Who should run banks?
The hapless Paul Flowers, former chairman of the Co-Op Bank, has been arrested and charged with possession of Class A drugs. The Flowers problem comes at the end of a simply horrible year for the Co-Op, in which it was forced to withdraw its bid to take on the TSB part of Lloyds TSB, its credit rating was downgraded to junk by Moody's and the PRA imposed capital requirements on it that it was unable to meet. It admitted in its half-year accounts that it was bust and proposed a recapitalisation plan that would have stiffed 15,000 grannies, only to see it trumped by two hedge funds who made the grannies a better offer - thereby presenting the world with the extraordinary spectacle of a group of vultures appearing considerably friendlier than the supposedly cuddly teddy bear that is the Co-Operative Group.
I don't intend to comment on Mr. Flowers's behaviour. The news reports speak for themselves. Though for me, the best bit was discovering that he had been chairman of a drugs charity. You couldn't make it up.
However, it is not Mr. Flowers's alleged criminal activities that are the main problem, nor his exorbitant expense claims, nor even his religious hypocrisy (he is a senior Methodist minister). No, the main problem is his incompetence. Among other things, in his presentation to the Treasury Select Committee he appeared to have no grasp whatsoever of the figures pertaining to the business he had been running. Jeremy Hunt asked on BBC Question Time:
"How did someone with no knowledge of banking become chairman of a bank?"
How indeed. It seems that Mr. Flowers reached this dizzy height by being very involved in the Co-Operatives Movement. He was appointed not because of his professional knowledge of banking (an incomplete ACIB qualification), nor even because of his expertise in business (almost entirely limited to co-operatives), but because of his political connections. As the Independent put it, it was the "worst kind of cronyism". And it shows not only the Co-Op Bank, but the Co-Op Group and even the Co-Operatives Movement itself in a very bad light. Appointing someone as head of a major bank purely on the basis of their political connections, even though they are otherwise in no way qualified for the job, is.....corruption, isn't it? And why on earth did the regulator approve the appointment of someone so manifestly unsuitable? As the FSA no longer exists, we may never know. But I fear this is yet another example of incompetence at an overstretched and politically captive regulator.
If only this were the only example of blatant cronyism resulting in inappropriate appointment. But it is not. In fact it seems top executives at failed UK banks were as a rule depressingly short of anything resembling genuine banking expertise. Iain Martin, in his book on RBS, notes that George Mathewson, an engineer by profession and a close friend of George Younger, the politician who chaired the RBS Board, was succeeded by Fred Goodwin, a chartered accountant. And he observes, in relation to Goodwin;
"Obviously Goodwin was an accountant not a banker by training, an oversight which was later to have important consequences for RBS and the British economy. The work of bankers and accountants overlaps to such an extent in a modern economy that it is often forgotten that originally they were envisaged as distinct types of work requiring contrasting worldviews".
He goes on to quote a veteran banker (my emphasis):
"An accountant exists to examine the numbers, take measurements, assess the situation and then put his or her signature on a piece of paper declaring that on a particular date everything that claimed to be there is there. A good banker knows that ultimately what he or she does rests on a benign white lie.....It is a construct built on trust. It all rests on creating sufficient confidence in order that everyone does not get worried enough to ask for their money back at the same moment. Because if they do the bank is probably sunk. Accountants and bankers should be different."
Goodwin's lack of knowledge of banking, and in particular investment banking, resulted in the bank that he ran taking insane risks without his knowledge, or at least without his understanding. Six years on from its collapse, RBS remains in hospital, though perhaps no longer in intensive care.
Over at HBOS, there was a similar set-up. James Crosby was an actuary by profession and spent his early career in life insurance. At least that is a financial industry, though in many ways insurance and banking are worlds apart. But he was a close friend of Gordon Brown, who appointed him to the board of the FSA while allowing him to remain as CEO of HBOS - a move which ended any possibility of effective regulation of HBOS during his tenure. And his successor, Andy Hornby, was a retail shopping man. He had been a senior executive at Asda before becoming Head of Retail and subsequently CEO of HBOS. It was symptomatic of the culture and beliefs of the time that retail banking and retail shopping should be seen as synonymous.....but in reality they are fundamentally different. As Kari Hale of Deloitte pointed out at the ICAEW's recent conference on the future of banking, at the heart of banking is risk - risk that can only be managed, not eliminated. In that respect banking is fundamentally different from any other sort of business.
The business of banks is accepting and managing risk in order to generate a positive return while minimising loss. Note that "managing" risk does not mean pushing it off the balance sheet, pretending it doesn't exist or dumping it on the unsuspecting. Unfortunately when someone running a bank does not understand what the fundamental business of the bank is, that is what they do. They fail to notice or report risks: they misprice products due to lack of understanding of the real risk: and they inadvertently transfer the risks they do not realise they are taking to their customers, their shareholders, their funders and ultimately to taxpayers.
At the LSE's recent debate on banking culture, Michael Powers of the Centre for the Analysis of Risk and Regulation observed that the position of the "risk function" in a bank was crucial. Risk management would be sidelined if the "risk function" was not central to the organisation and driven right from the top. Yet a look at the history of banks shows that in far too many, risk management has been seen as an optional extra. At UBS prior to its merger with SBC Warburg, Compliance functions reported to front-office directors - a clear conflict of interest. Other banks sideline risk and compliance in more subtle ways, typically by under-staffing, under-paying and excluding them from important decision-making. Board risk committees may be inappropriately staffed too: one of the problems highlighted at Barclays in the Salz review was the lack of banking expertise among non-executive directors, a problem by no means unique to Barclays.
With the FCA forcing through a new focus on customer service and market integrity, there is a need for risk management once again to become the primary business of banks. Banks cannot serve their customers well if they do not understand or care about the risks they are taking. A bank that will lend recklessly is dangerous not only to its depositors, bondholders and shareholders, but also to its borrowers. Lending too much to the wrong people is not good customer service. Sometimes the right thing to do is to say "no".
Too many banks have been brought down by incompetent management. Nor is this a new problem: the history of banking is littered with the corpses of those who lent unwisely, taking risks they did not understand, and paid the final price for their folly. The Co-Op Bank is only the latest addition to what is now a rather crowded graveyard.
So who should run banks? People who understand and are competent to manage the risks at the heart of banking. Never, ever again let banks be run by accountants, engineers, retail executives, ministers of religion or politicians. And never, ever again let someone be appointed to the board of a bank on the basis of who they know, rather than what they know. The people who should run banks are professional bankers.
Under the radar - Coppola Comment
Something's rotten in retail banking - Coppola Comment
Making it Happen: Fred Goodwin, RBS and the Men who Blew Up the World - Iain Martin (book)
Image from Wikimedia Commons.