commission. We would also like to thank Philip Augar for his input into this submission. 336

The full report is available at http://www.which.co.uk/documents/pdf/future-of-banking-commission-report-276591.pdf

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1446 Parliamentary Commission on Banking Standards: Evidence

16. This document contains our responses to the initial questions posed by the Commission. We would be happy to provide any further information required by the Commission and to appear to give oral evidence to the Commission. 17. This document is structured in four sections: — Section 1: The level of professional standards in UK banking This section defines what is meant by professional standards and assesses those in UK banking. — Section 2: The consequences of the low levels of professional standards in UK banking and their impact on public trust This section outlines the damaging consequences for consumers of the low level of professional standards and compares the level of public trust in the banking sector with other professions. — Section 3: The causes of the low levels of professional standards in UK banking This section examines the special features of the banking sector and the causes of low levels of professional standards including; the culture of banking; the relationship between retail and investment banking; the lack of effective competition; the role of shareholders and Boards; remuneration incentives; the regulatory approach; and the inability of consumers to obtain redress collectively. — Section 4: Recommendations for reform of the structure, regulation, culture and corporate governance of the UK banking sector Finally, this section outlines Which?’s recommendations for reforms to the UK banking sector to improve levels of professional standards and restore the public’s trust. WHICH? RESPONSES TO THE COMMISSION’S INITIAL QUESTIONS Section 1: The Level of Professional Standards in UK Banking Question 1: To what extent are professional standards in UK banking absent or defective? How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets? What is meant by professional standards? 18. Many attempts have been made over the years to define what it means to be a professional, or indeed for a specific industry to classify as a profession. In reality there is no ready definition available and there is no obvious dividing line between professional and other services that exhibit similar characteristics. In light of this, there are two ways in which one could go about assessing whether an industry is operating in a professional manner—firstly, by defining professional characteristics and then determining which industries “qualify”. Secondly, by listing those occupations generally regarded as professional and seeking common characteristics. For the purposes of this analysis, we take the former approach as a basis for assessing the banking industry. 19. Many lists can be drawn up of the relevant characteristics, but a good starting point has been given in the past by Sir Bryan Carsberg, the former head of the OFT who suggested that the key characteristics are: — A high level of training and education; — A high level of integrity with any drive to make profit modified by ethical constraints; and — Subjection to the constraints imposed by a professional body which monitors performance and takes disciplinary action. 20. Based on this, professionals would tend to be individuals with a specialised skill dealing in areas which involve risk of one kind or another to the client. We would suggest that professional controls should focus on the following issues: — Restricting entry to the profession in some way via requirements on education and/or training and tests of competence; — Ensuring appropriate behaviour via conduct requirements—this will frequently mean going beyond “the law” and will often be bound up in some form of code of conduct or similar; — Dealing with those who are no longer competent or are behaving inappropriately; and — Facilitating redress—perhaps through a complaints mechanism or through insurance. 21. When one looks at the structure of some of those industries and sectors that are commonly thought of as professions, most of these characteristics can be seen to be present. For example, anyone can call themselves a surveyor and can work for a professional body. However, to become a member of the Royal Institute of Chartered Surveyors (RICS) as a Chartered Surveyor, educational, training and experience standards must be met. Similarly, for accountants membership of a professional body is required to use titles such as certified, chartered and management accountant. This is important because without these titles it is not possible to take on the majority of professional work. 22. In addition to education and training, most commonly recognised professions will have a statutory register, and members of that register will be bound by high ethical and quality standards. The registers in turn

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1447

are controlled by registration bodies (often a statutory regulatory authority). An example here is the General Medical Council (GMC) who register Doctors for practice in the UK. The GMC have a number of aspects to their remit: — controlling entry to the medical register; — setting the standards for medical schools and postgraduate education and training; — determining the principles and values that underpin good medical practice; and — taking firm but fair action where those standards have not been met. 23. Most professions also tend to require adherence to a Code of Conduct or Practice. Sometimes (eg with doctors) this is required by law, in other cases (eg surveyors) it is more akin to voluntary self-regulation. Codes can cover many aspects of professional behaviour and will frequently cover issues such as handling of client money and ethics. For example, lawyers are bound by a Code of Conduct that requires them to meet standards such as: — act with integrity; and — act in the best interests of each client; and — behave in a way that maintains the trust the public places in you and in the provision of legal services. 24. Codes of Conduct which lay down the professional standards expected exist in both private sector professions such as accountants and lawyers, but also in public sector professions such as doctors, teachers and the police service. 25. The final key defining characteristic of a profession is that there will tend to be a formal complaints and disciplinary mechanism in place. Disciplinary mechanisms can take many forms—for example RICS has a scale of interventions including reprimands, fines, consent orders and removal from the register in extreme cases. This ultimate sanction of removal from the register is common to most serious professions such as medicine, where the registered practitioner again knows that they are liable to be struck off the register if they do not meet the required standards. 26. In terms of complaints, many professions took a long time to develop systems that were sufficiently responsive to complaints relating to quality of service. However, in recent years this is an area that has improved, as witnessed by the prevalence of ombudsman schemes and the widespread involvement of registration bodies in handling complaints relating to service, in addition to just complaints relating to professional misconduct. Specific areas where the extent of professional standards in UK banking are absent or defective A sales-focused culture 27. The prevailing culture within both retail and investment banks is focused on sales rather than on serving customers. This sales-based culture manifests itself in the many mis-selling scandals in the banking sector— from precipice bonds, endowment mortgages, risky investment funds to PPI. It also fed a culture of irresponsible lending—where the purpose of the bank seemed to be enhancing short-term performance by lending as much money to consumers and businesses as possible. Banks targeted a certain level of lending, with seemingly little regard for risk or the long-term sustainability of the business.337 28. Our research finds that many consumers feel that banks are just trying to sell them products, rather than focusing on whether the products/services are appropriate and providing great customer service. In our survey in July 2011, we asked consumers about their experience of their most recent contact with their bank/building society, as well as experiences over the past year and their attitudes towards selling.338 29. Fifty four percent (54%) of people were offered an additional product or service the last time they contacted their bank (either by phone or in branch). This is in addition to the subject of their initial enquiry. Given the fact that some people may have used an automated machine in branch or an automated system over the phone, we feel that this is high figure. We do not believe there is an intrinsic problem with the fact that banks are offering products. Indeed, some respondents welcomed it. However, we are concerned that of the people who were offered a product 4 in 10 felt that the product or services offered were not suitable for their needs and 50% of people felt these attempts by bank staff to sell products were unwelcome. “It’s good to be informed of new products and their benefits, but it is better to help the customer find what they are really looking for and matching to their needs, rather than pushing a product for a bonus.” “I think they should take into account the financial status of the customer when trying to sell anything not of their own financial status” “If I want it, I’ll ask for it! I feel strongly that they shouldn’t try to sell anything you don’t want.” 337 338

For example, see the comments in the HBOS FSA final notice. 4,365 GB adults who have a personal current account, July 2011.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1448 Parliamentary Commission on Banking Standards: Evidence

“I feel captured when I visit my branch for a specific reason and they ‘steal’ my time trying to sell me another product.” “Up-selling by banks is a nightmare. Every time you want to make a minor change or make an enquiry you are bombarded with offers. If I want a product I will buy it.” “I hate feeling pressured when I am in branch. I just want to do what I went in for and not try and be sold stuff I don’t require. If I wanted to I would research and ask about products/services, and most I can do online through internet banking if I wish.” 30. However, we believe that the sales-focused culture is a manifestation of the low level of professional standards towards the top of most of the major banks. In our experience, many individual frontline bank staff, including those who submitted evidence to our Future of Banking Commission disliked the sales-focused culture within their banks. Comments received included: “Counter staff are now under so much pressure to make referrals for sales they are threatened with ‘disciplinary action’ unless they meet targets.” “The way the banks treat their lowest paid customer-facing staff is appalling—never ending pressure, withdrawal of bonus payments for minor offences and humiliation in front of everyone for not achieving imposed targets that are constantly raised every couple of months.” “So that’s really my experience, and yes we were incentivised to sell products, we had targets we had to meet, we met those targets we got prizes, points and prizes, so the more you sold the more prizes you got, and the branch as a whole got prizes, and individuals got prizes” “The main problem is that sales targets are set on high and filtered down to individual staff who are well rewarded if they succeed and threatened with disciplinary action if they underperform and don’t achieve targets. No wonder there is so much mis-selling.” 31. This illustrates an important theme which we will return to throughout our submission. It is not the case that the thousands of people who work in the banking sector are inherently bad people—indeed our members often provide positive feedback where an individual member of staff has provided them with good service. Rather, it is the culture of the institutions, the incentives which frontline staff face and the pressure which comes from further up the banks to sell—which has led to the recent mis-selling problems and the breakdown of trust. Inappropriate and poor value products 32. Rather than designing products which meet customers’ needs and offer them a fair deal, too often the financial services industry designs products which it wants to sell. It does not adequately consider the target market for those products, or whether the product represents good value for money and can be understood by consumers. Too often, under the guise of “innovation” the industry designs products which are designed to exploit consumer vulnerabilities by increasing the opacity of products or adding worthless product features such as ID theft insurance. 33. Retail banks also often sell products designed by their linked investment banking arms which are rarely good value for their customers and expose them to significant risks. These products included a five year “Fixed rate Investment ISA” sold by Barclays, which was actually used to fund the Barclays group; and a number of structured investment products sold by Santander. The Key Features document of the Santander product described it as “very low risk” and makes numerous references to “guarantees” of capital despite the fact that they are not covered by the Financial Services Compensation Scheme. Several issues of the Santander products were called “Guaranteed Capital Plus” plans. 34. In the case of PPI, some products paid the bank which sold them up to 87% commission. This means that when a consumer was charged £10,000 for this product—£8,700 would have been paid to the bank selling it in commission.339 These products were sold to consumers who were taking out 25 year loans, despite the fact that the insurance only lasted for 5 years. These were toxic and extremely poor value products which should never have been sold to anyone—but the low level of professional standards in the banking sector meant that the banks did not consider these issues. Instead, they viewed these products as highly profitable and set high sales targets to sell these products to as many consumers as possible. Breaking the rules 35. The fine levied on Barclays by the FSA for manipulating LIBOR has been just one of a number of examples of low levels of professional standards. Barclays is the first bank to settle with regulators and the FSA continues to investigate seven banks for possible LIBOR manipulation. It comes on top of the mis-selling of PPI we refer to above as well as small businesses being sold interest-rate swaps without a clear explanation of the risks. There have also been substantial penalties imposed on HSBC for money-laundering and Standard Chartered for breaching sanctions. 339

Harison and another and Black Horse, 2010 EWHC 3152 (QB), Case No: A3/2010/2996.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1449

A lack of professional standards in the banking sector 36. Based on the characteristics of professionalism set out above, and our experience of the banking sector, it is possible to conclude that this is an industry that falls short in many key areas. In light of the important and valuable role that a well-functioning banking industry should play in our economy, steps should be taken to improve matters and we agree that this could be significantly improved by raising the level of professionalism. 37. Banking is for the most part a private activity, however, it also has an implicit (and explicit) public subsidy and a central role in ensuring that consumers and businesses are able to make payments, find a home for their savings and access the finance they need to invest. As such, it is important that their profitability should come from genuinely meeting the needs of their customers and the economy as a whole. Unfortunately, this has too often been missing in recent years. 38. The outcomes of the banking crisis have shown the extent that society as a whole is dependent upon a stable, well functioning, trusted and profitable banking sector. 39. The key weakness is that the banking system does not currently have a functioning system for managing the way in which its participants conduct their activities. The main existing control is through external regulation by the Financial Services Authority. However, this risks becoming an arms race in which some in the industry are incentivised to seek competitive advantage through regulatory arbitrage. The sector has also suffered from a tick-box culture where some banks see the law as the only guidance on acceptable behaviour. In sectors that a more deep rooted professionalism, there is greater emphasis given to honesty, integrity, values based judgements and the interests of clients and the public. 40. Instead of relying on a regulatory approach, professional sectors like those looked at above will tend to have a properly enforced code of conduct setting out core guiding principles. Banks and bankers are not required to sign up to or follow the principles—honesty, integrity and client interest—from the codes of conduct which govern other professions. In addition, there is no professional body that exists to maintain these standards, or indeed to hold a register of members. 41. Even where such principles are mentioned in the materials published by individual banks, they can contain get-out clauses which suggest that they are not taken seriously. This can be best illustrated by the Goldman Sachs ethics code highlighted by the Future of Banking Commission.340 This stated: “Integrity and honesty are at the heart of our business. We expect our people to maintain high ethical standards in everything they do, both in their work for the firm and in their personal lives”. 42. But Goldman Sachs ominously added a rider: “From time to time, the firm may waive certain provisions of this Code.” Lack of enforcement and consequences for those bankers which breach standards 43. In addition to a lack of standards, a further weakness in the banking industry is that unlike other professional sectors, the disciplinary mechanisms are weak—for example there is no formal mechanism for a senior banker to be struck off for poor performance. As we note below, many individual banks seem to have weak or non-existent controls regarding removing bankers which breach their own codes of conduct. There is also no transparency about what action individual banks have taken in response to breaches of their own codes of conduct. Poor complaints handling/ignoring problems of low banking standards 44. The final area to explore is complaints handling. There has been a long-standing culture within the banking industry to respond slowly to any criticism of low banking standards and to ignore problems for many years. Even when it is clear that a firm’s conduct is creating significant problems for consumers and small business, issues are not properly investigated. Where problems are identified internally by banks, they fail to take timely action to correct them. One example of this is that even where Barclays identified problems with the way it was selling risky investment funds to older consumers, it failed to review its conduct and compensate consumers until investigated by the regulator.341 45. Legitimate complaints, from consumers are also rejected, ignored or fobbed off, with the hope that the consumer will give up and not take their complaint to the Financial Ombudsman Service (FOS). This can be seen in the statistics published by the banks and the FOS, where major high-street banks were upholding as few as 10% of complaints, but the FOS was upholding over 90%. 46. Instead of taking the opportunity to learn from customer feedback/complaints and improve their services, banks allow the problems caused by low professional standards to mount up. This means that problems develop until they reach such a scale that they become extremely costly to deal with and damage consumers’ trust in the sector. 340 341

Future of Banking Commission report, page 55. http://www.fsa.gov.uk/pubs/final/barclays_jan11.pdf

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1450 Parliamentary Commission on Banking Standards: Evidence

47. We note the contrast between the supermarket sector and the banking sector. When supermarkets realise that a potentially unsafe product has been sold, they immediately institute a product recall and take the product off the shelves as soon as possible. They do not wait for regulatory action and nor do they wait for a large number of customers to complain. Section 2: The Consequences of the Low Levels of Professional Standards in UK Banking and their Impact on Public Trust Question 2: What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole? Question 3: What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector? 48. Through our events and engagement with thousands of consumers through our website, we have built up a picture of the impact on consumers of the financial crisis and their views of the banking sector. The crisis itself highlighted new concerns such as the safety of their deposits and the stability of the system which many previously took for granted. However, poor levels of customer service, a sales driven culture, unfair bank charges, problems of switching and a lack of transparency were raised as endemic issues which prevailed before the crisis. We would highlight the following issues: Lack of transparency and poor levels of customer service: A consistent theme emerging from our consumer facing events was a concern about lack of transparency as a reason for dissatisfaction. For example, the difficulty in finding out what interest rate consumers were receiving on their savings and concern about the lack of transparency of charges. For those who had been caught out by unauthorised overdraft charges, the level of these charges seemed unfair and disproportionate to the cost incurred by the bank. Over the past ten years, there have been low levels of switching in the current account market and banks offering better rates and customer service not growing their market share significantly. Mis-selling of products: Rather than concentrating on designing good quality products which meet the needs of consumers, banks have mis-sold poor value products to consumers. In 2011, UK banks received around 1 million complaints regarding the mis-selling of PPI and have set aside over £10 billion to cover the cost of compensating consumers. This poor value insurance was often sold inappropriately to consumers who would not be able to claim on it. Other mis-selling scandals have included risky structured products and precipice bonds, ID theft insurance, risky investment funds and inappropriate products sold to older consumers to fund their long-term care. Reduction in competition due to the financial crisis resulting in worsening terms for consumers: The level of concentration in major retail banking markets has increased. This has enabled the largest banks to use their increased market power to increase their margins on mortgages, unsecured loans, overdrafts and credit cards. For example, UK banks Standard Variable Rate for mortgages now averages 3.7% above the Bank of England base rate, compared to 1.7% before the financial crisis. An increasing proportion of consumers are stuck with their existing mortgage provider, so called “mortgage prisoners” and have little choice but to pay higher rates. The absolute level of interest charged on overdrafts is the highest since the Bank of England started keeping records in 1995. A move from feast to famine in the availability of credit: In the run-up to the financial crisis, some mortgage lenders were offering loans of 125% of the value of the house and mortgages worth up to 95% were widely available. Following the financial crisis, many banks heavily restricted mortgage lending with the best deals only available to consumers borrowing 75% of the purchase price. The level of net mortgage lending has declined substantially. A bloated cost base and inefficiently run banks: Government subsidies have reduced the incentive for banks to be run efficiently. This has allowed UK banks to avoid action to control their costs, with staff costs as a proportion of revenues (after impairments) now higher than at the peak of the boom. Bail-outs provided by UK taxpayers/consumers: In the UK, direct injections of taxpayer money into banks have amounted to over £120 billion or £2,000 for every man, woman and child in the UK. The current value of the Government owned holdings in the banks mean that UK taxpayers are sitting on losses of around £37 billion from their stakes in RBS and Lloyds. Impact on levels of trust 49. The financial crisis and banking scandals caused by the low level of professional standards have contributed to a loss of trust amongst consumers. In a poll we conducted after the LIBOR scandal, 60%i of consumers thought that the behaviour of UK banks had got worse since the start of credit crunch. 27% of consumers thought it had stayed the same and just 7% that it had got better. 50. Consumers continue to be dissatisfied with the level of improvement achieved by the banking sector. 84%ii of people think that the banks have not done enough to change the banking industry to ensure another credit crunch does not happen again (up from 76%iii in Sept 2011). Similarly, they do not think that the FSA or the Government have done enough to change the industry.iv There is little sign that consumers believe that

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1451

banks have addressed the fundamental problems with their culture. 71%v agree that banking culture hasn’t got any better since the start of the credit crunch and 80%vi agree that there is a deeper problem in banking culture than just a few individuals making bad decisions. 51. There is also a desire for greater accountability amongst senior banking executives. 78%vii of consumers think that when the law is broken by a bank the individual or individuals involved should be personally prosecuted. 52. Government and the banking industry have more to do to demonstrate to consumers that they have actually changed. Only 24%viii of people are confident that the Government will act in consumers’ best interests when implementing banking reform, 67% are not confident. It is clear that an erosion of consumers trust in banks is part of a longer term trend of reducing public confidence. The table below shows data from the British Social Attitudes Survey.ix Table 1 “DO YOU THINK BANKS ARE WELL RUN OR NOT WELL RUN?” Banks

1987

1994

2009

(1) (2) (3) (4)

31% 64% 5% 1%

9% 56% 28% 8%

1% 19% 38% 42%

Very well run Well run Not very well run Not at all well run

Comparison with other professions 53. We asked consumers their view of bankers compared to other professions with different levels of professional standards.x This covered their overall level of trust in different professions, their views about the profession and how likely the public believed bankers would be removed from the profession for bad behaviour. Overall bankers are seen negatively by the British public. The public has little trust in bankers and very few people think that they behave in an ethical manner. The public trusted bankers far less than doctors, engineers and lawyers. 54. Less than one in 10 people think that bankers act in the best interest of the consumer. Bankers rank similarly to estate agents, but people are more likely to say that estate agents act in the best interest of the consumer than bankers (14% and 9% respectively). 55. Overall, the banking profession scores fairly poorly on taking action when bad behaviour happens. Around a quarter of people think that bankers would be removed from their position if they failed to comply with codes of conduct; if they lied or cheated; or if they consistently delivered poor service; or received a high number of complaints. 56. These results may suggest that the regulation of the industry isn’t working, in the public’s mind. Just one in ten people think that bankers are well regulated and just 29% of people think that if a banker fails to comply with industry codes of conduct or ethical standards that they will be removed from their job. This compares with 78% who believe that Doctors would be subject to this sanction for breaching their Code of conduct. Table 2 TRUST IN PROFESSIONALSxi

Nurses Doctors Teachers Engineers Lawyers Accountants Civil servants Builders Estate Agents Bankers Journalists Politicians

Trust

Don’t trust

82% 80% 69% 56% 35% 29% 25% 19% 11% 11% 7% 7%

4% 6% 7% 6% 30% 28% 27% 35% 51% 65% 67% 72%

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1452 Parliamentary Commission on Banking Standards: Evidence

Table 3 ATTITUDES TOWARDS PROFESSIONSxii Properly trained and qualified

Act ethically

Act in the best interest of consumers

Well regulated

None of these

81% 78% 70% 68% 69% 59% 21% 22% 21% 13% 13% 7%

49% 49% 33% 20% 20% 15% 17% 7% 6% 7% 6% 7%

39% 43% 29% 27% 21% 22% 17% 15% 9% 14% 9% 9%

42% 34% 32% 29% 30% 26% 18% 14% 10% 12% 6% 5%

6% 7% 13% 13% 15% 20% 47% 56% 63% 63% 71% 77%

Doctors Nurses Teachers Engineers Lawyers Accountants Civil servants Builders Bankers Estate Agents Journalists Politicians

Table 4 CONSUMERS’ VIEWS ON THE LIKELIHOOD OF PEOPLE BEING REMOVED FROM PROFESSIONS IF THEY:xiii Failed to comply with industry codes of conduct/ethics 79% 78% 74% 64% 63% 52% 44% 36% 29% 29% 28% 26%

Nurses Doctors Teachers Lawyers Engineers Accountants Civil servants Builders Estate Agents Bankers Journalists Politicians

Lied or cheated

Delivered consistently poor service

Received a high number of complaints from customers/clients

71% 69% 63% 50% 50% 46% 38% 26% 24% 26% 20% 22%

73% 68% 61% 53% 61% 47% 37% 36% 30% 28% 31% 23%

71% 68% 64% 50% 57% 46% 37% 39% 34% 28% 27% 26%

Comparisons with other sectors 57. Our Quarterly Consumer Report asked a series of questions about how consumers’ views of different sectors compares in terms of levels of trust.xiv The banking sector scores below average for trust, with only the “trades”, “gas and electricity” and “cars” scoring lower. The provision of longer-term financial products which covers both investments and pensions sold by banks and insurance companies also performs poorly in terms of trust.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1453

Table 4 TRUST IN SECTORS WHERE 1=DO NOT TRUST AT ALL AND 5=TRUST A GREAT DEALxv Trust in sectors Food/groceries

3.57

Technology appliances

3.38

Domestic appliances

3.38

Broadband/home phone services

3.14

Airlines / holiday operators

3.09

Water

3.09

Mobile phone services

3.07

Train travel

2.99

Banking

2.92

Trades services

2.91

Gas and electricity

2.83

Longer-term financial products

2.72

Cars

2.64 1

2

3

4

5

Section 3: The Causes of the Low Levels of Professional Standards in the UK Banking Question 4: What caused any problems in banking standards identified in question 1? Special features of the market for banking services 58. When assessing the causes of the level of professional standards within the UK banking market, it is important to start by considering the special features of the banking market which can make it operate differently from other markets. These features affect the incentives on those in the banking profession to maintain the highest professional standards. Which? believe that these special features include: Consumers are not well placed to judge the price/quality of a financial product or bank due to complexity and the length of time before the quality of the product becomes apparent. This undermines consumers’ confidence or willingness to engage effectively with these markets. Consumers will not be able to monitor or to exert meaningful market discipline on a bank with a riskier business model by moving their accounts elsewhere. Financial products are also long-term in nature and it may be several years before the true consequences of their purchasing decision becomes apparent or whether they have been mis-sold. For many consumers and small businesses, retail banking products are essential but invisible “utility” services, with our attention only captured when things go wrong. Consumers and businesses cannot function without continuous access to these essential services. Banks have a unique role in providing parts of the economy with credit. If they want to borrow money, consumers and small businesses typically have few alternatives to the banking system. Banks may be able to take advantage of this unique position by making the provision of a loan depend (or appear to depend) on the purchase of an ancillary product such as insurance or derivatives. Banks can generate the appearance of greater short-term profits by taking more risk. This was summed up eloquently in the evidence given to the Future of Banking Commission by the late Sir Brian Pitman. He said: “One of the great differences I think between banking and other activities, is that [in banking] you can increase the profits of the outfit simply by changing the risk profile. I was chairman of NEXT [a retailer] at one time, and we couldn’t wake up in the morning at NEXT and say, what we’re going to do is greatly expand our business, what we’re going to do is increase the risk profile. But in banking, it’s perfectly possible, in the short term, to decide to be more risky than your competitors. That will get everybody to beat a path to your door, and will wind up [in the] short term with very big profits. And if you gear up the remuneration system appropriately, you can become rich quite quickly.”342 In banking, significant revenue is incurred before the costs are fully realised. A borrower may pay interest for a while, but is not until they repay in full, or default, that the cost of the lending is known. For example, a bank which lends irresponsibly to consumers even though it is unlikely that consumers will be able to repay the money will make higher short-term profits. A bank which designs a complex and expensive insurance product and mis-sells it for many years, will make higher short-term profits, but at the expense of substantial redress costs in the longer-term. Which? 342

Future of Banking Commission, page 19.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1454 Parliamentary Commission on Banking Standards: Evidence

calculates that the total provisions for mis-selling of PPI are now greater than £10 billion and certain to rise further. If the individual banker’s remuneration is linked to this short-term performance, then regardless of their level of professional standards they will benefit substantially from this short-term performance. The true consequence of the bank’s business model and the bank’s low professional standards will only become apparent when consumers begin to default on the loans or complain about mis-selling. Banks are inter-related through counterparty risk and taking similar exposures to the same source of risk that, with the subsequent steps to protect stability, erode market discipline and create moral hazard leading to banks that are too big or complex to fail. Bailing out poorly run banks which have not served consumers effectively distorts competition. It means that rather than providing a strong incentive for bankers to maintain high professional standards, UK consumers end up subsidising and bailing out the banks and the bankers with the lowest professional standards. Banks receive wide-ranging explicit and implicit subsidies from the Government/authorities. These can include direct subsidies by the injection of taxpayer money and explicit guarantees for toxic assets. Most importantly, the implicit guarantee of banks which are too-big-to-fail means that these banks have a lower cost of borrowing (because those who lend to the banks know that the Government will bail them out if things go wrong). The extent and distorting impact on competition of this implicit subsidy is a key concern. 59. A consequence of these features is that the incentives on banks and their senior executives are often not aligned with genuine consumer benefit or the longer-term costs and consequences of banks’ commercial decisions. Intertwining riskier, highly leveraged investment/wholesale banking with essential retail activities creates conflicts of interest due to the presence of Government guarantees. All of these factors weaken the incentives on banks and bankers to maintain high professional standards. 60. Corporate governance in the banking sector should seek to achieve long-term sustainable value creation for shareholders and society. This should be achieved by putting long-term goals ahead of short term gains. Creating long-term sustainable value means putting the customer at the heart of everything the banks do and providing products and services of high quality at the best possible price. Corporate governance should seek to introduce a system of checks and balances which align the interests of banks, boards and shareholders with their customers. It should seek to control the inclination of management to take more short-term risk in ways which put the long-term stability of the individual bank and the financial system in jeopardy. The causes of low banking standards The historical perspective 61. There is a romantic vision of British banking that harks back to better days. This nostalgic view sees the bank manager as a respected figure in the local community, offering wise counsel to couples seeking to borrow money for their first home and a warm welcome to small businesses wanting loans to expand. Banks were trusted, ethical and customer-friendly in this rose-tinted world. 62. The reality was somewhat different. Although bank managers were locally respected, let’s not forget that the iconic bank manager Captain Mainwaring as portrayed in Dad’s Army was a bumbling incompetent. After the Second World War right through to the end of the 20th century, British banks were widely criticized and frequently stumbled into crisis. In the 1950s, the Committee of London Clearing Bankers operated as a closed shop when it came to interest rates, wages and salaries, protected by an agreement not to poach each other’s staff. In the 1960s, a Prices and Incomes Board report said that banks were overstaffed, over-branched, secretive and did not stay open long enough. In the 1970s, fifty fringe banks had to be rescued in the secondary banking crisis having become over-dependent on leverage and wholesale funding. In the 1980s after Big Bang, they blundered into investment banking and then in the 1990s they blundered out again. 63. But while banking was not a particularly well-managed industry in the second half of the twentieth century, it was incompetent, clubby and protectionist rather than unethical—What caused it to change? 64. The origins of its downfall lay in the 1970s. Free market economics led to the deregulation of finance with the Wall Street reforms of 1975, the Big Bang reforms of the London stock market in 1986 and the progressive integration of investment and retail banking in the US culminating in the repeal of the Glass Steagall Act in 1998. Having been constrained by close supervision and legally enforced structural constraints for half a century, banks were now free to grow their businesses as they pleased. 65. This coincided with faster communications, the digital revolution and the dismantling of trade barriers. Computing and programming power and new theories of risk management expanded the derivatives market and deal hungry investment bankers invented new products such as currency swaps, CDOs, interest rate hedges. These expanded turnover in financial services and transformed the rewards available to practitioners. 66. In parallel with free market deregulation and financialization, shareholder value was elevated above other corporate goals. Legitimized by the academic research of Alfred Rappaport and others, business people came to believe that anything was justified provided that it created shareholder value. There was a relentless drive

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1455

to grow earnings per share characterized in the 1980s and 1990s by cost cutting, financial engineering and a wave of mergers and acquisitions. 67. This affected the banks in two ways. First, it made heroes of the investment bankers who propagated these seeds, validating their values and business practices. These included vast compensation packages and a bonus driven culture. Investment bankers were promoted to senior positions and the investment banking habit of putting the deal above the relationship became widespread. 68. Second, the people running the banks applied the shareholder value creed to their own businesses. In its best form, this was no bad thing. Lloyds Bank under Sir Brian Pitman led the shareholder value charge, cutting costs, eliminating waste and harnessing technology to the benefit of the bottom line. Less able bankers sought to achieve the same financial results by leveraging off the backs of their customers, selling them inappropriate products and running huge risks. Some bankers were prepared to run these risks and cut corners partly because they got paid so much that they could move on before the risk crystallized but also because they had shareholders on their backs if they did not deliver short-term results. 69. These shareholders made it clear that they would sell out to the highest bidder and underperforming banks for example Midland in 1992 and NatWest in 1999 were taken over. Pleasing shareholders therefore became a high priority for banking chiefs and fearful of the price of failure, corners were cut. As the investment banking culture spread throughout the British banks, customers became secondary in the rush for personal and corporate rewards and by the dawn of the 21st century banks had entered the era of “anything goes”. The culture of banking, including the incentivisation of risk-taking 70. Which? believe that the prevailing culture within UK banks has been a major cause of the low level of banking standards prevalent in the UK. The culture of an organisation plays a significant role in determining the behaviour of management and staff within it. It determines the way companies treat people and the other organisations they deal with. Culture determines the objectives set for bankers and what the organisation expects them to deliver. Culture influences how staff are rewarded and whether they feel empowered to challenge unfair treatment or excessively risky behaviour. 71. Good cultures can be characterized by terms like “integrity”, “fairness”, “respect”, “honesty” and “responsibility”; bad cultures are the opposite. The tone comes from the top and then has to be transmitted to the firm’s employees whose dealings with the outside world and with each other determine whether the culture is good or bad. 72. Superficially the major British banks have good cultures. They publish codes that are difficult to fault as statements of intent. Barclays’ code of conduct, displayed on the company web site and signed by John Varley prior to his departure as chief executive on 31 December 2010, is typical. A key section read as follows: “Our organisation was founded on traditional values of trust and honour and our success has been, and continues to be, dependent not only on the quality of our products and services, but on the way in which they are delivered. We expect every Barclays employee, and others who work on our behalf, to conduct themselves according to consistently high professional and ethical standards. This expectation applies to each of us, whatever our role and wherever we are located.” 73. Standard Chartered’s web site states: “By doing things the right way, we can support our customers and clients while having a positive impact on the wider economy. Our distinctive culture and values act as our moral compass and are the reason why clients and customers choose to bank with us and our employees want to join and stay with us. Our five core values are about openness, collaboration and putting the needs of the customer first.” 74. HSBC’s Values and Business Principles encourage employees “to make decisions based on doing the right thing but without ever compromising the ethical standards and integrity on which the company was built.” 75. Lloyds TSB’s Code of Conduct states “We will provide and promote a range of products and services which is responsive to customer needs and offers value for money. We will seek never to give inadequate or misleading descriptions of products or services. We endeavour to ensure that our products and services are readily understandable by our customers.” 76. When speaking in public senior British bankers are often explicit about the importance of culture and ethics in banking. Giving the annual Today programme lecture on 3 November 2011, Barclays then chief executive Bob Diamond said: “Culture is difficult to define, I think it’s even more difficult to mandate—but for me the evidence of culture is how people behave when no-one is watching. Our culture must be one where the interests of customers and clients are at the very heart of every decision we make; where we all act with trust and integrity.” 77. On 15 March 2010, Stephen Green, at the time chairman of HSBC, told the Which? Future of Banking Commission: “No banking business can afford to do without a board-led, senior management-supported, ethical approach to behaviour—to understand that there is a purpose to the business that you do, which is not simply measured by short-term profitability... is profoundly important. Unless that culture is there in an organisation, no amount of rule setting and no amount of careful compliance is going to be an adequate substitute”.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1456 Parliamentary Commission on Banking Standards: Evidence

78. Stephen Green’s comments proved to be percipient. We are not speaking here just about the reckless business practices that caused the banking crisis of 2007–8- although those practices do not stack up well against objective standards of responsible behaviour—but the evidence of malpractice involving most major British banks that emerged over the summer of 2012. 79. Unethical behaviour evidently happened in many sectors of banking. In retail banking, millions of customers were sold PPI that they did not need; in corporate banking businesses were sold interest rate and foreign exchange swaps without a clear explanation of the risks; in the central market the crucial reference point LIBOR was rigged; in clearing and settling money laundering in Latin America was facilitated on a grand scale and US sanctions against Iran were breached. The sheer volume of these cases and the variety of products and number of institutions involved indicate an industry badly in need of reform. 80. Many of these episodes involved banks where the top management appeared to have set explicit and impeccable cultural standards for employees. It was Barclays that was first fined for LIBOR rigging; Lloyds that mis-sold some of the most expensive and toxic forms of PPI and has set aside £4.275 billion to compensate customers; HSBC that had to set aside $700 million to cover expected money laundering penalties; and Standard Chartered that paid $340 million to settle sanctions busting allegations. 81. Coming on top of widespread customer dissatisfaction with High Street banks about service levels and transparency and complaints from small and medium sized enterprises about the price and availability of credit, it is difficult to escape the conclusion that when it came to culture, Britain’s banks failed to live up to their promises. 82. There are a number of key cultural failures that Which? believes contributed to the low level of banking standards: Lack of effective leadership 83. Culture change can only be led from the top. Senior Executives must seek to diffuse a positive culture throughout their organisations to all of their employees. Staff at all levels must know the standards that are expected of them and expect this standard to be attained by all of their colleagues. Senior Executives must embody the culture that the firm are trying to achieve in order for it to take hold across the firm. 84. In too many banks, senior management failed to show effective leadership and ensure that those within their organisations upheld high banking standards. As was noted by Stephen Green, former HSBC executive, “too often, people had given up asking whether something was the right thing to do and focused only [on] whether it was legal and complied with the rules”. In other areas, senior executives may have set the right tone, but failed to ensure that this approach was followed by middle management or to monitor whether high banking standards were being achieved. Weak controls and lack of Management Information 85. Setting appropriate banking standards is very important. However, it is even more important that such standards are adhered to and, when concerns are reported, they are properly investigated. This needs to go beyond simple having a “policy” in place, but to check whether it is being adhered to by using Management Information, feedback from customers and mystery shopping. For example, if senior management say that they have a culture in place which “deals with complaints fairly” then we would expect the Board to interrogate what specific evidence and monitoring systems they had in place to demonstrate whether it was being achieved. 86. In many cases it has become clear that senior management failed to put in place sufficient monitoring and failed to promote a culture where concerns about low banking standards are reported. It is notable that in the run-up to the financial crisis those who did raise concerns about particular strategies tended to be sidelined. Even where concerns were reported, the culture of the banks meant that little action was taken. Within Barclays, risks about LIBOR manipulation were reported, little action was taken and the poor conduct continued. Given that Barclays had a clear “policy” in place on acceptable conduct which senior management claimed to “take very seriously indeed”343 it seems strange that such a serious issue was not reported to the Board. Failures in decision making/risk management 87. Many banks failed to ensure that their decision-making processes were effective, took proper account of risk or were subject to robust challenge. Too many banks appeared to have a culture of optimism, which ignored the risks of a particular course of action.344 Risk management was seen to be a constraint on the bank, rather than an integral part of the decision-making process. Failures in risk management or a culture which excludes risk management poses particular problems due to the ability of banks to make substantial short-term profits by increasing risk. Banks also failed to document why particular decisions were taken, or to ensure that they were subject to robust challenge. Tick-box culture 343 344

Barclays Code of Conduct, page 2, http://www.personal.barclays.co.uk/PFS/A/Content/Files/pp_code_of_conduct.pdf See FSA Final Notice, HBOS, http://www.fsa.gov.uk/static/pubs/final/bankofscotlandplc.pdf

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1457

88. In too many banks a “tick-box” culture developed which saw regulation or regulators as the only arbiters of acceptable behaviour. We are aware of an instance where a firm identified “no major FSA concerns” and “no major regulatory sanctions threatened” as the only indicators that senior managers had met their target of treating customers fairly. 89. This attitude spreads to those who purport to represent the industry. In their application for a Judicial Review of the FSA’s action on PPI, the British Bankers Association contended that the banks did not have to provide consumers with an oral explanation of the terms of the policy, but merely had to tell them that it was important that they read the policy summary. It is a strange attitude to use a regulatory justification for failing to explain the terms of your product to consumers and instead referring them to a document which could involve pages of small print. Culture of gaming the regulator and rules 90. In common with a cultural approach to “tick-box” compliance with the rules, in some banks there also seems to be a culture of attempting to “evade” or “work around” regulations—to operate within the letter but not the spirit of the law. It is clear from the FSA letters that Barclays sought to “gain advantage through the use of complex structures, or through arguing for regulatory approaches which are at the aggressive end of interpretation of the relevant rules and regulations”.345 This was described as a culture of “gaming”. 91. This culture of gaming also appears to have been entrenched into the way some banks measure and manage risks. Which?’s Future of Banking Commission identified one bank, which expanded leverage and risk in ways which failed to show up in the official “regulatory” measures of capital. As Jon Danielsson of the London School of Economics told the Future of Banking Commission, it was “straightforward for any trader of financial institution to manipulate the risk measurement … indeed this is one reason why so many banks lost so much money in the crisis. They were measuring risk incorrectly, in no small measure because they were gaming the system to extremes.”346 Reward, remuneration and incentives 92. Even when senior management did pay lip-service to the need for high banking standards, they often failed to put in place the right performance management, reward and remuneration policies to ensure that all staff upheld them. If staff see colleagues promoted for hitting revenue targets, regardless of how those revenue targets were achieved, then a culture of low banking standards will be encouraged. 93. As Jayne-Anne Gadhia noted347, during her time at RBS: “people wanted to do the right thing for customers and wanted to do the right thing for shareholders…but the reward and structuring was all around driving profitability”. 94. She stressed that she was setting a different focus in her role as Chief Executive of Virgin Money: “it’s really important to be clear on culture and then drive it and reward those behaviours, otherwise it won’t just happen”. 95. Even where low banking standards did result in substantial losses from the firm, many banks have been unwilling to clawback remuneration from senior executives. We cover the impact inappropriate remuneration schemes had on the level of banking standards below. Failure to acknowledge the need to change the culture of banking 96. Finally, we are concerned that the banking industry still fails to realise that there needs to be a substantial change in the culture and ethics of the profession. Those within the banking industry often blame “international standards on capital and setting risk” for the crisis, rather than acknowledging the key cultural failures of the industry. Until those at the top, acknowledge the need for change then the banking industry will continue to be locked into a downward cycle of scandal, recrimination and loss of trust. The impact of globalisation on standards and culture; global regulatory arbitrage; the impact of financial innovation on standards and culture 97. These issues may have had an impact in that they relate to certain factors that Government and regulators may take into account which would prevent them from taking action against individuals and banks with low professional standards. In the run-up to the credit crisis, regulators were obligated to consider the desirability of facilitating innovation, the international character of financial services markets and the desirability of maintaining the attractiveness of a particular location for financial services activities. 98. This leads to a concern that regulators may fail to take action to challenge low banking standards because of their concerns that this may conflict with their other objectives. Regulators may believe that any action to tackle low levels of banking standards, particularly if it is unilateral could damage the attractiveness of a particular location for financial services activity. 345

Letter from Lord Turner to Marcus Agius, 10th April 2012 Future of Banking commission, page 59 347 Future of Banking Commission, page 76 346

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1458 Parliamentary Commission on Banking Standards: Evidence

Corporate structure, including the relationship between retail and investment banking 99. The course of history suggests that financial crises will recur at regular intervals and that it is not helpful to completely eliminate the risk of failure (or to claim that a Government or regulator will eliminate the risk of failure in all circumstances). The current corporate structure of the UK banking system allows banks to take retail deposits and be an essential part of the payments system, while at the same time engaging in all manner of risky and speculative investment banking activities including proprietary trading. 100. This corporate structure helps to create banking institutions that are “too big to fail” and results in the Government (and ultimately taxpayers) guaranteeing that these banks will continue in business. The implicit (and in reality explicit) taxpayer guarantee encourages banking corporate structures which intertwine highly leveraged wholesale investment banking activities with retail deposits and the payment system. When these, large complex banks are at risk of failure, in the past the Government has had little choice but to extend support to the full spectrum of retail and investment banking activities. The result has been that the UK taxpayer has provided guarantees against losses by banks on loans they made to hedge funds based in the Cayman Islands and losses on trading of complex derivatives. 101. Subsidies will inevitably be greater for those banks with low professional standards. This makes banking unique from other sectors. In no other sectors that we examine do firms actively obtain a government subsidy for behaving badly. The corporate structure also results in taxpayers paying the costs of low banking standards as they end up owning a majority stake in poorly run banks with the lowest level of banking standards. 102. Large, sprawling conglomerate structures also make it hard to enforce high-levels of banking standards across these vast organisations. Corporate structure also played a part in spreading the prevailing culture in investment banking into the retail bank. As the Future of Banking Commission noted: “The reintegration of retail, commercial and investment banking symbolised a state of mind that said “anything goes in finance”. That mindset encouraged investment bankers to gear up their own balance sheets and chase down the retail banks with new derivative products. It persuaded previously staid financial institutions—such as Northern Rock, Bradford and Bingley and HBOS—that it was safe, perhaps even expected for them to gear up to levels previously seen only at the most racy investment banks.” The level and effectiveness of competition in both retail and wholesale markets, domestically and internationally and its effects 103. First of all, it is important to state that Which? does not agree that too much competition was responsible for the financial crisis or that competition is contrary to financial stability. Those who put forward that argument tend to think that “stability” is achieved by preventing the failure of all large banks, no matter how incompetently or imprudently run. 104. Competition should be a dynamic process that rewards firms that successfully compete on the merits of their product offering, delivering good value and quality to consumers. Firms that serve consumers well should thrive while those that do not fail. Effective competition can both drive up standards and put pressure on business to offer good quality products and value for money. Which? would highlight three areas where the lack of effective competition has led to low levels of banking standards. — The market power of the largest banks has increased, leading to worsening terms for consumers and dominant positions in the market for the largest banks with the lowest levels of banking standards. — Distortions to competition from the government bail-outs and subsidies of the largest banks due to the lack of an effective regime to enable badly run banks to exit the market. — Barriers to switching: Customer inertia (and more recently captive customers) where, perhaps more than in any other industry, due to the switching barriers they face consumers have an inbuilt tendency to remain with their existing banks. This in turn, weakens the incentive on banks to compete for customers by maintaining high banking standards, offering value for money and good customer service. Market concentration and distortions to competition 105. Allowing mergers to take place which substantially increase the market shares of the largest banks results in less competition for consumers. It also increases the risk of the Government having to step in at some point in the future to support the largest banks due to the significance of their position in the economy. 106. The implicit subsidy distorts competition as it is clear that the subsidy is greater for larger institutions as the enhancement those larger banks gain from the probability of Government support being extended is larger. Small banks and new entrants (which are clearly seen as being small enough to fail) do not enjoy these benefits. 107. The suspension of normal competition law and the extensive support provided to the largest banks means that their market power is greater than ever. In 2001, Lloyds proposed acquiring Abbey National, but the OFT ruled that the merger would be anti-competitive and that it should be referred to the Competition

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1459

Commission, which eventually blocked the merger. However, in 2008 the Lloyds/HBOS merger was rushed through in the teeth of the financial crisis and created a bank which was just as dominant in the market. In no other market, would a business with such low level of professional standards be given state aid and Government support to enable it to gain a dominant position in the market. 108. The big five348 (Lloyds, RBS, HSBC, Santander and Barclays) have market shares of: — 85% of the current account market, compared to 71% before the financial crisis. — 67% of mortgage gross lending, compared to 38% before the financial crisis. — 61% of the savings account market, compared to 47% before the financial crisis. 109. The ICB report was clear that even after the limited divestments by Lloyds and RBS, major retail banking markets will still be more concentrated than at the time of the Cruickshank report.349 Consumer impacts—barriers to switching 110. For proper competition to exist, consumers should face low barriers to switching financial products and services. This allows consumers to drive improvements in products and practices by exercising their consumer power and switching to banks which offer better value for money, better products and better service. To successfully switch products, consumers first need to become aware that they are not getting the best deal, then they set about gathering information from other providers and comparing the products on offer by their existing bank. Finally, they need the confidence that if they do switch then the process will be handled smoothly. 111. In practice both real and perceived barriers to switching can be significant. A lack of transparency may mean that consumers are unable to compare the products offered by different banks. Concerns about the switching process going wrong or the hassle it involves may discourage consumers from switching. Low levels of trust or concerns about securing access to credit could also make consumers more wary of switching bank. 112. As part of our regular customers satisfaction surveys we ask about our members’ experience of switching. With regard to current accounts, switching rates remain low with an average of 6% of Which? members switching every year. The biggest barriers to switching remain the doubts over whether the benefits of switching are significant enough, concern over the complication/hassle involved in the process and the risk of errors affecting regular payments. 113. Our research also finds that the complexity of the banks’ charging structures can often make it difficult for consumers to compare the cost of different bank accounts. In our recent research people found it virtually impossible to calculate how much their bank would charge them for using an unauthorised overdraft, or to compare charges between banks as the fee structures are so complicated. A Maths PHD student participating in the research was unable to accurately calculate the level of charges. 114. In the mortgage market, a glut of irresponsible lending followed by a move from feast to famine in the availability of credit has left a legacy of “mortgage prisoners”—consumers who are trapped with their existing lender and unable to switch. In recent months, banks have taken advantage of these customers by increasing their Standard Variable Rates. Over 1.2 million customers have already been hit by these increases. 115. This lack of effective competition reduces the incentives on banks to maintain high banking standards. Many banks fail to compete by offering consumers better value products and higher standards of customer service. Many banks fail to increase the transparency of their products until forced to do so by regulators. For example, it is notable that some banks failed to clearly show the interest rate they were paying on their yearly statements for savings accounts until forced to do so by regulators. The role of shareholders and particularly institutional shareholders 116. Shareholders and institutional investors have failed to ask any questions about the culture or level of banking standards within the banks which they own. We are unable to determine the precise reasons for their lack of interest in these matters. It could be that their short-time horizons play a part in their lack of interest. The prevailing culture within institutional investors could also be related to receiving large rewards for mediocre performance. It might also be the case that as the financial penalties for low banking standards are so small institutional shareholders view them as just another cost of doing business. Only when financial penalties are much higher will shareholders take a greater interest in these issues. 117. There was also an important failure by shareholders in encouraging banks to borrow and lend more with the aim of maximising short-term returns on equity. This quest for unsustainable short-term returns ended up driving low levels of professional standards and in the long-term generating huge losses for the banks (and ultimately taxpayers). Stephen Green, then group chairman of HSBC told the Future of Banking Commission350 that: 348

Post financial crisis these numbers include Lloyds Banking Group, RBS group, HSBC, Santander and Barclays; Pre-financial crisis these numbers include Lloyds TSB, RBS group, HSBC, Abbey and Barclays. Mortgage gross lending figures are for 2006 & 2011. Current Account market share are for June 2007 & April 2011. Savings Account figures are for Oct 2006 and Feb 2010 and are by number of customers. Sources: Mintel & Council of Mortgage Lenders 349 ICB Interim report, pages 28 & 120 350 Future of Banking Commission, page 66

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1460 Parliamentary Commission on Banking Standards: Evidence

“questions would be asked [by fund managers] about why we weren’t gearing ourselves up more, why we weren’t buying shares back, why we weren’t realising certain assets where the book value was substantially below the market value-all of [which was] rather short-termist in its focus” Creditor discipline and incentives 118. It is clear that the incentives placed on creditors played a role in failing to prevent low levels of banking standards. During the financial crisis, bank shareholders lost substantial wealth but bondholders were largely protected by the Government guarantee. This led to a mis-pricing of risk and also reduced incentives to control risky behaviour and low levels of banking standards. 119. Retail depositors are not well placed to evaluate the credit risk of the bank in which they place their deposits. They are therefore not able to provide the proper incentives to encourage bank management to control risk. Those who lend to banks in the wholesale markets should be in a better position to impose market discipline by demanding higher rates of return from banks engaged in risky activities. However, these creditors may be reassured by the knowledge that they rank equally with depositors in a bank insolvency it is likely that the Government will protect their investment. 120. In the Irish banking crisis senior members of the Irish Government attempted to reassure senior unsecured creditors by saying that they ranked equally with depositors and that they would not be subject to a write-down unless depositors were affected in a similar way. However, at the same time the Government was making it very clear that it had no intention of imposing losses on retail depositors. Corporate governance including: the role of non executive directors; the compliance function and internal audit and controls 121. In well run organisations, appropriate corporate governance should act as a check and balance and prevent low standards from being entrenched. However, within some banks the systems of corporate governance and compliance failed in a number of respects: Lack of Board review of culture and incentives 122. The Board must also have a clear understanding and focus on risks, both to the institution and in its treatment of customers. Ideally the board should have three qualities: the ability to lead the business; the expertise to take good decisions; and the independence to challenge and change course. The Board should have a structured process in place for reviewing the firm’s culture. This should include leadership, strategy, decisionmaking, controls, remuneration and whistleblowing policies. Lack of Board knowledge about the level of professional standards throughout the bank 123. Boards seemed to have little appreciation or knowledge of the level of professional standards throughout the organisation. It is not clear what material was presented to them by the executives or whether warnings were given and ignored or were simply not considered. It is clear that in many areas, firms failed to provide sufficient information to their Board about the root causes of consumers’ complaints or what action the banks were taking to address these issues. Boards failure to encourage a culture where poor professional standards can be challenged and eliminated 124. Boards need to encourage a culture where concerns about poor banking standards are escalated to board level. That Boards failed to do this shows that in many cases they were not concerned about poor levels of professional standards or that they were remiss in failing to ask the right questions about these areas. Remuneration incentives at all levels The wrong incentives 125. Which? believes that an important root cause of low banking standards has been that staff at all levels of the bank, from senior executives down to frontline staff are given inappropriate incentives and targets. This can be short-term profitability, to sell as many products or hit certain sales targets regardless of whether the products are suitable for the customer. It is clear to us that incentive schemes are the root cause of the vast majority of mis-selling scandals, from PPI to interest-rate swaps. Incentive schemes can also lead to irresponsible lending if senior and frontline staff are encouraged to expand lending to meet short-term profitability targets, regardless of the risk to the business. 126. Commission payments and sales targets have been the main drivers behind a succession of mis-selling scandals that have caused significant consumer detriment and cost the industry billions of pounds. The potential for consumer detriment is particularly great in a market such as financial services where low financial capability and product complexity leave consumers vulnerable. Furthermore, the poor quality and suitability of the product often does not become apparent until many years after it is sold. 127. The link between mis-selling and remuneration structures can clearly be seen in, for example, the FSA’s final notice to Alliance & Leicester, which was fined £7 million for mis-selling PPI. It shows that advisers at Alliance and Leicester received six times as much bonus for selling a loan with PPI as for selling a loan

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1461

without PPI, whether the product was appropriate for the customer or not. If they did not sell loans with over 50% of loans then they would see a quarter of the value cut off their bonus. At another bank, executives set targets to sell PPI with 80% of loans.351 Pressure put on staff to meet sales targets were also a factor in the mis-selling of precipice bonds by Lloyds TSB. Despite the risk of capital loss, these products were sold to investors who had no previous experience of investing in equities.352 128. Culture is important here and for frontline staff, pressure from sales targets (with a threat of dismissal if they are not met) is just as potent a reason for low levels of banking standards as extra bonuses for selling products. 129. We return to our theme: that it is the culture of the banks and the incentives given to staff throughout the organisation which has led to the low level of banking standards. It is clear that those at the top of the banking organisations gave insufficient focus to the incentives they were setting for staff. 130. The FSA report into the collapse of HBOS found that “staff were incentivised to focus on revenue rather than risk, which increased the appetite to facilitate customers, increase lending and take on greater risk”. Targets were set which incentivised behaviours including “increasing the appetite to lend; increasing the appetite to take on greater credit risk;”353 131. In contrast with this approach, Sir Brian Pitman was clear to the Future of Banking Commission that: “Incentives for sales targets have been a large part of the problem … It’s a little short of crazy to incentivise people to maximise the number of loans they’re going to grant”. 132. Unfortunately, for consumers and the economy, the culture of the UK banks moved substantially away from that approach in the run-up to the financial crisis. 133. Extracts from FSA enforcement notices showing the link between incentive schemes and mis-selling: “advisers receiving inbound calls needed to sell six loans without insurance to achieve the same bonus that they would receive from only one sale with full insurance” and that “provision was made in the bonus schemes that advisers would suffer a 25% penalty to their bonuses if they did not achieve certain targets”.354 Similarly, the FSA’s final notice to HFC Bank, a member of the HSBC Group, shows that “the attainment of the PPI target penetration rate had a potentially significant impact on bonuses (ie it could double and potentially quadruple the value of the bonus)”.355 “During May 2000, it was considered that sales of the Extra Income and Growth Plan (EIGP) were a possible way of getting high volumes of business, thus helping distribution channels reach their sales targets….The financial consultants within the Network were under general pressure to perform and to meet sales targets for all products. The numbers of sales made within the Network were regularly monitored. Area Managers within the Network regularly emphasised the importance of selling the EIGP.”356 “The risk of pressure selling was further increased by the financial incentive schemes LVBS operated. Until 31 March 2007, LVBS’s telephone sales staff received bonus incentives based only in respect of their PPI sales, not in respect of their loan sales (for the period up to 30 September 2006, the amount of bonus the sales person received per PPI sale varied depending on their penetration rate for PPI). Even from 31 March 2007, the incentives to sell PPI still outweighed those for loans (on average a sales person could expect to earn four times as much from PPI incentives as from loan incentives). The amount a sales person could make from incentives was substantial—up to two thirds of their base salary. Telephone sales team leaders were also incentivised throughout the relevant period on the basis of the PPI sales of their teams, which created a potential conflict of interest with the supervision of their sales staff, especially as for a short period up until 1 June 2005 they were directly responsible for conducting a programme of sales monitoring”.357 “In one medium-size firm selling secured loans, sales staff were incentivised by a £20 bonus per PPI sale and the bonus structure on PPI and the loan could double their basic salary. In addition, targets of 50% PPI penetration were set for each member of staff for the award of these bonuses. Individuals failing to meet this target were not awarded any bonuses and were described as having ‘a training need.’ Furthermore, there was no clawback of the bonus if the customer subsequently cancelled the policy”.358 “Our review has found serious failings in the sale of interest rate hedging products to small and medium sized businesses (SMEs). We have evidence which raises concerns about the sales we have 351

FSA enforcement notices demonstrate that remuneration policies are often one of the causes of mis-selling http://www.fsa.gov.uk/ pubs/final/alliance_leicester.pdf http://www.fsa.gov.uk/pubs/final/hfc_bank.pdf 352 http://www.fsa.gov.uk/pubs/final/lloyds-tsb_24sept03.pdf 353 FSA, Bank of Scotland, Final notice, http://www.fsa.gov.uk/static/pubs/final/bankofscotlandplc.pdf 354 http://www.fsa.gov.uk/pubs/final/alliance_leicester.pdf 355 http://www.fsa.gov.uk/pubs/final/hfc_bank.pdf 356 FSA enforcement notice Sep 2003 http://www.fsa.gov.uk/pubs/final/lloydstsb_24sept03.pdfsep 357 http://www.fsa.gov.uk/pubs/final/liverpool_victoria.pdf 358 FSA, PPI thematic work, page 20, http://www.fsa.gov.uk/pubs/other/ppi_thematic_report.pdf

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1462 Parliamentary Commission on Banking Standards: Evidence

reviewed in certain banks. These concerns include (i) inappropriate sales of more complex varieties of interest rate hedging products (such as structured collars) and (ii) a number of poor sales practices used in selling other interest rate hedging products. We also found that sales rewards and incentive schemes could have exacerbated the risk of poor sales practice”.359 Arrangements for whistle-blowing; external audit and accounting standards 134. Arrangements for whistle-blowing could have been a cause of low banking standards if they were so weak that they prevented bank staff from challenging unethical behaviour. It is not clear how often reports of possible whistle-blowing about low levels of banking standards were reported to banking Boards. 135. Accurate and clear financial reporting and auditing of banks is crucial to the stability and integrity of the financial system. However, weaknesses in accounting and auditing standards can contribute to poor banking standards. Rather than being a transparent window onto corporate performance, unless subject to significant oversight, the accounting reporting methods themselves can encourage low banking standards which conceal risk. Honest and clear accounting and auditing standards are particularly important in the banking sector, where unlike other industries, banks are able to generate short-term profit by taking extra risk and mis-selling products. 136. Despite their primary responsibility being to shareholders, auditors frequently failed to provide an early warning of declining banking standards. It is also clear to us that auditors are not typically asked to monitor or “audit” the level of banking standards within a group and even if they are asked to do this we were unable to find any examples of auditors exposing low levels of banking standards. As audit firms may also provide ancillary services to the banks, they may have reduced incentives to expose poor practice. The regulatory and supervisory approach, culture and accountability 137. Which? believes that the overall regulatory approach, culture and accountability played a significant role in failing to tackle low levels of banking standards. We would highlight the following areas which we believe have led to problems in banking standards: Overall regulatory approach 138. Rather than taking robust action against banks with low levels of professional standards, the prevailing regulatory approach of the FSA was to concentrate on ensuring the information that was provided to consumers complied with the rules. Regulators did not pay sufficient, or indeed any, attention to the culture within a firm or the incentives given to staff and how this influenced standards. Instead, regulators focused on ensuring that firms complied with the rules. This “tick-box” approach had unsatisfactory consequences for the conduct of firms and the actions of the regulator; firms were given the green-light to continue practices that led to poor standards as long as rules were not broken and the regulator was only concerned with policing those rules. We think this could have played some part in fostering the damaging culture within firms which we referred to above; any course of action was acceptable unless it was specifically prohibited by the regulator. Therefore, neither the regulator nor the firm had an incentive to push for changes or reform. Failure to be proactive 139. A failure to be proactive meant that by the time problems emerged that were caused low levels of banking standards they had already caused substantial detriment to consumers, small businesses and ultimately for the balance sheets of firms. The issue of PPI is a good example of this. 140. PPI was designed to cover your debt repayments if you couldn’t work—for example, if you become ill, have an accident or are made redundant. It was sold alongside loans, mortgages, credit cards and store cards. In the past decade, PPI has been subject to widespread mis-selling, and this has resulted in millions of consumers holding expensive insurance they were never able to claim on. 141. PPI offers a clear example of a poorly functioning, uncompetitive market. The sale of this product involved: (a) a lack of adequate disclosure to customers about the product they were buying, and the resulting asymmetry of information between provider and customer; (b) inappropriate default settings, where it was left to the customer to opt out of buying the product when purchasing another financial product; (c) the existence of inappropriate commission structures, which focused the rewards for salespeople on selling PPI, rather than serving the customer well; and (d) accounting practices which allowed firms to book an upfront profit from selling single premium PPI policies. 142. The issue of PPI was not dealt with in a proactive manner by the FSA or the other regulatory authorities. Despite Which? raising concerns about the mis-selling of PPI in 2002, Citizens Advice submitting a super complaint to the OFT in 2005 and a market investigation reference to the Competition Commission in 2007 the problems caused by the mis-selling of PPI continue today. 143. The FSA began mystery shopping and supervision exercises in 2005 and then called on firms to take “urgent action” to ensure that their selling practices for PPI were compliant with regulatory requirements. However, firms did not respond to the FSA’s regulatory action and continued to mis-sell PPI. The FSA 359

FSA, Interest rate hedging products, Information about our work and findings, page 1 http://www.fsa.gov.uk/static/pubs/other/ interest-rate-hedging-products.pdf

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1463

responded by conducting further rounds of mystery shopping and eventually conducting enforcement action and levying fines. However, these fines were such a low proportion of the revenue gained by banks from selling PPI they failed to have the desired effect. It took until 2010 for the FSA to finalise it’s PPI complaints rules. However, these rules were then challenged by the banking industry and sent to judicial review. This judicial review was thrown out in April 2011 and has led to billions of pounds of redress being paid out to consumers who were mis-sold. To date, the big 5 banks (Lloyds, Barclays, RBS, Santander, HSBC) have set aside £8.9 billion to pay PPI compensation and up to the end of June 2012 £5.4 billion had been paid out to consumers. A more proactive approach from the regulator could have led to this problem being stamped out much earlier and reduced the costs that businesses had to bear. Failure to place the right incentives on individuals and banks to uphold high levels of professional standards 144. Ill conceived commission structures can contribute to mis-selling by creating inappropriate incentives for staff. Such incentives structures should have been picked up by the regulator and flagged as having the potential to lead to mis-selling. They were not. 145. Even where the regulator did eventually uncover poor conduct, the penalties imposed were insufficient to create a credible deterrent or an incentive for other firms not to repeat their actions. Once again, PPI provides an excellent example. 146. The fines first issued by the FSA for PPI mis-selling were such a low proportion of the revenue gained by banks from selling PPI that they failed to deter future mis-selling. Even after the FSA had decided to significantly increase the level of penalties it imposed for PPI mis-selling, the fine levied on Alliance and Leicester represented less than 3% of the revenue they gained from selling the product (around 5% of the net income or profit).360 147. If you compare this to other regulators you can see the FSA were not issuing fines that were in line with other regulators. Under the Competition Act 1998, the OFT has the power to levy a financial penalty of up to 10% of global turnover of the business involved. OFWAT and OFGEM have similar powers. British Airways was fined £121.5 million for collusion over fuel surcharges.361 Argos and Littlewoods were fined a total of £22 million for fixing the price of toys and games.362 OFWAT fined Severn Water £35.8 million for mis-reporting information and providing sub-standard service.363 Unless fines act as meaningful deterrents they have the danger to be considered as just another cost of business. Lack of enforcement action against individuals 148. Despite, widespread mis-selling, no senior management in financial services organisations had enforcement action taken against them for the mis-selling of PPI. The only senior management individual to have enforcement action taken against them for mis-selling unsecured loan PPI was the chief executive of a furniture retailer (Land of Leather).364 Not a single individual senior banking executive has ever had enforcement action taken against them for presiding over the mis-selling of products. 149. One area where the FSA has had some success in recent years is in the publication of complaints handling. Part of this success can be attributed to the decision to ensure a specific executive is responsible for overseeing complaints handling. This level of personal accountability has led to increased transparency and a sharper focus on how complaints are dealt with. Culture of the regulator 150. The culture of the regulator meant that it did not challenge inappropriate banking standards. As the regulator was so focused on ensuring that rules were complied with rather than looking at wider issues of culture and standards it did not have the necessary culture itself to challenge firms. Institutional culture can only come from the top of an organisation via senior management and the regulator’s statutory objectives. Taking this into account it is somewhat concerning that the incoming FCA will have a statutory objective of “ensuring the relevant markets function well”. The wording of this objective is not the type of objective that could contribute to improving the culture of the regulator itself. Lack of transparency on the part of the regulator 151. Even when the FSA began to examine the culture of the banks it regulates, it failed to provide timely disclosure of its concerns. The letter sent by Adair Turner to the Barclays Chairman states that “Barclays has a tendency to continually seek advantage from complex structures or favourable regulatory interpretations”. Given that as noted by Lord Turner, such activity was “unprecedented” it seems strange that the regulator would fail to highlight its concerns in public and fail to require Barclays to report the regulator’s concerns to its shareholders. Accountability and governance of the regulator 360

http://www.fsa.gov.uk/pubs/final/alliance_leicester.pdf http://www.oft.gov.uk/news/press/2007/113–07 362 http://www.oft.gov.uk/news/press/2003/pn_18–03 363 http://www.ofwat.gov.uk/regulating/enforcement/prs_pn2108_svtfne020708 364 http://www.fsa.gov.uk/pages/Library/Communication/PR/2008/039.shtml 361

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1464 Parliamentary Commission on Banking Standards: Evidence

152. The governance structure of the regulator will also have played a role in its failure to tackle low levels of banking standards. In the past, we have seen a situation where 10 of the 12 members of the FSA board had been currently or previously employed by the industry. This raised the risk that only the prevailing mindset of the industry gained credence in Board deliberations. There was a clear preference to codify existing industry practice instead of asking searching questions about whether markets were working efficiently and in the interests of customers. The political environment 153. The political environment in which the regulator was operating in also played a part in its failure to take action to protect consumers and to enforce high professional standards. Politicians on all sides queued up to criticise the regulator as promoting “chronic overregulation”, inhibiting “efficient businesses” or undermining the competitiveness of the UK as a location for financial services. This type of rhetoric was uttered by all parties and must have contributed to a regulator that was not willing, or able, to intervene when it found evidence of poor standards or damaging culture. The corporate legal framework and general criminal law Lack of individual accountability/responsibility 154. For too long, senior management have managed to evade the consequences of their policies which have led to low levels of banking standards and significant consumer detriment. Some senior management have presided over a culture which encouraged the mis-selling of products. Other executives actively set incentive schemes in their banks which led to irresponsible behaviour. They have not been held accountable for their actions. This sends a dangerous message to senior management that they can ignore the lack of professional standards within their bank and set inappropriate sales targets for products on their frontline staff and evade the consequences. 155. In other cases a lack of individual accountability can lead to problems of low banking standards being ignored by the firm. For example, if no single, defined member of senior management is responsible for ensuring that consumer complaints are dealt with properly then any problems of unfair treatment in this area will likely be ignored. We believe that the same problem also applies to issues such as the design of banking products. If there is no one individual responsible for signing off the terms of a new and potentially risky product then any concerns about low professional standards could be ignored. Individual accountability could force bankers to focus more on higher levels of professional standards. 156. Individual accountability forces people to consider broader issues and also means that they are firmly in the frame of the regulators if the product/process proves to be toxic for consumers. Senior management have to be clear that low levels of professional standards and breaching regulations will result in serious consequences for themselves and for their firm’s reputation and bottom line. 157. Even when management action could arguably have contributed to bank failure, the burden of proof required made individual action difficult. The FSA’s report into the collapse of RBS noted that “Enforcement Division lawyers concluded that there was not sufficient evidence to bring enforcement actions which had a reasonable chance of success in Tribunal or court proceedings”. Lord Turner recognised that “many people [would] find this conclusion difficult to accept”. 158. A lack of criminal sanctions could also have led to low levels of banking standards. It is clear that there are no criminal sanctions which can easily be imposed on those bankers who manipulated LIBOR. There is evidence from the enforcement of competition law which should be applied to the banking sector. A survey of companies by the OFT highlighted the importance of sanctions which operate at the individual, as opposed to corporate, level. In terms of the motivating compliance, criminal penalties were seen as most important, followed by the disqualification of directors, adverse publicity, fines and private damages actions. The OFT has noted that “Imprisonment is widely regarded as a very strong means of deterring anti-trust infringements and even a relatively low probability of facing a jail term may prove significantly deterrent relative to jurisdictions where this possibility is altogether absent.”365 When combined with an appropriate leniency regime, criminal sanctions can be particularly effective if they increase the probability of being betrayed by fellow participants in illegal activity. Inability of consumers to obtain redress collectively 159. Which? believes that in some areas, low levels of professional standards in the banking industry may have arisen or persisted due to the absence of an effective and comprehensive redress regime. Where clear rights to redress exist alongside an effective means of enforcing those rights, there is an increased incentive for companies to improve standards. 160. While the Financial Ombudsman creates a well-used system for individual claims, our experience shows that due to the time and hassle involved, consumers will generally only seek individual redress where the loss is significant and/or they feel substantially “wronged”. However, many practices will only lead to a small individual loss and typical consumer behaviour means these issues remain largely unchallenged on an individual 365

OFT, An assessment of discretionary penalties regimes, October 2009

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1465

basis. Nevertheless, such practices can still present a significant incentive to “bend the rules” or lower standards because where they affect large numbers of consumers, the collective benefit to the financial institution (and consequently, the total customer detriment) can be substantial. For example, in the case of the LIBOR scandal, a small manipulation in the rate may have a significant benefit for the bank, whilst the costs are spread amongst a large number of consumers or counterparties. 161. In addition, the recent experiences with the bank charges and PPI cases demonstrate that the Financial Ombudsman in and of itself is not a sufficient deterrent to poor standards. Section 4: Recommendations for Reform of the Structure, Regulation, Culture and Corporate Governance of the UK Banking Sector Question 5: What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally? Question 6: Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice Question 7: What other matters should the Commission take into account? 162. The financial crisis has had a devastating impact on consumers and damaged their trust in a sector which is vital to economic prosperity. It also exposed the fact that even before the financial crisis many aspects of the banking market were not working in the best interests of consumers or society as a whole. Simply, putting more capital into the banks and returning to “business as usual” is not enough. Restoring trust by improving the level of professional standards in the banking sector will require significant reform to the structure, regulation and culture of the banking sector. Reforms to banking structure 163. Which? agrees that structural reform is necessary to remove the conflicts of interest within large banking groups and deal with the problem of banks which are too big to fail. We need to reintroduce market discipline by reducing the scope of Government guarantees and subsidies for banks with low levels of banking standards. We recommend the following reforms: Ring-fencing of essential retail banking services 164. To ensure that banks with low levels of banking standards can fail, it is essential to fully implement the proposals to ring-fence essential retail banking services. The paramount importance of protecting retail deposits and the payment system means that to some extent the taxpayer will always need to stand behind the banking system. However, it is important that this is not a blank cheque and reform should ensure that the taxpayer no longer provides an open-ended subsidy to banks with low levels of professional standards. Reform must include requiring the ring-fenced bank to have its own balance sheet, liquidity and funding mechanism and to be operationally independent of the wider banking group. 165. We want to see full and robust implementation of the Vickers ring-fencing proposals to make sure that if poorly run banks fail it doesn’t have a damaging effect on their customers or the economy. Ring-fencing is required to limit the scope of Government guarantees and to tackle the conflicts of interest which exist in large complex banking groups. It will reduce moral hazard and help impose a credible threat of failure on parts of the bank outside the ring-fence—reducing the extent of taxpayer subsidies for low levels of banking standards. The Vickers proposals should also limit the spread of a damaging investment banking culture to the retail bank, by ensuring an independent board, independent chairs of the audit, risk and remuneration committees and prohibiting the sale of complex derivatives and structured products designed by the associated investment bank. 166. The Government is committed to introducing ring-fencing as part of the Banking Reform Bill. However, the nature of the legislation is likely to be extremely broad—leaving the risk that the lobbying power of the major banks may seek to water it down as it is implemented. Depositor preference and a clearly understandable deposit protection scheme 167. Reform is required to bank insolvency procedures so that depositors become a higher ranked creditor than bondholders. This will help protect the deposits of retail customers whilst ensuring that those who lend to banks through the wholesale markets have stronger incentives to monitor and constrain the behaviour of banks with low professional standards. Improvements to competition and regulation 168. More competition is essential to ensure that banks which have low levels of professional standards are subject to market discipline. Regulators need to do more to promote effective competition and take strong and robust action against any bank with low levels of professional standards.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1466 Parliamentary Commission on Banking Standards: Evidence

Refer the banks to the Competition Commission 169. Government subsidies and bail-outs have increased concentration in the market and entrenched the power of the largest banking groups. This is not a healthy position for consumers and a lack of effective competition risks blunting the drive to raise professional standards. Even after the required divestments, the largest banks will still enjoy a dominant position and major retail banking markets will be more concentrated than at the time of the Cruickshank Report. The Competition Commission is the only body with the power to restructure major banking groups. Easier switching for consumers 170. Measures should be taken to make it easier for consumers to switch. This will help encourage new entrants who may take greater care to uphold high levels of professional standards. Portable bank account numbers should be introduced to make it easier for people to switch banks and they should be able to download their usage data to enable them to make one-click comparisons of current accounts Give consumer protection and prudential regulators a clear mandate to promote effective competition 171. Which? wants both the incoming conduct and prudential regulators to be given an objective to promote effective competition for consumers. Under existing plans, only the conduct regulator, the FCA, has a competition objective. We are extremely supportive of the FCA’s competition objective. It will help it take steps to ensure that the characteristics and price of financial products are transparent and easily comparable. We also expect it to be better placed to prevent mis-selling by controlling products and product features, rather than relying on disclosure of information to consumers in long and complex documents. The FCA would also be required to take much stronger action to reduce the barriers to switching faced by consumers. 172. We also want the prudential regulator to have a competition mandate. At present, the PRA has no such mandate in its objectives. This is despite the recommendations of the Joint Committee on the draft Financial Services Bill: “Competition within the financial sector is an important part of developing a stronger, more diverse system. The actions of the PRA have the potential to affect the costs of individual firms or of particular types of institution, and affect the barriers to entry and expansion in the market. While the need to protect and promote competition in the sector should not dictate the actions of the PRA, nor detract from the clear role of the OFT in this area, we believe it is a factor that ought to be considered in the course of PRA decision making.” 173. Giving the PRA a clear mandate to promote effective competition would ensure that it tackled “barriers to exit” and enable market discipline to operate (whilst ensuring the continuation of vital economic functions and the protection of retail consumers). The prudential regulator could also take pre-emptive steps to ensure that resolution arrangements involved the continuity of all essential retail banking services and covered how consumers were going to be treated during the process. The prudential regulator would also have a key role in limiting the impact of the implicit government subsidy. 174. Finally, the PRA will have responsibility for issuing banking licenses. Without a statutory obligation to consider competition, the PRA will not have an incentive to encourage new entrants to the market or reduce significant barriers to entry for new players. Challenger banks can invigorate the market and force existing players to compete for custom by introducing new products and services. This should create a more dynamic market in which good firms will grow. FCA should be strong, open and proactive consumer protection regulator 175. The new Financial Conduct Authority must be a strong, open and proactive regulator. This means taking early action to tackle action to tackle low levels of professional standards, holding individuals and banks to account for poor practice and using transparency to shine a light on the performance of individual banks. Higher fines 176. The regulator needs to have the power to levy higher fines so that they can act as real deterrents. Which? has been highly supportive of the FSA’s move over the past two years towards significantly higher penalties. However, there is still recent evidence that the level of fines levied by the FSA, and the way in which fines are calculated, is unsatisfactory. In the recent Libor rigging scandal Barclays was fined £59.5m by the FSA. However, US regulators the US Commodity Futures Trading Commission and the US Department of Justice fined Barclays £230.5 million for the same offences. It also appears that there could be greater transparency around how the FSA calculates the level of fines. Following the Barclays fine a source within the FSA admitted that the approach to coming up with fines was “opaque” and that the figure was simple a “judgement call” by one of the regulators.366 This is not an appropriate way for the regulator to be determining the levels of fines. There are domestic legislative changes that could be made to improve this. The Financial Services Bill, currently in the House of Lords, could be amended to provide greater transparency around fines and give the new regulators, the PRA and FCA, clear instructions to levy higher fines. Senior Management accountability 366

http://www.bbc.co.uk/news/business-18623222

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1467

177. A lack of direct senior management accountability inside firms for specific areas of conduct is damaging to banking standards and can lead to problems for consumers. A lack of personal responsibility can entrench the box ticking approach to regulation. Assigning accountability to individuals for specific areas of conduct, for example complaints handling, can help to bring focus and attention to these areas. Which? think that the attention paid to complaints handling has increased significantly in the past few years thanks to this initiative. We would like to see corporate or regulatory changes made so that this approach was adopted for areas such as sales incentives for front-line staff or remuneration of senior members of staff and directors. Unfair charges 178. The regulator should be given a clear power to consider issues of “value for money” and price when looking at hidden and rip-off charges. At present the regulator does not have such a clearly stated power. The Government has stated that it wants the new consumer regulator, the FCA, to intervene on matters of price and value for money, yet does not use those terms when setting the FCA’s objectives in the Financial Services Bill. The failure to explicitly reference value for money could lead to regulator that is reluctant to take action in this area for fear of legal challenge from the industry. Recent history has shown us that where any possible Legal ambiguity exists the industry will challenge the right of the regulator to act. Bank charges and the PPI judicial review are the two most recent examples of this. legal challenges are also costly to the regulator. The OFT’s legal costs when the industry challenged its right to judge the fairness of bank charges was £1 million. The FSA ran up £900,000 worth of legal fees when the industry asked for a judicial review into the FSA’s judgement on industry’s handling of PPI complaints. This legislative change would help to improve the culture in the regulator and make it more likely to act in the interests of consumers. Improved regulatory transparency 179. At present the regulator is prevented from sharing information it has received in the course of its regulatory activities. Section 348 of FSMA prevents the FSA from disclosing information it receives in the discharge of its regulatory duties, except in certain defined circumstances. A breach of section 348 incurs a maximum penalty of two years in prison. Section 348 acts as a catch-all to prevent the publication of information that is in the public interest and the use of transparency as a regulatory tool. Inevitably, the comprehensive nature of section 348 has led the regulator to be particularly cautious with regard to the transparent use of information. We note that the way the regulator currently interprets section 348, forbids it from even revealing what instructions it has given to firms. The Treasury has now instructed the FSA to review transparency and accountability and the FSA is preparing a discussion paper on this issue. It is vital that the findings of this discussion paper are taken forward so that the regulator is able to use transparency as a regulatory tool that can encourage better standards in the banking industry. Strengthening of collective redress powers 180. Which? believes that the implementation of an effective collective redress regime would plug an important gap in the current legal regime and provide a significant incentive for businesses to raise standards. Currently there is no general collective redress mechanism and primary legislation would be needed to change the status quo. Which? believes such a system should be based around three core principles: (a) Only designated bodies should be able to bring a case. In order to avoid the development of American-style “class actions”, representative bodies should be limited to designated bodies that satisfy certain criteria. Legal firms should be excluded so as to avoid there being a vested interest in the cases being brought before a court. (b) The system must be “opt out”. This will ensure any designated bodies can take effective action for all consumers who have suffered loss (as opposed to only those who sign up in advance to the claim—this is known as an “opt-in” system) and are able to extract more, if not all, of the unlawful gains made by the miscreant firm or industry. It will also act as more meaningful deterrent to other potential transgressors. (c) The system must include a “cy pres” distribution of damages. “Cy pres” means that any money left over from damages paid out to eligible consumers can be used in a way specifically related to the claim, for example to fund financial education or some other specific consumer-based project, rather than returned to the defendant. Reforms to culture and corporate governance 181. The structure of the banking system can provide the right environment for a positive culture and can prevent some of the perverse incentives. Responsibility for doing this should be shared between the regulators and the firms themselves. Whilst the regulatory regime can prevent the worst excesses, it can often do little to prevent some of the more damaging actions which have not yet been thought of. Regulators cannot be everywhere at once and must avoid encouraging an attitude in the banking sector that unless an action is specifically prohibited then it is acceptable. 182. Financial services firms should seek to create a culture that focuses on the long-term creation of value for shareholders that is achieved by putting the customers at the heart of their business. There needs to be a significant change of corporate culture which moves away from a legalistic interpretation of whether a course

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1468 Parliamentary Commission on Banking Standards: Evidence

of action complies with the rules and towards an ethical approach which asks whether it is the right thing to do and meets the needs of their customers and society. No amount of detailed rules will be effective if it just results in a process of banks looking for elaborate ways around them. Making this work will also depend on the industry taking its share of the responsibility for ensuring that high standards of professionalism and ethical behaviour are met. Code of Practice—A Good Financial Practice Code 183. There is an urgent need for a redefinition of acceptable practice in banking that we believe should be based on a new Good Financial Practice Code. This code should have similar status amongst the banking profession as codes of conduct have in the medical and other professions. This code should lay out the standards by which bankers are expected to operate. It should cover the duty of care they owe to their customers, the behaviours and independence of view that are regarded as essential to a well-functioning profession, and the responsibilities they have to draw the attention of their own profession and regulators to behaviour that contravenes these standards. 184. The FSA already carries out a “fit and proper” test for approved persons, which makes an assessment of probity and competency. However, the proposed new Code should go further than this; it should apply to many more employees and the standards should go beyond probity and competency to incorporate wider cultural dimensions. Adopting some of the core principles from the codes and charters which govern the medical and legal professions, such as honesty, integrity and client interest, would be an important step in achieving the necessary cultural change within the banking sector. Professional Standards Body 185. This Code should be enforced by a new professional standards body that should operate in a similar way to organisations such as the General Medical Council and the Legal Services Board that enforce Codes of Practice for other professions such as medicine or the law. This body should operate with high standards of corporate governance—this means it should be independent of both government and the industry, and should have a lay majority on its board. Embedding and enforcing professional standards 186. As we have seen from the way in which codes were ignored by staff, statements of intent are not by themselves enough. Senior management must practice what they preach and ensure that all staff understand and meet their obligations. Individual banks should take more responsibility for bankers meet these higher professional standards. This should include an annual report describing how the Code has been implemented, any concerns which have been raised internally and what action has been taken. This report should be include a personal signed statement from the chief executive and independently audited and verified. 187. In terms of enforcement, there should be stiff penalties for those that transgress the expected standards, including the possibility of being “struck off” by the new professional standards body for severe breaches. Firms themselves must also take more responsibility for raising standards within their own organisations. 188. Where there is evidence of mis-selling or poor conduct this should be dealt with promptly and effectively. In particular, this means that Non-Executive Directors should be doing more to measure the culture and customer experience in their businesses and holding the executives to account for this performance. They should make greater use of their powers to appoint independent advisers to assess risk and to measure customer experience through commissioning their own research. 189. In the case of the publically owned banks, it will be important that UKFI play a more active role than they have to date to help ensure that these banks set an example to the rest of the industry. UKFI should be actively involved in promoting best practice and should work with other shareholders to ensure the system of banking into which the public shareholding is sold, is one which is sustainable, for long-term shareholders, customers and creditors. 190. The regulators will also need to play their part in ensuring that the “fit and proper” person test for senior executives is adhered to and that any concerns with the culture of individual banks are addressed. As a backstop to this new approach, it will be important to ensure that criminal sanctions for mis-conduct are clarified and strengthened where appropriate. Training 191. To support the proposed new Code of Practice, there should be a renewed focus on training before people are able to fully practice in their profession. This should include training in the ethical behaviour expected of the members of their profession, including how to resolve conflicts of interest. An understanding of, and commitment to, the high professional standards in the Good Financial Practice Code should be a compulsory and significant part of such training. Remuneration and incentives 192. Remuneration practices are a key driver of behaviour and in need of reform. Remuneration incentives in many banks have focussed too heavily on sales and led to a culture that excessively rewards sales at the expense of client interests. Remuneration incentive schemes at all levels of the bank, from the chief executive

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1469

to the frontline staff should be reformed to prioritise meeting the needs of customers over simply making sales. This means that discretionary rewards should be focussed on measures such as fair treatment of customers, customer satisfaction and the fair resolution of complaints. 193. A specific executive should be responsible for signing off incentive schemes for frontline staff and have enforcement action taken against them if the bonus scheme promotes mis-selling by putting excessive pressure on front-line staff. By the same token, where a mis-selling issue comes to light after the event bonuses should be clawed back. In too many cases it seems as though firms are unwilling or unable to clawback bonuses from senior executives. 24 August 2012 References i

Populus, on behalf of Which?, interviewed 2000 GB adults online between 3 and 5 August 2012. Data were weighted to be demographically representative of all GB adults. Q1. “Since the start of the credit crunch, do you think each of the following has got better, worse or stayed the same?—The behaviour of UK banks” ii

Poll of 2000 GB adults online, 3–5 August 2012. Q2. Overall, do you think banks, the government and the regulator (the Financial Services Authority) have done enough to change the banking industry to ensure another credit card does not happen again, or not? iii

TNS, on behalf of Which?, interviewed 1,299 GB adults online between 6 and 8 September 2011. Data were weighted to be demographically representative of all GB adults. Q2. Overall, do you think banks, the government and the regulator (the Financial Services Authority) have done enough to change the banking industry to ensure another credit card does not happen again, or not? iv

76% think that the FSA has not done enough to change the banking industry to ensure another credit crunch does not happen again (up from 69% in Sept 2011) Similarly, 75% of people think that the government has not done enough (up from 71% in Sept 2011) v

Poll of 2000 GB adults online, 3–5 August 2012. Q3. The Government has recently announced an inquiry into the standards and behaviour of banks. How strongly do you agree or disagree with each of the following statements? The banking culture hasn’t got any better since the start of the credit crunch. vi

Poll of 2000 GB adults online, 3–5 August 2012. Q3. The Government has recently announced an inquiry into the standards and behaviour of banks. How strongly do you agree or disagree with each of the following statements? There is a deeper problem with the culture in banks than just a few individuals making bad decisions vii

YouGov, on behalf of Which?, interviewed 1035 GB adults online between 28 and 29 June 2012. Data were weighted to be representative of all GB adults. To what extent do you agree or disagree with the following statements about UK banks?—Where the law is broken by a bank, the individual(s) involved should be personally prosecuted viii

Poll of 1035 GB adults online, 28–29 June 2012. The Government, with advice from other bodies, is reviewing how to reform the banks to promote financial stability and competition between banks. The reforms are intended to reduce the chances of the credit crunch happening again and limit the chances of taxpayers being asked to bail-out the banks. To what extent, if at all, are you confident that the government will act in consumer’s best interests when implementing banking reform? ix

The British Social Attitudes survey is an annual survey, running since 1983, is conducted by NatCen Social Research. It monitors the British public’s attitudes towards social, economic, political and moral issues. The survey involves over 3,000 face to face interviews with a representative survey of the British population annually. x

Populus, on behalf of Which?, interviewed 2,060 GB adults online between 17 and 19 August 2012. Data were weighted to be demographically representative of all GB adults. xi

Q1. To what extent do you trust or not trust each of the following professions to act in your best interest? 2,060 GB adults, 17–19 August 2012 xii

Q2. Which of the following words or phrases, if any, do you associate with the professions listed below? 2,060 GB adults, 17–19 August 2012 xiii

Q3. How likely or unlikely do you think it is that people in each of the professions below would be removed from their jobs if they? 2,060 GB adults, 17–19 August 2012 xiv

The Which? Quarterly Consumer Report includes a poll, conducted by Populus, of 2,006 GB adults conducted online between 8 and 10 June 2012. Data were weighted to be demographically representative of all GB adults. xv

2,006 GB adults, 8–10 June 2012.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1470 Parliamentary Commission on Banking Standards: Evidence

Written evidence from the Worshipful Company of International Bankers PRINCIPLES FOR GOOD BUSINESS CONDUCT Summary — The Worshipful Company of International Bankers is the Livery Company for International Bankers. — It developed its Principles for Good Business Conduct in 2004. — The 8 Principles focus on behaviours that are personal—trust, honesty and integrity. — In addition the Principles articulate the Company’s expectation that members will: — manage conflicts of interest; — observe all applicable laws, rules and regulations, and; — maintain and enhance professional competencies. — The Principles are public declaration of what the Company stands for. — All members are expected to observe the Principles in their business dealings. — A membership review procedure is in place should a member breach the Principles. — The Company’s Principles have been adopted by the Chartered Institute for Securities and Investment. Introduction 1. This paper is submitted by the Worshipful Company of International Bankers (WCIB) in response to question 1 of the Parliamentary Commission’s call367 for written submissions and addresses the issue of professional standards in the UK banking industry by discussing the development of its own Principles for Good Business Conduct. The Worshipful Company of International Bankers 2. The WCIB is the Livery Company for finance professionals. It combines the traditions of the medieval City Livery Companies with a modern outlook on the financial services sector and emulates the evolution of the original purposes of the Livery Companies and Guilds; namely fellowship, charity, education and the promotion of trades and professions. Its membership has grown rapidly since its formation in 2001, perhaps evidencing the desire of individuals in the financial services industry to belong to an organisation which promotes high ethical standards, as the WCIB seeks to do. Currently it has 784 members from almost 50 different countries of whom a quarter are women and a fifth below the age of 35. Although predominantly being made up of financiers working in the banking, insurance and shadow banking sector members also includes lawyers, accountants and other professional advisors. 3. Members of the WCIB are members in their personal capacity. The WCIB is not a trade body that lobbies on behalf of its corporate members. More information about the WCIB is available from its website at: http://www.internationalbankers.co.uk Membership 4. Potential members are usually proposed and seconded by existing Company members after having completed a membership application form, but where a candidate is not put forward by an existing member s/ he is interviewed by the chair of the Membership Committee. As a final step in the membership ratification process the potential candidate’s name is subsequently circulated to members of the membership committee for approval. 5. The membership form does not currently require a potential member to disclose whether they are on the FSA’s Register as being approved to carry out controlled functions. Neither does the Company office carry out a check on that individual’s FSA disciplinary history. The WCIB is now considering whether to ask potential members to disclose this information on their application form The Evolution of the Principles for Good Business Conduct 6. The first objective of WCIB’s Ordinances concerns “standards of excellence, integrity and honourable practice” and is therefore something which all members swear to adhere to when they are admitted to the Company as they agree to “well and truly observe and keep all By-laws, Rules and Ordinances.” 7. Following a speech by Christopher Fildes at a dinner in 2003, at which he had been reminiscing about standards of conduct in the City over the years, especially pertinent at the time, following the Enron and WorldCom scandals in 2001 and 2002, a sub-group was formed to draft a code and the Principles which emerged were approved by the Court on 27 September 2004. The idea of a code had been vigorously supported by Lord George, a former Governor of the Bank of England and it was fitting that they were published and 367

http://www.parliament.uk/bankingstandards

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1471

circulated to all members after the 2005 Guildhall banquet, during his tenure as Master and are now known as the Lord George Principles for Good Business Conduct, which are attached as Appendix 1. Developing the Principles 8. In drafting the Principles the sub committee took a number of factors into account. It believed that the principles should focus on behaviours that are personal—trust, honesty, integrity, recognising that corporate integrity and reputation flows from individual behaviours and that corporate culture is set at the top of the institution. As the WCIB’s membership focuses on senior figures in financial services both in the City and overseas, the principles of good business conduct would be a public declaration of what the Company stands for and how it wanted to be seen. 9. The Principles were specifically crafted to contrast with the prescriptive, form filling approach of SarbanesOxley, the need for which arose from business people’s desire to find ways through very prescriptive rules to create financing structures that were opaque, difficult to risk manage and did not share benefits fairly. 10. Those drafting the WCIB Principles were firmly grounded in the expectation that senior managers of banks are responsible for their banks (reflected too in the FSA’s High Level Principles) and that this construct meant that it would be easy for senior bankers in the City to also “sign-up” to the WCIB’s principles. Policing the Principles 11. The Company takes a passive approach to vetting the probity of a potential new member, relying on existing members’ knowledge of individuals active in the City and the proposing/seconding mechanism during the membership entry process. Only a very small number of individuals who have sought membership without being personally known to a member of the Company have been refused membership as a result of the interview process, not because their probity was doubted but because it was felt their motivation for joining the Company did not fit with its core purposes. 12. This issue of enforcement of the Company’s Principles was specifically addressed as they were being designed. It was decided that it would not be appropriate for the Company to establish a “stand alone” standards committee which would “sit in judgement” in relation to a particular individual’s behaviour because of the potential reputational damage that might be caused and the associated risk to the Company. Furthermore because of the close alignment of the Company’s principles to those of the FSA it was thought more appropriate that, at least in the first instance, the FSA should take the lead in pursuing breaches of its own Principles. 13. However in early 2005 a protocol was established to deal with occasions when concerns about a member’s conduct or circumstances arise that may be “injurious to the character and interest of the Company”, which could include a breach of the Company’s Principles. 14. According to this protocol the matter is progressed as follows: — the matter is brought to the attention of the Chair of the Membership Committee or the Clerk; — the Membership Committee will meet to decide whether the matter should be the subject to further enquiry at a further meeting; — if a decision is taken to enquire further into the matter the member concerned is notified of this and invited to make a written submission; — after the further meeting has been held the Chair of the Membership Committee will make a recommendation to the Court which will consider it and the oral representations of the member concerned; and — within 14 days of the Court making its decision the member concerned is notified by the Clerk of the decision, together with a statement of reasons for its decision. Further Developments 15. Following the promulgation of the Company’s Principles the Chartered Institute for Securities and Investment (CISI) quickly adopted the Principles, which now make up CISI’s Code of Conduct. 16. Members of the WCIB (and their guests) are reminded of the Principles at each annual banquet as they are reproduced in full on the menu card for the event. Conclusion 17. Recognising its role as an upholder of industry standards the WCIB created a set of Principles of Good Business Conduct shortly after it became a full livery company, basing them on the personal behaviours of trust, honesty and integrity that it expects its members to adhere to. The Company took a decision to not establish a standards committee believing that matters of misconduct are better addressed in the first instance by regulatory action although in the case of egregious behaviour an individual’s future membership of the Company would be considered, according to a pre-established protocol, in the first instance by the Company’s Membership Committee.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1472 Parliamentary Commission on Banking Standards: Evidence

APPENDIX 1 This description of the Lord George Principles for Good Business Conduct below is taken from the WCIB website. THE LORD GEORGE PRINCIPLES FOR GOOD BUSINESS CONDUCT Introduction The core purpose of international financial service providers is to promote global economic and social welfare by aggregating financial resources, converting them into specific services and products and delivering them in accordance with the mandates of their clients, customers and counterparties. Both the public good and the personal interest that stands behind this purpose and the capacity of providers to fulfil their mandates on a competitive, efficient and cost-effective basis can be substantially impaired, even frustrated, by dishonesty or by a lack of professional integrity, transparency and accountability. Accordingly, financial service firms and their officers and employees have both a collective and an individual commercial interest in the maintenance of high standards of behaviour and of their professional reputation. These objectives cannot be attained, however, through mere compliance with rules and regulations. Whether the prevailing regulatory environment is prescriptive or principles-based, the interpretation and observation of such rules and regulations, if it is to be meaningful, and if it is to ensure confidence at all levels, must itself be underpinned by behaviour that is rooted in trust, honesty and integrity. The principles set out below are founded upon and reflect the essential business values which are necessary to meet these objectives and, at the same time, support the function of regulatory compliance. Principles 1. To act honestly and fairly at all times when dealing with clients, customers and counterparties and to be a good steward of their interests, taking into account the nature of the business relationship with each of them, the nature of the service to be provided to them and the individual mandates given by them. 2. To act with integrity in fulfilling the responsibilities of your appointment and seek to avoid any acts or omissions or business practices which damage the reputation of your organisation and the financial services industry. 3. To observe applicable law, regulations and professional conduct standards when carrying out financial service activities and to interpret and apply them according to principles rooted in trust, honesty and integrity. 4. To observe the standards of market integrity, good practice and conduct required by or expected of participants in markets when engaged in any form of market dealings. 5. To be alert to and manage fairly and effectively and to the best of your ability any relevant conflict of interest. 6. To attain and actively manage a level of professional competence appropriate to your responsibilities, to commit to continued learning to ensure the currency of your knowledge, skills and expertise and to promote the development of others. 7. To decline any engagement for which you are not competent unless you have access to such advice and assistance as will enable you to carry out the work competently. 8. To strive to uphold the highest personal and professional standards. Observance of the 8 principles above is wholly compatible with comparable notions of good behaviour which may be expected or mandated by applicable law or financial or other regulations or by the membership requirements of any relevant professional association or by any other applicable code of good conduct. These principles comprise the general standards of conduct that are expected of members of the Company in their business relations. Their observance carries a hallmark of trust and a commitment to fair and honest dealings with colleagues, clients, customers and counterparties and to good stewardship of customer interests, whether wholesale or retail. A material breach of the principles would be incompatible with continuing membership of the Company. 24 August 2012

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1473

Written evidence from Tony Greenham Parliamentary Commission on Banking Standards Pre-Hearing Statement 1. Implicit Subsidy The First Report references Haldane’s TBTF calculation on page 17. We have produced figures for 2010 and 2011 using Haldane’s methodology (and he has referenced our work in his speeches). I attach the press release with the 2011 numbers (£34 billion), and the relevant extract from the report with the 2010 numbers (Quid Pro Quo)—£46 billion. 2. Banking as a Public Good There is a strong public interest element to banking. Retail banking, and specifically the provision of transactional banking services and of responsible affordable credit, is different from any other consumer product and should be explicitly recognised as such. It is a basic utility and the lifeblood of the economy. There is a positive impact for society as a whole if all adults are given access to these services, in all communities and areas of the country. It has qualities of a public good,368 such as defence, because banks create credit, the acceptability of which is enforced by law. It also has qualities of a merit good, such as health, because there are positive externalities from its provision, such as full citizen participation to e-commerce, helping disadvantaged regional and local economies to develop, and providing opportunity for enterprise. One further feature of financial services tends toward market failure. The nature of financial products is that the seller has much great information about the quality, value and suitability of the product than the customer. Such information assymetries will prevent pure competition from delivering optimal outcomes. Mis-selling is the result and is as predictable in theory as it is evident in practice. For all these reasons, if we rely entirely on profit-maximising shareholder banks then it is guaranteed that the retail banking system will be sub-optimal from the point of view both of many customers, and of the economy as a whole. It will leave sections of the population, sectors of the economy, and areas of the country underserved. Other countries address this problem by having a diversified banking system that includes stakeholder banks as well as shareholder banks. Stakeholder banks, such as customer-owned co-operatives, pursue a broader range of objectives, for example, maximising customer value. They operative on a commercial basis, but balance financial and social goals rather than focusing exclusively on the former. Last but not least, the stability of the financial system as a whole is an important public good. Systems that are more diversified are more stable and resilient to shocks, and the UK’s retail banking system is unusually concentrated and homogenous. For example, Switzerland’s large international banks, UBS and Credit Suisse, reduced their stock of loans by 34% between the end of 2007 and 2011 as they retrenched after the crisis. However, Switzerland also has local public banks in every Canton that specifically serve that Canton with retail banking services. The Cantonal banks increased their stock of loans by 22% over the same period. Figures in Germany where -10%, and +16% for large commercial banks and local savings banks respectively. When we look at the UK, we find that our large banks reduced their stock of loans by 16% between the end of 2007 and 2011. But the UK has no equivalent to the Swiss Cantonal banks, or the German savings banks, or US local banks. Our SME and personal lending has suffered by comparison and our economic performance suffers as a direct result of the structure of our retail banking industry. 3. Competition and Choice We argue that there is an important distinction between policy that fosters competition and that which improves choice. In some circumstances, competition will erode choice, and choice is important. The universe of possible lending opportunities can be divided into three groups: — Definite yes: loan applications from customers with excellent credit histories, a clear proposition and good collateral. — Viable but not straightforward: loan applications that are probably economically viable, but not yet clearly bankable. — Definite no: loan applications that are not commercially viable. At any prevailing set of interest rates and economic conditions, the proportions between the three groups will vary. The third group should not be given credit. 368

A service or good which is non-excludable and non-rivalrous

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1474 Parliamentary Commission on Banking Standards: Evidence

The first group is well suited to private shareholder banks that operate at national or international scale, with centralised credit scoring and underwriting systems. This issue here for the UK is lack of effective competition, as has been more than adequately documented. I believe that progress being made on lowering barriers to entry and encouraging challenger banks will help. I also believe that the role of disruptive business models such as crowd-funding and peer-2-peer lending will be a significant factor in driving competition. I do not have much to add to this that others present and previously before you cannot better express apart from one thing. It must be clearly understood that licensed deposit-takers create money. They create new, additional bank deposits when they lend. P2P lenders cannot create money, and are pure intermediaries, transferring existing bank deposits from savers to borrowers. If P2P lenders gain significant market share of the personal and SME lending market, then there will be an impact on the expansion and contraction of the money supply and hence a macro-economic impact will result from these structural changes in banking. This has not been given any recognition in my view, but should be investigated. The second group is where I would like to focus attention. Successful lending to this group requires more intimate knowledge of the customer and his circumstances. The loan size might also be on average lower, and for all these reasons the transaction costs are therefore higher. These commercially viable loans are not always profitable for large centralised national banks, who can deploy capital across multiple sectors, regions and countries.369 It is crucial to note that this economically viable lending does not take place purely because of structural factors in the banking industry. There are broadly two approaches by our industrial competitors to address this problem: 1. Public service obligation on private banks. This is the US approach through the Community Reinvestment Act. It uses transparency and other regulatory mechanisms to incentivise commercial banks to provide capital and other support to specialist community finance institutions that have the skills and expertise to serve the economically viable but not straightforward group. 2. Public service banks. This approach is characterised by European co-operative and public banking sectors. Either state-owned or mutual, these banks target a lower rate of return and effectively cross-subsidise to serve unprofitable customers and ensure provision of essential banking services (including branches) to all areas of the economy. 4. Recommendations There are two elements to improving competition in UK retail banking: — Measures to increase competition for easy to serve customers; — Measures to ensure choice and diversity of provision for customers that are not easy to serve. The second element could be achieved by. — measures to support the scaling up of the UK community investment sector, including incentives for private commercial banks to support financial provision by this sector; — creation of new mutual and public interest banking institutions, possibly with the involvement of local authorities; — retaining RBS as a public sector bank, stripped down to the core high street business and disaggregated into a network of local banks (at City and County level) with local stakeholder representation and objectives. 28 January 2013

Written evidence from the Financial Services Authority QUESTIONNAIRE ON SANCTIONS (CRIMINAL, CIVIL AND REGULATORY) AND THE APPROVED PERSONS REGIME (APER) The FSA welcomes the opportunity to contribute to the Parliamentary Commission on Banking Standards’ examination of sanctions and the approved persons’ regime. In this memorandum, we set out our response to the Parliamentary Commission’s questionnaire received on 7 January 2013. The FSA—and both the PRA and FCA—are committed to ensuring not only that the right individuals are appointed at the approval stage but that we remain satisfied that they are fulfilling their responsibilities throughout their life as approved persons. We believe that this requires an effective process for holding individuals to account both formally and informally. We are a strong supporter of criminal action in appropriate cases, for example in insider dealing. However, we think that where mismanagement rather than deliberate misconduct is concerned, improved regulatory approaches—including more proactive and intensive supervision—rather than criminal sanctions—is more likely to be successful. 369

It should be noted that the Basel rules are deeply unhelpful in this regard as they regard lending to a Greek restaurant in North London as 100% risky while lending to the Greek government is regarded as 100% safe.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1475

Extending criminal sanctions would provide a further credible deterrent if there was a real likelihood that successful prosecutions would take place in future. However, we believe that the difficulties involved means that this might not be the case. Instead, it would be better to strengthen the powers available to take regulatory action. We, therefore, extend our support for HM Treasury’s proposal to introduce a rebuttable presumption that a director of a failed bank should not be subsequently approved as a director of another bank. As expressed in our previous submission (September 2012), whilst we consider that our enforcement powers to be largely effective, there are some areas where we think legislative change may assist. With appropriate safeguards, we believe the following changes could help us address some of the existing limitations in this area: —

The extension of the limitation period for taking disciplinary action against approved persons;

—

A power to prohibit an individual from performing a controlled function on an interim basis; and

—

A power to take action against individuals that commit misconduct, yet fall outside of the approved persons regime.

We expand on these points further in our submission. We acknowledge that a number of respondents to the Commission have proposed the establishment of an independent professional body. Whilst we would welcome any initiatives that seek to raise standards across the industry, we believe the scope of any such body would need to be clearly defined to ensure that it does not duplicate or undercut the work of the regulators. Finally, we also draw attention to the work the PRA and FCA have underway to make more effective use of our existing powers. Since the financial crisis there has been an increasing focus in the FSA on the regulation of individuals, under our approved persons regime, as well as regulation of firms. We are planning for this work to continue, and be further developed, in both the PRA and the FCA. Criminal Sanctions As you are aware, on 3 July 2012 HM Treasury published a proposal to create a new criminal offence of serious misconduct in the management of a bank. The proposal considered four main possibilities for the kind of managerial misconduct by bank directors and senior management that might be subject to new criminal sanctions: (i) Strict liability—being a director at the relevant time of a failed bank. (ii) Negligence—failure in a duty of care which leads to a reasonably foreseeable outcome. (iii) Incompetence—failure to act in accordance with professional standards or practices. (iv) Recklessness—failure to have sufficient regard for the dangers posed to the safety and soundness of the firm concerned or for the possibility that there were such dangers. 1. What are your views on extending criminal sanctions to cover managerial misconduct by bank directors? The main objectives for extending criminal sanctions to such misconduct are that: (a) bankers would act more cautiously in taking risks with the bank’s and customers’ funds; and (b) the public would have greater confidence that something could be done to take action against mismanagement. We are not convinced that the creation of a criminal offence would be likely to achieve those objectives. As illustrated by the FSA’s Board Report on the Failure of the Royal Bank of Scotland, the causes of a major bank failure are always likely to be complex and include a combination of decisions made within the bank and inextricably linked external events. Establishing the essential causal link between a bank’s misconduct and the acts or omissions of an individual senior manager will rarely be easy. Establishing this causal link in disciplinary cases, where our policy requires strong evidence of an individual’s personal culpability in the events which led to the failure is necessary can be difficult. For a criminal case the evidential burden will be even higher. There is, therefore, a risk that a criminal offence of mismanagement however constructed would rarely be prosecuted and consequently lose its deterrent value through its lack of use. Criminal offences already exist for fraud and misleading statements or impressions but the Commission should be cautious of recommending the introduction of a criminal offence in relationship to mismanagement of financial institutions.370 We believe that a better solution could be found within the regulatory sphere whereby (a) it is easier for the regulators to ensure—and it is clearer to senior bankers—that those who have previously been involved in mismanagement of financial institutions are prevented from practising again in the financial services industry and (b) it is easier for the regulators to take disciplinary action against such individuals as well. Further consideration also ought to be given to ensure that the structure of remuneration and incentivisation of Boards of banks and financial institutions, including non-executive directors, is designed to ensure that proper account is given to downside risk (as raised in the FSA Board Report into the failure of RBS). We expand on this further in our response to Q37. 370

There are a range of criminal offences which could be brought by other bodies under the Companies Act 2006, the Insolvency Act 1986 and other legislation but these do not cover the specific misconduct contemplated by this paper.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1476 Parliamentary Commission on Banking Standards: Evidence

2. What are your views on the possible formulations of a criminal offence based on options (i) to (iv)? It is unlikely that a strict liability offence would be suitable for the complexities of a bank failure. Whilst the definition of “failure” could potentially be narrowly constructed, we agree with the difficulties identified in HM Treasury’s Consultation Paper on Sanctions for the Directors of Failed Banks371 regarding what constitutes the “relevant time” at which a bank could be said to have failed and the impact on directors who had been brought on to the board just prior to the failure to assist in the bank’s rescue. This risks the punishment of persons who were not culpable in the bank’s failure. Proving to a criminal standard that an individual, or group of individuals, has acted negligently or incompetently in a business context will always be a challenge. As pointed out above, the reasons for massive corporate failure are rarely simple. There needs to be proof that the individual failed to observe the requisite standards of behaviour in much the same way that the FSA currently needs to prove in a disciplinary case that the individual’s standard of conduct is below that which would be reasonable in all the circumstances. However, in criminal proceedings the evidential burden would be higher than is the case for a disciplinary action. Similar considerations apply in the context of proving recklessness. We note, by way of comparison, that the Department for Business, Innovation and Skills (BIS), can in certain circumstances seek to make a Company Directors Disqualification Order where it believes that a person is unfit to be concerned with the management of a company. The tests that have to be met are strict ones and we note that no such action, as far as we are aware, has been taken against the directors of any of the recently failed UK banks.372 If criminal proceedings are successfully brought, a disqualification order can be made as part of the sentence. 3. Do you think that an offence based on one of those options would be likely to discourage those considering positions of leadership within banks? There is a risk that the introduction of a criminal offence for mismanagement of a financial institution might discourage some from considering leadership positions within banks: we are not aware of any specific evidence on this but would expect that there must be some risk that if your exposure is greater at a bank than any other corporate it would deter some people. This risk would be greater the more exposed an individual becomes (ie the stricter the liability). However, we do not think that this risk should be an overriding factor in deciding whether this sort of misconduct should be criminalised. 4. Will the possibility of criminalising behaviour which can already be sanctioned under Financial Services and Markets Act 2000 (FSMA) act as a greater deterrent? One element of the FSA’s credible deterrence strategy over the past few years has been to pursue criminal prosecutions for insider dealing and market manipulation in appropriate cases notwithstanding that the FSA also has the ability to bring regulatory cases for market abuse under FSMA. This is based on the belief that the threat of a custodial sentence is a greater deterrent than the threat of a financial penalty. Similarly, we agree that the prospect of prosecution for mismanagement of a financial institution would act as a greater deterrent than disciplinary proceedings. However, the deterrent would only be effective if the existence of the offence were to be supported by successful prosecutions with custodial sentences. Further, custodial sentences may be less likely if the offence of mismanagement were a strict liability offence, due to the absence of the element of personal culpability. 5. Do you think that it is likely that the threat of criminal action will stifle perfectly legitimate activity and ultimately deter growth in the banking sector? Whilst these are risks, again they are unquantifiable. However, we do not think that these risks should be an overriding factor in deciding whether this sort of misconduct should be criminalised. Civil and Regulatory Sanctions Rebuttable Presumption HM Treasury also published proposals to amend FSMA in order to put in place a rebuttable presumption that a director of a failed bank is not suitable to be approved by the regulator as someone who could hold a position as a senior executive in a bank. The Government also proposed two groups of “supporting measures”, which could be taken forward by the regulators under existing FSMA powers: (a) Introducing clearer regulatory requirements on individual responsibilities and the standards required of people performing certain key roles; or, in the alternative, a “firm-led approach” (with the onus on the firm and individual to set out a detailed written statement of the responsibilities and duties of each role); and 371

Sanctions for the Director of Failed Banks, HM Treasury, July 2012 (http://www.hm-treasury.gov.uk/consult_sanctions_ directors_banks.htm). 372 The FSA passed the underlying evidence base gathered in its Enforcement investigation into RBS to BIS in February 2011 so that it could decide whether to start such proceedings.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1477

(b) Requiring banks explicitly to run their affairs in a prudent manner, and requiring bank boards to notify the regulator where they become aware that there is a significant risk of the bank being unable to meet the threshold conditions for authorisation. 6. What are your views on the proposal to introduce a rebuttable presumption that the directors of failed banks are not suitable to hold senior executive positions in other financial institutions? As set out in our previous submission to the Commission (September 2012), we would welcome an effective rebuttable presumption and believe that this would send a clear message that Parliament views the failure of a bank as a very serious matter with significant consequences for the careers of those senior figures involved in the failure. If successfully implemented, the rebuttable presumption should make it easier and more efficient for us to reject someone whose involvement with a past failure makes them unsuitable to hold another senior position in the financial services industry. However, as the questions below imply, there are certain risks to the proposal which would need to be successfully mitigated in order for it to be beneficial. 7. Does the rebuttable presumption go any further than the current regulatory regime? This is certainly an important issue. The current regime requires any applicant for approval to satisfy the FSA that they are fit and proper: the burden is on the individual to demonstrate this to the FSA. For the rebuttable presumption to be effective, it would need to be articulated in a way which clearly does go further than the current regulatory regime and ensure that a higher hurdles is put in place. It would also need to be clear whether the presumption applied to certain types of roles within institutions and if this would mean a change to the fit and proper test for those candidates to whom it applies. 8. Do you think that the introduction of the “rebuttable presumption” could discourage skilled individuals from accepting key management positions? We are conscious of the risk that the rebuttable presumption could discourage skilled individuals from accepting a management position, particularly at a firm which was perceived to be in difficulties. It would not be desirable to make it harder for a struggling firm to recruit new management. In order to avoid this, there would need to be a recognition, either in the legislation itself, or in associated guidance, that the presumption would either not apply, or would be easily rebutted, by someone who joined a firm which was already fatally damaged and was unable, despite their best efforts, to rectify the situation. We recognise that it may be challenging to frame this guidance in such a way that gives complete reassurance to the “white knights” it is intended to apply to, without undermining the general effect of the rebuttable presumption. 9. Do you think introducing the presumption would send a clear message that bank senior executives and boards have a responsibility to ensure there is a strong focus on downside risks? Yes, as noted in our original submission to the Commission we believe that introducing the rebuttable presumption would send such a message. 10. What are your views on the possible supporting measures aimed at clarifying management responsibilities and changing the regulatory duties of bank directors? A lack of clarity as to who was directly responsible for a particular area, and/or what was a reasonable standard to expect of someone in a particular role, has proved a barrier to bringing disciplinary action in the past. Therefore, we believe there is certainly merit in exploring the ideas set out in a) above. A firm led approach may have certain advantages, as it may prove impossible for a regulator to set out detailed expectations of every different role in all the different organisational structures under which banks or financial institutions may operate. Gaining greater clarity as to which individuals hold responsibility for which areas, in higher impact firms at least, has been identified as a priority for supervisory work after legal-cutover. Please see our answer to Q17 below for further details on this. Looking at the measures discussed in b) above: we believe that the draft PRA and FCA Threshold Conditions already make it clearer that banks need to conduct their business in a prudent manner. And we would already expect firms to notify us if there is a significant risk that they will unable to meet the Threshold Conditions. However, we can see merit in further emphasising that it forms part of a bank director’s personal duties to ensure that this happens, and that the firm has an appropriate prudential culture in place. This is something the PRA plans to explore when reviewing the standards of conduct it imposes on approved persons through its Statements of Principle and Code of Practice for Approved Persons.373 This review is scheduled to take place later this year. FCA will be undertaking a similar review as outlined in our response to Q17. 373

Issued under s. 64 of FSMA

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1478 Parliamentary Commission on Banking Standards: Evidence

Existing Regulatory Sanctions 11. Despite the range of enforcement powers currently available to the regulator, are additional powers necessary? If so, what would those powers be? The FSA already has a broad range of enforcement powers to discipline approved persons and also take action in respect of their fitness and propriety. The FSA can: —

impose a penalty on an individual of such an amount as it considers appropriate;

—

suspend, for such period as it considers appropriate, any approval of the performance by the individual of any function to which the approval relates;

—

impose, for such period as it considers appropriate, such limitation or other restrictions in relation to the performance by the individual of any function to which the approval relates;

—

publish a statement of the individual’s misconduct (ie a public censure);

—

withdraw his approval; and

—

prohibit him from performing a specific function, any function falling within a specified description or any function.374

As we stated in our submission to the Commission (September 2012), we consider that we have a range of effective enforcement powers, although we suggested that the Commission may wish to consider the case for further refinement across certain areas. This could include the following changes: —

the ability to take disciplinary action against employees outside the scope of our approved persons regime;

—

the extension of the limitation period for taking disciplinary action against approved persons; and

—

a power to prohibit an individual from performing a controlled function on an interim basis.

These are covered in more detail below in our answers to questions 20, 14 and 12 respectively. 12. As part of your response to the Commission’s initial call for evidence, you suggest the introduction of a power to prohibit an individual from performing a controlled function on an interim basis. Please provide further detail of why this would be a significant tool in addition to the current powers? When the FSA takes action against an individual on the grounds of a lack of fitness and propriety (ie to withdraw his approval or prohibit him), we have no direct power to remove him from his position (whether as an approved person or otherwise) pending determination of the action against him which in complex cases can take years before the RDC and Upper Tribunal.375 Such a power would be desirable in cases where we have sufficient evidence that an individual has been involved in serious misconduct and where they continue to pose a material risk to the FCA’s or the PRA’s objectives. A power to prohibit an individual on an interim basis from performing controlled functions would enable the FCA/PRA to temporarily remove individuals from the financial services industry where they continue to pose a risk to our objectives whilst the action against them is ongoing. The power could also extend to individuals who do not hold controlled functions by temporarily banning them from performing any functions in relation to a regulated activity. We recognise that this power would be a significant extension to our current powers and should only be used in cases where there is strong evidence of a need to remove an individual immediately on the grounds of a lack of fitness and propriety. Appropriate safeguards would need to be established to ensure that the power is properly used. For example these might include: —

FSMA would need to set out an appropriate threshold that the FCA/PRA would need to satisfy before it could exercise this power.

—

The power could be exercised through the Supervisory Notice process which gives the subject an immediate right to refer the matter to the Upper Tribunal as well as the right to make representations to the regulator.

—

s133(3) of FSMA already allows the Tribunal Procedural Rules to make provision for suspending a decision of the FCA/PRA pending determination of the reference or appeal.

However, this power would be a significant tool which would allow the regulators to act swiftly to counter any threat to their objectives by an individual remaining in position pending a final determination by the tribunal. 374 375

The prohibition power in section 56 FSMA applies to all persons and not just approved persons. The regulators may at times be able to achieve the same outcome through the use of their own-initiative powers by imposing a restriction on the firm’s permission requiring the firm to suspend the approval of the individual or impose additional controls or restrictions on his activities pending the outcome of the investigation. A specific statutory power focussing on the risks presented by the individual would however be clearer in its intention and scope, as well as being fairer to the individual by providing for dedicated safeguards.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1479

13. Considering the current powers and measures, do you think the perceived shortcomings in being able to hold individual directors personally culpable are as a result of statutory or regulatory deficits or as a result of regulators and law enforcement agencies not utilising the powers already available to them as fully as they could? We believe that the main difficulties in bringing cases against senior managers of financial institutions arise from the current need to evidence strongly an individual’s personal culpability for the failings of his employer and, in some cases, from a lack of clarity over the allocation of responsibilities within firms. We have suggested a number of ways we could explore achieving greater clarity for accountability in Q17. The FSA currently does not have the power to take enforcement action simply because a failure occurs in an area for which an individual is responsible (ie there is no strict liability requirement). The FSA Handbook provides instead that we can only take enforcement action against a senior manager (and approved persons in general) where he/she is personally culpable and defines personal culpability in two ways: — Deliberate misconduct; and — A standard of conduct below that which would be reasonable in all the circumstances (APER 3.1.4(1) G and DEPP 6.2.4G). In cases concerned with the competence of senior managers, the key issue is the extent to which their standard of conduct was reasonable given all the circumstances at the time. The FSA may not apply standards of conduct retrospectively as this would raise serious issues of unfairness. 14. The Commission notes your suggestion for extending the limitation period for taking action against approved persons. Please could you suggest what time frame you think would be appropriate and give an indication of the percentage of cases that have fallen foul of the three year time limit but which would likely have been viable if the limitation period was set at the number of years you have suggested. When taking disciplinary proceedings against an approved person (ie when imposing a censure, fine or suspension/limitation) the FSA must commence proceedings (ie give the individual a warning notice) within three years of the first day on which it knew of the misconduct. The FSA is treated as knowing of misconduct if it has information from which the misconduct can be reasonably inferred. This time limit does not apply when the FSA takes action against an individual on the grounds of a lack of fitness and propriety (ie when it seeks to withdraw an approval or prohibit a person). The PRA and the FCA will be subject to the same restrictions. The FSA and its successors are committed to holding senior management to account where they fall below the standards that we set—if we are to fulfil this commitment, we will have to take on increasingly complex cases which will take time to investigate to the standard required. Based on our experience of complex cases, we consider that three years may not always give the regulator sufficient time to determine whether there is a case to answer. Aside from the length of time it takes to investigate such matters thoroughly, the deadline can be a matter of dispute. A regulator will have had frequent contact with a bank’s senior managers as part of its supervisory function—for good reasons we may wish to work with a firm to try to fix problems before considering disciplinary action—and may have accumulated information relating to a senior manager’s competence over a period of time. The time limit creates the legal risk that a senior manager under investigation could successfully argue that the time limit commenced with the receipt of any initial information rather than at a later stage when the regulator received further information on which it based its decision to investigate the misconduct. Although we do not keep statistics on cases where the three year limit has caused significant operational difficulties, it has informed our decision in several cases not to commence an investigation where the appropriate outcome would have been a disciplinary sanction but not a prohibition. In other cases, we frequently have to make difficult decisions to streamline or limit our investigation in order to ensure that we meet the time limit—this creates litigation risk and means that we may not put forward as strong a case as we might otherwise be able to. External factors may also mean that the time limit becomes a significant issue. For example, overseas regulators may be running parallel investigations which can inevitably lead to delays in how quickly the investigation can proceed. Further, where criminal authorities may be investigating or considering investigating the same conduct, this may mean in some cases that our investigation is delayed in order to avoid prejudicing any criminal investigation. These difficulties could be resolved by amending FSMA to redefine the commencement of proceedings as the issue of a Notice of Appointment of Investigators rather than the issue of a warning notice. Alternatively, section 66 could be amended to increase the time limit to, say, six years in order to correspond with the standard limitation period for civil proceedings. There is no time limit when we take action for market abuse which applies to any individual and not just to approved persons. Further, no time limit applies when we are taking disciplinary action against authorised firms. We are aware of the impact that regulatory enforcement action has on individuals and we agree that regulators should progress their investigations efficiently and without undue delay. However, we would note that given senior managers are responsible for the conduct of their firms it is not clear why they should benefit from a limitation period for action particularly when cases are often more difficult to bring against individuals than they are to bring against firms.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1480 Parliamentary Commission on Banking Standards: Evidence

Legislation Versus Regulation 15. In order to make bank directors more accountable (due to the adverse impact a large failed bank can have on the wider economy), do you think there would be merit in amending the Companies Act 2006 and the Insolvency Act 1986 as well as amending the approved persons’ regime under FSMA? To the extent you consider changes should be made to the legal framework, please articulate how you think this could be achieved given the legislation would apply to all company directors We believe that, as a general principle, issues which relate specifically to bank directors (and do not have a similar bearing on directors of other companies) are generally best dealt with through the sector specific legislation in FSMA, rather than more general legislation. Amending other legislation should only be considered where the desired result cannot be delivered through FSMA, or where that other legislation is itself a barrier to achieving the desired result. We do not think that has been shown to be the case in this instance. Indeed, because we believe that the damage to society caused by the failure of a bank is of a different order to that caused by the failure of other companies, there is a strong case for saying that directors of banks should operate, and be held accountable, according to a different set of priorities to that which applies to the majority of companies—a point made in the Chairman’s Foreword to the FSA Board Report into the failure of RBS. Changing legislation in a which would affect all company directors is obviously unlikely to be compatible with this differentiated approach. The Approved Persons’ Regime (APER) 16. The Upper Tribunal ruling in John Pottage v The FSA (FS/2010/0033) highlighted that enforcement action against senior managers is only likely to be successful where there is evidence of actual wrongdoing by the executive concerned. In your opinion, what changes could be made to some of the statements in APER about the standard of conduct expected of directors in order to make it easier to bring enforcement? APER contains guidance as to the type of conduct which is likely to satisfy (or fall foul of) a senior manager’s regulatory obligations. However, APER does not seek to set out an exhaustive description of every potential situation in which a senior manager’s actions might be viewed as reasonable or unreasonable. Rather, it seeks to give high level guidance indicative of the types of issue which may need to be considered. For example, it is made clear that a senior manager needs to have a sufficient understanding of the business to allow him to understand the risks of the business—the guidance does not however go on to list all the ways by which they might achieve such an understanding or the specific matters they needs to apprise themselves of. These will vary from firm to firm, and from individual to individual. Thus, while the principle is clear, the steps which need to be taken by a particular individual at a particular firm need to be assessed in the overall context rather than in a vacuum. In John Pottage v The FSA [FS/2010/033], the Upper Tribunal accepted that the scope of the obligation imposed by APER was clear. The key question for determination was whether the steps Mr Pottage had actually taken were reasonable in all the circumstances. The point in issue was actually very narrow—the FSA did not contend that Mr Pottage had taken no steps to discharge his obligation. It accepted that he had taken a number of significant steps. However, the FSA contended that there were further steps he should reasonably have taken. Having considered the evidence in detail, the Tribunal took a different view. Assessing the reasonableness of steps which have been taken necessarily involves issues of judgment, and is not always straightforward. While there might be scope to expand the guidance in APER to give more detail of specific scenarios, it would not be possible to do so in an exhaustive fashion—as with all regulatory rulemaking and guidance, there needs to be sufficient flexibility to cover all future potential scenarios as well as those that have occurred to date. This is not an area which lends itself to codification. However, whilst we will never be able to cover every scenario the regulators will be considering whether there is more we can do in the Approved Persons’ Regime and through day-to-day supervision to make our expectations clearer. 17. In your opinion, has a lack of direct senior management accountability inside firms for specific areas of conduct contributed to the shortcomings in holding individuals personally culpable? Do you think APER should be revised to remedy this? The allocation of individual responsibility within some firms for specific areas of conduct is not always clear and, in some cases, this has been an important factor in no significant influence function (SIF) holders being held to account when things have gone wrong. This has, in some cases, been exacerbated by complex structures, often spanning jurisdictions, coupled with unclear, complex and confusing allocation of responsibilities amongst SIF holders. Board structures are usually made up of a number of executive directors and non-executive directors (NEDs). It is a feature of Company Law that places responsibility on directors collectively and our current regime tries to acknowledge this. However, we also need to take account of the important differences in the roles performed by NEDs and executive directors in practice. Executive directors will have a closer day to day involvement in the business, and will be responsible for much operational decision making, as well as the implementation of policy agreed by the board as a whole. NEDs could be seen as having a more strategic role, and will have a particular focus in oversight and challenge of proposals and decisions made by the executive. Failures can

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1481

occur at either the operational or strategic level—or at both—any decision by us in particular cases as to whether action would be taken against individual executive directors and/or NEDs would need to take into account the nature of the decision(s) concerned, including at what level it was taken, and at what level it ought to have appropriately been taken. Below board level, in some cases, a decision may be delegated to a committee, sub board or executive committee whose make up may include both SIFs and non-SIFs. These groups might consider an issue seriously, obtain advice but collectively make a bad decision. This leads to the question of who we would take action against: the person who made a recommendation to the group (who may use the committee’s decision as a defence), the individual(s) who executed the decision (but can they really be held to account for the bad decision); each member of the decision making committee (which would be unwieldy and often impractical); or a more limited number of individuals who were particularly involved in the decision making or had particular roles or expertise. Whilst it might be unrealistic (and, indeed undesirable) for every risk within a firm to be owned by a particular senior manager, we do believe that greater clarity over who is responsible for what within firms is desirable and could lead to a clearer line of accountability. The FCA is therefore planning to look, at least for the higher impact firms, at how it allocates responsibilities across its SIFs. This will encourage greater clarity within the firms themselves (to enable them to have better corporate governance and enhanced accountability), provide greater clarity of whom the regulators can look to address issues and to enable a more effective ongoing assessment of the fitness and propriety of SIF holders. Ultimately, ensuring that there is a clear allocation of responsibilities within firms, will provide a firmer starting point for taking formal enforcement action against individuals where shortcomings are material. We will keep APER under review in regard to this. 18. Would it be beneficial for the regulator to adopt a more intrusive approach to senior appointments as part of the Significant Influence Function (SIF) process? How could such an approach be adopted? In October 2008, the FSA implemented an enhanced process for approval of SIFs within higher impact firms. The main effect of this focus was to introduce a more robust approach to the fitness and properness of individuals put forward for such positions. Such assessments typically involve formal interviews conducted by senior regulators and senior advisers. An internal review of this process was undertaken in April 2012 to ensure that decisions to interview a candidate are robustly risk focused and in line with the PBU/CBU objectives. The aim is to have a process that conducts high quality assessments of those individuals who are genuinely in a position to put our objectives at risk (ie Chair; the senior independent director; the chair of the risk and audit committee; CEO, finance director and chief risk officer with others being judged on a firm specific basis). 19. Do you see merit in requiring the regulator to re-appraise SIF individuals at set intervals and on other occasions if it believes that circumstances justify it? Approved persons must—on an ongoing basis—continue to comply with the FSA’s Fit and Proper Test and APER. Approval letters to all individuals clearly set out that non-compliance of these standards by the approved person may result in the FSA taking action against them. We therefore believe that the ability already exists for the regulator to re-appraise whether an individual is no longer meeting the regulatory expectations of them in the role. In fact, as part of ongoing supervision we would expect supervisors of higher impact firms, on a risk-basis, to keep under the review the ongoing suitability of key approved persons within firms. However, this need not involve a SIF interview. It should be noted that, in circumstances where we view that an individual is no longer fit and proper under the current regime, this requires us to take formal enforcement action unless the firm and individual willingly cooperate in withdrawing the approval. The burden of proof to evidence that an individual is no longer appropriate to be an approved person is with the regulator once the individual is approved and involves us evidencing someone is no longer fit and proper. This is in contrast to decisions prior to approval where the burden of proof for a particular individual’s fitness to take on a particular function rests with the applicant firm and individual. On balance, therefore, we do not see merit in requiring the regulator to re-appraise all SIF individuals (bearing in mind many will be in smaller firms) against a particular schedule, or against certain criteria. This would require us to allocate considerable resources to checks which in many cases would not be justified by the risks involved. However it may be worth exploring the possibility of a more focussed and selective approach for certain categories of SIFs to either be reassessed in post or limiting their approval to a certain time period (in which case we may require them to reapply). This type of approach would likely only be applied to certain types of SIF approvals and limited to firms we consider present the greatest risks. In any case, the regulators should be prepared to take robust action against individuals who fall short against our regulatory obligations.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1482 Parliamentary Commission on Banking Standards: Evidence

20. What are your views on extending APER so that it applies to all bank employees in order to enable the regulator to take disciplinary action against employees who are currently outside the scope of APER—a proposal that you put forward in your response to the initial call for evidence? In our response (September 2012) to the Commission’s initial call for evidence we said: “It is worth noting that we have limited powers against individuals who are not approved. Whilst systems and controls and “tone from the top” are clearly key, it is obvious that a banking sector which functions well for consumers and the economy as a whole cannot be achieved unless employees below the level of senior management also act with honesty and integrity. Therefore, having the power to take action against individuals that commit misconduct, yet fall outside of the approved persons’ regime, could enable us to address existing limitations in this area.” The current way that our approved persons regime applies to individuals in the financial services industry means that those who have been approved by the FSA are liable to pay financial penalties for misconduct, whilst others, who might commit the same misconduct, are not liable. It is not necessarily the case that those who are liable are more senior; whilst a number of relatively junior individuals may be approved to perform the customer function (CF30) as their role requires them to engage directly with customers, the line management above them (provided they are not deemed to be senior managers or directors) do not currently need to be approved and are, therefore, not liable. Similarly proprietary traders are not all required to be approved. Extending the approved persons regime so it applies to a wider number of bank employees would remove these anomalies. Our approved persons regime consists of a number of elements including (i) pre-approval by the FSA for a particular controlled function (ii) publication of the name of the persons approved on the FSA register (iii) an obligation to comply with the requirements of APER once approved, which carries with it (iv) the possibility of enforcement action against these persons if they fall short of the APER standards. The FCA view is that whilst it is desirable to apply the full regime to senior management and other defined groups where there is a particular risk of significant consumer detriment should misconduct occur, it has until now been considered disproportionate to apply this to all bank employees. However, while the risks arising from conduct by those outside the approved persons group are lesser they are not negligible, and it may be that these could be addressed by a modified approach which included some, but not all, of the components of the approved persons regime. In particular, for this wider group we could dispense with the requirements for pre-approval and registration and apply only the requirement to comply with a code of conduct, of the type already applied to approved persons, and the liability to enforcement for breaches of this. Such an arrangement would not be as intrusive or costly as the existing regime—because there would no requirement for pre-approval—but it would provide the ability to take action against these people in the case of misconduct. In addition, it could raise standards in the industry because a code would provide a clear statement of the requirements of behaviour we expected from the financial services industry. If this proposal were to go ahead, there would be a number of issues that would need to be addressed, notably the content of the code of conduct that would apply to the persons concerned—which might be a modified version of APER—and also the coverage of the new arrangement. It would be desirable for this to be expressed in such a way that it was clear to those who were covered that this was the case. 21. Do you see merit in the establishment of an independent professional body with mandatory membership which has the power to impose civil and possibly criminal sanctions? In your view, could such a body provide a solution for the issue of global matrix management structures that can exist within universal banks? We would welcome any initiative that seeks to raise professional standards within the industry. However, the key will be that any initiative adds value rather than duplicates or overlaps with functions that are already provided for in the existing regulatory framework. A number of respondents to the Commission have proposed the establishment of an independent professional body, or “Banking Standards Board” as a way of raising standards within the industry. If this was to be established on similar lines to the professional bodies that already exist within eg law and medicine, it would have the following characteristics: — The professional body/Board would be established by statute—otherwise it would not have the power to compel membership by the target population—it would be operationally separate from any industry representative/trade bodies and it would have a governing body that was not composed primarily of practising members of the industry; — The Board would produce a Code of Conduct to which bankers would have to adhere; — It would maintain a public register of those bankers who subscribed to the Code; — It could take civil enforcement action against those who breached the Code. — Breaches of the Code could be subject to a range of sanctions, up to and including prohibition from further practice within the industry;

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1483

— —

Those accused of breaches would have the right to refer their cases to an independent tribunal. But although existing professional regulatory bodies generally have powers to impose civil sanctions on their members, it would be highly unusual for these to be accompanied by criminal prosecution powers.

The FSA—and in due course the FCA and PRA—already carries out these functions, at least in respect of some members of the banking industry. As explained above, we require certain employees of banks (directors, senior management, and some customer facing staff) to obtain FSA approval before appointment (as “approved persons”). Approved persons are then required to adhere to a code of conduct set out in APER, their names appear on the FSA public register and they can be subject to enforcement action for misconduct, which can result in penalties, including banning from the industry. Any proposal to establish a new professional body with mandatory membership which was separate from the existing regulator(s) could therefore duplicate and overlap with the FSA/FCA/PRA existing powers. Alternatively it could take over the role of regulation of individuals from the FSA/FCA/PRA. The first of these outcomes could lead to confusion of responsibilities and an increase in regulatory costs, whilst the second would lose the benefits arising from regulators which can look at the conduct of both firms and the individuals working within them on a unified basis. Any legislation drafted would need to take account of these points. There is a role for voluntary bodies, separate from the regulators, in raising standards above the level required by rules. There already exist a number of organisations that work in this area by eg providing training and setting professional examinations. Such voluntary bodies could make it a requirement their members adhere to a code of conduct. But because they are voluntary in nature, and have not been given powers by Parliament to impose civil sanctions or undertake criminal prosecutions, the only action that they can take themselves against breaches of their code would be expulsion from the voluntary body itself. (They would, of course, be able to report misconduct to the regulators to consider if they wished to take action.) We do not think it would be either necessary or appropriate for any new body to have powers to take civil or criminal sanctions against their members, as this would simply duplicate functions which are carried out by the FCA and PRA. Costs 22. Please could you give us an indication of the internal (for example, FSA employees) and external (for example, legal fees) costs for bringing a case such as the ones involving John Pottage and Peter Cummings. In the Peter Cummings case, approximately £1.4 million was spent on internal case costs and approximately £4 million on external fees. Approximately £1.7 million was spent on internal costs and approximately £2.2 million on external fees in pursuing the case against John Pottage, UBS and a number of other individuals. Of these amounts, approximately £460,000 was spent on internal costs and approximately £1.1 million on external fees in the proceedings against Mr Pottage between the issue of a decision notice and the Upper Tribunal reaching its decision. 23. Please provide a summary of how decisions are taken on whether to proceed based on the likely cost including the role of the cost benefit analysis. It may be helpful to explain first how the overall Enforcement budget is arrived at before turning to how costs are dealt with in individual cases. General The annual budget for Enforcement is set by the FSA Board alongside the budgets for all other functions as part of the annual planning and budgeting process. This then determines the amount that we need to recover through the levying of fees. The Enforcement budget reflects the likely demand for Enforcement activity in the coming year. This is based partly on prior experience (ie how many cases of a particular type would we expect to see in a particular year and what are the resource requirements to deliver those), partly on discussions with Supervision and Markets in particular about their work plans for the coming year and what role Enforcement is to play in that, and partly on the likely resource requirements of ongoing cases (the majority of Enforcement cases span more than one budget year). The sum allocated to Enforcement includes the budget for internal specialist resource within the Division and also a sum for external case costs, ie the costs of engaging external counsel or other specialists to assist on specific cases. This latter sum includes an amount for cases which are not yet known about at the time of the budget which allows Enforcement to take on cases without having to seek separate additional funding. Enforcement, like every other area of the FSA, is expected to run itself efficiently and to seek to stay inside the allocated budget. However, if that funding is not sufficient, for instance, because of a particularly significant investigation then additional funding can be made available either through internal re-allocation or by a request to the Board for additional funding. For instance when the investigations into the failures of the large banks commenced in 2009 it was clear that the resources required would be substantial and, in the event, external resources were appointed to do a

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1484 Parliamentary Commission on Banking Standards: Evidence

large proportion of the initial investigatory work (working alongside FSA staff). The costs of this were substantial and were met by an increase in Enforcement’s budget and, in the case of RBS, by the imposition of a special levy on RBS. The amount of the FSA budget allocated to Enforcement has increased over the last few years from £36.4 million in 2010–11, £38.5 million in 2011–12, and £43.7 million for 2012–13. Enforcement’s budget for the financial year 2013–14 is £51.1 million. This is largely driven by staff costs as we have increased headcount and recruited more staff into the Division over this period—headcount has increased from 319 in 2010–11 to 358 this financial year. We have a budgeted headcount of 390 for 2013–14. Specific Regulatory action is different from commercial disputes where, for example, the costs of bringing a claim for damages can be assessed against the prospects of succeeding in that claim. The fines recovered in disciplinary cases against individuals are often outweighed by the costs of bringing the specific case. The benefits to the regulatory system are, however, not limited to the amount of the penalty. Enforcement cases ensure the protection of consumers or the markets, eg by removing those who lack integrity, by improving standards cross the industry by making it clear people will be held to account and by ensuring transparency. In considering whether to commence or continue any Enforcement action, we take a risk-based approach: this includes considering our Regulatory Objectives (ie market confidence, financial stability, the protection of consumers and the reduction of financial crime), the Principles of Good Regulation and our Referral Criteria.376 We have a dedicated team within Enforcement who consider all cases where the use of Enforcement may be one of the appropriate options. That team, working with colleagues across the FSA, will consider the strength of the evidence (as known at that time), the nature of the misconduct, whether other regulatory tools might achieve a suitable outcome and, importantly, the likely impact a case will have on the wider market. Cases are then prioritised to decide which should be referred and which should be subject to other regulatory measures, eg supervision action. These decisions are not always straightforward and there can sometimes be difficult choices as to whether a case should be referred or not. We consider carefully what course of action would be a proportionate response, exercise a common standard of fairness in the use of our powers and act in a manner consistent with the Human Rights Act 1998. We consider in each case the likely impact of the action (ie how significant it will be in terms of general and specific deterrence), the need for protection and the probability of success. So we will take on cases we assess to be high impact and even where the probability of success is lower in order to send messages to the wider industry and to change behaviour. We view successful enforcement action against senior managers as very high impact. When we take enforcement action in new areas we expect more cases to be contested until we build up a track record when we see people increasingly willing to enter into early settlement discussions. We regularly assess ongoing investigations to determine the progress of the investigation against its objectives and whether resource (both internal and external costs) can continue to be justified on the matter or whether that resource is better spent on other investigations. This assessment focusses heavily on the evidential strength of the case (ie how likely is it that a successful outcome will be achieved) and the impact (ie has the nature of the case changed since referral and do we still believe it will deliver a significant message). 24. Please provide an overview of how enforcement action is funded. The costs of Enforcement activities, in common with the other statutory activities of the FSA, are funded by the periodic fees levied by the industry on the organisations that it authorises or registers. Further details of how the FSA sets its periodic fees can be found at: http://www.fsa.gov.uk/doing/regulated/fees/periodic. The FSA is now obliged to pay Enforcement fines it recovers to HM Treasury after it has deducted its Enforcement costs. 25. Would the appetite for pursuing enforcement action be increased if additional funding options were available to the regulator? If the regulators had additional funding then this would be likely to increase the amount of enforcement action it would take. However, any increase in Enforcement budget would have to be justified within the limits of the FSA’s overall budget on the basis that the additional money is better spent on Enforcement activities than other FSA activities such as authorisation or supervision. In any event, an increase in overall funding would be unlikely to affect decisions about whether to continue to pursue specific cases where we nonetheless consider that the resource is better spent on other cases. 26. Understandably, there is considerable cost in pursuing individual actions. What changes do you think could be made in order to ensure that cost does not act as a deterrent in pursuing all but the largest cases? As explained above, costs when taken in isolation do not deter the FSA from pursuing cases where we consider senior managers of large financial institutions are personally culpable for failures. We recognise that 376

These can be found at: http://www.fsa.gov.uk/pages/doing/regulated/law/criteria.shtml

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1485

cases against individuals are very different in their nature from cases against corporate entities and are mindful that an individual will generally face greater risks from enforcement action, in terms of financial implications, reputation and livelihood than would a corporate entity. As such, cases against individuals tend to be more strongly contested, and at many practical levels are harder to prove. They also take longer to resolve. Individuals are likely to be represented by experienced law firms and Counsel who may be funded either by their employers or by insurance policies. We acknowledge above that the FSA’s resources are of course limited, but whilst this in and of itself does not stop us from taking action where it is important, doing so means that we cannot do other things. However, taking action against individuals sends an important message about the FSA’s regulatory objectives and priorities and the FSA considers that such cases are an important deterrent. The FSA is therefore committed to pursuing appropriate cases robustly, and will dedicate sufficient resources to them to achieve effective outcomes. International 27. Do you think introducing additional criminal, civil or regulatory sanctions would have an impact on the international competitiveness of UK banks? Additional criminal, civil and regulatory sanctions would be expected to encourage directors to run their banks in a more cautious manner. More cautious banks will probably have smaller balance sheets than would otherwise be the case and efforts to promote greater caution in banks might also encourage greater complacency, meaning banks are less efficient than they would otherwise be. These results, plus the risk that greater sanctions may discourage talented individuals from joining UK banks, might make banks based in the UK less competitive against banks based in other jurisdictions and potentially deter some banks from basing themselves in the UK. However, this would need to be weighed against the positive effects on the UK’s competitive position of investors having greater confidence in the capability and honesty of those running banks, plus the more general (and very considerable) benefits of avoiding another financial crisis. 28. In your opinion, are there other legal or regulatory regimes that the Commission should be considering? Please provide your reasons for suggesting the applicable regime. Whilst our approach to regulatory action against senior managers is similar to many other countries, there is nothing that stands out about these other regimes which we would recommend the Commission look into further. Case Study—HBOS Enforcement Action Given the Commission’s case study of the failure of HBOS, the Commission would like to seek more information from the FSA in relation to the fine that was imposed on Peter Cummings. Please could you provide a written response to the following questions: 29. Why was enforcement action taken only against Peter Cummings? Please see our response to Question 30 below. 30. Did the FSA consider taking enforcement action against anyone else from HBOS? If not, why not? The FSA is producing a report on the failure of HBOS which will set out what it believes were the reasons for the failure of the bank. It will also explain why the Enforcement action focused on Peter Cummings’ management of the Corporate Division and collective failings in the governance of this division at Group level. In the FSA Board report into the failure of RBS, we explain the general principles that apply when the FSA decides whether to take action against an approver person such as a senior manager. The legislation requires the FSA to prove that either the individual has failed to comply with APER or that he or she was otherwise knowingly concerned in a breach by the firm. If it can demonstrate either of these matters, it can impose a financial penalty, publicly censure that person and/or suspend or restrict their approval. In more serious matters, if it appears that the individual is not a fit and proper person, the FSA can also seek a prohibition order preventing the individual from holding either any roles or specific roles within the financial services industry. The burden of proof is on the FSA and the standard of proof required is the civil standard (ie the balance of probabilities). However, the FSA can take disciplinary action against an approved person only where there is evidence of personal culpability on his or her part. Personal culpability arises either where the behaviour was deliberate or where the approved person’s standard of behaviour was below that which would be reasonable in all the circumstances at the time of the conduct concerned. For example, in cases where there is no indication of a lack of integrity on the part of a senior manager under investigation, the issue may be whether he or she has acted without due skill, care and diligence in carrying out the approved role, or whether he or she is competent to carry out the role. In such a case the FSA would have to show that the actions or decisions of that senior manager fell below those which could be considered reasonable taking into account all the relevant circumstances at the time.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1486 Parliamentary Commission on Banking Standards: Evidence

The Enforcement investigation into the conduct of Peter Cummings was begun in March 2009 in the context of £7 billion impairment losses (which by the end of 2011 stood at £25 billion) recognised on the HBOS Corporate book following the merger with Lloyds. The investigation therefore focused on the serious issues within HBOS’s Corporate Division and its oversight. The need to focus on Mr Cummings was clear given his role as both the CEO of the Corporate Division and also a member of the Group Board. HBOS’s federal structure gave Mr Cummings and other divisional chief executives significant autonomy in how they ran their divisions. Whilst other members of the Board wanted Mr Cummings to increase the Corporate Division’s profitability he was in a unique position to understand, and advise his colleagues on the Board about the risks inherent in the Corporate book and the deficiencies in the division’s control environment. At the same time the structure of Mr Cummings’ remuneration meant that he benefited directly from an increase in the profitability of Corporate’s business. Mr Cummings was also personally involved in the sanctioning of high value/high risk Corporate transactions and personally involved in the oversight of stressed transactions on the Corporate book, unlike other members of the Board. The Board placed significant reliance on Mr Cummings’ experience and expertise as a corporate banker, and Mr Cummings’ status as the highest paid member of the Board reflected this. The evidence gathered in the investigation demonstrated clearly that the most culpable senior manager for the Corporate Division’s failings was Peter Cummings. Nonetheless Enforcement obtained information about the roles that other senior HBOS officers played in overseeing the Corporate Division and kept under review whether the scope of its investigation into the failures within Corporate should be extended to include other individuals. However, the prospects of successfully establishing personal culpability against other individuals were considered to be very low and the decision was taken to focus on the case against Mr Cummings. 31. What are the legislative provisions that govern the imposition and calculation of fines that the FSA can impose? The FSA has the power to fine a number of entities under FSMA. In particular: — under section 206 the FSA may impose a penalty of such amount as it considers appropriate on an authorised firm which has contravened a requirement imposed on it by or under FSMA or by certain directly applicable EU legislation; and — under section 66 the FSA may impose a penalty on an approved person if he has failed to comply with APER or if he has been knowingly considered in a contravention by the relevant firm of a requirement imposed on the firm by or under FSMA or by certain directly applicable EU legislation. We are required by FSMA to publish our policy on how we will set penalties under these and other provisions. For fines under sections 66 and 206, this policy must have regard to: (a) the seriousness of the misconduct in question in relation to the nature of the principle or requirement concerned; (b) the extent to which that misconduct was deliberate or reckless; and (c) whether the person against whom action is to be taken is an individual. (see sections 69(2) and 210 FSMA) The FSA’s penalties policy is set out in the part of the Handbook called the Decision Procedure and Penalties Manual (DEPP). Following a public consultation, we changed our penalties policy in respect of conduct which took place after March 2010. 32. Please identify the provisions which allow the FSA to negotiate the level of fines and the factors it takes into account in negotiating them The penalties policy that applies to a specific case is the one in force at the time of the misconduct—as many ongoing or recently concluded enforcement actions relate to misconduct which occurred before March 2010 (eg Peter Cummings) we continue to apply the previous policy (where the period of misconduct straddles 6 March we apply the policy which was in place when the gravamen of conduct occurred). However, we are beginning to see more cases which apply the new policy. The following is a summary of both policies. They are also set out in full in Annex A and B. Policy Pre-March 2010 The policy applicable to misconduct up until 6 March 2010 provided that we would determine the level of financial penalty (if any) that is appropriate for the misconduct after considering all the relevant circumstances of the case. DEPP sets out a non-exhaustive list of factors which could be relevant to the particular case. These include: deterrence, the seriousness of the breach, the extent to which the breach was deliberate or reckless, the person’s financial circumstances, the amount of benefit gained or loss avoided, the person’s conduct following the breach, the person’s disciplinary record and compliance history, and whether action was

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1487

also being taken by other regulatory authorities. We are also required to consider penalties in other comparable cases: in practice this has been a significant factor to ensure consistency between different cases making it more difficult to increase penalties (which we have sought to remedy in our new policy). There is no formal weighting of any of the factors, rather it is an assessment in the round. Income and status are relevant in as much as the impact of a breach is more likely to be significant if someone is more senior and therefore likely to make more money but there is no direct correlation. Policy Post-March 2010 We amended DEPP in March 2010 to: — establish a more coherent and consistent framework; — provide greater transparency in penalty-setting; and — increase the amount of the penalties we impose: we anticipate that our proposals will often double or treble penalties compared to current levels. The new policy introduced a five step framework which is based on three underlying “Ds”: Disgorgement, Discipline and Deterrence. The five steps of the new framework set out in DEPP are: Step 1: the removal of any financial benefit derived from the breach; Step 2: the determination of a figure which reflects the seriousness of the breach; Step 3: an adjustment for any aggravating and mitigating circumstances; Step 4: allows us to make an adjustment to ensure that the penalty has a deterrent effect; and Step 5: if applicable, a settlement discount will be applied (see paragraph 3.14 below). These steps will apply in all cases but how we apply Step 2 will differ depending on the type of case: — For firms, where revenue is an appropriate measure the Step 2 figure will be 5%, 10%, 15% or 20% of the firm’s relevant revenue for the period of the breach. Where revenue is not indicative of the harm or potential harm that the breach may cause, we use an appropriate alternative. — For individuals in non-market abuse cases, the Step 2 figure will be 0%, 10%, 20%, 30%, or 40% of the individual’s gross remuneration and benefits for the period of the breach. The new policy therefore more explicitly links the amount of the penalty to the income of individuals and thus results in higher penalties for higher earners. Settlement The FSA operates a settlement scheme to award explicit discounts for early settlement of cases involving financial penalties. In all cases settlement is considered once the FSA has a sufficient understanding of the nature and gravity of the issue and settlement discussions can commence if both parties agree. The subject of investigation can benefit from a 30% discount if they settle early in “Stage 1”. Stage 1 begins when we send a letter including an offer of settlement and usually lasts 28 days. If settlement does not happen within Stage 1, this discount is reduced as follows: — to 20% if settlement takes place before the subject makes written representations to the RDC; or — to 10% if the case settles before the RDC issues a decision notice. Further, where new facts come to light in the course of settlement negotiations this may have an effect on the level of fine initially proposed by the FSA. However, settlement with the FSA is not a commercial negotiation. Whilst contested cases are decided by the RDC, decisions to settle an enforcement action are taken by two senior FSA executives. There is no legal difference between a settled outcome and an outcome which has been contested through the RDC and referred to the Upper Tribunal. In both cases a final notice is issued setting out the case against the subject of the notice. 33. How was the fine of £1m arrived at in relation to Peter Cummings and, how and on what basis, was it subsequently reduced to £800,000 and then to £500,000? Please see our response to Q34 below. 34. Why was the FSA keen to avoid a challenge being brought by Peter Cummings against the fine? Please provide copies of any legal advice received in relation to the prospects of success of any such challenge, including any that may have been provided by Counsel. In order to answer the Commission’s questions fully, we have had to refer in part to the settlement discussions that we held with Mr Cummings at various stages of the Enforcement process. The settlement discussions that the FSA has with subjects of Enforcement action are confidential due to their without prejudice nature. We are aware that Mr Cummings has already responded to the Commission’s questions on this matter.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:50] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1488 Parliamentary Commission on Banking Standards: Evidence

In accordance with the procedure outlined in our response to question 32 above, settlement was attempted at Stage 1 but not achieved. The RDC issued a Warning Notice proposing a £1 million fine in June 2011 based on consideration of the guidance set out in DEPP on how it will determine the appropriate level of financial penalty. The factors most relevant to Mr Cummings’ fine are set out in paragraphs 6.1 to 6.19 of Mr Cummings’ Final Notice. Following extensive written and oral representations by Mr Cummings and his legal team the RDC came to the view that, in light of the factors set out at paragraph 6.16 of Mr Cummings’ Final Notice, a reduction of the penalty to £800,000 was appropriate and issued a Decision Notice accordingly on 22 May 2012. In response to this Mr Cummings threatened to bring judicial review proceedings, alleging that the FSA’s Decision Notice was unlawful on the basis that it failed to provide adequate reasons for the decision to impose the fine of £800,000. After taking advice from leading counsel, the FSA informed Mr Cummings that we did not accept that the Decision Notice was unlawful but that in order to avoid delay we would withdraw the existing Decision Notice, reconsider the issue of penalty and then issue a new Decision Notice. Any legal advice received by the FSA in these proceedings is of course subject to legal professional privilege. Thereafter, Mr Cummings made clear that he was prepared to consider settling the matter. Until that point it had appeared that Mr Cummings would exhaust all of his options to challenge the FSA’s findings through his judicial review claim and, following that, a reference to the Upper Tribunal. Such further challenge by Mr Cummings would have greatly delayed the resolution of this matter and also publication of the FSA’s report into why HBOS failed, preparation of which was deferred to avoid prejudicing the Cummings’ proceedings. On a conservative estimate if Mr Cummings had taken up all avenues of challenge it would have been between two and three years until the Upper Tribunal had made its final determination (or longer if the matter were appealed to the Court of Appeal). Therefore, in order to avoid lengthy delay as well as the risks and costs of further litigation, the FSA decided that it would reopen settlement discussions with Mr Cummings. Subsequently Mr Cummings agreed not to challenge the FSA’s findings in the Decision Notice if the fine were to be reduced to £500,000. In considering whether to settle the case at this moment, we carefully weighed up the implications for the preparation of a public report into the failure of HBOS. We could not commence the preparation of a number of aspect of that report without the risk of prejudice to the ongoing proceedings against Mr Cummings. Accordingly we balanced the public interest in our commencing work on and ultimately publishing the HBOS report against the fact that continuing our action against Mr Cumming would add significant further delay to the preparation of that report. That drove both our decision to issue a new decision notice rather than risk a judicial review (which is likely to have added several years to the process) and our decision to explore settlement. We believed that the appropriate regulatory outcome was a prohibition and a large penalty and that this is what was achieved albeit at a lower level than the RDC had decided. In other cases we would have pursued this matter to the Tribunal but in this case the prospect of a larger penalty was in our view outweighed by the regulatory benefits of publishing a Final Notice quickly and getting on with the preparation of the HBOS report. 35. Please provide any other information you consider relevant to the imposition of the fine. We have nothing further to add. Other 36. What are your views on applying different sanctions for different types of directors—for example, nonexecutive directors? We do not see a need to distinguish between different types of directors in terms of the kinds of penalties to which they may be subject: NEDs for example ought to be subject to the same sanctions (ie fining, censuring, suspending, withdrawing approval and prohibiting) as Executives. We acknowledge, however, that executive directors and NEDs perform different roles in practice. As we stated in Q17 above, the role of NEDs may be more strategic whereas the role of executive directors may be more operational. That will be reflected in the choices we make about whether to take action against executive directors, NEDs or both in particular cases, which will depend upon the facts of the case concerned. The level of sanction in each case (eg amount of fine, length of suspension, or extent of prohibition) will reflect an individual director’s role, the seriousness of the misconduct, impact of the breach, etc. 37. Are there any other measures or legal/regulatory changes that the Commission should consider? In our response to the Commission’s initial call for evidence we put forward three specific suggestions for changes to our enforcement powers, namely the ability to take action against employees outside the scope of our approved persons regime, the extension of the limitation period for taking action against approved persons and a power to prohibit an individual from performing a controlled function on an interim basis. These are each covered in more detail above in our answers to questions 20, 14 and 12 respectively. In addition, our submission also expressed our support for HM Treasury’s proposal to introduce a rebuttable presumption that

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1489

a director of a failed bank should not subsequently be approved as a director of another bank. The detail of our views on this are set out in our answers to questions 6–10. The FSA—and both the PRA and FCA—are committed to ensuring that not only are appropriate individuals appointed at the approval stage but that we remain satisfied that they are fulfilling their obligations as approved persons. In the FCA context, we are pursuing some initiatives that will seek to improve our understanding on which an approved person is accountable for all important functions and risk responsibilities—in particular how we separate the concepts of responsibility and culpability. We have made some suggestions as to how this could be achieved in our response to Q17. We believe this will improve firms, and our, understanding of corporate governance and thereby mean that issues for rectification can be more easily targeted. And where things are materially deficient then the FCA will be in a better position to take formal action. We also are considering whether we need to set out more clearly our expectations of approved persons and we are increasingly emphasising our regulatory focus in this area in addition to authorised firms. Finally, there is an overriding argument in favour of ensuring that senior managers of banks face a different risk return trade-off than those which apply to senior managers of other corporates. In the FSA Board Report into the failure of RBS we state that one way we may choose to address this is through regulating the remuneration arrangements of executives and non-executive directors so that a significant proportion of remuneration is deferred and forfeited in the event of failure. Regulations of this form have already been introduced for executive directors: they could be strengthened by increasing both the proportion of pay deferred and the period of deferral. 18 January 2013

Written evidence from the Federal Deposit Insurance Corporation SANCTIONS FOR BANK DIRECTORS Enforcement Actions The Commission understands that the FDIC has the authority to bring a broad range of enforcement actions against banking organizations and their Institution-Affiliated Parties (IAP). 1. Has the FDIC historically brought more civil suits or enforcement actions against bank directors as IAPs? Uniquely among the various federal banking regulators in the United States, the FDIC acts as an insurer, a supervisor, and sometimes a receiver.377 The FDIC insures deposits of approximately 7,100 banks and thrifts of all charters. As supervisor, the FDIC is the primary federal regulator for state-chartered banks and savings institutions that are not part of the Federal Reserve System, generally known as state nonmember banks and state-chartered thrifts. The FDIC directly supervises approximately 4,500 insured state nonmember banks and savings institutions. As insurer, the FDIC has special (back-up) examination authority for over 2,600 FDIC-insured depository institutions for which the FDIC is not the primary federal regulator. These include state member banks that are supervised by the Federal Reserve Board and national banks, thrift institutions and insured branches of foreign banks supervised by the Office of the Comptroller of the Currency. The FDIC’s roles as an insurer and primary supervisor are complementary, and many activities undertaken by the FDIC support both the insurance and supervision programs. In these roles, the FDIC regularly monitors the potential risks at all insured institutions. If weaknesses are identified through the examination process, the FDIC promptly takes appropriate supervisory action. Formal and informal enforcement actions may be issued for institutions identified as having significant weaknesses or found to be operating in a deteriorated financial condition. Actions may also be taken, in appropriate circumstances, against individual directors or other IAPs of FDIC-supervised institutions for civil money penalties, restitution, or to remove them from banking. In 2012, the FDIC issued 121 Cease and Desist (“C&D”) orders under Section 8(b) of the Federal Deposit Insurance Act (“FDI Act”), 12 U.S.C. § 1818(b), all of which were issued pursuant to stipulation. The FDIC issued 108 stipulated orders of prohibition and/or removal against individuals pursuant to 8(e), 12 U.S.C. § 1818(e), and, where stipulations could not be obtained, filed Notices of Charges in 8 such cases. The agency issued 157 Orders to Pay under Section 8(i), 12 U.S.C. § 1818(i). Finally, the FDIC entered into 224 informal Memoranda of Understanding relating to safety and soundness matters during 2012. The FDIC exercises its supervisory and regulatory authority over open institutions and their IAPs almost exclusively through the administrative (ie enforcement) process. By contrast, civil actions are generally the province of the FDIC in its capacity as receiver. 377

Under the Dodd-Frank Act, the FDIC also has substantial responsibilities for large complex financial companies that may pose a systemic risk to the financial system.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1490 Parliamentary Commission on Banking Standards: Evidence

When an FDIC-insured institution fails, the FDIC is appointed as receiver. The FDIC’s role as receiver is independent of its corporate role as supervisor and insurer. In its receivership capacity, the FDIC steps into the shoes of the failed institution and assumes responsibility for maximizing recovery for the receivership estate. This includes the pursuit of the receivership’s claims against professionals who caused losses to the failed institution. Funds collected from the sale of assets and the disposition of valid claims are distributed to the receivership’s creditors under the priorities set by law. As receiver for a failed FDIC-insured depository institution, the FDIC, where appropriate, brings civil actions against the former directors and officers of the failed institution who caused losses to the institution in order to maximize recoveries to the receivership. (Professional liability claims also include claims against fidelity bond insurance carriers, appraisers, attorneys, accountants, mortgage loan brokers, title insurance companies, securities underwriters and issuers, or other professionals who caused losses to the failed institution.) Professional liability suits are pursued if they are both meritorious and expected to be cost-effective. Before seeking recoveries from directors, officers, and professionals, the FDIC as receiver conducts a thorough investigation of whether they breached duties to, and the extent to which they caused losses to, the failed institution. Most investigations are completed within 18 months from the time the institution is closed. Prior to filing a civil action, staff will attempt to settle with the responsible parties. If a settlement cannot be reached, however, a complaint will be filed, typically in federal court. Not all bank failures result in civil actions against directors and officers. The FDIC brought claims against directors and officers in 24 percent of the bank failures between 1985 and 1992. As of December 11, 2012, the FDIC has authorized civil actions in connection with 89 failed institutions against 742 individuals for director and officer liability. (Of the 742 authorized director and officer defendants, 11 were authorized in 2009, 98 were authorized in 2010, 264 were authorized in 2011, and 369 were authorized in 2012.) This includes 41 filed civil actions (4 of which have settled and 1 of which resulted in a favorable jury verdict) naming 324 former directors and officers. 2. Are formal enforcement actions usually preceded by informal actions or warnings by the FDIC? The FDIC has a variety of formal and informal remedial and supervisory tools at its disposal, and endeavors to match the tool to the circumstances. Where a problem is of only moderate supervisory concern and management appears willing and able to resolve the matter, the FDIC is likely proceed informally via, for example, a resolution adopted by the bank’s board of directors or a written Memorandum of Understanding between the bank and the FDIC. By contrast, where a bank’s actions or inaction threaten immediate or substantial harm to the institution, or management appears unwilling or unable to address FDIC concerns, the FDIC will proceed formally even in the absence of prior informal actions. In most cases involving IAPs, the objectionable conduct has already taken place and thus the FDIC typically proceeds directly to formal action. 3. Of the various types of enforcement actions (including civil money penalties, cease and desist orders (both permanent and temporary) and removal, prohibition and suspension orders), which has been the most effective tool for the FDIC? As noted, the FDIC undertakes in all cases to employ the tool most effective for the problem at hand. C&D orders for example are well suited to correcting unsafe and unsound or other poor banking practices. Civil money penalties can be imposed as punishment for violations of law and extreme or repeated forms of misconduct, and may also be employed when the objectionable behavior is not sufficient to warrant removal or prohibition. Finally, removal and prohibition orders have a largely preventative effect, by ensuring that persons who are unfit to serve at an insured financial institution are prevented thereafter from doing so. 4. In your view is the threat of a formal enforcement action taken seriously by bank directors? Yes. The possibility of formal enforcement actions is an effective deterrent from misconduct or haphazard management of an institution’s affairs. Directors understand that formal enforcement actions can result in serious personal consequences, including the imposition of money penalties or an industry-wide ban. In addition, formal enforcement actions are public, and thus may entail unwelcome attention. Civil lawsuits by the receiver of a failed institution against its former directors or officers for breaches of duty, while not “enforcement actions” as such, also serve to deter misconduct and mismanagement. 5. Do you think that the possibility of enforcement actions deters capable individuals from working in the banking industry? This claim surfaces during times when bank failures are high, but the FDIC has not seen evidence of qualified individuals actually foregoing bank service out of concern for unwarranted enforcement actions. 6. Does the FDIC have broad rule-making authority? If so, can the violation of a rule by an IAP lead to an enforcement action? The FDIC has authority to issue regulations pertaining to banks it supervises as well as to all depository institutions with FDIC deposit insurance. Violations of these or any other banking law or regulation can result

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1491

in civil money penalties against an IAP, as well as in a C&D order (against the institution) or a removal or prohibition action (against IAPs), provided that the other elements of such claims are met. Enforcement actions based on violations of law or regulation are not uncommon. Civil Money Penalties The Commission understands that three tiers of civil money penalties can be assessed by the FDIC against an IAP after written notice and, if requested, a hearing. Tier I civil money penalties can be assessed for a (i) violation of any law or regulation, (ii) violation of certain final and temporary orders issued by the bank regulators, (iii) violation of written conditions imposed by the bank regulators and (iv) violation of written agreements entered into between the banking organization and the bank regulator. Tier II civil money penalties can be assessed if the IAP has committed a Tier 1 violation and recklessly engages in an unsafe or unsound practice in conducting the affairs of an insured depository institution or breaches any fiduciary duty. Tier II also requires that the violation, practice or breach was part of a pattern of misconduct, caused or was likely to cause more than a minimal loss to such banking organization or resulted in pecuniary gain or other benefit to the IAP. Tier III civil money penalties are assessed for knowingly committing a Tier I violation or engaging in unsafe or unsound practices or breaking a fiduciary duty. 7. In respect of the various Tier I violations listed above, which occur most frequently in your experience? Violations of law or banking regulation are the most frequent basis for Tier I penalties. 8. Does the FDIC frequently enter into written agreements with banking organizations? Stipulated C&D orders rather than formal “written agreements” are the most common enforcement mechanism employed by the FDIC against banks. Such orders are enforceable by civil money penalties or other enforcement actions. While the FDIC has authority to enter into other forms of “written agreement,” such agreements are relatively uncommon. 9. In your experience, are breaches of a fiduciary duty by the IAP often the basis for Tier II and Tier III penalties? Breaches of fiduciary duty often form the basis for Tier II penalties. In most such cases, the conduct at issue constitutes an unsafe and unsound activity as well. Tier III penalties are assessed very rarely, and it is difficult to generalize about them. 10. How often are civil money penalties assessed against IAPs with the consent of the banking organization? It is common for civil money penalties assessed against a financial institution to be assessed with the institution’s consent. A banking organization has no role, formal or informal, in the assessment of penalties against its IAPs (versus the organization itself). 11. Do the “Interagency Guidelines Establishing Standards for Safety and Soundness” provide the basis for what practices may be considered “unsafe and unsound”? The Interagency Guidelines reflect developments in the law defining “unsafe and unsound” practices (largely developed through bank agency determinations and decisions) but do not provide rules of decision. The concept of unsafe or unsound practices is one of general application which touches upon the entire field of operations of a banking institution. The spectrum of activities that may be included cannot be captured by a single rigid or all-inclusive definition. Thus, an activity not necessarily unsafe or unsound in every instance may be so in a particular instance when considered in light of all relevant facts pertaining to that situation. Generally speaking, an unsafe or unsound practice embraces any action, or lack of action, which is contrary to generally accepted standards of prudent operation, the possible consequences of which, if continued, would result in abnormal risk of loss or damage to an institution, its shareholders, or the insurance fund administered by the FDIC. Courts have given the banking agencies broad discretion to define this term, and in turn give agency examiners substantial deference in opining about what activities are “unsafe and unsound”. Cease and Desist Orders The Commission understands that the FDIC, upon consent or notice and a hearing, can issue cease and desist orders against any IAP when that party has engaged or is about to engage in an “unsafe or unsound” banking practice, a violation of a law, rule, or regulation, any condition imposed in writing by the FDIC, or any written agreement entered into between the banking organization and the FDIC. Cease and desist orders can also require that certain affirmative acts be taken by the IAP including to pay restitution to or to reimburse, indemnify or guarantee the banking organization against the loss.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1492 Parliamentary Commission on Banking Standards: Evidence

12. Can cease and desist orders be combined with other enforcement actions? Yes. C&D orders, issued under the authority of Section 8(b) of the FDI Act, are most commonly issued against institutions, rather than against IAPs. C&D orders may be accompanied by a civil money penalty, but in most cases the C&D order stands alone. 13. Is it common for cease and desist orders to be issued upon consent? Yes. Most FDIC C&D orders are issued pursuant to stipulation. 14. Are temporary cease and desist orders frequently accompanied by asset freezes and prejudgment attachments? The FDIC has the authority to freeze assets and attach assets prior to judgment, but the power is not frequently exercised. Removal and Prohibition Authority The Commission understands that the FDIC has the authority to issue orders removing or suspending bank directors from office and prohibiting them from participating in any banking organization. In addition to a violation similar to the other enforcement actions discussed above, a removal or prohibition order requires a showing that (i) the banking organization has suffered or will suffer a financial loss, (ii) the interests of the banking organization’s depositors have been or could be prejudiced or (iii) such bank director has received financial gain or other benefit by reason of the violation, practice or breach, and (iv) the violation, practice or breach involved dishonesty or (v) demonstrates wilful or continuing disregard by such party for the safety and soundness of such banking organization. 15. Do removal and prohibition orders always result in the bank director being prevented from working in the banking industry in the future? Yes. The FDI Act, pursuant to which such orders are issued, sets forth the broad scope of such orders. See 12 U.S.C. § 1818(e)(7). Any person subject to an removal/prohibition order is prohibited from holding any office in or participating in the conduct of the affairs of: i) any insured depository institution; ii) any Federallyinsured credit union; iii) any Farm Credit Bank; iv) any Federal depository institution regulatory agency; v) any Federal home loan bank; and vi) the Federal Housing Finance Agency. Removal and prohibition orders continue in effect indefinitely. Each of the federal banking agencies has the authority to terminate an order of prohibition or removal that it has issued, but the authority is exercised very rarely. In addition, exceptions to permit a prohibited individual to become an IAP of a particular insured institution may be made on a case-by-case basis with the consent of the issuing agency and the agency with supervisory authority over the subject institution. This authority, too, is exercised only very rarely. Indeed most modifications of removal/prohibition orders approved recently by the FDIC are to permit the individual to sell or otherwise dispose of bank stock that the individual owned prior to the order’s entry. 16. Is it usual for the board of directors of the banking organization to dismiss the culpable director before the FDIC issues a removal order? It is not uncommon. In many cases, the bank itself discovers the objectionable behavior and both dismisses the culpable person and alerts the FDIC. In some instances the bank will retain the subject as an employee pending resolution of the FDIC’s charges. In some cases the culpable director is in a position of control at the bank and is not removed from the institution until the FDIC’s order is litigated and becomes final. 17. If the FDIC is unable to obtain a removal and prohibition order but can bring another formal enforcement action against the bank director, is there a way to ensure that the culpable bank director will not be reemployed by the banking industry in the future? Orders of removal and prohibition are the only supervisory means for obtaining a blanket prohibition on an individual’s involvement in the banking industry. There are, however, other mechanisms that may limit or prevent certain individuals from serving in the banking industry. Under Section 19 of the FDI Act, 12 U.S.C. § 1829, any person who has (among other things) been convicted of any criminal offense involving dishonesty, breach of trust, or money laundering, may not, without the prior written consent of the FDIC, act as an IAP of any FDIC-insured depository institution. Under Section 8(g), 12 U.S.C. § 1818(g), the FDIC may issue a Notice of Suspension and/or Prohibition when an IAP is charged with a felony involving dishonesty or breach of trust with potential punishments above certain levels, whose continued service or participation might threaten the interests of the institution’s depositors or threaten to impair public confidence in the institution. This action is typically temporary, and will remain in effect until the charges are resolved, allowing the FDIC to pursue a permanent prohibition if the IAP is convicted.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1493

Under Section 32 of the FDI Act, 12 U.S.C. § 1831i, any bank deemed to be in “troubled condition” (ie a composite CAMELS rating of 4 or 5) is required to obtain FDIC approval before adding new directors or executive officers. The FDIC may in appropriate circumstances use this authority to ensure that an individual does not gain employment at any troubled institution even when such individual is not subject to a general prohibition. 18. Does the FDIC have the authority to approve the appointment of senior bank directors and officers? The FDIC has no general authority to approve or disapprove the appointment of bank directors or senior officers of well-run institutions. However, the FDIC must be satisfied that management is satisfactory before approving an institution’s application for deposit insurance, and the FDIC reviews and may object to the appointment of directors or executive officers at banks deemed to be “troubled” under Section 32 of the FDI Act. C&D orders issued pursuant to Section 8 of the FDI Act also from time to time include a remedial provision requiring the subject bank to retain qualified management acceptable to the FDIC. Civil Suits 19. Does the FDIC frequently institute civil suits against bank directors? The FDIC brings administrative enforcement actions against directors and officers of open banks. These actions are subject to judicial review after final agency action. When banks fail the FDIC as receiver may bring civil actions to recover damages suffered by the bank. Not all bank failures result in civil actions against former directors and officers of a failed institution. The FDIC brought claims against directors and officers in 24 percent of the bank failures between 1985 and 1992. As of December 11, 2012, the FDIC has authorized civil actions in connection with 89 failed institutions against 742 individuals for director and officer liability. (Of the 742 authorized director and officer defendants, 11 were authorized in 2009, 98 were authorized in 2010, 264 were authorized in 2011, and 369 were authorized in 2012.) This includes 41 filed civil actions (4 of which have settled and 1 of which resulted in a favorable jury verdict) naming 324 former directors and officers. 20. In what circumstances, can the FDIC institute a civil suit against a bank director and what is the standard for director liability? The FDIC follows the policies adopted by the FDIC Board in 1992, Statement Concerning the Responsibilities of Bank Directors and Officers, which can be found at http://www.fdic.gov/regulations/laws/ rules/5000–3300.html#fdic5000statementct, and require Board approval before actions are brought against directors and officers. Professional liability suits are only pursued if they are both meritorious and expected to be cost-effective. Before seeking recoveries from professionals, the FDIC conducts a thorough investigation of professionals who caused losses to the failed institution. Most investigations are completed within 18 months from the time the institution is closed. Prior to filing the claim, staff will attempt to settle with the responsible parties. If a settlement cannot be reached, however, a complaint will be filed to initiate a civil action, typically in federal court. As receiver, the FDIC has three years to file tort claims and six years to file breach-of-contract claims from the time a bank is closed. If state law permits a longer time, the state statute of limitations is followed. Professionals may be sued under tort or contract theories available under applicable state law. Generally, for directors and officers, potential causes of action include breach of fiduciary duty and/or gross or simple negligence. Federal law pre-empts state law that insulates directors and officers from gross negligence or worse conduct. Bank directors are allowed to exercise their business judgment without incurring legal liability. Further information can be found in Managing the Crisis: The FDIC and RTC Experience, Chapter 11, Professional Liability Claims, http://www.fdic.gov/bank/historical/managing/history1–11.pdf. 21. What steps can the FDIC take when the bank director is suspected of committing a crime? The FDIC does not have authority to bring criminal actions either as a supervisor or as a receiver. When the FDIC as supervisor identifies possible criminal activity at an open bank, it will encourage the bank to gather supporting evidence and file a Suspicious Activity Report (“SAR”) with the Financial Crimes Enforcement Network (“FinCEN”) (a division of the U.S. Department of Treasury) regarding the activity. The FDIC itself may file SARs and refer matters to the FDIC’s Office of Inspector General for investigation and possible referral to the Federal Bureau of Investigation. For those convicted of criminal wrongdoing against failed financial institutions, a court may order a defendant to pay restitution or to forfeit funds or property to the FDIC as receiver for the failed institution as part of the criminal sentencing process. As of year-end 2012, there were 4,860 active restitution and forfeiture orders.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1494 Parliamentary Commission on Banking Standards: Evidence

Other 22. How are enforcement actions or civil suits by the FDIC funded? Enforcement actions are paid for out of FDIC general funds, which are made up of deposit insurance assessments paid by insured financial institutions. Professional liability investigations and civil actions brought by the FDIC as the receiver for a failed institution are funded through the individual receiverships. Professional liability claims are brought if they are both meritorious and expected to be cost-effective. Any funds recovered from those investigations and civil actions are returned to the receivership and are used to pay claims against the receivership estate in accordance with the priorities established by statute. These priorities generally provide first for payment of the receiver’s administrative expenses, second for any deposit liability, and third for general creditor claims. 23. Please could you give us an indication of the average internal (for example, staffing) and external (for example, legal fees) costs for bringing an enforcement action against an IAP. The costs of enforcement actions vary according to many factors, including the type, size and complexity of the claims, the number of respondents, the experience and/or tactics of opposing counsel, and whether the matter is resolved by stipulation prior to either the filing of a Notice of Charges or the administrative hearing. Most enforcement actions are resolved via stipulation and do not cause the agency to incur significant incremental costs. In contrast, a contested case that proceeds through the hearing stage may require the fulltime attention of two or more attorneys for a year or more, plus administrative staff and expenses such as document retrieval and production, and expert witness expenses. FDIC enforcement cases are litigated by FDIC staff attorneys and almost never involve outside counsel. 24. Please could you give us an indication of the average internal (for example, staffing) and external (for example, legal fees) costs for bringing a civil suit against an IAP. The cost to bring professional liability lawsuits varies depending on a variety of factors and may involve the retention of outside counsel to assist the FDIC as receiver with the investigation and litigation of a particular matter. The FDIC tracks the expenses associated with the overall professional liability program in comparison to the recoveries. From 1986 through 2012, the FDIC and the former Resolution Trust Corporation (1989–1995) collected $6.8 billion from professional liability claims. Over that same time, they spent $1.87 billion to fund all professional liability claims and investigations. Early in the process of professional liability claims, expenses will often exceed recoveries due to the costs incurred in handling new investigations. Professional liability program recoveries lag expenses by several years until settlements occur and judgments are awarded. 25. Does the FDIC conduct periodic on-site examinations of banking organizations? If so, how frequently? The FDIC is required to conduct a full-scope, on-site examination of every insured state nonmember bank at least once during each 12-month period. The FDIC may extend the period to 18 months for institutions that meet certain criteria (broadly, “well capitalized” institutions of less than $500 million in assets that were rated a composite “1” or “2” at their last examination and which are not subject to a formal order by a federal banking agency). In addition, the FDIC may accept reports of examination by state authorities and conduct its own 12 or 18 month examinations on an alternating basis with the state banking authority. 26. Are banking organizations required to submit periodic reports to the FDIC? Is there a penalty for failing to make required reports? A variety of reports are required. The most common—required to be filed by all banks—is the quarterly Consolidated Reports of Condition and Income, or “Call Report”. Banks with total assets of $500 million or more are also required to submit annual audited financial statements. Periodic progress reports are typically required at least quarterly when a bank is subject to a formal or informal enforcement action. Daily or weekly liquidity reports may also be required for troubled institutions. Civil money penalties against an institution for late filing of Call Reports are not common and will vary depending on duration of the violation and whether the violation is deemed intentional or unintentional. The late filing of Call Reports typically results in penalties in the low thousands of dollars, but has in some cases exceeded $100,000. Tier I penalties may also be assessed against individual board members for allowing their institution to file a Call Report with false information. 18 January 2013

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1495

Written evidence from the Office of the Comptroller of the Currency SANCTIONS FOR BANK DIRECTORS The Parliamentary Commission on Banking Standards was established to consider and report on professional standards and culture of the UK banking sector. One element of the Commission’s work is to consider the sanctions (criminal, civil and regulatory) that can be imposed on bank directors and make recommendations for any legislative or regulatory changes that may be required. The Commission is keen to better understand the regime that applies in the US and identify different areas that could guide the Commission on possibilities for reform in the UK framework. As a result, the Commission would welcome responses to the following questions by 18 January 2013. Enforcement Actions The Commission understands that the OCC has the authority to bring a broad range of enforcement actions against certain banking organizations and their Institution-Affiliated Parties (IAP). 1. Has the OCC historically brought more civil suits (pursuant to 12 USC § 93) or formal enforcement actions against bank directors as IAPs? While the OCC has authority to bring civil suits against bank directors under 12 USC 93, that authority is rarely used. Historically, actions against bank directors as IAPs have been initiated almost exclusively under the OCC’s administrative enforcement authority because that authority provides the OCC with a more efficient process and more options in terms of the scope of the relief the OCC can seek against an IAP. 2. Are formal enforcement actions usually preceded by informal enforcement actions or warnings by the OCC? Each decision to bring a formal enforcement is based on the particular facts of the case. If the facts warrant a formal action, nothing precludes the OCC from bringing a formal action even if there has been no prior warning or informal action. 3. Of the various types of enforcement actions (including civil money penalties, cease and desist orders (both permanent and temporary) and removal, prohibition and suspension orders), which has been the most effective tool for the OCC? Each enforcement tool has been effective at remedying violations, unsafe or unsound practices and other misconduct. Removal, prohibition and suspension orders are the most severe actions and are effective for getting bad actors out of the banking system. They are usually reserved to address the most egregious misconduct such as serious violations of law that result in loss to the bank or financial benefit to the IAP. CMPs are an effective tool for punishing IAPs for less severe misconduct and acting as a deterrent for future misconduct. Cease and desist orders, both permanent and temporary, are effective at getting banks and IAPs to take corrective action to fix unsafe or unsound banking practices and take other affirmative action to remedy past problems 4. In your view is the threat of a formal enforcement action taken seriously by bank directors? Yes. Bank directors and other IAPs are very much aware that their failure to obey laws, rules and regulations, conduct the bank’s affairs in a safe and sound manner, and act at all times in the best interest of the bank is likely to subject them to formal enforcement actions by the OCC. 5. Do you think that the possibility of enforcement actions deters capable individuals from working in the banking industry? No. Capable, qualified, and experienced individuals know that the OCC does not abuse its enforcement authority and that it is very unlikely they will be subject to a formal enforcement action unless they engage in violations of laws, rules or regulations, unsafe or unsound practices or breach their fiduciary duties to the bank. 6. Does the OCC have broad rule-making authority? If so, can the violation of a rule by an IAP lead to an enforcement action? The OCC has broad rulemaking authority as part of its mission to oversee the US national banking system. Violations of OCC rules provide a basis for formal enforcement actions as set forth in 12 USC 1818. Civil Money Penalties The Commission understands that three tiers of civil money penalties can be assessed by the OCC against an IAP after written notice and, if requested, a hearing.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1496 Parliamentary Commission on Banking Standards: Evidence

Tier I civil money penalties can be assessed for a (i) violation of any law or regulation, (ii) violation of certain final and temporary orders issued by the OCC, (iii) violation of written conditions imposed by the OCC and (iv) violation of written agreements entered into between the banking organization and the OCC. Tier II civil money penalties can be assessed if the IAP has committed a Tier 1 violation and recklessly engages in an unsafe or unsound practice in conducting the affairs of the banking organization or breaches any fiduciary duty. Tier II also requires that the violation, practice or breach was part of a pattern of misconduct, caused or was likely to cause more than a minimal loss to such banking organization or resulted in pecuniary gain or other benefit to the IAP. Tier III civil money penalties are assessed for knowingly committing a Tier I violation or engaging in unsafe or unsound practices or breaking a fiduciary duty. 7. In respect of the various Tier I violations listed above, which occur most frequently in your experience? While the OCC has initiated Tier I CMP actions based on all of the types of violations listed, the vast majority of our Tier I cases are based on violations of law or regulation. 8. Does the OCC frequently enter into written agreements with banking organizations? Yes. Formal written agreements are an integral part of the OCC’s enforcement strategy. Usually, such agreements are entered into when the bank’s condition is not critical or the practices being addressed are not egregious and bank management is cooperative and capable of remedying the problems. Formal written agreements are generally viewed as a less severe action than a cease and desist action even though their legal significance is similar to a consent cease and desist order. 9. In your experience, are breaches of a fiduciary duty by the IAP often the basis for Tier II and Tier III penalties? Breaches of fiduciary duty are often used as the basis for Tier II CMPs when the facts of a particular case support such an action. Because of the effectiveness of Tier I and Tier II CMP actions, and because a Tier III action requires the OCC to prove knowing and wilful conduct, Tier III CMP actions are rare. 10. How often are civil money penalties assessed against IAPs with the consent of the banking organization? CMP actions against IAPs are separate and apart from actions against banks. The actions against the IAPs are personal actions in which the IAPs are personally liable for the amounts assessed. By regulation, banks are not allowed to pay CMP assessments on behalf of IAPs. Under certain circumstances, banks may indemnify IAPs for legal fees and other expenses incurred in CMP actions brought against the IAPs, but the IAPs are responsible for repaying the bank for the amounts indemnified if a final outcome results in a judgement against the IAP. 11. Do the “Interagency Guidelines Establishing Standards for Safety and Soundness” provide the basis for what practices may be considered “unsafe and unsound”? The Interagency Guidelines were issued by the US bank regulatory agencies to provide guidance to banking organizations in specific areas. A failure to comply with the guidelines may require the submission of a safety and soundness compliance plan which, if violated, is a basis for a safety and soundness order, which is the legal equivalent of a cease and desist order. Practices that may be considered unsafe and unsound for enforcement action purposes extend to all aspects of a bank’s operations. Cease and Desist Orders The Commission understands that the OCC, upon consent or notice and a hearing, can issue cease and desist orders against any IAP when that party has engaged or is about to engage in an unsafe or unsound banking practice, a violation of a law, rule, or regulation, any condition imposed in writing by the OCC in connection with the granting of an application, or formal written agreement entered into between the banking organization and the OCC. Cease and desist orders can also require that certain affirmative acts be taken by the IAP including to pay restitution to or to reimburse, indemnify or guarantee the banking organization against the loss. 12. Are cease and desist orders only issued when an IAP has declined to enter into a consent order? Generally, yes. When the OCC makes a decision to initiate a cease and desist action against a party (a bank or an IAP), the party has two options. The party can consent to the action, which results in a consent order, or the party can contest the action which results in litigation. If the OCC prevails, a cease and desist order is issued against the party. There is no legal distinction between the two documents; a consent order is a cease and desist order issued by consent.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1497

13. Can cease and desist orders be combined with other enforcement actions? Yes. In many cases, cease and desist actions are combined with CMP actions. The cease and desist action are directed at remedying the underlying practices or conduct while the CMP actions are punitive. 14. Are temporary cease and desist orders frequently accompanied by asset freezes and prejudgment attachments? In the overwhelming majority of cases, cease and desist actions are initiated well before the bank’s condition deteriorates to the point where the underlying violations or unsafe or unsound practices are likely to cause insolvency of the bank, or a significant dissipation of the bank’s assets or earnings. These conditions must be present for the OCC to issue a temporary cease and desist order. Asset freezes and prejudgment attachments are extraordinary actions for the OCC to initiate and they are not common, Removal and Prohibition Authority The Commission understands that the OCC has the authority to issue orders removing or suspending bank directors from office and prohibiting them from participating in any banking organization. In addition to a violation similar to the other enforcement actions discussed above, a removal, suspension or prohibition order requires a showing that (i) the bank has suffered or will suffer a financial loss, (ii) the interests of the bank’s depositors have been or could be prejudiced or (iii) such bank director has received financial gain or other benefit by reason of the violation, practice or breach, and (iv) the violation, practice or breach involved dishonesty or (v) demonstrates wilful or continuing disregard by such party for the safety and soundness of such bank. 15. Do removal and prohibition orders always result in the bank director being prevented from working in the banking industry in the future? Yes. Removal and prohibition actions under 12 USC 1818 and 1829 always result in a lifetime ban on employment in the banking industry. IAPs subject to such a ban may petition for relief as section 1818 provides, but absent a grant of relief, employment in the banking industry while under a prohibition or removal subjects the IAP and the banking organization employing the IAP to severe criminal penalties. 16. Is it usual for the board of directors of the banking organization to dismiss the culpable director before the OCC issues a removal order? Generally speaking, the term “prohibition action” refers to an action against an IAP who is no longer working in the banking industry, while the term “removal action” refers to an action against an IAP still working in a bank. In the vast majority of these types of cases, the IAPs are no longer working at the bank when the OCC initiates such an action having either resigned or been dismissed by the bank. 17. If the OCC is unable to obtain a removal and prohibition order but can bring another formal enforcement action against the bank director, is there a way to ensure that the culpable bank director will not be reemployed by the banking industry in the future? No. A prohibition/removal action under 12 USC 1818, or a prohibition by operation of law under 12 USC 1829 is the only way the OCC can ensure an IAP will be banned from future employment in the banking industry. When a prohibition or removal action is not possible, the OCC can use its other enforcement tools such as a personal cease and desist order, to specifically address the underlying conduct, but a personal cease and desist order cannot serve as a “backdoor removal” in contravention of the requirements for obtaining a lawful removal or prohibition. As a general practice, however, the OCC routinely includes a term in all personal cease and desist orders that requires the IAP to disclose and show a copy of the order to any prospective employer in the banking industry. The OCC can also use its Prompt Corrective Action authority under 12 USC 1831o to direct a bank to dismiss a bank officer, but such a directive does not prevent the officer from working for another bank. 18. Does the OCC have the authority to approve the appointment of senior bank directors and officers? A bank is required to file a notice of changes in directors or senior executive officers when the institution is in troubled condition; is not in compliance with minimum capital requirements; or the OCC determines, in connection with its review of a capital restoration plan required pursuant to 12 USC 1831o (prompt corrective action) or otherwise, that prior notice is appropriate. The OCC may either disapprove or not object to a candidate for a director or senior executive officer position. The OCC determines whether the competence, experience, character, and integrity of a candidate, and all other relevant information necessary to evaluate the candidate, indicate that it would not be in the best interest of the depositors of the bank or of the public for the candidate to be employed by or associated with the bank.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1498 Parliamentary Commission on Banking Standards: Evidence

Civil Suits 19. Does the OCC frequently institute civil suits against bank directors? As discussed above in #1, while the OCC has authority to institute civil suits against bank directors under 12 USC 93 but the overwhelming majority of cases instituted against bank directors and other IAPs are administrative enforcement actions under 12 USC 1818. 20. Can the OCC bring a common law cause of action against a bank director for breach of a fiduciary duty? The OCC does not have specific authority to bring a common law cause of action against a bank director seeking damages for breach of fiduciary duty. A breach of fiduciary duty by a bank director can serve, however, as the basis for administrative enforcement actions under both 12 USC 93(b) and 12 USC 1818. 21. What steps can the OCC take when a bank director is suspected of committing a crime? When a bank director is suspected of committing a crime, the OCC can make sure the Bank files a Suspicious Activity Report to alert US law enforcement agencies to the possible crime. Alternatively, the OCC can file such a report itself. The OCC may also have a basis to take an administrative action against the director. Other 22. How are enforcement actions or civil suits by the OCC funded? All OCC expenses are funded by assessments on the regulated banking entities. The costs of enforcement actions are funded from the agency’s budget. 23. Please could you give us an indication of the average internal (for example, staffing) and external (for example, legal fees) costs for bringing an enforcement action against an IAP. OCC does not use outside counsel in connection with its enforcement actions. OCC has a dedicated staff of attorneys and professional staff assigned to its Enforcement & Compliance Division who work closely with the OCC’s national bank examiners to investigate and bring enforcement actions against national banks and IAPs. 24. Please could you give us an indication of the average internal (for example, staffing) and external (for example, legal fees) costs for bringing a civil suit against an IAP. The OCC does not have authority to bring civil suits against IAPs. The OCC’s authority to bring actions against IAPs is limited to its administrative enforcement authority. 25. Does the OCC conduct periodic on-site examinations of banking organizations? If so, how frequently? The frequency of on-site examinations of insured depository institutions is prescribed by 12 USC 1820(d). The OCC applies this statutory examination requirement to all types of national banks and federal saving associations (collectively “banks”), regardless of FDIC-insured status. See, 12 CFR 4.6.12. Banks must receive a full-scope, on-site examination at least once during each 12-month period. The OCC may extend this requirement to 18 months if the following conditions are satisfied: —

The bank has total assets of less than $500 million;

—

The bank is well capitalized as defined in 12 CFR 6;

—

At its most recent examination, the OCC: —

Assigned the bank a rating of one or two for management under the Uniform Financial Institutions Rating System (UFIRS), and

—

Assigned the bank a composite rating of one or two under the UFIRS;

—

The bank currently is not subject to a formal enforcement proceeding or order by the FDIC, OCC, or Federal Reserve System; and

—

No person acquired control of the bank during the preceding 12-month period in which a full-scope, on-site examination would have been required but for this exception.

The statutory requirement sets a maximum amount of time between full-scope, on-site examinations. OCC supervisory offices may schedule examinations more frequently under certain circumstances—for example, when potential or actual deterioration requires prompt attention, when a change in control of the institution has taken place, or when there is a supervisory office scheduling conflict.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1499

26. Are banking organizations required to submit periodic reports to the OCC? Is there a penalty for failing to produce the required reports? All banks are required to submit periodic reports of income and condition (“Call Reports”) on a quarterly basis. The OCC is authorized to assess civil money penalties for late or inaccurate filings. 16 January 2013

Letter from Andrew Bailey, Deputy Governor and Chief Executive Officer of the Prudential Regulation Authority, Bank of England First of all, can I apologise for the length of time that has elapsed since your request to me at the Banking Commission hearing on 6 March for a letter setting out my views on how the approved persons regime could be enhanced in respect of senior approved persons in financial institutions. We have, however, given a lot of thought to the issue during the intervening period. There are two objectives that I think we should have in mind: first, to be able to take enforcement action under FSMA against senior approved persons in authorised institutions where that is appropriate; and second where enforcement action is not considered appropriate, to be able nonetheless to place a formal “not fit and proper” determination under FSMA on an individual whether or not they remain in the role of an approved person at the time when the determination is made. I think it is important that senior figures therefore retain overall responsibility and accountability even where they have delegated responsibility for dealing with a particular matter to someone further down the management chain. This will ensure that the problem encountered by enforcement actions during the crisis, namely that in a literal sense the trail of evidence does not go to the top (ie the senior people do not themselves make the bad loans etc), would not in future get in the way of reasonable cases being brought against senior people. Of course, such actions should be subject to the same legal protections for the individuals involved as exist today. In other words, there is a strong case for broadening the scope of such actions in terms of the responsibilities of senior people, but keeping the due process that FSMA currently affords. In order to achieve these outcomes, I think it is worth examining how FSMA can be amended to ensure: — that enforcement action against individuals can be in respect of the reasonable responsibilities of their job, which they cannot delegate; and — that the regulators can more easily make not fit and proper determinations against individuals based on their past record even when they are no longer in the role. In its previous submissions to the Commission, the FSA made a number of helpful suggestions for changes to the approved persons regime, including: — reversing the burden of proof in cases where a significant failing has been identified. This would require an approved person who had responsibility for a particular area to show that they had taken all reasonable steps to avoid the failing concerned. The FSA believed this would make clear to approved persons that delegation of authority does not equate to delegation of responsibility or allow the person concerned to avoid accountability if something goes wrong; — a rebuttable presumption that approved persons who were in charge of a failed bank and seek approval for a new post are presumed not to be fit and proper unless they can convince us otherwise. Again, the FSA believed that this could lead to a change in how senior executives view their responsibilities. However, the FSA made clear that any legislative provision would need to be carefully drafted to ensure that the standard of review the regulators can apply to applications from other approved persons is not undermined; — the extension of the limitation period for taking action against approved persons (or having the limitation period start from the date on which investigators are first appointed); — the power to prohibit individuals on an interim basis pending an investigation, where their continued holding of a particular post gives rise to a serious threat to the regulator’s objectives (the FSA recognised that this would be a significant power that would need to be subject to appropriate safeguards); and — a power to allow time-limited approval in certain cases, for example to impose clear expectations that an incoming executive should resolve particular issues within a firm within a particular period of time. The FSA believed that this would allow for a targeted approach that could be deployed in the course of supervision. Taking these five suggestions in turn: the first (reversing the burden of proof) could be a means to achieve the point I made above on the responsibility of senior figures; the second (rebuttable presumption) concerns me because it may hinder our ability to ask good people to go into firms in difficulty, something that we do quite often—I would therefore not favour this approach; the third (extension of the limitation period) is sensible based on recent experience; the fourth (interim prohibition) would need to be carefully drafted to ensure the rights of the individuals are adequately protected, and I think could be quite difficult to put in to effect for the

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1500 Parliamentary Commission on Banking Standards: Evidence

same reasons. In sum, the first and third of these suggestions strike me as the most appropriate ones to pursue. And the fifth (time-limited approval) strikes me as potentially placing a significant administrative burden (and therefore increased costs) on firms and the regulator for something that on many occasions can be achieved through the regulator using its powers of persuasion. It has also been suggested that FSMA should provide for a form of strict liability; namely that senior executives who were in charge of a failing bank at the point of failure should be deemed to be automatically unfit to hold positions as approved persons in the future. While this may have some advantages in terms of rectifying some of the difficulties the regulators face, particularly in proving misconduct, it carries with it some significant drawbacks which Tracey McDermott laid out in her 13 February submission, including: —

it gives rise to real questions of fairness to those subject to it—a director may not have been responsible for the decisions which led to the firm failing, but they may nevertheless end up being held accountable;

—

it will often be difficult to determine when a firm is said to have failed. Our experience suggests that the seeds of firm failure are often sown by decisions which are made long before the firm is placed into the resolution process, or public funds are used to support it; and

—

the effect of strict liability should not be underestimated. There is a real risk that so-called “white knights” would be less willing to come to the rescue of a failing firm if there were the possibility of regulatory action being taken against them should the firm fail on their watch.

Finally, it is clear that the PRA’s own rules also have an impact on our ability to take action against approved persons who fall short of expectations. With that in mind, we intend to review our current rules applying to approved persons with a view to determining whether there are any changes that we could make to enhance the accountability of approved persons for the decisions they take. 22 April 2013

Letter from Andrew Bailey, Deputy Governor and Chief Executive Officer of the Prudential Regulation Authority, Bank of England Thank you for your letter of the 28 March asking for the PRA’s response to the recommendations of the Parliamentary Commission on Banking Standards (PCBS) as set out in its third report. Below I have responded to the questions raised in your letter in turn. Monitoring Trading Operations You stated that “many banks told the Commission that, at present, they do not engage in proprietary trading, nor do they wish to do so”. You asked the PRA to exercise its judgement and hold the banks to their word. Our approach is that firms must adopt and follow a risk appetite which is, inter alia, consistent with the PRA’s statutory objective to promote the safety and soundness of the firms it regulates. Where there are indications that a firm is operating outside this risk appetite, we expect prompt remedial action to be taken. We monitor firms’ adherence to their risk appetite by drawing together various evidence. For example, for the higher-impact banks, supervisors: —

conduct reviews, including on-site, of risk and risk controls in a particular area (for example, trading desks);

—

undertake analysis of business models, based on internal data and interviews with management, in order to understand how banks seek to make money, including reliance on client-related vs trading income; and

—

continuously assess bank performance, strategy and risk positions through reporting to the PRA, regular meetings and reviews of management information.

Tackling Concerns through the Capital Regime For all banks, we determine a minimum regulatory capital level (based on the Basel Pillar 1 & 2A methodology). A capital buffer is then calculated on top of this (Pillar 2B) to ensure that the minimum level of regulatory capital can be met, even after severe but plausible stresses. Pillar 1 market risk capital requirements apply higher capital charges for large open positions than against hedged or less volatile positions. Where a bank is taking risks that are not adequately captured under the Pillar 1 standards (for example illiquid trading book positions), we will impose capital add-ons via the Pillar 2 regime to ensure the risks are captured. Capital requirements must also be supported with robust risk management.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1501

Strengthening International Standards on Trading Operations A priority for the PRA is strengthening capital requirements for the trading book and we are engaging heavily with the Basel process to ensure tougher standards are implemented internationally to prevent opportunities for arbitrage. The Basel 2.5 agreement (transposed into the UK via CRD 3) delivered material increases in market risk capital requirements. In particular, it required banks using internal models to include periods of stress within their models and increase their capital for credit risk in the trading book. The Basel Committee is now conducting a fundamental review of the trading book further to toughen standards. There are significant changes being considered including: — strengthening capital charges on both sides of the trading book boundary to prevent banks from arbitraging capital requirements for risky positions by moving them between books; — Pillar 1 capital charges that require higher capital for positions which cannot be sold or hedged quickly in stressed conditions; and — reduced reliance on capital driven by internal modelling. These changes, once agreed and implemented, should ensure firms’ hold more Pillar 1 capital against the most risky positions. Reporting on Outcomes of Monitoring and Actions Taken I would be happy to discuss the arrangements for reporting further, where there may be a number of approaches we could take. Legislative Authority No further legislative changes have been identified as necessary to help us fulfil the approach outlined above. I hope that this letter outlines how we are tackling the prudential risks that can arise from proprietary trading in line with the PRA’s stated approach to banking supervision. 13 May 2013

Letter from Colin Tyler, Chief Executive, Association of Corporate Treasurers We have been prompted to write to you in regard to the idea that bankers (or, at least, bankers in some types of work) should belong to a body with an ethical code and a disciplinary system. Our members working in banking are concerned that it may be proposed to set up a special body for bankers, to which they are required to subscribe. For bankers who, for whatever reason, do not already belong to an appropriate body, this may indeed be a suitable requirement However, many bankers already are members of suitable professional bodies—including The Association of Corporate Treasurers. Like other professional bodies, membership of the ACT is usually by examination. And all members, including students studying for one of the several tiers of examined qualifications, are subject to the ACT’s ethical code and disciplinary process. While our raison d’être is corporate treasury, many bankers have taken our exams and joined the ACT either because of the overlap of the required content (bankers working in a bank treasury or in advisory roles, perhaps) or because it gives the opportunity to see the world through the eyes of the customer (relationship roles). And, of course, some who work in the treasuries of corporates later work in banks—and vice-versa. For example, at HSBC, the chairman, CFO and Treasurer and 193 others are subject to our ethical code. There can be a reluctance of employers to pay for more than one professional body membership for employees and, of course, the Inland Revenue normally only allows as tax deductible one professional body membership for those individuals paying for themselves. We urge that the Commission avoid suggesting that membership of a specific professional body be required for bankers. But recommending that certain bank staff should be required to be members of a suitable body with an ethical code we do think would be a useful step. For bankers who are not prepared to undertake the extensive studies needed to join a UK chartered professional body, perhaps a bankers “club” with membership based on type of employment and interview and some other screening might be necessary to give the completeness of coverage required. Obviously, such a scheme should be included the HMRC list of bodies whose membership is tax-deductible. However, we do not think that membership of a suitable body is likely to be sufficient of itself.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1502 Parliamentary Commission on Banking Standards: Evidence

Governance The ethos of a professional body, running through the professional formation of its members and their continuing professional development, can be influential. But within any particular organisation it can be difficult for an individual who is one among only a small number of members of suitable professional bodies in a division or department to influence behaviour. Individuals can face great pressure, even on their own behaviour. For individuals to consider their ethical position can be difficult and support can be lacking within the firm. The professional bodies can help: for ACT members, in addition to the support of the ACT itself, ACT members have access to the members’ confidential ethical advisor (Justin Welby, Bishop of Durham). However, once a critical mass of employees in decision making roles being members (or aspirant members) of suitable professional bodies is achieved in an organisation, an appropriate ethos can more easily be created or sustained. In terms of bank governance, the Board or its appropriate committee can establish a policy of ensuring an appropriate representation of professionally qualified staff in good standing with their professional body— through recruitment and training/development and support practices—at each level in the firm. The actual professional bodies considered appropriate does not need to be narrowly drawn. Certainly, a firm should require job applicants and employees and consultants too to notify them if they have been or are expelled for cause by a suitable professional body. Practice in this regard within a firm would seem to be an appropriate matter for a prudential or conduct regulator to take into account in its dealings with the institution. 7 December 2012

Letter from Sir David Walker, Chairman, Barclays I am writing in response to your letter of 4 April about the share releases that Barclays announced on 20 March 2013. In respect of the timing of the relevant announcement, I welcome this opportunity to set out the facts and process that led to this particular timing. The public announcement covered share releases made on 18 March 2013 to Barclays Directors and Persons Discharging Managerial Responsibilities (PDMRs) and accompanied a much broader vesting of shares for colleagues at other levels in the group. A large portion of the deferred share awards scheduled for release on 18 March 2013, were granted in March 2012. It was in March last year, therefore, that Barclays indicated the release date of 18 March 2013 in the formal award communication to employees. In November 2012, the Employee Incentives Financing Committee, which arranges for the provision of shares for releases such as these, confirmed 18 March 2013 as the release date for all awards scheduled to be released in March 2013 (except those with a contractual release date of 5 March 2013) and that the required Regulatory News Service (RNS) announcement should be issued on Wednesday 20 March 2013. This was in accordance with our obligations under the Disclosure and Transparency Rules, requiring us to notify the market by no later than the end of the business day following receipt of the relevant information in respect of the release of shares (ie by no later than 20 March 2013). Following the release (on 18 March 2013), sufficient time is needed to allow for final numbers to be confirmed including the number of shares sold for the satisfaction of tax and social security liabilities. This timing was consistent with the release of information in previous years. A copy of the paper presented to the Employee Incentives Financing Committee in November 2012, confirming the release date of 18 March 2013 and the RNS date for 20 March 2013, is attached. All of these decisions were taken prior to the announcement, on 11 December 2012, that the date of the Budget was to be 20 March 2013. Notification of the share release was made via an RNS announcement to the London Stock Exchange. Far from seeking to conceal the release of this information, we distributed it proactively, including emailing the press release to over 200 journalists. The story was covered in every national newspaper the following day. Against this background, the suggestion that the release of this information on the same day as the Budget was designed to minimise media attention is altogether without foundation. The Board Remuneration Committee reviewed very closely 2012 remuneration for the Directors and PDMRs and the release of unvested deferred remuneration to them. As previously confirmed, Antony Jenkins, Chris Lucas and Rich Ricci did not receive a bonus award for 2012. The Directors and PDMRs were also impacted by the risk adjustments implemented by the Board Remuneration Committee in 2012. As noted in our 2012 Annual Report, the Board Remuneration Committee made risk adjustments in 2012 of £1.16 billion. This included a reduction of £860 million to the 2012 incentives pool to reflect risk and compliance events during 2012 (including LIBOR, PPI and interest–rate product sales). It also included a reduction of £300 million in unvested deferred and long term awards. In respect of the awards made to Rich Ricci and Tom Kalaris, as you know, and for the reasons set out in my 2009 report on bank governance, referenced in my earlier letter of 14 March, we have and continue to

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1503

eschew disclosure of further remuneration detail in respect of individual executives below board level. I can, however, confirm that the majority of the shares released to these two executives, as indicated in the announcement, related to: —

releases of deferred share bonuses relating to the performance years from 2007 to 2011; and

—

releases of vested long term incentive awards relating to performance periods commencing in 2009.

The value of these releases as of 18 March 2013 was disclosed in the announcement, in line with the Disclosure and Transparency Rules. 19 April 2013

PAPER FOR EMPLOYEE INCENTIVES FINANCING COMMITTEE MEETING ON 22 NOVEMBER 2012

TO:

Members of the Employee Incenves Financing Commiee

DATE:

21 November 2012

SUBJECT:

Timetable of 2013 events

Agenda item: 4.

This paper outlines the metable of events for 2013 acvies. Date Tuesday 12 February 2013 13 Feb – 12 March 2013 Tuesday 5 March 2013

Monday 18 March 2013

Event Annual Results Announcement (TBC) 20 day VWAP price se!ng window for 2013 grants Release of Joiner Share Awards (JSVP) – condional rights. No PDMRs Grant of: • Share Incenve Award (Holding Period) for Code Staff • Deferred share & cash awards – 2012/ comp round

Monday 18 March 2013

Release of deferred share & cash awards

Wednesday 20 March 2013

RNS for PDMRs

TBC

DRR (TBC)

The Commi!ee is requested to note this paper.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1504 Parliamentary Commission on Banking Standards: Evidence

Letter from Sir David Walker, Chairman, Barclays Thank you for your letter of 25 March about Barclays’ 2012 Total Incentives Pool. You asked for a breakdown of the £860 million figure that we provided. This information is published in our Annual Report for 2012 of which I enclose the relevant pages378 (80 and 81) for your information. As I explained in my previous letter, the incentives pool was reduced by £860 million to reflect risk and compliance events in 2012. Within this total, the pool was reduced by £290 million reflecting the LIBOR fines and £570 million to reflect redress of other risk events including PPI and Interest Rate Hedging Products. On top of the £860 million specified above: —

Our Annual Report details an additional reduction to our 2012 incentives pool of £250 million to reflect Barclays’ intention to reposition its remuneration in the market; and

—

Our Annual Report also details the decision ofthe Board Remuneration Committee to claw back approximately £300 million of unvested deferred and long-term awards for 2012. The majority of this was in relation to the LIBOR investigation.

I trust that the information in this letter and the detail published in our Annual Report addresses your query fully. 3 April 2013

Letter from Antony Jenkins, Group Chief Executive, Barclays I write further to Sir Hector Sants’ evidence to the Parliamentary Commission on Banking Standards on 10 January and your request that Barclays provide a letter clarifying the safeguards that exist to manage potential conflicts of interest around regulatory cases relating to Barclays, given Sir Hector’s previous role. As you are aware, the FSA has approved Barclays appointment of Sir Hector and the application for him to perform the role of Compliance Oversight. The FSA has indicated its full support of our desire to restructure Barclays compliance function. As Sir Hector explained when he gave evidence, there is a statutory contractual period determined by the FSA Board during which former senior directors of the FSA are prevented from working for regulated firms and Sir Hector is beyond that period. This period ensures that the individual does not have any up to date, current regulatory information which could benefit the firm they are joining. Barclays and Sir Hector are absolutely aware of the importance of, and are committed to, managing any potential conflicts of interest around regulatory cases relating to Barclays with which Sir Hector would have had visibility during his tenure as CEO of the FSA. We have agreed with the FSA that Sir Hector will not be party to discussions on settlement of formal action by the FSA (or FCA or PRA in due course). However, as you would expect, this will not preclude Sir Hector from being involved in broader discussions on lessons learned from such cases. I hope that this letter eases your concerns but please do not hesitate to contact me should you wish to discuss further. 22 January 2013

Letter from Anthony Browne, Chief Executive, British Bankers’ Association By my reckoning there were two points which arose during my 14 January evidence session upon which I undertook to follow-up in writing: the BBA’s position on the Commission’s first report following its prelegislative scrutiny of the draft Banking Reform Bill and a specific issue on LIBOR. Draft Banking Reform Bill The first concerned the BBA’s response to the Commission’s report following its pre-legislative scrutiny of the draft Banking Reform Bill. This resulted from confusion between an article written prior to the release of the report expressing concern within the banking industry over the prospect of a full Glass-Steagall division of retail and investment banking of a type rejected by both the US and the European Union, since neither the Volcker rule nor the Liikanen report involve this. While the Volcker rule prohibits proprietary trading, this is clearly much more limited than a complete separation of investment banking; Liikanen, on the other hand, adopts an approach more akin to Vickers, though proposes the ring-fencing of activity to be excluded from the retail banking part of a banking group. 378

Not printed. Available at: www.barclays.com

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1505

We issued the attached Press Release on the day of the report outlining that we broadly viewed its publication as a step forward. As you can see, it starts by saying in unambiguous terms that: “We welcome this report which broadly endorses the Government’s approach to banking reform. The industry is strongly committed to taking the necessary steps to ensure that taxpayers are never again asked to bail out failing banks.” We also said that the report: “...shows that the Commission has thought very fully about many of the key issues arising out of the ICB’s recommendations and not just the immediate ones arising from the from the draft primary legislation”. Within this context we then listed what we saw as some of the key issues, including the potential effect of imposing a more constraining leverage ratio than that set out by the Basel Committee and the importance of the limitations and safeguards relating to the “electrification” of the ring-fence. More generally, and we can send you copies, it can be seen from submissions to the Treasury Committee back in 2011 and our responses to the Government consultations—and indeed your pre-legislative scrutiny exercise—that, from the time that the Government announced that it supported the Vickers’ recommendations, we have focused our efforts on trying to help get the technical detail right. This is about ensuring that there is minimum disruption to customers and ensuring that the statutory provisions work. To give two examples: we have explained in various submissions that the position on ring-fenced banks being able to provide trade finance in support of exporters appears in conflict with the geographical limitations; and we have set out concerns relating to the proposed reliance upon Part VII FSMA transfer powers to reassign bank accounts and contracts to the new legal entities. This is purely about making sure that the legislation works as well as it can. LIBOR Turning to LIBOR, Lord McFall asked whether the BBA had placed any legal impediment upon my predecessor, Angela Knight, from commenting publicly. The position here is that the BBA places all employees under a confidentiality obligation. This is common in commercial organisations and is not unlike the obligation placed upon civil servants and other public sector employees. It does not preclude commenting publicly, but involves ensuring that the right director is fielded and that the BBA has an overview of what is being said on industry issues on behalf of its members. The circumstances in which ex-employees would be expected to comment on issues from the perspective of their time at the BBA is quite limited and may even be said to be non-existent other than in the case of the current Parliamentary inquiry. I would say that the BBA’s general expectations on confidentiality would not usually place limitations on what can be said to Parliament. LIBOR is however an exception since there are criminal and regulatory enforcement actions taking place not only in the UK but in other jurisdictions around the World. This does not prevent any information being provided in support of Parliamentary interest, but it did mean that the BBA, for instance, in providing evidence to the Treasury Committee (and this is available to the Parliamentary Commission) took great care to ensure that the information put into the public domain did not unknowingly prejudice any of these on-going actions. This is a point that was underlined for the handful of BBA employees with access to information concerning LIBOR upon the public announcement of regulatory investigation, which preceded my joining the BBA. 23 January 2013

Written evidence from the British Bankers’ Association 1. The British Bankers’ Association welcomes the opportunity to provide input to the Parliamentary Commission’s consideration of the issues arising out of the draft secondary legislation on the provision of derivatives by ring-fenced banks. 2. The Government response to the Parliamentary Commission’s report on its pre-legislative scrutiny exercise on the draft Bill published in October 2012 explained that the Government agreed with the Parliamentary Commission that “in principle ring-fenced banks may be permitted to sell certain simple derivatives to their customers, subject to strict safeguards to ensure that derivatives do not undermine the resolvability of ringfenced banks, and to guard against mis-selling.”379 This would appear a good starting point from which to achieve a suitable balance between enabling ring-fenced banks to be able to service directly their customer’s hedging needs and the desire to limit the complexity of products and risks involved from the perspective of both the customer and the ring-fenced bank. As the call for evidence illustrates, there remain significant intricate issues which need carefully thinking through if the limitations to be placed on ring-fenced banks through the secondary legislation are to be appropriately struck. 3. We would further add that there are also issues relating to the provisions in respect of ring-fenced banks being able to meet their customers’ trade finance needs, including the proposition that permitted services need 379

“Banking reform: a new structure for stability and growth”, HM Treasury and Department for Business Innovation & Skills, February 2013.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1506 Parliamentary Commission on Banking Standards: Evidence

only extend to letters of credit (so excluding, for example, cross-border guarantees and some common forms of trade loan). Although not raised in the call for evidence, we would draw to the Parliamentary Commission’s attention the importance of also getting these provisions right if ring-fenced banks are to be able to support client import and export activities. 4. This underlines the importance of the consultation on the secondary legislation expected to be undertaken over summer and the need to ensure that the draft secondary legislation formally presented to Parliament adequately addresses issues raised by the Parliamentary Commission and other interested parties. 5. The remainder of this submission is based upon the specific questions raised in the call for evidence. 1. Is it appropriate for SMEs to be able to hedge risks arising from price fluctuations directly with a ringfenced bank, rather than with a non-ring-fenced bank, and if so, why? We can see three clear benefits for SME and other account holders being able to hedge risks arising from changes in interest or exchange rates or changes in commodity prices directly with the ring-fenced bank with which they principally undertake their banking: — The need for collateral and security in support of the risk in the derivative contract which is more likely to be readily available to the ring-fenced bank holding deposit monies and rights in support of secured lending facilities. Absent these, hedging facilities may prove difficult to source or only be available at a significantly higher price. — The ability for the customer to have their banking needs met within a single banking relationship without having to go through duplicative credit assessment processes and other administrative tasks in support of their financial services. — The added security for the SME and other account holders of the hedge and the hedged item remaining intact in the event of bank failure and therefore their continuing to be insulated against market risk. We believe that a consequence of unduly limiting the ability of a ring-fenced bank to meet its client hedging needs may be that some may choose to open themselves up to market risk which they otherwise would have taken action to remove or mitigate. 2. Is it appropriate to permit ring-fenced banks to sell derivatives to customers when the “main” purpose is to hedge risks, rather than simply when the “sole” purpose is to do so? We would be concerned about a definition based upon “sole or main” if this, for example, required a bank to validate any foreign exchange hedge against the client’s order book and outgoings, which implies a degree of investigation which may prove impractical. Given that the purpose for which a product is selected by a customer is ultimately defined by or known to the customer, there may be cases where their potential need for risk management products is ascertainable, but the particular purpose of a transaction may not be clear to the ring-fence bank. We therefore would recommend a revision of regulation 4(1)(a) so that it requires a ringfenced bank to sell derivative products only when it has reasonable grounds to believe that the use of those products is for risk management. This would remove the ambiguity around the concept of what a customer’s “sole or main” purpose is, which may not be fully known to the bank This would be consistent with requiring the ring-fenced bank to be content that the hedge is consistent with the customer’s ordinary business without necessitating a validation process that would stand in the way of the transactions being completed effectively. We would be concerned in particular if “sole or main” inferred a strict correlation between need and usage which could prevent the customer from entering into a hedging arrangement once they had made an assessment based on an estimation of their needs. It needs to be borne in mind that in the event that an SME is unable to hedge an exposure with a ring-fenced bank, there is a real possibility that it may remain unhedged and exposed to significant risk, as it may not be easy or cost-effective for it to maintain a secondary banking relationship with a non-ring-fenced institution. 3. What challenges is the PRA likely to face in defining rules to assess the purpose of derivative transactions and does the draft secondary legislation provide a clear enough mandate to support such rules? At this stage we would view it as premature to set out detailed rules, given the difficulty of establishing the intention behind a transaction. We would see the need more as being for the FCA to develop conduct rules in support of a ring-fenced bank’s derivatives product offering being suitable for its client base and processes in support of individual transactions. We note that the PRA will, in any case, have wide powers to vary the regulatory permissions of a ring-fenced bank. 4. Is a restriction based on BIPRU 7.10.21(1) appropriate for limiting the provision of derivatives to simple products which serve the majority of SME needs? As the call for evidence identifies, clause 4(2)(a) of the draft of the Order proposes to restrict the sale of derivatives to those which fall within Section BIPRU 7.10.21(1) of the FSA Handbook, namely “linear

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1507

products, which comprise securities with linear pay-offs (eg bonds and equities) and derivative products which have linear pay-offs in the underlying risk factor (eg interest rate swaps, FRAs, total return swaps)”. Although we would agree that basing the definition of permitted “simple” derivatives products on instruments with linear features should enable the ring-fenced bank to meet the hedging needs of many of its customers, it would exclude others that are commonly used and not unduly complicated. We therefore see a case for the dividing line to be drawn in a different place. It is arguable that derivatives falling within BIPRU 7.10.21(1), 7.10.21(2) and in BIPRU 7.10.21(3) should be permitted. Allowing these would enhance the ability of the ring-fenced bank to meet the customer’s needs, but at the same time exclude more complicated instruments listed in 7.10.21(4), which we agree would not be in keeping with the objective of limiting the complexity of the derivative product range and the risk exposure which they entail. Including instruments listed in 7.10.21(2), for instance, would permit cross-currency swaps, which involve exposure between two or more risk factors, and are therefore not linear, and also simple options such as caps and floors on interest rate exposures which may be better suited to the customer’s needs. Including instruments listed in 7.10.21(3) would add options typically used to hedge foreign exchange exposures which cannot be defined at the outset of the contract, but can be based on an average over the course of a certain timeframe. This, for instance, might include a customer with a subsidiary or majority shareholding in an overseas firm where the profits of the subsidiary are in the local currency and the UK company notionally converts this profit into sterling in every month or every quarter to help it manage its business effectively. An option available under 7.10.21(3) enables the company to purchase the right to convert its foreign currency profit at the average exchange rate over the accounting year meaning that the notional profit which the company took throughout the year is guaranteed, regardless of whether exchange rates change against it over the course of the 12 months. Should further consideration lead to the conclusion that the products included in BIPRU 7.10.21(2) and 7.10.21(3) involve an element of complexity discernibly higher than those in 7.10.21(1), the answer may be for the conduct rules to be drawn up in such a way that the customer processes involved are aligned to the level of complexity involved. These are issues which should be explored more fully as part of the consultation exercise on the secondary legislation due to take place this summer. It is a matter for discussion whether broadening the definition of “simple” derivative product in this was would better achieve the right balance between wanting to simplify the product range directly available from the ring-fenced bank while at the same time ensure that SME customers in particular can receive the hedging services which they need from the ring-fenced bank. We do however believe that the planned restriction based on the fair value hierarchy, upon which we comment in response to question 5, provides an anchor point for reducing complexity that potentially enables a more inclusive approach to be taken to the derivative product range that can reasonably be provided from within the ring-fenced bank. We would further add that definition of the exposures against which a ring-fenced bank is entitled to hedge itself provided in clause 6(2) of the draft excluded activities and prohibitions order differs from the definition of exposures that the bank can offer to hedge for SME customers as defined by clause 4(1). As matters stand, the lack of symmetry means that the ring-fenced bank would be permitted to hedge a client’s exposure to commodity price changes but not to aggregate and hedge its own exposure. (This must be an oversight or be based upon provision via a different route within the draft Order that we have not as yet managed to identify.) 5. What will be the effects of the restrictions relating to evidence of the fair value of the investment, and how does will it help address the Commission’s concerns? The call for evidence also identifies that clause 4(2)(b) of the draft of the Order proposes to require that derivatives can be sold to customers only if there is evidence available to assess the fair value of the investment concerned in accordance with IFRS 13 and that evidence would be considered to constitute a level 1 or a level 2 input within the meaning of IFRS 13. This limits ring-fenced banks to providing derivative products that are capable of being valued using either quoted market prices or upon the basis of observable market data, but not products based upon more complex models. While this may debar ring-fenced banks from providing customers with newer products that become available, we view the restriction as being entirely in keeping with the aim of permitting ring-fenced banks to provide products which are readily understandable and which do not unduly complicate the ring-fenced bank’s risk management arrangements. In fact, we see this as the principal means through which ring-fenced banks can be enabled to provide “simple” derivative products, but for the line to be drawn at instruments embedding greater complexity and risk. 6. Is the proposed methodology for calculating a gross cap on the total of derivatives sold the appropriate one, and is it resistant to gaming? The final question relates to clause 4(3)(b) of the draft of the Order proposing a methodology for setting a gross cap on the total volume of derivatives sold to clients. The difficulty with setting a hard limit at this early stage is that it is difficult to see what a reasonable pattern of activity will look like until we have a clearer picture in terms of the way in which corporates will choose to organise their banking relationships. A breach

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1508 Parliamentary Commission on Banking Standards: Evidence

of the gross cap proposed could arise from market movements without the ring-fenced bank writing any further contracts, but it is not clear how the bank could remedy such a breach in the near term (given that no position risk requirement could be set off against any other position risk requirement). We would therefore suggest that a firm basis for defining a gross cap should be agreed at this stage and in this respect we would recommend a definition based upon IFRS accounting and regulatory capital calculations which essentially amount to the aggregate mark-to-market value of relevant contracts gross of collateral but net of legally enforceable netting agreements. This would provide an objective and practicable base for the limitation. The application of such a limit in practice is still likely to require a degree of caution: the mark-tomarket value could vary significantly from day to day without the ring-fenced bank writing any new derivative contracts. We would advocate that the cap be a threshold for enhanced supervisory interest rather than a hard limit since temporary fluctuations may otherwise result in a statutory breach and a need for the ring-fenced bank to suspend the availability of hedging services for clients (thereby exposing them to market risk). 27 March 2013

Written evidence from the Campaign for Regulation of Asset Based Finance Introduction 1.1 We strongly believe that Asset Based Finance is a product that should be promoted by banking companies and used by the private sector as a means of getting funds into businesses in the UK once the industry is regulated. 1.2 Figures from the Asset Based Finance Association (ABFA) showed that invoice financing in the UK and Ireland had risen by 7% in 2011 while net lending to businesses had fallen by 3.7%, with the industry expected to lend £260 billion against invoices in 2012. 1.3 The Enterprise Act (2002) which sets out the frame work for the industry to operate within must be applauded for it’s vision. Unfortunately those individuals who conceived the Act could not have foreseen the abuse that an unregulated industry would create. One of the key aspects of the Act was removal of Crown preference in an administration only to replace them by the factoring companies, the irony has probably not been lost on HMRC. 1.4 The un-regulation of the industry which was the lynch pin of the Act has created a culture where a significant number of asset based providers are no longer bound by the confines of acceptable behaviour and they believe that they can do what ever they like to make substantial profits regardless of the consequences. We have outlined three examples that illustrate the size of the problem and the abuse: 1.5 It is not uncommon to see a lender fund Oldco which has already ceased trading so that the finance company can apply termination fee (this can be half a million pounds) as well as fund Newco out of administration. 1.6 Factoring brokers who are owned by insolvency practitioner (IP) gives the client to the factoring company who force the company into administration who gets the termination fees and then gives the administration work to the original IP Company, everybody wins except for the client. 1.7 There are numerous cases where a factoring company has put viable companies into either administration or liquidation when there is absolutely no grounds for doing so, including companies who were literally put into liquidation days before leaving their current factor for a new one. In one case ten minutes, the client rang up to confirm the new factoring company to be told his company had been placed into administration without his knowledge. 1.8 The trouble is that the Liquidators benefit from this practice as does the finance companies, who are one of their greatest sources of businesses for IP’s, so they are loath to say anything negative about them. 1.9 HMRC and unsecured creditors are the financial losers with factoring companies siphoning around £7bn from the treasury in these excessive fees. 1.10 The biggest losers unlike a number of other baking scandals are ordinary working people whose employer got closed or had to pay excessive fees to stop liquidation who lose their livelihoods by the tens of thousands. 1.11 How has the Industry got away with this? The industry imposes a wall of silence about their excesses by the use of expensive lawyers that only the most fool hardy or committed take on. Most people who witness these excesses accept them as an example of a rotten and corrupt banking system. 1.12 The Campaign for the Regulation of the Asset Based Finance Industry is a group of grass root campaigners from all aspects of society who have been involved with the industry who have to got together to put right what is evidently wrong with the industry to seek natural justice.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1509

The Unregulated Asset Based Finance Industry 2.0 The Enterprise Act 2002 which the industry operates within was written in a completely different culture and time where the relationship between the banking sector, Government and the public was shaped by the actions of a different generation of bankers and feels like a lifetime ago. The pendulum has simply swung too far with this Act probably now one of the worst examples of allowing excesses in the banking industry with no consequences. 2.1 Unfortunately, the days of bank managers being pillars of society like Captain Mainwaring are long gone instead with the Asset Based Finance Industry at times.Managers at a number of finance companies appear more like Gordon Gekko, the unscrupulous corporate raider in the 80’s film Wall Street. The only difference between Gekko and this industry is that his actions could be curtailed by regulation. 2.2 The Financial Services Ombudsman, which polices banks and financial services firms that are regulated by the Financial Services Authority, has no control over asset based finance firms which are not regulated by the FSA unless they sign up voluntarily. The ombudsman, the FSA and the Office of Fair Trading, all have no power to intervene in disputes between the company and their clients, both existing and former. 2.3 The only route for an individual to find justice is via the High Court; in most cases this is simply not viable for a number of reasons, including contractual clauses, cost and the need for determination to win regardless almost of the consequences on the individuals family, who have already suffered. The Appointment of Administrators 3.1 This is probably the only area that may be outside the remit of the Commission. We strongly request that an investigation is carried out into the incestuous relationship between Factoring Brokerages, Factoring Companies and the Administrators within the Asset Based Finance Industry. The reform of the legislation and regulation of Administrators industry should be part of the recommendations of the Commission (we would accept this may be outside the original remit). 3.2 As a secured creditor, not only can the Finance company force their client into administration but they also decide who the administrator to be appointed should be. We would question where the loyalty of the Insolvency Practitioner would lie? With the unsecured creditors or the factoring company who will supply them with future work. 3.3 There are significant concerns about the relationship between the asset based finance industry and the administrators they appointment when their clients going into administration. Indeed, it could be argued that it may be beneficial for both the administrator and lender for the viable business to be closed rather than lead a successful rescue. Factoring Brokerages 4.1 Factoring Brokerages are not governed by the rules for Independent Financial Advisors (IFAs), they are normally owned by an Insolvency Practitioner or Finance Companies who do not mention these details on their websites, sales literature or when face to face in nearly all cases. 4.2 So although they are perceived by the public to be covered by the same checks and balances as IFAs, they are not and do not meet the strict qualification and competence requirements of IFAs. In reality, the factoring brokers do not need to meet any competence standard at all and therefore many do not. 4.3 Even those brokerages, who are members of the Independent Factoring Brokers Association, can dispense whatever advice they want, regardless of the consequences except to their own conscience and their bottom line. 4.4 Therefore factoring brokers do not offer independent financial advice to their clients, there is no reason for them to recommend suitable financial products from the whole of the market or even part of. They can offer products which may not be suitable, expensive, potentially lead the client into insolvency. This advice is totally legal as they are not IFAs with the wronged client having no rights of appeal. 4.5 Factoring brokers could be guilty of mis-selling on a grand scale and have broken no law and not held to account for their actions. 4.6 What we cannot understand about the brokerage industry is that, although there is no legislation or regulation, these companies hiding their true identity and purpose with their marketing material. 4.7 An example was given by the managing director of one Invoice Factoring Company on his Blog Appendix 2.1 “There could be pressure exerted from the broker to put business back to their IP arm; in the worst case it could be—we give you [factoring company] a client—you bust them—you get the termination fees and we get the administration—everybody wins, twice! Oh …but not the client.” Securities and Termination Fees 5.0 The asset based finance industry is able to deliver unlimited profit that can be made at the expense of the client, HRMC and unsecured creditors through termination and collection fees when companies go into

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1510 Parliamentary Commission on Banking Standards: Evidence

either administration or liquidation. The asset based finance industry is making vast profits at the expense of the Treasury and this simply cannot be allowed to continue. 5.1 An industry insider said: “We were always delighted when a company went into administration or liquidation; we would collect our various termination fees from the monies that we collected over and above the amount we had lent against the debtor book. It is a very large source of profit nevertheless. Factoring companies have got less and less scrupulous about these fees and deliberately set up deals so that they maximised these fees.” 5.2 Most factoring arrangements contain a minimum annual charge which is what the factoring company expects to earn over a year. Most contracts however are now multi-year contracts. So if a company goes into administration or liquidation, the factoring company can charge the annual minimum fee for the number of years left on the agreement plus whatever notice period is. On the larger deals this can mean a £40k annual fee over three years with six months notice can become a £140k charge. 5.3 In addition most contracts will contain a “collect out” fee if the company goes into liquidation, this will typically be 10–20% of the ledger—so on a £1 million ledger an additional £200k fee can be taken quite legally, although substantially less is lent. 5.4 Then they have a whole range of smaller disbursements and other charges including a charge, which is not in the contract but has been proven in court, for interest that would have been earned over the course of the agreement had it run its full term. 5.5 In short the factoring company can find charges to account for the vast majority of any excess they have from collecting the trade debtors after a client goes into liquidation. 5.6 It is not unknown for a factoring company to put a company into liquidation when there is absolutely no grounds for doing so, including companies who are put into liquidation days before leaving their current factor for a new one. The trouble is that the insolvency practitioner also benefit from this practice and as factoring companies are one of their biggest sources of businesses so they are very reluctant to say anything negative about them. 5.7 For those companies that are going into Pre-Pack administration the implication to business owners is often minimal when the administrators are appointed and the factoring company takes a substantial income at the expense of others. Conclusion 7.0 Small to medium (substantial) sized businesses are being pushed by banks (which are regulated) and by companies operating solely in this sector to use unregulated products without the client understanding at the outset that there is no regulation, ombudsman or right of appeal for this kind of lending. 7.1 The industry remains unregulated, and while it may be providing a lifeline to a number of companies unable to access bank lending, for others there are drawbacks in the worst cases been forced into administration even when the company is viable so that the funder can profit from the termination fees. 7.2 We would like to emphasise that there are factoring companies working to higher standards than regulation than would ever imposed. We are keen to see these companies expand. 7.3 SME businesses are central to our country’s economy. We cannot understand why this industry has been allowed to operate unregulated for so long and all we are requesting is a regulated industry that acts in the interest of the 40,000+ companies and their employees, at the same time safe-guarding and encouraging banks to lend to SME’s to the same standard as the rest of the banking sector. 7.4 This industry has been making significant profits at a time when the rest of the economy is paying a heavy price for the banking crisis. We believe that the industry should repay the £7 billion that it has siphoned off from monies that were due to the Government in unpaid taxes. 7.5 We therefore are requesting that this Commission in it report to Parliament recommends the following points with respect to the Asset Based Finance Industry including Administrators. (1) Put the Industry under the regulation and rules of the FSA. (2) Parliament to appoint an Ombudsman funded by the Industry. (3) Apply the strictest guidelines to Factor Brokerages, coming in line with other financial service advisory companies. (4) The stopping of factoring companies from being allowed to appoint their preferred administrator. (5) A recommendation to review the Insolvency Industry to address perverse incentives to close businesses that are viable. (6) Termination Fees and other Collection Fees to be urgently reviewed and recommendations made to ensure they are fair and ethical to the Client and unsecured creditors, while giving the protection to the finance companies envisaged in the Enterprise Act 2002.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1511

(7) Giving companies the ability to leave their contract if the service is poor with no charges for leaving. The ability to leave one factoring to move to another must be encouraged to improve competition. (8) To Review the Frame Work that the Industry operates in. (9) To apply a Multi Billion Claw Back Tax to reclaim the money that has been siphoned off by the industry at the expense of the Treasury. (10) The ability of those who have been wronged by the actions of the finance companies and in some cases administrators to retrospectively make claims against them as we have seen with PPI. 7.6 The industry is terrified of regulation and has been fighting it for years. At present, the law under which it operates is essentially the Sale of Goods act, so there is no regulatory body or law addressing the industry. 4 September 2012

Written evidence from Forrest Capie The questions posed in the document you sent me are very good ones and for that reason it is frequently difficult to provide robust answers. Furthermore, my answers are brief to the point of terse given the time constraints under which I am operating. Many of the points deserve small papers to themselves. As far as the historical perspective goes I think there is a need to go back further than 1900 to support most of the case since much of interest lies in the nineteenth century and earlier. A. Historical Perspective—Has Culture Evolved Over Time? I am sure culture is always changing even if only slowly but I am not sure “evolving” is the appropriate word. It seems to be feature of the human condition that most generations see declines in standards of behaviour from one generation to the next. And yet equally clearly in many areas of life behaviour not only seems to be better than it was, but is. I would much sooner walk around twenty-first century London than seventeenth or even the nineteenth century London. Changes in behaviour are likely to have been shaped by a multitude of factors. English banks learned their business through many financial crises in the first part of the 19th century. They found their own way to the appropriate capital, liquidity, cash and other ratios. Some banks failed every year but that did not disturb the system. There were also new entrants in most years. And the biggest bank of its time, Overend Gurney, failed in 1866 without dreadful consequences. That all happened in a very lightly regulated environment and one that had been progressively lightened from the 1820s onwards. One clear factor affecting behaviour must be changes in the law. So, for example, while failure to pay debts was once a serious offence with heavy punishment, and bankruptcy was similarly treated harshly, the law on both of these gradually eased to the point where there was little punishment at all. The stigma attaching to both all but disappeared. But the question is: which way did causality flow? Was it culture that changed and so the law, or was it the other way around—as almost everything in economics can be? But the decline in religion and a system of belief must also play a part. I think that the question might be tackled at some grand level that would argue that we in the west have lost our faith in our values and our institutions, perhaps our faith in truth. When that happens there is a need for some substitutes. The more one gets into these questions the more difficult they become. 1. Was banking ever a profession? Banking did professionalise from the mid-to-late nineteenth century onwards. In Scotland the Institute of Bankers in Scotland was formed and a similar institute was founded in England shortly after that. These bodies set out the educational and behavioural requirements for a career in banking. They set the examinations and issued the qualifications. In the last twenty or thirty years for a complicated mix of educational and other reasons entry to banking at one level suffered while at the other end it became more attractive. At the former the quality of labour suffered while at the latter it benefited. But standards were lost in both. What I have in mind is that as more young people went to university the quality of school leavers attracted to banking fell. Standards of competence fell and customer satisfaction fell. At the other end of the scale whizz kids were attracted to the newly complicated world. But that was one where there was not the same tradition or formal banking training and standards of behaviour were lower than they might have been. 2. Have incentive structures changed? I believe that across the twentieth century there was increasingly a socialisation of risk. This began particularly in the 1920s in the U.S. and has not let up. Where once it was possible for banks to fail like other firms that possibility was gradually effectively removed. That, I should say, was the principal incentive change but it was a big one. 3. Has trust in bankers ever been so low? It is difficult to measure trust (though that has not prevented some people constructing indices of trust and charting its movements). But it seems safe to say that trust in banks in the U.S. in the 1930s, and possibly parts of Europe, reached a low point. Famous Congressional Hearings in

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1512 Parliamentary Commission on Banking Standards: Evidence

the U.S. found bankers guilty of many misdemeanours and to be responsible for much of the calamity of the depression. This was not true of the U.K where banks remained stable across the interwar period and where of course we did not suffer a great depression. 3.1 Was trust restored? For some of the reasons just stated that is difficult to say. The banks’ activities clearly became accepted again. 3.2 How long did it take? I don’t think it took a long time but there were other factors at work such as the Second World War and the renewed or intensified patriotism it generated. 3.3 How was restoration achieved? For the U.K. there was nothing to achieve. The banks were stable and not under any suspicion of being otherwise at least until the secondary banking crisis of the 1970s. In that crisis it was the secondary or shadow banking sector that brought problems. For the U.S. banking historians tend to give credit to changes in regulation of the 1930s. At least some of the explanation for things getting back on the road and looking like normal must be attributed to some of the measures taken in the 1930s such as the introduction of deposit insurance and the separation of investment and commercial banking. (There is a great debate on whether or not this was actually needed or did what it was intended to do but in the immediate aftermath of the crisis it probably contributed to encouraging confidence since so many had seen the large banks as problematic.) 4. Is trust now low because of transparency? One could point to instances in the past where transparency was low—not required—and where banks were more cautious than they needed to be and probably better trusted. For example, small banks in England were not required to publish accounts in the same way as jointstock banks and were inclined to hold greater cash reserves than was believed. I see regulation as a substitute for trust. The more regulation that is imposed the less trust is needed. But again which way does it go? Which came first? And do people trust transparency? Is transparency a good thing? If there is little trust around people may not trust those claiming to be transparent. 4.1 Was “my word is my bond” ever real? Maybe. I like to think so. But of course there were many things in place at the same time that protected the consumer. 4.2 Was Big Bang a cultural watershed? It certainly seems to be a significant date. Again, though it was the outcome of a certain clamour for change and that needs to be understood. Some of it was domestically generated and some of it was foreign in origin. For example, I believe it was encouraged by an influx of Americans whose approach to regulation was different from ours. Their view was more a case of “if it is not forbidden (written down) then we can do it”. 4.3 Was pre-Big bang different? Possibly, although changes were underway by then. 4.4 In the 21st century has more transparency been created? Transparency is desirable but calls for it can produce similar responses to those to regulation. Unfortunately, calls for transparency can result in opacity or loss of information. Operation of the Freedom of Information Act has shown how greater desire for openness can be obstructed and the true picture distorted. The fear that communications could be revealed will result in a change in the way in which discussions are conducted and the way in which recording is made. But the danger is that the call for transparency will encourage concealment. 4.5 What impact on future standards? Impossible to say, but I would not be overly optimistic. B. Precedent 5. Apart from common factors listed are there other factors in bank failure? 5.1 A well-behaved bank could fail through no fault of its own if a shock hit the system and a panic developed. That should not happen with a proper lender of last resort in place. And indeed the understanding of that was a major factor in crises being avoided in England. 6. Why does history repeat itself? It doesn’t quite but often gets pretty close to it. It is extraordinary and hubris must lie beneath it. There seems to be the recurring belief that we have finally cracked it. 6.1 Is it driven by banks leveraging? Yes. 6.2 Is this just human nature? Yes. 6.3 Is it dynamics and not standards? To some extent. 6.4 Should corporate memory be drawn on? It should and probably once was. When labour was less mobile and professionalization meant there was a career within a bank. 6.5 Is corporate memory also affected by higher board turnover? I think that must be likely. 6.6 Is this incentive based? Possibly, but I wonder why accountability can’t be retrospective? 6.7 Is there a case for strict liability for boards? I think so. 7. Should there be surprise that common factors have had the effect of increasing short-term profits? No. 8. Who should stop banks’ poor behaviour? 8.1 I think that is down primarily to the directly interested parties, the shareholders and nonexecutive directors, and not regulators.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1513

8.2 How have shorter holding periods for shares affected attitudes? The shareholding periods are likely to be affected by shareholders feeling powerless. If they do feel impotent then selling shares (ie leaving) is one way of showing dissatisfaction. 9. Who will hold the board to account? Non-executive directors and possibly auditors. 10. Do these features appear in other industries? They probably do but might be less easy to see. There is no big externality elsewhere as exists in banking. In addition, other firms are less protected. C. Policy Response 11. What policy responses have followed banking crises? 11.1 Legal changes? Yes, but sometimes fortuitously preceded and allowed a readier resolution as in the Australian crisis of the early 1890s. 11.2 Regulatory changes? Yes, but sometimes these were deregulatory changes as in England in the years 1826 to 1860. 11.3 Supervisory changes? Yes, as followed the secondary banking crisis of the 1970s. 11.4 Other changes. Undoubtedly. 12. Has policy ever attempted to improve standards? I can’t think of anything directly aimed at standards. 13 Why has prudential bank supervision not prevented/limited the impact of failure? I think it is fair to say that it did for a long time in the U.K., say from the 1880s to the 1970s. 14. What sort of policy response could be developed that might improve standards? I believe that starting with a clean slate and making it clear that failure is a distinct possibility—it is everywhere else—and will be tolerated and dealt with. There will be no rescues. There will be a lender of last resort to take care of the payments system but that is it. Banks within the payments system can still fail. The lender of last resort is simply there to provide the liquidity needs of the market as a whole in times of stress. Regulation could then be extremely simple. Transparency could be encouraged but not legislated for. An appropriate resolution regime would help convince the market that a failure would not lead to a major disturbance. Behaviour would surely then change and if that is read as improved standards there could be little objection. There may also be a case to make for the kind of unlimited liability that was in place thirty years or so ago across a range of the professions and that must have affected activity. 31 October 2012

Written evidence from Michael Cassidy This submission relates to the practices of the banking insolvency departments and how the banks deal with small business customers and is a response to the call for evidence by the Parliamentary Commission on Banking Standards. I submit that the banks are dishonest and that their activities are detrimental to the wider economy as well as their customers. I submit that the legal immunities that the banks have in law is a large part of the reason for this. The banks are also allowed to break the law. I have enclosed a history of my own experiences with Lloyds Bank as an explanation. The issues raised are restricted, as best as they can be, to those likely to be of relevance to the work of the Commission. A summary of the general points are: (a) The banks are able to foreclose by demanding immediate repayment of an overdraft. Clearly this is impossible. (b) The banks have legal immunities. They do not owe their customers a duty of care, which means that they cannot be sued for negligence. (c) The banks are able to deliberately increase their customers’ debts and expect the customers to pay those debts. Banks do not owe any duty to mitigate their losses. (d) Banks are able to continue charging interest on loans that they have called in and after they have foreclosed on a business. Receivers, in practice, do not pay any interest and operate on a totally different basis to that of the customer. (e) In as much as banks can be sued for breaching various duties in equity, in practice the judiciary manipulate the interpretation of those duties to enable the banks to avoid liability. (f) The judges are strongly biased in favour of the banks and will manipulate court hearings and interpret the law to advantage the banks and their receivers. (g) Even when the banks and/or their receivers have broken the criminal law, the police are strongly opposed to investigating their crimes. This puts them completely above the law.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1514 Parliamentary Commission on Banking Standards: Evidence

(h) In theory the banks and receivers are not allowed to sell to themselves or their agents. In practice, they can do so freely and with impunity. (i) The legal process is very drawn out and expensive. A customer is supposed to wait until the receivership is concluded before he can make any claim for damages. The fact that a customer does not see the reports and other documents produced by the banks and receivers makes this very difficult. There is no longer any legal aid for business matters. (j) In theory, the banks and receivers are supposed to account for the proceeds of sale and any income. In practice, they do not have to properly do so. Even when monies are missing, the judges will cover this up. (k) The banks, the receivers, their lawyers and the judges use smear tactics to try and discredit the customers and cover up the banks’ and receivers’ actions. (l) There is a wider public interest. One of the Receivers who I was involved with subsequently sued the Bank of England using the same smear tactics deployed against me. (m) The above problems will not be rectified without a change in the law and in the approach to dealing with banks and their receivers. There is no point in the government wondering why banks act as if they are above the law, when they are in fact above the law. Recommenations for Action 1. The law should be changed so as disallow the banks demanding instant repayment of overdrafts, which is clearly impractical. 2. The courts dealing with receiverships should no longer be presided over by judges alone. Two small business representatives should sit alongside the judge. A levy can be placed on the banks to pay for this. 3. The owners of a business should be able to ask the courts to investigate a receivership for any reason. 4. The law should be changed to impose a duty of care on the banks to their customers, and to ensure that banks are obliged to mitigate their losses. Banks should be liable for negligence just as is the rest of society. 5. Banks should no longer be able to charge interest or other costs on borrowings once they have foreclosed on a customer. The outstanding debt should be frozen as at the date of foreclosure. 6. Neither the banks nor their customers [nor receivers] should be allowed to claim legal costs for a court hearing. If a party chooses to employ lawyers then they would be of course free to do so, but it will be at their own expense. Presently a businessman cannot claim legal aid relating to a business matter and, especially in a foreclosure situation, he is at a complete disadvantage. A bank should be able to explain to a court the financial position without the aid of barristers and solicitors. This will be made easier if business people are sitting alongside the judge as they will be able to draw upon their own business experience and knowledge. 7. When banks or receivers have behaved in a criminal manner, they should be prosecuted with the full force of the law. The police should no longer be allowed to turn a blind eye to criminality. 8. Judges who aid and abet criminality by the banks should be struck off—if not prosecuted. 9. The banks and receivers should not be allowed to sell customer assets either to themselves or their agents and subcontractors. This should be a criminal offence. The owner of an asset should be allowed an opportunity to match a bid from another source. 10. Reports produced by receivers should be disclosed to the owners of a business as a matter of routine. They should not be able to continue operating in secret. Banks should likewise disclose full details of their expected recovery of a debt and the expected amount that will need to be written off. 5 October 2012

Written evidence from the CBI The Provision of Derivatives by Ring-fenced Banks 1. The CBI contribution to the ring-fence debate focuses on the “business user” view of the banking system, helping to align the stability and resolvability objectives of the ring-fence with the need for banks to continue to provide the services businesses need to grow. 2. This submission makes the following points: — Businesses should be able to hedge risk from price fluctuations directly with a ring-fenced bank. — Good progress has been made to define a “simple” derivative but further work is needed. — Requiring full validation of the purpose of a derivative contract is too restrictive. — The FCA has an important role to play in determining the appropriateness of individual products and policing their market deployment.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1515

Businesses should be able to Hedge Risk from Price Fluctuations Directly with a Ring-fenced Bank 3. When appropriately marketed and sold, the ability to manage normal business risk arising from fluctuations in currency, interest rates and commodity prices, for example, is important for businesses seeking to grow. This is particularly true of those looking to export to new overseas markets. 4. Small and medium-sized businesses in particular greatly value a single, comprehensive relationship with their principle provider of banking services and this relationship should include the provision of hedging products. 5. Indeed one of the implicit aims of the ring-fence, in comparison to full structural separation, is to preserve certain aspects of the universal model including a diverse product range. 6. Excluding the sale of simple derivatives from inside the ring-fence would increase costs on business. A split banking proposition involving dealings with a ring-fenced bank (RFB) derivative contract from a nonring-fenced bank (NRFB) would result in additional costs for the business, given that the NRFB will require collateral to cover the risk in the derivative contract, whereas the RFB is likely to have existing security that may already cover the transaction. Good Progress has been made to Define a “Simple” Derivative but Further Work is Needed 7. The CBI welcomes the good progress made towards a concise and durable definition of a “simple” derivative. The CBI is supportive of the requirement that only simple derivatives be sold to customers from the RFB. However the proposed restriction based on BIPRU 7.10.21(1) seems unduly restrictive in that it would prevent customers purchasing some relatively simple derivative products such as interest rate caps or foreign exchange options which may be better suited to customer needs. 8. The limitation to offer products only if there is evidence available to assess fair value in accordance with IFRS 13, where that evidence would be considered to constitute a level 1 or a level 2 input, is intended to ensure products or their component parts are traded on liquid markets, with observable prices. While the CBI supports this approach in principle, the application of these rules is complex and this proposal would benefit from further analysis to ensure that it does not inadvertently limit business access to appropriate products. Requiring Full Validation of the Purpose of a Derivative Contract is too Restrictive 9. Attempting to validate the specific purpose of a derivative contract, including distinguishing between its “main” or “sole” purpose, seems too forensic an approach. The differing circumstances applying to the use of derivatives contracts by different businesses makes determining their purpose beyond doubt extremely difficult. For example, a bank cannot see a client’s order book/outgoings, which would be necessary to fully validate the purpose of a foreign exchange hedge that they would like to place. 10. A more balanced approach would be that a RFB be required to take reasonable steps to satisfy itself that the hedge is consistent with a business’ commercial needs and not for speculative or other purposes. 11. This broader approach to determining the purpose of a derivative contract would be supported by a strong conduct framework, policed by the FCA, such that the bank could satisfy the regulator it has taken the reasonable steps set out above (paragraph 10). The FCA has an Important Role to Play in Determining the Appropriateness of Individual Products 12. In evidence previously submitted to the Parliamentary Commission, the CBI called for a greater focus from the regulator on product governance. We stated that, “the Financial Conduct Authority should therefore focus on product governance throughout the product life cycle, rather than the products themselves. This would include focussing on the process of designing new products including the approval process; financial promotions and marketing; the sales process; and customer satisfaction and complaints monitoring.” 13. It is important that the FCA has strong powers to police individual products. Indeed the FCA now has these powers under the Conduct of Business regulations. These powers ensure that banks are effectively assessing the suitability of a product for a particular business and should be exercised in relation to the sale of derivative products by RFBs. 27 March 2013

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1516 Parliamentary Commission on Banking Standards: Evidence

Further written evidence from The Chartered Banker Institute Registers Copies of the Institute’s registers of a) Fellows and members holding Chartered Banker status, b) mortgage advisers and c) other members (Associates) participating in the Institute’s CPD scheme, which are available to the public on request, are attached.380 Registers of individuals holding or studying for lower-level professional banking qualifications (approx. 6,500 individuals) or who previously studied qualifications which did not at the time lead to membership of the Institute (approx. 6,800 individuals) are not published. Are honorary members/fellows created currently and if so how? Honorary Fellowships have been awarded to the following individuals in recent years to recognize their contribution and service to the Institute, to the banking profession more generally and to the conduct of business more broadly. They are awarded by Council after consideration by a Nominations Committee.

Mr William Leslie Hutton Mr Kenneth Douglas Schofield Sir Angus Grossart The Reverend Group Captain Donald Wallace Sir John Ward Mr Edward Bowen (deceased) Mr Ewan Brown Sir William Purves Mr Angus McLennan

Type

Awarded

Honorary Fellowship Honorary Fellowship Lifetime Achievement Award Honorary Fellowship Honorary Fellowship Honorary Fellowship Lifetime Achievement Award Lifetime Achievement Award Honorary Fellowship

2005 2005 2007 2007 2007 2008 2008 2009 2012

In previous years, and in particular in the 1990s and early 2000s, Fellowships including full membership rights were awarded to senior industry figures to try to encourage them to support the Institute and, in particular, professional qualifications in their organizations. Following Simon Thompson’s appointment as Chief Executive, this policy was changed and today, Fellowships including full membership rights are awarded by Council to individuals who are either (a) existing members of the Institute deserving recognition, or (b) individuals with significant banking experience, whom Council believes have made a significant contribution to banking, or to the objectives of the Institute. Monitoring standards and the processes for taking action (and what type of action) against members and honorary members/fellows? (a) Institute Disciplinary Powers The Institute does not have statutory powers and is, for the most part, dependent on regulators and other competent bodies to investigate cases and take action. Notwithstanding this, the Institute does, where it can, take disciplinary action and a copy of the disciplinary procedures is attached. In summary the Institute may begin disciplinary proceedings when: —

Criminal sanctions have been imposed on a member;

—

Sanctions have been imposed by a regulator or other competent body;

—

The Institute is informed that a member has been dismissed by their employer for misconduct;

—

A member is believed to have knowingly breached the Institute’s CPD requirements;

—

A student is suspected of misconduct including cheating in exams and plagiarism; and

—

A complaint is received from a member of the public.

The Institute’s disciplinary committee comprises three members drawn from a panel of fellows and members, who may not sit on the Council. If the disciplinary committee considers that there has been a breach of the code it may impose one or more sanctions including expulsion from membership, suspension of membership for a specific period, as well as cancellation of passes in current or previous exams. The disciplinary committee will determine if the sanction(s) should be notified to the regulator, member’s employer or made publically available. 380

Not printed.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1517

(b) Monitoring of Chartered Banker Code of Professional Conduct and Professional Standards Implementation The CB:PSB member banks are putting in place systems and processes to ensure individual adherence to the Chartered Banker Code of Professional Conduct, and investigate any breaches. In July 2013 the member banks will be subject to the first annual review of implementation of the Chartered Banker Code of Professional Conduct and the Professional Standards. The review will comprise a)selfevaluation and b) an external audit by the Chartered Banker Institute. This monitoring process will be overseen by the CB:PSB Advisory Panel which comprises representatives of consumer and business groups. 11 January 2013

Letter from Jim Lindsay, President, Chartered Banker Institute As President of the Chartered Banker Institute, I represent nearly 12,000 “ordinary” retail and business bankers who have made, over the years, a personal commitment to gaining professional qualifications and supporting others who want to make similar commitments. For most of us, this has been a very significant undertaking in terms of time and expense, when professional qualifications and membership have not been supported by most employers nor encouraged by regulators. Until the end of last year I was Chief Executive Officer of Airdrie Savings Bank, a bank that, I believe, represents the kind of community banking we need more of in this country. I should make it clear that I am not, in any sense, a representative of the banking industry more widely. Following my colleague Simon Thompson’s recent appearance before the Parliamentary Commission on Banking Standards, I am writing to provide you, and the other members of the Commission, with further information on the Chartered Banker Institute’s Rules and Regulations, and, in particular, the situation regarding Mr Fred Goodwin’s continued membership. Not only is Mr. Goodwin’s continued membership of the Institute, in my view, a matter of very considerable concern to the great majority of our members, it is a legitimate matter of public interest and concern and I acknowledge that it is entirely appropriate that the Commission should question why he remains a member of the Institute. I would also like to take this opportunity to bring to your attention some of the wider implications for the future regulation of individuals working in the banking industry, and our proposals as to how this may be improved, as I agree with you that the current state of affairs is unsatisfactory, and a fresh start is needed. 1. The Chartered Banker Institute 1.1 The Institute is established by Royal Charter and the Privy Council has approved the Institute’s Rules relating to monitoring and sanctioning members. Further approval from the Privy Council is required for any changes to these. As an FSA Accredited Body (which relates to the issuing of Statements of Professional Standing for Retail Investment Advisers), the Institute’s Rules have also been approved by the FSA, who oversee the monitoring and discipline of relevant members. In practice, the same Rules apply to all members. 1.2 The Institute is also subject, as are other professional bodies in the UK, to a growing body of case law based on the application of Article 6 of the European Convention for the Protection of Human Rights and Fundamental Freedoms, most recently Kaur v Ilex (2011), which means we would be subject to legal challenge (likely to be successful, as I detail below), should my Council colleagues and I simply expel an individual from membership, without following due process. 1.3 Last year the Institute removed from our register more than 70 individuals who failed to comply with our Continuing Professional Development (CPD) requirement. In addition, sanctions were imposed on two students who were found to have breached our Examination Regulations, and, following the establishment of Disciplinary Committees, two members who had been investigated and sanctioned by regulators resigned, and will not be re-admitted to membership in the unlikely event they chose to re-apply. The Institute only has jurisdiction over current members, and it a member resigns we are unable to take the disciplinary process forward. 1.4 As you will be aware, all individuals have a right “to a fair... hearing by an independent and impartial tribunal” conferred by Article 6 of the European Convention tor the Protection of Human Rights and Fundamental Freedoms (1953). This includes professional disciplinary tribunals of the kind operated by the Institute and other UK professional bodies. There have been a growing number of cases in recent years of individuals succeeding in overturning the decisions of professional disciplinary tribunals via appeals based on Article 6, where this right has not been respected, which has led, together with the need for independent professional regulation to replace self-regulation, to the development of statutory, independent, quasi-judicial disciplinary regimes in many professions, of which good examples include the General Medical Council, General Teaching Councils, Chartered Accountancy bodies, and the Solicitors’ Regulatory Authority. These bodies, and others, have legal power and are able to conduct quasi-judicial disciplinary hearings that are far removed from the straightforward hearings conducted by professional bodies in the past.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1518 Parliamentary Commission on Banking Standards: Evidence

1.5 The key distinction between such bodies and the Chartered Banker Institute (and other professional bodies supporting bankers in the UK, such as the Chartered Institute of Securities and Investments) is that they are statutory bodies, or have some form of statutory underpinning, with legal powers to investigate individuals and operate disciplinary systems that are compatible with the protections conferred by the European Convention. As statutory bodies, they are able to bear the high costs of operating lengthy, quasi-judicial adjudication and sanctioning procedures as they are supported by industry levies and/or statutory membership. In banking, the FSA is the independent regulator investigating conduct matters relating to individuals on the FSA Register (encompassing some 38,000 individuals in banking), not the Chartered Banker Institute. 2. Mr. Goodwin’s Membership of the Chartered Banker Institute 2.1 Mr Goodwin, at the time (and remaining) a qualified Chartered Accountant, was made a Fellow of the Chartered Institute of Bankers in Scotland in the mid-1990s, whilst Deputy Chief Executive at Clydesdale Bank. 2.2 In 1997 Mr. Goodwin was nominated by Clydesdale Bank to be President of the Institute, for a two-year term. At that time the Institute Presidency rotated between the four main Scottish Banks who nominated a candidate in rotation. In 1999 he stepped down as President and played no further active role in the Institute. 2.3 The fact that Mr Goodwin remains a Fellow is clear from our register and has been well reported in the press. You may not be aware, however, that Mr. Goodwin appears to be a Fellow of at least one further organization which has given evidence to you in public session recently, as a search of the register of Chartered Accountants will show. 2.4 Following the collapse of the Royal Bank of Scotland (RBS), my Council colleagues and I (at the time, I was a Vice-President of the Institute) debated what action we could and should take against Mr. Goodwin. As you might imagine, we had received heated correspondence from members asking what action we were planning to take (including from current and former staff at RBS), and there was considerable media interest at the time too. Following what I can assure you was very considerable debate and discussion, and after seeking legal advice and consulting with other professional bodies, Council agreed in 2009 that it had no alternative but to continue to follow the Institute’s Rules and Regulations, and to apply them to Mr. Goodwin in the same way as they would be applied to any other individual. 2.5 In investigating the conduct of Mr. Goodwin, and, should they arise, other similar high-profile cases, it is not possible for a body with no statutory investigatory powers, such as the Institute, to ensure a fair hearing as required by the European Convention, for several reasons, most notably our inability to secure evidence that would ·be acceptable to a Court of Law. Furthermore, in a case such as Mr. Goodwin’s, where the FSA, as the statutory regulator, has investigated and not censured or sanctioned him, it would be impossible for us to reach a different conclusion without this being successfully challenged in court. To put it simply, if Mr. Goodwin has not been judged to have breached the FSA’s Principles for Approved Persons (APER), to which the Institute’s Code of Conduct has been mapped, he could not be judged by the Institute to have breached our Code of Conduct. Mr. Goodwin also remains on the Register of Chartered Accountants. 2.6 Clearly, the current situation is unsatisfactory to you and your Commission colleagues, and to the public at large. In the event that a legal or regulatory sanction is imposed on Mr. Goodwin, or indeed any other member of the Institute, you can be assured we will act as quickly as we can to ensure any such individual is removed from our register, as we have done with other individuals who have been censured or sanctioned. 3. Other High-Profile Members 3.1 It was suggested during the evidence session that there must be many more senior individuals implicated in the collapse of RBS and Bank of Scotland who remained members of the Institute. This is not the case, as can be seen from our publicly available membership register. Two high-profile individuals (Johnny Cameron and Peter Cummings) were members of the Institute but, following investigation and sanctions imposed by the Financial Services Authority (FSA), were removed from our register of members. 3.2 Most senior UK bankers are not, unfortunately, professionally qualified nor members of a relevant professional body, including our own—something we would like to see change, provided they are also subject to a regulatory regime which means they can be effectively “struck off” following investigation. 4. Monitoring and Disciplinary Powers 4.1 I hope you will understand, therefore, why, in investigating conduct matters such as this, the Institute can and does rely on investigations and sanctions imposed by the courts, or by relevant, competent regulators, primarily the FSA, but also including others such as the accountancy bodies, in cases where an individual is a member of such a body. I hope you will also understand why I cannot agree with the suggestion that we should take action against a member based on media reports and public opinion alone—in my view that would be an unprofessional approach and wholly inconsistent with the standards expected of a body such as the Institute to deal with such matters in an objective and dispassionate manner. Nor can I agree with the suggestion that, in the case of Mr Goodwin, we simply meet with him and ask him to leave. This would prejudice any future hearing that took place, and would also be an example of exactly the kind of “sweeping under the carpet” that has no place in a modern, professional, regulatory system.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1519

5. The Way Forward 5.1 Clearly, there is a need for the Commission to develop proposals and make recommendations to ensure that a strong professional culture in banking is developed, supported by widely-applied professional standards and a professional regulatory regime where bankers who do not meet the standards required can be effectively monitored, investigated and, where need be, struck off. 5.2 The members of the Chartered Banker Institute want to see this too. As Mr. Thompson stated, the Institute has tried to bring the issue of culture and standards in banking to the attention of regulators and policy-makers, as well as to senior bankers, for many years. Most recently, you will recall the evidence we submitted on this subject to the Treasury Select Committee on Financial Regulation in September 2010, and we submitted similar evidence urging regulators to look at standards and culture to the Independent Commission on Banking. We publicly supported the Future of Banking Commission’s report, and have consistently, over at least the past 10 years, sought to persuade the FSA in particular of the need to develop and embed higher professional standards in banking, with little support until recently. 5.3 As a number of submissions to the Commission have made clear, the Institute took the initiative in 2008 to seek support for and establish a professional standards board for bankers, the Chartered Banker Professional Standards Board (CB:PSB). The Code of Conduct developed by the CB:PSB has been subscribed to by banks accounting for 75% of UK banking employees, and 70,000 individuals will have met the CB:PSB’s Foundation Standard for Professional Bankers by July 2013. The CB:PSB has considered and resolved many of the key issues currently under discussion, including: — How can a Code be implemented and enforced? — To whom should professional standards apply? — How can professional standards be successfully implemented, monitored and enforced? — How can customers and other stakeholders be involved in the standards-setting and monitoring process? I would urge you and your colleagues to look closely at the CB:PSB’s work to date, therefore. It is unique in that it is not just talking about culture and standards; it is actually implementing professional standards in banking. 5.4 The Institute and CB:PSB will, in the near future, submit further evidence to the Commission, setting out in greater detail our views on the issues above, building on proposals from the BBA, CB:PSB and others. In brief, however, we believe that: (a) The great majority of, if not all individuals working in UK banking should be subject to an industry-wide Code of Conduct, and expected to meet professional standards supporting such a Code; (b) The existing Code and professional standards developed and promulgated by the CB:PSB should be further expanded to form the basis of an industry-wide Code, given their coverage of 75% of UK banking employees; (c) The Code and standards should, in future, be overseen and enforced either by the FCA, via an extension to the Approved Persons Regime and the Register, by a new independent registrar, or by some combination of the two; (d) The current FSA Accredited Body regime should be extended to cover many more senior individuals and key, customer-facing roles in banking, so that the system for monitoring and enforcing professional standards is consistently overseen by the regulator; (e) Breaches of the Code of Conduct should be investigated by the FCA, or a new independent registrar; (f) Relevant professional bodies should support the work of the FCA or a new independent registrar by developing relevant professional qualifications and CPO schemes to develop bankers’ ethical and professional competence; (g) Greater numbers of senior executives, and other key individuals within banks, should be required to hold relevant, Chartered level, professional banking qualifications; (h) There should be greater encouragement from regulators for bankers in key customer-facing and customer-supporting roles to achieve relevant, professional banking qualifications, and firms should be asked to provide evidence to the regulator of their plans in this regard; and (i) Regulators should seek evidence of an individual’s positive commitment to and promotion of professionalism in banking when considering their suitability for Significant Influence Functions and other key roles. I hope you will find this submission on behalf of the Chartered Banker Institute helpful. My colleagues and I are happy to provide further information should you require this. 25 January 2013

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1520 Parliamentary Commission on Banking Standards: Evidence

Written evidence from Malcolm Crow Improving Banking Standards—An Outline Approach The content of this document are my own personal views, and not endorsed in any way by Skandinaviska Enskilda Banken AB, my Swedish bank employer for the last 30 years. Background The suggested approach is based upon the following considerations: 1. There has indeed been a behavioural problem in certain sectors of banking, in certain institutions. In a small number of cases this has been deliberate malfeasance, but generally it has been a reflection of a cultural malaise which puts profit and selling ahead of attention to the client’s needs. However, in many other parts of the industry, and in many organisations, there have not been material problems. 2. Given the declining returns to banks in the face of the increasing regulatory burden, whatever solution is adopted to alleviate the problem should be (a) effective, and (b) low cost—n particularly since in the last resort increased costs are likely to be passed on to the users of bank services and/or shareholders. This means building on what is already there ton the greatest extent possible, without adding anything that will not have a real impact in behaviour at the financial coal face. 3. The FSA’s regulation failed to prevent problems from arising—in part, because their regulations only gave them direct sanction over the defined Controlled Functions, and even then (outside of the high level Principles) only in relation to specific matters which they had recognised as needing regulation. 4. Adding new technical requirements to the FCA’s rulebook is unlikely to provide a universal solution, even within consumer-facing banking. Increasing requirements for mandatory training are unlikely to assist, save in a small number of customer-related functions, given that the problem arises more from cultural influences than a lack of education. 5. Equally, whilst most banks have had some form of a Code of Ethics (behaviour, morals or whatever) governing their staff, this has been insufficient to prevent abuses from arising. It is difficult to see how merely adding another layer of moral requirements above this will achieve any real impact. 6. Any high level mandated code of conduct faces the choice between being universally applicable or honed to deal with particular parts of the banking industry. In the first instance, it is likely to be based on universally acceptable broad standards, which are unlikely to add greatly to the FCA’s Principles. In the latter instance, it will require a great deal of work to target the code to particular business areas—resulting in a plethora of subcodes and training requirements, adding complexity and cost without actually bringing any real additional benefit. There is a great risk, therefore, that any British Banking Standards Board (call it what you will) will merely be a costly sinecure without producing any tangible additional benefit, other than appeasing the demand for action. 7. Equally, any mandatory ethical training, or membership/licensing requirement is going to: (i) involve great cost (welcomed by the providing institutions); (ii) result in restraint of trade problems and a reduction in the transfer of skills between countries and industries; and (iii) to the extent that withdrawal of membership/licence results in an inability to work in the sector again, provide a fruitful field for employment lawyers. The numbers of persons engaged in implementing and policing any such approach would be considerable. 8. Any approach which seeks to be targeted to specific sectors of the financial community runs foul of the problems inherent in attempting to define what “banking” is, and will result in arbitrary divisions between those functions covered, and those not—giving rise to the risk that coverage is later deemed to be too narrow when new risks are recognised (usually too late to prevent the resultant harm). 9. The ideal would therefore be a high level approach which is as universally applicable as possible, and which reinforces, and lies alongside, what is already in place. The Proposed Approach 10. If there is seen to be an overwhelming need for one, a new Banking Standards Board (the “Board”) comprising the great and the good could be formed to draw up a non-technical Model Code of behaviour for “bankers” in general , monitor the observance on this code at a high level, and produce guidance for both the banks and consumers. 11. I see no reason why such a Board should not be a Financial Industry Standards (rather than a “Banking”) Board—since (a) the standards should be as high level and universally applicable as possible, (b) this avoids the definitional problems identified above, and (c) it will broaden the effectiveness of the scheme without adding materially to the cost. 12. The Model Code would be endorsed by the FCA, which would require all financially regulated institutions under its purview to take steps to implement the functional equivalent of the Model Code within their organisations, incorporating it (or its locally adopted equivalent) into the employment contracts of all members of staff. If a firm did not adopt the Model Code itself, then the FCA could seek to approve (or at

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1521

least be given powers to seek modifications to) any local variant. There is no need to define which parts of the industry are within the code, and which not. 13. At this point it should be noted that the FCA could achieve precisely the same end on its own account, without any need for a new high level Board—which thus represents a costly palliative. In the event of there being no high level Board, any of the PRA, HM Treasury, or the Financial Services Ombudsman could be given authority to introduce potential adjustments to any FCA-based Code. 14. Whatever its origin, the Model Code would require firms to provide appropriate professional and ethical training to all employees. The precise scope and content of this training would not be mandated, but the Board/ FCA (and any bodies endorsed by it) could provide guidance. This requirement is effectively already enshrined in the SYSC principles governing regulated institutions. This would, however, stop short of requiring specific examinations or licensing registrations—since at heart, these are not necessary, and thus represent an unnecessary financial burden on the industry. 15. The Model Code would not only reinforce the existing encouragement for management to introduce whistle-blowing procedures, but would go further—by requiring the inclusion in employment contracts of a clause obligating the employee to bring to the attention of their superiors and/or their compliance officers any concerns the fact that it appeared to the employee (based on his/her technical understanding of the business) that the relevant internal requirements equivalent to the Model Code were not being met. Provided that the Model Code was simple, this would not represent too great a burden on the employee. 16. Each firm would be required by FCA rules to monitor the observance of its own internal equivalent of the Model Code. The existing compliance, audit and risk control functions within firms would assess the implications in the light of the Model Code of all findings of routine monitoring and incidents (including those indicated by internally generated reports analysing complaints received), and would report the results upwards, together with appropriate management information. This requirement could be added to the FSA’s requirements of such controlled functions, and of senior management in general. 17. Where individual breaches of the Model Code are identified, firms would be required by FCA Rules to take disciplinary action, to record this formally—and, possibly, to report the matter individually to the FCA, although this could be left to a periodic report, for which see further below. If the ability of firms to impose appropriate sanctions on persons responsible for breaches of the Code who are not themselves Controlled Functions, then the FCA could require submission and prior approval of proposed sanctions—although this would risk adding unnecessary administrative burden, and is perhaps thus a step too far. 18. The approach proposed above thus places the policing of the new order in relation to non-Controlled Function staff where it should be, namely within the context of the contract of employment. No new disciplinary bodies would be required, and any additional costs would be borne by the firms whose staff had failed to meet the required standard of behaviour. The Board/FCA would need to give guidance as to what forms of activity (in terms of breaches of technical rules relating to the conduct of business in specific areas) would amount to a breach of the Model Code. 19. When employees are dismissed for (or leave b y consent as a result of) material breaches of the Model Code (and where applicable, after any associated employment law proceeding have established the truth of the failing), their name would be forwarded to the Board/FCA which would record them on a central register. This is a sensitive matter for employees who do not fulfil a Controlled Function, but the interests of society as a whole should override those of the errant individual. This would produce a wider coverage and a more effective mechanism than the current requirement to inform the FSA of the reason for an Approved Person’s departure from his position, and is as equally effective and far less costly than any licensing requirement. 20. The central register of dismissed persons would retain the names of individuals only for a stated period; it would be available (directly or via an enquiry to the FCA) to the compliance officer of each firm, and firms would be required to review and take into account such entries when hiring new staff. Individuals appearing on the register might be taken on by firms subsequently—for example where they have changed their attitude/ behaviour, or where the circumstances leading to their entry are deemed not to be applicable to their new post); however, in such instances the justification for te proposed hire could be required to be submitted to the FCA for review. 21. Each firm or major division within large firms would have its own senior-management level Code Oversight Officer (much as it today has a Money Laundering Reporting Officer) , whose responsibility would be to ensure that the firm’s behaviour at the level of individuals was monitored effectively pursuant to the Model Code. 22. The FCA SYSC rules would require senior management to put in place arrangements to ensure that every HR, Audit, Risk Control, Compliance or other “incident” to be analysed for its implications in terms of a potential breach of the Code and recording the appropriate actions taken as a result. This position would be an FCA Controlled Function. This would form the basis of management information reports upwards within the organisation, demonstrating its effective compliance (or not) with the Code on an overall basis. There could be a requirement for quarterly reports to be forwarded to the FCA for oversight review and potential prompt corrective action.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1522 Parliamentary Commission on Banking Standards: Evidence

23. The board of each firm would have a non-executive director whose responsibility would be to ensure that the firm’s behaviour and reporting in this area was effective. 24. The board of each firm would oversee the production and publication of an annual formal report on the arrangements in place and the extent to which the firm had met the behavioural standards underpinning the Model Code. This report would be made public, and would be forwarded to the FCA/Board. 25. The Board/FCA would review all such reports, and produce a high-level report into the efficacy of the Model Code Regime for the financial industry as a whole (potentially analysing it in terms of the different sections of the industry. The Board/FCA would be able to publicly criticise those institutions which in its eyes fall short of the requirements. 26. If there was a Board, it would be granted the status of Super Complainant, and would thus be able to encourage consumers to bring matters to its attention. It would not investigate them itself (since this would require a larger level of staffing support than is necessary), but would passing them on to the FCA, which would then either launch its own investigation (to the extent that the matter implicated a Controlled Function), or require the senior management of the firm involved to do so and to report back. 27. There would thus be no need for the FCA to greatly expand the Approved Person regime (which would place additional staffing requirements on it), since it could require firms to accept the costs of sorting out their own internal miscreants. Of course, if firms have failed to put in place appropriate arrangements, then the relevant Approved person would be sanctioned for a failure to observe the SYSC rules. 28. The regime would apply (as in the case of the Bribery Act) to all branches and subsidiaries (wherever located) of UK incorporated financial institutions, and to all UK branches of foreign financial institutions. 17 April 2013

Written evidence from Bruce Dalton Preface On 26 July 2012, Andrew Tyrie, MP leading The Parliamentary Commission on Banking Standards called for written evidence of how far standards in British banking had declined |*| “We need evidence to gauge both the scale of the problem and to identify likely remedies.” he said, and asked whether there was ever a “golden age” of British banking. |FT 27 Jul 2012| The Commission’s solicition for evidence lists many questions including the following: The Commission would welcome responses to the following initial questions: 1. To what extent are professional standards in UK banking absent or defective? 2. What have been the consequences of the above for (a) consumers, both retail and ...? 3. What have been the consequences of any problems identified in question 1 for public trust and in, expectation of the banking sector? ……… 5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action... ? 6. Are the changes proposed by (a) Government, (b) regulators and (c) the industry sufficient? Re: Questions 1, 2 & 3 As evidence of how low standards have sunk this memorandum cites specific examples |*|of dishonourable behaviour by banks, including deliberate breaches of the key term they had advertised and promoted as a permanent—“for ever”—benefit of becoming a customer. This memorandum also cites examples of behaviour by the Nationwide Building Society which torpedo the myth that its mutuality makes it very different from the untrustworthy banks. Re: Questions 5 & 6 Although a solution to the decline of trust in banks, and the retail financial sector as a whole, is not formulated, aspects of the changes needed and a key feature of the means of achieving them are recommended—as those currently on offer from the Government are inadequate.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1523

Introduction & Summary 1. Trust — —

—

Banks continually offer a master class in how not to foster trust, let alone rebuild it. Banks breach crucial terms they previously promoted extensively as promised benefits “for life” or “for ever” of contractual agreements enshrined in their products. Specific shameful named examples include business banking accounts and credit cards. Banks are currently stepping up their campaign, incredibly with the public support of Lord Adair Turner, chairman of their regulator, the Financial Services Authority, to breach the “free-if-in-credit” contract terms for current accounts by imposing fees.

[Paragraphs 2 and 3 redacted] 1. Trust The surest way for regulators to reinforce the public’s distrust of banks and the financial sector as a whole, is to allow banks to breach contract terms such as “free-if-in-credit” banking—especially as banks hide behind the regulator &/or small print to do so. Consider three instances … (1) Santander Business Accounts: Not “free forever” On Sunday 29 July 2012 the story broke in these tweets and on BBC NEWS. Tweets by Paul Lewis (@paullewismoney) Presenter BBC Radio 4’s Money Box Santander reneges on promise of “Free day to day business banking forever” and imposes £7.50 a month charge on 230,000 business customers. “Free day to day business banking forever could mean a real and lasting benefit for your business” but Santander reneges with £90 a year fee. “We guarantee that unless there are ... changes to the law ... you’ll benefit from free day to day business banking forever” or bank charges £90. Santander ends free business banking on accounts which were sold as “free” with “no time limits ...” with £90 charge from later in 2012. Santander says T&Cs allow it to make £90 a year charge on 230k biz accounts on 60 days notice despite promise of “free banking for ever”. Extracts from the report on BBC NEWS Money About 230,000 small businesses that bank with Santander have been told that their accounts, supposedly free for ever, will now cost £7.50 a month. The word “forever” is emblazoned in big blue letters on the brochure so the application of a new monthly fee is in clear contradiction to its original marketing promise. Both the Financial Ombudsman Service (FOS) and the Financial Services Authority (FSA) have advised ... to complain to Santander in the first instance, ... The Federation of Small Businesses (FSB) says it is investigating whether bank may be in breach of contract. The terms and conditions of account make it clear that they can be varied by the bank with proper warning. The bank says it will issue all its customers with the required 60 days notice. Chris Warner, a lawyer at the consumers’ association Which? warned that small businesses do not have the same legal protection against being taken by surprise by the small print in contracts. “Businesses are not protected as consumers are against unfair terms in contracts,” he explained. Marc Gander, of Consumer Action Group, says ... should think about going to the County Court to obtain a judgement that Santander has breached its obligation to treat customers fairly, under the Banking Conduct of Business (BCOB) regulations. “These regulations set a statutory duty on banks to act fairly. They are hugely powerful but no-one seems interested in using them.” (2) Access and Barclaycard promises “Never” to charge an annual fee The Access credit card, issued jointly by Lloyds, NatWest and Midland banks, and Barclays’ Barclaycard were the first credit cards marketed in Britain. Consumers were wary of credit cards and baulked at paying a fee for having a card. Throughout the 1970s and early 1980s large outdoor poster hoardings were saturated with advertisements for Access and Barclaycard promising there was no charge to have a card. Using a variety of clever advertising variations the headlines always promised the bank would “never” charge an annual fee for having an Access card or Barclaycard. The same message featured prominently in advertising on TV and in the press. In 1989 Access reneged and levied a fee (£12.00pa), and in 1990 Barclaycard did likewise. Like thousands of others I complained quoting their “never charge an annual fee” promise.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1524 Parliamentary Commission on Banking Standards: Evidence

Both replied without any mention of their “no fee” promise, instead boasting of their cards’ ancillary benefits ... [I still have the correspondence.] (3) Banks lobby for imposition of fees on existing “free-if-in-credit” current accounts My 30 July 2012 letter to Lord Turner, FSA chairman, copied to George Osborne MP, Chancellor of the Exchequer, after Lord Turner’s Banking at the Crossroads speech, which follows on next page [not printed], details why such a fee would fail to achieve its two objectives intended by proponents, and ineluctably instill intense distrust—not restore trust. [Pages 6 to 8 of Original Submission Not Printed] 2. Nationwide Building Society The Parliamentary Commission on Banking Standards should include Nationwide—which is effectively a “bank” as it operates, competes with and behaves like banks, despite its name not including “bank” and its mutuality structure—in its considerations and report. The Nationwide Building Society peddles the notion that its mutuality makes it nicer than its (implied nasty) bank competitors. Until Halifax Building Society demutualised the Halifax, which had been the largest society by far, was deservedly admired as the gold standard for rock-solid unimpeachable standards of behaviour. Well before the infamous rescue of HBOS (Halifax Bank of Scotland) by Lloyds Bank the Halifax halo had permanently slipped. Nationwide promotes itself as the modern equivalent of the old Halifax: large and safe, reliable and decent in its dealings, impeccable traditional standards of service. Nationwide’s current theme in all its advertising, literature and branches is: ON YOUR SIDE. Nationwide’s smug self-righteousness is breathtaking in its Orwellianism. Every time I visit a branch to transact on my savings account and hand my passbook to the clerk behind the screen, the clerk delays me, and everyone in the queue behind me, by using one of the sales strategies which is drilled into them during so-called customer service training to ensare customers into having a “review with one of our advisers”. After I decline, they often continue the sales pitch by asking me to defend my refusal. The atmosphere becomes sour and strained. Sometimes I’ve been treated as some kind of inferior idiot when the clerk or their supervisor bleats: “s/he was only trying to help you”. A blind person visiting Nationwide could easily think they were at their bank. The unrelenting sales culture which has permeated banks is equally dominant in Nationwide. Jeff Prestridge, Editor Financial Mail on Sunday, and Personal Finance Journalist of the Year, wrote on 23 August 2009: “Nationwide likes to think it is whiter that white and that it can simply do no wrong. Yet, this isn’t the case. It is showing a commercial ruthlessness usually reserved for the nasty banks. Low savings rates and poor service have generated anger. [the] poll indicates that more than 70% of customers are unhappy. With grumbling of discontent among some branch staff over work practices and greater pressure to sell more products, Nationwide isn’t the happy ship it wants the world to think it is.” And on 4 July 2010 he wrote: “Nationwide is in danger of doing irreparable damage to its brand unless it gets a grip on its chronic service problems. The truth is that it is no better than the banks. Incompetent monoliths such as Nationwide need to change. Their bosses need to wake up and realize that a mindset that says ‘I am unable to provide a timescale at present’ is a mindset not fit to do business.” (1) Payments Council: Plan to abolish cheques In January 2010 I wrote to Nationwide chief executive Graham Beale, enclosing a copy of my letter to the Payments Council detailing ample evidence of the permanent harm banks would inflict on consumers if the planned abolition of cheques was allowed. l also highlighted it would be impossible to operate my branch-based passbook operated savings account without cheques, and sought his support to prevent cheque abolition. Nationwide’s reply, from the senior manager, corporate affairs, assured me Nationwide would abide by the decision of the Payments Council Board. Nationwide sat on the Board! So it legitimised its support for cheque abolition by reference to and hiding behind itself. This contravened the ancient principle of nemo judex in sua causa—which holds that any body cannot be a judge in its own proceedings. To partially get around the forthcoming absence of cheques, the senior manager advised me to open a Nationwide current account. In July 2010 I wrote to Nationwide chairman Geoffrey Howe, explaining why I would not be supporting the Board at the forthcoming 2010 AGM. Nationwide’s then theme was: “You talk. We listen”. The AGM voting guide leaflet boasted: “Your needs set our agenda”. After summarising my letter to Graham Beale, and his senior manager’s reply, I wrote:

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1525

“Fundamental flaws in the application of such a convoluted series of transactions, let alone the inconvenience of having to open and operate an extra bank account with concomitant need to: maintain files of statements, letters and literature, have more security numbers; and complicate my tax return, instead of continuing with complete convenience, immediacy and security of cheques, attests to NVV’s refusal to put my needs first. I should be obliged if you would please place NW’s support for cheque abolition—a cause not endorsed by all your peer building society chairman and chief executives in letters to me—on agenda of NW’s next board meeting with a recommendation to reverse NW’s support.” The Nationwide chairman’s reply included whole paragraphs unrelated to the subject, eg two template-type paragraphs excusing Nationwide’s appalling service on its ISA business! Then he wrote “[cheque abolition] should not inhibit our employees from taking ownership of a customer service issue.” (I defy anyone to explain what that means?) He concluded Nationwide would continue to support abolition of cheques, adding sentences verbatim I recognised from Payments Council Newsletters, press releases and answers given by Sandra Quinn. its director of communications, on Radio 4 and BBC NEWS. It would have been delicious retribution for the Nationwide chairman and chief executive if they had been witnesses alongside the Payments Council executives, at the Treasury select committee oral hearing on The Future of Cheques in Committee Room 8, at the Palace of Westminster, on Wednesday 15 June 2011, when the TSC chairman Andrew Tyrie MP used the letter written by Mark Hoban MP, Financial Secretary to the Treasury, the previous day (14 June 2011) to reduce the Payments Council witnesses to jibbering dust. —

QED—Nationwide is as bad as banks. But worse than banks because Nationwide hides behind its mutuality to claim it is superior. The truth is it’s: Nasty Nationwide.

(2) Nationwide Chief Executive’s response to its near—£1 million fine for risking customers’ security In February 2007 Nationwide was fined almost £1 million for risking customers’ security when a laptop, on which customer details were stored, was stolen from an employee’s home. Nationwide said its chief executive had apologised in writing to all 11 million members. Most of the letter, headed: THIS IS IMPORTANT PLEASE READ CAREFULLY was dedicated to telling customers how they could improve their own security by following some simple steps all listed in bold paragraphs, and enclosed two leaflets on protection from fraud. The irony of this was that Nationwide’s chief executive had the bare-faced cheek to lecture customers on the “simple steps” they should take to protect themselves from identity theft, when it was Nationwide itself that needed lessons in basic security, not its customers. —

That was the type of letter one would expect a bank chief executive to write.

(3) Nationwide thinks 50,000 customers is a “small” number to be debited twice incorrectly On one day in July 2012 Nationwide processed all its customers’ debit card transaction made that day, and again the next day, ie it debited current accounts twice for same sum. In an official statement, Jenny Groves, Nationwide’s divisional director, said that of the 704,426 accounts affected a “small” number “estimated to be less than 50,000” had been “adversely impacted”. It’s difficult to imagine even Barclays, HSBC, Lloyds or NatWest banks admitting they regard any five-figure number of customers adversely impacted by their own staff’s incompetence as a “small” number. —

Nationwide’s statement reveals it really is different from banks, but—embarrassingly— not in the way Nationwide would like us to believe.

3. Project Verde: “Evasive action” to stay with Lloyds The sale of 632 branches by Lloyds Banking Group to satisfy EU state-aid demands, known as Project Verde, has a concomitant total embargo on any proactive promotion or activity by Lloyds to highlight advantages to customers of the branches about to be sold, of remaining with Lloyds, albeit no longer registered with the same branch. But, if customers ask what steps they need to take to ensure they remain with Lloyds, Lloyds must— obviously—provide full information without any obfuscation or delay. The information I was twice given in writing, the second time after a newspaper story prompted me to ask for the information to be confirmed “with absolute cast iron total certainty after verification with Lloyds head office”, is—according to two financial journalists who were briefed by and questioned Lloyds on 19 July 2012, the day Lloyds announced the sale of the named 632 branches to the Co-Op, whom I spoke to that night— “absolutely wrong, it’s completely untrue”.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1526 Parliamentary Commission on Banking Standards: Evidence

[Redacted last 3 Paragraphs of this Section] [Pages 12 and 13 in Original Submission Not Printed] Effective remedial change I do not have a solution to remedy the decline in banking standards, as typified in the foregone examples of my own experience of appalling bankers’ behaviour. But, I recommend the Commission considers adopting certain principles and pointers to formulate the direction and thrust of its recommendations for effective remedial action, namely: 1. Bankers will only be deterred by FORCE and knowing they will SUFFER PERSONALLY if they transgress. Commitments of adherence to Principles or Codes of Good Practice are a waste of time. Think: the defunct Banking Code Standards Board, and the FSA’s Treating Customers Fairly principles—more honoured in the breech than in practice. 2. Recommendations alone, however perfect and apposite, no matter how much they are “welcomed” by ministers who routinely swear they are “committed” to solving the problem which has “highest priority”, will never change bankers’ behaviour without those recommendations being enshrined in Statute and/or Statutory Regulations, then policed with sufficient resources to catch miscreants, and enforced effectively with severe punishments affecting bank directors and senior executives personally—to act as an effective deterrent to others. 3. Directors and senior executives of offending banks must be punished so it hurts them personally—not just namby pamby bans from holding jobs in the financial sector—but by sufficiently large personal fines to reduce their personal wealth substantially and by long prison terms sufficient to deprive them of their liberty (without parole) for years. [Mega million pound fines on the corporate bank entities themselves are ineffective. They penalise shareholders, not the bank’s directors and senior directors responsible. Shareholder institutions have proved useless in eradicating banks’ disgusting treatment of customers. Fund managers and pension funds care only about a bank’s share price and dividend paying prospects next quarter and next year. Its cloud cuckoo land to think fund managers and institutional shareholders will do what only government must do.] 4. Re: Report by Sir John Vickers, Independent Commission on Banking, and government’s current legislative proposals for implementation of the ICB’s recommendations: Just “ringfencing” the retail from the investment business (the commercial from casino) is insufficient. It invites trouble for the future. It must be enforced total “separation”. Anyone who sat and listened to the whole of Treasury select committee oral hearings with ICB commissioners themselves, and with the chief executives from four banks, would never buy the bankers’ self-interested arguments for avoiding separation. 5. Yes, there was a “golden age” of banking. I remember it well in the 1940s and 1950s. Captain Mainwaring of Dad’s Army fame may be a character of fun and fond derision, but the real bank managers of his era were the apogee of total trust and respectability. They were universally held as the most honourable of men, with unimpeachable integrity who genuinely knew all the customers of their branch—face-to-face, not as a number. 6. Branch staff were of the same ilk, studied for banking exams, and behaved impeccably. All banks’ senior executives had ascended to their roles after many decades of experience on the front line in branches, working up through various grades of clerk and manager. The ethos, the culture, the mindset was: they were bankers—and they behaved as such. 7. Retail banking is simply a utility service. A simple service all retail customers need. Customers don’t need (to be sold) ancillary products or services such as: investments; pensions; life assurance; household or motor, travel or pet insurance; identity protection insurance; etc from banks. 8. Bankers must be re-focussed back onto pure retail banking, and compete on service. 9. Bank directors and shareholders must adjust how bank shares are expected to perform accordingly, ie as equivalents of gas, electricity, water or land line (only) company shares. 10. Banks must radically change the desired profile for staff recruitment (no longer taking on someone just because they’ve had sales experience at Marks & Spencer or PC World). 11. Banks need to attract and train staff who want to be actual bankers—not salesmen. 12. Bank staff must study (in their own time = commitment) for and pass bank CIB exams. 13. Bank in-house training must be on real customer service, not sales masquerading as such. 14. Banks must not be allowed to use call centres outside the UK—no matter how much training in English and British idiom, ways and culture foreign staff are given. 15. All executive directors and senior executives must work periodically full-time for two consecutive days in a branch and in a call centre (ie total four days), dealing personally with customers face to face or on the phone, every quarter (ie 4 times per year).

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1527

16. Instead of giving seal of acceptance that poor current account balance management by customers is inevitable, and devising services (initially free, but probably for a fee later) to “help” their undisciplined or imprudent customers, banks must promote thrift, saving and current bank account balance management in interest of the customer, not the bank. The mantra: Instead of buying on credit, if you really want it, you can save up for it. 17. nb: Bank support for financial education in schools is commendable, but no matter how much money banks deploy in such support, it’s the change in culture manifested in what happens in branches and over the phone in call centres that matters. Every bank senior executive, manager, supervisor and clerk needs a root and branch [no pun intended] reversal of how they were trained, and how they are now assessed and rewarded. 18. Three related insights (below) are critical as the key to achieve effective change in banks: — “Any organisation that has poor service will have a management that tolerates those conditions.” — “Customer service is about a mindset, not about a set of rules and regulations. It’s instinctive and reactive. Be under no illusion, super-service spreads from the top down. Senior staff set the tenor and style of performance.” — “A fish rots from the head down!” Without a total clearout of current bank directors and all senior executives, exchanging them for an entirely different breed, with the mind set and motivation fit and a tuned to direct and manage a purely retail bank, and proud to be part of a “boring” retail bank, the cultural change necessary to revert back to the “golden age” of banking will never be achieved throughout each bank’s head office hierarchy, and its branch and call centre regional/area managements, to reach the branch and call centre staff on a sustained basis. By doing all the above the government can achieve banking nirvana for retail customers. Ritual grumbling about “bloody” banks will fade away, and complaints about banks will rarely feature on the Financial Ombudsman Service radar. 1 August 2012

Written evidence from the Financial Conduct Authority ENHANCING ACCOUNTABILITY WITHIN THE FINANCIAL SERVICES SECTOR 1. Further to our written evidence (dated 18 January), and the evidence session of 27 February (involving FSA Executive Chairman, Adair Turner, and FCA Chief Executive, Martin Wheatley), this memo sets out the requested detail on improving individual accountability within the financial services sector. This note focuses firstly on the areas within our control under the existing legislative arrangements and then goes on to highlight some potential legislative improvements. 2. In the FCA context, we plan to continue with our increased emphasis on ensuring accountability for approved persons across all stages of the regulatory lifecycle (ie at authorisation, supervision and enforcement) and across all firms. This is a continuation of the priority work which began in the FSA and was referred to in the 18 January submission. In this memo, we expand on these issues further, providing an overview of measures the FCA is taking to enhance individual accountability across firms. We plan to publish the outcome of this work following our consideration of your final recommendations. Similarly, this is an area of focus for the Prudential Regulation Authority (PRA), and we will continue to work in close cooperation with them going forward. 3. Through all our efforts in this area, the focus is firmly on firms themselves, and in particular their senior management and board, for ensuring the correct corporate governance and high standards within financial services firms. Vision 4. The FCA’s vision for approved persons is that firms have the right people in the right roles to promote the right culture, governance and conduct of firms to achieve fair outcomes for consumers and ensure market integrity. 5. To deliver this vision, the regime needs to: — Facilitate messaging of the expected standards and obligations we set out in the Statements of Principle and Code of Practice for Approved Persons (APER); — Provide deterrence—a hurdle that keeps out those that do not meet the required standards and encourages positive behaviours of those in the regime; —

Enable firms and the FCA to check for past misdemeanours or other adverse information;

—

Enable the assessment of an individual’s fitness at the gateway and on an on-going basis;

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1528 Parliamentary Commission on Banking Standards: Evidence

— — —

Assist supervisability—transparency of roles and responsibilities within a firm, enabling supervisors to monitor and challenge performance and delivery where required; Reinforce personal accountability to the regulator—firms and the FCA know who is responsible for delivery of the firm’s obligations; and Ensure effective enforcement activity.

6. And the outcome for approved persons that we seek to achieve from this focus is that: — Firms’ due diligence in assessing the fitness and propriety of their candidates is robust; — Firms are clear about how and why they have delegated responsibility and to whom—and ensure continuous monitoring of those delegations; — Approved persons take their responsibilities for meeting expected standards seriously; and meet those standards through their lifecycle as an approved person, act as a role model and promote positive behaviours. Previous Submissions 7. As set out in our previous submissions, there are some additional powers that we believe would enhance our ability to ensure greater accountability of individuals within firms. 8. Whilst we consider our powers to be largely effective, there are some areas where we think legislative change may be required. With appropriate safeguards, we believe the following changes could help us address some of the existing limitations in this area: — We support HMT’s proposal for a rebuttable presumption against Directors of failed banks being re-approved as approved persons in new firms; — An additional rebuttable presumption to reverse the current starting position that we will not discipline someone simply because something went wrong in the area for which they were directly or indirectly responsible. This position could be reversed so that in certain circumstances and for particular types of misconduct, where something goes wrong in an area for which an individual is responsible, then they will be held accountable unless they can demonstrate that they took all reasonable steps to avoid the misconduct or that no other reasonable steps could have been taken. We consider that it is likely that legislative change is needed to effect this outcome, but we are currently doing some more analysis on this; — As highlighted in our submission of 18 January 2013, where mismanagement rather than deliberate misconduct is concerned, improved regulatory approaches such as those as mentioned above, with appropriate safeguards, rather than criminal sanctions is more likely to be successful. Extending criminal sanctions would provide a further credible deterrent if there was a real likelihood that successful prosecutions would take place in the future. However, we believe that the difficulties involved mean that this might not be the case; — The extension of the current limitation period of three years for taking disciplinary action against approved persons from the time the FCA becomes aware of the potential misconduct. An extension to six years, for example, would correspond with the standard limitation period for civil proceedings; — A power to prohibit an approved person from continuing to perform a controlled function on an interim basis whilst disciplinary investigations are ongoing; — A power to take action against individuals that commit misconduct, yet fall outside of the approved persons regime. This would be accompanied by the application of a code of conduct to these individuals, so they would be clear what behaviour was and was not acceptable; — The ability to require that approved persons must seek regulatory re-approval by the FCA if circumstances necessitate it. (For dual-regulated approved persons requiring re-approval, the FCA would have the ability to reconsider the consent previously given to the PRA.) This would cover situations such as: when the role performed by the person has changed sufficiently from the original position approved for (eg the firm significantly increasing in size/complexity or the scope of the role changing materially which may require different skills or skills at a different level); and where we have approved someone where the firm intends the individual to perform only an interim role (eg in emergency situations) but the individual then takes this role for a longer-term; and — The ability to approve individuals/roles for a specific limited period of time (beyond the provision in the existing Handbook for cover to be put in place for a period of up to 12 weeks without regulatory approval). This could be used in emergency situations where we need to approve an individual quickly but where the permanent appointment may take the firm/regulator longer to identify/approve. This could also be used in non-emergency situations where, for example, the FCA wishes to approve individuals only for the length of their initial contract. 9. We have identified other potential changes which could increase the likelihood of holding senior managers to account when failings occur which may not require legislative change. For example, we are considering

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1529

whether to strengthen the Statements of Principle issued under our approved persons regime to impose wider duties on senior management. This will be considered as part of a broader review of the APER section of our Rules in the light of the findings. We will progress these further in the context of your final recommendations. Banking Standards Board 10. There is one further area of possible legislative change which we would like to comment upon; proposals have been made by several respondents to the Commission for the establishment of a new independent statutory professional body, or “Banking Standards Board” (BSB), as a way of raising standards within the industry. There are a number of proposed models that have been put forward, but the basic idea is that such a body would license individuals working within the industry, and would have powers to take disciplinary action, including the removal of their license. 11. In our February submission, we expressed our concerns about the establishment of such a body, and we would like to expand on this. We think it would be helpful to separate consideration of this proposal between the ultimate ends, or objectives, which are sought, and whether the best means to achieve these would be the creation of a new body. 12. The objectives sought might include, for example, a wider application of a code of ethics to individuals working in the banking industry, an increased focus on training and an enhanced disciplinary procedure. We agree it is desirable to consider each of these, but we think any necessary changes could be achieved through amendment or modifications to the existing FCA and PRA approved persons regime, as proposed in paragraph eight above. 13. It is also possible that this could be achieved by creating a Banking Standards Board with statutory powers and responsibilities, but it is not clear why this would be a better approach. Such a body would either replace, and/or duplicate, functions that are already provided for in the existing regulatory framework. Rather than enhancing the framework and improving standards, the creation and staffing of what would effectively be a third regulator would create an overly complex regulatory structure, diluting the impact of the FCA. The creation of a separate BSB would take time, and its ongoing operation would impose additional costs to the banking industry, including to potential new entrants. 14. Whilst we would support proposals that seek to improve the professional standards of individual bankers, including the work that is already being done on a voluntary basis by the existing banking and financial services professional bodies, we do not think there is a compelling requirement to create an additional statutory body to sit alongside the FCA and PRA. Specific Activities in Progress to Enhance the Approved Persons Regime in the FCA 15. We are currently working on enhancing our approach to approved persons and individual accountability more generally within our existing legislative powers. Please find below an overview of some of our work in this area: 16. Review of Significant Influence Function (SIF) responsibilities—A pilot review of SIF holders within firms (which we have previously referred to as a “SIF Audit”) has commenced with the aim of establishing clear SIF responsibilities at firms, and whether individuals have been approved for controlled functions appropriate to their roles. This will also consider whether firms have appropriately identified and allocated key functions and activities to an accountable SIF. The first (pilot) stage of the review has commenced with a sample of 8 larger firms across different sectors. The results of this pilot review will be used to consider our approach to a full review of responsibilities of SIF holders at all larger firms and to inform our thinking on potential changes to our rules to introduce more specific controlled functions or approval for specific roles. 17. The overall aim of this activity is that the results of the review will enhance our supervision of senior management at firms, and make it easier to identify which SIF is responsible for a particular area or function when failings occur. 18. Increased enforcement focus on senior management—This has been clearly communicated to staff by Senior Management of the Enforcement and Financial Crime Division and we have increased the resources which are allocated to investigating senior managers at large firms. In practical terms, during investigations into failings at firms, we will place greater focus on obtaining information about which senior manager was responsible for the area where the failings occurred, their job description, how they were paid and what their targets or objectives were; and conducting an interview of the senior manager to understand their knowledge of and involvement in the failings. 19. We are also considering options for addressing the “accountability gap” by pursuing an approach of taking action against the most senior person who is responsible for the failings, even if they were comparatively junior. This would have the effect of bringing home to those individuals their own responsibility and may incentivise different behaviours such as better escalation of issues, more forceful demands for resources and a better audit trail of who knew what when. Over time, this may provide us with evidence to pursue more senior management.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1530 Parliamentary Commission on Banking Standards: Evidence

20. Communicating the FCA’s expectations of approved persons and the competency framework—Setting out our regulatory expectations of approved persons is a priority for the FCA. Through our external communications, supervisory work and ongoing engagement with industry we will emphasise the responsibilities of approved persons. 21. We are also developing a more explicit competency framework to provide a clearer articulation of the FCA’s expectations of SIF holders to be used to achieve more consistent and better justified assessments at both the authorisation gateway and during the supervision stage of an individual’s regulatory lifecycle. 22. Introduction of specific controlled functions or approval for specific roles—The FSA has previously published plans to introduce a number of new significant influence controlled functions within the approved persons regime (PS10/15, Effective Corporate Governance and the Walker Review). Implementation of these plans had to be deferred for operational reasons, and we are now considering these plans in light of the new regulatory framework. 23. Firms continue to be responsible for assessing the fitness and propriety of candidates, including an individual’s competence for the specific role to be undertaken. However, we are committed to enhancing our focus on specific key roles within firms, and by doing so improve our ability to i) assess an individual’s capability for a particular role, both at the gateway and afterwards, and ii) more readily identify those responsible for key functions within the firm. 24. This includes considering the existing scope of the approved person regime and what improvements can be made to identify key roles, as well as identifying if there are additional key roles that should be brought within the scope of the regime. All proposals will be consulted on as necessary, in due course. Conclusion 25. We hope that this is helpful in giving an overview of our ongoing work in relation to approved persons. The FCA will continue to work to enhance individual accountability and raise standards of corporate governance in authorised firms. 17 April 2013

Written evidence from the Financial Services Authority Further Details on the FSA’s Whistleblowing Service 1. This memorandum provides further details about the FSA’s whistleblowing service following the request from the Chairman of the Commission. What is the process the FSA follows when an individual blows the whistle? 2. There are three principle ways disclosures are received: by post, telephone and email. (a) Telephone calls are received on a dedicated recorded line which is publicised on the whistleblowing page of the FSA’s website. There are typically between 10 and 20 calls a day. (b) We receive about two to five disclosures by post daily; these are often anonymous disclosures because the postal system allows a whistleblower to ensure their disclosure cannot be traced. (c) Between fifteen to twenty-five whistleblowing disclosure emails are received daily to a dedicated secure inbox to which access is limited to ensure confidentiality. 3. Newly-received submissions are reviewed to ascertain whether they are disclosures that fulfil the criteria of the Public Interest Disclosure Act (PIDA) 1998, or, if not, nonetheless provide relevant intelligence the FSA can use to discharge its regulatory responsibilities. We afford the same level of security and confidentiality to all whistleblowers regardless of whether their disclosure is covered by the statutory safeguards set out in PIDA. 4. Disclosures are recorded in a secure auditable system. A small number of submissions are not progressed further because, for example, they are duplicates, are unclear and lack contact details for follow-up, they are illogical, or are malicious. When the whistleblowing team judges that the disclosures provide actionable intelligence, an intelligence report containing redacted information is prepared. This is passed to an appropriate member of staff in the FSA (such as a supervisor responsible for managing the FSA’s relationship with a firm named in the disclosure). 5. Some submissions are not about regulatory breaches or concern matters that sit outside our remit. The whistleblowing team will consider if another body should be advised of the redacted information: the officer may also advise the whistleblower to consider approaching an alternative body directly. 6. Once the redacted intelligence has been passed on, responsibility for further regulatory action sits with the recipient. Supervision will consider the information in the context of other material known to them about the firm or its circumstances. The whistleblowing team remains responsible for the ongoing management of the relationship between the FSA and the whistleblower. If further contact is required with a whistleblower for

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1531

any reason this is undertaken through the whistleblowing team, unless the whistleblower has provided their confirmation that they are willing to allow their contact details to be passed on to others. Who processes the information, and at what level? 7. The operation of the whistleblowing team is undertaken by an experienced senior associate, with a manager overseeing the whistleblowing operation. Lawyers are available to provide advice on specific cases. What response is provided to whistleblowers? 8. An acknowledgement is sent to the whistleblower if they have provided contact details and if it appears safe to do so. If an address, phone number or email address appears to be insecure or related to an employer we will not send an acknowledgement unless the whistleblower has specifically given authority for us to do so. This is in order to safeguard the whistleblower’s anonymity and confidentiality. Confidentiality provisions in the legislation under which the FSA operates prevent us from disclosing to the whistleblower details of the actions were taken as a consequence of their contacting us. As we have outlined in our “Journey to the FCA” document, in the interests of transparency the FCA will seek opportunities to provide feedback to whistleblowers where legally permissible. 9. As the FSA is unable to provide legal advice to whistleblowers, callers are regularly referred to Public Concern at Work, an independent charity whose aim is to provide advice and support to whistleblowers and promote the reporting of wrongdoing in the workplace. What protection is offered to whistleblowers? 10. The majority of individuals providing information place great store by the confidential manner in which their name and contact details are handled, and many ask us to explain how this takes place. The FSA has developed a secure system designed to protect whistleblowers’ information as far as is practically possible. The whistleblowing team only releases redacted information to others in the FSA or to other bodies to ensure a whistleblower’s identity is protected. The whistleblower’s express consent is requested before their contact details are passed beyond the whistleblowing team. Although we provide a confidential facility designed to protect a whistleblower’s identity, this is not an absolute guarantee of anonymity: circumstances may arise (such as a Court Order) which could force the FSA to divulge information, although this is relatively unlikely in practice. This is explained to all whistleblowers. 11. Care is also taken to ensure a whistleblower is not “tasked” to provide information to the FSA that is not already within their knowledge: for example, we would not ask the whistleblower to seek out documents able to corroborate their concerns. To do so may run the risk of making the whistleblower a “covert human intelligence source” (CHIS) under the Regulation of Investigatory Powers Act which would place further duties on us when handling contact with that individual. 12. Beyond the care exercised by the FSA, whistleblowers are protected by law. If a whistleblower is victimised or dismissed in breach of PIDA he can bring a claim to an employment tribunal for compensation. Awards are uncapped and based on the losses suffered. An element of aggravated damages can also be awarded. Presently where the whistleblower’s claim is for victimisation (but not dismissal) he may also be compensated for injury to feelings. Where the whistleblower is an employee and is sacked, he may, within seven days, seek interim relief so that his employment continues or is deemed to continue until the full hearing. What will happen after the FSA is replaced by the Financial Conduct Authority and the Prudential Regulatory Authority? 13. The FSA whistleblowing facility was established in 2001. After April 2013, the FSA’s existing whistleblowing facility will transfer to the FCA in its present form. The PRA intend to create a whistleblowing facility to accept disclosures, and will mirror the secure recording and database systems currently in place; the PRA has appointed an intelligence co-ordinator who will liaise directly with the FCA’s whistleblowing team on a day-to-day basis, and the two teams will cooperate to ensure both organisations benefit from intelligence arising from whistleblowing disclosures: it is intended there will be a free flow of redacted whistleblowing intelligence between the two bodies. Is it feasible to apply an obligation to employees who are not approved persons to blow the whistle? 14. The Statements of Principle for approved persons set out in the FSA’s Handbook of Rules and Guidance state “an approved person must deal with the FSA and with other regulators in an open and cooperative way and must disclose appropriately any information of which the FSA would reasonably expect notice” (Principle 4). As a consequence, an individual who is an approved person is arguably under a regulatory duty to disclose concerns they have about regulatory breaches to the FSA: the whistleblowing line is one option by which they may do so. It would not, however, be the only way. It should also be noted that appropriate internal disclosure could satisfy the obligation notwithstanding that, in fact, that information was not passed to the FSA.381 381

The FSA has published 31 Final Notices involving breaches of Principle 4.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1532 Parliamentary Commission on Banking Standards: Evidence

15. The FSA is only able to make rules which impose obligations on individuals if they carry out what FSMA describes as a “Controlled Function”. We are not therefore able to impose a reporting obligation on all employees of a regulated firm (although if the scope of the Principles were expanded as suggested in our submission of 18 January 2013, this would provide a route). We currently also note that our guidance to regulated firms on establishing internal whistle-blowing procedures in SYSC 18 in our Handbook covers all their “workers” and not just Approved Persons. What consideration has been given to introducing a US-style financial incentivisation system for whistleblowers, and what are the pros and cons of such an approach? 8 February 2013

Written evidence from the Financial Services Authority 1. This memorandum follows Martin Wheatley’s oral evidence to the Commission on 25 October. We set out below our current approach to whistleblowing, discuss the possibility of providing financial incentives to whistleblowers and set out how we might go about reducing the associated moral hazard. 2. We are already considering a number of steps that may encourage further whistleblowing. These are outlined below. However, on current evidence any potential benefit from providing financial incentives to whistleblowing would be outweighed by the disadvantages. We will however keep the international evidence and our position under review. The FSA’s Current Approach to Whistleblowing 3. We take all information received from whistleblowers extremely seriously, working to protect the confidentiality of the whistleblower and to ensure the information is followed up appropriately. 4. Our whistleblowing service receives over 3,500 contacts each year regarding the firms we regulate. The information is graded by our Intelligence Interface Team: about one in eight disclosures are judged to provide actionable intelligence382 and are passed to firm supervisors, our Unauthorised Business Department, Markets Division, or others as appropiate. The service has comprehensive procedures in place to ensure its duty of care and confidentiality to whistleblowers is maintained. Most whistleblowers are motivated by a perception they have identified regulatory breaches or conduct that they regard to be criminally or morally wrong. However, approximately one in ten appear motivated by frustration or animosity towards a current or former employer, while a much smaller number seem to have vexatious motives. 5. Our whistleblowing service sits alongside other measures that encourage the reporting of wrong-doing, including our contact centres dealing with the public and the arrangements in place for receiving suspicious transaction reports. We also place wider regulatory obligations on firms to deal with us in an open and cooperative way, and disclose issues of which we would reasonably expect notice. Protection provided by UK law to whistleblowers 6. Protection under law: The Public Interest Disclosure Act 1998 gives some protection to employees against dismissal or victimisation if they make “Protected Disclosures”, meaning disclosures made in good faith regarding actions and conduct which are criminal, dangerous or damaging. Public interest protections from disclosure also exist in the general law, under the Financial Services and Markets Act 2000 and in the Upper Tribunal. Public interest immunity can be used to protect the identity of whistleblowers if their material is presented to a court or tribunal, although this will be balanced against the potential for injustice to the defendant if the material is not disclosed. If it is consequently possible we may abandon a case rather than be required to disclose a whistleblower’s identity. 7. However, there are practical limits to the protections that may be available. If a whistleblower’s identity becomes public they may reasonably fear damage to their chances of future employment. It is unlikely any law could offer credible protection against this. Incentives for whistleblowing 8. While we do not provide financial incentives for whistleblowers, there are a number of other mechanisms by which we may seek to encourage whistleblowing reports or fill intelligence gaps. These include: (a) Support at employment tribunal: we are currently exploring what information we can provide to employment tribunals to support whistleblowers who have lost their position. (b) Publicity and awareness raising: we have seen an upward trend in the number of whistleblowing reports following increased media attention on the financial sector. 382

Many submissions are recorded but not progressed because, for example, they are not about regulatory breaches or are about matters that sit outside our remit, or because they are duplicates, unclear but with no contact details for follow-up, illogical, or clearly malicious.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1533

(c) Closing intelligence gaps: we are considering new sources of information to help us identify insider-dealing. This is sensitive for operational reasons. US Experience of Incentivising Whistleblowers 9. The 2010 Dodd-Frank Act created whistleblower programmes for the US Commodity Futures Trading Commission and for the Securities and Exchange Commission (SEC).383 This scheme invites whistleblowers to report securities law violations, with the whistleblower taking a mandated 10% to 30% of any money collected by prosecutors as a result of the disclosure, provided the whistleblower’s information led to at least $1 million being recovered. Whistleblowers can remain anonymous and are advised to act via a legal representative. The Act also ensures whistleblowers can seek damages from their employer if disclosure leads to their dismissal. There are limitations on payment being made: for example, whistleblowers must not have gained the information through audit or regulatory work, or through breaking the law. About 2.5% of reports the SEC receives come from the UK: the top non-US source of tips.384 10. Since this scheme was introduced, the SEC has reported an increase in the volume of reports. However, to date, it has only made one whistleblower payment, of $50,000 in September 2012. It is therefore too early to draw clear conclusions from the US experience. Providing Financial Incentives to Whistleblowers in the UK 11. If there are potential whistleblowers who have not been setting out their concerns to us, the extent to which they can be incentivised to come forward will depend on the size and structure of the package available. 12. Size of payments: Larger payments offer a greater incentive, and may destabilise criminal conspiracies from which participants stand to make substantial gains such as insider dealing rings. In such cases the rewards would need to be substantial, perhaps in the millions because, in addition to losing out on the proceeds of the crime, a well-remunerated City high-flyer would reasonably expect their career prospects to be harmed by reporting other insiders and being associated with a criminal act. Handing over such sums would be a substantial shift in UK policy norms. 13. More modest rewards may prompt, for example, bank branch staff concerned about mis-selling to blow the whistle. 14. It is possible an appeal to financial self-interest may prompt reporting that would not otherwise occur, although we will perhaps only learn what kinds of sums are effective through trials. 15. Qualification criteria: A whistleblower motivated by a reward would need to be confident of receiving the money, particularly if making a report put their career in jeopardy. Likewise, we would not want to reward those providing poor information, particularly if it were not provided in good faith; doing so could increase moral hazard. The SEC sought to achieve this balance by placing emphasis on the criteria for receiving rewards being simple and clear; they will not, for example, reward whistleblowers if information prompted an investigation, but did not lead to a prosecution. Reducing moral hazard 16. Financial incentives could create a number of moral hazards: (a) Malicious reporting: The introduction of financial incentives may lead to more approaches from opportunists and uninformed parties passing on speculative rumours or public information. We already receive a small number of such reports, and have processes in place to filter out low value information, although, on occasion, investigations prompted by what proved to be wrong information from a whistleblower have taken place. Reputations of innocent parties may be wrongly damaged as a consequence. (b) Entrapment: It is conceivable that some market participants may seek to “entrap” others into an insider dealing conspiracy in order to then blow the whistle and benefit financially. Not rewarding offenders and only acting when reports are corroborated by further, independently gathered, evidence would obviate this danger. (c) Conflicts of interest in court: If a whistleblower’s disclosure led to a criminal prosecution (such as in an insider dealing case) the court could call into question the reliability of their evidence because the witness stood to gain financially. Our case would not rest solely on the whistleblower’s testimony, as we would present our own investigatory evidence, however the fact the whistleblower stood to gain financially from their disclosures may undermine the prosecution’s case. 383

This was modelled on the US tax authority’s whistleblower programme (that encourages insiders with knowledge of tax fraud to come forward and take a mandated share of funds recovered by the taxman) and the False Claims Act (which allows whistleblowers to sue for fraud against the public purse on the government’s behalf and share the proceeds). 384 See the SEC’s latest annual report on the programme here: www.sec.gov/about/offices/owb/annual-report-2012.pdf

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1534 Parliamentary Commission on Banking Standards: Evidence

Other considerations 17. There are a number of other factors which should be taken into consideration: (a) Public Interest Disclosure Act: Whistleblowers’ protections under the Public Interest Disclosure Act depend upon their acting in the public interest. If whistleblowers are motivated by financial gain, the Act may need amendment so that whistleblowers can still benefit from these protections. (b) Consistency with FSA’s “principles for businesses”: Rewarding whistleblowers for performing what is arguably their regulatory duty may sit uneasily with the principle that firms deal with their regulator in an open and cooperative way and the principle that financial firms should conduct business with integrity. (c) Public perception: It may be reasonably expected that individuals who have knowledge of any crime or wrongdoing should report it to the relevant authority without incentive. Paying significant sums to high-income individuals for fulfilling a public duty could reinforce some attitudes that the financial sector may appear to be at odds with the rest of society. (d) Needless rewards: Some rewards are likely to be paid to whistleblowers who would have come forward anyway, and hence not be a productive use of our resources. (e) Funding: A number of options for funding are available. The FSA’s general budget is raised by fees on regulated firms. Using the general budget to fund whistleblower incentives would require us to make an assessment each year of what we think the costs of whistleblowing will be and levy that fee in advance. We are not convinced that the best use of any rise in general fees would be incentivisation of whistleblowing. (f) Whistleblowers could be paid from proceeds confiscated after a criminal prosecution, where that occurs: this is chiefly in insider dealing cases. (g) An alternative approach would be to fund whistleblowers from fines imposed on firms following our Enforcement work. Until recently, such fines were used to reduce the fees of other regulated firms. However the Financial Services Bill currently passing through Parliament contains changes that will mean fines from this year, less some Enforcement costs, are instead paid to the Exchequer. Further changes in legislation would be needed to allow us to use fine revenues to reward whistleblowers. Conclusion 18. On current evidence, the FSA considers any potential benefit from incentivising to be outweighed by the disadvantages. 19. Although the US model is one the UK can learn from, it is too early to assess whether or not it has been successful. With no long-standing model successfully applied in a regulatory context elsewhere, any UK system will be subject to a degree of trial and error the scale of payment that would be effective at promoting useful disclosures is unknown to us. 20. There are serious moral hazards associated with any change in policy. These can be reduced by only rewarding whistleblowers with clean hands whose information leads to action. Nevertheless, an increase in spurious reporting is also likely. 21. Adequate incentives may need to be sizeable; this would go counter to UK policy norms and could lead to public disquiet, particularly if it was seen to be richly rewarding people on high salaries for what is arguably their regulatory duty under existing legislation. If changes were made, the perception may remain that this is not the most appropriate use of the FSA’s resources. 22. Some legal amendments would be necessary: whistleblowers cannot currently be paid a share of regulatory fines, while the protections offered to whistleblowers who gain personally from a disclosure may need to be clarified. In any event, the courts may have doubts about witnesses who have been paid for their evidence. 23. It is not clear to us our existing whistleblowing measures need to be augmented by a process that would be complex to administer, has risks that are difficult to assess and—as yet—no proven benefits. We will keep this position under review as evidence becomes available from the US. We are also considering other measures to enhance our existing arrangements, which already generate sizeable volumes of intelligence and have frequently prompted supervisory interventions and enforcement action that could not otherwise have taken place. 11 December 2012

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1535

Written evidence from Global Witness FURTHER FAILURES IN UK BANKING STANDARDS SHOWING NECESSITY FOR INDIVIDUAL CRIMINAL SANCTIONS 1. Summary There is a widespread failure to comply with anti-money laundering (AML) regulations within the UK banking sector. This is a further example of the wider malaise in banking standards and culture. It is a serious problem presenting threats to the UK financial system and economy, as well as causing a massive human cost in developing countries. These compliance failures provide further evidence of the necessity for senior bankers to be held individually responsible for their actions and the actions of their banks, including through bonus claw-backs and criminal sanctions, in order to improve standards and culture. This builds on a more detailed submission Global Witness made to the Commission in August 2012. We believe it is particularly helpful to highlight how the issue of AML failures has direct relevance to the debate on individual responsibility which has continued to develop. 2. The Extent of Anti-money Laundering Failures There is a global anti-money laundering regime that requires banks to carry out checks on their customers and report any suspicious activity to the authorities. However, Global Witness has repeatedly shown how a poor culture of compliance within the banking industry and weak enforcement by regulators has allowed corrupt politicians to access the financial system to hide and process their ill-gotten gains.385 For example despite the shocking revelation in 2001 that 23 banks in London had taken over £900 million in suspect funds from Nigerian dictator Sani Abacha, a number of major UK banks subsequently took millions from other corrupt Nigerian politicians. This included at least £50 million from James Ibori (whose appeal against a UK prison sentence was quashed this week).386 These findings were reinforced by the FSA in a damning 2011 review into how banks deal with money laundering risks.387 It found that 75% of UK banks had failed to properly implement the money laundering requirements, including the majority of the major banks, and a third were prepared to take high moneylaundering risks if they thought they would not be found out. Yet the FSA/FCA has only taken action against a handful of banks for violating AML regulations. On the rare occasions it has taken action this has been far too weak. For example in March 2012 the UK bank Coutts was fined £8.75 million by the FSA for failures that were described as “serious” and “systemic”, yet this is only 2% of its post-tax profits over the period of the failures. In one of the most egregious cases, HSBC Group agreed to pay a record $1.9 billion fine by US authorities after admitting to systematic anti-money laundering failings, including laundering hundreds of millions of dollars for drugs cartels, terrorists and pariah states. A Senate Committee described its culture as “pervasively polluted”.388 Recent developments in the US suggest this settlement has yet to be endorsed by the supervising judge opening-up the possibility that a tougher sanction could be imposed including, at the most extreme a revoking HSBC’s US license. In August 2012 the New York banking supervisor threatened to remove the banking licence of the UK bank Standard Chartered after it was accused of helping Iran to evade financial sanctions.389 3. Significant Costs of Breaches in AML Standards The failure of our banks to comply with AML standards presents serious problems. Not only does it make our financial system vulnerable to a wide range of financial crimes, it also creates significant risks to the UK economy through the threat of UK banks having their licenses revoked in other countries. Furthermore money laundering is not a victimless crime: it depletes state coffers, and drives poverty, inequality and suffering in some of the poorest countries in the world. For example, as a result of striking oil in the 1990s Equatorial Guinea has a per capita wealth higher than some European countries, yet because of systematic corruption by the ruling family 70% of the population live on under $1 per day. More broadly, developing countries lost six 385

See Global Witness reports: “Undue Diligence: how banks do business with corrupt regimes” (March 2009) http://www.globalwitness.org/library/undue-diligence-how-banks-do-business-corrupt-regimes ; and “International Thief Thief: how British banks are complicit in Nigerian corruption” (October 2010) http://www.globalwitness.org/sites/default/files/pdfs/international_thief_thief_final.pdf 386 For details of this case see Global Witness press release: “Sentencing of former Nigerian politician highlights role of British and US banks in money laundering” (April 2012) http://www.globalwitness.org/library/sentencing-former-nigerian-politicianhighlights-role-british-and-us-banks-money-laundering 387 See the FSA’s “Banks management of high money laundering risk situations” (June 2011) http://www.fca.org.uk/your-fca/ documents/fsa-aml-final-report 388 See The Guardian: “HSBC pays record $1.9bn fine to settle US money-laundering accusations” (11 December 2012) http://www.guardian.co.uk/business/2012/dec/11/hsbc-bank-us-money-laundering 389 New York Department of Financial Services, Order Pursuant To Banking Law § 39 in relation to Standard Chartered, 6 August 2012 http://www.dfs.ny.gov/about/ea/ea120806.pdf

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1536 Parliamentary Commission on Banking Standards: Evidence

times as much in corruption, tax evasion and other illicit financial flows (US$859 billion) as they received in aid (US$131 billion).

4. Conclusion and Proposed Solution It is clear that a woefully poor culture of compliance with AML standards is widespread among UK banks, and regulators are failing to enforce these standards adequately. On the rare occasions when they do impose penalties these are far too weak, and do not hurt the individuals responsible. This has resulted in an ineffective set of disincentives for the banking industry which needs to be significantly improved. It seems evident from the transcripts of the Commission’s hearings and also press reports that it is considering the need to increase individual responsibility for senior bankers, and in particular the possibility of criminal sanctions. While the debate seems to have identified a genuine difficulty in distinguishing between extremely reckless business decisions and criminal behaviour, failures in applying AML standards are a much more clearcut case of violations to UK legislation390 and the necessity to introduce criminal sanctions for senior bankers as a response.

Global Witness has five broad proposals for the Commission to include its final recommendations: (a) Senior bankers should be held legally responsible for their banks’ money laundering performance Someone at board level needs to be personally accountable for anti-money laundering compliance in order to make banks take these obligations seriously. In the most egregious cases, senior bankers should face serious criminal penalties, both fines and jail and at the very least be banned from working in the industry and have their bonuses clawed back.

(b) Increasing Sanctions on Banks Sanctions for banks should be increased from the current levels being imposed in order to be more dissuasive and more proportionate to the offence. This is necessary in order to correct the current risk/reward ratio which encourages banks to take on risky customers.

(c) FCA should improve their supervision of how financial institutions are carrying out anti-money laundering due diligence The FCA should use a wide range of tools to identify institutions with poor systems and controls. This should include carrying out mystery shopping exercises to test how well the money laundering laws are being implemented, as well as surprise spot checks of banks’ client customer due diligence files. Banks that fail in their obligations should be named and shamed.

(d) Take measures to ensure that banks adequately monitor high risk customers Banks should be required to annually review the business they do with Politically Exposed Persons (PEPs): public officials who by dint of their position could potentially have opportunities to appropriate public funds or take bribes, or their family members or close associates). For high risk customers, such as senior foreign politicians, the burden of proof should be flipped, so that such customers have to prove that their funds are legitimate, rather than allow banks to simply find a plausible explanation for a customer’s wealth. At the moment if banks can find a slightly plausible explanation for the source of funds (eg unverified claims of a substantial inheritance) they can take it. Banks should review all of their PEP clients annually and where they cannot be sure this business meets the above stipulations, they should terminate the business relationship with these them.

(e) Include anti-money laundering failures in scope of recommendations Global Witness believes that the scope of the Commission’s potential recommendation on individual criminal responsibility, along with any others, should include the issue of anti-money laundering compliance too. 3 May 2013 390

These include the AML Regulations (2007) which stipulate a set of requirements banks must put in place and implement systems to identify and prevent AML risks.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1537

Written evidence from Professor Charles A.E. Goodhart A. Property Finance has been the Main Common Factor There have been three financial crises in the UK since the 1970s. All of them have centred around property finance, especially bank lending for commercial property, but also mortgage lending for residential property. This was the case in 1973–76 (the Fringe Bank crisis), 1989–91 and 2007–09 (Northern Rock, HBoS). Similarly housing finance was at the centre of the crisis in the USA, Ireland and Spain. Houses, and commercial property, vary a lot in value, whereas mortgage finance is fixed in value. Hence, during up-turns the leveraged value of the owners rises dramatically, while in downturns the owners get under water. When the latter happens, foreclosure just amplifies the price decline, whereas forebearance makes it difficult to value the bank mortgage asset and leads to criticisms about lack of transparency, etc. It is difficult to reform housing finance in the middle of a crisis, and the American authorities have tried and largely failed. If half of the effort expended on bank reform had gone into housing finance reform, we might be in a better condition. The Danish covered bond mechanism is worth exploring. The normal perception of bank intermediation is that this involves taking deposits from households to lend to non-financial corporates. This is invalid. As Adair Turner has frequently documented the vast majority of bank assets now take the form of loans to households, mostly house mortgages, and much of the remaining assets are property related. The separation of retail banking, as in Vickers and Liikanen, will reinforce their focus on housing/property finance. Far from making the retail bank safer, by reducing such banks’ diversification the present trend of bank “reform” is helping to guarantee another bank/housing/property crisis some 20/25 years ahead. The present crisis is driving house building well below the demographic underlying build-up of demand. This will lead to a long period, in the medium term future, of rising housing prices. As memories of 2007–09 fade, and they will, people (and bankers and politicians and even regulators) will extrapolate that upwards housing price “trend” into the future, perhaps gaining extra confidence from current banking “reforms”, as the introduction of Basel II, inflation targetry and the great moderation helped to instil confidence in 2003–07. B. Competition and Macro-prudential Counter-cyclical Policy When housing/property prices have been rising, it is fairly obvious why borrowers want to increase their leverage, to ascend the rungs of the property ladder. But why do banks let them do so, since such assets are in fixed debt form, and hence subject to tail risk? An important cause of such excessive leverage in booms is competition. Challenger banks, such as Northern Rock and Anglo Irish, ease terms (down payments, etc) aggressively in order to make larger short-term profits and grow into “too-large-to-fail” status. Other, bigger and more staid, banks have to ease terms alongside, or lose market share. Countries that did best in the crisis, eg Australia, Canada, India, maintained a protected, cartelised domestic market. The concept that competition is inimical to financial stability is somewhat unpalatable, but nevertheless true. The great crash and depression of 1929–33 was at the time ascribed to “excessive” competition and the financial reforms subsequently introduced were largely aimed at reducing competition within the financial system, eg by constraining banks’ ability to vary their interest rates. Everyone enjoys a housing boom. If it was realised that it was “unsustainable”, it would stop on its own accord. Whereas in hindsight it may seem obvious that it was a “bubble”, at the time most people, including most borrowers, most bankers, most commentators and most politicians—and even perhaps most regulators— believed, either in the boom’s continuation, or, at worst, a “soft landing”; “this time it’s different”. Consequently the use of counter-cyclical macro-prudential policy will normally be contrary to majority, conventional wisdom, as it would have been in 2005–06 for example. Not only does it take great courage to defy majority opinion, but, if successful in preventing a crisis, this will be used as evidence that the policy was not needed in the first place! The Bank of England’s FPC has not even asked for the power to vary LTV ratios; it is thought that this is because of concern that public opinion is not ready for its use as a counter-cyclical mechanism. In this context I have proposed the identification, and use, of presumptive indicators, which, if triggered, require the FPC either to take countervailing action, or to explain in public, why not. Such a “comply or explain” for regulators may stiffen their backbones in a boom. Dealing with financial busts is even harder. Almost by definition a financial bust means that the prior safety barriers had proven insufficient. The inevitable human response to that is that “This must never happen again”, and to reinforce the safety barriers, ie to tighten and toughen such regulatory safety barriers. But to do so in a bust is pro-cyclical, as now. It would be countercyclical, post 2008, to lower capital adequacy requirements; instead, of course, they have been ratcheted sharply upwards, with the predictable consequence of greater deleveraging. Can regulatory policy ever be other than strongly pro-cyclical, (as it is now) immediately after a serious financial crisis? Counter-cyclical macro-prudential policy is likely, for such reasons, to be a weak reed. Instead, there is a longer-run dynamic to financial regulation. Immediately after a crisis it is reinforced into a much tougher straitjacket. This restricts financial intermediation, as it is meant to do. A combination of such restriction, and the effect of the memory of the crisis on risk aversion, keep bankers conservative and crises at bay. So the restrictions come to seem unnecessary and get relaxed. Such liberalisation leads to greater credit expansion, growth and higher asset prices, until the subsequent crisis. It will happen again. This is almost inevitable.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1538 Parliamentary Commission on Banking Standards: Evidence

C. Incentives Let me revert to the question of why bankers allowed leverage to increase so rapidly in the period before 2007. In large part this was because they shared the conventional wisdom of the time which was that lending based on real estate was not risky. There are several papers by Stulz, and co-authors, documenting that bankers, like most others (such as Greenspan) shared a common fallacy. It was, of course, such lending (mortgage based assets) that brought down Lehman Bros; their derivative trading had remained profitable. If one should define residential mortgages, and mortgage-based derivatives, and property loans as part of the natural “utility” functions of a bank, then it was the “utility”, not the “casino” that sank the system. The logic of this has been accepted by some of the keener structuralists, such as Kotlikoff and Kumhoff. They would divide the financial system into narrow banks, which could hold only perfectly safe (public sector) near cash assets, and be the sole providers of deposits and payments services on the one hand, and fully equity, (or long-dated fixed time deposit), financed investment trusts on the other hand. The reduction in maturity mismatch, and the resultant increase in funding costs, would raise spreads over the interest rates on public sector debt, and lower credit expansion, savings and investment. In a system without exchange controls on capital flows much financial intermediation would move abroad. Even with exchange controls, there would be disintermediation into other channels, eg peer to peer lending. Whether such radical changes would be beneficial or publicly acceptable is far from clear. A second reason why bankers allowed leverage to increase so rapidly, at the expense of enhanced tail risk, was that they have had incentives to behave in this way. Bankers are responsive to, and largely remunerated in the same way as, shareholders. They generally have bonuses in equity form; most senior bankers have, and are expected to have, a large equity shareholding in their own bank. Equities have limited liability status. The down-side is limited; the up-side is not. This convex pay-off, equivalent to a call option on the bank’s assets, makes the pursuit of risk an attractive way of enhancing one’s own welfare for a banker. To follow such incentives is natural. Given the incentives to raise the return on equity by increasing leverage, the surprise is perhaps that it took them so long to do so. There are three main strands of proposals for reducing (tail) risks in banking. These are: (1) To adjust regulation so that the safety barriers rise as banking risks increase. (2) To prevent banks undertaking risky business at all. (3) To change the structure of bankers’ incentives. Earlier in this note it was argued why counter-cyclical macro-prudential regulation was unlikely to work. The kind of structural limitations on banking necessary to prevent future crises, which the Vickers/Liikanen proposals will not achieve, are (probably) too radical to have any chance of successful acceptance. This suggests that more thought/effort needs to be applied to a reconsideration of bankers’ incentive structures. This is beginning to happen. Liikanen suggested that bankers’ bonuses be paid in the form of bail-inable bonds, not equities. Sir Martin Jacomb proposed, in an FT op-ed, that the most senior management of a bank be required to accept unlimited liability on their (inalienable) equity position. In a similar vein, one could require any bank employee whose remuneration was beyond some limit to take some minimum percentage of their total remuneration in the form of equity shares, whose particular feature would be that they would be subject to double (or treble, or choose the multiple) liability in the event of default. These could not be sold, until n years after leaving the company, except in the event of death or of inability to meet essential payments (eg divorce) without such sales. Most of the public’s fury with bankers has occurred because they seem to have continued to receive huge payment despite widespread failure. But given their incentive structure bankers have behaved entirely rationally; indeed given that structure one could argue that most of them have been surprisingly responsible. Now would be a good time to review the remuneration arrangements of senior bankers. No doubt any such measures would lead to an exodus of “stars”. Would that matter? 24 October 2012

Letter from Andrew Haldane, Executive Director, Bank of England You requested my thoughts on whether the financial services industry should have a statutory duty of care to customers, following your letter of 19 November and Lord McFall’s question to me at the PCBS hearing on 7 November. Here are some reflections on that question, bearing in mind that this bundle of issues is somewhat off the Bank’s patch. First, it is widely recognised that customers require protection when dealing with financial firms. The imbalance of bargaining power demands, in the interests of fairness, that freedom of contract be tempered by law and regulation. This is the purpose of much “conduct” regulation. Currently, this protection is achieved mainly through: — the FSA’s powers, including its general rule-making power, based on its statutory objectives; — the Consumer Credit Act 1974;

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1539

— —

the Financial Ombudsman Service’s (FOS) powers to provide redress; and general statutes requiring “fairness” in contracts.

Some of these are derived from European legislation. Taking these in turn, the FSA has a general objective of “securing the appropriate degree of protection for consumers” (the “Consumer Protection Objective”). Many of the Authority’s rules and standards are designed to promote and support this objective. Some of the rules made by the FSA to support this objective are presented as high level “Principles”, with which all authorised firms are required to comply. These Principles include requirements to “treat customers fairly”. If firms do not treat customers fairly, the FSA can take enforcement action, such as by imposing fines. It can also require firms to provide redress directly to people who have suffered. The FOS is the main route for individuals—retail customers—to have their complaints dealt with directly if they are not satisfied with the response they receive to complaints they make to a firm. The FOS looks at what is fair and reasonable and requires firms to respond appropriately. It can order financial compensation to be paid to bank customers. Alternative routes for customers who are dissatisfied with the response to a firm to a complaint include suing the firm for breach of FSA rules (although not for breach of the Principles, as these are currently excluded), or under the common law for negligence or breach of contract.391 However, the unequal position of an individual in bringing an action in court against a firm, in terms of resources and information as well as the time it would take, make litigation a much less attractive route compared to seeking redress through the FOS. How will this differ under the FCA? The Financial Services Bill gives the FCA the same consumer protection objective as the FSA currently. However, the list of things that the FCA must “have regard to” is expanded and includes: “the general principle that those providing regulated financial services should be expected to provide consumers with a level of care that is appropriate having regard to the degree of risk involved in relation to the investment or other transaction and the capabilities of the consumers in question”. The new law will therefore guide the FCA to a greater extent than at present, providing at least some of the potential benefits of a statutory “duty of care”. If necessary, adherence to this “general principle” could be further strengthened. For example, the Financial Services Bill could require the FCA to give priority to this principle and/or specify how the principle is to be translated into action through rules. Although discretion is normally left to a regulator to make such rules, there is precedent in the existing FSMA and in the Banking Reform Bill for specifying things about which the regulator must make rules. The FCA could already strengthen its rules (subject to constraints of European legislation), for example by applying the “best interests” requirement more broadly. Looking beyond the duties that can be imposed through the regulator, statute law already provides some further protection. For example, the Supply of Goods and Services Act implies a term into contractual arrangements that services must be provided with reasonable care and skill. And the Unfair Contracts Terms Act and the Unfair Terms in Consumer Contracts Regulations also limit freedom of contract, in favour of the consumer, by rendering certain contractual terms unenforceable. In certain relationships, the case law goes further and imposes a fiduciary relationship. For example, in the financial services industry this duty is supplemented in some places by FSA rules such as requirements around the “best execution” of client’s orders. So there is already a body of law, rules and standards which intervene between customers and firms. In some places the intervention is minimal and allows a high degree of freedom of contract; in others, where the level of customer dependency is greater, the fiduciary standard applies. This makes sense: the relationship between a firm and its customer can take many forms—from taking deposits to agency broking. Imposing the same standard of behaviour in all cases would be too intrusive. Are there significant gaps or shortfalls in the current conduct standards made under FSMA with which a general statutory duty of care would assist? The FSA has indicated previously that a specific statutory fiduciary duty in the Financial Services Bill would not necessarily clarify or resolve all the kinds of specific issues and tensions in varied financial services relationships, which tailored requirements under existing rule-making powers can address. In addition, there are various “codes of conduct” which firms sign up to on a “voluntary” basis. An example would be the Lending Code, which is sponsored by the BBA, the Building Societies Association and the UK Cards Association. Although such codes are not legally binding, breaches would be taken into account by the FOS where relevant to a consumer complaint. Without reaching a strong view on its merits, it is against this backdrop that a new statutory “duty of care” on firms would need to be assessed. The relevant test seems to me: what would such a duty add over the existing provisions outlined above? Certainly, the nature of the duty and how it would apply in particular circumstances would have to be carefully defined to differentiate it from alternative courses of action and to ensure it could be applied in practice. That is because the courts would not have the benefit of a substantial body of case law to guide interpretation of such duties. 391

Other actions, depending on the nature of the bargain and of the parties, could include breaches of the Unfair Contracts Terms Act 1977, the Unfair Terms in Consumer Contracts Regulations 1994, or the Consumer Credit Act 2006.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1540 Parliamentary Commission on Banking Standards: Evidence

Against this background, it is possible that the kind of statutory strengthening suggested above, including imposing obligations on the FCA to make rules for specific consumer protection purposes, might be a more expeditious method for improving consumer protection. 20 December 2012

Written evidence from Professor Richard Harris Executive Summary Growth of the financial sector The widely used measure of value-added shows that the relative size of the U.K. Financial Intermediation (FI) sector rose by about 210% between 1995 and 2007. Up until 2001, financial intermediation in the U.K. was in the region of 3.5% to 4.5% of total U.K. value-added. However, in 2001 the FI sector’s share began a spectacular rise from 3.4% to 8.1% in 2009—a rate of increase of over 10% per annum. This was a rise not seen in any other country with a large banking sector. Such shorter-term increases followed by a downturn were likely to be a reflection of an underlying “bubble” in the FI sector rather than “true” sustainable value-added. Financial sector volatility FI sector volatility rose from below the average for the economy as a whole in the 1980s (85% of the average) to well above the average (some 222% times more) in the last decade. Overall, there is evidence that the banking sector was increasingly volatile, both over time and relative to other sectors. Relative efficiency in the financial sector The U.K. performed relatively poorly over most of the 1980–2009 period. Until 1990, average efficiency in U.K. banking was only just over 86% of that achieved in the most efficient country. However by 2000 all the banking sectors in all the countries covered had converged on efficiency levels close to the frontier. Concentration in the financial sector In 2011, the big 5 banks (Lloyds TSB, Barclays, The Royal Bank of Scotland, HSBC, and Santander U.K.) accounted for over three-quarters of the FI sector in terms of turnover. Profits in the financial sector The big 5 banks made huge losses in 2008, dwarfing the losses of the smaller banks. For example, on a per employee basis, the big 5 banks made losses of £54.8k in 2008, ten times the losses per employee made by the smaller banks. Indeed, 98% of the £28.9 billion reported loss in 2008 came from the big 5 alone. Thus, the big 5 comprised some 77% of the turnover, but almost all the reported losses. And post 2007, the smaller banks are notably more profitable than the big 5 banks. How did the banks made such large profits in the run-up to the crisis? A key part of the explanation is that banks’ borrowed to lever up their returns on assets into much greater returns on equity, and in the years before the crisis U.K. banks were operating with leverage ratios of (on average) over 20—that is to say, for every £1 in equity capital they were borrowing in the region of £20 or more. Since then, the best available evidence suggests that banks’ losses were more than enough to render the banks insolvent—for the U.K. banks as a whole, losses over this period were almost £100 billion; on average, these losses amounted to 185% of their capital; and for RBS, these losses amounted to 189% of capital, for HBOS they amounted to 205% of capital. This “story” of profits being strong and generally rising before the crisis, but turning into losses afterwards, is also consistent with the “bubble explanation” suggested earlier when discussing value-added. Tax revenues and the cost to the taxpayer With regard to the financial assistance to Lloyds, RBS and Northern Rock, against the taxes paid by these banks, it is clear that: the financial assistance received by these totally dwarves their tax contributions to the state; in 2008, the cash outlays from HM Treasury alone for these three banks were over £100 billion, and the amounts covered by state guarantees were over £1,100 billion or £1.1 trillion. Remuneration in the financial sector The gap between the average remuneration in the FI sector and that in the economy as a whole is both large and has been rising over time. Average annual pay in FI rose from just under 170% of the national average in 1999 to over 240% of national average in 2011. For the top 10% of earners in the FI sector, the gap (relative to the top 10% of earners in the economy as a whole) doubles from 60% in 1999 to 120% in 2011.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1541

Lending constraints to SMEs There has been much conjecture that post-2008 the banking system has been constraining the credit offered to the small-to-medium sized business sector, which is dependent on overdrafts (and to a lesser extent loans) from the banking sector. Net lending by the banking sector to businesses in the U.K. has been negative since December 08: that is, the banks have been consistently cutting back their lending for over five years—and there is no sign that this will change anytime soon. There is strong survey-based evidence to suggest that SME’s have experienced greater credit rationing from the banking system, during a period when credit is necessary to mitigate against the problem of cash flow that impacts more on SME’s compared to larger companies.

Overall summary This report highlights the unsustainable growth that occurred in the FI sector in the last 15 years, which suggests the largest banks (the “big 5”) were creating “spurious” value-added, but nonetheless continued to pay themselves much higher salaries. A consequence is that since the burst of the “bubble” in 2007–08, they have become relatively unprofitable compared to the rest of the FI sector (and indeed other sectors of the economy). In addition, they have curtailed responsible (and much needed) lending to SMEs. If this summary is “harsh” (and others may wish to put forward other explanations for what has happened as represented by the data presented here), it is nonetheless one that generally seems to accord with wider public perceptions, and that in itself is a major problem for the FI sector going forward.

1. Relative Size and Growth of the Financial Sector Figure 1 shows the relative size and recent growth in the U.K. financial sector, as measured by “real valueadded” (that is, value-added adjusted for inflation) using Standard Industrial Classification (SIC) data. In all the countries shown, the relative size of the FI sector—the size of the sector relative to the size of the economy as a whole—shows a marked increase since the early 1970s.392 In the case of the U.K., the index of relative size rises from 60 in the mid 1970s to a little under 80 in 1995; it then shows a big surge and rises further to peak at over 180 in 2007 before falling back about 12% from its all-time peak three years later. Thus, by the value-added measure, the relative size of the U.K. FI sector rose by almost 300% between the mid-70s and 2007, and by about 210% between 1995 and 2007.

Figure 1 REAL VALUE-ADDEDa IN FINANCIAL INTERMEDIATION (SIC 65) AND BANKING SECTORS (SIC65+66) IN SELECTED COUNTRIES, 1970–2010 (1995=100) Figure 1 is not printed: available on request. Of the countries shown, three have very big FI sectors relative to the rest of the economy—the U.K., Japan and the US—but in terms of total size, the US financial sector is much bigger than any of the others: for example, it was approximately 7.5 times the size of the U.K. FI sector in 2007.393 The other countries shown in Figure 1 all had financial sectors that were much smaller relative to the sizes of their economies; however, their financial sectors all increased over time. These increases are especially notable for France over the whole period, where the FI sector rose from a very small base, and for Spain post-1995, where the relative size of the FI sector had effectively doubled by 2010. Long-term increases in the sizes of the FI sector have traditionally been interpreted as evidence of a postindustrial transition to a more services-oriented economy, in which the FI sector plays an increasingly important role. However, shorter-term increases followed by a downturn—such as those in the U.K. post-1995—are more likely to be a reflection of an underlying bubble in the FI sector rather than “true” sustainable value-added. The combination of rapid growth in the U.K. followed by a falling off once the crisis hit is consistent with this “bubble explanation”. 392

Much of the analysis here is underpinned by value-added data for financial services/banking. Using data on value added, while absolutely necessary in the absence of alternative sources, requires care when interpreting the results because much of the value of financial services is not revealed directly through the price mechanism, but through interest margins over a hypothetical riskfree rate, and through fees, charges and leverage. This makes the association between value added and ‘economic contribution’ more difficult to interpret vis-à-vis the use of VA in manufacturing: ceteris paribus, banks can increase their VA by taking on more risk and charging higher fees to customers. 393 This is an exaggeration as the U.S. figures in Figure 1 include insurance and pensions; even if that sector accounts for one-third of total financial services, financial intermediation in the U.S. still is around five times the size of UK financial intermediation.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1542 Parliamentary Commission on Banking Standards: Evidence

Figure 2 VALUE-ADDED IN FINANCIAL INTERMEDIATION (SIC 65) AND BANKING SECTORS (SIC65+66) IN SELECTED COUNTRIES, AS A PERCENTAGE OF TOTAL VALUE-ADDED IN ECONOMY, 1990–2010 Figure 2 is not printed: available on request. Figure 2 presents (nominal, or not-inflation-adjusted) value-added figures for the financial intermediation sector as a percentage of total economy value-added, for the same countries. By this criterion, the US and Australia have the biggest FI sectors relative to the size of their economies,394 and most other countries (the U.K. excepted) have FI sectors that were usually less than about 5% of the size of their economies. Up until 2001, financial intermediation in the U.K. (like many of the other countries shown in Figure 2) was in the region of 3.5% to 4.5% of total value-added. However, in 2001 the FI sector’s share of the U.K. total value-added began a spectacular rise from 3.4% to 8.1% in 2009.395 Thus, by this measure, the share in valueadded by the U.K. FI sector increased by almost 240% between 2001 and 2009—a rate of increase of over 10% per annum. This was a rise not seen in any other country with a large banking sector. One possible explanation of this rise is a sudden spurt in true value-added, but there is little or no evidence to corroborate this interpretation. A more plausible explanation is simply that much of this rise in apparent value-added merely reflects a post-Millennium bubble—and this explanation is consistent with the very rapid growth rate before 2009 and by fact that this “value-added” then fell back sharply afterwards. Table 1 VOLATILITYa IN U.K. REAL VALUE-ADDED BY SECTOR, 1970–2008 Sector (SIC 2003 code) Mining & quarrying (B) Financial & insurance (K) Business services (M-N) ICT (J) Accommodation & food services (I) Distribution (G) Real estate (L) Agriculture, fishing, forestry (A) Construction (F) Community, social & personal services (O-U) Arts, entertainment, recreation & other services (R-S) Utilities (D-E) Transportation & storage (H) Manufacturing (C) All industriesb

1970–79

1980–89

1990–99

2000–10

2000–08

4.95 1.31 1.36 0.68 0.80 0.87 1.33 1.76 1.92 2.15 1.49

1.63 0.85 1.36 0.76 1.31 1.53 1.18 1.25 1.95 0.35 1.32

2.59 1.07 1.64 1.58 0.83 1.08 1.00 0.58 0.62 0.65 1.59

3.29 2.21 2.28 2.09 1.10 1.08 1.11 0.91 0.99 1.03 0.63

2.56 2.22 2.21 1.75 1.10 1.10 0.92 0.89 0.89 0.88 0.64

2.12 1.49 1.48 2.1

1.09 1.08 1.39 5.4

1.18 1.67 0.64 6.4

0.58 0.61 0.60 6.3

0.58 0.47 0.23 6.8

Sectors ranked highest-to-lowest on basis of last column of data. a

Figures are ratio of sector to all industry standard deviations.

b

Actual standard deviation across the period for the total of all industries based on value-added being expressed as an index number (2005 = 100). 2. Financial Sector Volatility Then there is the issue of FI sector volatility, ie, is the FI sector more susceptible than others to changes in value-added? Table 1 shows the standard deviation in (real) value-added by sector relative to the figure for the whole economy, for various sub-periods from 1970 to 2010. A high relative standard deviation indicates that a particular sector is experiencing above average changes in value-added compared to the other sectors. The first thing to note is that “volatility” as measured here was increasing for the economy as a whole, rising in each sub-period following the 1970’s. Part of this is associated with a larger economy due to higher growth in 1980–89, 1990–99 and 2000–08, of on average 2.7%, 2.6% and 2.3% p.a., respectively, compared to the 1.5% p.a. growth rate of the 1970’s. But this is by no means the only—or necessarily even the main—reason for increased volatility; the U.K. standard deviation was 6.3% during 2000–10, when growth was only on average 1.6% p.a. 394

Note that the U.S. data are biased upwards by the inclusion of insurance and pensions, as separate U.S. banking sector data do not exist in EU KLEMS. 395 Note FI value-added fell in 2009 but its share increased, as the UK economy overall declined more steeply than in FI.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1543

More interesting in Table 1 is the relative rankings across industries. During 1970–79, financial services was ranked 11th out of 14 sectors for relative volatility; in 1980–89 it was 12th; but rose to 8th by 1990–99; and then came second only to mining & quarrying (which includes the oil and gas sector) by 2000–08. As another indication, FI sector volatility rose from below the average for the economy as a whole (0.85) in the 1980s to well above the average (some 2.22 times more) in the last decade. Thus, there is evidence that the banking sector was increasingly volatile, both over time and relative to other sectors.396 Figure 3 DISTRIBUTION OF EMPLOYMENT IN FINANCIAL INTERMEDIATION (SIC65) ACROSS REGIONS IN GREAT BRITAIN, 2010 Figure 3 is not printed: available on request. A related issue is the impact of FI sector volatility on other sectors. One way to address this issue is via the extent to which the sector is embedded in the U.K. economy in terms of inter-industrial linkages (vis-à-vis other sectors); data from input-output tables can then provide information on the likely “transmission” of shocks originating in the FI sector. Data are only currently available for 2005 (based on the U.K. I-O table for that year), and these indicate that banking has an output multiplier of 1.53 (see Table A.1 in the appendix). The interpretation is that if there is a £1 million decline in demand for services produced in financial intermediation then this will lead to a £1.53 million decline in the economy as a whole, given the loss of demand in other sectors linked to banking (and the “knock-on” effect transmitted through lower demand from such affected sectors).397 It also turns out that this multiplier is actually quite low relative to other sectors: in fact, banking is only ranked a lowly 102 (out of 123 industries) in terms of the size of its multiplier. This is considerably smaller than the output multipliers of industries ranked at the top—which is typically around 2.6 in such sectors—and smaller even than the output multiplier for insurance and pensions (at 1.836—which achieves a ranking of 38th).398 3. Regional Distribution of the U.K. Financial Sector Figure 3 shows the distribution of employment in the FI sector across different regions of Great Britain in 2010. This distribution is very much weighted towards London (with 32.1% of total employment) and the South East (42% if one includes London). The next largest regions for FI employment are the North West and Yorkshire/Humber (both 9.9%), the South East excluding London (9.6%) and Scotland (8.9%). Next are the West Midlands (6.8%) and the South West (7.6%), and lowest are East Midlands (4.5%), the East (4.4%), the North East (3.4%) and Wales (2.9%). The South East region (including London) is thus very heavily dependent on the FI sector, and would be most directly hard-hit by a major downturn in this sector.

396

This increased volatility could be due to a number of factors, such as deregulation and capital market liberalisation. It could also be due to more general changes as wholesale and retail banking became more inter-twined. Further work is study to disentangle the various causes. 397 One should however be careful of pushing the ‘low multiplier’ argument too far, not least because these multipliers can only be interpreted as reflecting the impact of small shocks on “an other things being equal” basis. Thus, these results do not enable us to conclude that a future large banking would only have a small impact on the economy. In fact, they tell us nothing whatever about the impact of large banking sector shock on the rest of the economy. 398 The large pre-crisis growth in the relative size of the FI sector also raises the possibility of a ‘Dutch disease’ type impact: this is typically associated with how oil price shocks impact on petrocurrencies and push up the real exchange rate; it is also associated with how the rise in the oil sector might adversely impact other sectors through investment being ‘crowded out’. It is possible that the pre-crisis expansion in the FI sector might have given rise to similar effects, but we can’t tell without a much more rigorous analysis.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1544 Parliamentary Commission on Banking Standards: Evidence

Figure 4 BANKING TECHNICAL EFFICIENCY

Source: Farrell (1957)

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1545

Box 1 MEASURING INEFFICIENCY IN BANKING

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1546 Parliamentary Commission on Banking Standards: Evidence

4. Relative Efficiency in Banking We now turn to banking efficiency. The basic approach is to consider whether inputs (typically, capital and labour) are used efficiently to produce value-added, based on concept of a “frontier” of best-practice combinations of inputs. Thus, Figure 4 shows inputs X1 and X2 (eg, labour and capital) used relative to output (Y) with the curve (denoted unit isoquant) indicating where the “best-practice” or “frontier” firms would operate. Hence a firm operating at any point “x” inside the frontier is using more inputs than the “best-practice” firms which are located on the frontier. For firm A, its relative efficiency is measured as the ratio OB/OA, where the line OA from the point of origin to the point “x” and OB is the line running from the point of origin to the frontier. A ratio of OB/OA < 1 indicates that the firm is inefficient (and so lies beyond the frontier) whilst a ratio of OB/OA = 1 indicates a firm that is located on the frontier and is efficient. This approach is useful because we can apply it to real-world data using the estimation method set out in Box 1. This Box also sets out the results obtained using EU KLEMS data, the main one being that greater use of ICT capital led to a major reduction in inefficiency over time. Figure 5 RELATIVE EFFICIENCY IN FINANCIAL INTERMEDIATION, VARIOUS COUNTRIES, 1980–2009 Figure 5 is not printed: available on request. These results are illustrated in Figure 5, which shows relative inefficiency in banking both over time and across EU countries. Overall, Italy followed by France, Belgium and Spain had on average the most efficient banking sector, but there was little difference in these average values over the period covered (as shown by the figures in the legend in Figure 5). By contrast, the U.K. performed relatively poorly over most of this period. Until 1990, average efficiency in U.K. banking was only just over 0.86, which was only just better than the worst-performing country, Austria, with an average efficiency of 0.82. However by 2000 all the banking sectors in all the countries covered had converged on efficiency levels close to the frontier. Thus, during the first decade of the new Millennium banking was operating at or close to the frontier in most major countries, at least in relative terms. This type of efficiency analysis is standard in the economics literature. Nonetheless, any economic methodology is only as good as its assumptions, and one should question whether the results seem plausible. For example, the results in Figure 5 suggest that banking in 2009 is more or less as technically efficient as it can be; they also flag up a puzzling question: if the UK banking system was traditionally one of the better ones (which is widely believed, and consistent with the results in Figures 1–2), then why does Figure 5 rank it so poorly? And does one really believe that the Italian banking system in 1980 was much more efficient than any of the others? Part of the answer to these questions relates to the narrower measurement of technical efficiency being undertaken; this does not necessarily imply full welfare efficiency (which also involves the allocation of resources in addition to how well such resources are utilised). 5. Concentration in Banking It is also important to examine concentration in banking.399 In 2011, the U.K. banking sector had total of 244 companies with non-zero turnover. Total turnover was £206.2 billion (in current prices), of which the big 5 banks (Lloyds TSB, Barclays, The Royal Bank of Scotland, HSBC, and Santander U.K.) accounted for £157.4 billion (or over 76% of the sector).400 According to the company accounts, employment in the sector was 679.2 thousand in 2011, with the “big 5” accounting for 527.4 thousand (or 77.7% of the total). Thus, the “big 5” account for over three-quarters of the sector in terms of turnover. A more sophisticated indicator of concentration is the Herfindahl index, which is based on data on the relative shares of all companies in a sector. The value of this index lies between 0 (which indicates a fully competitive market with very large numbers of very small operators) and 1 (which indicates a pure monopoly of only one company in the market). Using turnover data for 2011, we estimate an H-index of 0.146. This number can be divided into 1 to obtain what is known as the equivalent (hypothetical) number of equal-sized firms that comprise the market. Thus, an H-index of 0.146 implies 1/0.146 = 6.85 which rounds up to 7 equalsized companies competing with each other. 399

Information on concentration is available from the company accounts collated by Bureau van Dijk (http://www.bvdinfo.com), although this generally comprises consolidated accounts (which therefore cover more than just UK operations) and information is not always complete (eg, information on turnover is mostly incomplete across the years). We make use of data for SIC 641 (2007 Standard Industrial Classification) which covers financial intermediation. 400 Standard Chartered Bank had a larger turnover than Santander, but since it operates primarily in Asia and Africa it is not included in the ‘big 5’ used here. Note that the UK Government owns a controlling stake of 84% of the Royal Bank of Scotland, while 43% is owned of the Lloyds Banking Group, although both companies remain independent of government in terms of their operations. Note also that the figures reported here do not include building societies (although only Nationwide would likely be considered a major bank if it was not mutualized), but they do cover the banking divisions of certain retail companies (eg, Sainsbury’s and Harrods) but not others (eg, Tesco which trades as Tesco Personal Finance and is assigned to SIC 649 with a turnover of £0.9 billion in 2011; whilst M&S which trades as Marks & Spencer Financial Services, is assigned to SIC 649 with a turnover of £0.55 billion in 2011).

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1547

We can also obtain estimates for H-indices over time using relative shares based on employment data for 2004–11. These (and the previous estimate) of the Herfindahl index are plotted in Figure 6.401 This shows that the H-index has hovered in the range 0.16 to 0.17, but in this period has always stayed between 0.15 and 0.19, corresponding to between 5 and 7 hypothetical equal-sized firms. In short, concentration ratios have not changed much, and estimates based on turnover and those based on employment are fairly consistent. Figure 6 HERFINDAHL INDEX OF INDUSTRY CONCENTRATION (BASED ON EMPLOYMENT 2004–11; TURNOVER FOR 2011*)

Source: author’s analysis of FAME data 6. Profitability in Banking Figures 7 and 8 give results for the reported profitability of U.K. banks over the period 2004–11. (Note, as explained above, the data refer to only SIC 641 under the 2007 Standard Industrial Classification—Financial Intermediation—and so exclude investment funds, insurance companies, mortgage finance companies, financial leasing, pension funds, and other financial activities.) The former gives profitability in terms of reported profits made, and the latter in terms of reported profits per employee. The big 5 are presented in red and the others in green.

401

Note that these results differ from those presented in Figure 7.1 of the Vickers Report (2011). The latter covers different aspects of retail banking while the data underlying Figure 6 is turnover and employment for those firms classified to Financial Intermediation (SIC 641).

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1548 Parliamentary Commission on Banking Standards: Evidence

Figure 7 PROFITS BEFORE TAX IN U.K. FINANCIAL INTERMEDIATION, 2004–11

Source: author’s analysis of FAME data

Figure 8 PRE-TAX PROFITS PER EMPLOYEE IN U.K. FINANCIAL INTERMEDIATION, 2004–11

Source: author’s analysis of FAME data These Figures paint a consistent picture: —

On a per employee basis, the big 5 banks were generally less profitable than the smaller banks.

—

Banks’ profitability peaked in 2006, fell in 2007, turned negative in 2008 and has since been positive, but lower than before the crisis.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1549

—

—

The big 5 banks made huge losses in 2008, dwarfing the losses of the smaller banks. For example, on a per employee basis, the big 5 banks made losses of £54.8k in 2008, ten times the losses per employee made by the smaller banks (at only £4.2k per employee.) Indeed, 98% of the £28.9 billion reported loss in 2008 came from the big 5 alone. Thus, the big 5 comprised some 77% of the turnover, but almost all the reported losses.402 Post 2007, the smaller banks are notably more profitable than the big 5 banks.

This “story” of profits being strong and generally rising before the crisis, but turning into losses afterwards, is also consistent with the “bubble explanation” suggested earlier in our discussion of value-added. In other words, the patterns of both value-added and profits are consistent with the hypothesis that the FI sector was undergoing a bubble, and they are not easily reconciled with the hypothesis that the FI sector was undergoing sustained long-term progress. An interesting question relates to how the banks made such large profits in the run-up to the crisis. The banks’ profits are closely related to their return on equity, and U.K. banks on average delivered returns on equity in the region of 10%–15% p. a. in the years before the crisis.403 However, the corresponding returns on assets were much lower: indeed, average returns on assets by U.K. banks before the crisis were below 0.8% p. a.404 A key part of the explanation is simply leverage, ie, bank borrowing to lever up their returns on assets into much greater returns on equity, and in the years before the crisis U.K. were operating with leverage ratios of (on average) over 20—that is to say, for every £1 in equity capital they were borrowing in the region of £20 or more.405 Thus, the high profits that the banks earned before the crisis can largely be attributed to the banks being highly leveraged. However, there is good reason to believe that the banks’ true profits were in fact much smaller than reported in the banks’ accounts. The problem is that banks’ profits are reported using the International Financial Reporting Standards (IFRS) introduced into the U.K. in 2005, and IFRS are not fit for purpose because they allow banks to overstate their profits and “game” the system.406 If IFRS allows banks to overstate profits, then it allows excessive distributions to shareholders, and this, in turn, runs down bank capital and ensures that capital is also overstated in banks’ reports. The best available evidence suggests that banks’ losses over 2007–2010 were often well in excess of their capital, ie, the losses were more than enough to render the banks insolvent:407 — For the U.K. banks as a whole, losses over this period were almost £100 billion. — On average, these losses amounted to 185% of their capital. — For RBS, these losses amounted to 189% of capital, for HBOS they amounted to 205% of capital. 7. Tax Revenue and the Cost to the Taxpayer Figure 9 shows the financial assistance to Lloyds, RBS and Northern Rock against the taxes paid by these banks. A number of points stand out: — The financial assistance received by these totally dwarves their tax contributions to the state. — In 2008, the cash outlays alone for these three banks were over £100 billion, and the amounts covered by state guarantees were over £1,100 billion or £1.1 trillion. — The cash outlays have remained stable since then, but the amounts covered by guarantees have fallen considerably, and are “only” about £260 billion. 8. Remuneration Table 3 presents evidence on average annual gross pay in the U.K. for 1999–2011, covering all industries, financial intermediation and insurance & pensions.408 For example, from the 1st and 3rd columns, we can see that in 1999, average pay across all industries was £16,054, but average pay in the FI sector was £25,791. However, this comparison is not entirely fair because it ignores the different occupational compositions between the FI sector and the economy as a whole. To allow for this, the second column adjusts the “All industries” data to include only those occupations that are prevalent in the FI sector (see Table 4, eg, functional managers) 402

To be more exact, the aggregate losses of £28.9 billion mask the huge £40.7 billion loss made by RBS, the £4.9 billion loss by Credit Suisse and the £1.4 billion loss by Northern Rock. The other large institutions mostly were in profit in 2008 (although in the following year Lloyds made a loss of £4.4 billion while the RBS made additional losses of £2.6 billion). 403 Figures taken from Engelen et alia (2011), Figure 4.5b, p.111. 404 Figures taken from Engelen et alia (2011), Figure 4.5a, p.110. 405 Figures taken from the Financial Stability Report, June 2010, p. 44. 406 For more on the problems with IFRS, see Kerr (2011) or Bush (2011). These led Steve Baker MP to introduce a Private Member’s Bill—the Financial Services (Regulation of Derivatives) Bill—into Parliament in 2011 that would have required banks to prepare reports using the older accounting standards that IFRS replaced. For the various ways in which the banks can game the system, see, eg Dowd et al (2011) or Kerr (2010, 2011). So egregious were these games that Kerr (2010) found himself wondering why the banking system took so long to collapse. 407 Figures taken from Bush (2011, p. 3). 408 Note that all data are weighted to ensure they are representative of the UK population of employees.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1550 Parliamentary Commission on Banking Standards: Evidence

and the 4th and 6th columns give the remuneration data for the FI and Insurance and Pensions sectors adjusted for differences between the occupational structures in FI and the economy as a whole. Figure 9 FINANCIAL ASSISTANCE TO LLOYDS (INCLUDING BRADFORD & BINGLEY), RBS AND NORTHERN ROCK (WITH OFFSETTING CORPORATE TAX PAID), £ BILLIONS

Source: author’s analysis of FAME data and NAO (2010, and updated figures) Table 3 AVERAGE ANNUAL GROSS PAY (£) IN THE U.K. FOR FINANCIAL INTERMEDIATION (SIC 65), THE INSURANCE & PENSIONS INDUSTRY (SIC66) AND ALL INDUSTRIES, 1999–2011

Year

All industriesa

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

16,054 16,979 17,803 18,741 19,458 20,085 20,554 21,735 22,524 23,474 24,121 24,713 24,680

Financial All Financial intermediation— Insurance & industriesb intermediationb adjustedb,c pensionsb 17,824 19,052 20,259 21,495 21,893 22,287 22,191 23,606 24,723 26,198 26,525 26,840 27,320

25,791 26,800 32,443 30,993 31,466 31,749 30,589 34,856 39,934 44,829 41,012 44,684 52,458

25,545 26,872 31,791 31,381 27,813 29,501 26,422 31,838 35,222 38,162 37,543 41,976 44,254

30,465 32,407 33,760 35,648 36,405 40,517 44,596 43,870 45,952 50,301 49,563 49,492 51,043

a

Including all occupations

b

Only includes occupation groups that dominate in financial intermediation (see Table 4 below).

c

Insurance & pensions— adjustedb,c 23,977 26,215 27,370 29,467 28,063 28,704 31,563 33,402 35,404 38,488 38,233 39,020 39,484

Adjusts the occupational distribution of the industry considered (eg, Financial Intermediation) to give the same distribution as the U.K. average (see text for details). Source: (weighted) Annual Survey of Hours and Earnings (ASHE)

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1551

Table 4 OCCUPATIONS (2000 SOC) THAT DOMINATE FINANCIAL INTERMEDIATION (SIC 65) Code

Description

113 114 115 123 213 242 313 353 412 413 415 421 711 712 721

Functional Managers (eg, finance managers, marketing & sales, advertising, personnel, IT) Quality and Custom Care Managers Financial Institution and Office Managers Managers and Proprietors in Other Service Industries ICT professionals Business and Statistical Professionals (eg, chartered accountants, management accounts) IT Service Delivery Occupations Business and Finance Associate Professionals (eg, brokers, underwriters, tax experts) Administrative Occupations: Finance (eg, credit controllers, accounts clerks, counter clerks) Administrative Occupations: Records (eg, filing, pension & insurance, stock control clerks) Administrative Occupations: General Secretarial and Related Occupations Sales Assistants and Retail Cashiers Sales Related Occupations Customer Service Occupations

Source: Annual Survey of Hours and Earnings (ASHE) If we use these adjusted series, we see that in 1999 the average FI worker earned £25,545 against an economy-wide average of £17,824, ie, the FI worker earned 43% more than the average worker adjusted for occupational differences. By 2011, the average FI worker earned £44,254 against an economy-wide average of £27,320, ie, the FI worker earned 62% more than the average worker adjusted for occupational differences. The gap is even larger if we go by the “raw” numbers unadjusted for occupational difference: by this criterion, the gap rose from 61% in 1999 to 213% in 2011. In sum, the gap between the average remuneration in the FI sector and that in the economy as a whole is both large and rising over time. Figure 10 shows plots of remuneration in the FI sector relative to other sectors over the period 1999 to 2011. We see that remuneration in the FI and Insurance and Pensions sectors is consistently well above average: in the former case, it rises from just under 170% of national average in 1999 to over 240% of national average in 2011. At the other extreme is remuneration in Distribution and Hotels sector, which is consistently close to 70% of national average. One can then say, for example, that in 2011 the average FI sector work earned more than 230/70 = 3.29 or about 330% of his or her counterpart in the Distribution and Hotels sector. Figure 10 a

AVERAGE ANNUAL PAY (RELATIVE TO U.K. AVERAGE = 100) Figure 10 is not printed: available on request. Figure 11 shows plots of remuneration by percentile for the FI and Insurance and Pensions sectors and the economy as a whole. There is a “pay gap” over all percentiles, but the gap is highest at either end and lowest in the middle: — At the left end, we see that those in the lowest paid percentiles had the biggest percentage earnings gap, mostly because low-paid workers in financial services do not work in the lowest paid occupational sub-groups (eg, workers in distribution and hotels & restaurants). — In the middle range where the gap is lowest, we still see that the gap is wide. For example, the gap for FI workers in 2011 is never much lower than 60%. — At the right end where pay is highest, we see that the gap is not jus high but also rising: for example, for the top 10% in the FI sector, the gap doubles from 60% in 1999 to 120% in 2011. Figure 11 DISTRIBUTION OF U.K. AVERAGE ANNUAL GROSS PAYa IN FINANCIAL INTERMEDIATION AND INSURANCE & PENSIONS RELATIVE TO U.K., AVERAGE 2011 Figure 11 is not printed: available on request. 9. Lending Constraints to SMEs There has been much conjecture that post-2008 the banking system has been constraining the credit offered to especially the small-to-medium sized business sector. This sector is especially dependent on “cash flow” for its growth and survival, and most of the external finance it seeks to maintain its cash flow comes from banks in the form of overdrafts and to a lesser extent loans.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1552 Parliamentary Commission on Banking Standards: Evidence

Figure 12 shows net lending by the banking sector to businesses in the U.K. since 1997. Net lending was very healthy in the middle years of the last decade, but then fell sharply post April 08 and has been negative since December 08: thus, the banks have been consistently cutting back their lending for over five years—and there is no sign that this will change anytime soon. Figure 12 U.K. 6-MONTH GROWTH RATE (ANNUALISED) OF NET LENDING TO PRIVATE NON-FINANCIAL CORPORATIONS, 1997–2012

Source: Bank of England (LPMB3Z9 series) We turn now to the obstacles facing SMEs shown in Figure 13. This based on data collected by the Department for Business, Innovation and Skills (BIS) as part of its regular Small Business Survey (SBS) (see also BIS, 2012). The data are weighted to be representative of the population of SME’s operating in the U.K., and Figure 13 shows the returns from the 2007, 2010 and 2012 surveys.409 Before the 2008 financial crisis obtaining finance was ranked 9th in its importance as an obstacle to the firm realising success (20% of SME’s ranked this a major obstacle), significantly behind reasons such as the economy (58%), taxation, etc (53%), competition and regulations (49%), cash flow (44%), availability/cost of suitable premises (22%) and shortages of skills generally (22%). By 2012, obtaining finance was ranked 6th out of 12 options, with 36% of SME’s being concerned about this obstacle. The only other obstacle to see a major increase was concerns about the economy (up from 58% to around 77% stating this was an obstacle). In short, obtaining finance has become more of an obstacle to SMEs since the onset of the crisis, but the biggest obstacle is simply the state of the economy itself. Figures 14 and 15 provide further evidence on the obstacles faced by SMEs: — Figure 14 shows that 23.1% of SMEs in 2012 saw obtaining finance as an obstacle to growth, up from 14% in 2007 and 22.5% in 2010. — Figure 15 shows that the proportion of SMEs having no difficulties obtaining finance fell from just under 70% in 2007 to just under 50% in 2010 to about 45% in 2012; the same Figure also shows that the number of SMEs unable to obtain any finance at all rose from 17.5% in 2007 to 36.3% in 2010 to 41.2% in 2012.

409

For 2012 we have used the smaller SBS Barometer survey results pooled for February and June.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1553

Figure 13 BIGGEST OBSTACLES TO THE SUCCESS OF U.K. SMALL-TO-MEDIUM-SIZED ENTERPRISES (SMES), 2007, 2010 AND 2012

Source: (weighted) data from Small Business Survey Blue represents responses from 2007, red represents response from 2010 and green represents responses from 2012.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1554 Parliamentary Commission on Banking Standards: Evidence

Figure 14 PERCENTAGE OF U.K. SME’S PLANNING TO GROW THE BUSINESS IN NEXT 2–3 YEARS

Source: (weighted) data from Small Business Survey Figure 15 U.K. SME’S SEEKING FINANCE IN LAST 12 MONTHS

Source: (weighted) data from Small Business Survey Lastly, Figure 16 takes those SME’s who stated that they were not able to obtain any of the finance they sought (most of which was from the banking sector), and breaks the figures down by the size of the company. In all years, the smaller the company, the harder it was to obtain finance. However, the situation deteriorated significantly between 2007 and 2010, with even medium-sized enterprises in 2010 having more problems than enterprises with zero employees in 2007. Since 2010, this situation has also deteriorated considerably for

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1555

SME’s with one to nine employees—the proportion of SMEs in this range unable to obtain finance has gone up from 16% in 2007 to 37% in 2010 and up further to 45.5% in 2012—and there has been negligible change for other SMEs.410 Figure 16 PERCENTAGE OF SME’S UNABLE TO OBTAIN ANY FINANCE IN THE LAST 12 MONTHS BY SIZE OF FIRM

Source: (weighted) data from Small Business Survey In summary, there is strong evidence to suggest that SME’s have experienced greater credit rationing from the banking system, during a period when credit is necessary to mitigate against the problem of cash flow that impacts more on SME’s compared to larger companies. 13 March 2013 References BIS (2012). SME Access to External Finance. BIS Economics Paper No. 16. Bush, T (2011). UK and Irish Banks Capital Losses—Post Mortem. London: Local Authority Pension Fund Forum. Dowd, K, M Hutchinson, S Ashby and J Hinchliffe (2011). Capital Inadequacies: The Dismal Failure of the Basel System of Bank Capital Regulation (Cato Institute Policy Analysis No. 681.) Engelen, E, I Erturk, J Froud, S Johal, A Leaver, M Moran, A Nilsson and K Williams (2011). After the Great Complacence: Financial Crisis and the Politics of Reform. Oxford: Oxford University Press. Kerr, G (2010). How to destroy the British banking system—regulatory arbitrage via “pig on pork” derivatives’. Article posted on the Cobden Centre website. Available on the web at http://www.cobdencentre.org/2010/01/ how-to-destroy-the-british-banking-system/ Kerr, G (2011). The Law of Opposites: Illusory Profits in the Financial Sector. London: Adam Smith Institute. Vickers Report (2011). Final Report. Recommendations. Independent Commission on Banking.

410

Note the figures for 2012 are based on the smaller SBS Barometer series, and as such do not contain any firms with 0 employees.`

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1556 Parliamentary Commission on Banking Standards: Evidence

APPENDIX Table A.1 OUTPUT MULTIPLIERS FOR U.K. INDUSTRIES, 2005 Rank

Product

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61

Dairy products Meat processing Railway transport Gas distribution Forestry Electricity production & distribution Soft drinks & mineral waters Grain milling and starch Ancillary Transport services Fish and fruit processing Insurance and pension funds Construction Animal feed Social work activities non-market Sewage and Sanitary services non-market Agricultural machinery Agriculture Metal ores extraction, Other mining and quarrying Domestic appliances nec Other food products Bread, biscuits, etc Inorganic chemicals, Organic chemicals Articles of concrete, stone etc Recreational services NPISHs Transmitters for TV, radio and phone Confectionery Structural metal products Coal extraction Shipbuilding and repair Fishing Wearing apparel & fur products Public administration & defence Soap and toilet preparations Alcoholic beverages Sports goods and toys General purpose machinery Wholesale distribution Insurance and pension funds NPISHs Structural clay products, Cement, lime and plaster Sugar Weapons and ammunition Recreational services non-market Furniture Other land transport Printing and publishing Pulp, paper and paperboard Glass and glass products Iron and steel, Non-ferrous metals, Metal castings Other transport equipment Architectural activities & Tech. Consult Health and veterinary services NPISHs Miscellaneous manufacturing nec, recycling Industrial gases and dyes Textile fibres, Textile weaving, Textile finishing Market research, management consultancy Social work activities Hotels, catering, pubs etc Office machinery & computers Plastic products Metal boilers & radiators Social work activities NPISHs

Output multiplier 2.629 2.555 2.256 2.232 2.224 2.220 2.186 2.160 2.160 2.159 2.151 2.141 2.137 2.093 2.061 2.053 2.027 1.992 1.974 1.969 1.952 1.951 1.940 1.934 1.926 1.915 1.914 1.904 1.904 1.903 1.899 1.889 1.878 1.871 1.857 1.844 1.839 1.836 1.833 1.829 1.826 1.815 1.814 1.804 1.801 1.800 1.790 1.772 1.770 1.769 1.755 1.741 1.730 1.724 1.724 1.723 1.722 1.715 1.713 1.706 1.700

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1557

Rank

Product

62

Made-up textiles, Carpets and rugs, Other textiles, Knitted goods Electric motors and generators etc, Insulated wire and cable Sewage and Sanitary services Mechanical power equipment Renting of machinery etc Water transport Special purpose machinery Oils and fats processing Motor vehicles Leather goods, Footwear Fertilisers, Plastics & Synthetic resins etc, Pesticides Tobacco products Other Metal products Ceramic goods Retail distribution Other service activities NPISHs Machine tools Water supply Jewellery & related products Public administration & defence non-market Other business services Medical and precision instruments Air Transport Paints, varnishes, printing ink etc Auxiliary financial services Advertising Recreational services Owning and dealing in real estate Postal and courier services Paper and paperboard products Motor vehicle distribution & repair, fuel Receivers for TV and radio Telecommunications Metal forging, pressing, etc Wood and wood products Other service activities Electrical equipment nec Aircraft and spacecraft Other Chemical products, Man-made fibres Pharmaceuticals Banking and finance Membership organisations nec NPISHs Health and veterinary services non-market Education Computer services Research and development Cutlery, tools etc Other business services NPISHs Legal activities Estate agent activities Education non-market Rubber products Electronic components Membership organisations nec Health and veterinary services Letting of dwellings Accountancy services Coke ovens, refined petroleum & nuclear fuel Oil and gas extraction Research and development NPISHs Education NPISHs Private Households with employed persons

63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123

Source: 2005 U.K. Input-Output table

Output multiplier 1.697 1.697 1.694 1.693 1.691 1.686 1.678 1.670 1.667 1.662 1.662 1.660 1.660 1.643 1.638 1.638 1.632 1.630 1.629 1.629 1.628 1.625 1.625 1.624 1.619 1.619 1.597 1.593 1.589 1.585 1.576 1.575 1.574 1.572 1.572 1.564 1.563 1.559 1.543 1.539 1.530 1.523 1.500 1.486 1.483 1.472 1.470 1.469 1.465 1.449 1.444 1.435 1.434 1.407 1.391 1.382 1.370 1.366 1.321 1.301 1.280 1.000

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1558 Parliamentary Commission on Banking Standards: Evidence

Written evidence from ifs School of Finance Further to the oral evidence provided by ifs School of Finance Principal Gavin Shreeve on 14 January 2013 we are taking up the Commission Chair’s invitation to submit further written evidence below. Given the nature of some of the questions from both Pat McFadden and Lord Turnbull, it might be helpful to clarify that the ifs School of Finance was previously known as the Chartered Institute of Bankers. Although we changed our name in 2006 we have retained the rights to the Chartered Institute of Bankers name and more importantly we remain an organisation incorporated by Royal Charter. The Chartered Banker Institute is the “trading” title for the Chartered Institute of Bankers Scotland (CIOBS) which also retain the rights to, and occasionally uses, the CIOBS name. Membership Like the GlOBS/Chartered Banker Institute we have no statutory or regulatory powers. However, we are regulated by the QAA in relation to our Taught Degree Awarding Powers, are an Ofqual accredited awarding organisation and an FSA Accredited Body in respect of the issuing of Statements of Professional Standing (SPS) to retail investment advisers. As a result we have very clear disciplinary and malpractice procedures for all students, members and SPS holders, as well as a code of conduct and clearly defined ethical standards. In addition to this, where the conduct of a member may bring the reputation of the ifs into disrepute we have taken informal action, such as that suggested by Commission Chair Andrew Tyrie, to request that a member resign his or her membership. On the very small number of occasions we have felt it necessary to pursue such a course of action, the result has been positive ie the member has resigned with immediate effect. It is worth noting that fitness to practise is a matter for the regulatory body ie the FSA and even if an individual is struck off from our membership they remain at liberty to continue to work in the industry unless the FSA deems otherwise—a significant distinction from several other professional bodies in the legal and medical professions. The Commission will doubtless be aware that dismissals and suspensions by the FSA have hit a five year high with 1,373 workers being sacked for disciplinary reasons in 2012 (a 76% increase on 2011) which suggests the regulator may now be taking these issues more seriously. Student Numbers Lord Turnbull suggested that a decrease in membership numbers at a time when the number of those employed by banks had increased was “shameful”. This ignores evidence in our 2012 submission to the Commission that in today’s complex financial services industry, that demands increasing specialisation, the term “banker” could be used to describe a range of individuals in a bank performing a very wide variety of different roles having achieved professional qualifications from a variety of professional bodies. Furthermore, whilst the quality of our offering and reputation of our organisation ensures we maintain a relatively strong membership base in excess of 20,000 individuals, the total number of students currently enrolled on one of our programmes is more tha·n double this figure at approximately 50,000 (this figure does not include the 40,000 teenagers who participate in our annual investment challenge over a four month period). This success can be largely attributed to the fact that, unlike most other professional bodies, we do not insist on membership in order to study with us. Whilst membership provides a range of benefits, we believe that improving knowledge, skills and confidence through studying and Continuing Professional Development should be the key focus. Codes Once again it must be stressed that codes are cultural within an organisation. As made clear during the oral evidence session earlier this month, you can have as many codes as you like, but people will still break them. Most professional bodies and every major UK bank have a code of conduct. They are all broadly similar and they have all been in place for many years. The creation of a single code of conduct for bankers via a standards board is unlikely to make any discernible difference to the behaviour of bankers. Lord Turnbull disputed this but in the following evidence session attended by the BBA’s Anthony Browne, Lord McFall of Alcluith acknowledged that codes of conduct were “worthless”. He went on to state that banks, “...have these codes of ethics; they look good in their annual report, but there is always an escape clause.” The Commission implied that having a conduct code independent of the banking industry might improve matters. However, this has already been achieved in part as the Banking Conduct Regime commenced on 1 November 2009.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1559

This Conduct Regime applies to the regulated activity of accepting deposits, and replaced the non lending aspects of the Banking Code and Business Banking Code (industry-owned codes that were monitored by the Banking Code Standards Board). The Regime includes a new Banking Conduct of Business sourcebook (known as BCOBS), which contains rules and guidance. Indeed, the ifs has specifically designed a number of qualifications to develop skills and understanding in the area of customer service, and to help UK retail financial services providers embed the FSA’s revised framework for the conduct of retail banking business within their organisations. These are the Certificate in Retail Banking Conduct of Business (CertRBCB); Certificate in Business Banking and Conduct (CertBB&C®) and Diploma in Retail Banking Conduct of Business (DipRBCB®). These recently developed qualifications have been taken by almost 6,000 frontline bank staff and, as our previous evidence submission indicated, we expect this number to more than double over the next 12 months. We agree that it is essential that the issues of behaviour, culture and ethics are addressed, but we do not believe that codes of conduct are a useful means of achieving this. Instead we believe that ensuring all bank staff are appropriately educated will prove much more effective. We recognise that appropriately educating an entire workforce takes considerably longer than the simple establishment of another code of conduct but are certain that the medium to long-term rewards for consumers, the industry and the economy will be far greater. Training v Education There appeared to be some uncertainty about the distinction between training and education and we would like to help clarify this issue. A professional qualification is an assurance that a student has met rigorous, peer-developed and quantified standards through testing, endorsed by a regulated and respected awarding body. They confirm that knowledge has been acquired through learning. Training and training courses are a step along the same path, knowledge or skills are taught, students learn and acquire knowledge. The difference between training and qualifications is proof of learning; training infers it through participation, qualifications certify it through structure and independent, rigorous testing. Training does not differentiate between students who have understood and digested the learning material into knowledge, and those who have not. Even if some form of testing is part of the training, it is not done under the same rigorous conditions that qualifications are, and therefore their results cannot be judged with the same degree of confidence or certainty. Above all, training programmes are almost always focused on internal processes and procedures, often relating to sales and promotion techniques and building customer relationships. They are corporate specific and do not provide the wider contextual knowledge and understanding that comes with a proper qualification. There are intrinsic benefits to qualifications. They are recognised and respected by the individuals taking them and those looking to employ them and they enhance self-awareness and self-confidence which allows employers to increase productivity and attract a higher calibre of staff to drive better organisational performance. Common Standards Mark Garnier asked if the ifs has, “...a commonality of culture and standards...specifically, do [we] teach people who are working in the banking sector-albeit there are different parts within it-what a bank actually is and what the overall requirements are in terms of standards and culture?” As confirmed during the oral evidence session, we do provide a core of knowledge for all students regardless of whether or not they specialise. As requested, module summaries for our core learning materials are enclosed. These are the fundamentals of leadership and management, financial markets and risk and retail lending. 24 January 2013

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1560 Parliamentary Commission on Banking Standards: Evidence

Letter from Vernon Soare, Executive Director, Professional Standards, Institute of Chartered Accountants in England and Wales Following my evidence in January, I promised to come back to your committee on two points raised during the session by Lord McFall and Lord Lawson. Disciplinary Action Against the Big 4 Firms +2 Lord Lawson requested information on what disciplinary action we have taken against the top six UK accounting firms (PwC, Deloitte, Ernst & Young, KPMG, BOO and Grant Thornton) and their senior partners. Between 2008 and 2012, we processed 22 cases relating to the top six accountancy firms: — In five cases, ICAEW has taken disciplinary action and/or levied regulatory penalties against a Big Four firm, and six cases against BOO and Grant Thornton. These ranged from a caution and costs, to a severe reprimand and fines exceeding £40,000. — In ten further cases deemed to be of public interest, we referred disciplinary cases relating to the top six firms to the Financial Reporting Council (FRC). The FRC took action in five of those cases. The FRC can independently and directly call in cases without our intervention when they deem them to be in the public interest. These cases are not recorded in our figures. — We have taken action against at least seven individual partners at the top six firms. Provision of Non-Audit Services Lord McFall asked about which non-audit services are prohibited under our code of ethics. This code mandates auditors to comply with APB Ethical Standard 5. It gives examples of safeguards that can, in some circumstances, eliminate the threat or reduce it to an acceptable level. In circumstances where this is not possible, either the non-audit service should not be undertaken or the auditor should cease the audit of the company in question. A copy of APB Ethical Standard 5 is attached as Appendix I.411 The fee income from non-audit work to audit clients for the Big Four accountancy firms fell 6% from 2005–2010 and accounts for only 15% of total free income, according to the latest information from the FRC. 18 March 2013

Written evidence from the International Academy of Retail Banking Introduction Banking is different. It has yet to mature into a profession in the same way as law and accountancy... and it’s high time that it did. A separated, independent retail banking sector should be led by professionally-qualified retail bankers, bound by an ethical code similar to those already in place for accountants and lawyers. This ethical code should, amongst other things, oblige retail bankers to act in a customer’s best interest. Bankers who persistently fail to comply would be barred from membership of the profession. This is the guiding philosophy of the International Academy of Retail Banking (IARB) which believes that the foundation stone for a profession must be the complete separation of retail banking from both investment banking and large-scale corporate banking. Corporate banking has very little in common with retail banking and merits its own professional body. Investment banking, on the other hand, seems ill-suited in many of its current activities to being considered a profession at all. The International Academy of Retail Banking was founded in London in 2011 with the objective of educating retail bankers worldwide to a high professional standard. During this time, it has enjoyed the support of senior bankers and regulators in many countries. In just a year of existence, retail bankers in some 20 countries have studied IARB programmes. IARB is currently in the process of applying for recognition from OFQUAL in the UK and similar licensing and regulatory bodies in other countries. The current challenge is how to move British banking from its current sad state of affairs to one of true professionalism. We offer our recommendations to achieve this noble objective. Recommendations 1. The foundation stone for the development of professional standards in UK banking should be complete separation of retail banking from both investment banking and large-scale corporate banking. 2. As a minimum, there needs to be complete separation of retail banking from investment banking because the culture of the latter is alien and destructive to the obligation of providing consumers and small businesses with high quality banking services for the long-term. 411

Appendix 1 is not attached to this document—it can be found instead at: https://www.frc.org.uk/Our-Work/Publications/APB/ES-5-(Revised)-Non-audit-services-provided-to-audi.aspx

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1561

3. The chief executives of retail banks and all senior executives including individual branch managers should be professionally-qualified bankers who have successfully completed an accredited banking education programme. These professionals would also be bound to observe a demanding code of professional ethics similar to accountants and lawyers. 4. The predominant criterion for non-executive board membership of a bank should be in-depth risk management experience over several economic cycles. 5. The corporate culture of a retail or commercial bank must foster personal and business ethics and employee professionalism. These are absolute prerequisites for good customer service and employee retention. Specific Questions 1. To what extent are professional standards in UK banking absent or defective? The UK banking industry has its origins in the clearing banks, building societies and merchant banks—and each sector had its own professional standards, although these were not codified or published in the way they have been for decades by professions such as accountants. 2. Until some 25 years ago, aspiring branch managers (and consequently most senior managers) of the clearing banks were generally expected to study for, and pass, the examinations of the Chartered Institutes of Bankers. This tradition was undermined as the shock waves of the so-called financial services revolution took hold in Britain in the 1980s and 1990s; not least in the wake of “Big Bang” at the London Stock Exchange in 1986 and the gradual repeal of the Glass-Steagall Act (separating commercial banking, the securities industry and insurance) in the United States in the 1990s. 3. By then, it was fashionable to talk about “financial services supermarkets” which sold all manner of retail and corporate financial services—with an accompanying assumption that there was no good reason for the continuance of the old industry barriers. The term “banking” gave way to “financial services” in industry discussions and before long the London-based Institute of Bankers followed suit, renaming itself twice in a decade—first as the Institute of Financial Services in 1997 and then as the ifs School of Finance in 2006. 4. As a result, the Chartered Institute of Bankers in Scotland (now trading as the Chartered Banker Institute) remained as the only traditional banking institute in Britain. Founded in 1875, it is the oldest banking institute in the world. 5. By the 1990s, bank branches and their managers had ceased to have anything like their former status in the clearing banks and this, in turn, resulted in a considerable fall-off in students taking the banking institute examinations. 6. While all this was going on, the process of deregulation in the financial world spread throughout Western Europe and to most other parts of the world as globalisation became manifest. It was around this time that Wall Street’s investment banking and securities trading houses moved to London en masse, spreading a distinct and aggressive sales culture. The London merchant banks were soon absorbed into big UK, US and European banks and the same banks later moved further afield to Frankfurt, Amsterdam, Paris—and more recently to Hong Kong and Singapore. 7. The process of UK financial industry convergence reached its zenith when the retail banking and investment banking sectors merged in the 1990s to become what are now known as “universal banks”. Before long, investment bankers had become the CEOs of these new banks and would claim to be providing all manner of services with great efficiency to all types of customers. A similar evolution occurred in many other countries’ banking systems. 8. Hand-in-hand with the emergence of universal banking, the phenomenon of mis-selling became endemic in British banking. As the many mis-selling scandals now show, staff members in branches and elsewhere were now employed to push products onto unsuspecting customers and were given powerful financial incentives to achieve sales targets. Many of these products were manufactured by the banks’ own investment banking, insurance or pensions divisions. 9. More often than not customers did not realise that they were not getting good advice. The inevitable scandals followed in country after country, particularly in the UK. How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets? 10. The UK leads the world in virtually every area of professional services—from law to accountancy, from medicine to engineering—and all of these are rightly admired for their world-class professional standards. Each has its own professional bodies—whose members must be educated to a high standard, pass examinations and observe continuous professional education (CPE) requirements. 11. They are also bound to comply with demanding ethical codes that provide a conceptual frame of reference to practitioners confronted by a host of compliance rules. The absence of professional standards in UK retail banking is broadly paralleled in other leading markets.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1562 Parliamentary Commission on Banking Standards: Evidence

12. Like the UK, regulators in many countries have introduced detailed compliance and competency rules for retail banking staff who sell investment products, but these are a far cry from professional standards. Ideally, both go hand in hand, with professional standards providing practitioners with a conceptual framework to guide their interactions with clients. 13. More generally, it should be remembered that London has spawned some of the most egregious financial scandals of the last five years. In addition, it was the UK-based division of AIG that created credit default swap products that landed the group into severe financial distress after the Lehman debacle. The “London Loophole” label is not without merit. The net result of all these retail and wholesale banking scandals is that the reputation of Britain and London as an international financial centre has suffered considerably. 14. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole? Both retail and wholesale banks have been forced to shrink their balance sheets by de-leveraging and derisking in order to meet higher capital requirements. Shareholders have been reluctant to provide additional funding and many banks had to seek government bailouts. Banks reduced their loan books which had a negative effect on the real economy by virtue of lower spending on consumer durables and business investment. The result is a prolonged weakened economy with severe financial distress for citizens. The absence of a culture of professional standards in British banking has had serious negative consequences for consumers and small businesses—primarily because of the culture of mis-selling. As a result customers have often invested in investment products that are not suitable for their needs. Consumers suffered in several ways. Unemployment increased and savings rates dropped close to zero as monetary authorities engaged in large-scale monetary stimulus; home prices collapsed in many parts of the country and labour incomes have fallen dramatically. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector? 15. A recent report shows that over 60% of UK residents do not trust the country’s banks. This is not surprising when viewed in the context that consumers are continually hit by front-page stories ranging from LIBOR rate-fixing, technical problems with customer accounts and money-laundering accusations 16. This is one of the reasons why we propose a complete separation of retail banking from investment banking. It is easier to create an ethical culture and introduce professional banking standards when the dissonance arising from a clash of retail and investment banking is eliminated. 17. What caused any problems in banking standards identified in question 1? the culture of banking, including the incentivisation of risk-taking; It is ironic that investment bankers earn large fees advising industrial conglomerates to focus and dispose of non-core activities yet they refuse to apply the same logic to the universal banks they manage. They will argue that universal banking is good for shareholders, good for corporate clients and good for the country. In reality, the main beneficiaries of universal banking are typically the investment bankers who run the banks. the impact of globalisation on standards and culture; No comment 18. global regulatory arbitrage; The consequences of banks exploiting sources of regulatory inefficiency for arbitrage profit have given birth to a series of scandals, many of which have their origins in London. The relatively mild regulatory environment in the UK is reflected in what US policymakers call the “London loophole”. Some believe that that is evidenced by JP Morgan moving its derivative business to London that culminated in the recent $2 billion trading loss (a figure which could rise to as much as $9 billion according to some sources by the time they fully unwind the position taken by traders in the bank’s London office). the impact of financial innovation on standards and culture; 19. Financial engineering is a complex field where the level of mathematics involved presents a major hurdle, even for some very smart people. Indeed, it is not clear that the creators of exotic products—the result of complex mathematical modeling—understand the nature of the risk management features of their own creations. Therein lies the problem. 20. Financial innovation that is based on highly mathematical expertise is within the purview of a select few. The risk governance implications are clear. There is a gulf of understanding between the specialists who created exotic instruments and the executives and board members who must decide on the bank’s risk appetite.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1563

21. Weak risk governance tops the list of potential causes of the recent financial crisis. In addition, corporate culture suffers in that “specialist stars” tend to be “born”, especially when they earn a run of high profits. Disaster typically follows. It is noteworthy that in a recent report by Forbes, a trader in exotic financial products from Goldman Sachs is described as a “rock star”. 22. A corporate culture that encourages star quality in specialists who engage in seemingly excessive risktaking and trade products that are born from mathematical models is not conducive to customer care. 23. the impact of technological developments on standards and culture; No comment 24. corporate structure, including the relationship between retail and investment banking; Commercial banking (in particular, retail banking) and investment banking should never be allowed to operate within the same bank or even the same banking group via a series of subsidiary companies. Known as “Anglo-Saxon style universal banking”, this structure is fundamentally destructive to retail banking, as well as to the safety of the deposits of the taxpaying public. 25. Universal banking is also very often organized so as to bring extraordinary rewards to investment bankers, and abuse to the retail clients. (Universal banks that buy retail deposit-takers are typically looking for a “feeder” of cheap retail funds for their investment bankers to engage in excessive risk-taking). 26. Furthermore, the practice of transfer pricing between retail and investment banking within universal banks usually results in investment banking divisions taking all the spreads from interest rate, currency and options markets while leaving counterparty credit risk to be borne by the retail banking divisions. 27. Surprisingly, universal banking has also been a disaster for shareholders because of the value destruction that has been going on within these banks. If universal banks were totally broken up, it is likely that the retail bank would be where most, if not all, of the value is shown to reside. Whatever investment banking CEOs of universal banks may claim, most bank profits come from retail banking. When bank annual reports say otherwise, serious questions need to be asked about transfer pricing, which is all about shifting retail banking income over to the investment banking profit pool.We emphasise that while the organisational structure of a universal bank is detrimental to retail banking, it is really the clash of cultures that requires separation of the two activities. A utility encased by a casino will bear the losses and give up any profits. taxation, including the differences in treatment of debt and equity The favourable tax treatment of debt relative to equity has a bias towards the use of debt by banks. There is also the mistaken belief by some banking leaders that the requirement by Basel III for more core Tier 1 capital to support risk will raise the cost of equity. (b) Weaknesses in the Following Somewhat More Specific Areas: the role of shareholders, and particularly institutional shareholders; 28. Institutional shareholders have an interest in exerting influence on excessive risk-taking by management since information asymmetry between bank managers and large shareholders is likely closer to zero. But there are benefits to these large shareholders arising from private control. creditor discipline and incentives; 29. The economics of deposit insurance typically demonstrate that depositors have an asymmetric information relationship with managers and this could lead to bank runs and macroeconomic stability. It is likely that the provision of deposit insurance would reduce the urgency for depositors to monitor the risktaking activities of managers. This creates a moral hazard problem where the existence of deposit insurance encourages managers into excessive risk-taking. The costs of such actions will be borne by the insurance authority and finally by the tax-payer. corporate governance, including — the role of non-executive directors; — the compliance function; — internal audit and controls; and — remuneration incentives at all levels 30. Banks operate in a very complex environment with a web of agency relationships making corporate governance more difficult. This difficulty is increased in a universal bank where the personality of the bank is

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1564 Parliamentary Commission on Banking Standards: Evidence

rendered amorphous and the seemingly exciting world of investment banking dominates. The role of nonexecutive directors is obviously critical since they are at the heart of corporate governance. But we caution on the selection criteria for non-executive directors. Here is a case in point. The recent Liikanen Report recommends that the chief risk officer (CRO) in a bank should report directly to the Risk and Audit Committee of the board as well as to the CEO. This is fine in principle but misses a key point. It is not the CRO’s reporting line that counts. It is the background skill and experience of the board committee to whom he/she reports. Unfortunately the non-executives on these committees are more often than not people with top-level industrial experience in everything from whiskey to tobacco rather than finance or risk. 31. We recommend that the predominant criterion for board membership is in-depth risk management experience over several economic cycles. recruitment and retention; 32. Banks should recruit on the basis of banking expertise and experience. New entrants to the banking profession (similar to non-executive directors—see paragraph 30 above) must have successfully completed an accredited banking education programme. The corporate culture must foster personal and business ethics and employee professionalism which are absolute prerequisites for employee retention. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally? 33. No comment Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice. 34. No comment What other matters should the Commission take into account? 35. No comment 9 October 2012

Letter from Huw Jenkins Letter Relating to Question 2241 Thank you for the opportunity to attend the Select Committee Hearing on Banking Standards at Portcullis House on 10 January 2013. The Chairman, in his closing remarks, stated that the former UBS senior managers present had been guilty of gross negligence and were out of their depth. This appeared to be a personal statement by the Chairman rather than as a question: it was certainly not put to me individually nor did I have time to formulate my reply before he moved on. At no time throughout our evidence was any consideration given to the materiality of the UBOR setting process in the context of the size, scale and complexity of UBS’s business and the finding of three regulatory bodies that we were unaware of this issue, and that five internal audit reports failed to identify it, were completely discounted. For the record I strongly refute the conclusion that I was negligent as I said in my oral testimony. I am also somewhat surprised by the statement bearing in mind that after very in depth investigations by regulators in the US, Switzerland and the UK, which I understand included the review of many 10,000s of internal UBS documents, they reached the very clear conclusion that knowledge of these widespread practices had not reached or been condoned by senior management within the bank. I, and my colleagues, made it clear that we deeply regretted both the conduct and the fact that we did not spot this issue at the time, but at all times I acted in good faith to address the risk and other issues that we considered to be the priorities at the time. With hindsight those issues could have been better prioritised but that clearly does not constitute negligence. Indeed we candidly accepted that both the risk systems within UBS has become too formulaic and that the appalling conduct of which we are now aware evidences the failings of the culture in UBS, but this cannot be seen as a snapshot of any one person’s failings or incompetence but rather the result of an industry that had been allowed to set its own agenda for far too long. 15 January 2013

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1565

Letter on behalf of Jerker Johansson from the Dontzin Law Firm LLP Letter Relating to Question 2058 We represent Jerker Johansson. Mr. Johansson has reviewed the transcript of his testimony before the Parliamentary Commission on Banking Standards on January 10, 2013. During his testimony, Mr. Johansson gave evidence that he was unaware of the manipulation of interest rates at UBS and an internal review of those practices and agreed that this was a “failure of leadership.” (Transcript at 7). He was then asked whether he agreed that this failure constituted negligence. Id. Mr. Johansson stated that he did not understand the precise difference between a failure and negligence, and when asked by the Chair whether he would “agree that it is negligence, as you can’t tell the difference,” Mr. Johansson answered: “Okay.” Id. Mr. Johansson would like to clarify that he did not mean to suggest that he was negligent in not knowing of the LIBOR manipulation at UBS or the internal review of LIBOR submission practices. For the avoidance of doubt, Mr. Johansson maintains that he was at no time negligent. We respectfully request that this clarification be appended to the published transcript or included therein as a footnote to the exchange highlighted above. Thank you. 17 January 2013

Letter on behalf of Jerker Johansson from the Dontzin Law Firm LLP Letter relating to Question 2241 We represent Jerker Johansson. Mr. Johansson would like to make two additional corrections to the transcript of his testimony before the Parliamentary Commission on Banking Standards on 10 January 2013. The first relates to a comment by Baroness Kramer on page 12 of the transcript. Ms. Kramer stated: “Well, the LIBOR fixing continued, so when you came on board in March 2008, a systemic daily low balling of the LIBOR rate was still standard operating procedure.” Mr. Johansson responded: “Right. I was not aware of that at the time, as I said earlier ....” Mr. Johansson would like to clarify that he did not mean to suggest, when acknowledging Ms. Kramer’s comment with the word, “[r]ight,” that he agreed that a “systemic daily low balling of the LIBOR rate” was “standard operating procedure” in March 2008. Second, the transcript reflects on page 38 that all of the witnesses “indicated assented” to the Chair’s closing remarks. Mr. Johansson did not indicate his assent to the Chair’s closing remarks and does not believe any of the other witnesses did either. We respectfully request that these corrections be appended to the published transcript or included therein as a footnote to the exchanges highlighted above. Thank you. 1 February 2013

Written evidence from JP Morgan Chase & Co. 1. What are JPM’s defining values and principles; how are these embedded through the organization and impressed upon its workforce;and how has JPM’s approach to instilling its values through the organization changed since the 2008 financial crisis? Since the 2008 financial crisis we have placed renewed emphasis on our defining values and principles throughout the firm. For example, attached in Appendix 1412 are our business principles, which are readily available on our internal website and which all employees—especially new hires—are encouraged not only to read but to keep nearby and reference often. An excerpt from a statement by J.P.Morgan Jr. before the Sub Committee of the Committee on Banking and Currency of the US Senate on 23 May 1933 appears at the end explaining what it means to do “first-class business in a first class way”. This enduring business principle is embedded in our heritage, and the senior leaders of the firm emphasize it and live it every day. Attached as Appendix 2 are our attributes of leadership which form a core part of the teaching to our managers through training programs. Finally, our Code of Conduct appears prominently on our internal website, and all employees are required to affirm each year that they have read, understand and are in compliance with the Code. 2. How did the mergers of J.P. Morgan with Chase Manhattan in 2000, and with Bank One in 2004, influence the culture and values of the organization? To what extent was there a clash of cultures, and how was this reconciled? Throughout the evolution of J.P. Morgan Chase, mergers have always led to both an opportunity and a challenge to meld the cultures of the resulting organization and achieve the best both have to offer. In each case, there has been a focus on clients, collaborating across businesses and building a high performance culture within the firm. The CEO and his leadership teams have emphasized these themes repeatedly through 412

Not printed. Available at http://www.jpmorgan.com/cm/BlobServer?blobtable=Document&blobcol=urlblob&blobkey=name& blobheader=application/pdf&blobwhere=jpmc/about/business_principles.pdf

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1566 Parliamentary Commission on Banking Standards: Evidence

innumerable town hall sessions, written communications and broadcasts to all employees, leadership training programs in which tens of thousands of employees have participated, investor presentations and annual report chairman letters. We have had more than a decade’s worth of experience in putting together large mergers and acquisitions. Our attitude has always been to pick the best people, systems and strategies. None of that has been easy but the most important part of all has been not to wait to make tough decisions. Delays in integrating people, systems and strategies can prolong the establishment of a unifying culture. 3. To what extent do you believe JPM’s reputation enables it to command higher fees from clients? Do you believe this reputationaladvantage,if it exists, derives from the values set out in answer to Question 1? Fees in our main business lines are predominantly set by competitive market forces. Accordingly, we do not believe our reputation per se allows us to command higher fees. We believe the values discussed in Question 1 are a foundation of our reputation. And we believe our reputation for focusing on clients, integrity, strong execution capabilities and innovative thinking allows us to attract business and to be a leading firm in all of our key business lines. It is worth observing that some business lines such as a high net worth wealth management do command premium pricing because of the services offered and it is critical to have a strong reputation in order to be competitive in that business. 4. Do you believe there were distinctive elements of JPM’s culture and corporate governance arrangements that enabled it to weather the financial crisis better than its competitors? If so, what were these? We strive to implement a culture and governance structure designed to identify, assess and escalate material business and risk issues so that they can be addressed expeditiously. There is no one structure or set of structures demonstrably superior in all circumstances. All of our business line CEOs, their key reports and senior risk and finance colleagues meet regularly to review key developments and to establish appropriate actions and strategies. The CEO provides leadership on all such matters through daily discussions, monthly business reviews and a firm-wide Risk Committee. Throughout the crisis itself, all senior business heads, risk and finance leaders met with the CEO three times per day. Having a strategy focused on supporting clients and investing in our businesses through all types of economic and financial environments, including highly stressed periods, means that we establish and maintain a fortress balance sheet based on strong capital and liquidity and conservative accounting. The combination of our fortress balance and risk management practice allowed us to weather the storm of the financial crisis. 5. What key factors determine JPM’s risk appetite and tolerance levels? How does the Board monitor the effective implementation of the risk appetite? How have the structure, activities and remuneration of JPM’s risk management and control operations changed since the 2008 financial crisis? The firm’s risk appetite policy lays out the framework by which its risk appetite is established, reviewed, approved, monitored and managed. The framework integrates return targets, risk metrics and capital management to set the firm’s risk appetite in the context of its objectives for all stakeholders, including shareholders, depositors, regulators and customers. Each line of business is required to establish a risk appetite net income loss tolerance, return targets and limits on other relevant risk parameters, which must be approved by a combination of the firm CEO, CFO and CRO and reviewed at least quarterly by its risk committee. An overall firm-wide net income loss tolerance is established by the CEO and reviewed at least annually with the firm’s Operating Committee. The firm-wide net income loss tolerance is based on the firm’s adverse stress scenario (created as part of compliance with Dodd-Frank and the Federal Reserve’s Comprehensive Capital Adequacy Review). Firm-wide market risk and minimum liquidity tolerances also are established and updated at least annually. There is an escalation process for notifying the CEO and CRO of results exceeding risk appetite tolerances. The Risk Policy Committee of the Board is responsible for approving the firm’s risk appetite policy on behalf of the Board of Directors, and for reviewing actual or forecast results exceeding risk appetite tolerances. The Risk Policy Committee receives periodic reports and updates to facilitate this process. Since the financial crisis we have made a number of enhancements to our risk management and control processes, including but not limited to the following: — The Risk Management organization was changed to be independent of the lines of business. — Established a senior Firm-wide Risk Committee to address cross-business risk issues and to be an escalation point for lines of business risk committees. — Established and evolved the firm’s risk appetite statement and methodology. — Enhanced the market risk stress framework. — Expanded the scope of the model review and approval policy and established a complimentary model governance group to oversee model use. — Established senior risk roles with the mandate to look across the firm and review for consistency including market risk, wholesale credit risk, consumer credit risk and reputation risk. — Established a Firm-wide Oversight and Control Group, as well as control officer roles in each line of business and corporate function, to anticipate, detect and escalate control issues.

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1567

—

Expanded Country Risk Management from focusing exclusively on emerging market countries to include developed countries.

Please also see the answer to Question 6 below. 6. What failings of oversight and controls enabled the “London Whale” trading loss to occur? What changes has JPM made to its corporate governance as a result? Following disclosure by the firm on May 10,2012 that its Chief Investment Office (CIO) had incurred significant mark-to-market losses in its synthetic credit portfolio, the firm established a Task Force, led by Michael Cavanagh, currently co-Chief Executive Officer of the Corporate and Investment Bank, with the assistance of outside counsel, to review and assess the circumstances surrounding the CIO losses. The firm’s Board of Directors in May 2012 formed an independent Board Review Committee to oversee the scope and work of the Management Task Force review, assess risk management processes related to the issues raised in the Management Task Force review,and report to the Board of Directors on the Review Committee’s findings and recommendations. On 16 January 2013, the firm announced that the Management Task Force and the independent Board Review Committee had each concluded their reviews relating to the 2012 CIO losses and had released their respective reports.413 The Management Task Force summarizes the key events and sets forth its observations regarding the lapses in oversight and controls that contributed to the losses incurred by the CIO. Among the failings of oversight and controls identified by the Task Force were: the firm did not ensure that the controls and oversight of CIO evolved commensurately with the increased complexity and risk of CIO’s activities in the first quarter of 2012;CIO risk management lacked the personnel and structure necessary to manage the risks of the synthetic credit portfolio; CIO’s risk limits were not sufficiently granular; and the approval and implementation during the first quarter of 2012 of the CIO VaR model related to the synthetic credit portfolio had been inadequate. The Management Task Force report also describes the broad range of remedial actions taken by the firm to respond to the lessons it has learned from the CIO events, including: — revamping the governance, mandate and reporting and control processes of CIO; — implementing numerous risk management changes, including improvements in model governance and market risk; and — implementing a series of changes to the Risk function’s governance, organizational structure and interaction with the Board. The full text of the Management Task Force Report can be accessed on the Firm’s website at: http://files.shareholder.com/downloads/ONE/2255849611x0x628656/4cb574a0–0bf54728–9582–625e4519b5ab/Task Force Report.pdf The Board Review Committee Report also recommended a number of enhancements to the Board’s own practice to strengthen its oversight of the Firm’s risk management processes. The Board Review Committee noted that some of its recommendations were already being followed by the Board or its Risk Policy Committee or had recently been put into effect. The Board Review Committee’s recommendations included: — better focused and clearer reporting of presentations to the Board’s Risk Policy Committee,with particular emphasis on the key risks for each line of business, identification of significant future changes to the business and its risk profile, and adequacy of staffing, technology and other resources; — clarifying to management the Board’s expectations regarding the capabilities, stature, and independence of the firm’s risk management personnel; — more systematic reporting to the Risk Policy Committee on significant model risk, model approval and model governance, on setting of significant risk limits and responses to significant limit excessions, and with respect to regulatory matters requiring attention; — further clarification of the Risk Policy Committee’s role and responsibilities, and more coordination of matters presented to the Risk Policy Committee and the Audit Committee; — concurrence by the Risk Policy Committee in the hiring or firing of the Chief Risk Officer and that it be consulted with respect to the setting of such Chief Risk Officer’s compensation; and — staff with appropriate risk expertise be added to the firm’s Internal Audit function and that Internal Audit more systematically include the risk management function in its audits. The full text of the Board of Review Committee Report can be accessed on the firm’s website at: http://files.shareholder.com/downloads/ONE/2255849611x0x628655/752f9610-b815-428c-8b22d35d936e2ed8/Board Review Committee Report.pdf 413

The Management Task Force Report and the Board Review Committee Report set out facts that in their view were the most relevant for their respective purposes. Others (including regulators conducting their own investigations) may have a different view of the facts,or may focus on other facts, and may also draw different conclusions regarding the facts and issues.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1568 Parliamentary Commission on Banking Standards: Evidence

The Board of Directors will continue to oversee the remediation efforts to see that they are fully implemented. 7. Would you characterise the US retail banking markets as more competitive than the UK equivalent? Has JPM considered undertaking retail operations in the UK? As a general matter, the US banking market is less concentrated and represents a smaller percentage of Gross Domestic Product than other developed countries, including the United Kingdom. (Please see Appendix 3 which is a slide produced by the US Treasury Department. )The US retail banking market in particular is more competitive than the United Kingdom’s. The Riegle-Neal Act of 1994 prohibits bank acquisitions if the resulting institution will have insured deposits greater than 10% in the nation or 30% in any one state. This, along with other regulations, has led the US banking market to be materially more fragmented than the United Kingdom’s: on a per capita basis,the United States has -3.5x the bank institutions and over 2.5x the bank branches the United Kingdom has. For each million citizens, the United States has -20 banks and -300 branches, while the United Kingdom has 5 banks and -125 branches. Retail banks in the United States have limited pricing power and offer a relatively standard set of products. As a result, they differentiate their offering in other ways. One of the chief dimensions of competition is convenience, which has driven the proliferation of branches and ATMs that make US consumers more heavily branched per capita. Even among the theme of convenience, some of the largest retail banks place varying emphasis on sub-themes, including location convenience, their online platforms, their in-branch features (eg free coin counters), mobile apps and other convenience features. We note that there has been a lot of focus in the United Kingdom on the difficulty of switching accounts, as discussed in the Vickers Report. This is not a material consumer complaint in the United States. In fact, many popular services (eg online bill-pay) are considered drivers of relationship “stickiness”. We have not considered undertaking retail banking operations in the United Kingdom. 8. Does the existence of non-bank “alternative” providers of finance in the US have a meaningful influence on levels of competition in the retail market? What other factors does JPM believe contribute, either positively or negatively, to the competitiveness of the US retail market? Two types of alternative financial services have recently evolved in the United States. One example is storefront and online lenders who are addressing short-term liquidity needs of customers who they believe are underserved by banks but with exceptionally high interest rates. A second is retailers (in partnership with thirdparty specialist providers) who offer money transfer agent services which look and feel like deposit taking, sometimes without being FDIC-insured. Alternative payments providers such as Google Wallet, Paypal and others offer new technologies which reduce or eliminate friction from the overall shopping experience. In response to these developments, traditional retail banks are taking the best ideas and improving upon them. For example, we have launched Chase Liquid, generally considered to be best-in-class prepaid card to give consumers a prepaid option with the full service and protections afforded by a regulated banking institution. The new Consumer Finance Protection Bureau, created by Dodd-Frank, is bringing renewed focus to the consumer protection aspects of these developments. Their mandate includes focusing on disclosures, standardization, privacy and pricing issues. Ensuring a fair and competitive marketplace, which includes traditional banks and alternative service providers subject to comparable rules and standards, ultimately will further improve the quality of consumer financial services in the United States. 9. What advantages does JPM believe it derives from operating as a combined global investment bank and a US retail bank? How does JPM ensure that the scale and breadth of its operations does not compromise its values and governance? The affiliation of the firm’s global investment banks and its US retail bank provide substantial benefits, including lower volatility of revenues, sustained investments and cost synergies. Lower volatility of revenues and sustained investments The combination of retail and global investment bank franchises leads to lower volatility of top line revenues when compared to mono-line competitors. From 2009–2012,JPM’s total revenue volatility was lower than a sample11 of US retail banks (20% and 33%, respectively). This was achieved thanks to a balanced portfolio of Net Interest Income versus fee income revenue sources, and a balanced wholesale versus retail revenue stream. We have seen that wholesale and retail revenues have behaved differently to changes in important variables such as interest rates, volatility, disposable income and GOP, among others. As a result, JPM has maintained positive net income throughout and since the financial crisis. The combination of retail and investment bank lines of business also affords larger scale to sustain investments through cyclical downturns. During 2007–2010,we continued investing in our businesses while

cobber Pack: U PL: COE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Parliamentary Commission on Banking Standards: Evidence Ev 1569

maintaining a fortress balance sheet, which allowed us to capture market share as mono-line firms cut investments. Cost Synergies The combination of retail and investment bank franchises allows JPM to generate significant cost synergies it would not be able to achieve otherwise. The firm recently reported annual savings in excess of “$3 billion (firm wide) that result from being able to spread significant technological investments among a broader client base, and from achieving significant cost savings due to “volume discounts” in key areas such as Technology, Communications, Real Estate, among others. 10. As a place to do business, what are the main differences between London and New York, and what factors influence how JPM allocates its business between the two cities? What are the key risks, if any, to London retaining its status as one of the world’s preeminent financial centres? JPM’s origins go back to the London of the 1830’s and we have had a strong presence ever since. London’s stable regulatory, fiscal and political environments have always been important factors in attracting international financial businesses. The robustness, independence and commercial focus of the English legal system and the rule of law; the proximity of other related business services such as accountants, auditors and consultants; the English language; time-zone and geographic location in between the East and West; availability of talented employees have all been key factors in this attraction. Notwithstanding the changed political and public mood towards the industry in the last five years, London arguably still presents advantages over other financial centers in the region. It is clear that the current government is not complacent about what is needed to sustain the UK’s position as a leader in financial services and to remain competitive. There are challenges, however, and businesses owe it to their shareholders and employees constantly to keep under review where they invest and locate. In London, corporation tax is coming down, although the bank levy has gone up. Personal taxation (a factor that is relevant when we ask people to relocate to London), is going down but still remains higher than some other international financial centers. European Union rules on bank bonuses could significantly impact our ability to attract and retain senior people from outside the EU to run parts of our business in and from the UK. The UK has successfully ensured that new EU Banking Union structures do not restrict its access to the EU single market. However, the Prime Minister’s recent speech on UK membership of the European Union inevitably will raise questions for inward investors over the next few years, despite his expressed wish that the UK remain in the EU. JPM’s London office is the headquarters for the Europe, Middle East and Africa region. From London we conduct business across the EU and our offices in Europe’s major capitals are a mix of branches of our London bank and of our US bank- and we value the flexibility London offers as a platform for access to the single market in a variety of formats. Our trading activity in London benefits from an EU passport across the EU. London’s location and role as a financial center also make it a sensible location from which we oversee activity in Russia, the Middle East, and Africa. London’s regional and global strength—not least in terms of human capital—in foreign exchange, derivative, bond, equity and commodities markets also make it an obvious place from which to run some of those businesses, although the mobility of especially that human capital should not be underestimated and much of that activity could take place from other locations equally well, in the event of a relative diminution in London’s attractiveness. 11. Do you agree with the opinion, expressed in some quarters, that a regulatory “race to the top” is underway, with authorities competing to raise, rather than lower, standards and sanctions? Do you think this is a good thing? We do agree that to some extent there is a “race to the top” in terms of new standards and sanctions. Prime examples of this include capital and liquidity rules where some countries are going considerably beyond internationally-agreed minimum standards. As a general matter, strong standards and sanctions bolster safety and soundness and financial stability. However, it is important to recognize the global nature of banking and finance today and that vastly different standards and sanctions can have significant impacts on the competitive landscape and, by extension, where, how and by whom credit is channeled in the economy. Regulatory authorities should be mindful that racing to the top could actually reduce competition in some sectors if firms are unable to cope with escalating standards; lead to some activity being conducted outside of the traditionally regulated firms, making it potentially more difficult to address imbalances or stressed market conditions; and adversely affect consumers of financial services through restricted product and service availability and higher prices. It also is worth observing that racing to the top can lead to government decision-making through the imposition of regulatory standards replacing firms’ judgment and economic decision making. The risk of such a trend is a reduction in the efficient allocation of resources in the financial system and the economy.

cobber Pack: U PL: COE1 [E] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02 Source: /MILES/PKU/INPUT/027059/027059_w203_steve_S186 Simon Hussey (redacted).xml

Ev 1570 Parliamentary Commission on Banking Standards: Evidence

12. Does JPM anticipate that differences in the implementation of global regulations (eg Basel Ill) at a national level, and “super-equivalence” and “front-running” in certain jurisdictions, will provide significant opportunities for regulatory arbitrage in the future? Differences in regulatory regimes can adversely affect the competitive landscape and spawn arbitrage opportunities. The extent to which this happens is a function of the specifics of the final rules, how they are implemented and how the market perceives them. To understand this in the context of regulatory capital, for example, it is important to ensure rules and impacts are fully comparable. Consider that Jurisdiction A might have a nominally higher capital requirement than Jurisdiction B, but Jurisdiction A might make certain exemptions or modify methodologies such that its requirement is actually less conservative than Jurisdiction B’s. Of particular concern is where the measurement of exposure in a particular activity or asset class differs significantly across jurisdictions, leading to unequal capitalization of the ultimate risk even though overall calibration levels might be comparable. A prime example are the market risk capital requirements for derivatives in CRD IV which appear to exempt exposures to corporate counterparties, sovereigns and pension funds from the requirements in contrast to Basel and US rules. If regulatory capital methodologies are fully consistent then it is possible that the market will compel all banks to achieve at least the highest level of capital under the proposed regime even though some banks technically would have a lower requirement (eg because they have a lower capital surcharge based on their relative global systemic importance ). The market may perceive the highest level to be prudent and reasonable and therefore any bank operating below such a requirement would be considered less credible. To the extent a national authority goes considerably beyond what the market perceives as necessary to operate in a prudent manner, unduly tying up scarce capital resources, it is possible that banks not subject to such super-equivalence could benefit by operating at lower levels of capital, gain market share and achieve higher levels of return. The ultimate impacts remain to be seen as Basel Ill is finalized and implemented in each jurisdiction. 13. What changes has JPM made, or planned to make, to its business in preparation for the “Volcker Rule”? Has this caused JPM any difficulties? How, if at all, has it affected JPM’s business in London? The “Volcker Rule” is currently being considered as a regulation by multiple U.S. regulators. Given the complexity of the proposal, the numerous possible approaches proffered therein, and the number and variation of comments provided to the regulators, we at this time do not know what the content of any final rule will be, or even whether there will be one or multiple final rules. As such, while we made substantial efforts to study the potential effect of the proposed rule on our businesses, we have taken only limited steps towards implementation. Since the inclusion of the Volcker Rule in Dodd-Frank, JPM and other firms essentially have eliminated pure proprietary trading activities. Our greatest concern with the proposed rule was the difficulty of distinguishing valid market making activity- which requires putting principal at risk- from impermissible proprietary trading, and we have no further insights. In the funds area, we have begun taking steps to discontinue investment in certain funds, and limit our own investment in covered funds along the lines of the proposed rule. 8 March 2013 Appendix 1 not printed.

Treats All People Right and with Respect - Treats people with respect regardless of their level or role Exports talent to develop people and meet firm needs - Helps people navigate their careers at the firm Champions and personally engages in diversity initiatives to create an inclusive environment Manages Performance - Provides honest and direct feedback on a consistent basis Judges performance in an objective way - Makes people decisions based on meritocracy - Removes obstacles in order to facilitate team’s success

Discipline - Conducts regular and thorough business review of function - Uses well-organized processes to manage business and solve issues - Maintains a strong system of internalgovernance and controls - Creates efficiencies, reduces costs while maintaining a strong balance sheet focus.

Sets High Standards - Exemplifies the highest standard of ethics and integrity - Sets a high performance benchmark for team - Proactively takes initiative, even if outside of his/her area of responsibility - Demonstrates a strong work ethic

Fosters Openness & Teamwork - Puts loyalty to the institution ahead of personalagenda Collaborates effectively across boundaries, levels and functions to solve issues in a productive manner - Acts as if colleagues priorities are his/her own - Encourages people to say what is on their mind

Client/Customer Focus

JP Morgan Chase & Co

Sets Things up for Success - Builds a client and service centered organization - Creates a nimble, efficient structure for managing the business and making decisions - Seeks out and listens to customer’s clients view to proactively address concerns Builds teams that succeed by assessing the deliverable and aligning team members with the appropriate skills Fortitude Has RealHumanity Drives Innovation - Demonstrates determination, resilience and - Shares recognition with others - Challenges the status quo/traditional way tenacity - Shows compassion when an employee is of doing things - Eliminates bureaucracy or activity that struggling - Applies fresh, innovative thinking to drive does not add value - Celebrates team success and owns team better client/customer experience - Executes with appropriate sense of failures - Drives change by hetping others to urgency - Acknowledges that it requires a team to be overcome their resistance/concern successful Faces Facts Strategic thinking - Deals with the facts, regardless of how - Applies a global perspective in bad they may be establishing direction for team - Raises difficult issues and problems in a - Strategic thinker with respect to industry timely manner trends and how best to drive in the market - Is open and transparent by disclosing key - Communicates with clarity of thought and facts and information focus

Business Execution

People Leadership

JPMC Attributes of a Leader Partnership

APPENDIX 2

cobber Pack: U PL: CWE1 [O] Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1571

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1572 Parliamentary Commission on Banking Standards: Evidence

APPENDIX 3 A CONSOLIDATING BANKING INDUSTRY Bank Concentration, 2011* Sweden Netherlands Belgium Switzerland Italy Canada

Top 4 Banks as a Percentage of Total Banking Assets

100% 80%

Germany 60% 40%

France U.K.

Japan U.S.

20% 0% 0%

100%

200% 300% Top 4 Banks as a Percent of GDP

400%

500%

* Note: These numbers reflect local accounting conventions (e.g. US. GAAP.(FRS) and therefore may not be directly camparable. Source SNL Financial Federal Reserve FDIC, IMF, Bankscope Y-9 BHC

However, the United States is among the least concentrated banking system of any major economy and among the smallest banking system relative to the size of its economy. Written evidence from the Law Society of England and Wales414 and the Association of Corporate Treasurers General Comments 1. The Law Society and the Association of Corporate Treasurers support allowing ring-fenced retail banks to offer some types of derivatives to their customers. Not allowing them to offer derivative products could hamper small and medium sized enterprises (SMEs) and medium sized businesses (MSBs) in particular, while also having some impact on larger corporates too. 2. The statutory instrument (SI), drafted for formal consultation by the Treasury, should be based on a number of important principles. These include: 2.1 the rules should be proportionate to achieving the stated policy; 2.2 the rules should be as simple as possible and be aligned with existing rules where it is sensible for that to be the case eg rules being adopted at EU level will be binding on the UK and current indications as to their likely shape need to be taken into account from the start; and 2.3 the rules should not undermine the policy objectives of the Bill ie the difficulty of resolving ring-fenced banks should not be increased nor should there be any discernable impact on the stability of the banking system under the new regime. 3. We believe the Government has not chosen the most straightforward way of regulating the sale of some derivative products by ring-fenced banks. 4. We believe that the European Union’s EMIR (European Market Infrastructure Regulation)415 rules already set out a sensible framework and offer ready-made solutions to a number of the definitional and other issues the PCBS is examining. 5. EMIR already contains definitions regarding derivatives that have to be centrally cleared and which are thus heavily regulated. It also has a definition of those who will sit outside this system of clearing. Therefore we consider that much of the definitional work has already been done by EMIR and it makes sense to either cross refer to EMIR or copy over the appropriate rules. 6. We do not believe it makes sense to create a separate set of rules, which sit alongside the EMIR rules. This creates unnecessary complexity and greater compliance costs. The use of the EMIR rules does not (in our view) undermine the policy goals of the ring-fence. Their use is highly compatible with the objectives of 414

The Law Society contribution has been prepared by members of the Banking Reform Working Group. This group is chaired by Dorothy Livingston of Herbert Smith Freehills LLP and is comprised of senior and specialist lawyers with expertise in financial services regulation, banking, competition, EU and international commercial law and economists. 415 Details about EMIR can be found on the FSA website, here: http://www.fsa.gov.uk/about/what/international/emir

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1573

increased stability in the system, easier resolution of banks and protecting the continuation of domestic retail banking operations in times of crisis. 7. However, if the Government is intent on establishing a set of additional rules, we believe the model of regulation set out in the Government’s draft SI416 is a good attempt at allowing ring-fenced banks to offer derivatives to customers who might need them. We acknowledge the intention that the business model(s) of ring-fenced retail banks are intended to be relatively “simple” and so accept the limits by classification of derivative.417 Albeit, these classification limits could—in our view—be widened without endangering the policy objectives of the ring-fence. 8. We believe however that an approach which creates additional rules, when the EMIR ones would suffice, is very much the second-best solution. 9. However, in the context of this second-best solution, there may be ways the SI could be refined further to improve its effectiveness and ensure the right balance between the needs for a robust and hard-to-game set of rules with the need for flexibility in order to meet customer needs on an ongoing basis. 10. As a second best option the SI should place three restrictions on the nature of the derivatives and who can purchase them. These three restrictions should consist of: 10.1 Class of derivative—only currency, inflation, interest rate and commodities hedging products could be offered to customers; 10.2 Purpose of derivative—must relate to the hedging of risk arising in the course of a customer’s own business activities; and 10.3 Applicable only to dealings with non-financial customers.418 11. We believe these are reasonable, workable restrictions which will enable banks to offer the derivatives most of their clients are likely to need while compatible with the bank being resolved relatively easily (in circumstances of insolvency) in a way which will not unduly detract from financial stability. Questions Question 1: Is it appropriate for SMEs to be able to hedge risks arising from price fluctuations directly with a ring-fenced bank, rather than with a non-ring-fenced bank, and if so, why? 12. We strongly support allowing ring-fenced retail banks to offer derivatives to customers and especially to those customers who are SMEs and MSBs.419 Indeed, ideally there should be no restriction by size of enterprise. The derivative needs of SMEs and MSBs 13. As a practical matter at present, the types of derivatives which are most regularly used by SMEs (and MSBs) in carrying out their business are: 13.1 interest rate derivatives eg swaps and derivatives hedging inflation exposure (for firms supplying the government sector or regulated entities on a long term basis); 13.2 foreign exchange derivatives eg forwards (although these may not always qualify as derivatives) or options; and 13.3 commodity derivatives—to hedge commodity prices, particularly when they produce, import or trade in the relevant commodity. 14. These are the minimum types of derivatives that ring-fenced retail banks should be able to offer to their customers.420 15. In addition we note that a significant number of businesses who commit to longer term contracts hedge against inflation risk and this may be important to their ability to offer best value for money when tendering for contracts of this nature with central and local government and other public sector bodies. 16. A smaller number of firms also use other types of derivative products, such as equity options and weather derivatives (eg for entertainment events or seasonally affected business such as ice cream manufacture) or inflation derivatives. 416

The draft Excluded Activities and Prohibitions Order can be accessed here: http://www.hm-treasury.gov.uk/d/draft_excluded_ activities_and_prohibitions_order_070313.pdf Reg 4 of the draft Excluded Activities Order permits a ring-fenced bank to sell (1) interest rate (2) foreign exchange and (3) commodity price derivatives for the purposes of permitting an account holder to limit the extent to which it may be adversely affected by those risks. 418 This restriction would need to be subject to further study and consultation. 419 Medium sized businesses with a turnover in the range £10m-500m. 420 We note for example that Lloyds-TSB (the current bank most like a ring-fenced bank) offer all these to their customers. More details can be accessed on the Risk Management pages of their website: http://www.lloydsbankcommercial.com/Products-andServices/Risk-Management/ 417

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1574 Parliamentary Commission on Banking Standards: Evidence

17. While we would prefer to also see ring-fenced banks being able offer these types of derivatives too, the levels of need for these are not as great. Therefore the potential negative consequences of ring-fenced banks not being able to offer these types of derivative is much less than for interest rate, foreign exchange and commodity derivatives. 18. We wish to draw particular attention to the position of MSBs, which we believe includes companies considerably larger than those classified as “medium sized” under company law. MSB includes, for example, professional firms such as solicitors, except for the very largest, and a wide range of manufacturing, services and high-tech business which are not yet large enough to tap capital markets or develop relationships with investment banks. These MSBs will be particularly affected by these proposals in terms of their banking relationships, in that their traditional banks, to a greater or lesser extent, would not be able to meet their needs.421 19. The Treasury’s approach overlooks the advantages for businesses of engaging in this type of transaction with their banks applies not just to SMEs but to all businesses. While the need decreases with size, even the very largest company will gain economies through netting and set-off arrangements from using the bank which provides its payment services for trade related derivatives required within its day to day cash management. The possible consequences for SMEs and MSBs 20. The ring-fenced bank is likely to be the first port-of-call for the large majority of SMEs and MSBs needing to obtain derivative products. Prohibiting these banks from offering these products would inevitably lead to a significant reduction in their availability and introduce unnecessary “frictions” (additional transaction costs) into the market. This would significantly increase the costs of accessing such products for SMEs and MSBs, and may make it very difficult for some to access these products at all. In practice restrictions will make it more difficult and more expensive for SMEs and MSBs to do business in the UK and overseas, limiting their growth potential and making their business more risky with potential knock on effects for the UK economy. 21. We therefore consider that the right approach is to allow SMEs and MSBs to buy from ring-fenced banks those sorts of derivatives which are most suitable for their risk management needs without unduly constraining the sources from which those products are available to them. 22. Restricting the main suppliers of SME/MSB finance and payment services (ring-fenced banks) from offering derivatives to this class of customer will have a severe effect on the availability of necessary hedging products for smaller businesses. In other words it is likely that SMEs will see the supply of derivative products severely reduced. 23. A reduction in availability of derivative products would have a severe effect on the ability of SMEs and MSBs to manage risk (including risks related to exports) and to grow their businesses. The simple reason for this is that the bank which holds the customer relationship with these businesses is able to offer these products within its overall credit envelope for the customer without carrying out additional credit assessments or incurring other costs and would already be collateralised appropriately (eg through set-off rights and charges in respect of the customer’s assets, including account balances). Third-party providers and SMEs 24. A third party provider would not have an established relationship with the customer and the consequent advantages that this brings to both parties and thus is likely to be much more expensive option in practice. There is also a risk that third party providers may not be interested in small business customers because of the smaller margins which offering derivatives to SMEs may entail. Even if some third party providers are prepared to deal with smaller businesses, the costs of additional credit assessments and provision of specific collateral (if indeed any is available) may mean that these services are simply unaffordable by smaller businesses, so that they have to take exchange and interest rate risks which larger businesses can avoid. These businesses do not have the scale which would enable them to deal with additional financial providers in relation to services their ring-fenced bank is prevented from providing. The exporting needs of SMEs 25. Further, we note that the provision of currency hedging is one of the oldest functions of a bank for its business customers and its removal would be to negate the value of a ring-fenced bank to serve exporting businesses. It would also make difficult the provision of foreign currency services generally—such as foreign currency accounts, yet these are needed in the modern world, even when trading largely in the UK or in the EEA: for example oil, gas and many commodities are traded in US$s in wholesale markets domestically as well as internationally and euro accounts may be maintained in this country by businesses regularly trading with the Eurozone. 421

In addition, we believe that the rules should include a requirement whereby if a ring-fenced bank chooses not to offer a permitted product itself, that a ring fenced bank is obliged to facilitate its provision by another institution—e.g. where they hold all the available collateral, they should be able to/required to provide a guarantee/share the collateral so as to enable access to the product, where this falls within the overall credit limit for the company concerned; and there should be arrangements in place to allow participation in the syndicated loans of banking clients.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1575

26. We believe that as long as sales of such derivatives are carried out in a suitable fashion there is little to be concerned about from the clients’ point of view. Where there are risks of mis-selling these are best dealt with through the FCA’s developing approach towards “conduct risk” rather than by prohibitions on the sale of derivatives.422 Indeed, the FCA will have extensive product banning powers, under the new UK regulatory regime, which could clearly be invoked to prevent the sale of inappropriate derivative products 27. Given the intended product restrictions, we see no reason to limit the size of customer that a ring-fenced bank can have. Further, in the context of robust selling rules and effective regulators further restrictions suggest a lack of confidence in the wider regulatory framework. 28. Even if SMEs and MSBs are in practice limited to dealing with ring-fenced banks, the fact that larger MSBs can potentially deal with other banks, especially for particular products, can create competitive incentives for ring-fenced banks and non-ring-fenced banks to offer a good range of permitted products on reasonable terms. In practice the main lending bank (or banks) contractually limit the ability of companies up to mid+ size (and larger credit constrained companies too) from doing ancillary business with other banks. The indications are that the figure of £6.5 million turnover will be used, which appears reasonable, since non-ringfenced banks will not be interested in very small businesses, but it must be recognised: 28.1 Businesses with very much lower turnovers than this trade in currencies other than sterling and take on floating rate loans which involve interest rate risk. 28.2 Businesses very much bigger than this often choose to have only a single bank relationship: of necessity that is with the bank which can provide account and money transmission services as well as a range of other financial services—as clearing and money transmission services of existing universal banks will have to be put into the ring-fenced member of the group—that relationship will naturally be with a ring-fenced bank. We note the Independent Commission on Banking envisages that many larger companies will choose to keep their accounts with a ring-fenced bank and that their deposits will make an important contribution to the liquidity of ring fenced banks: but if a ring-fenced bank cannot offer an attractive range of services, then these companies will go elsewhere—eg to a universal bank regulated elsewhere in the EU or to a UK regulated bank outside the ring-fence. Fundamental need for flexibility 29. We believe that the rules around what types of derivatives can be offered and to whom should not be unduly restrictive. In particular, the types of derivatives ring-fenced banks should be able to offer should not be limited to those which can be standardised, bearing in mind that many businesses will have an ongoing need for bespoke OTC derivative products to address particular risks arising in the context of their own business activities. 30. There needs to be flexibility in the system for a number of practical reasons: 30.1 Commercial and industrial firms’ exposures will be contingent on the business model and method of financing of the relevant enterprise, as well as the actual transaction it is carrying out in its business and associated matters affecting the timing and levels of cash flow. Examples of factors which can affect the derivative required by a particular business include: actual dates of manufacture and despatch, sailings and arrivals of carriers, delays in customers approving payments or delays in trade documentation handling etc. In other words, some features of the needed derivatives may make them unsuitable for standardisation, on exchange trading, etc. Therefore we do not consider the required flexibility is found in non-relationship derivatives, reflecting an obvious need for many of these products to be documented on a bespoke OTC basis. 30.2 With regard to derivatives, particularly currency derivatives, non-financial companies, other than the very largest do not usually have spare financial assets or cash available for margining (collateral provision) for derivatives with a provider which is not also providing banking services and may often lack the systems to manage daily margin movements. Of course, some larger non-financial companies do have the needed collateral: utilities, for example, are often required to keep large amounts of cash or equivalents on hand that can be used for margin. But many other firms do not and would have to use debt facilities to fund specific margin provision: while some larger companies can manage this without excessive expense or an adverse effect on working capital, smaller companies cannot. Using direct relationship derivatives and taking advantage of the exemptions available under EMIR423 rather than centrally cleared derivatives, such companies can agree more flexible arrangements within the prudent credit limits of their bank(s). 30.3 The biggest non-financial corporate uses of derivatives (foreign exchange and interest rates) are not necessarily suitable for this kind of exchange trading. To require them to be available only that way would convert manageable risks (including credit risks on the derivative supplier) into 422

Of particular note is the existing suitability and appropriateness regime, which is likely to be amended in the near future as a consequence of the ongoing review of the Markets in Financial Instruments Directive (MiFID). 423 EMIR imposes margin requirements for non-cleared derivatives and applies concessions in the case of non-financial counterparties.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1576 Parliamentary Commission on Banking Standards: Evidence

large-scale cash-flow risk. Non-financial companies, SMEs and MSBs in particular are likely to be at a disadvantage were they limited to using exchange traded instruments only. Even very large companies cannot cope with the characteristics of exchange traded derivatives which is why there are substantial carve-outs within EMIR to allow companies to continue hedging direct wit their banks. The question of when non-standardised derivatives should be available is a regulatory not a structural matter and is in our view not for this legislation. 31. We believe aligning the rules with those in the EMIR would offer sufficient flexibility to enable ringfenced banks to meet their customers needs. The needs of larger enterprise 32. The needs of large businesses can be met in their totality elsewhere, but, as the ICB recognised, this would not be desirable, could be more expensive and in the event of another major shock would leave much of the resolution outside the control of UK regulators. Given the other restrictions on type of derivative envisaged, we see no reason to restrict business with larger firms. If payment systems are within the ring-fence there is additional advantage in large firms dealing with ring-fenced banks. 33. The importance of flexibility in arrangements should not be overlooked—provided that suitable prudential arrangements are in place, as they will be. Therefore ideally, we would not wish to see any restrictions placed on the sorts of business to which ring-fenced banks can offer derivatives. We consider that the Treasury is mistaken in opposing this. EU Law 34. We also recognise that at the EU level steps may be taken to limit the types of derivatives which may be made available to SMEs in the future. We consider that some elements of the EU approach are unduly conservative and underestimate the ability of SMEs to make informed decisions about the sorts of products which best serve their needs. Therefore it may be the case that, in future, the UK is forced to accept some limits on what derivatives can be offered to SMEs, to the extent that there is an EU law prohibition on the sale of certain types of derivatives. The EU legislation (notably MiFID) would be determinative of the issue, meaning that UK banking reform legislation is not the place to address it. Question 2: Is it appropriate to permit ring-fenced banks to sell derivatives to customers when the “main” purpose is to hedge risks, rather than simply when the “sole” purpose is to do so? Using EMIR is the best way forward 35. If the legislation aligned itself with the EMIR rules, then discussion over some of these issues would be much less complex. In many ways EMIR offers a ready-made solution to a number of the areas under consideration. 36. Derivatives will be regulated under the EMIR. The rules contained in this piece of legislation provide for flexibility in credit risk management for non-financial firms using derivatives “objectively measurable as reducing risks”. ESMA’s (European Securities and Markets Authority) technical standards expand on this definition. This would appear to create an adequate framework for governing this whole area, consistent with and not undermining of the policy objectives of the ring-fence. 37. The FCA will interpret the EMIR rules for the UK as they affect both non-financial and financial firms including banks. To introduce another set of related definitions will be a complication and require even more record-keeping and analysis by firms of all sizes. We strongly urge that the approach taken by the FCA is replicated in this new context. 38. Following EMIR is the least complex way forward and will reduce compliance costs for all parties. Creating as simpler system as possible, given the EU framework within which the UK has to operate. Second best option 39. However, if alignment with the EU rules is not deemed the sensible way forward by the Government, and we would urge the PCBS to recommend that it is, then a second best alternative is to legislate purposively in this area and then to leave detailed issues to be resolved through guidance by the regulator. 40. The FCA/PRA is likely to develop detailed guidance on where it is acceptable, from a regulatory perspective, to draw the line in relation to the purpose of the derivative and the amount of leeway the banks and customers will have in how to use it. 41. A purposive rule, with detailed guidance developed by the regulator in the context of the three-part criteria we set out above and in conjunction with the new approach to regulation being developed by the regulators and their enhanced powers424 under the Financial Services Act 2012 cumulatively provides a 424

Recently enhanced CONFIRM regulatory tools in the hands of the FCA for the control of undesirable products or behaviours by banks in relation to these products or behaviours e.g. the power to outright ban certain products.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1577

powerful phalanx of restrictions around the offering and use of derivatives by ring-fenced banks and customers respectively. 42. Therefore, in our view wording which broadly described the purpose of the derivative as “…hedging risk in the client’s own business activities” would suffice. However, if there was still concern a qualification along the following lines could be added: “Derivatives must be reasonably related to the risk the client is seeking to hedge in terms of period as well as substance”. 43. We believe that in order to have a suitably robust set of rules there is a need to avoid “menu drafting” in the legislation and to use clear, broad classifications. Banks need to be able to serve their customers without requiring a change in the law to adopt a useful innovation. 44. A purposive approach would not prevent banks from adapting their product offerings to meet their customers’ needs. Currently, forwards, swaps (notably including currency swaps that exchange fixed and floating interest rates and currencies and so effectively combine a currency swap and an interest rate swap) and contracts like forward rate agreements and related options (sold by the bank) are commonly used in transactions between banks and their customers and arrangements for a letter of credit, for example, may embed this type of transaction. Question 3: What challenges is the PRA likely to face in defining rules to assess the purpose of derivative transactions and does the draft secondary legislation provide a clear enough mandate to support such rules? 45. Under EMIR, non-financial firms’ derivatives used for hedging are exempted from standardisation, clearing, and margining and centralised trading. As we describe in our response to Question 2 (above) and set out in our three principles in the General Comments section we consider that it is important to build on existing regulation which already addresses some of the questions posed and not to proceed as if legislating in a vacuum. 46. The FCA, will be interpreting the rules and it should apply the same interpretations to ring-fencing and the PRA should use the same. It would be counter-productive to introduce a new set o rules to be administered in parallel with the EMIR classifications. Further, the FCA (as a conduct regulator with product banning powers and supervisory responsibility for exchanges, trading platforms and clearers) is likely to have more practical knowledge of derivative transactions in its day-to-day activities than the PRA. There will therefore be a clear and unequivocal need for the FCA and the PRA to co-operate closely when taking regulatory decisions in relation to derivative transactions. 47. Article 4(2)(a) of the draft of the Order proposes to restrict the sale of derivatives to those which fall within Section BIPRU 7.10.21(1) of the FSA Handbook, namely: “linear products, which comprise securities with linear pay-offs (eg bonds and equities) and derivative products which have linear pay-offs in the underlying risk factor (eg interest rate swaps, FRAs, total return swaps)”. In light of our points on EMIR we do not consider these restrictions to be necessary. Question 4: Is a restriction based on BIPRU 7.10.21(1) appropriate for limiting the provision of derivatives to simple products which serve the majority of SME needs? 48. We welcome that the proposal intends to use existing definitions and not to craft new ones. However, we believe that simple “put and call” options (for the permitted types of derivatives) should also be allowed within the ring-fence. 49. For the client they have the advantage that once the option fee is paid upfront, there are no further negative cash flows for the client irrespective of outcome.425 It is easy for the bank providing the option to purchase an offsetting option to hedge its own exposure if it is other than small. 50. To discourage smaller firms from buying options where they are the appropriate risk management tool could lead to some counter-productive outcomes. 51. If such options are not available within the ring-fence, we believe that the ring-fenced principal bank of a company should not be permitted to restrict the company’s access to another provider if the ring-fenced bank cannot sell options to the client. Question 5: What will be the effects of the restrictions relating to evidence of the fair value of the investment, and how does will it help address the Commission’s concerns? 52. We welcome this use of an existing definition. However we are concerned that changes to IFRS are not within the control of the UK authorities and so it may be necessary to “freeze” the definition to its current position. 53. Furthermore we note that in times of market disruption or temporary illiquidity, even Level 1 and 2 instruments fall into Level 3. Accordingly we believe that the working for the intended purpose should be expressed as referring to instruments that “are normally expected” to fall into Level 1 or 2. 425

Few small firms use options but in many cases the type of exposure they are hedging is best dealt with by options. Options should not be made more difficult for smaller firms.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1578 Parliamentary Commission on Banking Standards: Evidence

54. However, we have strong concerns about how this type of restriction might work when derivatives are not generally an “investment” in the true sense and may be in the nature of a wasting asset.426 55. Therefore we urge caution in relation to the use of this type of definition. Question 6: Is the proposed methodology for calculating a gross cap on the total of derivatives sold the appropriate one, and is it resistant to gaming? 56. We do not consider there to be a need for a “cap”. As we have stated the best option is for the rules on derivatives to be aligned with those in the EMIR. 57. We consider that the best way of reducing the risk to the ring-fenced bank from derivative business is through the supervisory process and requiring that the net exposure to derivatives after hedging by the bank be restricted. Given the embedded prudential requirements of the EMIR and CRD IV (Capital Requirements Directive) as regards derivative (and other) exposures relative to bank capital etc we see no need for especial treatment of ring-fenced banks with the implied commercial distortions that follow. 58. Even under the second-best solution we have also described, we do not consider the argument for a “cap” to be a strong one. The kinds of restrictions we have outlined as constituting the second-best option should create an adequate framework to govern the offering of derivatives by a ring-fenced bank. In addition the points in the above paragraph, regarding CRD IV for example, still hold true. 59. Indeed by its nature such a cap is likely to cause material operational difficulties in practice and lead to arbitrary “rationing” decisions. These could have damaging consequences for businesses. 60. Given the small amount such corporate derivative exposures make up of a bank’s total balance sheet we doubt whether a cap is a proportionate response ie the benefits which it produces may not outweigh the potential costs it imposes. The level it would be set at might advantage or disadvantage certain banks over others eg those with the heaviest levels of international trade or working in a sector where trading takes place in another currency (eg oil and gas) could be negatively affected. 61. There is a risk of duplication, as the size of exposures to individual clients and the consequent credit risk are dealt with in capital adequacy legislation, so that further controls on individual limits are not relevant and would be distortive of client relations, as client needs differ. 27 March 2013

Written evidence from the Legal Services Board Introduction 1. The Legal Services Board is the independent body responsible for overseeing the regulation of lawyers in England and Wales. Our goal is to reform and modernise the legal services market by putting the public and consumer interests at the heart of the system. The Board is independent of Government and of the legal profession. It oversees ten separate bodies, the Approved Regulators, which themselves regulate the circa 120,000 lawyers practising throughout the jurisdiction. The Board also oversees the Office for Legal Complaints, which runs the newly established Legal Ombudsman scheme. 2. Our clear focus is on delivering the eight regulatory objectives, set out in the Legal Services Act 2007 (LSA). These are: —

protecting and promoting the public interest;

—

supporting the constitutional principle of the rule of law;

—

improving access to justice;

—

protecting and promoting the interests of consumers;

—

promoting competition in the provision of services in the legal sector;

—

encouraging an independent, strong, diverse and effective legal profession;

—

increasing public understanding of citizen’s legal rights and duties; and

—

promoting and maintaining adherence to the professional principles of independence and integrity; proper standards of work; observing the best interests of the client and the duty to the court; and maintaining client confidentiality.

3. The LSB has no locus to take a policy position on the future of standards setting within the banking industry. It offers the comments which followed purely by way of reflection on its own experience of operating for four years in the Legal Services Sector. 426

It would be necessary to have only a single point for valuation when the transaction is entered into—it would not be possible to change it or abandon it later.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1579

Can two levels of regulation work effectively? 4. The Commission has been considering whether it is practicable or desirable for there to be some form of separate ethical supervision of individuals within the banking industry, which would sit apart from formal statutory regulation of banking entities and the formal regulatory supervision of “approved persons”. 5. The tradition in the legal services sector has been for regulation to focus only the behaviour of individuals. However a number of changes in the marketplace over the last 10 years, not simply the LSA, have increasingly placed the focus of regulation as much on entities as on individuals. The LSB considers that this dual focus is absolutely the right one. Individuals need to be given every incentive to live up to the high aspirations of their professional calling, whilst the firms and other entities which employ them need to be held to account for their direct statutory responsibilities and the maintenance of proper systems of control and governance and internally, not least to enable individuals within the firm to meet their own obligations. The “ethical infrastructure” of organisations has to depend on corporate ethos and behaviour led from the Board downwards quite as much as on ethical obligations on individuals and both elements call for proportionate regulatory supervision. 6. In our context, we consider that it would be very difficult indeed for these roles of individual and entity supervision to be divorced, primarily to ensure that there is no scope for an offending individual or firm to attempt to “shift blame” from the entity to the individual level or vice versa and that any investigation of misconduct can be carried on as seamlessly as possible, without artificial bureaucratic boundaries getting in the way. 7. In relation to financial services regulation, where the statutory regulator has controls which bite on companies not only in relation to formal systems as well as also corporate culture and practice, but also on defined individuals within them, the introduction of a separate body with a focus on ethical standards seems potentially to raise even more complex issues of governance, public understanding and “inter-operability” between organisations. 8. The experience of the legal services sector is that, with considerable effort, it is possible to devise “work arounds” which tackle some of these issues. The rest of this memorandum sets out how these work in practice, However, the Commission will need to consider whether introducing a similar level of complexity into financial services regulation would achieve compelling benefits which were otherwise unattainable or whether simpler regulatory architecture could be more effective. Issues for consideration in a two tier model 9. Should a division of regulatory labour be envisaged despite the very significant issues noted above, the LSB’s experience suggests that a number of requirements would need to be met as a minimum, were it to have any prospect of success. These conditions include: — a common set of objectives, ideally with statutory backing, for both sets of regulators- the LSA helpfully gives both the LSB and the bodies which we oversee a common set of regulatory objectives. While there is often room for debate about the precise intent of the objectives and the relative weight to be given to each of them in a given set of circumstances, the commonality of approach nevertheless provides a common language and viewpoint and reduces the scope for conflict; — clear differentiation of roles and function -the LSA makes clear that it is not the job of the LSB to duplicate the activity of the bodies which it oversees nor to substitute its judgement for theirs on matters of detailed regulation or intervention in the regulatory management of the behaviour of an individual or firm. However, the Board does have a wide range of functions, specified below, to ensure that the overall regulatory system operates in the public interest. The fact that both the FCA and the new “ethical body” may bite on the same individuals in financial services places a particular premium on both clarity of role and consistency of approach to decisionmaking; and — strong oversight backed by powers of intervention (by the senior regulator or perhaps a Parliamentary body) for use when necessary—where a private or self-regulatory body, even with strong, majority independent membership at Board level, exists to provide essentially public functions, it is, in the LSB’s judgement, imperative that a framework of proportionate control exists in order to both protect the independence of those bodies from those they regulate and to incentivise them to perform against best regulatory practice in the same way as statutory regulators. In the case of legal services, it is important that this is done very clearly at arm’s length from both legislature and executive to ensure that there is similar protection from the perception or reality of unjustified political interference in the process, but this may not be the case in every sector. Functions of Oversight Regulation in a Two Tier Model 10. To the extent that a banking standards body were a “pure” professional organisation which did not seek to do more than offer a mark of excellence of performance and set aspirational standards of behaviour, rather than to operate any direct approval or exclusionary role in the labour market, then there may be no need for

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1580 Parliamentary Commission on Banking Standards: Evidence

any formal regulatory approval or oversight of its activities. (The Medical Royal Colleges are perhaps an apposite example here). There may be some merit in some form of memorandum of understanding between such a body and the FCA! Bank of England to facilitate information exchange, but the relationship would essentially be no different to that which the regulators enjoy with other trade and professional bodies. 11. However more formal arrangements may be necessary if the standards body were seen to be exercising some kind of formal or statutory powers. In this case, the LSB’s experience suggest that an oversight role would be needed to ensure that: —

the standards of behaviour were properly challenging and arrived at through due process;

—

the body had the capacity and capability to ensure that its aspirations were achieved in practice;

—

the overall framework for this division of responsibility remained under constant review and was updated in the light of change in market conditions; and

—

the governance and financing framework was such as to secure its independence from those which it regulated.

12. In the legal services market, the LSB carries out these roles in a number of ways. In relation to tl1e maintenance of standards, the Legal Services Act mandates us to review and approve changes to the “regulatory arrangements” of those bodies which we oversee. Although the majority of proposals put to us can be agreed very rapidly indeed and often do not need require detailed scrutiny, in other cases testing the proposals against the regulatory objectives and the better regulation principles is helpful in securing a more appropriate outcome. 13. On standards of performance, the LSB has developed a model of best regulatory practice in the legal services sector, which focuses on ensuring that the bodies we oversee: —

have codes of conduct based on outcomes rather than very highly elaborated rules;

—

identify and assess the risks of their part of the market robustly;

—

supervise firms and individuals effectively especially those which present the greatest risk; and

—

have a wide range of strong enforcement tools which they are not afraid to use where necessary.

We are currently completing our first round of assessments of frontline regulators against these requirements. The Commission may wish to consider whether a similar toolkit could be helpful in ensuring that any ethical body was effective in both standard setting and enforcement. 14. In terms of maintaining the overall framework, the Act gives the LSB a variety of powers to recommend to Ministers and Parliament the creation of new regulators (and Licensing Authorities for alternative business structures) and new “reserved activities” (that is, specific legal services, which can only be provided by an authorised person regulated by one of the front-line regulators). Although the processes in all cases are defined at very considerable length and could benefit from simplification, that split of responsibility between regulator and ministers ensures an absence of “regulatory creep” on the part of the former and “regulatory dabbling” on the part of the latter. 15. On the final point, should a banking standards body emerge from a currently existing body, there would be the opportunity to achieve a clear understandable division, by the regulatory responsibility remaining with the current body and its lobbying and representative arm being spun off, with a challenge to find its own place in the marketplace. Because the reverse process happened in the legal services market, the LSA mandated the LSB to draw up “internal governance rules” to protect the independence of frontline regulators. 16. The rules, which are directly mandated by the LSA and have been the subject of extensive consultation by LSB, include provisions for: —

ensuring that there is a lay majority with appointments made through a Nolan-type process. Some stakeholders have argued that there should also be a guarantee that the Chair is lay. The LSB, at present, has not taken this view, but the rules made clear that there can be no presumption of a professional Chair;

—

assurance that the regulator will have the resources necessary to do the job. The Act makes clear that the LSB has to approve the annual practicing certificate fee level set for both individuals and entities. As a discipline, this has worked effectively for three years. This has the effect that the representative arm of the approved regulators cannot withhold funds in a way that prevents the regulator from doing its job, but, equally, ensures that there is a degree of transparency in the regulator’s budgetary request to give proper incentives for efficiency. The LSB has been insistent on proper consultation and transparency of regulators’ plans to those they regulate to ensure that this discipline is further re-enforced; and

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1581

—

clear separation of all relevant decision-making—effective “Chinese walls” within bodies means, not simply that representative arms should take no part whatsoever in decisions on individual cases, but also that key regulatory strategy has to be totally independent of the representative body (although they will be a legitimate and often influential commentator on what is proposed). Additionally, it is also important that the corporate structure of the body does not mean that the regulator’s discretion can be limited by, for example, the imposition of human resource management rules or IT requirements which are not fit for its purpose. Arrangements do need to be put in place to deal with the extreme case of major regulator failure, should a regulatory board turn out to be unfit for purpose, but it is clear that the representative body would need to deal with such an issue in the closest collaboration with the LSB.

17. The implementation of the rules was a far from easy process, although considerable progress has now been made. Ongoing compliance is the subject of an annual audit process overseen by the LSB. 18. The Commission may wish to consider the extent to which the types of disciplines may be necessary to protect the independence of and thereby build public confidence in the effectiveness of an industry-led banking standards body, especially if it were to be part of a body with a lobbying role. Developmental Activity 19. Finally, it is worth noting that the LSA gives the LSB the responsibility to assist in the promotion and development of best practice in regulation and in legal education and training. In practice, of course, much of this responsibility is rightly discharged by frontline regulators, but it is helpful for the oversight regulator to have such a power in order to: —

Make connections between practice of the various bodies which it oversees and practice in other sectors to raise standards generally —in the financial services world, for example, there may be lessons to be drawn from bodies such as the Chartered Insurance Institute of a broader relevance.

—

Act as a fulcrum for research, both in helping to ensure that there is not a duplication of effort but also in commissioning material that may not be developed independently. In our case, this work is developed in collaboration with a Strategic Group drawn from both frontline regulators and academic stakeholders.

—

Ensure constant challenge to performance through the regulatory effectiveness model described in paragraph 11 above.

—

Ensure that a range of routes are possible to enter the professions in a way which maintain standards, but also enhances diversity in line with the regulatory objectives.

One example of developmental activity which may be particularly relevant in this area is the Board’s recently commissioned work on the measurement of professional ethics. https://research.legalservicesboard.org.uk/wpcontent/media/designing_ethics_indicators_for_legal_services_provision_lsb_report_sep_2012.pdf This study, prepared by Professor Richard Moorhead of University College London, begins to develop thinking about ways in which the “ethicality,” importantly of both individuals and organisations, can be assessed and also tracked over time. While the concepts involved are complex and would need significant further development before being capable of putting directly into operation, the LSB believes that the work is very suggestive and look forward to discussing how it can be taken to the next stage with our own frontline regulators on the basis that it is important to move beyond bland assertions of the importance of professional ethics into something which can be robustly incorporated into regulatory practice. 20. We would commend this work to the Commission, which may wish to consider the extent to which it is directly transferable or whether there would be benefit in exploring a more sector-specific approach for banking services, irrespective of where the organisational responsibility for its development should lie. 24 January 2013

Letter from Lloyds Banking Group Thank you for your letter dated 28 February 2013 to Antonio Horta-Osorio, who has passed this onto me to respond, as Group Director of Retail. I am pleased to provide the answer to the question from Lord McFall. Firstly let me clarify the circumstances under which Sentinel Card Protection (“CP”) product has been sold to our customers and the fees charged. The CP product forms part of the range of benefits offered by our Lloyds TSB AVA packaged accounts, along with other benefits such as travel insurance, mobile phone insurance and AA Breakdown cover. The fee charged for our AVA account varies from £9.95 to £25 per month depending on the type of product the customer chooses. Also, up until 31 January 2012 customers could purchase a standalone version of the CP product when they applied for a credit card. The cost of this product was £30 for one year’s cover and £70 for three years.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1582 Parliamentary Commission on Banking Standards: Evidence

We entered in to an agreement to sell Sentinel CP because the product offers a range of benefits that we believe satisfy the needs of a broad section of our customers. The key benefit of the Sentinel CP product is the 24 hour card cancellation service. Policy holders can cancel all their credit and debit cards with a single telephone call should they lose or have them stolen. Also, replacement cards are ordered straight away, to limit the amount of time customers are inconvenienced by their loss. This service removes the need for customers with a number of different cards to have to contact each individual card issuer. Other benefits included in the cost of the Sentinel CP product are personal belongings and money insurances. Customers can claim on these insurances for a replacement bag or wallet and money contained within them, should these items be lost or stolen along with their cards. Every year there are a significant number of customers who use the service offered by their Sentinel CP policy, and a number go on to make an insurance claim. Only a small proportion of the fee for Sentinel CP covers the cost of insurance related benefits, one of which was fraud cover. With specific regard to fraud cover, we acted last year to remove this feature from our CP products. We also attempted to remove all references from CP product literature, websites and any other customer facing materials. Unfortunately, due to an oversight, the page referred to in Lord McFall’s question, hosted by a 3rd party supplier, was missed from the removal process. This page was not directly accessible from the Lloyds TSB website. It would not have been possible for a customer to purchase Sentinel CP directly from the link; if a customer had followed up with us, or with the Sentinel CP supplier directly, then from the 24 March 2012 (when literature was updated), they would not have received any product literature that featured this element of fraud cover. The page in question has now been removed by the supplier and further checks have taken place to ensure no further references exist, either on our own or any other 3rd party supplier’s website. I hope the above clarifies that we offered Sentinel CP to our customers to meet a number of their needs, and also that the changes we have made to the CP product are in line with customers liability for fraudulent activity, referred to by Lord McFall. If you have any further questions then please do not hesitate to contact me. 18 March 2013

Written evidence from Gregory Mitchell QC Sanctions for Bank Directors 1. These submissions are the views of Gregory Mitchell QC of 3 Verulam Buildings and have been prepared for the assistance of the Parliamentary Commission on Banking Standards. 2. I have set out my views in a summary form at the outset. Thereafter I have set out brief answers to the particular questions raised based upon the views I have set out in summary form. Where I have left a question blank that is because I have no particular view on that question. Introduction 3. I have practised as a commercial barrister for 31 years including 15 years as a QC. My core areas of practice have been banking litigation and insolvency. I have acted in many claims both for banks and also against banks in relation to a wide variety of issues. I have advised companies, creditors and insolvency practitioners on many aspects of insolvency law and have also acted in claims against directors in claims for compensation for alleged breach of duty. I have sat as a Recorder in crime (a part time judge) since 2000 and have presided over trials by jury in several cases of fraud and other financial crimes. Summary 4. The core question is: what additional sanctions are necessary under English law in order to deter commercially unacceptable conduct by the directors of banks? The question can only be answered by looking first at what sanctions already exist under the law as it stands today and considering whether existing law is adequate or not. There would appear to be little purpose in enacting new law if existing law already provides adequate remedies. My view is that the civil law already provides adequate remedies so as to deter commercially unacceptable conduct of directors of any company including banks. To the extent that there has been a failure on the part of banks to pursue such remedies that is a matter that requires further consideration but not legislation. 5. A director of a company who has been guilty of misconduct is subject to potential sanctions of some significance under existing law. These sanctions can be classified under three headings: (1) claims for compensation for losses caused by the breach of duty made by the company and/or a liquidator; (2) disqualification from acting as a director under the Company Directors’ Disqualification Act 1986 (“CDDA 1986”) and/or disqualification from acting as a director under any regulatory regime applicable to the particular business eg under the Financial Services and Markets Act 2000 (“FSMA”); (3) criminal sanctions eg under the Fraud Act 2006 or for breach of the Companies Act 2006 (“CA 2006”) or the Insolvency Act 1986 (“IA 1986”).

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1583

(1) Claims for Compensation 6. Company directors owe fiduciary and common law duties to the company. Prior to the CA 2006: “(9) The directors of a company stood in a fiduciary relation and owed fiduciary duties to the company (and not in general to individual shareholders) in the exercise of their power as directors. These fiduciary duties had been worked out by the application of traditional equitable principles relating to the analogous role of trustees: the fundamental duty was that of undivided loyalty to the company. (10) Directors also owed a duty of care to the company (and not in general to individual shareholders).” (Hollington 6th ed para 2–08). Although the fiduciary duty of a director in equity had been extensively determined by case law the allied question of a director’s duty of care had not been the subject of the same amount of case law. 7. In civil proceedings the Court will award compensation to the company against a director for any loss caused to the company by a breach of those duties. The Law Commission (Law Com No 261) reported in September 1999 on “Regulating Conflicts of Interests and Formulating a Statement of Duties” and recommended a statutory statement of director’s duties (4.48). In Part 5 the Law Commission recommended: that the duty of care and skill of a director should be set out in statute as a dual objective/subjective test (5.2). The CA 2006 has set out in broad terms the content of the duties of company directors. The Act is not an exhaustive statutory code because under s. 170(4) “The general duties shall be interpreted and applied in the same way as common law rules or equitable principles, and regard shall be had to the corresponding common law rules and equitable principles in interpreting and applying the general duties”. 8. S.172 provides a statutory statement of a director’s duty to promote the success of the company. It is in part subjective since the duty is to act in the way the director “considers, in good faith, would be most likely to promote the success of the company…”. S. 172 goes on to list some of the factors to which a director should have regard. It is well established that commercial decisions are for the board and not for the Court, see “There is no appeal on merits from management decisions to Courts of Law: nor will Courts of Law assume to act as a kind of supervisory board over decisions within the power of management honestly arrived at” (Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 at 834. 9. S. 174 provides an important clarification and statement of the duty of a director’s duty to exercise reasonable care, skill and diligence. It provides for a dual objective/subjective test: (1) A director of a company must exercise reasonable care, skill and diligence. (2) This means the care, skill and diligence that would be exercised by a reasonably diligent person with: (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company, and (b) the general knowledge, skill and experience that the director has. 10. This dual objective/subjective test is similar to the test for the statutory liability of “wrongful trading” which was introduced in s. 214 IA 1986 as a result of the recommendations of the Cork Committee on Insolvency Law and Practice (1982—Cmnd 9558). The report dealt with the inadequacies of insolvency law as it then stood and led to the IA 1986 and the CDDA 1986. One of the many innovations suggested in the Cork Report was the introduction of a new statutory liability of “wrongful trading”. The justification for this is set out in Chapter 44 of the Cork Report. The difficulty that then existed was that directors of an insolvent company could only be made liable under statute for fraudulent trading under s. 332 of the Companies Act 1948 and this required proof of subjective dishonesty on the part of a director to a criminal standard. The Cork Report recommended (paragraph 1783) the introduction of a new liability determined on an objective test. A director could be made personally liable for the debts of an insolvent company if he caused it to carry on trading incurring debts, where he knew or ought to have known, that there was no reasonable prospect of the company meeting those debts. This new liability was introduced by s. 214 IA 1986. A precondition for a claim for wrongful trading arising at all is that “the company has gone into insolvent liquidation” (s. 214(2)(a)). 11. The introduction of this new liability for wrongful trading has not been as effective as might have been anticipated at the time of the Cork Report. Directors may avoid the insolvent liquidation of a company (a precondition for liability under s. 214 IA 1986 at all) by the appointment of administrators and/or the release of debt under a Company Voluntary Arrangement (“CVA”) or if some other “rescue” occurs. Even where insolvent liquidation has not been avoided the liquidator may often be unwilling to risk the costs of bringing proceedings even where the case is a strong one. Claims under s. 214 are usually expensive to prosecute because of the factual complexity of reconstructing the financial affairs of the company. 12. Where a bank which might otherwise have become insolvent has been rescued by governmental action liquidation is of course avoided and a claim under s. 214 IA 1986 is inapplicable. It is worth noting however that s. 214 was expressly disapplied in respect of Northern Rock PLC and Bradford & Bingley whilst wholly owned by the Treasury (SI 2008/432 Art 17 & SI 2008/2546 Art 13(1)) suggesting that some possible risk from s. 214 was anticipated. 13. However wherever a bank has suffered loss as a result of negligent business decisions taken by the board` a claim for breach of duty under s. 172 or s. 174 CA 1986 might succeed depending upon the particular facts

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1584 Parliamentary Commission on Banking Standards: Evidence

of the case. A claim under s. 172 may be more difficult to prove because the section makes it clear that the duty is to act in the way the director considers in good faith will promote the success of the company having regard to the matters specified in that section. Nevertheless where a director has caused a company to embark on what transpires to have been a seriously mistaken transaction there will be some burden upon him to establish that he did in good faith consider the transaction to have been likely to promote the success of the company and why. 14. Where a bank has failed as a result of imprudent transactions and has been rescued by governmental action then a claim under s. 174 may be less difficult to prove than one under s. 172. The standard of care is variable depending under s. 174 depending upon the circumstances and the Court might well expect the highest standard of care from a director of a bank. The Court hearing such a claim will apply a standard of care that is appropriate in all the circumstances of the case, including the knowledge skill and experience of the director, the particular role that he played in the transactions that led to failure, and the remuneration that he received. 15. A failed bank which has been rescued by governmental action is likely to have a new board of directors appointed after rescue—even if not immediately. A claim against a former director is an asset of the company and the new board are under a legal duty to consider whether or not there is a claim worth pursuing. The new board might take the view that making a claim was not in the best interests of the bank because of the reputational damage that could be caused to it by litigation, the costs of the litigation and the likelihood that the defendant directors even if wealthy would have wholly insufficient assets to meet any judgment. 16. There may be powerful commercial reasons why no litigation for compensation has been brought against directors of failed banks. However company law does provide an appropriate remedy if the new board of a failed bank decided to pursue it. One matter for detailed consideration is how on rescue of a failed bank some contractual provisions may be inserted so as to facilitate the bringing of proceedings against the former directors. This is a matter for the future. In relation to the rescues that have already occurred questions may arise as to whether potential civil claims have already been fully investigated and if so with what result. (2) Disqualification 17. S. 9 of the Insolvency Act 1976 provided for the disqualification of a director where he had been a director of two companies each of which had gone into insolvent liquidation, the second having occurred within 5 years of the first, and his conduct making him unfit to be a director. The Cork Report in Chapter 45 recommended a wider disqualification regime and this was brought into effect under the CDDA 1986. The power in the court to disqualify directors for up to 15 years arises in various circumstances: s. 2 conviction of an indictable offence in connection with the company, s. 3 persistent breach of the companies legislation, s. 4 fraud in the course of winding up, s. 6 director of an insolvent company and unfit to be concerned in the management of a company. Most disqualification cases are brought under s. 6 a precondition for which is the insolvent liquidation of the company. 18. A separate disqualification regime applies under FSMA. (3) Criminal sanctions 19. There are many criminal offences that may be committed by directors of a company for example under the CA 2006, IA 1986, the Fraud Act 2006. There are many circumstances where there appears to be strong evidence that an offence has been committed and yet no prosecution is brought. The costs of prosecuting financial crimes is often substantial because of the complexity of the material that has to be assembled. The costs of jury trials are particularly high in factually complex cases and the outcome is often unpredictable. A jury may not reach a conclusion at all—if they are not unanimous or there are insufficient numbers for a majority verdict (essentially 10 of 12 agreeing with the verdict). A jury never gives reasons for its decision. Specific Answers to Questions Raised 1. What are your views on extending criminal sanctions to cover managerial misconduct by bank directors? I believe it would be wrong to do so. Managerial misconduct by bank directors can be adequately sanctioned by civil claims for compensation made under the CA 2006 and existing common law and equitable principles together with disqualification where appropriate. If there is a reasonable case that a director of a bank has caused loss to the bank by acting without due care and skill then a claim for compensation could be brought. The civil courts are the most appropriate forum for the determination of the difficult factual question as to whether or not the particular defendant was in breach of duty or not. Although civil claims are expensive to litigate the result is a public and reasoned judgment by an experienced judge who has read and heard all of the evidence. The civil courts have a wealth of experience in deciding the facts, the appropriate standard of care, and whether or not a particular defendant has been guilty of a breach of duty. It would be wrong in principle to introduce criminal sanctions for mere negligence in the conduct of a business. There are also powerful pragmatic considerations against such an offence. Even if such an offence were introduced prosecutions might be substantially more costly than civil proceedings, the criminal standard of proof (being sure) rather than the civil (more likely than not) would apply, and juries might well not convict

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1585

or reach a verdict at all. The Cork Report recommended the introduction of a statutory liability in civil law for “wrongful trading” because the criminal offence of fraudulent trading under s. 332 of the Companies Act 1948 was hard to prove. It would therefore be a retrograde step to create a criminal liability of negligence in the conduct of a banking or any other business. Even where the jury returned a conviction on such a charge, a powerful plea of mitigating circumstances could be made based upon the particular circumstances of the case. Judges would be unlikely to impose severe sentences for offences of negligence in business judgment. The end result could be a substantial expenditure of taxpayers’ money for very questionable benefits. 2. What are your views on the possible formulations of a criminal offence based on options (i) to (iv)? Strict liability offences tend to be summary offences tried in the magistrates courts and on conviction punished by a small fine. More serious offences require proof of fault—mens rea—and are indictable and subject to custodial sentences. If a strict liability offence of being a director of a failed bank were enacted then what would be the penalty? A fine which in relation to the loss caused to the bank was small would hardly appear to be appropriate at all and might result in considerable public disquiet. A custodial sentence would be equally inappropriate for different reasons—it would hardly seem fair to impose a serious penalty for an offence for which no mens rea had been proven. Negligence and incompetence can be sanctioned as above by civil proceedings which are a much more appropriate forum for determining such issues than criminal proceedings. Recklessness is an ingredient of many offences which require mens rea. Recklessness is often a difficult concept for juries to apply. There is a considerable body of case law on its meaning in different contexts both in civil and criminal law illustrating the difficulty of the concept. If a criminal case could be proved showing that a director had acted recklessly then a civil claim for compensation could be proved. 3. Do you think that an offence based on one of those options would be likely to discourage those considering positions of leadership within banks? Yes and see answer to 5 below. 4. Will the possibility of criminalising behaviour which can already be sanctioned under Financial Services and Markets Act 2000 (FSMA) act as a greater deterrent? No. 5. Do you think that it is likely that the threat of criminal action will stifle perfectly legitimate activity and ultimately deter growth in the banking sector? It could cause significant damage to the banking industry in the UK in different ways. First such an offence might lead to the resignation of experienced directors of a bank that was encountering difficulty at the most inopportune time for the further conduct of the business of the bank. Resignations of directors might lead to speculation that the bank was in trouble leading to a run on the bank at the worst possible time and aggravating its difficulties. Second such an offence might make it difficult for new directors to be appointed leading to a vacuum at the top of a bank which was capable of rescue at the time when it most needed experienced directors. Third such an offence might lead to banks over time moving their seat to other jurisdictions. Fourth such an offence would be damaging to the reputation of English law. A criminal offence of being a director of a failed bank whether based on strict liability or on negligence would be likely to be seen as irrational and unfair. 6. What are your views on the statement that there appears to be significant reluctance from regulators to take criminal prosecution against banks or individuals responsible for compliance functions? To the extent you agree with the statement, what, in your opinion, are the reasons for this reluctance? Criminal prosecutions are costly and time consuming. The result of a prosecution particularly where the outcome depends upon the decision of a jury is often very uncertain. Regulators will naturally be cautious about starting prosecutions even where the evidence appears strong because of the risk that large amounts of money and time will be invested in a prosecution that may fail. Civil and Regulatory Sanctions Rebuttable Presumption On 3 July 2012, HM Treasury published proposals to amend FSMA in order to put in place a rebuttable presumption that a director of a failed bank is not suitable to be approved by the regulator as someone who could hold a position as a senior executive in a bank. The Government also proposed two groups of “supporting measures”, which could be taken forward by the regulators under existing FSMA powers: (a) Introducing clearer regulatory requirements on individual responsibilities and the standards required of people performing certain key roles; or, in the alternative, a “firm-led approach” (with the onus on the firm and individual to set out a detailed written statement of the responsibilities and duties of each role); and

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1586 Parliamentary Commission on Banking Standards: Evidence

(b) Requiring banks explicitly to run their affairs in a prudent manner, and requiring bank boards to notify the regulator where they become aware that there is a significant risk of the bank being unable to meet the threshold conditions for authorisation. 7. What are your views on the proposal to introduce a rebuttable presumption that the directors of failed banks are not suitable to hold senior executive positions in other financial institutions? My view is that this would be wrong in principle. If a person is to be disqualified from pursuing his particular profession or business that should be on proof of wrongdoing. A rebuttable presumption would in practice punish the innocent along with the guilty. A director who was entirely innocent of any wrongdoing might be unable to afford the cost of rebutting any such presumption and be unable to work. question whether such a provision might be challenged under human rights principles. Furthermore such a provision might lead to the resignation of the board of a bank in difficulty at the most inopportune time and result in real difficulty in new appointments being made—as in Answer 5 above. 8. Does the rebuttable presumption go any further than the current regulatory regime? Yes. 9. Do you think that the introduction of the “rebuttable presumption” could discourage skilled individuals from accepting key management positions? Yes. 10. Do you think introducing the presumption would send a clear message that bank senior executives and boards have a responsibility to ensure there is a strong focus on downside risks? No. The Companies Act 2006 together with the common law and equity should send that message if they were applied. A successful civil claim for compensation made against a director who had failed to focus on downside risks would be likely to send that message in a clearer and fairer way. A reasoned judgment of a civil court setting out the standard of care and the respects in which the director had failed to comply with the standard would send a much clearer message for the future. There would be a detailed analysis by a Judge which would provide significant guidance to the industry for the future. 11. What are your views on the possible supporting measures aimed at clarifying management responsibilities and changing the regulatory duties of bank directors? A clarification of responsibilities and duties is a good idea in principle. However it is for the directors to exercise their commercial judgment. It seems doubtful whether any stated clarification would have avoided the errors made in the banking industry. Existing Regulatory Sanctions The Financial Services Act 2010 provided the FSA with greater enforcement powers. The FSA has the power to fine authorised persons and approved individuals for misconduct. The 2010 Act extended these powers to enable the FSA to suspend or limit an authorised person’s permission or an approved person’s approval. It also enabled the FSA to impose a fine on an individual performing a controlled function without approval in addition to being able to prohibit the individual from working in the financial services industry. It also included provisions in respect of the disclosure by the FSA of decision notices. 12. Despite the range of enforcement powers currently available to the FSA, are additional powers necessary? If so, what would those powers be? No. 13. What are your views on amending FSMA to include a power to prohibit an individual from performing a controlled function on an interim basis? This might be useful. The civil courts grant injunctions on an interim basis in order to prevent harm from occurring and there is no reason in principle why there should not be such a power provided it was exercised subject to adequate safeguards. 14. Considering the current powers and measures, do you think the perceived shortcomings in being able to hold individual directors personally culpable are as a result of statutory or regulatory deficits or as a result of regulators and law enforcement agencies not utilising the powers already available to them as fully as they could? On the rescue of a failing bank the new board should be specifically required to take legal advice on whether or not there are civil claims for breach of duty that can be taken against the former or outgoing directors of the bank. Even without such an express requirement the new board of a bank or any company is always under a duty to consider whether there are claims against former directors that ought to be pursued.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1587

15. What are your views on extending the limitation period for taking action against approved persons? Legislation versus Regulation 16. In order to make bank directors more accountable (due to the adverse impact a large failed bank can have on the wider economy), what are your views on amending the approved persons’ regime under FSMA rather than the Companies Act 2006 and the Insolvency Act 1986. To the extent you consider changes should be made to the legal framework, please articulate how you think this could be achieved given the legislation would apply to all company directors As above directors can be made personally liable for breach of duty and that should be a sufficient sanction. The Approved Persons’ Regime (APER) 1. The Upper Tribunal ruling in John Pottage v The FSA (FS/2010/0033) highlighted that enforcement action against senior managers is only likely to be successful where there is evidence of actual wrongdoing by the executive concerned. In your opinion, what changes could be made to some of the statements in APER about the standard of conduct expected of directors in order to make it easier to bring enforcement? 2. In your opinion, has a lack of direct senior management accountability inside firms for specific areas of conduct contributed to the shortcomings in holding individuals personally culpable? Do you think APER should be revised to remedy this? 3. Would it be beneficial for the regulator to adopt a more intrusive approach to senior appointments as part of the Significant Influence Function (SIF) process? How could such an approach be adopted? 4. Do you see merit in requiring the regulator to re-appraise SIF individuals at set intervals and on other occasions if it believes that circumstances justify it. 5. What are your views on extending APER so that it applies to all bank employees in order to enable the regulator to take disciplinary action against employees who are currently outside the scope of APER? 6. Do you see merit in the establishment of an independent professional body with mandatory membership which has the power to impose civil and possibly criminal sanctions? In your view, could such a body provide a solution for the issue of global matrix management structures that can exist within universal banks? Cost 23. Understandably, there is considerable cost in pursuing individual actions. What changes do you think could be made in order to ensure that cost does not act as a deterrent in pursuing all but the largest cases? There are no easy solutions to the problem of the cost of civil proceedings. Sir Rupert Jackson reported in December 2009 in his comprehensive Review of Civil Litigation Costs. Some parts of the report have been introduced in Part 2 of the Legal Aid Sentencing and Punishment of Offenders Act 2012. However cost remains a serious problem in civil litigation. Costs are also a serious problem in criminal proceedings. International 24. Do you think introducing additional criminal, civil or regulatory sanctions would have an impact on the international competitiveness of UK banks? Yes the impact would be adverse see answer to question 5 above. 25. In your opinion, are there other legal or regulatory regimes that the Commission should be considering? Please provide your reasons for suggesting the applicable regime No. Other 26. The regulator has an extensive range of enforcement powers but is arguably hesitant in using those powers. What are your views on the introduction of sanction(s) that could be imposed against the regulator to the extent they do not deploy their powers appropriately? I doubt whether such a proposal is feasible or useful. A regulator is obliged to act in accordance with his statutory duties and in an extreme case could be subject to an application for judicial review. 27. What are your views on applying different sanctions for different types of directors—for example, nonexecutive directors? Company law already provides a nuanced distinction between different directors according to their knowledge skill and experience—see s. 174 CA 2006 and s. 214 IA 1986. The particular distinctions to be made should depend upon the particular circumstances of the case and not upon the label put upon a particular office.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1588 Parliamentary Commission on Banking Standards: Evidence

28. Are there any other measures or legal/regulatory changes that the Commission should consider? Yes. Where a company becomes insolvent the liquidator is bound to consider whether to bring civil proceedings for compensation against the former directors and the Secretary of State for Business Innovation and Skills may bring proceedings for disqualification under the CDDA 1986. Where a company has been rescued then neither of these apply. The Commission should consider how to encourage the board of directors of a rescued bank to pursue civil claims against any directors where there is good evidence that they have acted in breach of duty and caused loss. A rescued bank may often be reluctant to commence such litigation for many commercial reasons, such as the adverse publicity that may result, legal costs, management time and difficulties of enforcement. One matter for detailed consideration is how on rescue of a failed bank some contractual provisions may be inserted into the agreements under which the rescue is achieved so as to facilitate the bringing of proceedings against the former directors. Where the rescue has already occurred and there are no such provisions in place then the question arises as to whether the board has given sufficient consideration to the issue of civil proceedings for breach of duty against former directors. 2012

Written evidence from Paul Moore 1. Introduction, Background and Foreword 1.1 My name is Paul Moore. I gave evidence to the Parliamentary Commission on Banking Standards on 30 October 2012. Members will recall that I was the former Head of Group Regulatory Risk at HBOS who also gave evidence to the Treasury Select Committee in February 2009 when it was looking into the causes and implications of the banking crisis. My evidence was published on the day that the Committee interviewed the ex CEO’s and Chairmen of HBOS and RBS. It was widely publicised in the media worldwide and led directly to the resignation of Sir James Crosby who was then the Deputy Chairman of the Financial Services Authority. My evidence alleged that Sir James Crosby, when he was the CEO of HBOS, dismissed me as Head of Group Regulatory Risk for reporting that the sales culture had become markedly out of balance with risk and compliance systems and that the Board should reconsider its continued strategy for sales growth if it wished to avoid risks to customers and colleagues. I maintained that failures in corporate governance, risk management and compliance were at the heart of the banking crisis. In particular, I pointed to strategies with an excessive focus on sales, cultures that facilitated “group think” and resisted challenge and the lack of rigorous oversight and challenge by internal control functions, the non-executive, statutory auditors, shareholders and the FSA. 1.2 I am a Barrister by original training and an experienced professional adviser on risk management, regulation, corporate governance and ethics in the financial sector. I have been involved in risk management, regulatory compliance and governance in the financial sector since 1984 before the first version of The Financial Services Act 1986. After eleven years in industry, and just prior to joining HBOS in 2002, I worked at KPMG in London for seven years as a Senior Manager, Director and then Partner where I advised large banks, insurance companies and fund managers including quite a number of FTSE 100 companies. I often led engagements where significant regulatory failures had occurred where our reports were also used as part of the regulator’s supervisory or enforcement processes. 1.3 I have written more detailed papers setting out all the reasoning behind my recommendations and am prepared to share all that reasoning with the Commission if it is thought desirable. I have already provided much of this material both to the TSC as well as the PCBS. This paper, however, is deliberately designed as an executive summary of my views in all the key areas. 1.4 I am confident that that Andrew Tyrie and the PCBS will find this document useful in preparing its final report which, as has been stated, will be focused on recommendations for the future. I request that the PCBS treat this paper as formal evidence, distribute it to all members of the Commission and publish it in the usual places. I also intend to publish this document widely for the benefit of other interested parties. 2. Approach, Layout and Contents of this Document 2.1 This document can loosely be described as laid out in a “bottom-up” approach. This means that I deal with the current governance “systems” from the bottom upwards rather than the top downwards. This naturally means that the big picture policy points (eg about our monetary system and director’s fiduciary duties) are made at the end. 2.2 In line with this approach, the contents of this document firstly follow, in order, all key parts of the governance system of banks (in the most holistic sense) which, if carried out effectively, would be most likely to prevent another banking crisis like the one we have experienced. These are as follows: 1. Internal control functions—risk management, compliance and internal audit. 2. Non-executive directors and the internal corporate governance systems. 3. Audit and accounting and other professional services provided to banks. 4. Shareholder stewardship. 5. The external regulatory system.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1589

6. Government & political involvement and accountability for the regulatory system. 2.3 Having dealt with each key element of the governance system of banks, I then turn to the bigger picture policy points. These are as follows: 7. The “permitted business” of banks ie what banks should be authorised to do. 8. The ring fence proposals by the Independent Commission on Banking. 9. Size matters—banks are too big. Public policy needs to support community banks and crowdfunding such as “Peer to Peer Lending”. 10. The inadequacy of the “fiduciary duties” of company directors. 11. Whistleblowing policy. 12. The inadequacy of our monetary system. 13. Our democracy and the excessive power of banks and other financial institutions. 2.4 In section 16, I cover what are, ultimately, the most important areas to “get right” if we are to have a banking system that leads the world in performance as well as good business practice, ethics and social responsibility. This is: 14. Executive business leadership, strategy, culture and associated incentive systems. 2.5 The final section of the paper is: 15. Conclusion and final thoughts. 2.6 I repeat that this document is drafted as a summary of the policy recommendations that I make without setting out the detailed thinking and arguments which support such recommendations. If the Commission requires the supporting arguments, it only has to ask for them. Many of the recommendations that I make are clear from previous papers/evidence that I have submitted either to The Treasury Select Committee or the Commission (PCBS). 3. Internal Control Functions—Risk, Compliance and Internal Audit 3.1 Believe it or not, you can become a Chief Risk Officer or a Head of Compliance or Head of Internal Audit with no formal qualifications. This is just plain wrong. These roles are now equally as important as the CFO’s job and we need to be totally confident in their technical competence, their skills and their integrity. 3.2 People who run and work in these functions must be professionally qualified by a new Chartered Institute (or the like) to the same level as Actuaries, Accountants, Lawyers and Doctors, with their own rigorous Code of Conduct and regulatory system. They must not only be trained in the technical aspects of risk management, oversight and assurance but also in the skills they need including how to carry out ethical based decision making. They must also be trained in the laws of evidence as it is often the case that failures in assurance are caused by reliance of self-serving statements from management without adequate corroboration. 3.3 All three control functions should be combined and should not work separately. They are all involved in policy, advice on that policy, process design to implement policy and in oversight, assurance and reporting of the bank’s “systems and controls”. An internal audit department without risk or regulatory content knowledge is next to useless. It audits process without even knowing whether the process does what it needs to do and this provides false assurance. Likewise, a risk department without knowledge, skills and experience in carrying out rigorous oversight and assurance is also next to useless because it sets policy and process but never checks whether it is being carried out. By combining these functions into one department, the policy thinkers in risk and regulatory compliance obtain the oversight and assurance expertise of Internal Audit and Internal Audit obtains the content expertise that can be provided by risk and regulatory compliance. For the sake of this paper, I shall call this department “Risk, Compliance and Audit” or “RCA” for short. I should add that all regulations relate directly to risk management. They are the regulators’ formal risk mitigation requirements in relation to matters which they consider of risk to the overall system, so the idea that risk management in a bank is just about the mathematics of credit risk management is wrong. In fact, the mathematics is often the simplest part of the equation. 3.4 All staff working in RCA or carrying out RCA accountabilities must always report directly and solely to the RCA department and never on a dual reporting-line basis both to the local executive and then “on a functional basis” through to the RCA department. This is even more important in a “divisionalised” organisation with Group RCA functions as well as divisional RCA functions. This dual reporting line approach is very common in large financial sector organisations and does not work. It creates unnecessary tension and adds cost. 3.5 The “three lines of defence” governance model (designed by consultants with little or no practitioner experience) which is commonly in use in large organisations does not work and is dysfunctional. As I say above, there should be one department called RCA and all staff responsible for these accountabilities must report directly into RCA. In fact, this approach will reduce cost for banks not increase cost.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1590 Parliamentary Commission on Banking Standards: Evidence

3.6 All RCA staff must ultimately always report to the non-executive and never to the executive for the very obvious reason that, then, if they raise challenge with which the executive is not comfortable, they should be protected (assuming that the non-executive are independent and powerful). I recommend that they report through to the Board via a new dedicated non-executive director of “Risk, Compliance, Audit and Ethics”— “RCAE” for short. I have developed a detailed accountability description for this role which I can provide to the PCBS if required. 3.7 There must be additional “whistleblowing” protections for RCA staff and especially the Heads of Department. After all, it is actually the job of RCA staff to “raise the red flag”/“blow the whistle” when necessary. These protections must operate so that they avoid the current “close the door after the horse has bolted” approach to whistleblowing protection ie they must operate to prevent inappropriate dismissal as opposed to provide compensation after dismissal. This means people working in the RCA department cannot be dismissed without the formal approval of the whole non-executive in a minuted meeting and the prior written approval of the regulator. The standard post dismissal protections for whistleblowers are inadequate. This may mean that ultimately the internal professional whistleblower gets financial compensation but this also means that the wrong-doing always gets covered up through gagging orders. RCA staff subject to dismissal actions must be given representation rights in any such proceedings inside the company in question. 3.8 For all major strategic decisions eg material acquisitions, the Head of RCA must be required to draft a formal opinion to be placed on the record and shared with the regulator. In this regard, where were the opinions of the CROs of RBS and Lloyds on the acquisitions of ABN Amro and HBOS respectively? 4. Non-executive Directors & the Internal Corporate Governance Systems 4.1 All non-executive directors (“Neds”) must be trained in the basics of risk management, compliance and internal audit prior to taking up their roles. It is good to have diversity in the board room and, therefore, not all Neds need great expertise in these areas or great expertise in the business of the Board on which they sit. But they must know the basics of risk management, regulation and audit in the firms on the boards of which they sit. This needs both formal and informal training—as well as assessment—because training with no assessment often goes in one ear and comes out the other! 4.2 The senior Neds with special responsibilities ie The Chairman, the SID, the Ned of RCAE, the Chairman of the Risk, Compliance, Audit and Ethics Committee, The Chairman of Divisional RCAE Committees must have been trained and have direct personal experience and expertise in these areas. The Ned of RCAE must be highly experienced in these areas both strategically and operationally. These NEDs must also be experts in the relevant business areas as well. 4.3 There must be a complete and public register kept of all professional and social connections and activities between Neds and the executive. I suggest that this should include a register of all clubs, associations, alumni groups and if they are members of the Masons. Andy Hornby told me that he was a personal friend of Charles Dunstone who was the Chairman of the HBOS Retail (Halifax) Risk Control Committee. 4.4 Neds need to spend much more time, even than the additional time recommended by Sir David Walker in carrying out their duties. The specialist Neds need to spend even more time than the standard Ned. The Ned of RCAE would probably spend at least two days a week in a well controlled large company and more in an organisation in crisis or development. The Ned of RCAE would also spend a good deal of time focusing on the cultural and people aspects of good governance and not just on policy, process and structure. 4.5 Executives of other publicly quoted companies are too busy to manage their own businesses, let alone oversee the management of others. Indeed, the volume of paper they currently have to review, in itself, may create an appearance of governance but often achieves the exact opposite by making it impossible for the nonexecutives to “see the wood for the trees”. In this regard, Charles Dunstone, the founder and Chairman of the Carphone Warehouse, who was the Chairman of the HBOS Retail (Halifax) Risk Control Committee, said to me one day—“Well, even if I had time to read the papers, I would not understand them”! 4.6 It is far better to have one governance committee dealing with RCAE rather than three. The risks and issues are all intertwined on these matters and trying to separate them will cause communication and decision making risks. As I say, all these functions should work together as one seamless group. With the new Ned of RCAE, these meetings can be managed to a sensible agenda as not all Neds will now be required to read all the detailed papers and the Ned of RCAE will be able to “synthesise” and “summarise” the really key risks for discussion in a manageable way. Rather than reviewing a huge risk register, it is perfectly possible to use a one page risk map, an example of which I can provide. This ensures a much better quality discussion than attempting to wade through vast quantities of paper. In a large, divisionalised organisation there should also, of course, be a Group RCAE Committee as well as Divisional RCAE Committees. 5. Audit & Accounting & other Professional Services Provided to Banks 5.1 Audit does not “do what it says on the tin” and needs to be completely redesigned top to bottom. Currently, it is worse than a waste of money because it gives “false assurance” to stakeholders. We need to conduct a root and branch investigation and review of the role of the auditors and accountants in the banking

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1591

crisis and, then, reform of statutory auditing, accounting standards, the regulation of the accounting profession and competition in the accounting profession. 5.2 In a short summary such as this, it is just not feasible to cover all the key points. An independent Commission should be set up to investigate this area of policy and come up with detailed recommendations. See my letter to the FRC provided as evidence to PCBS in this regard more generally. 5.3 Auditors must be required to have far more rigorous “statutory duties to report”. This means that they will be legally obliged to “blow the whistle” to regulators much more often. Having been a Partner at KPMG, I know just how difficult it is to get Audit Partners to exercise their statutory duties to report even when there are clear investor protection risks and issues. I also know that the Auditors have real in depth knowledge of the firms they audit and definitely would have known the risks within banks in the build up to the crisis. 5.4 Accounting standards need to be developed by a truly independent body. A CFO of a bank told me that one of the major causes of the crisis was “accounting standards designed for a different purpose”. The International Accounting Standards Board is not sufficiently independent. 5.5 Audit services must be kept completely separate from any non-audit services. This means that audit must become more expensive and must be capable of living in a business model in which non-audit services are not provided. I believe that the non-audit fees at HBOS during the period that I worked there were many times the level of audit fees. KPMG were paid over £1 million to investigate my allegations that Crosby had dismissed me for inappropriate reasons. The conflicts of interest are just totally obvious. 5.6 In regulated sectors such as financial services, the terms of reference of the audit should be agreed in tripartite discussions with the relevant regulator which will require increased intensity of audit in higher risk firms. 5.7 The regulatory system for the accounting profession needs to be completely overhauled along the lines of the ideas proposed for the regulation of the media. The FRC and the ICAEW are “in the pockets” of the accounting profession and they do not supervise and enforce the profession adequately. 5.8 The accounting profession, and particularly the Big 4, carry out far too much work for the financial sector regulators—previously the FSA and now the PRA and FCA. 5.9 The Big 4 need to be broken up. The average length of audit of a FTSE 100 firm is, I believe, 48 years! This cannot be allowed to continue. 5.10 In my view and in the view of many others, audit and accounting is at the absolute rotten heart of the current system and needs total change. The mere fact that the FRC has not conducted public interest investigations into bank auditing and professional advice given by the Big 4 is just plain wrong. 6. Shareholder Stewardship 6.1 Shareholder focus on what the companies they own are doing is absolutely vital. It has been sadly lacking in the build up to the crisis other than through the relentless cry of the investment analysts (who don’t care much about governance) for more short term profit. I recommend that the Commission reviews the excellent work carried out by Tomorrows Company in relation to “shareholder stewardship” and looks at the progress which has been made in Scandinavian countries in this area. 6.2 I recommend that the large institutional shareholders (who hold the legal title to shares on behalf of ordinary pension fund and collective investment scheme investors) agree and constitute their own “Shareholders Oversight Committee” which agrees a programme of work with the Ned of RCAE and the Head of the RCA Department. This will cover all key areas such as nominations, remuneration, RCA Committees etc. In particular, I believe that shareholders representatives should run Nominations Committees. 7. The External Regulatory System 7.1 I have written extensively on this subject in the consultation process to the Walker Review and elsewhere. I have provided these papers to the PCBS. 7.2 In a nutshell, you can move as many deck-chairs as you like on the “regulatory Titanic” in terms of structures but, unless the right regulators focus on the right things, it won’t do any good. 7.3 It is also vital to recognise that regulators can calculate capital requirement “until the cows come home” but it never has and never will save us from a financial crisis brought about by inherently reckless business strategies, an inadequate separation and balance of power in the boardroom caused by ineffective governance combined with cultures of greed, unethical behaviour and an indisposition to challenge. 7.4 Of course, we need more capital and competition in the banking world but The Prudential Regulatory and The Financial Conduct Authorities need to work very closely together. And, the greater the conduct risks in a firm the more capital must be required. Indeed, in my mind, the capital required for a culturally dysfunctional firm should be pretty much penal in nature to reflect the massively increased risks. In any event, the current proposals for additional capital are inadequate.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1592 Parliamentary Commission on Banking Standards: Evidence

7.5 In order to assess the right amount of capital and to prevent conduct failures, the absolute focus of the regulators must not be primarily on process, structure, governance committees and words in an annual reports but must be on the following:— The quality of the culture of the organisation as a whole must come first and the assessment of this must be conducted in the most rigorous way possible. I have developed a list of key cultural indicators against which assessments can be made but even further work needs to be done in this area. Evidence gathering in this regard needs to be conducted not only through electronic survey but also in one on one meetings with front line staff and junior managers, well designed focus groups, meetings with senior executives, control function staff and Neds as well as Auditors. Preferably, this work should also involve “undercover participative observation” which is the way in which anthropologists understand and assess culture. Members may have seen the TV programme “Under cover boss” which shows just how effective this approach is? As I said, in my original evidence to the TSC in February 2009 and which is probably the most important point I made—“You can have the best governance processes in the world but if they are carried out in a culture of greed, unethical behaviour and indisposition to challenge, they will fail.” This is true. — The quality and ethics of the executive leadership. There is now plenty of academic evidence that, in fact, the wrong sort of people have been getting to the top of major organisations— people with excessive “psychopathic” attribute. It is perfectly possible to stop this by the right recruitment processes and governance by a truly outstanding “unconflicted” Nominations Committee. One of the academics that works on this subject is Holly Andrews of Worcester Business School with who I did a short interview on the Jeremy Vine Show on BBC Radio 2 on 3rd of May at about 1.30pm. — The quality and ethics of the leadership and staff of the internal control functions and the systems and controls they have implemented. We need specific standards for what great looks like in this regard, both in terms of process and structure as well as culture and people and competence frameworks. — The quality and ethics of the Neds. 7.6 On specific regulatory points, there should be an absolute limit on bank leverage. 7.7 One absolutely crucial structural point on the regulatory system is that the policy, rule-setting and supervision accountabilities of the regulators must be kept organisationally completely separate from the investigation and enforcement accountabilities of the regulatory system. And, regulatory enforcement, once it has passed the “case to answer” test must be held in a public tribunal to ensure proper scrutiny by the media and other stakeholders. 7.8 Regulators should themselves also be held accountable in law for their serious failures—not mere negligence but reckless or wilful disregard to their duties. 7.9 Regulators must be enabled to recruit higher calibre staff who are incentivised to stay; my motto is “pay twice as much, get four times as much done at eight times the quality”. This is trite but telling. The good staff only stay for a short time whilst eyeing up where they can double their salaries by moving to the private sector as game-keepers turned poachers. The less good staff stay. 8. Government & Political Involvement and Accountability for the Regulatory System 8.1 My small firm conducted a survey of risk management professionals into the causes and implications of the banking crisis (see the News Tab at www.moorecarter.co.uk ). This provides valuable insight to policy makers. The survey obtained 563 responses from senior professionals involved in risk management and was overseen by Professor Andrew Kakabadse of Cranfield School of Business. The survey and its free format comments prove that the majority of risk professionals expected a major financial crisis well in advance. 8.2 One of the findings was that nearly 50% of respondents thought it was either important or very important that there was a government minister accountable for the performance of the regulators. Personally, I believe this is crucial. The argument against this is that this avoids government and political interference. I believe it creates a terrible democratic accountability gap in which the government can effectively abdicate its accountability to the “independent regulator”. 8.3 The Treasury Select Committee must be given much greater powers of oversight (accompanied by the appropriate resources). For example, key appointments at the regulator must be pre-approved by the TSC. It should also commission proper reviews of the performance of the regulators by “getting inside” their operations and checking what is going on. 9. The “Permitted Business” of Banks ie what Banks should be Authorised to do 9.1 We very much need to look at banning proprietary trading in investment banks. This was something that the ICB did not look at. Prop trading is not banking business. It’s not even investment banking in the sense of corporate finance or merchant banking. It is also tantamount to market manipulation through the abuse of a

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1593

dominant, anti-competitive position that prop trading departments have in information (often obtained through ignoring Chinese Walls and abusing conflicts of interest through their investment banks and their fund management arms), in mathematics and in computer science. It is like gambling in a rigged market. I suggest the Commission asks for anonymous evidence from day traders (who risk their own capital) and they will be able to show Members exactly when the market is being manipulated by the big players. Prop trading also creates artificial liquidity in the markets which makes people think that shares and other financial instruments are nothing to do with real people’s lives but only “chips” in a Casino. Ultimately this is bad for society—even if it does generate tax revenue for the Exchequer. It does not just serve little useful social purpose; it serves a highly negative social purpose. In addition, market making is also often used as a guise for prop trading. 9.2 If a bank wants to conduct this sort of business it should be run and regulated in the same way as any other fund management business and the capital investment risk should always fall on the investor or the lender and there should be limits to the amount of leverage that the fund can use ie it needs operate and to be regulated like a Hedge Fund. 10. The Ring Fence Proposals by the Independent Commission on Banking 10.1 The ICB pretty much completely ignored the issues of corporate governance, culture and conduct of business risk even though the TSC did its very best to hold it to account in these areas. They excluded my input to the Commission because it was slightly late even though I clearly had important input to add. They, like many others, seemed to assume that the calculation of capital and competition were the only key issues when we all know from the lessons of history (Barlow Clowes, BCCI, Morgan Grenfell, Barings, and the banking crisis), that, as I put it, you can calculate “capital until the cows come home” but, whatever amount it adds up to, capital will never save an organisation from a conduct of business failure brought about by a greedy, unethical and dysfunctional culture combined with inadequate corporate governance. 10.2 Nor did the Commission even dare to consider the really fundamental question (referred to above) as to whether proprietary trading should be permitted inside banks when it is not banking business and when it raises very strong inferences of market manipulation by the abuse of a dominant position in information, mathematics and computer science which effectively means that banks can “count cards” while they gamble with their shareholders capital, the funders credit and the leverage which their depositors’ funds gives them. 10.3 Of course, as someone said, even if the proposals to ring-fence retail operations from investment banks were a good idea and the way to solve things, it will now take longer to implement the proposals than it took Kennedy to put a man on the moon! 10.4 The ring fencing proposals (even electrified) are a “red herring” which has swum into the “long seaweed”. They should be ignored in favour of banning prop trading and the introduction of “Full Reserve Banking” (see below). 11. Size Matters—Banks are too Big. Public Policy needs to Support Community Banks and Crowdfunding such as “Peer to Peer Lending” 11.1 Banks are too big and should be limited in size to a maximum of £100m balance sheet or even smaller. 11.2 Parliament should encourage and support the creation of as many community banks as possible. A good start would be to break up RBS and mutualise it into regional community banks/building societies. At the same time, it should use its shareholding in Lloyds Banking Group to demerge The Halifax and turn it back into the world beating Building Society it once was. 11.3 Parliament should educate itself about and proactively support what is called “Crowdfunding”. This is the approach by which capital is raised by way of equity, loan, reward or donation by connecting willing investors, lenders, participants directly via an internet platform with organisations needing capital. 11.4 Peer to Peer Lending (P2PL) is an example of Crowdfunding which is gaining traction. 11.5 Crowdfunding has the potential to unleash a powerful new force for growth and jobs at the same time as creating a fairer, democratised world for investors/lenders. It is a powerful new force for lending without the need for a bank. It can become the EBay of the financial world. 11.6 Here I must disclose a personal interest as I am the Chairman of a new P2P Lender called Assetz Capital. 11.7 Barry Sheerman MP has set up and sponsored The Westminster Crowdfunding Forum where interested parties have been meeting to discuss how to educate MPs on the subject, promote the ideas and manage the regulatory requirements in an appropriate way. The time may come when this informal group should “morph” into more of a formal Commission?

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1594 Parliamentary Commission on Banking Standards: Evidence

12. The Inadequacy of the “Fiduciary Duties” of Company Directors 12.1 In my view, and taking into account all my professional experiences since 1984, both as an in-house expert, as well as one of the top performing partners at KPMG, the corporate governance in large publicly quoted companies with balance sheets larger than many sovereign governments (and more power than many of them), simply does not work. In addition, when you take into account the rapid increase in the speed and complexity of large corporations since the internet revolution, the current paradigms for corporate governance are totally inadequate. 12.2 Company Law and its associated regulatory and “quasi regulatory” regimes were never designed for companies this large, with this much power, acting with this much speed and complexity and with such huge societal importance. When the East India Company got out of control, the only way the government could solve the problem was by nationalising it. 12.3 The fiduciary duties of directors of such companies are currently an inadequate constraint on their behaviour and actions when they are driven by the insatiable drive and addiction of the investment analyst (and, therefore, shareholder) to short term profit. The drive for short term profit, at best leads directly to moral and ethical relativism, and, often, to actual civil and criminal wrongdoing, especially when the fines and consequences are lower than the profits made. For example, the systemic miss-sale of PPI was obviously ethically wrong but it was also certainly serious civil wrongdoing under the regulatory regime but, for some reason, no directors of the offending banks have been held to account. But, worse than this, some experts would say that the action of directors and executives raises a very strong inference of a criminal offence under S397 of the Financial Services and Markets Act 2000 as well as The Fraud Act. 12.4 The fiduciary duties of directors of large and publicly quoted companies now MUST include specific public duties. This can be done very simply by changing the list in The Companies Act 2006 S172 (1) (a) to (f) from being matters that directors should have regard to (ie a permissive list) to matters they MUST have regard to (ie it needs to become a list of mandatory considerations). The list of items (already set out in S172 but currently solely permissive) that the Directors must consider in fulfilling their fiduciary duties should be as follows: (a) the likely consequences of any decision in the long term; (b) the interests of the company’s employees; (c) the need to foster the company’s business relationships with suppliers, customers and others; (d) the impact of the company’s operations on the community and the environment; (e) the desirability of the company maintaining a reputation for high standards of business conduct; and (f) the need to act fairly as between members of the company. 12.5 Making this one simple change to the Companies Act, would set directors of large companies free from the slavery of having to focus solely on short term profit with the consequential moral, ethical and legal relativism which this encourages. With this one simple change directors would be obliged in law to consider their other important stakeholders. 13. Whistleblowing Policy 13.1 Whistleblowing policy just does not work and needs to be overhauled. It closes the door after the horse has bolted. Key points are as follows: —

Whistleblowing law does not really work yet and it is a vital part of holding businesses to account.

—

Internal tribunals are not really independent because there is a natural conflict of interest and they especially do not work in organisations which need to have the whistle blown on them!

—

Where regulators are involved, the regulator should investigate the matter themselves.

—

Anonymity is a real problem both for the whistleblower and the firm on whom the whistle is blown. Wherever possible the whistleblower’s identity should be kept secret.

—

Obviously whistleblowing complaints need to be properly challenged to avoid excessive power to disgruntled people and complaints not in good faith should have consequences for the individual concerned.

—

If there is a financial settlement, this should not permit the firm to “sweep the matter under carpet”; the firm must still be held to account by the appropriate regulator so it must be a requirement that such matters are always shared with the regulator.

—

As set out above, there must be special rules for compliance officers/risk managers/internal auditors and anyone else whose job is to blow the whistle.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1595

—

—

The whistleblowing law itself is flawed in a number of ways but especially by the fact that the Claimant has to prove that “the dismissing officer” subjectively fired him or her due to the raising of Protected Disclosures. This is a very difficult onus of proof. The test should be changed and should be objective in nature ie what a reasonable person would believe was the motivation of the dismissing officer. It is vitally important that the law should prevent discrimination for employment on grounds of having been a whistleblower. As anyone who has publicly (or often even privately) blown the whistle it is almost impossible to get another job.

13.2 The Commission set up by Public Concern at Work is a good idea but those of us in the whistleblowing community do not have high regard for PCAW. However, I do not think it would be right to go into detail in this paper, although I am happy to provide the reasons privately. Another point to make about this Commission is that, although there are two whistleblowers on the panel (Gary Walker (NHS) and Michael Woodford (Olympus)), there is no representation from the financial sector where whistleblowing is so very important and this may be because of the background of PCAW’s Chairperson. 13.3 A better option would be for Parliament to set up a Commission to look into the whole question with a view updating the law. 14. The Inadequacy of our Monetary System and the need to Investigate what is called “Full Reserve Banking” but which is, in fact, a Wholly New Monetary System 14.1 I have to say, at this point in my paper, that I really do not think we have got anywhere near solving the problem of banking in this country (or the world) or the excessive power the big 4 banks have over our monetary system, economy and lives. 14.2 Over time, I have come to the very firm conclusion that ring-fencing, more capital, stronger corporate governance and regulation simply will not do the trick and that, to solve the huge economic problems we face, the entire monetary system and banking needs fundamental reform by the introduction of a system of “Full Reserve Banking” as proposed by Positive Money. 14.3 The whole idea that 97% of our money supply is created, and its use in the economy is directed, by private commercial banks when they make loans is wrong. It bases pretty much everything we do economically on debt which banks are incentivised to oversell to make interest for themselves. It directly causes a constant transfer of wealth (through interest—about £160 billion per annum) from society as a whole (and particularly the poor) to the banks and so is a direct cause of the inequalities and associated social problems discussed in the great book called The Spirit Level. It means that asset bubbles (property) and boom and busts are inevitable and, most importantly, it cedes far too much power over our economy, our society and our lives directly to the banks and a tiny group of executive directors who are incentivised (and required by Company Law) to generate short-term profit. Of course, only around 10% or so of bank lending is made to the productive economy ie the SMEs with the vast majority going to residential and commercial mortgages and financial intermediation. Indeed, SME’s deposit more with banks than they ever borrow. Finally, the big 4 banks control well over 80% of the money supply which means that something like 25 executive directors, with no public duties whatsoever, to a very large extent control our monetary system and economy. 14.4 Even Mervyn King has commented that this way of organising our monetary system and banking is not the best way to do it. Martin Wolf summed it up perfectly when he said—“The essence of the contemporary monetary system is the creation of money out of nothing, by private banks’ often foolish lending.” 14.5 Positive Money which was set up and is run by a remarkable young guy called Ben Dyson makes the case for reform of the monetary system through the introduction of Full Reserve Banking very powerfully indeed in their new book “Modernising Money”. You can check out what they say on their website here http://www.positivemoney.org/ . I am on the Advisory Committee of Positive Money. 14.6 Policymakers need to look very carefully at introducing “Full Reserve Banking” (see Positive Money about all this) as this will completely remove the need for the State ever to stand behind banks again. The ICB simply ignored the idea of full reserve banking and its recommendations do not achieve this. It is wrong that the taxpayer has to provide a guarantee of £85,000 to each account holder in each bank. Full reserve banking is the best way to resolve this problem and the best way to ensure that banking is carried out in the interests of customers and society as a whole. It means that there can never be a run on current accounts and customers choose savings accounts with the level of lending risk with which they are comfortable just like collective investment schemes and the saver/investor bears the risk. 15. Our democracy and the Excessive Power of Banks and other Financial Institutions 15.1 Jesse Norman MP said—“Lobbying is a canker on the body politic”. He is right. [I hasten to add that I am not and never have been party politically aligned.]

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1596 Parliamentary Commission on Banking Standards: Evidence

15.2 We don’t live in a democracy any longer. We live in “corporatocracy” where the power of corporate money buys public policy. Some say we live in a “bankocracy” as they have control over the money supply. Whatever we call it, it is a plutocracy and we need to do something about it. The corporate giants in oil, weapons, banks and financial services, pharmaceuticals, agrochemicals (oil again), gambling and drinking etc (plus illegal drugs which fundamentally affects the standard economy)—just have too much power and the rest of us end up feeling helpless, fed up and sometimes, when our spirit rises through the latest corporate scandal, angry. 15.3 The Centre for Investigative Journalism (Neil Mathieson, I believe) did a detailed analysis of the money spent in just one year by banks and other financial sector giants in the UK on lobbying. The sum was huge— about £100m, if my memory serves me correctly. But this still ignores the money those organisations, and their rich leaders, spend on funding of political parties. This is wrong and means that democracy does not work. It leads to a greedy and powerful elite with no proper accountability to ordinary people. And they own the politics. 15.4 Here are just three ideas to solve this: — Introduce a detailed register of all lobbying contacts with public bodies and officials both business and social. — Require all companies over a certain size to keep detailed and transparent accounts on the money they spend on public and government affairs and, in particular, on lobbying relating to new public policy. — Use internet technology to engage in the political debate with ordinary people through organisations like 38% and Avaaz ie bring our democracy truly into the internet age and give us back the power that the corporate giants now have. 16. Executive Business Leadership, Strategy, Culture and Associated Incentive Systems 16.1 All organisations are dynamic “systems”. Change one part and it affects all the others. If we are to get our large and publicly quoted corporate world working properly, we need to look at the problems we face holistically and design our public policy response accordingly. 16.2 A good way to visualise the overall way in which we need to look at the huge beasts we have created (out of the essentially good idea of splitting personal risk from corporate risk) is shown in the diagram below on the next page.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1597

16.3 So, if you have a reckless strategy, even if your people and culture and structures are right, the organisation will fail. Likewise, even if you have a good strategy, if your people and culture are dysfunctional, the organisation will fail. 16.4 The key to all of this is ultimately the centre of the diagram—Leadership. And here, I return to the very heart of the problems we face. If we promote the wrong people to lead our large, publicly quoted and societally important businesses, the whole system will fail. Sadly, this is what seems to have happened to a large extent over the last sixty years or so. 16.5 The academic evidence on this is now clear that we generally promote people to the top who have the wrong personal attributes—narcissism, lack of empathy, charm but manipulativeness, lack of conscience, ruthlessness etc. Yes, this does seem to drive short-term results but, in the end, these characteristics will fail the business and fail society. 16.6 I repeat what I wrote earlier about the crucial requirement of the quality and ethics of the executive leadership. There is plenty of academic evidence that the wrong sort of people have been getting to the top of major organisations—people with excessive “psychopathic” attribute. This is obviously not the case throughout all organisations and there are plenty of really great leaders around. 16.7 However, it is now time for the FCA to focus a great deal of attention on this and to implement systems to prevent this happening as part of their Approved Person’s regime. It is perfectly possible to stop this by the right recruitment processes and governance of those processes by a truly outstanding “unconflicted” Nominations Committee. Much more work needs to be done in this area to inform the public policy debate and to design appropriate risk mitigation systems to avoid this happening. A good place to start might be for members of the Commission and others to read the book “Snakes in Suits: When Psychopaths Go to Work” by Paul Babiak and Robert D. Hare. I would also recommend engaging with Holly Andrews to whom I referred earlier in this paper. 16.8 Finally, members may have noticed that, thus far, I have not mentioned remuneration at all even though this is normally where everyone starts. This is not because I do not consider it to be important. It is ultimately one of the most visible symptoms of what is wrong with the system of corporate governance. However, I believe that the problems of remuneration will ultimately be solved by proper corporate governance and the changes described above (including shareholder approval of remuneration systems). 16.9 The fact is that because there is no real governance of remuneration, compensation consultants have not been independent nor have remuneration committees. It is a type of self-feeding vicious circle of selfinterest at work. You don’t need much common sense to conclude that the pay packages in pretty much all large publicly quoted companies are designed by the very same people who receive them and are, on any analysis, an unfair reward for the risks taken.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1598 Parliamentary Commission on Banking Standards: Evidence

16.10 When I was at HBOS, I was one level below main board director. I almost certainly got paid too much but I was paid only 25% of what the lowest-paid main board director got paid and less than 10% of what the highest-paid director was paid. My two direct reports got paid less than 33% of what I was paid. This is not fair on any proper independent analysis of value. 16.11 I am not sure I or anyone really knows the final answer to dealing with the problems of the ludicrous pay of plc directors and executives when they take no real personal risk. Nevertheless, here are some ideas to consider while the problems of corporate governance and independent checks and balances, which I believe will solve the problem, are resolved: —

Remuneration committees should be chaired or, at least nominated, by shareholder representatives. See Tomorrow’s Company’s work on this.

—

The work of supposedly independent compensation consultancies needs to be rigorously checked and corroborated to ensure that no conflicts of interest exist or irrational recommendations are made. This could be conducted by the proposed new Ned of RCAE as explained above. It could even involve the Regulators to ensure that the design of the remuneration system does not incentivise dysfunctional behaviour.

—

All remuneration should be in cash as it is too easy to hide pay in the complexity of long-term incentive share schemes and incredibly valuable pension schemes. Also owning huge packages of shares creates conflicts of interest.

—

Bonuses should be allowed but, for every £1 of bonus upside, there should also be £1 of downside.

—

The assessment of any bonus (de-bonus!) must be formally signed off as fair and independent by internal control functions and the Ned of RCAE before approval by the remuneration committee.

—

Bonuses should be held in trustee accounts and invested in safe financial instruments for a minimum of three years (better five, even better ten) as security against subsequent underperformance.

—

Public income taxation policy should be linked to what we want to achieve here. For example, there should be different income tax rates for entrepreneurs who drive growth and employment in the economy and take significant personal risk and directors of publicly quoted companies who seem to be able to negotiate employment contracts which reward them even when they fail.

—

Although highly unlikely to work because of the power of the vested interest in politics, the G20 should start a debate and work hard towards a recommended multiple of top-level remuneration packages to average pay in any country—say 20Xs for top-level public sector jobs and 40Xs for top-level publicly quoted companies (not private close companies which are normally owner managed).

In the UK this would mean about £500,000 in public sector and about £1 million in private sector. These levels should only be recommended and not a legal “incomes policy”. However, there should be a regulatory requirement that any organisation that goes outside these recommended parameters must publish a detailed “comply or explain” report and that this report, which must be independently signed off by internal control functions and the Ned of RCAE as true and fair. 17. Conclusion and Final Thoughts 17.1 It’s not just that—“There’s something rotten in the State of Denmark.”:—it’s actually that “Pretty much everything is rotten in the State of Denmark.” 17.2 This means that there is an awful lot to do to put things right. 17.3 The fact is that we should have had a thorough and transparent investigation into the whole banking crisis right at the outset. This because the only way to get to the bottom of what caused it (ie what went wrong and who did wrong) and what we need to do to make sure it does not happen again, is to carry out a thorough, forensic and transparent judicial investigation as we have done in other areas of equal public importance— Equitable, Iraq, Mid-Staffs, Leveson etc. 17.4 The work of the PCBS on HBOS has done this country a huge service. At last, some of real problems and causes have been exposed to the bright light of public scrutiny. 17.5 We can, at least, still do a thorough investigation into the aspects of the RBS and HBOS scandals that have not already been done. We own most of RBS and a lot of HBOS. The good work already done will not be wasted but there is more to see. The work done by PwC on behalf of the FSA into RBS was totally inadequate and the independent overseers were not even permitted to check the decisions as to whether enforcement action should have been taken. This was made even worse when Margaret Cole, who took the decisions, apparently with no outside legal opinion, then walked through the revolving door to become the General Counsel of PwC.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1599

17.6 The roles of FSA, the accountants and their regulators (FRC, ICAEW etc) must be investigated thoroughly first. This must be done independently as the current structures are flawed and there are too many conflicts of interest. I disagree with the PCBS requiring the FSA to continue with its own investigation into HBOS and its own role in the scandal. After all, Sir James Crosby was the CEO of HBOS while also a Ned of the FSA and then became Deputy Chairman of the FSA in November 2007. 17.7 In any event, there is so much to do that I venture to suggest that what we need to lead this is properly is a Royal Commission with powers to take evidence under oath but also to call evidence on a truth and reconciliation basis, if it considers that this may the best way to get to the bottom of things that have not been investigated. This Royal Commission could look both backwards, if it feels that there are still matters to be discovered. It could also require criminal investigations if necessary. But, most importantly, it can look forward and redesign the entire system so that we can truly move on as a country with one of the finest financial sectors in the world. 17.8 Some final thoughts come from an Encyclical written by Pope Benedict XVI called Caritas in Veritate (Love in Truth) which, as even the Deputy Chairman of Goldman Sachs, Lord Brian Griffiths, has publicly acknowledged, is one of the most eloquent narratives on the problems we face today, not only in the UK but throughout the developed world where, in effect, the love of money has taken over from all else and where GDP is the only mantra in town. There must be a better way to lead our societies. “Once profit becomes the exclusive goal, if it is produced by improper means & without the common good as its ultimate end, it risks destroying wealth and creating poverty. The economy needs ethics in order to function correctly... Development is impossible without upright men and women, without financiers and politicians whose consciences are finely attuned to the requirements of the common good. Both professional competence and moral consistency are necessary. When technology is allowed to take over, the result is confusion between ends and means, such that the sole criterion for action in business is thought to be the maximization of profit, in politics the consolidation of power, and in science the findings of research.” 13 May 2013

Written evidence from Lord Phillips of Sudbury OBE, Sir John Banham DL, Tim Melville-Ross CBE and Sir Stephen O’Brien CBE Restoring Public Trust in Britain’s Banks and Major Businesses For the last 18 months a small group convened by Andrew Phillips (Lord Phillips of Sudbury) has been considering the steps that need to be taken to restore public trust in the integrity of Britain’s banks and major businesses. Originally set up in the immediate aftermath of the occupation of St Paul’s churchyard, the group— Lord Phillips, Sir John Banham, Tim Melville-Ross and Sir Stephen O’Brien (see end)—have watched aghast as the “licence to operate” of some of the most important businesses in Britain has been called into question by a series of public scandals that threaten to do massive damage both to an economy already struggling to cope with the global financial crisis and the problems of the euro-zone and to the society it serves. Of course, we are all too well aware that we are a self-selected quartet answerable to no one. However, we are also aware that the general public is looking for answers to the central question: can anything useful be done to moderate the insatiable and anti-social greed that seems to infect society at large? The extent of the challenge has been brought into sharper focus since the Commission was established by the LIBOR scandal. Even as their paper is being written we learn of the developments at Eurasian National Resources Corporation (see later) and the implications for Western clothes retailers of the tragedy in Dhaka. Our experience of leading major organisations over more than two decades (see the tailpiece) suggests that the answer to this question must be “Yes!” Our conviction has been reinforced by conversations with a number of very senior figures in the City, many of whom are understandably reluctant to say in public what they really believe about the prevailing value-system. What are sure of is that reform cannot be imposed from the top by Codes of Corporate Governance, let alone by more regulation. Most of the corporations that were associated with the financial crisis were highly regarded by the corporate governance commentators. In any case, rampant materialism is not confined to big business and the City of London as anyone familiar with the local planning system will recognise. Society already altered. Yet, our combined experience shows that outstanding returns for shareholders can be delivered by large businesses that take their corporate social responsibilities seriously and have created and preserved a sustainable corporate culture in face of the markets’ pressure for short-term results and rising dividends. We have drawn on this experience of what works to prepare this memorandum for the Commission, fully aware of the dangers of seeming to be self-serving—the most expensive words in British public life are said to be: “I told you so!”.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1600 Parliamentary Commission on Banking Standards: Evidence

The first part sets out the summary background to our thinking; the way forward sets out seven ideas for action by individual businesses to restore the public trust in Britain’s banks which is an essential pre-condition of economic growth. Background If ever big business enjoyed broad public trust in Britain, it seems recently to have lost it. This loss of trust has happened against a background where many of the major institutions that make up our society—Parliament, the Churches, the media, the police have seen a similar erosion of trust and respect by the general public. But there are some special factors at work for business: — An increasing, and seemingly vain, focus on short-term financial gains for investors- most of whom would have been better served with their savings under their mattress than invested in the UK equity markets over the last decade; — Some extraordinarily ill-judged financial remuneration packages which do not seem to reflect executives’ performance in creating value for those who ultimately own the business—the shareholders. In the case of the financial sector, the direct and indirect costs of excessive remuneration have contributed to the crisis which continues to impose such heavy burdens on society at large. These two factors particularly have in turn led to general debate focussing on the limited values underpinning the governance of many organisations in the public and private sectors. The US Journal of Public Affairs recently (Volume 10, pages 121–138) published a paper introducing the concept of the corporate psychopath— ruthless , selfish and conscience-free individuals in senior management positions who pose important challenges for companies and their boards. Corporate Social Responsibility (CSR), as a concept and system, began as a way of earning and retaining civic respect and public recognition that business was an integral part of society at large and the communities in which individual businesses operate. It saw itself as a change agent, to create a more socially engaged, prosperous society and integrated community. However, the CSR “movement” has developed into literally hundreds of separate initiatives with little coordination; and the effectiveness of the UK corporate governance “industry” must be called in question by recent events: as was stated earlier, all the UK’s banks and largest companies met all the requirements of the various codes of corporate governance practice—indeed, it can often seem that the more good practice “boxes” that are “ticked”, the more shareholder value seems to have been destroyed. BP is a prime example. In any case , the general public seems unconvinced. According to the Institute of Business Ethics, some 42% of the public does not believe that the British business sector behaves ethically; and typically less than a third of those questioned say that they trust business leaders to tell the truth. [The Times, 13 August 2012] The current so-called crisis of capitalism , and the recent riots in Britain, France, Greece and Spain, have emphasised that business is not creating sufficient jobs to support a secure democratic system. With unemployment among young people in Spain approaching 50%, and no end in sight to the era of austerity, it is small wonder that the outlook for the newly-elected Spanish government and democracy in Spain itself is guarded at best. The success of the London Olympics and continuing falls in crime rates [The Economist 20 April 2013] should not blind anyone to the uncomfortable facts that cuts in UK public spending have not yet fully begun to “bite” and total UK indebtedness remains significantly higher as a percentage of GDP than in Italy, Spain or Greece, because of bank debt. The worst of all outcomes would be if, after all the sound and fury, nothing much changes: “The dogs bark; but the caravan moves on.” A culture where private, public and social enterprises really worked together with shared values and an overlapping agenda—rather than in a climate of mutual blame and distrust between business, the public and politics—could make a huge difference in current circumstances. Blaming the sensationalism of the discredited media would be a totally inadequate and escapist response to the current crisis of public trust in the integrity of our banks and major financial institutions. So what specific steps can and should be taken by the leaders of every major business in Britain and the boards of Britain’s banks in particular? This is the subject of the next section of this memorandum. Ways Forward for Business Rebuilding public trust and confidence in the City will be essential to creating jobs and growth in an era of austerity. Unfortunately, too often, suggestions to this end amount to little more than bland generalisations reminiscent of the old definition of a British diplomat: “generally speaking, he was generally speaking”. This group has drawn on their individual personal experiences, of the public and private and voluntary sectors , to recommend seven steps for Banks and other City institutions to take, namely: 1. Corporate governance that emphasises the character and independence of non-executive directors over quotas and a “tick-box” approach;

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1601

2. An externally-monitored Mission Statement that has fairness to all the key stakeholders at its heart; 3. A Code of Conduct, binding on all employees, that puts client interests first—above those of the owners or employees; 4. A new approach to remuneration that is fair to all stakeholders and reflects individuals’ success in building long-term shareholder value; 5. Effective whistle-blowing machinery, overseen by independent outsiders who are not deterred from “asking the unasked questions”; 6. Individual accountability of directors and senior management for the performance of the organisations for which they are responsible; 7. Direct involvement in initiatives to address eg. the current housing crisis, to bring the concept of Corporate Social Responsibility to life for a sceptical public. If these ideas commend themselves to the Commission, it will be necessary to identify an existing organisation to take ownership of them—assuming responsibility for publicising and promoting them as widely as possible. We do not underestimate the difficulties involved; leading membership organisations criticising their own members is not a recipe for a quiet life or long tenure. But these are extraordinary times; and the cost of failing to restore public trust in Britain’s banks will continue to be unacceptably high. The rest of this memorandum describes each of these steps in turn. 1. Corporate Governance Tempting as it is for commentators to blame ineffective regulation, external auditors in the pockets of executive management and professional advisers with conflicts of interest for the problems that have afflicted Britain’s banks and other major companies (such as BAE Systems, BP and Shell) on whom pensioners have relied for their retirement income, these problems are all the result of failures of corporate governance. The various Codes of Good Corporate Governance Practice may have been necessary. But they have been shown not to be sufficient to prevent the catastrophes from which the economies of the developed world are struggling to recover: Barclays, along with every other UK High Street Bank, met all the requirements of the various codes governing the composition of their boards of directors and their corporate approach to risk management. There is an obvious danger in undue reliance on quotas that have been negotiated by the various special interests involved: quotas are judgement free—either a board has the “right” proportion of independent directors (or women) or it does not; and the corporate governance industry can react accordingly. But what matters is the effectiveness of boards of directors, not whether(or not) some quota in their make-up has been met. For example, the widely welcomed appointment of Sir David Walker as Chairman of Barclays was totally incompatible with existing corporate governance rules.] This issue was confronted by the RSA Tomorrow’s Investor project. One of the project’s publications, “Securing Decent Returns for Investors in Troubled Times”, advised all investors and their fund managers (inter alia) to satisfy themselves that the Chairman and independent directors of “their” companies had the combination of competence , courage and commitment to call management effectively to account? Are they in a position to insist on satisfactory answers to difficult questions, like those associated with trade with Iran or corporate tax avoidance schemes? Will they be prepared to resign if they are not satisfied that the business is being run in the interests of all the stakeholders rather than management? The best independent directors are those who can devote the necessary time, have reputations to lose and who can afford to resign when they do not like what they see and hear. The character of independent directors is far more important than their quantity. After all, independence is a state of mind rather than some career-derivative; and a willingness to express an independent point of view in face of a board and senior management consensus requires an unusual combination of moral courage and well-founded self-confidence based on experience .In our experience such independence is especially valuable when major acquisitions are under consideration. There is long-standing evidence that most takeovers destroy value for the shareholders of the acquiring company. Nonetheless, “giantism”—the management and shareholder urge to expand a business regardless of the risks involved—can be difficult to resist, as the shareholders of RBS and Lloyds TSB know to their cost. Our experience suggests there is much to be said for relatively small (7–9) boards of directors, predominantly made up of properly remunerated independent directors with executive representation limited to the Chief Executive (CEO) and perhaps the Chief Financial Officer. Too often in the past,the boards of Britain’s banks have been too large to be effective. There have been too many “serial” non-executives unable to devote sufficient time to understand a complex business; while executive directors are very rarely, if ever, prepared to challenge their CEO in board discussions of key issues.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1602 Parliamentary Commission on Banking Standards: Evidence

2. Mission Statements At the heart of every successful business is a corporate culture that reinforces and informs the company’s strategy. Put less positively, many of the problems that caused the financial crisis have been attributed to “the wrong culture” within the business. In today’s mobile employment world ,where people move from firm to firm much more frequently, every business needs a clear statement of its mission and core values or culture: “the way we do things and what matters around here”. Too often these statements seem to have done little to establish trust in the business itself. The statements are often left in limbo; and a single act of “bad behaviour” can easily negate decades of hard work. The solution lies in firm implementation by Boards of Directors of agreed and published values which are enforced world-wide, and subject to regular external audit to ensure that, at all levels in the organisation, everyone is aware of the mission and values and pays more than lip-service to them. Most long-term shareholders do not believe that a company should sacrifice ethical considerations to increase short-term profitability; in fact , many invest in successful global businesses precisely because they have confidence in the management to invest wisely for the longer term—increasing capital and R&D spending in difficult times , in an effort to “never waste a good crisis”. As with any initiative, the process of developing a mission statement needs to involve as wide a cross-section as possible of the people whose support will be essential to its effectiveness in influencing individuals’ behaviour. The notion of “fairness” needs to be at the heart of any corporate mission statement. This is not as vague or as impossible as it sounds. Treating customers fairly is now a core Financial Conduct Authority principle. But, long before the regulators acknowledged the importance of the concept, Nationwide was using it as a guide to management action at a time when many of their competitors were giving way to pressures from their members looking for an allocation of free shares to convert to publicly-quoted banks—abandoning the mutual ownership structure, with disastrous consequences for the Building Society movement in general and Bradford & Bingley, Cheltenham and Gloucester and Halifax in particular. 3. Code of Conduct Many studies have shown that the general public is not particularly interested in financial matters and devotes little time and effort to planning for their families’ financial future. As a consequence, a disturbingly high percentage of households are failing to save enough for their retirement. This lack of preparedness is compounded by the widespread distrust of financial institutions fuelled by recent examples of aggressive misselling of pensions and complex financial products to customers who did not understand the risks they were taking on, and were not well placed to assess the balance between the risks and the rewards they were being offered. Every company in the financial services industry needs a Code of Conduct, binding on all executives and staff, that specifies that the interests of the client comes first at all times—ahead of those of the company or its owners. Indeed, the only way to prosper in today’s litigious world is to have a well-founded reputation for putting the clients’ interests first. Failure to live by the Code of Conduct should bring serious consequences, in terms of compensation and career prospects; and Audit Committees should routinely satisfy themselves that the Code of Conduct is both signed up to and understood by all new employees and reflected in compensation and career decisions. The way that the global fund management industry works is often cited as one of the underlying causes of the financial crisis, because of the mismatch between the interests of the agent ( the fund manager) and the principal (their clients). The former can feel compelled to operate to a very short time horizon, often driven by market , media and even political considerations; and there are often quarterly reports to trustees, where their performance will be scrutinised. Meanwhile, pension funds and financial institutions operate to much longer time horizons, with liabilities measured in decades. In such circumstances, it is especially important that everyone within the fund management organisation knows that their first obligation is to safeguard the clients’ interests, even if this means that there is a risk of losing the account by “doing the right thing”. The imperative to put clients’ interests first was recognised by the Board and new senior management team of Invesco, now one of the largest and most successful independent fund managers in the World, when the company was struggling with serious regulatory problems in the US six years ago. As a result, new management was brought in. A new mission statement and set of strategic priorities and approach to risk management put clients’ interests first and the Code of Conduct was revamped. Invesco’s Code of Conduct and the business strategy that follows from it is accessible for clients and employees alike on the Company’s website, Invesco.com. 4. A Fair Approach to Compensation There can be no doubt that the compensation practices of the financial services industry have been the single most important source of public concern at the way major financial institutions are managed. The annual bonus “campaigns” of City employees are perceived to have encouraged, if they did not cause, the risk-taking that

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1603

has caused so much damage to the wider economy; while the resulting differentials in reward are widely seen as unacceptable. Excessive executive compensation also fails the fairness test. It can also mean that investment in the future of the business and in risk management are sacrificed to meet compensation demands that are often dressed up by an industry of compensation consultants as “the market rate for the job”. While clients’ interests are inevitably disadvantaged by high staff turnover, as executives leave to secure higher bonuses at another firm, they are not held to account for their decisions and advice. Excessive staff turnover also makes it far more difficult to build and sustain the kind of corporate culture which is widely seen as the key to the long-term success of any business or enterprise. Finally, shareholders suffer from the lower profits and dividends resulting from excessive compensation and the higher capital requirements imposed by financial regulators to offset the perceived risks in the business. Plainly, it must be for Parliament to ensure that the personal tax structure both reflects the prevailing political consensus on acceptable levels of pay differentials and is effectively policed. Moreover, EU attempts to legislate lower bonuses as a proportion of basic salaries seem likely to have the unintended consequence of inflating salaries and thus fixed costs—with no discernible impact on individuals’ overall remuneration. So far as corporations are concerned, the best way to secure shareholder support for their compensation policies and practices is greater transparency—there are very few conditions where more “sunlight” is not beneficial. The Shareholder Spring came a year earlier in the United States than it did in Britain and delivered a timely wake-up call to many boards of directors: despite what was generally seen as a robust and prudent process, to align executive compensation with financial and strategic performance, and regular endorsement by UK shareholders when the company was quoted in London (as Amvescap) over 40% of Invesco shareholders voted against the Board’s recommendation in the advisory vote on executive compensation at the 2011 Annual Meeting. The Company responded to this vote by engaging with its principal shareholders and greatly increasing the levels of disclosure of the compensation decisions for individual senior managers. The proxy materials circulated to shareholders ahead of the 2012 Annual Meeting ran to 23 pages and explained the company’s compensation philosophy and practices in considerable detail. In view of the Banking Commission’s interest in remuneration within financial services companies, it is perhaps worth summarising Invesco’s approach: —

Base salaries of senior managers comprise only around 10% of their total annual compensation, including pension contributions, because of the strong emphasis on pay for performance in delivering results for clients and the use of deferred compensation;

—

The company’s total incentive compensation is linked directly to a narrow range (below 50%) of pre-cash bonus operating income, thus meeting the “fairness” test: incentive compensation is only paid when the company is generating operating income;

—

Compensation of senior executive management is heavily weighted (60–70%) to deferred compensation, paid in the form of shares that vest over a period of four years. A significant portion of the deferred compensation is tied to Invesco’s financial performance—specified levels of operating margin and diluted earnings per share—and is thus aligned with the interests of shareholders;

—

A “clawback” policy is applicable to executives’ performance-based long-term equity awards, permitting the Company to recover compensation based on fraudulent or wilful misconduct;

—

An insider trading policy prohibits short-selling, dealing in publicly-traded options and hedging or monetization transactions in the Company’s common shares;

—

The various equity incentive plans prohibit re-pricing of options without the express approval of the shareholders at the Annual Meeting.

Despite strong financial results in 2011 and substantial strategic progress during the year, including the successful integration of a significant acquisition, incentive pools and the incentive compensation of senior managers was maintained at the same level as in the prior year; salaries of senior executives were maintained at substantially the same levels as have been in place since 2007. All senior Invesco executives make their own pension arrangements; there is no equivalent of the UK “Top Hat” executive pension plans which have caused such reputational damage to British business, as “pay-offs for failure”. The contrast with the pay policies and practices in the City of London speaks for itself. The reaction of shareholders to these decisions and the enhanced transparency was overwhelmingly positive. At the 2012 Annual Meeting, in a record poll, 96% of the votes by Invesco shareholders approved the Say-onPay proposal. Current indications suggest that shareholder opinion will be similarly supportive in the 2013 vote. We need to add a reservation to the forgoing. If it should prove that such a reformed approach by UK public companies is not voluntarily adopted, Government will be forced to act, for the antisocial consequences of the present culture are unsustainable.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1604 Parliamentary Commission on Banking Standards: Evidence

5. Whistle-blowing It has long been recognised that wrong-doing in any organisation is very rarely uncovered by external auditors. Hence the importance of effective risk management policies and procedures , backed up by internal audit arrangements that are equal to the complexities of the business and the scale of the risks for shareholders. But even these arrangements are not guaranteed to work. They have, self-evidently, failed to prevent rogue traders costing shareholders £billions and great institutions like Barings and the NatWest their independence. The implications of the LIBOR scandal are potentially very serious indeed for the banking system as a whole— particularly once the US Plaintiff’s Bar becomes involved. In each case, the immediate perpetrators could not have been the only people to know what was happening. But those “in the know” chose to remain silent, either because they were not aware of the existence of whistle-blowing machinery, or because they did not see it as their responsibility to use it or because they did not trust the system to protect them and take their concerns seriously. The result has been huge damage to the economy at large and to the trust in business’ ethics by the general public. Market manipulation and insider trading are crimes. So are undisclosed payments to local councillors for obtaining planning permission in the area they represent. Yet successful prosecutions for these crimes in Britain are very rare, further reducing the incentive for would-be whistle-blowers to incur the often acute personal risks involved. Especially damaging to public confidence in the NHS and planning system has been the systematic failure by the bureaucracies involved to take whistleblowers’ concerns seriously. The prosecutorial authorities need much stronger resourcing so as to make such financial crimes a real risk to their perpetrators rather than the merely theoretical threat they now are. Legislation protecting whistleblowers from retaliation or victimisation by employers has been on the UK Statute Book, ever since enactment of the Public Interest Disclosure Act 1998. Effective whistle-blowing machinery should be seen as the last line of defence for the public and shareholders. The forthcoming findings of the Whistleblowing Commission established by Public Concern at Work, should be heeded by the Government. Every company should install some form of well publicised whistle-blowing telephone hotline, enabling employees and individuals outside the company (customers or suppliers, for example) to make anonymous complaints or register concerns regarding compliance with applicable laws, rules or regulations and the Code of Conduct as well as accounting, auditing and ethical concerns. The US Foreign Corrupt Trade Practices Act and its recently enacted UK counterpart make such machinery particularly important for any global company. Calls to telephone hotlines should be monitored at least every week and reported to the independent chair of the Audit Committee, who can decide on the necessary action—including initiating an independent investigation of any particularly serious allegations.It goes without saying that the person over-seeing the system should be completely independent of management and seen to be so. 6. Individual Accountability The concept of personal accountability for results lies at the heart of any successful enterprise. If individuals are not to be held to account for their performance, it is difficult (if not impossible) for Boards (or Governments) to delegate authority without abdicating their overall responsibilities for effective governance of the business or institution; and there will be even further reliance on regulation to avoid the mistakes of the recent past. Public confidence in business is not enhanced by the realisation that very few senior people have paid any price for presiding over catastrophic misjudgements and worse which have cost millions of families dearly. The case of Eurasian National Resources Corporation (ENRC) offers a stark illustration of the cost of greed in the City to thousands of UK pensioners. It was quite apparent when the possibility of ENRC securing a London quote for less than 20% of its shares was under consideration in 2007 that this would not be an appropriate investment for UK pension funds. Yet the flotation went ahead, earning the City institutions concerned fees well in excess of £150 million according to recent press reports. As a constituent of the FTSE 100 index most UK pension funds were required to hold the shares; and by the beginning of May 2008, when many UK pension funds had joined the register, ENRC shares were trading at £13.15p. However, by late April 2013 ENRC shares had fallen nearly 80% to 270p; and The Times (27 April) was reporting that Macquarie was telling clients to “get out now, while you still can” and the Serious Fraud Office had decided to open a criminal inquiry into suspected fraud at the company. The total loss incurred by UK investors will eventually be over £1 billion as a direct result of the decision by City institutions to support the original ENRC public share offering.Yet no individuals and no advisers or financial institutions have so far been called to account for this entirely foreseeable loss. There seems to be a conspiracy of silence when there should be accountability and recompense for the losses incurred. The problem does not seem to be confined to the private sector. For example: accusations against the leadership of the NHS, which would usually result in charges of corporate manslaughter against any private sector employer, have (so far) resulted in no-one being called to account for the situation at the MidStaffordshire Hospital Trust that has caused such public concern and outrage. Individual accountability for performance would be strengthened by the following steps:

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1605

(a) Shareholders should be required to approve at their Annual Meeting any payoffs for executives who have been in leadership positions. For too long, Britain’s financial institutions have been in the position of absentee landlords with respect to the companies in which their clients/ members own shares, acting as “share-holders” rather than “shareowners”; (b) At least half of the total remuneration of all chairmen and independent (non-executive) directors should be in the form of shares in the company; and all directors should all be required to hold shares to the value of at least one year’s remuneration for the duration of their term as a director. This is the current practice at Invesco, which serves to align the interests of the Board and management with those of the owners of the enterprise; (c) Early Leveson-style public enquiries should be launched into large scale corporate failures impacting society at large. The general public still do not really know what went wrong and why in the major banks and with UK financial regulation. There are very few problems that can be addressed without the sunlight of full public disclosure and forensic examination by independent experts. The scandals in the City deserve public inquiries every bit as rigorous as those into Parliamentary expenses, press standards, the Jimmy Savile affair and the failings of the NHS in Mid- Staffordshire. In each case, the combination of foot-dragging until public anger cools and what seems like a conspiracy of silence has left some awkward questions to be answered, beyond blaming “lighttouch” regulation: why did the Boards of directors, their highly paid managers, their auditors and other professional advisers all fail to prevent catastrophe? Where were the whistle-blowers and how were they treated? Where, in the words of the Chairman of the US House of Representatives opening the public hearings into the failure of Lehman Brothers less than a month after the event, was common sense? (d) Remuneration Committees should explain to all stakeholders why they are agreeing to pay bonuses on top of generous salaries and “top hat” pensions when their company is not profitable. Every manager claims to want to be judged by the “bottom line”; yet, too often, there seems no discernible relationship between corporate results and the remuneration of the managers responsible. Few people begrudge paying for success; but there is widespread anger at payments for failure; (e) Good practice should be highlighted and recognised more widely. Chairmen who insist on their remuneration moving precisely in line with that of the employees in their companies are the unnoted exception rather than the rule. It is even more exceptional for senior executives to have to meet the cost of any regulatory fines for misconduct on their watch out of their own pockets, as has recently been agreed by the remuneration committee of a UK mutual organisation. Individual accountability is central to the effectiveness of any large organisation. “Where everyone is responsible, no-one is responsible”. Too often, managements in both the public and private sectors, seem to be more concerned with avoiding individual responsibility for results, syndicating risks (and the possibility of blame) rather than managing them effectively. 7. Corporate Social Responsibility Finally, every major City firm needs to determine its attitude to Corporate Social Responsibility. In today’s fevered environment this will be far more challenging than was the case with sustainability, where a little “greenwash” went a long way. With the general public suffering the after-effects of the excesses of the precrisis era, there is a widespread perception that compensation in the City is generally still excessive and out of line with performance in creating shareholder value. The City needs to demonstrate that it is about more than self-interest and that it is an important part of the solution to some of the most pressing problems facing the Nation. As the new Chief Executive of Barclays is recently reported (Financial Times, 11 May) to have put it in a recent BBC documentary: “We have to be realistic that rebuilding trust in the banking industry is going to take a long time. It’s the responsibility of Barclays to change perceptions through what we do” [emphasis added] For example, the current housing crisis provides a massive opportunity for the City both to help address a problem that impacts millions of households in virtually every community in Britain and to spur economic growth—for at least a decade, Britain has been under-investing in residential housing compared with France and Germany to the tune of at least two percentage points of GDP or some £30 billion a year. With a multiplier of 2.8x, this means lost economic output of over 5% of UK GDP (sic) or the difference between recession and healthy growth in output and jobs. As a result, there are over two million families on housing waiting lists; and Housing Benefit is costing over £20 billion a year, or over £1,000 for every household in Britain.The RIBA Future Homes Commission has concluded that for the next two decades, the number of new homes built every year needs to treble, to around 300,000. The Commission, whose report “Building the Homes and Communities Britain Needs” has been widely welcomed by the various stakeholder groups, shows that the increase can be funded without a cent of additional public spending, by a combination of UK pension funds and financial institutions. Unfortunately, the

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1606 Parliamentary Commission on Banking Standards: Evidence

fragmented UK pension fund industry is under-exposed to property and particularly to residential property— less than 1% of a typical UK pension fund property portfolio is invested in the residential sector, compared to around 20% elsewhere in Northern Europe and over 25% in the US. The current structure of local authority pension funds (there are over 100) is particularly damaging; it could have been designed to encourage individual funds to invest anywhere except in their own localities. Yet, if the largest 15 funds were each to contribute (say) 15% of their assets to an independently managed £10 billion Local Development Fund the result would be an enormously powerful engine for economic growth—and a wonderful example of the City and local Government at work in the public interest. The £180 billion of Local Authority Pension Fund assets were recently described as having been “in a state of suspended animation” for the last two years, an appalling commentary on those responsible. If the City could demonstrate that it is simultaneously able to secure better returns for local authority pension funds and finance the trebling of home-building in the right places, the reputation of the financial services industry would be transformed; and Corporate Social Responsibility would begin to realise its initial promise. Tailpiece If the above seven steps were implemented by every major City institution and big company it would help to restore public trust in their integrity, a trust that is a vital pre-condition of sustainable economic growth hand in hand with social responsibility. Our combined experience convinces us that these are not unrealistic expectations. On the contrary, they already characterise many good businesses in Britain today. What is now needed, urgently, is for best practice to become common practice. 14 May 2013 The Backgrounds are Summarised Below Andrew Phillips (Lord Phillips of Sudbury OBE) a practising solicitor for over 50 years, set up Bates Wells & Braithwaite, London in 1970, where he is still a consultant. He has specialised inter alia in the charity sector and helped set up a number of socially innovative charities in the business domain including the Charity Bank, Public Concern at Work, Business in the Community, the Fairtrade Foundation and The Citizenship Foundation, which he founded. For 24 years he was the “Legal Eagle” on the BBC Radio 2 Jimmy Young show. He is Chancellor of the University of Essex. He was made a Life Peer in 1998. Sir John Banham, DL was the first Controller of the Audit Commission (1983–87) and Director- General of the Confederation of British Industry from 1987–92. Since returning to the private sector, he has successively chaired four FTSE 100 Companies which all earned exceptional returns for shareholders during his tenure while taking corporate social responsibility seriously: Tarmac, Kingfisher, Whitbread and Johnson Matthey. He is currently an independent director of Invesco , where he chairs the Compensation Committee. He chaired the RSA “Tomorrow’s Investor” project and is the Chairman of the RIBA Future Homes Commission. Tim Melville-Ross, CBE worked at the Nationwide Building Society for 20 years from 1974, becoming Chief Executive in 1985. He was Director-General of the Institute of Directors from 1994–99. Since leaving the IOD he has chaired a number of public and private sector organisations including Investors in People and Bovis Homes plc. He is currently chairman of Royal London Insurance, the Higher Education Funding Council for England and the Homerton University Hospital NHS Trust. Sir Stephen O’Brien, CBE spent 16 years in the City, where he was Chairman of Charles Fulton (International Money Brokers) and served as Chairman of the Foreign Exchange and Currency Deposit Brokers Association from 1968–71. He was the first Chief Executive of Business in the Community and served from 1983–92. He then went on to be the founding Chief Executive (later Chairman) of London First from 1992–2005. He was the founding co-chairman of Teach First from 2002–09. He is currently Chairman of St Bartholemew’s (Barts) Health, having been Chairman of the Barts and Royal London NHS Trust from 2010–12.

Letter from Andrew Bailey, Deputy Governor and Chief Executive Officer of the Prudential Regulation Authority, Bank of England COMPARING LENDING WITH CAPITAL At the Governor and my last appearance at the Parliamentary Commission on Banking Standards, the Governor said “There is a deeper problem for the banks themselves, and certainly for SMEs, and if you look at the banks, there is a clear distinction. The banks with the largest amounts of capital are expanding their lending. The banks which have bigger legacy balance sheet problems are contracting their lending. The reason why there is a difference between those two types of bank has nothing to do with the demand situation; it has everything to do with the position of the bank.” On the back of this, you requested that the PRA send a table that sets out this point “clearly and unambiguously”. The chart below compares the major UK banks’ real economy lending growth in H2 2012 with their capital ratios using published data. The chart is based on FLS lending data for all but HSBC, which does not take part in the FLS. HSBC’s lending data comes from published accounts data.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1607

As you can see, there is a positive relationship between banks’ published end-2012 Basel 2.5 capital ratios and lending growth in H2 2012.

Basel 2.5 (published data) and lending growth

16 April 2013

Written evidence from the Prudential Regulation Authority, Bank of England THE IMPACT OF EUROPE ON THE PRA’S APPROACH TO SUPERVISION The PRA has adopted an approach to supervision which I have described in summary as “judgement against a framework of rules”. A key element of this is the emphasis on forward-looking judgement (eg what is the possible impact of risks facing the firm(s) as distinct from a backward-looking test of whether a firm has met a rule-based test, which is often described as “box ticking”). This is therefore a crucial change in the approach to supervision. The framework of rules against which judgements are made is predominantly EU in origin (though in bank supervision a substantial part of the EU rules reflects standards agreed in Basel and then transposed into EU law, though not always exactly). Insurance supervision does not have a Basel equivalent, but there is a substantial body of EU law which is set to expand substantially whenever Solvency 2 comes into effect. Traditionally, EU law has been so-called “minimum harmonisation”, setting minimum standards. Use of this flexibility has been important in order to reflect national features and risks, and where the EU transposition of Basel is thought to be inadequate. It has, of course, also been the source of challenging on “gold plating”. Until recently, the EU approach has not in principle unduly constrained the use of judgement (here, I draw a distinction with whether or not appropriate judgement was used). However, a number of developments either have, or are likely to, pose a risk in future to the exercise of appropriate judgement. 1. The introduction of “maximum harmonisation” (for instance in the Regulation (CRR) part of the overall CRD4 package for bank capital adequacy) will constrain the ability of the PRA to use the flexibility to go above minimum standards. The important word here is “constrains” because the effect tends to be that, where sensible judgement needs to be exercised, the means by which it is achieved in a world of maximum harmonisation becomes more indirect and thus less transparent. There is a cost to such approaches in terms of the clarity of policies and supervisory actions. 2. The EU processes have moved in the direction of using more detailed rule-making, both at the level of legislation (Directives and Regulations) and the so-called Technical Standards that are developed and implemented by the European Supervisory Agencies (EBA, EIOPA, ESMA). This has led to a major increase in detailed rule-making. Moreover, in my view it tends to be a self-reinforcing process as detailed rules which apply to 27 countries tend to require more detailed rules to deal with the inevitable exceptions to reflect national circumstances. With such a detailed body of rules comes, a much larger overhead of monitoring and compliance in regulatory bodies and firms. Moreover, more rules tend to encourage more effort and cost to “interpret” and apply them. In my view, there is no meaningful process of cost and benefit assessment which has a real impact on whether to adopt such rules. 3. A further extension of this trend towards more detailed rules involves the proposal by the European Banking Authority to create a single Handbook of supervision. This could lead

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1608 Parliamentary Commission on Banking Standards: Evidence

towards attempts to harmonise not just the rules of supervision but also the process of supervising and thus the application of judgement. That said, the outcome could be more benign in terms of compulsion to adopt whatever form the Handbook may take, and thus the PRA is heavily engaged in the process in order to limit the damage. There is also an important link to the Banking Union here because we understand that the ECB will seek to develop its own Handbook. To summarise, there is a substantial lack of clarity in this area, and it is one that we are watching very carefully. 4. Last, the financial crisis has placed a major strain on the operation of the single market in financial services in the European Union, and particularly the freedom of banks to operate across borders without restrictions from the national authorities in which they establish outside their home country. In my view, the root of this development lies in the erosion of confidence in the solvency of some sovereign states and thus the national depositor protection insurance schemes on which depositors in branches of banks operating around the EU depend (ie when a bank from an EU country branches into another country rather than establishes a legal entity subsidiary company in that country, depositors in those branches look to the home country of the bank for the deposit insurance). The root of the problem is not therefore an issue to do with supervising banks. That said, I have observed a pressure from EU institutions to make rules, or seek rigidly to enforce rules, to counter this pressure on the single market. This strikes me as going against the fundamental economic logic of the pressure on the single market, and it raises the danger of a resort to burdensome rules which will fail to achieve their effect because they go against that logic. I hope that this description of current pressures from European developments is helpful in providing a sense of the threat that we could face to the new approach to supervision. I would be happy to discuss the issues. 11 April 2013

Letter from Dr Marcel Rohner After long and careful deliberations I have come to the conclusion that I will accept your invitation to appear before the Parliamentary Commission on Banking Standards, primarily out of respect for the House of Commons and for the House of Lords of the United Kingdom, and based on the United Kingdom’s centuries old tradition of fairness and due process. Further, given my involvement in the financial industry as a chief executive of a major global financial institution between 2007 and 2009, I accept my responsibilities and I am willing and honoured to contribute to your understanding of the reasons for and lessons learned from and during the financial crisis. I know that my position has been the subject of correspondence and discussions between the Commission and my UK counsel, but for the avoidance of doubt, I would like to make you aware of the following points: 1. I was not involved in any way in the LIBOR manipulation, as has been explicitly stated by the investigating regulatory authorities. I have up until now neither been questioned nor asked for any comments by any party involved in this matter. As a result my understanding of the issue is very limited and I will not be able to answer any detailed questions with respect to the functioning, setting and reporting of the LIBOR rate, or any alleged misconduct by anyone at UBS relating to LIBOR. Thus, I assume that I will not be asked questions which the Commission already knows I will not be able to answer. 2. I am a Swiss citizen and resident, and as such, I am entitled to express protections under the law of Switzerland. Because of my responsibilities as the former CEO of UBS AG, I have elected to appear voluntarily before the Commission, and to waive these protections notwithstanding the fact that I will, as a result, expose myself to the possible risk of reputational harm. I left UBS nearly four years ago and have not held an executive position in a financial institution ever since. I will almost certainly never hold one in the future. The request to appear before the Commission has created a serious personal dilemma for me which I opt to resolve by appearing and giving evidence. I now depend on your understanding of my specific situation. 6 January 2013

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1609

Letter on behalf of Dr Marcel Rohner from Kingsley Napley LLP Letter Relating to Question 2241 Dr Rohner read with considerable concern today remarks which are attributed to Mr Tyrie, in the Times. The relevant extract from the report is as follows: “Andrew Tyrie, the chairman of the commission, lamented the fact that some of the four were still holding senior jobs in the City and had not been struck off the Financial Services Authority’s approved persons register.” “Since they’ve just acknowledged in front of us that they were ignorant and grossly incompetent...it strikes one that they shouldn’t be on an approved persons list”, he said As the Commission will be well aware, Dr Rohner did not accept at the hearing yesterday any element of personal fault, in fact he specifically denied that he had been negligent. I can only assume that Mr Tyrie’s statement to the Times refers to his closing remarks. The uncorrected transcript states: “We have also heard about some appalling mistakes, which can only be described as gross negligence and incompetence. The best construction that many of us will place on that is that you were not only ignorant of what was going on but out of your depth. Do any of you want to challenge any of that?” The video recording is clear in showing the Dr Rohner did not react at all to Mr Tyrie’s statement. There is no basis for any assumption that he accepted Mr Tyrie’s assertions. I am writing to make it clear that Dr Rohner does not accept that he was grossly incompetent, nor does he accept that he acknowledged this in front of the Commission. It is important that the Commission is aware of Dr Rohner’s position on this, since it seems likely that the Commission will wish to make some reference to this evidence session in its final report. 18 January 2013

Letter on behalf of Dr Marcel Rohner from Kingsley Napley LLP Further Letter Relating to Question 2241 You will see that most to the proposed amendments are fairly minor. However, we are very concerned that the transcript at Q2241 states incorrectly that all the witnesses indicated assent to Mr Tyrie’s concluding comments. We wish to express in the strongest terms that this is not correct. Dr Rohner does not agree with Mr Tyrie’s remarks and, as is clear from the video recording, did not in any way indicate agreement or assent at this point. I know that my colleague has written separately to the Clerk on 11 January in relation to this point and subsequent comments in the press which have been attributed to Mr Tyrie. I should be grateful for your reassurance that this amendment will be made. You will see that I have added the phrase “due to the financial crisis” in square brackets in Dr Rohner’s response to Q2062. While Dr Rohner did not in fact say these words, we are concerned that the meaning of his sentence may not be clear without this addition and that the sentence may be misconstrued to be taken as a reference to the environment at UBS as opposed to what he meant, which was the environment in banking generally due to the financial crisis. We are aware that such an addition may not be permissible as part of the correction process but we would ask you to consider allowing these words to be added, in square brackets, in the interests of clarity and fairness to Dr Rohner. 11 January 2013

Written evidence from Santander UK RESPONSE TO THE PARLIAMENTARY COMMISSION ON BANKING STANDARDS CALL FOR EVIDENCE ON DERIVATIVES (A) Introduction (a) Santander UK welcomes the opportunity to respond to this call for evidence. (b) Santander UK has consistently argued for the need to allow ring-fenced banks to act as principal in the sale of risk management products. It has been the concern of Santander UK that if ring-fenced banks are not permitted to originate these products and provide them to businesses (most notably, SMEs) then a significant number are likely to be blocked from accessing them all together. (c) Santander UK has also consistently argued that these products can be provided by ring-fenced banks without any significant impact on their resolvability or stability. (d) We welcome the conclusion of the Parliamentary Commission on Banking Standards that ring-fenced banks should be able to act as principal in the sale of simple risk management products, subject to the conditions which it set out.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1610 Parliamentary Commission on Banking Standards: Evidence

(e) We feel that the draft Statutory Instrument on excluded activities and prohibitions (SI) related to the Banking Reform Bill has the ability to meet the second and third conditions of the Parliamentary Commission; namely to define simple customer derivatives in a way which is limited and durable and to place limits on the proportion of a bank’s balance sheet that can be taken up by customer derivative products. (f) We also believe that the SI can contribute toward the first condition of the Parliamentary Commission, namely to provide safeguards against mis-selling. As can be seen in Santander UK’s response to this call for evidence, restricting the range of risk management products to those which are relatively easy to understand and act in predictable ways, will contribute toward a regulatory regime which can protect effectively against the risk of mis-selling. (g) However, Santander UK considers that conduct risk can never properly nor effectively be addressed through the Statutory Instruments of a Parliamentary Bill. As conduct risk is concerned with how products are sold, rather than the nature of the products sold, it will inevitably be present regardless of the restrictions on products provided for in the SI. Conduct risk is most properly and effectively addressed by an empowered conduct regulator. Santander UK welcomes the creation of the FCA and has every confidence it will be able to fulfil this task. (h) Santander UK further notes that this is more properly an issue for the conduct regulator as risk management products may be sold by ring-fenced banks, non-ring-fenced banks and other specialist financial companies. Therefore, measures in the Banking Reform Bill to guard against mis-selling cannot provide for an effective market-wide solution. (i) We believe that the SI as drafted goes some way to ensure that the rules on the provision of risk management products are limited and durable. With some adjustments, we believe that the SI will be able to fully achieve this aim. Santander UK also welcomes the inclusion in the Banking Reform Bill of measures to “electrify” the ring-fence. This measure, which will permit the regulator to impose full separation on banking groups seen to be gaming the ring-fencing rules, will act as a powerful additional tool to ensure the durability of the rules. 1. Is it appropriate for SMEs to be able to hedge risks arising from price fluctuations directly with a ringfenced bank, rather than with a non-ring-fenced bank, and if so, why? 1.1 Santander UK considers it essential that SMEs are able to hedge risks arising from price fluctuations directly with a ring-fenced bank. 1.2 Even for some very small SMEs, being able to access products which enable them to hedge the risk arising from exposure to foreign exchange rates or interest rates are essential to help their businesses grow. This is especially true for those SMEs seeking to export goods to new markets overseas, or managing supplychains in more than one currency zone. Both of these activities are increasingly common, even for very small businesses, as the market in which they operate becomes more global and more competitive. With this in mind, it is essential that the Banking Reform Bill preserves choice for SMEs that consider hedging risks with standalone products to be the best route for business growth and success. 1.3 As set out in our response to the Commission’s call for evidence on the draft Banking Reform Bill in October 2012, Santander UK believes that for many SMEs, buying risk management products from ring-fenced banks is the most appropriate option. This is due to the relationship which the SME will have with the ringfenced bank and because the products will be much more affordable for SMEs if they are originated and purchased from a ring-fenced bank. In fact we believe that if businesses are unable to access simple risk management products from ring-fenced banks, then it is highly likely that many SMEs which want or need these products will not be able to access them at all. 1.4 Inclusion within the ring-fence for these products is desirable on the grounds of customer service and long term relationships. Particularly for smaller SMEs, the ring-fenced bank is likely to be the customer’s primary banking relationship. As per Santander UK’s relationship model in our corporate and commercial bank, this means that businesses across the country will have a local relationship director (or in the case of other banks, dedicated branch staff) who has taken time to get to know the customer and has a long-term interest in maintaining a close relationship with them. If an SME is forced outside the ring-fence to a wholesale or investment bank it is unlikely to be able to access the same network of local bank staff and certainly will not be able to deal with a bank or banking team that has the same relationship with it. 1.5 Inclusion within the ringfence for these products is desirable on the grounds of cost and access. When the ring-fenced bank holds the primary banking relationship with the SME, it is able to use collateral already posted for other banking services (such as a standard business loan) to act as security on the hedge. If these businesses were forced to go outside the ring-fence to procure these products (or even purchase them from a ring-fenced bank acting as agent for a non-ring-fenced bank in its group), they would either have to take short term unsecured products, or the non-ring-fenced bank would require cash-backed or carved our security packages. It is very unlikely that an SME would be able to provide these, effectively restricting them from accessing the products at all.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1611

2. Is it appropriate to permit ring-fenced banks to sell derivatives to customers when the “main” purpose is to hedge risks, rather than simply when the “sole” purpose is to do so? 2.1 Santander UK agrees that ring-fenced banks should only be permitted to provide derivatives which are designed to hedge a customer’s legitimate business risks. This is achieved by: (a) restricting the product set which is permitted within the ring-fence; and (b) linking that product set with the purposes for which it may be used by the customer. 2.2 While element (a) specified above is met by regulation 4(1)(b), Santander UK does not believe that regulation 4(1)(a) is the most effective way of delivering element (b) of this objective. 2.3 Given that the purpose for which a product is taken by a customer is ultimately defined by or known to the customer, there may be cases where the customer’s potential need for risk management products is ascertainable (eg a business exporting or importing goods or services is likely to have a need for FX products to hedge its currency risks), but the particular purpose of a transaction may not be clear to the ring-fence bank (eg the business enters into an FX product to hedge its currency risk on a particular order). 2.4 Santander UK recommends a revision of regulation 4(1)(a) so that it requires ring-fenced bank to only sell derivative products when it has reasonable grounds to believe that the use of those products is for risk management. This would remove the ambiguity around the concept of what a customer’s sole or main “purpose” is, which may not be fully knowable to a bank. It replaces this requirement with a much clearer and more realisable obligation on a bank to only sell derivatives to customers when the bank itself, in its own judgement, “has reasonable grounds to believe that the transaction would be used for the purposes of risk management.” 3. What challenges is the PRA likely to face in defining rules to assess the purpose of derivative transactions and does the draft secondary legislation provide a clear enough mandate to support such rules? 3.1 In line with our preliminary comments, Santander UK believes that it will be difficult to define rules in secondary legislation that will be sufficiently clear and flexible to be capable of practical application by a ringfenced bank to the specificities of each customer on a granular, transaction by transaction basis. Santander UK suggests that a preferable approach is a code published by the appropriate regulator to provide guidance to ringfenced banks on factors or principles which would support customer transactions being for hedging purposes. 3.2 Furthermore, as the language of regulation 4(1)(a) seems to centre on conduct risk, rather than the potential prudential and systemic risks that customer derivatives may pose to a ring-fenced bank, Santander UK suggests that the FCA is the more appropriate regulator to define any rules or code. 4. Is a restriction based on BIPRU 7.10.21(1) appropriate for limiting the provision of derivatives to simple products which serve the majority of SME needs? 4.1 Santander UK is concerned that a restriction based on BIRPU 7.10.21(1) would be much too restrictive to meet the needs of many SMEs seeking to hedge risk. We do not believe that BIPRU 7.10.21 gives an appropriate meaning to “simple” derivatives. 4.2 For instance, a restriction of this kind would prevent the sale of “vanilla options” and “Asian options”. Despite the complex names which these products are given in the FSA Handbook, they are all used by SMEs to manage different kinds of risk due to the additional flexibility and protection that they provide without adding undue complexity; both for the customer and the ring-fenced bank. 4.3 Below is an example of how each of these might be used by a customer to hedge its from foreign exchange risk: 4.3.1 Vanilla option (BIPRU 7.10.21(2)): A company which exports to a foreign currency zone, such as the USA, may use a vanilla option to give it certainty as to the rate in which it can covert its USA sales from US dollars into sterling. The company hedges the risk of exchange rate fluctuations before sales are made and so has to predict what the value of its sales over a fixed period will be. While a company could use a forward to guarantee the price it sells back US dollars (FX forwards fall under (BIRPU 7.10.21(1)), it could stand to lose significantly if it did not meet the projected sales target it set for itself at the outset (because it may have to buy back its oversold US dollars at a higher market rate). Unlike a forward, an option gives the customer a right to sell rather than an obligation to sell at a future date. A vanilla option guarantees a minimum value of the US dollar sales income while also limiting the cost to the customer to the premium of the vanilla option. 4.3.2 Asian Strike option (BIPRU 7.10.21(3)): This kind of option provides the same kind of protection to an SME customer as the example above. An Asian option is used by an SME or mid-cap company where the price at which they want to convert a foreign currency exposure cannot be defined at the outset of the contract, but rather needs to use an average over the course of a certain timeframe (usually an accounting year). For instance, this product might be used by a customer with a subsidiary or majority shareholding in an overseas firm. The profits of the subsidiary are in the local currency (for

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1612 Parliamentary Commission on Banking Standards: Evidence

instance, US dollars). The UK company may wish to notionally convert this profit to sterling in every month or every quarter to help it manage its business effectively. At the end of the accounting year, when the company wants to convert this US dollar profit into sterling, an Asian option allows it to convert the US dollars at the average exchange rate the business has been using over the accounting year. This means that the notional profit which the company took throughout the year is guaranteed, regardless of whether exchange rates change against it over the course of the 12 months. Like the vanilla option above, the Asian option guarantees a minimum value of the US dollar sales income while also limiting the cost to the customer to the premium of the Asian Strike option. 4.4 These are common and straight forward examples of how SMEs use hedging products. They also demonstrate that BIPRU rules are not an appropriate tool to implement a proportionate and workable ringfence. BIRPU is designed to ensure appropriate capital is held against market risk exposures, it is not designed to establish the types of risk management products that can be provided by a ring-fenced bank without threatening the stability or resolvability of that bank, or the wider integrity of the ring-fence. 4.5 For this reason, Santander UK recommends that that Clause 4(2) is redrafted so that it specifies clear principles for the provision of derivatives, and so that it is tailored to the objectives of the Banking Reform Bill. 4.6 Santander UK proposes the new Clause 4(2)(a) below:427 (2) The requirements referred to in paragraph (1) are: (a) the investment payout to the account holder is defined entirely by the movement in a single underlying instrument, per risk that is being hedged, This measure prevents complex OTC derivatives being offered that track multiple indices or underlying instruments per hedged risk. The market risk arising from a product that is defined by a single underlying per hedged risk is straight forward for the ring-fenced bank to hedge and easier to replace or novate in a resolution scenario. This kind of product is also simpler for a client to understand. (b) the investment payout to the account holder is in direct proportion to the movement in the underlying instrument (for FX products, payout as measured in one of the two currencies in the pair), subject to any pre-determined cap or floor, This measure ensures that only products with a clearly defined maximum notional exposure can be offered by ring-fenced banks and that products with higher power payouts are excluded. Products of this nature allow both the customer and the ring-fenced bank to have a clear understanding of the worst-case scenario from the outset, making both market and credit risk simpler to determine. (c) the investment agreement includes a fixed final date by which all currency notional exchanges or interest payments are completed, This principle ensures that a definite maturity date is known from the outset. Products with this characteristic are more transparent and straightforward for the client to understand and for the ring-fenced bank to hedge. (d) the risks arising from the investment can be managed by the ring fenced bank using liquid interbank instruments, and It should always be the case that products which follow points (a)–(c) above are able to be risk managed by the ring-fenced bank using liquid interbank instruments. Santander UK recommends that this measure is added to provide an additional safeguard and to ensure that the ring-fenced bank will be able to hedge its risk even in extreme market circumstances following a systemic shock. (e) there is evidence available to assess the fair value of the investment concerned in accordance with international financial reporting standard 13 (“IFRS 13”) on fair value measurement issued by the International Accounting Standards Board, as that reporting standard is amended from time to time, and that evidence would be considered to constitute a level 1 input within the meaning of paragraph 76 of IFRS 13, or a level 2 input within the meaning of paragraphs 81 to 82 of IFRS 13. See answer to question (5) below. 4.7 Santander UK believes that amending the Statutory Instruments with tailored measures such as these provide a high level of protection for the ring-fence. We also believe that these measures provide clear direction to the PRA, making the rules concise and durable, yet sufficiently flexible to ensure that they remain relevant as the market develops in the future. 427

The text in italics is explanatory notes for the purposes of this response.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1613

5. What will be the effects of the restrictions relating to evidence of the fair value of the investment, and how will it help address the Commission’s concerns? 5.1 Santander UK supports the inclusion of this measure and considers it to be an effective tool in protecting the resolvability and stability of the ring-fenced bank. 5.2 By being able to easily assess the fair value of the products, the ring-fenced bank is better able to hedge the risks arising from them. This adds to the stability of the ring-fenced bank. 5.3 The ability to assess fair value is also essential to protect the resolvability of the ring-fenced bank. In a resolution scenario, level 1 and level 2 products are easy to value and therefore easier to unwind or move to other institutions. 6. Is the proposed methodology for calculating a gross cap on the total of derivatives sold the appropriate one, and is it resistant to gaming? 6.1 Santander UK considers that the methodology proposed is appropriate for implementing a gross cap on derivatives that limits the quantum of products provided. 6.2 Given the simple, transparent and specific nature of the rules proposed, we believe that they will be highly resilient to gaming as they will provide the PRA and banks with very clear direction. 27 March 2013

Letter on behalf of Alex Wilmot-Sitwell from Mark Humphries Legal Letter relating to Question 2241 We acknowledge receipt of the transcript of proceedings for 10 January 2013 and now write with comments and corrections on behalf of Alex Wilmot-Sitwell. The following comment is of a general nature but it also relates specifically to Question 2241: Mr Wilmot-Sitwell was not asked questions during his evidence about his role and responsibilities and was therefore never given the opportunity to explain his role to the Commission. By this letter he therefore takes the opportunity to provide that explanation. UBS, like many banks, has both private side and public side businesses. Prior to becoming co-CEO of UBS Investment Bank, Mr Wilmot-Sitwell worked exclusively on the private (rather than the public) side of the business and therefore had no responsibility for the part of the business in which the LIBOR manipulation occurred (namely, the public side). Neither did he exercise any supervisory role in relation to that part of the business during that time. Following his appointment as co-CEO of the investment bank in May 2009, Mr Wilmot-Sitwell worked jointly with Carsten Kengeter. Mr Wilmot-Sitwell dealt with the private side of the business by way of an allocation of functions between the co-CEOs. With regard to issues of concern arising on the public side of the business, Mr Wilmot-Sitwell was reliant on those issues being escalated to his attention, since he was not involved in the day to-day management of the public side businesses. For the reasons that were very clearly explained in the evidence given to the Commission, none of the four former UBS CEOs who gave evidence to the Commission was made aware of the LIBOR manipulation at the time. In relation to himself, Mr WilmotSitwell made this clear in his answer to Question 2230. At Question 2241 when the Chair said: “Do any of you want to challenge any of that?” it was unclear to the witnesses at the time whether a question was being asked, not least because the hearing moved on immediately to a question about a different topic. The consequence of this is that it has been mis-reported that the witnesses acknowledged that they were incompetent. For the avoidance of further misunderstanding, we take this opportunity to clarify that Mr Wilmot-Sitwell does not accept any suggestion of any incompetence or negligence. Mr Wilmot-Sitwell stepped down as co-CEO of the investment bank in September 2010. We have reviewed the transcript of the hearing which was kindly provided to us. We would like to make the following corrections on behalf of Mr Wilmot-Sitwell: 1. With respect to Question 2202 on page 30 of the transcript, the transcript indicates that Mr Wilmot-Sitwell responded “yes” to the question; however, the question was put to all of the witnesses and the answer was actually provided by Huw Jenkins. 2. With respect to Question 2203, on page 30 of the transcript, the transcript states that Mr WilmotSitwell indicated assent to the statement in the question; however, Mr Wilmot-Sitwell did not respond to this question before the questioner moved on to the next question.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1614 Parliamentary Commission on Banking Standards: Evidence

If there is anything in our corrections above which is unclear, please do not hesitate to contact us. 18 January 2013

Letter from Antony Townsend, Chief Executive, Solicitors Regulation Authority I was grateful for the opportunity to provide evidence to the Parliamentary Commission on Banking Standards earlier this week. I hope our experience and approach as the largest regulator of legal services has been valuable in your consideration of proposals to regulate bankers. I am writing to provide you with the further information I committed to make available to the Commission. (1) The Commission was interested in the appointment and composition of the Solicitors Disciplinary Tribunal, the body to which we refer disciplinary cases. The Solicitors’ Disciplinary Tribunal is constitutionally independent of both the Solicitors Regulation Authority and the Law Society, the approved regulator, and is established by virtue of Section 46 Solicitors Act 1974. It is largely funded by a levy imposed by the Law Society. Its members are appointed by the Master of the Rolls and are either solicitors of not less than 10 years’ standing or lay members who must be neither solicitors nor barristers. There is no statutory limit on the total number of members of the Tribunal but at present it comprises forty solicitor members and twenty lay members. For the purpose of hearing and determining applications, the Tribunal members sit in divisions of three, comprising two solicitor members and one lay member. A solicitor is the Chairman of the division. We have no say in its composition; we are simply the prosecutor before the tribunal. (2) I was asked how many solicitors have been struck off or suspended. To give you an indication, I can confirm that from 1 May 2011 to 30 April 2012 52 solicitors were struck off. Reasons included misappropriating clients’ money, criminal convictions, grossly misleading clients and failing to discharge their professional duties honestly. In this time 18 Solicitors were suspended indefinitely, 29 Solicitors were suspended for one year or more and 13 Solicitors were suspended for less than one year. These were cases where the solicitor’s offences were very serious but were not considered sufficiently serious to justify permanent removal of a right to practise. In the case of an indefinite suspension, the solicitor may apply for the period of suspension to be brought to an end in specified circumstances. As I mentioned in my evidence, many cases in the less serious category do not get as far as the tribunal and can be disposed of by the SRA with appropriate sanctions. (3) One of the most important aspects of changing or putting in place a regulatory system is trying to identify what the drivers are that aid compliance. As I outlined in my evidence, the SRA undertook extensive research into attitudes to compliance in 2011. I enclose the full copy of this report as requested by the Commission. The research, involving 200 firms, highlights some important findings which may be helpful to the work of the Commission. The research found that firms accept the rationale behind regulation but a strong motivator for compliance is professional pride. Many firms accept regulation because of their pride in being part of the solicitor’s profession, and the role in regulation in upholding standards. The research found that the fear of reputation damage, and the denting of professional pride, appeared to be of greater significance than the risk of receiving a sanction, but for those not motivated primarily by pride, sanctions were an effective deterrent. (4) We will shortly be publishing the findings of follow-up research on this issue, to see if our new risk-based and outcomes-focused approach is beginning to percolate through the profession. As soon as this is published I will make it available to the Commission. 14 January 2013

Written evidence from TheCityUK Since the beginning of the financial crisis, many failings in the banking industry have come to light. Some involve the poor conduct or low standards of employees, institutions and the industry as a whole. These failings have had a particularly significant impact due to the importance of financial services to the UK economy. The banking sector has recognised these failings in conduct and standards and has identified five main reasons why these occurred: — Accountabilities at Board level were unclear. This resulted in weak governance structures, lack of oversight and visibility at the “top of the house” and insufficient checks and balances for executive management. This was especially true with regard to risk appetite and risk, capital and liquidity management. — Risk and Control functions were not always sufficiently independent, powerful or resourced to appropriately influence strategic decision-making or day-to-day behaviour. This resulted in excessive risk-taking at some banks.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1615

—

Remuneration structures for senior managers and risk-taking employees at some institutions allowed cash bonuses to be awarded and vest on the basis of short term financial performance, resulting in a misalignment of incentives between employees and external stakeholders.

—

Certain institutions and individuals lost their way in terms of acceptable ethical standards. At its height this was a fundamental cultural failing in the industry.

—

Punishments for breaches of conduct or standards—both internal (applied by the institution) as well as external (applied by the supervisors)—often lacked teeth, with very few penalties limited to the extremes of “job loss” and “individual legal action” for individuals; pre-crisis, the financial penalties for institutions were relatively low.

The banking industry is determined to address the failings and has therefore been making efforts to improve standards and conduct. Many of these efforts have been prompted or supported by the range of legislative and review findings and recommendations since the financial crisis, and are aligned with the direction of travel that the Commission has indicated that it wishes to see. We point to the following areas where progress has been made over the last five years: —

Improved Board governance and oversight since the 2009 Walker Review of Corporate Governance, coupled with greater emphasis on the “stewardship” role of Boards and their shareholders.

—

More independent, larger, more influential and better equipped Control functions.

—

More appropriately structured executive and front-line remuneration.

—

Increased transparency for shareholders, bondholders, regulators and customers.

—

Tougher penalties for breaching standards.

—

Improved core business practices (training, whistleblowing, sales and product approvals).

—

Product simplification, particularly in wholesale markets.

It is reassuring to see that the steps taken are widely considered key to improving standards, as evidenced by them repeatedly being reflected in evidence put before the PCBS. However, it will take time before the full benefits of the above will be completely realised. There remains further progress to be made across several of the above dimensions (noting that some banks have more to do than others) and it will be key when looking at next steps to recognise this, while reinforcing the progress already made. In this regard we request that the Commission: 1. Provide a balanced review—recognise progress made thus far, as well as the many failings. 2. Consider how a “charter for bankers” may practically raise standards in institutions which have to operate at a global level. 3. Recognise that poor financial outcomes for customers do not always equate to poor standards; many banking products involve risk for both parties. 4. Differentiate between markets (particularly between retail and institutional clients) and recognise the diversity of banks (particularly differences between non-UK and UK domiciled banks) in the UK banking sector. 5. Augment and complement (rather than replace) the recommendations of the Walker review and consider the potential impact of UK regulatory super-equivalence on competitiveness. 6. Support the role of the FCA, keeping realistic expectations as to what can and cannot be achieved through regulation alone The issues outlined above focus on the banking industry, but the proposals and recommendations in this letter are informed from the experience and approaches of UK financial institutions more broadly. All of the above should be considered in the context of the UK as a global financial centre. As noted in both The City of London Corporation and TheCityUK submissions to the Commission (23 and 24 August respectively), a strong financial and professional services sector, enjoying confidence and trust, are key to the UK’s future prosperity. This is further evidenced in TheCityUK review “UK competitiveness in financial services” (9 November). When conducting its deliberations, we encourage the Commission to be mindful of the international competitiveness of the sector and its position as the nation’s leading net export earner contributing £47 billion to the Exchequer last year, its role as a major employer employing 2 million people across the UK (two-thirds outside London), and the fact that it has many aspects that extend well beyond banking, such as insurance, asset management and investment. We believe the Commission is timely, as it offers a chance to look to the future of financial services, clarifying the changes already made and underway, and highlighting the role the sector plays in helping our nation’s economy prosper. We consider it critical that the sector, its regulators, its customers and clients focus on the future. Our vision is for the sector to put the unhappy past behind it and move forward in doing all that it can to grow the economy and to help businesses and individuals to thrive.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1616 Parliamentary Commission on Banking Standards: Evidence

Introduction This letter is a submission to the Parliamentary Commission on Banking Standards on behalf of TheCityUK and The City of London Corporation addressing the topic of standards and conduct in the UK banking sector. It does not address issues relating to the draft Financial Services (Banking Reform) Bill: — TheCityUK is a national membership organisation representing the UK’s financial and related professional services sector. Our members are drawn from across the banking, insurance, asset management, legal, accountancy and other related areas of a sector which employs two million people. Our purpose is to promote and explain the role and value of the sector in society and the economy, and to promote the sector abroad. — The City of London Corporation is the elected governing body for the City of London that promotes and supports the UK-based financial services industry, as well as providing a wide range of services for the City, London and the nation as a whole. This letter has been signed off by TheCityUK Advisory Board. To inform the content of the letter, senior executives and non-executives from 11 financial institutions (comprising UK domiciled banks, the UK operations of non-UK domiciled banks and other UK-based nonbank financial institutions) have been interviewed on a non-attributable basis. The issues covered in this letter focus on the banking industry, but the proposals and recommendations are informed from the experience and approaches of UK financial institutions more broadly. This letter seeks to highlight the progress that has been made in the three years since the Walker Review and how the sector continues to try to address the root causes of past failures. It recognises that much work is yet to be done, with some banks having made more progress than others, and outlines some of the challenges facing the industry in doing this. It recognises and welcomes the support and guidance that the Commission is anticipated to provide, and makes several overarching suggestions for the consideration of the Commission. The letter is structured as follows: — Progress made since the Walker Review (2009). — Suggestions for the Commission. Progress made since the Walker Review (2009) Since the Walker Review of Corporate Governance was published in 2009, UK banks have made significant progress implementing its recommendations. In parallel, UK banks have recognised the need to go further than the Walker recommendations to address broader issues relating to business conduct and standards. While good progress has been made, the process of adaptation and learning is continuous and banks are making efforts in several areas to meet the expectations of their stakeholders, with some banks further along the journey than others. In this section we outline some of this recent progress on conduct and standards, and identify areas for future attention. We divide the discussion across seven main themes: 1. Board governance and oversight. 2. Risk and Control function design and application. 3. Remuneration and performance management. 4. Information and transparency. 5. Tougher sanctions. 6. Core (conduct-and-standards-related) business practices. 7. Product simplification. 1. Board governance and oversight The ability of the Board to monitor, assess and manage key risks is vital to the development and maintenance of high standards and appropriate conduct in banking institutions. The Walker Review made a number of recommendations regarding both Board size and composition and Board functioning and performance. The G30 report “Toward Effective Governance of Financial Institutions” published in April 2012 has brought further clarity to the role and operation of the Board. Since the Walker Review, Boards of UK banking institutions have implemented considerable change. Notably, non-executives are now committing more time to their role and are in a better position to provide oversight and challenge given more experienced and knowledgeable backgrounds in financial services. Boards are supported by senior committees with clear roles and responsibilities and more timely and relevant information. Distinct Board-level Risk Committees (BRCs) are commonplace (all major UK banks now have distinct BRCs) and exert greater influence. They are supported by new executive-level committees, such as Reputational Risk Committees, with specific mandates to ensure appropriate business standards and ethics. In short, the structures and resources required for effective Board level governance have been reinforced and Boards are better able to oversee and challenge the executive.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1617

It is recognised that Board governance and oversight could be improved further. First, better focused reporting (recognising the significant advancements already made) would facilitate greater levels of insightful challenge and scrutiny, supporting debate between executives and non-executives. Banks are continuously evolving Board-level reporting, especially with regard to risk. Second, new governance structures are still bedding in and the specifics of roles and accountabilities are being worked through to establish the most appropriate and effective governance frameworks. Banks face challenges regarding Board governance and oversight. First, under current ring-fencing proposals (which are also under review by the Commission), UK banks will have separate Boards and governance frameworks for the two ring-fenced entities. Establishing separate governance processes with roles and responsibilities appropriately delineated will not be straightforward. Second, it is important but increasingly difficult to strike the right balance between ensuring adequate Board oversight and taking Board engagement so far that imperils the independence of the Board. It should also be recognised that non-executives remain to a large extent dependent on the executive directors, internal audit and external auditors, so need to pay particular attention to the calibre and culture of those groups. The increased expectations, accountability and scrutiny for a non-executive in financial services could make the role less attractive to quality candidates. Third, foreign banks with subsidiaries operating in the UK need to comply with UK governance requirements as well as regulations in their domiciled countries. Any legislation reinforcing UK governance structures should avoid making cross-geography governance too complex and burdensome for non-UK banks. 2. Risk and Control function design and application Within many UK banks, significant change has been made to the size and importance of control functions such as Risk, Compliance and Audit. There has been heavy investment by banks in people, tools and infrastructure, with checks and controls in place for processes such as planning and product design. For example, for 5 participating banks, the proportion of UK staff that are in control function roles has increased by over 25% since 2007.428 Aside from increased scale, the independence and the influence of the control functions has improved. For example, at the largest five UK banks, the CRO is part of the Executive Committee and has direct reporting lines into both the CEO and the Board Risk Committee. This is supported by clearer reporting lines and better articulated roles and responsibilities within the function. The tools on which risk and control functions rely have been bolstered. In particular, better articulated Boardlevel risk appetite statements (the declaration of how much and what types of risk an organisation is willing to accept in the pursuit of returns) are now established at most banks. Banks are now working to cascade these risk limits throughout the organization, embedding risk appetite into core business practices and decisions. In addition, many banks have significantly upgraded the quality of risk reporting and systems, with focus on more holistic coverage of risks, more metric-based information and more timely data provision. Risk management and governance can be further improved in the following ways: — Ensure that there is a clear articulation of responsibilities and accountabilities for operational risks (including conduct and reputational risks) across the three lines of defence (the business, the control functions, and internal audit). — Ensure that risk appetite “bites” in all aspects of front-line activity. Many institutions are attempting to better articulate their appetite for conduct and reputational risks. — Continuous improvement of the timeliness, accuracy, insightfulness and relevance of risk reporting. The better reflection of non-financial risks such as operational risks, conduct risk and reputational risk is a particular focus. — Banks are tackling the challenge of defining and establishing an appropriate “risk culture”. For example, several banks are conducting internal independent cultural reviews to better understand how their risk and control culture influences behaviour and outcomes. Their ambition is to articulate the desired risk culture and ensure that it is appropriately embedded into the organisation through incentives, training, recruitment, communications, and performance management, etc. 3. Remuneration and performance management There has been a recognition that financial incentives and rewards must promote the right behaviour and culture, as promoted by regulations, including the Walker Review, the Capital Requirements Directive (CRD) and the FSA Remuneration Code. Consequently, there has been significant change in the way employees are financially rewarded, particularly for senior managers and risk-taking employees. The remuneration structure of senior managers is now broadly consistent across banking institutions. All have fixed and variable components. Variable pay has been reduced as a proportion of total compensation. The majority of variable compensation is paid in long-term incentives and deferred payments, with deferred 428

“Control functions” include Risk, Compliance, Internal Audit and Legal functions. UK control function FTE as proportion of total UK banking FTE: 2007: 3.7% 2011: 4.6% (increase of 26%)

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1618 Parliamentary Commission on Banking Standards: Evidence

payments typically vesting after periods of approximately three years. The majority of variable compensation is paid in stock and subject to risk-adjustment. Deferred portions are subject to “malus”; deferred but unpaid compensation can therefore be clawed back if performance targets or behavioural standards are not met. Compensation for frontline Wholesale banking staff has changed dramatically. As with senior managers, fixed pay has increased as a proportion of total compensation and variable pay is deferred and subject to malus. Cash remains a key element of deferred compensation, but the use of equity continues to increase. Guaranteed bonuses for new hires are used very rarely, and only to attract key new hires who have large outstanding deferred payments due with existing employers. Such appointments require Remuneration Committee approval and are significantly reduced. Multi-year guaranteed bonuses have all but disappeared. Pay structures of frontline retail banking branch and telephony staff have also been subject to scrutiny. Following the 2012 FSA review of frontline retail remuneration schemes, many major banks have changed frontline compensation structures, increasing focus on conduct risk gateways, higher weightings towards customer service metrics and removing incentives for sales volumes. Further refinements will be made as tradeoffs between network performance and reward structures are better understood. Remuneration structures are defined by committees and driven by performance management frameworks. The Board-level Remuneration Committee defines the organisation-wide principles for compensation, review and challenges significant compensation rewards, and sets and approves risk-adjustment mechanisms (with guidance from the Board Risk Committee). There is a greater emphasis on performance management as a means to influence behaviour. The trend is towards more frequent and more detailed appraisals and reviews with a strong focus on conduct and standards. Progress on this varies between banks and most do not yet employ the best practices. It is broadly recognised that the changes made to remuneration structures and practices are good for the banking industry. However, work remains to be done: —

There is still a large divergence in the methodology and robustness of risk-adjustments to compensation between banks. Most banks risk-adjust the total variable compensation pool. However, due to data and systems constraints, banks find it difficult to cascade risk-adjusted performance metrics beyond product lines, and metrics are not always consistent and robust. Improved systems and more granular metrics are needed to ensure risk is better aligned with remuneration.

—

Linking pay to individual performance remains a challenge. For example, malus is typically dependent upon group-wide—as opposed to individual—performance; the value of equity rewards are subject to external factors; and drives to increase fixed pay decrease the “bite” of variable or deferred rewards.

—

Increased fixed pay as a proportion of total compensation increases the fixed costs of banks, leaving less flexibility to manage costs in times of poor returns and, hence, increasing risk.

—

Large deferred pay components reduce staff mobility within and across firms and, hence, reduce the efficiency of the financial services labour market.

—

CRD IV proposals to cap variable pay as a proportion of fixed salaries are still being debated. Opposition to the proposal has arisen due to potential impacts on fixed costs, reduced cross-firm mobility, and restrictions on the ability to reward outperformance.

It should also be noted that questions still remain about absolute levels of compensation which are subject to much public and regulatory scrutiny and discussions continue about the appropriate sharing of rewards between shareholders and employees. 4. Information and transparency Increased levels and frequency of disclosures, especially around the risks taken by institutions, have resulted in better information and greater transparency for external stakeholders, including customers, shareholders, bondholders, regulators and rating agencies. There is also some evidence of increased investor engagement (eg “The Shareholder Spring”), following upgrades to the FRC Stewardship Code and a greater willingness from bank executives and non-executives to engage with investors. Increased information and transparency can be beneficial. It enables industry analysts—and, therefore shareholders and bondholders—to better understand institution-specific dynamics and risk profiles. Increased dialogue and information flows to regulators enable them to identify risks ex ante, and improved dialogue with investors can act as a check on management actions and behaviour. However, there are challenges with increased disclosure: —

Ensuring consistency across banks is difficult (often due to organisational structures and legacy data storage systems).

—

Not all users of information are able to interpret and use new information properly; there is a risk of information being misinterpreted by less sophisticated stakeholders, which could impact reputation or the stability of a bank.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1619

—

Significant senior management time can be taken by investor interactions and regulatory liaison, diverting attention from day-to-day business matters.

Increased information does not always translate to improved transparency. In order to increase transparency, the Enhanced Disclosure Task Force (EDTF) have recently published recommendations for developing highquality, transparent disclosures. These address a bank’s business model, the key risks that arise from this and how they are measured, a bank’s liquidity position, the calculation of RWAs, the relationship between market risk measures and the balance sheet; and the relationship between a bank’s market risk measures and its balance sheet. 5. Tougher sanctions Personal responsibility for failures in standards is increasingly clear and severe for those working within the banking industry. This is true of sanctions applied by institutions as well as supervisors. This has been seen in some recent high profile cases involving senior managers and in many lower profile cases. Sanctions placed on banks for failures in standards (eg PPI redress and LIBOR) are also much more severe than pre-crisis, when financial penalties for institutions tended to be small. This is supplemented by increased discipline underpinning the FSA approved persons register. This ensures that those performing a controlled function (ie roles with particular regulatory significance) have sufficient experience and expertise to perform the role and will do so in accordance with a set of standards. There is open, positive discussion about the potential benefits and practical application of a “charter for bankers” for all banking employees. There are different ways in which such standards could be established which would influence the success of the initiative. Creating clear rules, guidance and/or training to avoid equivalent but opaque processes would be beneficial, but it will be important to avoid overlap or dilute existing approved persons frameworks. 6. Core (conduct- and standards- related) business practices Standards and conduct considerations increasingly influence the way business is conducted within banks. For example: — Mandatory compliance and conduct training have been significantly increased. — Most banks have introduced a more stringent product approval process. This typically includes the requirement for authorisation from a senior Reputational Risk Committee before products can be launched. — Some banks have conducted front-to-back sales process redesigns for frontline retail banking sales activities to mitigate the risk of mis-selling liabilities. — Improved whistleblowing mechanisms are in operation in both banks and the regulator. — Many banks are recognising the importance of a robust culture that supports prudent decision-making and good conduct, from the “tone at the top” to front-line staff. A number of banks have commissioned reviews to better understand and identify steps to strengthen their own culture. The creation of the Financial Conduct Authority (FCA) as part of the twin peaks regulatory framework will be a major influence in the future. The FCA has been established to “protect and enhance confidence in the UK financial system”. Early indications are that the FCA will be more interventionist and pro-active on conduct-related themes than the FSA has historically been. They are likely to require improved and more consistent use of support mechanisms, such as processes, training and management supervision to ensure that all decisions are taken with the appropriate consideration for standards and ethics. Banks will need to adapt to the new regulatory approach and work closely with the regulators to implement further changes to governance, standards and processes. It is hoped that these will be introduced mindful of the global context and the benefits of striving to achieve an international level playing field which will, over time, offer consistency and stability. 7. Product simplification The inherent complexity of the UK tax structure and customers’ desire to protect against uncertainty (eg interest rate or exchange rate movements) will always create a base level of demand for some complexity in financial products. However, banks have taken steps to begin to simplify product structures to make it easier for customers to make informed decisions about the products they are purchasing. For example, in retail banking, some banks have withdrawn parts of the packaged current account range to ensure that all products represent good value to customers. Another example is the drive towards simplification of overdraft fees and charging structures. In wholesale banking, the shift towards flow products is in part driven by simplicity considerations. Furthermore, Basel III will increase capital requirements for complex illiquid or structured products. There is further to go to reduce product complexity and ensure that all products offer customers a fair value exchange and that all are suitable for the customer. We welcome the creation of the FCA, and anticipate that

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1620 Parliamentary Commission on Banking Standards: Evidence

the recommendations from the Simple Financial Products Steering Group and increased competition in the retail banking market will support the continuation of the current trend towards reduced product complexity. Suggestions for the Commission We have identified the following themes as having relevance when considering governance issues, and request that the Commission take these into account: 1. Provide a balanced review. We hope that, alongside an objective analysis of the historical and current failings in the industry, many of the above areas of progress will be recognised by the commission and given time to take effect 2. Consider how a “charter for bankers” may practically raise standards in institutions that operate globally. A poorly structured “charter” could do more harm than good. If it duplicates other similar lists (eg the FSA approved-persons list), then this is unlikely to be useful. We understand the BBA will be coming forward with specific points on this matter. 3. Avoid ex post revisionism. Certain outcomes cannot be guaranteed for customers: many financial products will have uncertain outcomes and it is important to recognise that some unfavourable outcomes (eg base rates rising during the term of a variable rate mortgage or base rates falling during the term of a fixed rate mortgage) do not directly equate to a failure in banking standards. For banks to continue to fulfil the role of financial intermediation, they need ex ante regulatory, surety not ex post revisionism 4. Differentiate between markets and between banks. It is important to recognise the difference between retail customers and institutional or market counterparty clients. The sophistication of different types of customers varies dramatically and the approach to “conduct” beyond universal ethical principles (eg regarding burden-of-proof compliance requirements, relevance of caveat emptor principles, acceptable levels of product complexity etc.) needs to be tailored accordingly. It is also important to note the different structures of banks operating within the UK, the different degrees to which institutions have made progress with regards to governance and conduct in recent years, and the implications for regulatory cross-over between UK and non-UK regulations 5. Support the Walker review. We believe that the Walker recommendations are being acted upon and provide a solid foundation upon which new regulation should build and support rather than replace. We also believe that the impacts of UK regulatory super-equivalence on competitiveness should be carefully considered 6. Support the role of the FCA. The new twin-peaks UK regulatory environment is a major change. The FCA has the potential to be a force for good in the industry by providing a more focused view on conduct and standards issues. We believe this should be supported by the Commission, with realistic expectations as to what can and cannot be achieved through regulation alone. The FCA will lack the resources to investigate all idiosyncratic instances of failings in conduct and standards and therefore it is important that the Commission support the development of an appropriately defined mandate to that effect. We also recognise the importance of prudential supervision for the sector as a whole. All of the above should be considered in the context of the UK as a global financial centre. As noted in both The City of London Corporation and TheCityUK submissions to the Commission (23 and 24 August respectively), a strong financial and professional services sector enjoying confidence and trust are key to the UK’s future prosperity. This is further evidenced in TheCityUK review “UK competitiveness in financial services” (9 November). When conducting its deliberations, we encourage the Commission to be mindful of the international competitiveness of the sector and its position as the nation’s leading net export earner contributing £47 billion to the Exchequer last year, its role as a major employer employing 2 million people across the UK (two-thirds outside London), and the fact that it has many aspects that extend well beyond banking, such as insurance, asset management and investment. 15 January 2013

Written evidence from Theos Theos—The Religion and Society Think Tank Theos is a think tank working in the area of religion, politics and society. We aim to inform debate around questions of faith and secularism and the related subjects of values and identity. Theos conducts research, publishes reports, and runs debates, seminars and lectures on the intersection of religion, politics and society in the contemporary world. We also provide regular comment for print and broadcast media. In addition to our independently driven work, Theos provides research, analysis and advice to individuals and organisations across the private, public and not-for-profit sectors. Theos was launched with the support of the previous Archbishop of Canterbury and the Cardinal Archbishop of Westminster, but it is independent of any particular denomination. We are a mainstream Christian

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1621

organisation, committed to the belief that religion in general and Christianity in particular has much to offer for the common good of society as a whole. We are committed to the traditional creeds of the Christian faith and draw on social and political thought from a wide range of theological traditions. We also work with many non-Christian and non-religious individuals and organisations. Paul Bickley is Theos’ Senior Researcher and Director of Political Programme and is the author of several Theos publications. He has a background in political research and public affairs and holds an MLitt from the School of Divinity at the University of St Andrews. Nick Spencer is Theos’ Research Director. He has previously worked as Research Director at the London Institute for Contemporary Christianity, researcher for the Jubilee Centre, and, before then, as a researcher and consultant for Research International and The Henley Centre. He is a Visiting Research Fellow, at the Faiths & Civil Society Unit, Goldsmiths, University of London and is author of Rebuilding Trust in Business: Enron and Beyond. Summary — A false distinction is made between regulatory, structural and cultural change of the banking system. Cultural change will result when the interests of shareholders, employees and the general public are appropriately aligned. The public interest needs to be structurally recognised. — The duty of bank directors to act in the interest of their shareholders is part of common law, and now statute law (Section 172, Companies Act 2006). The public utility function of the banking sector has been assumed, rather than recognised in statute. Where these roles conflict, directors have failed to recognise the public interest. — The shareholder/director relationship in a bank is unlike other limited companies. Shareholders suffer a massive informational disadvantage—capital allocation decisions are too frequent and rapid for shareholders to track and value and major banks are far too large and complex shareholders and non executive directors to exert any strategic traction. — Employees are insufficiently exposed to the risk of their own capital allocations. In order to avoid shorttermism, action needs to be taken to ensure that rewards have a horizon which matches the considered interests of shareholders. — We are concerned that competition will be seen as a panacea. Competition can have negative outcomes when it seeks ends other than the common good. Competition is not only too narrow but also too monochrome—we don’t need more entrants offering the same kind of services, but more diverse entrants offer more relational and local services. — We submit that banks are probably too large to govern prudentially, and that scale results not in economies but in greater complexity, uncertainty and regulatory convolution. Introduction—The Cultural Problem The ongoing discussion around values and culture is beset by uncertainly about the ways in which change might be achieved. Compared to applying leverage ratios, capital requirements, and stronger regulation, corporate culture seems indefinite. We want people to behave better, but how does that happen? Most attempts to address the challenge of distorted banking cultures offer a persuasive diagnosis of what went wrong, followed by a restatement of the need for ethical behaviour. Such critiques don’t take account of the plethora of influences present in the ecology of any business, all the more so with large and complex institutions like multi-national banks. Too often, “values” have been seen in the abstract—purely a matter of what people think and believe to be good or acceptable, rather than the habitual practices, cues, incentives and accretion of decisions over a that over time shape, re-shape and potentially distort, culture. The debate is at risk of making a false dichotomy between hard changes (structure, governance, incentives on the one hand) and soft changes (around culture and values on the other). This is not to say that deliberation and thinking about culture and ethics is not necessary. It is to suggest that tangible changes should be made to change how employees and managers view risk, agency and accountability within the financial services. We propose adjustment under three headings—addressing the issue of banking purpose, questioning the role of competitive pressure, and changing culture in the context of size and complexity. *** 1. Addressing the issues of ownership and purpose a.

As has been widely observed, the gradual change from banks being privately owned to publicly trade companies has created misaligned interests in the banking sector. Under Section 172 of the Companies Act the primary legal duty of any company director has been to “act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1622 Parliamentary Commission on Banking Standards: Evidence

b.

c.

d.

e.

f.

whole” (while having “regard” to other factors).429 The benefit of members was understood at time of the Act’s passage to refer mainly to the financial interests of shareholders, albeit those interests considered over time. In short, bank directors are tasked with ensuring a return on equity for investors. Whether in the medium term they have been successful in doing this is, of course, now in doubt. Meanwhile, the public utility function of banks has been assumed, rather than recognised in law. Section 172 (2) of the Companies Act provides for the existence of companies that have a purposes other than the benefit of members. Ironically, this describes banks precisely, but both culturally and legally they have been assumed to be a company like any other. We have assumed that this dual role (providing profit for investors and financial plumbing for the economy) could be reconciled. In fact, they have not. The services that banks provide to the broader economy (safeguarding deposits, operating payment systems, channelling savings to productive investment) have been damaged by attempts to maintain or increase profitability (and thus value of equity and size of the bonus pool) by over-leveraging, entering more esoteric markets, or indeed by engaging in profitable and legal but socially questionable activity (eg, advising corporation on reducing their tax burden). At times they have acted against the public interest. In terms of behaviour which led both to the banking failures since 2008, as well as further malpractice, responsible shareholding (as well as responsible management) should have acted as a brake on the changing culture of the sector. Why did shareholders exert so little influence in this period? Although treated as limited liability companies, there are a number of ways in which banks are unlike other corporations. As well as being essential to the wider economy in operating payment systems, and extending credit through the wider economy through fractional reserves, the relationship between shareholders and senior managers in a bank is almost completely different to that of other corporations. In the latter, major capital allocation decisions are made by a small team of senior managers on a (relatively) infrequent basis, and can be (relatively) easily understood and their value judged by shareholders over time. That investment is then usually illiquid, and any returns are measured over a reasonable period of time. In banks, however, large numbers of employees tend to be involved in repeated, short term investments in rapidly moving markets where prices and profits are measured daily. Employees are able to point to profits as a measure of skill (and hard work) in capital allocation, and demand a high proportion of the gains. Senior managers also depend on this narrative to justify their own remuneration. In view of the implicit state guarantees, employees and senior management are not exposed to any downside risk. This is the context where a culture of excessive risk taking, high reward for low value activity, and disdain of long term investment emerged.

g.

In the equity markets, horizons have also shortened.430 Shareholders and intermediaries are liable to let banks get on with doing what they like with their capital, accept that employees deserve to keep a high proportion of gains and assume that their legal duties of directors have been met. In short, they have not understood that a wider view of their own interests may run against short-term profitability. Limited liability shareholding compounds this detachment of shareholders from the business. They may loose the value of their investment, which may be substantial and serious, but there is no motivation for them to seek to influence anything other than the profitability of the bank. Indeed, owners and their intermediaries usually try and avoid the risk of a concentrated stock, and again their influence is diffused. In the context of banking understood as an economic utility, in which the wider stake of society must be represented, we must ask whether this detachment is acceptable.

h.

Increased shareholder engagement or activism has often been seen as one way to correct the culture of the banking system. There are obvious barriers to this, even beyond those set out above. Even in existing mutual institutions, there are clear power imbalances between shareholders (even those who are wary, public spirited and sufficiently large to exercise influence) and boards. In the large combined high-street and investment banks, all the more so. Even large institutional investors of good will have neither the information nor skills to act as a brake on the interests of employees and boards.431 Non-executives, who exist theoretically to protect the interests of shareholders, have seemed similarly under-skilled in understanding the plethora of activity taking place and, again, were prepared to accept stable returns on equity as evidence that the bank was being run in the interests of shareholders.

i.

In view of the above (i) We should consider how banks can be structurally engaged with the notion that they have an important public purpose, and that as well as being bound by legal and fiduciary requirements for

429

The Companies Act 2006 only came into force in 2007, and thus it may be argued that it is irrelevant to any crisis inducing behaviour, which must have become embedded in advance of this date. However, Section 170 (4) suggests that “general duties shall be interpreted and applied in the same way as common law rules or equitable principles”, apparently in response to concerns about establishing possibly inflexible statutory general duties. The Companies Act effectively set common law with regard to duty to shareholders on a statutory footing, while also having the policy intent of establishing that corporations should not be run regardless of the interests of other stakeholders or with a view to short term profitability alone. 430 As the Kay Review identified, the equity markets in general lean towards “exit” (sale of shares) rather than “voice” (exchange of views) and the means of shareholder engagement, and increasingly emphasise trading rather than investment. They favour anonymous traders over a concerned investor. 431 Nor, in spite of claims that Section 172 was a radical new departure, substantial legal footing on which shareholders can take action.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1623

the members of the company, they are also bound to consider the common good. Academics have argued that Section 172 does not seem to have substantially changed the activity of directors, and indeed that its primary function is educative. Statements of purpose are also helpful in setting the tone. (ii) Can shareholders be helped or encouraged to engage more substantially in corporate governance? The role here of non-executives needs to be reconsidered. Given the size of complexity of banks (see point 3), they are unlikely to be able to exercise strong oversight without greater external assistance. Could banks be obliged to offer customer groups representation on boards, offering greater recognition of the ecology of interests in seeing banks profitably but wisely run. (iii) Ultimately, a series of factors have coalesced to allow individuals within the system to act for significant personal gain without risk of personal loss. Remuneration, at the minimum, needs to be re-focused to long term profitability as well as being adjusted for risk. This need not be seen as a moralistic censure against banker greed, but to accept that if that financial incentives are significant, then they should not be so structured as to incentivise short term investment which put institutions and financial stability at risk. 2. Questioning the role of competitive pressure a.

In a market environment, the prevailing assumption is that competition between similar businesses will give customers greater power and result in a more efficient allocation of resources. These lie behind the Vickers Commission’s proposals to make it easier to switch personal and small and medium sized business accounts. However, as the Vickers Report (albeit briefly) acknowledges, competition can—depending on the prevailing values and ethos of the sector, an institution or a part of a bank—have negative outcomes. In the pre-crisis period, for instance, it led to excessive leverage in order to maintain return on equity as returns on assets fell.

b.

Debts, deposits and loans are not simply commodities traded at an isolated point in time, but ongoing relationships built around mutual trust. Nor are they necessarily an equal partnership—banks have a far greater level of knowledge than almost any customer, and wield considerable power over borrowers who may depend on their services. Customers could and should be able to move personal and SME accounts more easily, but it is not so easy to envision how this might apply to pensions, mortgages, or a host of other financial services. In any case, freedom to leave is not the same as the opportunity to seek redress. By analogy to the John Kay’s point about equity markets emphasising exit over voice (see footnote 2 above), will enabling customers to move more easily result in a significant improvement in customer service? Or will it in fact just result in more moving of banking accounts between providers who may or may not offer marginal improvements? Or with banks offering incentives to encourage customers to move?

c.

Similarly, if the culture is already formed around the desire to maintain a bonus pool, to maintain share price, and to provide high dividends for investors (ie, if those are the things that are valued) then competitive pressure will create activity around activity around those goals, not in the interest of the customer. Without addressing the sector’s understanding of its fundamental objectives (ie, it is not a primary business, but a service and utility sector), then increased competition will have some positive, but perhaps largely negative effects.

d.

The Vickers Commission recommended broadening competition, making space for new market entrants. But competition is not only too narrow, it is also too monochrome. Customers should be able to switch easily, but they should also have avenues for greater involvement, relationship and control—a factor of banking on a smaller scale. The issue is not just the number of competitors, but the kind of banking service on offer. Bolstering the position of smaller—possibly regional—banks, operating a partnership model, would mean that owners could exercise greater and more effective oversight. Improving the offer of credit unions, peer-to peer-lending, genuinely open mutuals or even faith-based banking would create more dynamic competition in the sector.

e.

Regional banking would in turn address structural problems in the economy overall, which include a lack of capital to support SME’s in the regions. Local banks, established with the explicit purpose of supporting local economies, would be more able to take informed investment decisions, filling a gap in the market that has been vacated by the big high street banks, who have relied on impersonal central credit control models to govern regional lending. Quantitative Easing has effectively been used to rebuild the balance sheets of major banks, while the stock of lending to large businesses and SMEs continues to fall. Creating and endowing regional banks, providing a supply of credit to businesses in areas that have relied heavily on public spending to secure the local economy.

3. Culture in the context of size complexity and uncertainty a.

Investment banks are large and complex—often incorporating departments or activities which for regulatory reasons must be kept separate. In 2012, Barclays had over 150,000 employees worldwide. Lines of accountability are often muddy. The very fact that directors have claimed that, in cases of malpractice, they did not know what was taking place indicates that banks are too large. Non-executive directors and shareholders are massively disadvantaged in tracking and overseeing the range of activity across an institution. They are probably too big to govern prudentially.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1624 Parliamentary Commission on Banking Standards: Evidence

b.

c.

d.

e.

This makes talk of a single culture of standards impossible. Banks of any size or complexity will have a number of cultures, and a variety of standards. Redressing the imbalance between the prevailing trading/ investment culture, and the customer and relationship focused culture, will no doubt help. We should not, however, imagine that it will resolve all problems. In addition to this, the basic business of investment banking, while not inherently speculative, is inherently uncertain. Bad outcomes are highly possible. Logically, this should lead to a high degree of caution. However, given the lack of job security in investment banking, this very uncertainty drives a mentality of short-termism and leveraged speculation. Again, the skewed payoff to employees (exposure to losses is capped at zero, exposure to upside is unlimited) creates incentives which are counter to the interests of shareholders and society as a whole. Conversely, there is no consensus on the relationship between a bank’s size and efficiencies of scale, and any that do exists must be balanced against the considerable inefficiencies associated with managing and regulating complexity. Scale is a problem on so many levels that attention should be given to addressing this. This will partly be through lowering barriers for new and alternative entrants, but whether this can be done while large multinational banks that still enjoy and implicit subsidy still dominate the market must be open to question.

Conclusions The cultural problems in banks arise not just from changes in societal values, but from the interaction of a range of issues around structure, incentives and size. Changing culture is a daunting prospect, and it is always easier to will the ends than it is to define the means. Above we have outlined three themes under which concrete action could be taken to change the culture of the banking system overall. We need to look for a realignment of interests—and particularly a structural recognition of the public interest in the effective operation of the banking system. We need to make sure that there is not just more competition, but more diversity and less uniformity in the banking sector. Finally, we need to ensure that banks are small enough to govern prudentially. 20 February 2013

Letter from Andrea Orcel, Andrew Williams and Philip Lofts, UBS Thank you for the opportunity to appear before you last month. There were a number of matters on which members of the Commission asked us to provide further information. Our responses are set out below: 1. Attached as Appendix 1 is a list of personnel whose employment was terminated432—in all but one case by agreement—as a result of the investigation into LIBOR and EURIBOR. As you will see from Appendix 1, there were in fact 17 such employees, not 18 as we wrongly stated during the hearing. Swiss Federal criminal law prohibits us from disclosing the identity of those employees resident in Switzerland. However, we can assure you that FINMA, our primary regulator, is fully aware of all the relevant details and the FSA has copies of the agreements relating to the former UK employees. 2. In answer to the Commission’s question at Q1896, Mr. Orcel referred to informing counterparties in relation to individuals who had already left the bank and then been found to be “guilty”. We should clarify that this was a reference to notifications that are made to the relevant regulators, and which are therefore subject to the procedures of those regulators, particularly in relation to their on-going investigations. Mr. Williams explained the FSA’s procedures in the next answer to Lord Lawson (Q1897). 3. Lord McFall asked if we would consider establishing a culture and ethics hotline with independent scrutiny. Although ethical matters are already covered under our whistleblowing policy, a copy of which we enclose for your reference, we will undertake a major relaunch of the policy by our Chairman and Chief Executive to publicise this further to encourage employees to report such matters. 4. Attached as Appendix 2 is a summary of matters raised in our quarterly whistleblowing report since our new policy was introduced in 2010. 5. We have not been able to ascertain when or by whom a decision was taken that the LIBOR submitters would also be traders. However, we can say that UBS has been a member of LIBOR panels since the BBA started calculating LIBOR in its current form in 1986. 6. As to Mr. Hayes, he joined the bank in June 2006 from Royal Bank of Canada in London. He left to join Citi in Japan in autumn 2009. His salary and bonuses received from UBS are set out in Appendix 3.433 7. As requested, a copy of our standard reference for both the UK and Japan is attached in Appendix 4. Citi did not request a reference for Mr. Hayes and one was not given. 432 433

Not printed. Not printed.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1625

8. Members of the Commission asked what proportion of the profit that Mr. Hayes made for UBS during his period of employment is attributable to his manipulative conduct. UBS has been exploring this extremely complex question, but has not been able to produce an answer to date. 9. In 2011, which is the most recent year for which we have information available, UBS hired a total of 478 permanent employees who work in a revenue generating area (excluding support staff), of which 153 are graduate trainees. With regard to the integration of our new joiners into the culture of UBS, in the UK we operate an “onboarding” programme for all new hires. On their first day this provides an opportunity for them to get an overview of working at UBS, and also covers legal and compliance controls. The programme continues with various mandatory courses and eLearning events covering subjects including Working with Respect (creating a fair and inclusive work environment) and Understanding UBS (on divisions, businesses and capabilities). New joiners are also provided with access to a portal with links to global, regional and division specific information. A quarterly new joiner learning event takes place with a senior speaker covering business relevant updates, leadership skills and career development. Line managers also provide support, outlining key activities for new joiners as well as being encouraged to discuss the vision and culture of the firm. In terms of managing an employee’s performance and behaviour, objective setting is conducted within the first few weeks of employment to ensure employees gain an understanding of the performance expectations. Performance feedback occurs at key points during the year. The formal appraisal process occurs at the end of the performance year, and both employee and manager evaluate the year’s performance against the employee’s objectives and his/her expected capabilities for his/her rank. All employees are evaluated by their line manager and 360 feedback is also available from peers, internal clients, direct reports, and others. A conversation between the line manager and the employee is a core element of the appraisal process and is used for evaluating an employee’s performance and contribution to the bank: it links the strategies and objectives of the bank to the individual goals and aspirations of its employees. This year our appraisal process has been enhanced to emphasise the importance of compliance and remediation activities. A failure by an employee in either of these areas will both negatively affect their compensation and disqualify the employee from promotion. Once again we thank you for the opportunity to appear before you. Please let us know if we can assist the Commission further.

New whistleblowing notifications

2010

2011

2012

Total

Accounting

3

6

7

16

Employmentrelated allegations

17

26

15

58

Retaliation alleged

5

8

9

22

Anonymous whistleblowing

22

28

22

72

Total cases

51

80

86

217

Whistleblowing cases per region 2010-2012

45 EMEA

102

Switzerland APAC 41 29

Americas

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1626 Parliamentary Commission on Banking Standards: Evidence

W histleblow ing events - outcome 2010-2012 6 39 No actions 89

Verbal Warnings Written Warnings Terminations, Resignations Soft M easures

25

Settlements 23

13

(S146) Appendix 4 UK: To Whom It may Concern: We confirm the following information with regard to the above named. Mr xxxx was employed by UBS London between xxxx and xxx. Mr xxx last position with UBS London was as a xxx within our xxxx function. Subject to compliance with any legal and/or regulatory requirements, it is not the policy of UBS to provide any further information for references. This does not imply any comment, positive or negative about the individual or the course of their employment with UBS. Any use of the term Director is purely to reflect titular status. This does not imply any shareholding or legal interest in UBS on behalf of the above named employee. In accordance with this policy, this information is given in the strictest of confidence and without financial or other liabilities on behalf of UBS or any of its officers. UBS AG will not respond directly to any verification queries; verification can only be made as detailed below. Yours faithfully For and on behalf of UBS AG Japan: To Whom It May Concern Re : XXXX This is to certify that Mr XXXX was employed by UBS Securities Japan Co., Ltd. (the “Firm”) between XXXX and XXXX. His last position with the Firm was XXXX within XXXX Division, and he held the corporate title of XXXX. It is not the policy of the Firm to provide any further information for references. This does not imply any comment, positive or negative about the employee or the course of his employment with the Firm. In accordance with this policy, this information is given in the strictest of confidence and without financial or other liabilities on behalf of the Firm or any of its officers. 20 February 2013

Written evidence from Martin Woods 1. My name is Martin Woods, I am a whistleblower. I am presently employed by Thomson Reuters as the Money Laundering Reporting Officer for the FSA regulated businesses, Reuters Limited (RL) and Reuters Transaction Services Limited (RTSL) . I am grateful to the Parliamentary Banking Commission of Banking Standards (the Commission) for inviting me to make this written submission, I am confident my submission will add value to the Commission’s work. 2. The submission is all my own work, my own words, my own thoughts, my own proposals based upon my own experiences and my own assessments of instances within the police service and the financial services industry. 3. I commenced working as an anti-money laundering (AML) compliance officer within investment banks in London in 2001. Prior to this I had served as a police officer for eighteen years, ultimately working as a

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1627

detective within the then Money Laundering Investigation Team (MLIT) of the then National Crime Squad (NCS). From 2001–04 I worked for ABN Amro Bank NV (now part of the Royal Bank of Scotland (RBS), I then spent approximately 6 months with Society Generale, before joining Wachovia Bank NA (now part of Wells Fargo NA) where I eventually blew the whistle in relation to concerns the bank was laundering the proceeds of Mexican drug trafficking. 4. Between 2009 and 2012 I worked as a self-employed consultant, within the area of financial crime and specifically AML. The Commission has requested I comment upon some specific issues, as set out below: — What steps should be taken to tackle the “adverse culture within banks which is detrimental to whistleblowing” which you mention in your previous cover letter; — What practical steps could be taken to encourage/facilitate whistleblowers and/or to make the whistleblowing process more straightforward and transparent; — What would be the perceived advantages of providing a financial incentive to whistleblowers as provided for in the US by the Dodd-Frank Act? 5. Within this request you have referenced my prior submission to the Commission in September 2012 and for the benefit of easy reference I will re-submit the same documents again. Such documents set out a number of whistleblowing issues which I have encountered over the prior years. When drafting and submitting this document I am conscious of a need to assist the Commission to identify a new approach, which will improve the flow and use of intelligence provided by whistleblowers within banks. 6. It is a big task, but not one I shy away from, indeed for some time I have been working with a number of fellow whistleblowers (WBUK)434 to improve the general perception and treatment of whistleblowers, in essence to make a difference for the whistleblower of tomorrow. Thus, I am focussed, but there is a danger I will drift towards my own issues, my own agenda, perhaps more than any other issue, my own anger. 7. The fact is the vast majority, perhaps all whistleblowers are often gripped by a deep sense of injustice, which in turn fuels anger and frustration. As a result I have become very self-obsessed and when asked to talk about the issues that have impacted me and my family emotions come into play, which will not necessarily help the Commission. Therefore, I have structured this submission in a way which I hope will be helpful, in essence, the first section answers the questions posed to me and the second section provides some of the background to my own experiences, which clearly drive the answers provided. 8. What steps should be taken to tackle the “adverse culture within banks which is detrimental to whistleblowing” which you mention in your previous cover letter? 9. Senior managers need to derive benefit from whistleblowing, they need to recognise whistleblowing as an important piece of the bank’s overall control framework. Whistleblowers need to be encouraged. This may actually be championed by shareholders, who have suffered and will continue to suffer, significant losses, because of the failure of banks to control some of the rogue elements amongst their employees. 10. Prior experiences and instances suggest there is a need for some independent, totally independent element within the whistleblowing process. Ordinarily, legitimate whistleblowers raise concerns about failures or perceived failures, which mean someone, somewhere within the bank may have made a mistake. My experience within the investment banks I worked for is that there is a blame culture, and quite naturally people seek to avoid being blamed. In the event a whistleblower raises a concern which impacts a manager, the manager may seek to suppress the “concern” as they may perceive it is in their own interties to do so. Hence there is a need for some independence, most certainly away from a vertical management structure. 11. It is my belief that the culture within the investment banks is not conducive to supporting whistleblowers, as short term greed and self interest are too often the dominant factors. It is my experience that all employees within investment banks are eligible for a bonus, which is both a good and bad thing. It does create a short term, self centred outlook, and many employees focus entirely upon securing as big a bonus as possible, occasionally by whatever means. 12. [Redacted] 13. [Redacted] 14. I will lose friends for stating this, but nonetheless, it needs to be stated, I do not believe the compliance function, the risk function and perhaps other support functions should be within the bonus regimes of the investment banks. I believe it creates the wrong focus and generates a poor outcome. I would pay these employees more money within their salary, but would not pay a bonus that was subject to their performance as in my experience the bonus may be used to compromise their performance. 15. I also believe the industry needs to be better trained about what whistleblowing is all about. It has a very negative image. In July of last year I presented at a financial crime conference ***. A fellow presenter was a solicitor from a major London law firm. ***. Two things she said struck me as negative and damaging, 434

WBUK Is a group of whistleblowers who support each other and are lobbying for changes to the way in which society, employers and the legal system treats whistleblowers. At the same time the Group offers advice and support to people who are contemplating blowing the whistle.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1628 Parliamentary Commission on Banking Standards: Evidence

firstly she said “Don’t let lunatic whistleblowers run around your firm.” Secondly she said, “Don’t let people write arse covering emails.” 16. Following the solicitor’s presentation and prior to a panel discussion I told the conference organiser I needed to return to the asylum and I left the conference. This little episode is very enlightening, I later learnt none of the 100+ delegates challenged the solicitor about her comments, which actually demonstrates that whistleblowers are viewed very negatively, they are often seen as the enemy. 17. If we pause for a moment and carefully consider the actions of a legitimate whistleblower, he/she is ordinarily seeking to tell the truth. Likewise, “arse covering emails” only work when they contain the truth and therefore I contend the solicitor was seeking to suppress the whistleblower and the truth. This has to change, as suppression of the truth is not in the best interests of the public, the bank, the bank’s shareholders and the thousands of honest hard working bank employees. 18. The Commission should wonder, how did we ever arrive at a juncture, where a solicitor from a prominent London law firm openly tells bank compliance officers to suppress the truth? Clearly the solicitor was comfortable and confident in her actions. Equally the compliance officers were not disturbed as none of them challenged her. 19. In contrast, earlier this week, Tuesday 12th February 2013, a prominent London based law firm invited clients and regulated firms to an event referenced “Managing an effective internal whistleblowing programme.” This perhaps indicates diverse opinions in the City or a change of views and culture as a result of the LIBOR scandal. Whatever the reason, such an event is most welcome. 20. Importantly, the regulator needs to take a lead here. The FSA needs to be clearer and more consistent with the messages sent out in relation to whistleblowing. My own experience with the FSA, as set out below has not been a positive one, but this is compounded by FSA actions in respect of people who did not report incidents to them. 21. The FSA has implemented an approval process for many people working in banking and the financial services industry. This approval applies to many functions, including, compliance heads, investment advisors and persons selling investment products. Within the “approved persons” regime435, such employees must maintain an open and cooperative relationship with the FSA and report suspicious transactions and significant incidents. 22. In early 2012, the FSA sanctioned two individuals for their failure to comply with their reporting requirements. In referencing the individuals, a senior FSA employee likened the two men to “the dog that didn’t bark436“ Both men admitted failing to report suspicious transactions, each was fined, but retained their status as approved persons. Seen from one perspective, the men were indirectly rewarded for staying silent, no lunatic whistleblowers here. 23. When I blew the whistle, the FSA told me I would never work for the bank again and it took me a long time to recover my status as an approved person. The FSA action in relation to the two individuals did very little to encourage whistleblowing, on the contrary, these two men were fortunate and in the long-term the outcome for them was far more positive than it ordinarily is for whistleblowers. 24. I believe that one of the difficulties of blowing the whistle in a bank is that in parallel, the individual doing so is also blowing the whistle against the FSA. It is important to understand the role of the FSA and the connection to regulated firms and banks. The FSA supervises banks and therefore, when there is a big failure within the bank, it commonly follows, there has been a failure in the supervisory process. 25. What practical steps could be taken to encourage/facilitate whistleblowers and/or to make the whistleblowing process more straightforward and transparent? 26. We need to ask ourselves, what do we want from a whistleblowing process and how will we secure that? The primary issue is the negative way in which whistleblowing and whistleblowers are perceived, as articulated by the solicitor at the conference, referenced above. I would encourage the Commission to look at those firms that positively champion and promote whistleblowing, a very good example of which is (I believe) BHP Billiton. 27. Absent to a change of culture and attitudes, it is not easy to encourage whistleblowers, there are far too many unhappy endings in the stories of whistleblowers. The change of attitude could/should start with an improved welfare programme, whistleblowing is very stressful and if whistleblowers are to be encouraged and valued we need to recognise that value and help them with their stress. 28. As a society we need to value whistleblowers, they need to be seen for the force of good that they are. If banks want to encourage whistleblowing, they need to openly promote and support it. 29. As to a more straight forward and transparent process, there are two issues here, one being the process and the other being transparency. Each firm has its own process, likewise the FSA has its own process. Ideally all processes should provide for anonymity, therefore, reduced transparency. The actual act of blowing the 435 436

FSA PRINCIPLES PRIN 2.1.1.11 Arthur Conan Doyle

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1629

whistle is one which ordinarily requires lots of analysis and assessment by the whistleblower, who will commonly wish he/she were wrong in their assessment and consequently the need to blow the whistle will evaporate. 30. The question needs to be considered in the context of culture, BHP Billiton have a very straight forward process which constantly encourages the whistleblower. This makes the whistleblower’s assessment and analysis quicker and the actual whistleblowing easier. Put quite simply, that is because the firm wants to hear from the whistleblower. This refreshing approach is not one I have identified within banking. 31. The transparency point works both ways, as stated above the lack of transparency can protect the whistleblowers, but conversely, the lack of information provided to a whistleblowers, increases stress and isolation, often causing the whistleblower to question the wisdom of their actions. For my part I requested FSA update me on their actions pursuant to my whistleblowing, I also made a formal complaint in respect of Wachovia Bank’s detrimental treatment of me as a whistleblower437. FSA declined to give me any information and ultimately stated they would not be writing to me again. So what did the FSA do in respect of my two whistleblowing reports referenced below? The answer is, I do not know. Thus transparency is something that is missing and needs to be addressed. It is as though the information/intelligence business, is one way and the whistleblower is not to be trusted with the information. There may be some logic to this, as he/she having blown the whistle once before, may do it again should he/she be unsatisfied with the actions of the FSA. 32. It is also difficult for the FSA and banks to openly advertise the success of a case brought because of a whistleblower, without potentially impacting upon the anonymity of a whistleblower. The process would benefit from improved dialogue between whistleblowers and banks and whistleblowers and the FSA. 33. What would be the perceived advantages of providing a financial incentive to whistleblowers as provided for in the US by the Dodd-Frank Act? 34. Prior to answering this question, the Commission must keep in mind that whistleblowers in the UK do not currently receive statutory rewards for the information they provide. Thus most legitimate whistleblowers take action based upon a sense of right and wrong. They take risks, and sacrifice their own self interest. Where whistleblowers have received payments, they have ordinarily resulted from employment tribunal proceedings instigated against employers who subjected the whistleblower to detrimental treatment. 35. I believe the whistleblowing provisions of the Dodd Frank Act arose through a sense of regulatory failure. A failure by the regulators to gather and act upon important intelligence and information. Senators Dodd and Frank determined a change was necessary in order to protect the public. Of course the US have been rewarding whistleblowers for a protracted period of time, through the False Claims Act, which provides a mechanism whereby individuals can instigate legal proceedings on behalf of the Federal Government. It has been very effective in the US and has been recognised as a check and balance against many instances of corporate misconduct. 36. In the event the Commission wishes to ensure whistleblowers and whistleblowing has a more positive impact upon banking culture and regulations, then provisions similar to those set out within the Dodd Frank Act should be enacted. I support such provisions, not because I believe I should have been rewarded a huge sum of money,438 but because the present system is not working. The FSA have not been given the important intelligence and information, the current “approved persons” regime mandates they should have been given. The “open and cooperative” regime has failed, no doubt, in part because of poor culture, fear and intimidation. 37. I am fortunate to count a number of whistleblowers as friends and I have witnessed some very unjust suffering, as both corporate and government machines have been deployed to discourage, dismantle and destroy people, who should actually be applauded, supported and rewarded for their selfless actions. 38. Thus, there is logic to a reward process. Overall, society benefits from whistleblowing and whistleblowers, therefore, they should be encouraged and where appropriate, rewarded, or perhaps more appropriately, compensated for the sacrifice they make and for what will happen to them as a consequence of their actions.439 39. I believe it is appropriate to examine this proposal in the context of the LIBOR fixing scandal, after all, this was the straw that broke the camel’s back and the reason the Commission is undertaking this exercise. Recent evidence revealed within the FSA enforcement notices against UBS and RBS reveals a gang mentality amongst traders. By which I mean a group of people predominantly, perhaps exclusively, men with considerable power and influence, deriving strength from each other, from the size of their gang, the impact of and the power of their actions. 40. This gang mentality was substantially influenced by a notion of “we fix LIBOR [and other rates] because we can.” It was a belief based upon an ability to influence, perhaps even intimidate others and. Significantly 437

FSA SYSC 18.2.3 The FSA would regard as a serious matter any evidence that a firm had acted to the detriment of a worker because he had made a protected disclosure about matters which are relevant to the functions of the FSA. Such evidence could call into question the fitness and propriety of the firm or relevant members of its staff … 438 Wachovia paid a penalty of $160 million, $50 million of which was payable to the OCC, at a minimum, under the provisions of the Dodd Frank Act I would have been eligible for a reward of $10 million. 439 96% of whistleblowers never again secure permanent fulltime employment in the industry where they blew the whistle (Flirting With Disaster by Marc Gerstein)

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1630 Parliamentary Commission on Banking Standards: Evidence

the power and strength was fuelled by a perception that they could do what they wanted, because they would not be caught. This is evidenced within the email and chat room dialogue which has since been reviewed by the Commission and published by the FSA. There was no fear that anyone amongst them would break ranks and report the criminal conduct to the authorities. There was no fear of the authorities, in particular the FSA as there was no credible deterrent for their actions. 41. They sought to increase their power, strength and influence by compromising other parties (paying broker substantial fees on “wash” (synthetic) transactions) and drawing them into their gang, their philosophy, the criminal conspiracy. There is no doubt in my mind rewarding whistleblowers would have had a very positive impact upon the LIBOR scandal. These were intelligent people, with a straight forward sense of right and wrong, they knew their actions were wrong, some would have been a little troubled by the same, but as a member of the gang, they decided to stay loyal to and safe within the gang. The potential of a reward would have added a different dimension to the whole conspiracy. 42. An innocent party in the back office of the bank would perhaps have seen the “wash” transactions and reported them. The reward concept gives people an incentive and gives the criminal something to fear from being reported. Paying for intelligence is not wrong, in fact it is totally logical and governments have been doing this for a very long time. Ordinarily the informant/the whistleblower is taking a risk and often a reward is necessary to encourage them to do so. 43. I believe it was this approach which proved to be very successful when the authorities in the UK tackled Irish republican terrorism, post the bombing of Canary Wharf in 1996. I believe it was the provision and the offer of substantial rewards to the informants/whistleblowers which fractured some of the terrorist cells and resulted in a number of failed campaigns on mainland UK. 44. The reward, the offer of a reward changes the way people think, it makes criminals, including criminal traders more vulnerable to each other. It actually stops many crimes taking place, because the criminals determine not to trust each other. The criminal’s risk management will assess the upside and the downside of their actions, their weakness and their vulnerability. Their strength is having control and influence over others, this is substantially reduced when third parties offer incentives which undermine the criminal and the conspiracy. 45. I note that in prior testimony provided to the Commission by Tracy McDermott, the Head of Enforcement she raised the way in which the UK courts view the evidence of whistleblowers. I was somewhat surprised at the statement, which appeared to suggest the courts question the value of the evidence and testimony of whistleblowers. This is in the context of whistleblowers who are not presently rewarded and ordinarily speak out against a sense of wrong doing. I would be deeply offended if a court determined to question the value of my testimony or evidence, because I was a whistleblower. 46. That stated, there are not a lot of instances of whistleblowers actually testifying before the courts. The primary conduct of a whistleblower is to provide intelligence or information. The police informant who tells the police where there is a quantity of drugs does not subsequently provide evidence to the court. I actually believe this shows a lack of understanding by the FSA of how whistleblowers fit into the system, be it legal or regulatory. This is the same FSA who in a way rewarded the non-whistleblower, “the dog that did not bark” by allowing the two men to retain their jobs, as well as the confidence of the FSA. 47. Ms. McDermott also stated, that she did not believe the whistleblowing system is defective, I strongly disagree, and the LIBOR scandal bears full testimony to the failure of both the regulatory system and the whsitleblowing system within it. I would strongly encourage the Commission to carefully consider why they are even looking at the whistleblowing system and I would respectfully suggest the reason is that system is defective. 48. I also note Ms McDermott has stated the FSA has enhanced the intelligence systems and department within the FSA, which is a very welcome and positive move. Of course whistleblowing and whistleblowers fit within the intelligence system and I believe they can add considerable value to the same. Such value will itself be enhanced if whistleblowers are offered the incentive of financial rewards, financial security. 49. Below is some background to the statements I have made above and evidence of my own experiences of the way in which whistleblowing and whistleblowers are treated in banks. 50. Whistleblowing is not something that is new, although legislation in this area is not mature and has constantly been shown to be out of date and riddled with holes. Ordinarily public spirited whistleblowers (all member of WBUK) take such action for a greater good and in the long-term, society, the common man will benefit from such actions, but often, in the short-term, powerful people and organisations potentially have a lot to lose when faced with reports or allegations from whistleblowers. 51. Consequently, the powerful organisations, including governments and banks, as well as powerful people, seek to attack, undermine and discredit the whistleblower, in order to protect their own short-term and longterm interests. The whistleblower is almost always outnumbered, out manoeuvred and invariably outlawyered. In the majority of instances, whistleblowers act alone, it is not that other people do not see what the whistleblower sees, rather they see it, but decide to do nothing about it. People like the status quo and whilst

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1631

they witness wrong doing, they become passive observers, often controlled and influenced by colleagues and managers and are therefore consciously and sub consciously persuaded to accept the said status quo. 52. When an individual contemplates blowing the whistle, he/she will often hope they are incorrect in their own assessment and judgement, that way they can subscribe to the status quo and remain in the safety of the group of passive observers who constitute the majority. Potential whistleblowers recognise the jeopardy they will face if they cross the line and actually blow the whistle. I know from my own experience it is very isolating, deeply disturbing, one finds oneself in a situation where one questions so many things, in particular one’s own judgement and one’s own conduct. There are very few happy endings for whistleblowers. I have likened my own battles to that of David verses Goliath, in which my sling shot was the legal protection on my household insurance policy, which meant I could fight on more equal terms. 53. Whistleblowers are often “big picture” players as they see the connections between one action and others. A tragic case which highlights this is that of the Challenger space shuttle, where no one actually blew the whistle loud enough and where many dismissed connections which painted a very negative, ultimately tragic picture. 54. So how is all of this relevant to banks and banking culture? The context is simple, banks and senior bankers have become some of the most powerful entities and people in the world. Money buys power, money is power and the banks have a lot of money. Thus, when an individual blows the whistle in a bank, he/she is blowing the whistle against some very powerful and very strong people, who may be threatened by the whistleblower. 55. The key here is information. The whistleblower is a person who seeks to provide information which he/ she believes is important, more often than not it relates to mistakes made by others, wrong doing, improper conduct, even criminal acts. The banks, the financial services industry value information, it is arguably the most valuable element within the financial services industry. 56. Information is also critical to effective law enforcement. This is highlighted in the campaigns pursued by the Counter Terrorist Department at Scotland Yard, in one poster campaign, the strap line was “It’s probably nothing but!” Essentially the police were telling the public and continue to tell the public, please provide information, please blow the whistle and report information. Without the support of the public and the provision of vital information, the detectives and investigators within the Counter Terrorist Department would not be as successful as they are. The detectives and investigators within the Counter Terrorist Department are in the market for information, all information and they are actively pursuing it. 57. In contrast, the regulators, and I include the FSA and the Securities and Exchange Commission (SEC) in the US supervise an industry where fortunes are made and lost using information, not always legally. Prior to the advent of the “Global Financial Crisis” (GFC) there is evidence that the supervisors and the regulators were not in the market place for information, or perhaps more precisely, not information from people. 58. The man who blew the whistle against the convicted fraudster Bernie Madoff is a good friend of mine called Harry Markopolos. He submitted a number of reports and made personal presentations to the SEC in which he stated Bernie Madoff and his companies (which included a UK FSA regulated company, Madoff Securities Ltd.) were running the world’s biggest fraud. The SEC took no action and the fraud continued, causing even greater losses to victims. Harry later wrote a book called “No One Would Listen.” The point being, Harry was talking, he was talking loud and clear, he presented scientific, mathematical evidence that Madoff was a fraudster, but he was ignored by the regulators. 59. It maybe the regulators did not understand the complicated mathematics which Harry had applied when concluding Madoff was a fraud and rather than appear to be unintelligent, they ignored it. We have subsequently learnt there were many other “red flags” the regulators ignored when supervising Madoff and his companies, “red flags” which could have corroborated Harry’s evidence were not seen in a “big picture” context by the regulators. 60. Ultimately, the regulators did not discover Madoff’s fraud, rather he gave himself up, because his Ponzi scheme had run out of money. Subsequently the SEC contacted Charlie Rawl, another good friend of mine, the primary whistleblower against Alan Stanford, Sir Alan Stanford, as he once was. Charlie had blown the whistle and submitted documentary evidence to the SEC almost a year earlier and they appear to have done very little with the submission, as Stanford continued in business and continued his fraud. The catalyst for action by the SEC was Madoff giving himself up, this caused the SEC to seek to head off another impending disaster and it was hoped the SEC could suggest Stanford’s arrest and conviction was because of their good work. 61. In the UK it was Paul Moore who, as the Chief Regulatory Risk Officer with HBOS raised concerns about the bank’s business and in particular the failure of risk management to keep pace with the ballooning loans and mortgage business. At the time HBOS like many other banks was making lots of money from such business, the share price was up, dividends were up and on the face of it all was well. Clearly the Board had endorsed and supported the business model and were delivering “great value” to shareholders, albeit, shortterm. Thus when Paul spoke out, he was challenging the herd, a strong, powerful herd and the leader of the herd, then James Crosby, now Sir James Crosby, the former Deputy Chairman of FSA, disposed of him, perhaps in order to protect the herd from him.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1632 Parliamentary Commission on Banking Standards: Evidence

62. Of course hindsight is an exact science and if we could turn back time, there can be no doubt Sir James Crosby would have made a different decision. The Commission must find a way to ensure that in future the correct decision is made, it is vital for the economy and it is critical for the wellbeing and welfare of the thousands of good, honest hard working people in the finance and banking industry. 63. The added problem for Paul and too some extent myself was that not only did we blow the whistle in regard to what we considered to be improper, if not criminal conduct,440 we also blew the whistle in relation to regulatory failure. This is an important consideration in relation to the questions posed by the Commission and it should not be ignored. 64. My own experience with the FSA should have been a better one. I did not blow the whistle in order to be rewarded, I did so because I saw the connection between the conduct of Wachovia Bank and the thousands of murders in Mexico. It was Tony Blair, who, in 2001, when championing the Proceeds of Crime Act 2002 said, if you take the proceeds out of crime you stop the crime. From an early stage I raised concerns about the anti-money laundering (AML) programme within the bank. I was supported by some outstanding AML professionals in the US as well as some colleagues in London. *** I was not supported by managers within the Compliance and AML function. 65. [Redacted] 66. There came a time when the US authorities took decisive action against Mexican firms laundering millions, perhaps billions of USD through Wachovia. There followed widespread, international media coverage, the most senior managers of the bank in London congratulated me in regards to my actions. [Redacted] 67. 68. [Redacted] 69. [Redacted] 70. [Redacted] 71. [Redacted] 72. [Redacted] 73. [Redacted] 74. As a detective working for the Metropolitan Police and the then National Crime Squad, I had worked with informants who had provided excellent information and intelligence that had resulted in the arrest of robbers, drug dealers, murderers, escaped prisoners and more. Informants were an extremely valuable asset, and the value increased when they remained within or adjacent to criminal groups. Hence I was struck by the FSA’s notion that they did not want the whistleblower, informant staying within or close to the alleged criminal enterprise. 75. This is where the difference crystallizes, detectives are constantly seeking intelligence and information, in particular intelligence from informants, within or adjacent to criminal groups, whereas supervisors are employed to ensure regulated firms operate within the rules and regulations, they are not automatically in the business of seeking intelligence and information, in my instance, more information or intelligence. 76. At the end of the meeting the FSA gave me the telephone number of Public Concern at work (PCW) a whistleblowing charity and the FSA advised me to call them should I encounter any difficulties. This was the FSA’s welfare programme for whistleblowers. The whole episode left me with a sense of emptiness and even further isolation. 77. [Redacted] 78. [Redacted] 79. I contend that this is not in keeping with a whistleblowing system that “is not defective.” 80. I was very surprised and disappointed by this reaction. It contradicted my detective’s way of thinking, it was illogical. Here was an informant contacting the authorities, it was reasonable to presume the informant was about to provide more information. This was clearly not how the FSA and the supervisors saw it, they were not thinking in the way I presumed they would, they were not thinking like detectives. 81. I later submitted a second substantial whistleblowing report to the FSA, the FSA have never responded to this second report. [Redacted] 82. What is the point of this? It is inaction, it is a refusal to listen, it is a refusal to properly investigate, it is wrong and it is dangerous. The whistle was blown, but the authorities were informed, the whistleblower took a risk and at the end of the day nothing was done. Who knows where it will end? 83. [Redacted] 440

My former employer Wachovia Bank paid a penalty of $160 million for laundering the proceeds of Mexican drug trafficking.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1633

84. [Redacted] 85. [Redacted] 86. In May 2009, the Bank and I settled my tribunal claims by way of mediation and I left the employ of the bank. I subsequently gave evidence to the US authorities at a hearing in Miami. As stated above, I submitted a complaint to the FSA alleging detrimental treatment of a whistleblower by Wachovia Bank. I requested an update as to FSA actions. I was informed FSA would not provide such an update and eventually the FSA wrote to me and stated they would not be writing to me again. 87. In March 2010, Wachovia Bank paid a penalty of $160 million for implementing weak AML controls and laundering millions of USD from the proceeds of drug trafficking. The then Comptroller of the Currency John Dugan wrote to me and commended me for my actions. I later asked if I could provide AML training to the Office of the Comptroller of the Currency (OCC) and the FSA, both organisations declined. 88. I do not believe it will be possible to change the whistleblowing culture within banks until we change the whistleblowing culture of the regulators, only then can the regulator, in the UK, the FSA, fully understand and value whistleblowers and what they can add to safer and sounder regulation. 89. The fact that the FSA do not believe the present whistleblowing system is, in my submission something which should disturb the Commission. 90. [Redacted] 91. [Redacted] 92. ***. As the Commission assesses the culture within banks, set against the background of the LIBOR fixing scandal, I respectfully request you consider the AML issues within RBS, Wachovia, HSBC and other banks. The FSA Final Notice against RBS in respect of the LIBOR fixing contains a list of AML penalties imposed against the Bank, including and £8.75 million penalty imposed upon Coutts. In that instance the FSA stated the AML department was not robust enough to challenge the private bankers. I clearly am robust enough, but RBS do not want me, you may ask yourselves is this in keeping with a change of culture. 93. Ultimately it is all about culture, a culture which promotes the rights morals and values, a culture which encourage people to speak out and rewards them for doing so. The traders criminally fixed LIBOR, because they could, because there was no fear of being caught, there was no credible deterrent, there was there remains a defective whistleblowing system. 14 February 2013

Written evidence from Professor Stella Fearnley and Professor Shyam Sunder We welcome the opportunity to submit evidence to the Commission based on our research and observations of the banking crisis. We do not respond to all the questions, concentrating on topics where we can make a contribution. Executive Summary 1. Introduction 2. Loss of trust and excessive remuneration in the banking sector We recommend that the work of the High Pay Commission, and its data on pay structures be given a much higher profile and its recommendations be included in the UK Corporate Governance Code. The High Pay Commission should be funded to continue its work for another ten years. 3. Qualifications, professionalism and the public interest in the banking sector We recommend that the boards of all banks be required to accept their public interest duty and state publicly that441 that they have fulfilled their responsibility to provide public service without placing depositor and taxpayer money at undue risk. Banks’ boards should also confirm that internal processes of the bank ensure that all staff are obligated to serve the public interest in an ethical manner. 4. Prohibiting investment banking and commercial banking within the same organisation The ethical code for banks should be based on the cardinal virtues deriving from Plato (prudence, restraint, fortitude and justice) rather than three deadly sins (greed, envy and pride). We support the proposal to separate completely, not merely “ring fence” retail/commercial banking from investment, banking, because there is no practical and implementable way of isolating them from each other within a single organization. Investment banks, excluded from any actual or potential taxpayer support, should 441

This could be achieved by an addition to the corporate governance code for banks eligible for taxpayer support.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1634 Parliamentary Commission on Banking Standards: Evidence

be required to establish, observe and enforce ethical codes, and maintain effective control and governance systems because they also are entrusted with other people’s money. 5. Globalisation We recommend that UK regulators and government should be particularly mindful of the risks associated with cross border activity in the financial sector. The UK economy needs to be protected against the financial consequences of importing high risk financial developments or activities originating in other countries on the grounds of maintaining competitiveness. Before allowing unbridled expansion in financial products, regulators and government should ask if they are promoting a race to the top or to the bottom. 6. The introduction of IFRS in the EU in 2005 and convergence with US GAAP We believe that the concept of a common set of “high quality” accounting standards for use around the world has been seriously flawed from the outset and the IASB has misused its resources in a convergence project which was bound to fail. It let down its users, particularly in the EU, by concentrating on convergence with US GAAP instead of ensuring that the standards were of “high quality” for existing users. The UK government should not blindly support the principle of common global standards because of the self-interested lobbying by a relatively small number of large organisations. Also, as argued below, the IASB is not capable of producing “high quality” standards. Neither is it possible to achieve uniformity of results from a single set of rules in a world of economic, social, legal, and political diversity. 7. The accounting model, auditing and the banking crisis We recommend from the evidence shown above that the UK government should no longer trust the IASB standards to produce credible accounting numbers, which are drawn up under the principles of prudence and reliability, show a true-and-fair view and reflect the economic substance of the business. Also it is clear that the true-and-fair view requirement has not been retained in IFRS. Therefore UK company law should be changed so that directors and auditors are required to report that the accounting numbers are prudent, reliable, show a true-and-fair view and reflect the economic substance of the reporting entity. Both directors and auditors should be required to override the IFRS standards and conceptual framework as necessary. In the case of banks the agreement of the banking regulator should be required. In the case of other companies the market regulator should be consulted. 1. Introduction (i) Great economic damage has been done to the UK and many other economies by the banking crisis of the recent years. Banks’ managers designed, adopted and operated business models with highly volatile outcomes, so they could reap the benefits of positive results, and have their shareholders and taxpayers (filling in for insured depositors) bear the losses. The public investors incurred heavy losses on their savings and investments, whether directly in the banks or via intermediaries, such as financial advisors, investment institutions and pension funds. These include low interest rates, low share prices in banks and poor returns on annuities for citizens retiring. The UK is now suffering from a major economic downturn and high unemployment, damaging the wellbeing of its citizens. (ii) Failures of regulation have been equally as significant as the failures of bank management. These include: Basel II allowing high leverage with insufficient attention to bank solvency and capital protection; the Financial Services Authority’s (FSA’s) failure to recognise the implications of significant changes in the banks’ business models and failure to communicate with bank auditors; and the imprudent International Financial Reporting Standards (IFRS) mandated by the European Union in 2005 for group accounts of all EU listed companies. The IFRS requires booking of unrealised gains on financial assets as profits under its mark-to-market accounting model and delays recognition of loan losses until they are realised. Both these features of mandated IFRS inflated the profits banks reported, and bonuses they paid. The IFRS regime legitimised clean audit opinions on false profit reports and led to payment of bonuses and dividends out of such profits. (iii) In other words, regulators failed both by writing and enforcing rules which produced dysfunctional actions and false reports, and by ignoring the consequences of the rules they promulgated. Bank auditors, too, provided clean audit reports for 2007 barely months ahead of the emergency bailouts of some of them, using large amounts of taxpayer money. In the following paragraphs, we address a number of key issues that the Commission has raised in its invitation for submission of evidence. 2. Loss of trust and excessive remuneration in the banking sector (i) The bailout of banks with taxpayer money, and the heavy investment and employment losses suffered by many ordinary citizens have understandably led to a loss of trust in the banking sector, labelled “banker bashing” by some. The high pay and large bonuses based on short-term

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1635

profits, whether false or true, have induced higher pay and shorter decision horizons in managers of other sectors of economy. Executive remuneration as a multiple of employee pay has risen sharply. According to 2011 Report of the High Pay Commission,442 the ratio of top to average pay at Barclays rose from 14.5 in 1979 to 75 thirty years later. We recommend that the work of the High Pay Commission, and its data on pay structures be given a much higher profile and its recommendations be included in the UK Corporate Governance Code. The High Pay Commission should be funded to continue its work for another ten years. 3. Qualifications, professionalism and the public interest in the banking sector (i) Surprisingly, the industry waited until October 2011 to issue a high level code of conduct443 for banking professionals. We are not convinced that the issuance or even widespread signing of the code will improve bankers’ adherence or conduct. Its content, progress, management, and enforcement should be overseen by the Financial Conduct Authority. (ii) Close attention to public interest is essential in this publicly subsidised and protected industry; yet the code does not even mention public interest. In a capitalist economy, banks serve many essential functions. These include being a safe haven for savings, accumulating and allocating these savings to investment, and facilitating management of personal and organisational financial affairs through provision of services such as cheque clearing, credit cards, transfers, etc. Provision of the functions is a public service. (iii) However, in order to have many competing private parties to provide such public service in an efficient manner, society combines subsidies with opportunity for them to make a reasonable amount of profit. To this end, banks are licensed and overseen to serve the needs of society, while protecting the public purse and citizen’s savings from abuse in pursuit of profits beyond what is reasonable for a subsidised industry. From activities and assertions of banks, their managers and employees in the recent decade, it is clear that their public service responsibility to society which justifies their special status and special support is not understood and accepted by them; the support is widely taken for granted, and used for unbridled pursuit of private profits in violation of public trust and duty to serve. Until such time as the duty-to-serve the public interest and to conduct business in an ethical manner are embedded in the banks’ culture from the top down, events such as the recent LIBOR manipulation scandal will continue to occur. We recommend that the boards of all banks be required to accept their public interest duty and state publicly that444 that they have fulfilled their responsibility to provide public service without placing depositor and taxpayer money at undue risk. Banks’ boards should also confirm that internal processes of the bank ensure that all staff are obligated to serve the public interest in an ethical manner. 4. Prohibiting investment banking and commercial banking within the same organisation (i) Despite significant cultural differences and conflicts of interest, investment and commercial/ retail banking operations have be allowed to reside under the same roof during the recent decades. The Vickers report (2011) recommends ring fencing retail from investment banking, while others, including Lord Lawson445 recommend total separation of commercial/retail and investment banking. (ii) Even the commercial/retail banking activities have often crossed the line of serving public interest, for example, by mis-selling financial products. They have also engaged in reckless lending such as Northern Rock’s mortgages for 125% of the value of the property, a significant proportion of which defaulted.446 (iii) Although the activities of the investment banks are best described as casino banking447, care is needed in interpreting the metaphor. In casinos, gamblers put their own money at risk; the odds and the law of large numbers make it virtually certain that casinos do not have a losing day, much less a losing month or year. In investment banking, risk is borne not only by the clients but also the bank itself, which makes it essential that banks engaging in such activities have NO access to either the insured deposits or the public trough in any form, especially the discount window of the central bank. (iv) The government proposals for a Banking Bill focus on ring fencing the retail/commercial banks from investment banks based on the Vickers Report. Given past regulatory captures by the 442

http://highpaycommission.co.uk/wp-content/uploads/2011/11/HPC_final_report_WEB.pdf. The High Pay Commission makes valuable proposals about control over and transparency of executive remuneration. 443 http://www.cbpsb.org/media/code_of_conduct_a5_-_final.pdf. 444 This could be achieved by an addition to the corporate governance code for banks eligible for taxpayer support. 445 Lord Lawson of Blaby (2012) Forget Fred and focus on the real banking scandal. Financial Times. 6 February. p.11. 446 Myra Butterworth (2009) “More than 12,000 Northern Rock 125% mortgage borrowers in arrears”. Daily Telegraph 6 August 2009. http://www.telegraph.co.uk/finance/personalfinance/borrowing/mortgages/5973130/More-than-12000-Northern-Rock125pc-mortgage-borrowers-in-arrears.html 447 An example of a reference to casino banking may be found at: http://www.metro.co.uk/news/712220-mps-call-for-casinobanking-ban.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1636 Parliamentary Commission on Banking Standards: Evidence

industry and glaring failures, it is naïve to believe that anything short of complete separation between investment and commercial/retail banking will work. (v) Rules, however well-crafted, can be, and always have been, bypassed when rewards from doing so are sufficiently tempting. Ethics, risk management, governance and control systems cultures of investment and commercial/retail banks are, and have to be, so different that allowing them to operate under a single roof, no matter how well they are said to be “ring fenced” will not work. Giving one part of the “ring fenced” organisation access to taxpayer support, while the other is free to take unsupervised risks is simply an invitation to creative financial engineering, and well-financed political lobbying to regulators to either bend the rules or to look the other way. Moreover, the aftermath of the demise of Lehman Brothers furnished ample evidence that the consequences of even “private” risk taking by large financial institution have systemic effects paid for by taxpayers. (vi) It is misleading to attribute major scandals in the investment banking sector to weak internal controls because, in spite of built-in “deniability” protections, it is evident that approval and consent of most such activities came from the top echelons of management. Attribution of such failures to poor internal controls must be supported by evidence of intent and serious efforts to control such activity. The problem is absence of ethical standards in the industry, or reckless and widespread disregard for them at all levels. The case of Goldman Sachs being fined $550 million by the SEC in 2010448 for misleading investors was the deliberate result of corporate policy which might be called moral turpitude in individual contexts; it is not a mere failure of internal controls in the organisation. (vii) The Commission should be mindful that investment banks also indirectly are responsible for the public’s money via various investment institutions. We suggest that the ethical codes in all financial institutions should be based on social norms which have stood the test of time. An ideal model would be the cardinal virtues of Plato449: prudence; restraint; fortitude and justice. The behaviour observed in the recent decade appears to have more in common with three of the deadly sins of greed, envy and pride. The ethical code for banks should be based on the cardinal virtues deriving from Plato (prudence, restraint, fortitude and justice) rather than three deadly sins (greed, envy and pride). We support the proposal to separate completely, not merely “ring fence” retail/commercial banking from investment, banking, because there is no practical and implementable way of isolating them from each other within a single organization. Investment banks, excluded from any actual or potential taxpayer support, should be required to establish, observe and enforce ethical codes, and maintain effective control and governance systems because they also are entrusted with other people’s money. 5. Globalisation (i) While globalisation brings the benefits of cross-border trading in financial assets, multiple listings, and financing; it also lowers the barriers to transfers of economic, legal, regulatory and cultural weaknesses. For example, both the Enron as well as subprime mortgage crisis originated in U.S. but had major impact outside its economy. The Euro debacle is another example of the failure to recognise and manage intra-Eurozone cultural and economic disparities. Few global mechanisms that exist for regulated globalised phenomena remain weak and ineffectual, since the bulk of regulatory and disciplinary powers reside in domestic government for historic reasons. Absent effective global regulation, unintended consequences of cross-border activities continue to leapfrog piecemeal national efforts, and need more comprehensive solutions. (ii) The financial services industry has often used staying competitive as the excuse for adopting the highest risk financial schemes independent of where they originate. Regulators of financial service industry must decide if they wish to encourage in a race to the top or to the bottom. We recommend that UK regulators and government should be particularly mindful of the risks associated with cross border activity in the financial sector. The UK economy needs to be protected against the financial consequences of importing high risk financial developments or activities originating in other countries on the grounds of maintaining competitiveness. Before allowing unbridled expansion in financial products, regulators and government should ask if they are promoting a race to the top or to the bottom. 448 449

http://www.sec.gov/news/press/2010/2010–123.htm. Prudence—able to judge between actions with regard to appropriate actions at a given time; Justice- proper moderation between self-interest and the rights and needs of others; Temperance or restraint- practicing self-control, abstention, and moderation; Fortitude or courage- forbearance, endurance, and ability to confront fear and uncertainty, or intimidation. http://en.wikipedia.org/ wiki/Cardinal_virtues. Prudence as a cardinal virtue in relation to accounting was discussed and supported by Professors Sudipta Basu, Yuri Biondi, Shyam Sunder and Ross Watts at a panel during the Annual Meetings of the American Accounting Association in Washington in August 2012.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1637

6. The introduction of IFRS in the EU in 2005 and convergence with US GAAP (i) The IFRS accounting model was introduced into the EU for group accounts of listed companies for December 2005 year ends by an EU Regulation issued in 2002. Shortly after the Regulation was issued the International Accounting Standards Board (IASB) the body responsible for setting the standards, announced that it was planning to converge its standards with US accounting standards, known as US GAAP450. The US standards are set by Financial Accounting Standards Board (FASB)451. There was no public consultation on this decision which is quite extraordinary, given the significance of the consequences of this decision. Perhaps the IASB hoped that, in the long term, the US Securities and Exchange Commission would approve the converged standards in the form of IFRS for use by US companies. Neither the source of this decision, nor the identity of the parties involved in making it is known. (ii) The US GAAP convergence project changed the IASB working plans, and considerable resources were redirected towards joint projects and meetings on various standards. In spite of many warnings to the contrary, the convergence project was based on, and promoted, the astonishingly naive proposition that it was possible to bring about the development and acceptance of a single set of “high quality” accounting standards for hundreds of countries of the world with their diverse economic, legal, business, political and social systems. This vision was actively supported by global accounting firms who stood to benefit greatly from common global standards by driving out competition from smaller local firms. Not only the meaning and substance of “high quality” standards remained unspecified, for reasons discussed in point (v) onwards, the resultant standards were everything but of high quality. (iii) The naive proposition was also supported by regulatory groups such as IOSCO452 as well as politicians of G-20 who understood little of what they recommended. Very large international companies and investors in international markets who also stood to gain from not having to deal with different accounting regimes in the countries where they had interests. It was assumed that the FASB and the IASB were competent to produce “high quality” standards which were fit for use around the world. It was also assumed that culture, context and widely differing legal and regulatory framework in countries could be ignored or overruled by the converged standards. Scores of developing countries, hoping for inflows of investment capital from conformity with IFRS, promptly declared their adoption in name, and IASB loudly trumpeted these swollen number of “adoptions” to those who saw through the game and were reluctant to follow suit. (iv) Professors Fearnley and Sunder repeatedly warned about the obstacles to achieving global standards in August 2005453 and May 2006454,455 ie at an early stage of IFRS adoption. We believe that the concept of a common set of “high quality” accounting standards for use around the world has been seriously flawed from the outset and the IASB has misused its resources in a convergence project which was bound to fail. It let down its users, particularly in the EU, by concentrating on convergence with US GAAP instead of ensuring that the standards were of “high quality” for existing users. The UK government should not blindly support the principle of common global standards because of the self-interested lobbying by a relatively small number of large organisations. Also, as argued below, the IASB is not capable of producing “high quality” standards. Neither is it possible to achieve uniformity of results from a single set of rules in a world of economic, social, legal, and political diversity. 7. The accounting model, auditing and the banking crisis (i) There has been much criticism of the IFRS accounting model in the UK and in other countries since it was introduced in 2005. The complexity of the standards, (note ) 456 and the counterintuitive outcomes of some of the standards are best examined in the context of the banking crisis, the mark-to-market regime (under the comforting but misleading label of “fair value” accounting) for financial assets and liabilities and the incurred-loss regime for loan losses. (ii) These criticisms are not new. Extensive academic and practice debates have existed over the past century over the appropriateness of marking assets to their market prices for accounting purposes (note 457). More recently, Fearnley and Sunder criticised mark-to-market in the US context in 2007 before the depth of the crisis manifested itself and reinforced their views on 450

GAAP: Generally Accepted Accounting Principles. FASB: Financial Accounting Standards Board. 452 IOSCO: International Organisation of Securities Commissions. 453 Fearnley, S and Sunder, S, (2005). The headlong rush to global standards. Financial Times, 27 Oct, p. 14. 454 Fearnley, S and Sunder, S, (2006) Global Reporting Standards: The Esperanto of Accounting. (2006). Accountancy Magazine. May, P26. 455 When considering this debacle we are reminded of the words of A. E. Houseman in his Preface to Juvenal’s Satires. “Three minutes thought would suffice to find this out but thought is irksome and three minutes is a long time”. 456 Beattie, V, Fearnley, S and Hines, T (2009). The accounting standards debate: the academics. Finance Director Europe. April 2009. pp 16–17. 457 See Andrew G. Haldane, “Accounting for Bank Uncertainty,” Remarks given at the Information for Better Markets Conference, Institute of Chartered Accountants in England and Wales, December 19, 2011. 451

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1638 Parliamentary Commission on Banking Standards: Evidence

(iii)

(iv)

(v)

(vi)

(vii)

(viii)

(ix) 458

the impossibility of global convergence (note 458) demonstrating how a mark-to-market change in the rising market in the US had enabled US banks to report significantly higher profits. As the banking crisis developed, the House of Commons Treasury Committee set up an Inquiry in 2008 to which Fearnley, Beattie and Hines responded. They expressed concern about the complexity of IFRS and the mark to market accounting regime, which allowed unrealised gains on financial assets marked to a rising market to be treated as profits (note 459). Other academics, eg, Page and Rayman also criticised the accounting regime for the same reasons in their submissions (see below note 16). Rayman blamed bad financial theory and bad economic theory for the accounting failures. The IASB’s own submission to the Inquiry (see also note 14) was subsequently reinforced by evidence given by its Chairman, Sir David Tweedie. The submission makes the statement, subsequently repeated by Sir David: Fair value accounting did not cause the banking and credit crisis—it has simply helped to reveal it (note19). It is factually correct that accounting was not the cause of the crisis as there were other factors involved. However, this statement does not acknowledge that fair value played a role in causing the crisis by blowing up asset prices in a bubble market and allowing banks to book unrealised gains before the market for the overblown assets collapsed and prices marked to market fell dramatically. The IASB sought to glorify itself without admitting the problem its standards helped to create. It is disturbing that a body holding itself out as fit to set accounting standards for the world could make such a statement to a parliamentary committee. If the IASB was not aware of the problems its standards were causing, it is unfit for its self-proclaimed role as the world’s leading expert in accounting. If the IASB did know of the problems its standards were causing, it is incompetent in its duty to serve the public interest. The denial of accounting’s role in the crisis was repeated by the current IASB chairman Hans Hoogervoorst (note 20) in 2012. Unsurprisingly, the accounting establishments gave such broad support to IASB in submissions to the Treasury Committee that the latter shied away from seriously addressing the role of IASB’s standards in the financial crisis. The Committee also accepted the IASB’s contention that bank regulators are not a targeted user of financial statements produced under IFRS, and therefore these standards should not be evaluated on the basis of their consequences for prudential regulation, such as determining bank capital. It was suggested that bank regulators should establish separate accounting standards of their own to attain their prudential goals (which are often incompatible with the mark-to-market regime). The Committee also questioned the value of audit. After the Report of the House of Commons Treasury Committee Inquiry, the House of Lords Economic Affairs Committee set up an Inquiry into “Auditors: Market Concentration and their Role” in 2010. In the interim, more problems had emerged over the accounting for loan loss provisions. IASB had switched from expected-loss to incurred-loss provisioning on loans. Even in a normal economy, not all borrowers can be expected to pay their creditors in full. The expected-loss model considers this credit risk associated with bank’s a portfolio of debts, and recognises the appropriate amount as a loss at the time credit is extended, and when the estimated creditworthiness of the borrower changes. Under this model, the bank does not wait until a specific loan is in default to recognise the loss. In contrast, the incurred-loss model adopted and enforced by IASB in EU requires a provision for loss to be delayed until there is evidence of default. The definition of default can vary significantly. In the opening evidence session, Beattie and Fearnley (note 460) pointed out many problems of IFRS including (1) the mark-to-market accounting model; (2) incurred-loss model of loan loss provisioning; (3) the complexity of the presumably simpler “principles-based” IFRS; (4) dysfunctional consequences of attempts to converge with US GAAP; (5) the compliance-driven regime undermining the true-and-fair view; (6) the absence of the principle of substance-overform and its consequences; (7) the identification of distributable profits under the mark-tomarket regime and disbursement of dividends and bonuses out of paper gains; and (8) the loss of prudence associated with the IFRS switch from lower-of-cost-or-market to mark-to-market regime. They also pointed out that although the House of Lords Inquiry was focussed on auditing, it was essential for the Committee to appreciate that auditing is a subset of accounting. Therefore, if the accounting model with which auditors are required to comply is defective, under a strong enforcement regime such as the UK has, the defects would leak through to the audited accounts. Other witnesses criticised the mark-to-market regime, the loan loss provisioning and the abandonment of the principle of prudence in financial reporting. A comment from Steve Cooper of the IASB claimed that: prudence does permeate accounting standards, revenue recognition, and all sorts of areas. We are careful to make sure that profits

Fearnley, S and Sunder, S, (2007). Pursuit of convergence is coming at too high a cost. Financial Times. 23 August. House of Commons Treasury Committee: Banking Crisis (2009) : Volume 2 Written Evidence. Beattie et al EV.10; Page EV.5; Rayman EV 59. IASB EV 66. http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/144/144ii.pdf. 460 House of Lords Economic Affairs Committee (2011) Auditors: Market Concentration and their Role. Vol 2. Evidence. Pp. 1–27. http://www.publications.parliament.uk/pa/ld201011/ldselect/ldeconaf/119/119ii.pdf. 459

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1639

are only recognised when they really are profits. Since mark-to-market accounting in illiquid markets can hardly be described as prudent, the logical basis of IASB’s position remains mysteriously vague. The IASB used a euphemism “improved” when it furiously back-pedalled from its incurred loan loss disaster in light of experience with financial crisis. Since this “improvement” will have to wait at least till 2016 to be implemented, there is a yawning gap between IASB’s rhetoric and acts. Since serious differences have arisen between IASB and US FASB on which model is of “higher quality” as the single standard for the world, even 2016 may not see the implementation. This is just one more example of the impossibility of attaining a single set of global accounting standards. (x) Unlike most aspects of human endeavour, creativity and innovation are not appreciated in accounting. Indeed, they have an unsavoury connotation in this context, because they imply a deviation from tried and true, and well-understood principles of prudence (conservatism) in order to maintain trust and faith in the credibility of financial reports. Development of mathematical finance and financial engineering has goals which are the diametrical opposite of prudent accounting because the former seeks to design transactions, instruments, and organizations to manipulate what appears in the financial reports. In the pursuit of clear written accounting rules, the IASB and the FASB have fallen prey to financial engineering innovation; the more they clarify the rules, the easier it is for financial engineers to evade them through new designs. (xi) In addition to offering one side of the double-entry to a Parliamentary Committee and providing unhelpful evidence to the Economic Affairs Committee of the House of Lords, the IASB suggested that banks keep two sets of book, one for the shareholders and another for the regulators! The proposition that regulators are not a primary user of audited accounts remains in the IASB’s conceptual framework and was re-iterated by IASB chair Sir David Tweedie in a letter to the Financial Times on 29 March 2012. This letter was followed by a letter from Sir Chips Keswick (note 21) offering a donation of £1,000 to a charity chosen by anyone who could explain the IFRS gobbledegook as set out by Sir David. In response to Sir Chips’ letter a series of highly critical and at times mocking letters followed which ran for several days. (xii) The Economic Affairs Committee itself questioned if the banks who had been bailed out with large doses of taxpayer money shortly after their accounts had been signed off as true and fair were, indeed, going concerns on the date of the report. (xiii) We find it surprising that, following the debate on the Economic Affairs Committee Report, the government accepted IASB’s facile claim about the prudence in IFRS (note 21). Acceptance of IASB’s position on two sets of books, and rejection of bank regulators as legitimate and important users of audited accounts, also implies that accounting valuations are inappropriate for regulatory purposes’ (note 461 refers to note 20 para 192). While regulators are asked to make their own adjustment for capital maintenance, how would they know when accounting valuations are inappropriate? It may be observed that the recent changes made to the IASB conceptual framework such as the removal or prudence, reliability and accountability to regulators have emerged since the mark to market and loan loss provisioning changes began to be recognised as seriously problematic. (xiv) Countries, such as India and China have hesitated to adopt IFRS in their entirety, and have indicated their intent to deviate when it suits their interest. Japan also has not come aboard after several years of intensive deliberations. Despite having absorbed huge resources the IASB and the US FASB could not reach agreement on changes needed to the standards in the wake of the banking crisis. They have substantially weakened their commitment to work towards convergence, and seem intent to go their own respective ways. In June 2012, Fearnley and Sunder published another article in the Financial Times yet again emphasising the impossibility of a single set of global standards and questioning the trustworthiness of the IASB (note 22). In July 2012 the US SEC issued a staff paper making it clear that in the short to medium term the SEC was not going to approve IFRS (note 22) adoption. One reason given was that there was insufficient support for the changeover to IFRS in the US. It is surprising that it has taken them so long to acknowledge this key fact. (xv) Questions were raised in the UK almost immediately after the introduction of IFRS about compatibility between the new EU Regulation and the UK company law. That accounts should show a true-and-fair view as well as comply with accounting standards and other regulations has been a long standing principle in UK company law. Some took the view that IAS 1 (a part of IASB’s IFRS suite of standards) weakened the true-and-fair view and, in spite of IASB rhetoric to the contrary, drove companies towards a rules-based accounting regime closer to US GAAP (note 462). After these concerns were raised, the need for accounts to show a true-andfair view was emphasised in the 2006 Companies Act; yet it remain ambiguous whether the 461 462

Note 20 para 196. Plender, John (2005). Battle for Truth in European Accounts. Financial Times, July 11.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1640 Parliamentary Commission on Banking Standards: Evidence

true-and-fair perspective is or is not a part of the current regime in UK (note 463). Also concerns have been expressed as to whether accounts prepared under IFRS and the current auditing regime show the economic substance of a business, especially when the business is a bank. (xvi) There are inevitable questions about the role of auditors in the crisis. The concerns about trueand-fair view, going concern and the payment of dividends and bonuses out of unrealised profits of banks as a result of the IFRS’s mark-to-market and incurred-loss provisions have been widespread for some time. Yet, no reference in public to the impact of these changes in inflating profits of the banks has been made by auditors and representatives of the accounting profession. Neither has the widespread unpopularity of IFRS among preparers (see note 15) and audit partners as a results of its complexity and lack of understandability received much acknowledgement. (xvii) In respect of the true-and-fair view and going concern, the auditors have faced a dilemma in that compliance with the IFRS standards was expected under the UK’s strong enforcement regime. Prior to the introduction of IFRS, the true-and-fair view was used by auditors in negotiating with clients when the latter pressed for deviation from law or regulation (note 24) to make the results look better. The threat of a qualified report from an auditor that the accounts did not show a true-and-fair view usually sufficed to persuade clients to abandon such aggressive postures. (xviii) In absence of a standard to account for a particular transaction(note 464) the true-and-fair view was used to negotiate an accounting treatment which was acceptable to the auditor. Application of IFRS to banks confronted auditors with the choice between accepting overstatements and deviating from the written standard. IFRS strongly discouraged auditors from deviating for the standard in this new situation. Auditors, as well as the UK Accounting Standards Board, unfortunately chose silence at the time and now face criticism for not challenging the inflated numbers from a true-and-fair view perspective. There can be little doubt that the auditors would have known of the inflated profits. The large firms and the professional accounting bodies pursued their significant economic interest in promoting a global accounting model and supporting the IASB. Whether they pursued their duty to serve the public interest remains unclear. (xix) Going forward, a number of initiatives to improve audit reporting, disclosure and the role of auditors and directors in going concern issues are on the table. Given the seriousness of the past failures to make stakeholders aware of the uncertainty associated with banks’ financial reports, it does not seem prudent to wait for the outcome of these proposals. Instead, urgent steps are needed towards a stronger regime for auditors and companies to report accounts that reflect the economic substance of their business. We recommend from the evidence shown above that the UK government should no longer trust the IASB standards to produce credible accounting numbers, which are drawn up under the principles of prudence and reliability, show a true-and-fair view and reflect the economic substance of the business. Also it is clear that the true-and-fair view requirement has not been retained in IFRS. Therefore UK company law should be changed so that directors and auditors are required to report that the accounting numbers are prudent, reliable, show a true-and-fair view and reflect the economic substance of the reporting entity. Both directors and auditors should be required to override the IFRS standards and conceptual framework as necessary. In the case of banks the agreement of the banking regulator should be required. In the case of other companies the market regulator should be consulted. 3 September 2012

Written evidence from Simon Hussey Banking Standards Inquiry RE: PCBS. How the FSA’s failure to assist whistleblowers in financial services (the FSA has never acted, assisted, intervened or sanctioned a firm that fired a financial whistle-blower) is putting the UK financial system at risk. And how the PCBS can make a simple recommendation in its report finding—whereby ALL financial whistleblowing cases are required to be heard by a tribunal hosted by the FSA (or PRA) ahead of any employment tribunal proceedings (ala General Medical Council) in order to assist regulators and establish the merits and bone fides of so-called “Whistle-blowers” claims. The intent would be to give regulators (FSA or PRA) an inside seat at the workings and alleged whistleblowing at regulated firms in order to “nip problems in the bud” and save taxpayers from bigger issues and later bailouts. 463

Beattie, V, Fearnley, S and Hines, T Reaching Key Financial Reporting Decisions: how Directors and Auditors Interact. 370pp. Wiley. London, find that after the introduction of various reforms following the Enron crisis, the UK now has a more compliance driven accounting and auditing regime. 464 See also note 27.

cobber Pack: U PL: CWE1 [O]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Parliamentary Commission on Banking Standards: Evidence Ev 1641

1. Background and history of frauds and financial scandals in the UK: I. *** II. Most Frauds or scandals in financial services are uncovered by insiders—employees of the firm and not by regulators or by City analysts. The US frauds at Enron (2001—$30 billion), WorldCom (2002—$50 billion plus) were uncovered by diligent employees. Indeed the auditors (Arthur Anderson was complicit in the Enron fraud). III. The UK and therefore FSA regulated entities have experienced many financial services frauds: BCCI (1991 £20 billion collapse); Barings (1995 £1 billion collapse), Sumitomo (1995 $1.8 billion loss “Copper scandal”); Credit Suisse (2008—€3.5 billion mismarked CDO book); UBS (2011—$2 billion-$6 billion) with the current Kweku Adoboli case, where all unearthed by insiders NOT regulators. IV. The recklessness of RBS (required a £47 billion UK cash injection) and HBOS (required a £17 billion UK cash injection) was well known to insiders who were silenced, pushed out or fired (Paul Moore—Head of Risk at HBOS evidence to TSC). V. The National Audit Office (NAO) calculated the current financial crisis has cost the UK £67 billion in direct equity investment in saving banks like RBS, HBOS, Northern Rock, and £1.2 trillion (peak) in indirect subsidies to the banking sector via programs such as the £250 billion asset protection scheme (RBS), UK issuing guarantees to banks, and the Bank of England “repo” facilities. (NAO July 2012: HM Treasury Resource Accounts) VI. A Freedom of Information (FOI) request by the BBC to the FSA revealed—the FSA has never intervened in a financial whistleblowing case or sanctioned a financial firm that fired a whistleblower, since the introduction of Public Interest Disclosure Act (PIDA) 1998. So in the FSA’s discredited eyes, we have a 100% perfect financial system. It’s as if the financial crisis, Northern Rock, RBS and HBOS bailouts, LIBOR scandal, PPI and now SME interest rate swap scandals never happened. VII. The FSA’s stance is in direct contravention of its own handbook “The FSA encourages firms to be responsive to whistleblowers under the Public Interest Disclosure Act 1998—law since 1999. It can help nip problems in the bud, preventing or limiting any harm to the firm or its customers”. “The FSA would regard as a serious matter any evidence that a firm had acted to the determent of a worker because he had made a protected disclosure about matters which are relevant to the functions of the FSA”. VIII. Lord Turner, executive chairman of the FSA declined a BBC interview to defend the FSA’s record (or lack of it) on whistleblowing in the financial sector. BBC Newsnight link: http://www.youtube.com/watch?v=_Hz8PinmVEA&feature=youtu.be 2. Why Nobody Should Whistle-Blow in UK Financial Services: I. Financial services companies and UK law discourages whistleblowing. Banks adopt brutal tactics to discredit and discourage whistleblowing in the financial sector: (a) Cost—legal fees incurred by an employee are circa £400,000—£750,000 (post tax income) and non-deductible unlike those incurred by the bank which are tax and VAT deductible. Banks can offset their legal cost as a business expense, whistle-blowers get no such tax relief and all legal costs are from post-tax income in effect doubling their costs (ie £400,000 legal fees mean a whistle-blower must have £800,000 tax earnings or savings. (b) Financial—squeezing the employee by withholding past deferred compensation even if due as a bargaining position to dissuade the any would be whistle-blower. (c) Reputation—destroying the employee’s reputation in the press (d) Evidence—Banks will withhold and manipulating evidence. 3. Why Banks and the BBA (British Bankers’ Association) Cannot be Trusted: I. It is a matter of public record that LIBOR scandal was BBA member banks lying to the BBA on the most critical global interest benchmark—LIBOR. The scandal and subsequent fines are proof that banks cannot be trusted. The BBA is a discredited organisation looking for role. Its suggestion to the PCBS that it is now fit to police a register of so-called “rogue bankers” is ludicrous and laughable. There should be only one register of “approved persons” and that should reside with the FSA or its successor PRA. II. Recent disclosure of the pressure Barclay’s ex-chair Marcus Agius, as a BBA member put on Angela Knight—then BBA CEO, suggests banks will attempt to exercise undue influence.

cobber Pack: U PL: CWE1 [E]

Processed: [19-06-2013 16:51] Job: 027059 Unit: PG02

Ev 1642 Parliamentary Commission on Banking Standards: Evidence

4. How Current UK Employment Law Requires all Financial Whistleblowing Cases to Come Before Financial (Challenged) Employment Tribunals: I. Presently, UK employment law requires all whistleblowing cases (as they are an employment matter), to be heard by employment tribunals. Employment tribunals are ill equipped to deal with financial whistleblowing—being staffed by part-time, often county solicitors, doubling as chair, a so-called business man and former union member or worker. From actual experience, few would know the difference between a CDO and a UFO, a pivot hedge and a hedge fund. II. Often, the sole financial experience of a tribunal—is having a bank account or mortgage. However wellintentioned these individuals are, the current financial crisis has manifestly demonstrated, that in many cases, the management of major financial institutions did not or failed to understand the businesses and risks they were running. It is a matter of record that NO UK bank CEO has survived the crisis—Peter Sands of Standard Chartered being the exception. 5. What the PCBS and do to Remedy the Situation: I. The PCBS, in its findings could encourage a proactive FSA or Bank of England Prudential Regulatory Authority (PRA), without ANY change in law, by recommending in its report—that all financial whistleblowing cases first be held in front the FSA (or PRA), in a system akin to doctors being forced in front of the General Medical Council (GMC) for “disciplinary and professional mis-conduct” hearings. The purpose would be for all parties, including the FSA, to hear the whistleblower’s evidence and the firm’s defence, to opine, if, it is relevant to the “functions and activities of the FSA”. This would give the FSA (or PRA) a “window” and “ring side” seat on the activities happening in the firm. The FSA report would then be available for any subsequent employment tribunal hearings as evidence to assisting the employment tribunal in its findings. This would greatly ease time wasting by non bona fide whistleblowing cases. To date, No financial whistleblower has won a UK employment case. 23 October