Bank governance


BANK REFORM

GOVERNANCE 

          Under current legislation, at least two individuals must effectively direct the business of all UK banks and every director, controller or manager must be a fit and proper person to hold the particular position which he holds. In so determining, the Regulator may consider his probity, competence, diligence, soundness of judgement, financial standing and, indeed, “any business practices appearing to be deceitful or oppressive or otherwise improper (whether unlawful or not)”.

          So, what is the problem? Simply that everyone considers themselves to be fit and proper. Regulators have found it difficult to accuse individuals of failing the test without compelling evidence. ‘Whether unlawful or not’ sounds fine, but it is a matter of opinion whether a lawful and profitable business practice is such as merits banning a Banker. Would disqualification be upheld on appeal?

          There has been a temptation to leave recruitment of a Chief Executive to the Board of the bank concerned, but this very properly contains industrialists and investors whose primary concern is profitability.

          There are two areas where regulation can and should be tightened:-

          First, who are the individuals effectively directing the business? It is ludicrous to believe that anyone could effectively direct the mammoth clearing banks of today other than by means of a Chairman’s office comprising a small number of heads of divisions frequently updating the Chief Executive.

          Secondly, having identified the individuals concerned, are they competent in having the necessary skills and experience. Do they, for example, understand the complexities and risks inherent in the latest derivatives which their bank is trading?

          One pair of eyes who understands is not sufficient. There must be two individuals. When banks were better run, the two individuals were normally a full time executive Chairman and a Chief Executive backed up by two deputies. Now, Chairmen are sometimes part time with other business interests.

          Moreover, theoretical knowledge is rarely adequate. Professionals sit rigorous examinations but are not allowed to practice without serving as trainees. For example, would it be appropriate to have a Chief Inspector who had never been a branch manager or personally inspected a number of branches?

          Recent events suggest that the malaise in banking extends well below senior management to relatively junior staff who sell inappropriate products to the public in order to obtain bonuses. It is for consideration whether bonuses at all but the senior level should be banned and replaced by pay rises.

RECENT HISTORY

          The Preface to the first edition of Lingard’s Bank Security Documents published in March 1985 contains the following:-

‘Unfortunately, – – – banks from overseas – – – flood into London. Such banks often lend at highly competitive rates to strong customers. The result has been to increase the competitive pressures on banks to a point where they are sometimes denied the detailed financial information needed to make a proper assessment of the prospects of a company – – -. Unless these pressures abate, the authorities may well find they have to mount some bank rescues.’ 

          The pressures increased and were compounded by credit default swaps under which gullible banks participated in bad loans in return for fees which enhanced the bonuses of the ‘bankers’ responsible. Grossly inadequate provisions for the bad debts were made in the audited accounts and regulatory returns.

          The Preface to the fourth edition published in August 2006 – before the crash – again warned of “the distinct possibility of forthcoming troubled economic times”. Senior bankers were giving priority to selling the bank’s products in a highly competitive market and failed to invest adequate resources in risk assessment. Only recently is interest being shown by banks in risk assessing software available from major actuaries such as Towers Watson.

          The fifth edition as at 31st August 2011 has now been published to assist bankers and their advisers to structure sound security and sound lending and insolvency practitioners to identify defective security.

ESSENTIAL REFORMS

          The regulatory failures of the recent past have now been admitted and the Bank of England will again take charge. However, competitive pressures remain and the policy of the EEC and British Government is to increase competition by splitting some of the larger banks. This is desirable to assist in ensuring adequate governance and to fill voids left by cost cutting branch closures, but past experience has highlighted the dangers of too much competition.

          The question is: how will the regulators ensure that banks do adopt prudential risk assessment? Will overseas banks continue to take big risks to grab the business? And how will credit default swaps and other derivatives be policed?

The nub of the reforms now required is (a) the protection of depositors and (b) promotion of the UK economy by ensuring that retail deposits are used to finance UK businesses and house purchases. It is unacceptable that protected deposits are used to fund investment banking speculations, credit default swaps and such like. These may be profitable but are akin to gambling with other people’s money.

          Cash rich banks have and will inevitably attract predators. Present proposals envisage banks being controlled by supermarkets, grocers and other commercial entities. In the past, British banks have frequently been taken over by banks regulated in cultures which encourage and reward massive risk-taking of a type which caused the present crisis.

          The solution surely is that in return for having deposits with them protected under the Deposit Protection Scheme, deposit taking banks and building societies must (a) be controlled and managed by ‘fit and proper’ retail bankers with relevant lending experience and (b) comply with defined criteria.

1. A cap could be placed by the regulator on the maximum amount lent to any borrower group, region, country or sector.

2. A specified percentage of deposits could be restricted to be used solely for lending to UK small businesses / house purchases – deposits surplus to lending being lodged with the Bank of England.

3. Such activities would no longer require highly paid risk takers.

4. The Bank of England to be empowered to prevent takeovers.

          The above restrictions would not apply to banks which do not take deposits covered by the Deposit Protection Scheme.

          Who would provide the capital for the deposit taking banks? I suggest the present High Street banks hive down and decouple their deposit taking branches, distributing shares in the new entities to their then existing shareholders. Such shares would ideally be listed on the Stock Exchange. 

James Lingard 

James Lingard is a retired partner in Norton Rose who specialised in banking and insolvency law. He was Chairman of the Banking Law Sub Committee of the City of London Law Society and the original author of Lingard’s Bank Security Documents (LexisNexis Butterworths) and Bankers to Bankruptcy (Kindle/M-Y ebooks)

This paper will shortly be available in the Risk Library

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