What ultimately caused the crisis that led to the collapse of two of Britain’s largest banks? Peter Westmore reports.
Reckless salary packages which encouraged senior bank executives to take risks with their institutions’ funds, were an important contributor to the British banking crisis, a recent British parliamentary inquiry has found.
The crisis led to the collapse of two of Britain’s largest banks, the Royal Bank of Scotland and Lloyds Banking Group, both of which have nevertheless been enabled to survive through direct government injections of taxpayers’ money.
The UK House of Commons Treasury Committee’s ninth report, Banking Crisis: reforming corporate governance and pay in the City, was tabled in the House of Commons on May 12, 2009.
It found systemic failures by non-executive directors, institutional shareholders, credit-rating agencies and auditors who are supposed to act as a check on, and balance to, senior managers and the executive boards of banks.
The inquiry found serious flaws and shortcomings in remuneration practices in the banking sector and, in particular, within investment banking.
The report said: “We found that bonus-driven remuneration structures encouraged reckless and excessive risk-taking and that the design of bonus schemes was not aligned with the interests of shareholders and the long-term sustainability of the banks.”
In relation to the salary packages of the two now part-nationalised banks, it said “there is a strong case for curbing or stopping bonus payments for senior staff in Lloyds Banking Group and Royal Bank of Scotland”, but accepted arguments that “if bonuses were prohibited at these banks, they would struggle to recruit and retain talented staff”.
It nevertheless called for reforms to make executive bonuses transparent. The Treasury Committee also found that independent directors had failed to provide effective oversight of management. It found “serious flaws and shortcomings in the system of non-executive oversight of bank executives in the banking sector. Too often, eminent and highly-regarded individuals failed to act as an effective check on, and challenge to, executive managers, instead operating as members of a ‘cosy club’.”
It found that institutional shareholders, who often control the majority of shares in large corporations, had shown little willingness to “scrutinise and monitor the decision of boards and executive management in the banking sector”. In some cases, they “encouraged the risk-taking that has proved the downfall of some great banks”.
It also found that credit-rating agencies (CRAs) often operated with a conflict of interests, because they rely on financial institutions for their income, while the agencies are rating their financial products.
“CRAs now operate an ‘issuer pays’ business model. This means that the issuer of debt or a financial instrument, as opposed to the user of the rating, pays the CRA for producing the ratings.
“The conflict of interest generated by this model can be characterised in a number of ways. Undeniably, CRAs have an interest in maintaining the income stream of fees from the issuers. Arguably, rating an issuer’s product increases the likelihood of an issuance being successful and therefore of the issuer continuing to thrive and therefore of future issuances with their associated fee payments taking place in the future.
“A more short-term characterisation of the conflict might be that clients may be more inclined to commission the services of a CRA whose reports appear flattering.”
The British inquiry found little evidence that this matter was being addressed by the banking and finance industry. It also concluded that the audit process failed to highlight developing problems in the banking sector, “leading us to question how useful audit currently is”.
The report added, “We also remain concerned about the issue of auditor independence and argue that investor confidence and trust in audit would be enhanced by a prohibition on audit firms conducting non-audit work for the same company.”
While the UK parliamentary committee’s report is, in effect, closing the stable door after the horse has bolted, it does highlight the institutional failures which contributed to the collapse.
The report followed an earlier report into the failure of the UK banks, released in April 2009, which found that “bankers have made an astonishing mess of the financial system”.
It found that over the past two years, the value of the top UK banks had fallen to 40 per cent of their pre-collapse price, measured by the stock exchange.
It found that five of the nine top banks in March 2007 “are now partly or wholly in public ownership. None of the four demutualised building societies … now exists as a stand-alone bank in its own right”.
It concluded: “Thousands of jobs in the financial services sector have been lost. The full implications of the credit squeeze on the UK’s industries and services remain unclear, but its impact is likely to be highly damaging. Unemployment is fast rising. The stock market has suffered severe losses.
“Property prices have fallen sharply and mortgages are much harder to obtain. Other lending has also contracted.
“It is hard to estimate what will be the eventual cost to public funds of the banking crisis, but the damage will be substantial and long-term.”
– Peter Westmore