The Organisational Behaviour section of this website summarises the difficulties caused by the often unpredictable and sometimes antisocial behaviour of larger organisations. This page describes some of the most serious failures of regulation of recent years..
The Financial Crisis
A number of factors interacted to cause the financial crisis of the early 21st Century. In particular, there was clear evidence of a willingness to exploit the vulnerability of their customers (see separate note on consumer protection) together with plenty of herd behaviour, groupthink, cognitive dissonance and the Prevention Paradox, as well as classic principal-agent problems. (Click here for a detailed discussion of these five behaviours.)
It was fairly obvious at the time, and subsequently it became crystal clear, that the individual financial institutions - and in particular their Boards - did not appreciate or did not care about:
- the riskiness of sub-prime lending (mainly in the US); nor..
- the riskiness of mortgages which represented a high proportion of asset value and/or of loans which were based on "self-certified" and hence exaggerated borrower income (both in the UK); nor..
- the riskiness of certain commercial lending made by certain aggressive lenders; nor..
- the dangers posed by off-balance sheet borrowing (as particularly evidenced by Enron and Lehman Bros - see the Valukas report's reference to "actionable balance sheet manipulation"); nor..
- the riskiness of relying on wholesale markets, instead of retail deposits, for their funding; nor the dangerous short-term incentives that were built into bonus structures; nor..
- the fact that the apparently clever spreading of risk via CDOs did not in fact reduce the total risk undertaken by the financial institutions when taken together, nor ...
- the fact that between 1986 and 2006 the average annual return on banking rose from its historical norm of 2% to 16%, as a result of the banks taking riskier bets, and rising leverage - which in practice amount to the same thing. There was no skill, efficiency, intelligence or judgement involved.
Alistair Darling was Chancellor of the Exchequer during the 2008 financial crisis and tells the nice story that, the night after Royal Bank of Scotland went belly up, he was taken aside by the chairman of one of Britain's biggest banks and offered the reassurance that 'they had had a meeting last night and decided that, from now on, we will only take on risks that we understand'.
Indeed, as Alex Brummer said in in The Crunch:- "There was a central paradox at the heart of the mortgage boom. How as it possible to make money by lending large sums to people who had not a hope in hell of paying it back?"
The interesting thing about the incipient financial crisis was that there were plenty of hard indicators which backed up the critics' warnings that something odd was going on.
- It was pretty obvious that senior appointments in major banks were made on the basis of 'who you knew' rather than through any objective process. (Four of Lehman's ten outside directors were over 74 years old.)
- Investment banks were leveraged to an unprecedented degree. (Lehman Brothers were leveraged at 30.7 to 1.)
- All large financial institutions earned very big profits year after year.
- And investment banks paid (and still pay) fantastically high salaries and bonuses, not just for genuine stars but for people who could never have earned anything like the same income in any other walk of life (see Notes 2 and 3 below).
- It was far from clear why these profits and incomes were not competed away over time.
- Equally worrying, the media was full of stories of institutions' unethical behaviour:- retail customers receiving unfair treatment - high penalty charges, surreptitious reductions in interest rates, and so on.
- And then there was the the fantastic growth in the unregulated shadow banking systems.
- Indeed, much financial innovation was (and probably still is) principally intended to get round regulation, for instance by reclassifying businesses as anything but banks.
Some banks (including Goldman Sachs, JP Morgan and Cantor Fitzgerald) did understand the risks and did take steps to reduce their exposure to them. But most of the major banks did not. As Margaret Heffernan says, in Wilful Blindness, 'As long as everyone was making money, many CEOs either didn't see a reason to change, or lacked the courage to do so'.
Another interesting point is that the deregulation and light touch regulation that preceded the crisis was encouraged by the mainstream banks who complained that the old-style separation of investment and commercial banking - designed to protect the latter from the risks associated with the former - led to their competing on an uneven playing field with a plethora of other, non-bank institutions which weren't subject to the same rules. They were making a valid point, but the wrong way round. More regulation was needed - of the new inter-linked non-banks banks.
By the end of the financial crisis, the UK taxpayers' support for the banking sector totalled £850 billion, and the cost of the consequential economic recession was estimated by the Bank of England to be up to £7,400 billion (Andrew Haldane speaking in Hong Kong in March 2010).
Those interested in the detail are recommended to read Adam Tooze's Crashed: How a Decade of Financial Crises Changed the World.
It also turns out that it was well known that LIBOR was being manipulated (see further below). Writing in the FT in July 2012, Douglas Keenan said that:
'In 1991 I had live trading screens that showed the Libor rates. In September of that year, on the third Wednesday, at 11 o'clock, I watched those screens to see where the futures contract should settle. Shortly afterwards, Liffe announced the contract settlement rate. Its rate was different from what had been shown on my screens, by a few hundredths of a per cent. As a result, I lost money. The amount was insignificant for me, but I believed that I had been defrauded and I complained to Liffe. Liffe explained that the settlement rate was not determined by what rates were actually in the market. Instead, the British Bankers Association polled banks, asking them what the rates were. The highest and lowest quoted rates were discarded and the rest were averaged, giving the settlement rate. Liffe explained that, in doing this, they were adhering to the terms of the contract. I talked with some of my more experienced colleagues about this. They told me banks misreported the Libor rates in a way that would generally bring them profits. I had been unaware of that, as I was relatively new to financial trading. My naivety seemed to be humorous to my colleagues.'
But there appears to have been no serious attempt to hold senior staff to account. Facing criticism from the Upper Tribunal, which hears appeals against decisions by financial regulators, the Financial Conduct Authority said that "the documentation that is referred to as fingering senior people is not extensive. ... As is the way of these things, the senior people somehow manage to keep their fingerprints off the relevant documents sometimes." There is little sign, however, that senior managers were treated other than very gently, or subjected to rigorous interview and investigation.
The Psychology of Legislators and Regulators
The standard riposte to all the above is that - if the problems were so very obvious - why didn't more investors start selling their shareholdings and taking other steps to shield themselves from the coming storm? One answer, of course, was that the banks were benefitting from the implicit government subsidy (and the moral hazard) associated with being 'too big to fail'. This not only cut their borrowing costs but also encouraged risk taking. (See also note 4 below.)
Another answer, I suggest, is that both regulators and their governments were to some extent caught up in the herd behaviour and groupthink, but were in particular the victims of cognitive dissonance and the prevention paradox. National governments, standing behind the institutions, the investors and the regulators, certainly appeared oblivious to the growing danger, and to the scale of the danger, despite all the warnings. But they were also very keen to promote the virtues of 'light-touch' regulation, especially as a way of supporting an industry which appeared to be generating large profits, large tax revenues, and significant employment. No government or national regulator dared step out of line for fear of deterring financial institutions from investing in their countries. But there was a clear (and with hindsight clearly dangerous) erosion of regulatory independence.
The UK government even failed to act on its own HM Treasury/FSA/Bank of England November 2006 'war game' which showed that the UK government's investor compensation scheme was inadequate and could too easily cause panic, as happened on 14-17 September 2007 when there was a run on Northern Rock. The Treasury's own March 2012 'lessons learned' report identified a number of causes of its own and regulators' failure, including serious tensions between the Treasury, the Bank of England and the Financial Services Authority. Particularly noteworthy, however, were the report's portrayal (to quote Larry Elliott) of 'a department bedazzled by the City and captured by groupthink'. However, even this report did not (for obvious reasons) criticise politician's pressure on regulators to apply the lightest possible of regulatory touches.
One must nevertheless acknowledge the difficulty of regulating large global banks which, as the Economist noted, 'have been a nightmare to run. ... Citi is in 101 countries, employs 241,000 people and has over 10,000 properties ... No boss but Jamie Dimon of JP Morgan Chase gives a convincing impression of being in full control - and even he suffered a $6 billion trading loss in 2012.'
But incompetence or complacency surely played a part as well. It is not much of a defence to note that government and regulators did not appear to be aware that the credit rating agencies themselves did not understand the risks associated with the financial instruments (SIVs (structured investment vehicles), SPVs (special purpose vehicles) and the rest that they were rating, and/or were conflicted because they were being paid by those designing ever-more-complicated instruments rather than those buying them. And financial regulators (the Bank of England and the FSA in the UK) also did not know or did not understand what risks the institutions were taking with the financial instruments or off-balance sheet vehicles, nor did they seem at all concerned that financial deregulation, on both sides of the Atlantic and in Japan, allowed even the regulated banks to lend to a much wider (and riskier) range of borrowers, and failed to recognise the 'moral hazard' associated with such lending. The moral hazard is that the risk-taking borrower wins if his risk pays off, but the bank (and the state behind it) loses if it all goes catastrophically wrong. Finally, both regulators and investors did not seem to appreciate that the hedge funds' models were bound to lead to eventual large losses, perhaps after many apparently good years.
Further depressing evidence of the Bank of England's incompetence became available in January 2015 with the release of 500 pages of minutes of the meetings of its Court of Directors between June 2007 and May 2009. The Financial Times led its report on the documents by noting that Lord King, the Bank's Governor, had kept the Court (its governing body) 'in the dark on internal dissent, denied non-executive directors information about financial stability and fell out with them over alleged leaks'.
The failure of Halifax Bank of Scotland (HBOS) (and its rescue by Lloyds Bank) was perhaps the biggest event of the UK experience of the financial crisis. Subsequent analysis, including two reports published jointly by the Financial Conduct Authority and the Prudential Regulation Authority in November 2015, make sad reading, noting for instance that the FCA's predecessor, the Financial Services Authority, was a 'deficient' regulator which was 'too trusting of firms' management and insufficiently challenging'. The general view within the regulator, one enforcement manager said, was that 'enforcement against big bankers had become virtually impossible'.
The reports go on to reveal that the FSA's Chief Executive Hector Sants and its Director of Enforcement Margaret Cole would not take responsibility, or could not remember, or disagreed about why senior HBOS executives and Board Members had not been fined or banned from taking further City appointments. The minutes of crucial FSA meetings were unclear and no definite record was made of important decisions, still less who had made them. One perceptive commentator, Daniel Davies, commented that:
'Given the benefit of hindsight, the [authors] are good at spotting cultural failings at HBOS but overlook the weaknesses in their predecessor organisation, the Financial Services Authority. Regulators were under pressure, they say, because of the laissez-faire attitude of the times, the economics of the Great Moderation and, of course, sparse resources. All these things mattered. But they have little to say about an office culture in which responsibility for crucial decisions was always fudged and awkward questions were avoided or passed on to “neutral” outside parties. ... If the defining cultural weakness of HBOS was arrogance and myopia, the defining weakness of the old FSA was a paralysing fear of doing something that might be criticised. And just as an obsession with growth caused HBOS to dwindle to nothing, the regulators’ fear of being criticised has led them to greater depths of opprobrium.'
The likely end of this unpleasant saga came in September 2022 when a joint PRC/FCA review of their previous decisions concluded, yet again, that no further action should be taken against any HBOS directors or senior managers because of 'legal restrictions' - but the regulators refused to say what those restrictions might be. It seems more than likely that one factor in their decision making was that both regulators were keen to avoid further embarrassment.
Major UK Banks
But there were plenty of other things going wrong within major banks. The following is far from a complete list.
Following persistent stories (mentioned above) of unethical behaviour throughout the 'noughties', Barclays were the first of the major UK banks to admit manipulating LIBOR (the economically vital London Interbank Offered Rate) both to inflate their own profits but also, probably, to avoid appearing financially stretched. They were fined £290m and many more banks were subsequently fined, and employees prosecuted, in the UK, US and elsewhere. UBS, for instance, paid fines totaling $1,500m imposed by a number of regulators. At least 45 UBS traders, managers and senior managers were involved in, or aware of, the attempts at manipulation, and investigators found at least 2,000 requests for improper submissions. The misbehaviour spanned three continents and was widely discussed on group emails and in internal chat forums. UBS' internal compliance function failed to pick it up, despite making five audits of this part of the bank during the period.
Deutsche Bank was one of the leading culprits and angered the regulators even more by deliberately obstructing their investigation, including lying to them. The bank was fined a total of £1.7 billion in the US and UK and was ordered to fire seven staff ('though one wonders why they had not done so on their own accord).
It was far from clear why regulators had not reacted much more quickly to the persistent rumours of serious problems. The FT's Gillian Tett ruefully reminded her readers that she had tried to expose the problems back in 2007, only to be accused, by the industry, of 'scaremongering'. But the generality of politicians (as distinct from a minority) at last turned on the industry, as did Sir Mervyn King, the Governor of the Bank of England, who demanded immediate and far-reaching action to reform the structure and culture of the UK banking industry:- "That goes to both the culture in the banking industry and to the structure of the banking industry, from excessive levels of compensation, shoddy treatment of customers, to deceitful manipulation of one of the most important interest rates and now this morning to news of yet another mis-selling scandal." But he, of course, appeared to have done little or nothing to address these cultural problems until they exploded in his face.
The FCA failed, however, to hold senior executives to account. Its counsel ruefully admitted that "As is the way of these things, the senior people somehow manage to keep their fingerprints off the relevant documents".
The LIBOR revelations came hard on the heels of admissions, by Barclays and many other banks, that they had mis-sold Interest Rate Derivatives to very small firms. In 2013 the FSA entered into agreements with nine banks, which resulted in over £2.2 billion in compensation being paid by those banks to thousands of customers who had been mis-sold Interest Rate Hedging Products, or IRHPs, over the period from 2001- 2011.
All the major UK clearing banks had mis-sold huge amounts of PPI (payment protection insurance) to the wider public.
There had also been persistent criticism of the fees earned by fund managers:- see for instance The Times 6 November 2010: 'The ten things that Fund Managers do not want you to know about'. And only the most active savers had been able to achieve a fair return on their savings. Which? reported in November 2010 that "Of 188 accounts offered by the five biggest banking groups for savings ... 90 pay 0.1% or less interest each year, while 141 pay 0.5% or less." (The best account paid 2.89%.).
Over in the US, Goldman Sachs' Board member (and ex-McKinseys Chief Exec) Rajat Gupta had been found guilty of insider dealing whilst ...
... back in the UK "an employee of Zurich Advice Network received about £25,000 in commission after persuading ... a man in his late eighties who was suffering from cataracts, deafness and advancing dementia to make a series of wholly inappropriate investments ... the company denied any wrongdoing and forced the man's son to go through years of stress ... the ombudsman decided that the investments were clearly mis-sold ... you might imagine that Zurich would [then] apologise and and bend over backwards to right the wrong ... You would be wrong ... the pattern of mis-selling by Zurich suggests that the company is simply unfazed by occasional visits by the ombudsman ... there is little incentive for Zurich or any other company to rein in rogue salesman." (Andrew Ellson, The Times 31 July 2010)
HSBC was fined £1,200m in December 2012 for allowing drug traffickers to launder £ billions in the US, and £ billions to be moved across e.g. the Libyan and Burmese borders in the face of sanctions. Their whole compliance team had been totally ineffective despite receiving many warnings and seeing many rules being broken. One email, internal to the compliance team, read as follows: 'Please note that you can dress up the USD10 million to be paid ... to the US authorities as an 'economic penalty' if you wish but a fine is a fine is a fine, and a hefty one at that ... What is this, the School of Low Expectations Banking? ('We didn't go to jail! We merely signed a settlement with the Feds for $10 million!') ... We have seen this movie before, and it ends badly'. One wonders if the author would have done more if he had suspected that the fine would be 100 times larger - or did he know that, as alleged by US investigators, the bank's business interests were trumping its compliance obligations?
HSBC was also heavily involved in facilitating tax avoidance. Somewhat surprisingly, its ex-Chief Executive and then ex-Chairman Stephen Green became a government minister in 2011, and previous non-exec director Rona Fairhead was deemed appropriate for appointment in 2014 as Chair of the BBC Trust.
It was reported in November 2013 that 15 of the World's biggest banks - again including Barclays - were being investigated for alleged manipulation of the £5.3 trillion-a-day foreign exchange market, resulting in higher costs for pension funds and many other bank clients.
The Royal Bank of Scotland was fined $100m by New York regulators in December 2013 for hiding transactions that breached US sanctions against Iran and other countries. The regulators noted that RBS' group heads of anti-money laundering, operational risk, and global transaction services were fully aware of what was going on. Needless to say, none of them were dismissed.
Lloyds Bank was fined £28m in the same month - and will likely have to pay £100m in compensation - for putting staff under intense pressure to sell products that customers did not want - or face demotion and pay cuts. One commentator, Aditya Chakrabortty, referenced The Hunger Games, noting that retail banking staff have been coerced into turning predatory - and we are their feedstock.
It was revealed in December 2013 that Paul Flowers, the regulator-approved Chairman of troubled Cooperative Bank (assets £47 billion), had no relevant experience and was an expense-fiddler and habitual drug-taker and rent-boy-user - facts which were on the public record and known to his previous employers.
The Guardian estimated in December 2013 that the total cost of fines and compensation, for 10 major US and European banks in the period 2008 to 2013, was £130,000,000,000. It was reported in August 2017 that the total for all banks had reached £150 billion.
RBS confessed, in March 2015, that they had mis-sold Enterprise Finance Guarantees (taxpayer backed loans) to small businesses.
The 2015 collapse of Invexstar Capital Management led to losses probably approaching £100m for a number of banks. The company was only months old and yet was able to trade billions of pounds of government and corporate bonds.
Later that year Barclays was fined £72m for entering into a £1.9 billion transaction which might have been used to launder money or finance terrorism.
The National Audit Office, reporting in February 2016, concluded that the Financial Conduct Authority did not know whether its activities were in fact reducing the overall scale of mis-selling to customers, and banks' handing of complaints had been 'poor'.
In July 2017 the Bank of England accused lenders of using balance sheet trickery and regulatory arbitrage to 'circumvent the spirit' of post-financial crisis rules. But banks' behaviour did not improve, and the Bank of England's Financial Policy Committee continued to appear quite toothless. See, for instance, Note 7 below.
Michael Lewis published Flash Boys in 2014/15, a fascinating critique of High-Frequency Trading. Just one example: In 2014 the clients of one giant US pension fund manager "were effectively paying a tax of roughly $240 million a year for the benefit of interacting with high-frequency traders in unfair markets".
After a fairly quiet period, the Financial Conduct Authority found itself under fire again in early 2019 when London & Capital Finance went bust, having given the impression to unsophisticated investors that FCA authorisation implied that its products too - bonds which offered 8% interest - were also FCA approved. But the FCA had first been tipped off about this misleading marketing as long ago as 2015.
And then the FT reported as follows in June 2019:
The Bank of England has found widespread weaknesses among the UK’s challenger banks in stress tests that showed new lenders cutting corners in an aggressive pursuit of growth. A senior regulator at the central bank wrote to chief executives this week, ordering them to tighten standards and correct “overly optimistic” risk modelling. In what was for some of them a damning assessment, the BoE found that many new lenders displayed an “inability to explain assumptions” in their stress-test models and an “aggressive” focus on growth, even though they tend to make riskier loans. The intervention shows that regulators are concerned about the behaviour of the challenger banks, whose rise has been encouraged in a bid to loosen the dominance of the big five high street lenders.
It is not strictly a regulatory issue but it is interesting to note that Nicholas Shaxson argues persuasively that the USA and UK suffer from The Finance Curse - see his book with the same name. Put shortly, the high proportion of the economy that is now devoted to financial services has greatly depressed growth in the wider economy. This is partly because the sector's wealth does not flow (or even trickle) into the wide economy, and partly because the sector's ridiculously high salaries and bonuses attract too many bright young people.
The underlying causes of the problems in the financial services are structural. Those who take the risks are not those who get stuck with the bill when it all goes wrong. The losers can be the shareholders, but many banks even became 'too big to fail' in which case risk-taking by City traders is like playing Russian roulette with someone else's head. Those traders who do not make money are soon fired, of course, but even that is counterproductive. "When you can be out of the door in five minutes, your horizon becomes five minutes", said one City worker.
So the structural problem created the cultural problem. "Dictum meum pactum" - My word is my bond - had become "Caveat emptor" - Buyer beware.
LIBOR's 1960's inventor, Minos Zombakis, was reported in 2012 as confirming that LIBOR was originally built on honesty and trust: It was a matter of behaviour; you always assumed that you were dealing with gentlemen, and you assumed that people acted honourably because they couldn't afford to act otherwise. But the culture within Barclays in particular had become very aggressive. There is also some evidence that there was a culture of fear within the bank, although an alternative view is that no trader would 'rock the boat' for fear of both losing his very well paid job and being branded unemployable in the industry. Whatever the truth, Bob Diamond took the credit for Barclays' culture for many years, although he hesitated to take the blame when that culture was shown to have caused problems. It is less clear whether he know what was going on within his organisation and if so whether he approved of it. (The principal agent problem?) He was certainly lauded by his peers and was one of the leaders of extensive herd behaviour.
But Mr Diamond's successor Martin Taylor (FT 9 July 2012) reported a somewhat similar serious failure of internal controls in Bob Diamond's part of Barclays in 1998. 'This breach was not made public, although the regulators were fully aware of it.' Fast forward to April 2012 and the FSA was writing direct to Barclays' Chairman expressing concern that 'Barclays often seems to be seeking 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'. But managements who have come to pride and value their aggression will not change their behaviour as a result of a mere chastising letter, and Barclays' reply is far from contrite. Bob Diamond, appearing before a Parliamentary committee only three months later, hardly seemed to have remembered the exchange of letters. This is a classic case of a gentlemanly regulator not having a clue - over a period of at least 14 years - how to handle such a large and badly-behaved regulated entity.
This saga reminds me that one of the 'big five' accountancy firms, Arthur Andersen, had a Barclays-like reputation with the UK tax authorities as long ago as the 1970s. They supported the most aggressive tax avoidance schemes, and were the least helpful when challenged in correspondence or meetings. They accordingly attracted staff and clients who saw nothing wrong with this. Fast forward, in this case thirty years, and one of their biggest clients was Enron ...
More generally, of course, financial regulators should be hanging their heads in shame at their failure to identify and tackle the failings summarised above. It is not good enough to come along with fines and demands for compensation many years later. The economic damage - to individuals, companies and the wider economy - had already been done and could not be repaired.
But little has changed. Philip Stephens appears to have been pretty well spot-on when he wrote the following in the FT in January 2014:
'It is time to admit defeat. The bankers have got away with it. They have seen off politicians, regulators and angry citizens alike to stroll triumphant from the ruins of the great crash. Some thought the shock of 2008 might change things. We were fools. Bankers are still collecting multi-million-dollar bonuses even as they shrug off multi billion-dollar fines. Countries and companies have gone bust, political leaders have fallen like skittles, and workers everywhere have been thrown out of jobs. We are all a lot poorer than we might have been. Yet on Wall Street and in the City of London, it is business as usual. Has the world been made safe for liberal financial capitalism? The short answer is No.
Two subsequent news items caught my attention. .. Take the whopping fine on JP Morgan. The institution led by Jamie Dimon is paying $2.6bn to settle criminal and civil claims linked to Bernard Madoff's Ponzi scheme. The penalty raised barely a ripple. No one in authority was vulgar enough to suggest Mr Dimon, once a poster boy for play-it-straight banking, might consider his position. .. What, anyway, is another couple of billion to an institution such as JP Morgan, which has totted up penalties of $20bn? In no other business would a chief executive survive such expensive ignominy. Bankers have made themselves an exception. The fines make only a small dent in the vast rents they extract from productive sectors of the economy. They may even be tax-deductible. With the Basel decision, rule-setters let big investment banks off the hook by easing new requirements on leverage ratios, thus limiting the amounts they have to raise in new capital to set against their casino trading activities. The concessions chalked up another success for the industry's slick public relations operation. Sometimes it almost seems the banks were victims rather than villains of the crash.
This has been the story since 2008. True, laws have been changed and regulations have been tightened to curb the most egregious dice games. Capital requirements have been raised a tad, lowering slightly the insurance risk to governments and reducing by the same small amount the implicit taxpayer subsidies that pay for the bankers' bonuses. The Dodd-Frank legislation has increased compliance burdens on Wall Street. Welcome as they are, these represent changes at the margin. The basic structure of the system - with its perverse incentives, too-big-to-fail institutions and too-powerful-to-jail executives - remains untouched. The universal banks, combining straightforward commercial banking with high-risk trading, live on. The result is that the organising purpose of banking - to provide essential lubrication for the real economy - remains entangled with dangerous and socially useless speculation.
Taxpayers are still providing big subsidies in the form of guarantees that, perversely, encourage banks to take more risks. In the absence of real competition, a self-sustaining oligopoly of senior bankers continues to set its own rewards. Banks complain about the fatter rule books, but what we have seen is a series of 'tweaks' rather than the radical shake-up needed to make the system safe. What Paul Volcker, the former US Federal Reserve chairman, has called the 'unfinished business' of reform remains just that.'
A similar conclusion was reached by Joris Luyendijk writing in The Guardian in September 2015. This extract begins with a quote from a City veteran:
''“Sometimes I feel as if finance has reacted to the crisis the way a motorist might after a near-accident, ... There is the adrenaline surge directly after the lucky escape, followed by the huge shock when you realise what could have happened. But as the journey continues and the scene recedes in the rear-view mirror, you tell yourself: maybe it wasn’t that bad. The memory of your panic fades, and you even begin to misremember what happened. Was it really that bad?" He was a soft-spoken man, the sort to send a text message if he is going to be five minutes late to a meeting. But now he was really angry: “If you had told people at the height of the crisis that years later we’d have had no fundamental changes, nobody would have believed you. Such was the panic and fear. But here we are. It’s back to business as usual. We went from ‘We nearly died from this’ to ‘We survived this’.” ...
...The European commission president, Jean-Claude Juncker, memorably said in 2013 that European politicians know very well what needs to be done to save the economy. They just don’t know how to get elected after doing it. A similar point could be made about the major parties in this country: they know very well what needs to be done to make finance safe again. They just don’t know where their campaign donations and second careers are going to come from once they have done it. Still, the complicity of mainstream politicians is not the whole story. Finance today is global, while democratically legitimate politics operates on a national level. Banks can play off one country or block of countries against the other, threatening to pack up and leave if a piece of regulation should be introduced that doesn’t agree with them. And they do, shamelessly. “OK, let us assume our country takes on its financial sector,” a mainstream European politician told me. “In that case, our banks and financial firms simply move elsewhere, meaning we will have lost our voice in international forums. Meanwhile, globally, nothing has changed.” This then opens up the most difficult question of all: how is the global financial sector to be brought back under control if there is no global political authority capable of challenging it?
Seven years after the collapse of Lehman Brothers, it is often said that nothing was learned from the crash. This is too optimistic. The big banks have surely drawn a lesson from the crash and its aftermath: that in the end there is very little they will not get away with.'
And the FT’s John Gapper, writing in 2018, noted that nothing much had changed when it came to giving advice. A $58m fee paid to Goldman Sachs in the USA was no more than “a kind of alchemy … less to ensure the best possible deal for the client than to make the believe they are getting it”.
BP - Texas City
An explosion at the Texas City Refinery in 2005 killed 15 workers and injured more than 150 others. The plant had been poorly maintained, was badly managed, had a strong blame culture, and had been subject to several rounds of cost-cutting whose safety implications were not understood. This was a clear example of BP's 'top brass' not having any understanding of what was happening deep down in their organisation:- the classic principal-agent problem.
BP - Deepwater Horizon
Rather like the major financial institutions in the run-up to the financial crisis, it became clear that BP's Board and their US regulators were not aware of the risks being taken by BP's staff and contractors managing the Deepwater Horizon drilling activity, a classic example of the principal agent problem in action. Indeed, the root cause of the disaster may have lain with the difference between BP's culture and that of Amoco, the American oil company which it had bought some years previously. BP preferred to delegate considerable responsibility to its operational managers, but expected them to behave responsibly and to be held accountable for their decisions. Amoco had a much more centralised and controlling management style. There are strengths and weaknesses in both approaches, but add the two together and the result might have been ex-Amoco teams whose behaviour was no longer closely monitored, and who had a good deal of freedom which they did not have the experience to handle. It is therefore interesting, though hardly surprising, that BP's board announced in late 2010 that it would tighten its oversight of the company's day-to-day operations.
Whether or not the above theory is true, the Head of the Presidential investigation into the disaster announced in November 2010 that they had identified "a culture of complacency" on the Deepwater Horizon rig, though he did not believe that this was driven by over-enthusiasm for cost-cutting. This is consistent with what we know of the consequences of principal-agent interaction within a large organisation. And the US National Academy of Sciences had previously said that BP had demonstrated inability to learn from past near misses and "insufficient consideration of risk".
It is also worth noting that the Academy also made serious criticisms of the "education, training and personnel of [regulatory] personnel involved in the oversight ... of deepwater exploration operations" and expressed concern about the failure of any one of "the multiplicity of regulatory agencies and classification societies" to develop "an overall perspective of the exploratory operation" and their individual failure to understand the duties of the other bodies.
The principal-agent problem was no doubt the main reason why the Mid Staffordshire Board and its regulators were not fully aware of the depth of the problems in Stafford Hospital where patients were left unwashed in their own filth for up to a month as nurses ignored their requests to use the toilet or change their sheets; four members of one family, including a new-born baby girl, died within 18 months after blunders at the hospital; and wards were left filthy with blood, discarded needles and used dressings while bullying managers made whistle-blowers too frightened to come forward.
Similar problems then came to light at Morecambe Bay NHS Foundation Trust, where 11 babies died as a result of a 'them and us' culture in which midwives at the Furness General Hospital - keen on natural birth - called themselves 'the musketeers' as they fought battles with doctors. Clinical records were destroyed and the Trust suppressed a critical report in order to get a clean bill of health from the regulators en route to achieving 'Foundation' status. Whistle-blowers alerted several regulators, all of whom failed to take effective action. The Trust's Chief Executive left with a £225,000 payoff and set up a consultancy, boasting of 'getting the best from teams'. It would be funny of it weren't so tragic.
And then there were the East Kent hospitals where 45 babies died due to appalling care between 2009 and 2020. One grieving mother was told that "It's God's will. God only takes the babies he wants to take."
More detail is in the Lessons Learned Report into the failings of the relevant regulator, the Nursing and Midwifery Council. The report was complied by the Professional Standards Authority whose Chief Executive made the obvious (though necessary) observation that "following the rules and being correct is not enough . You have also got to have humanity in the way in which you deal with people".
As an aside, huge credit is due to James and Hoa Titcombe who fought for years to have the nursing regulator take seriously their concerns following the death in Barrow of their new born son Joshua. The regulator, of course, began to see him as an annoyance.
Junior doctor Rachel Clarke tells another salutary tale here.
There was a particularly shocking failure of corporate ethics when several very senior GlaxoSmithKline executives ignored a whistle-blower's complaints in 2003 about contamination and mixed drug types and doses being put in the same bottles in GSK's Puerto Rico plant, probably because they feared the impact on US Food and Drink Administration approval of new products. GSK were seven years later fined $750m, of which the whistle-blower received $96m. But I said at the time that I would not be surprised if GSK privately were to believe that they would do the same again in the same circumstances. The company made a pre-tax profit of £2.25 billion in the three months to December 31 2009, so the fine was hardly catastrophic; almost all the (very highly paid) executives remained in post; and neither the company nor its executives appeared to have suffered significant reputational damage.
My scepticism appeared to have been justified when GSK was fined $3bn (£1.9bn) in July 2012 in the largest healthcare fraud settlement in US history. The company pleaded guilty to promoting two drugs for unapproved uses (an adult-only anti-depressant drug was promoted for use by children) and failing to report safety concerns about a diabetes drug Avandia.
The News International phone hacking scandal, which culminated in the 2012 Leveson Inquiry, provided much fascinating evidence of real world relationships between senior executives, politicians, the police, and the regulator (the Press Complaints Commission). Even senior lawyers admitted that their professional standards could slip under pressure. The Times itself reported that the head of its legal team had instructed one of the newspaper's reporters to submit a witness statement to the High Court that was "not entirely accurate", did not give the "full story" to the court and had been "oblique to an extent that is embarrassing".
Volkswagen - Vehicle Emissions
It was revealed in 2015 that VW, and probably other manufacturers, had installed 'defeat device' software which manipulated vehicle emission levels under test conditions. There had been many previous allegations that emissions measured during formal tests bore little resemblance to the emissions that were made when vehicles were driven by regular drivers on normal roads. The fact that these allegations had not previously been thoroughly investigated, and that the vehicle manufacturers were allowed to choose their testing companies, were clear evidence of regulatory failure both in the US and the EU.
It is worth noting, however, that the origins of this scandal almost certainly lay in European (and particularly German) politicians using regulation as a substitute for industrial and trade policies with the aim of benefitting European vehicle manufacturers. Centre for Competition Policy (CCP) researchers have pointed out that European regulators have never been as concerned about NOx emissions as American authorities. As compared with petrol engines, diesel vehicles save fuel, improve mileage, and have lower greenhouse gas emissions (so Europeans could set greenhouse gas standards that were substantially tighter than their American counterparts). Given concerns about global warming, such a position was arguably sensible though it came at the cost of more localized pollution and health hazards. By focussing on the reduction of greenhouse emissions, and by enacting standards that they did not intend to enforce (unlike the USA), European legislators favoured production of diesel vehicles and strengthened their manufacturers' dominant position in the European automobile market. Indeed, CCP argue that Europe’s emissions policies served to protect the European market by the equivalent of a 20% import tariff.
Within VW there had of course been what its chairman described as a "whole chain" of errors, and a mindset that tolerated rule-breaking.
The Grenfell Tower Fire
It looks as though several regulatory failures may have contributed to this terrible tower block fire in June 2017 . A detailed examination of the issues will be found here, updated from time to time as more facts and analysis become available.
The Japanese report into the causes of the 2011 post-tsunami damage to the Fukushima nuclear plant included the following:
The Tepco Fukushima Nuclear Power Plant accident was the result of collusion between the government, the regulators and [private plant operator] Tepco, and the lack of governance by said parties. They effectively betrayed the nation's right to be safe from nuclear accidents. Therefore, we conclude that the accident was clearly "man-made"...
We believe that the root causes were the organizational and regulatory systems... rather than issues relating to the competency of any specific individual.
[All parties] failed to correctly develop the most basic safety requirements - such as assessing the probability of damage, preparing for containing collateral damage from such a disaster, and developing evacuation plans for the public in the case of a serious radiation release.
The FCA (Financial Conduct Authority) was severely criticised because it 'did not effectively supervise and regulate' London Capital and Finance which collapsed in 2019 causing nearly 12,000 investors to lose £236m. The FCA ignored multiple warnings, and failed to warn investors that, although LCF's marketing activity was FCA-approved, their very risky high interest mini-bonds were not. The regulator was apparently very reluctant to peer beyond its regulatory/legal perimeter.
To be fair, most regulators fear being criticised for engaging in regulatory creep - and for seeking resources to enable them to creep. They also fear being challenged in court by those whose activities they seek to regulate. But regulators should clearly not ignore seriously bad behaviour when - as in this case - this might cause many thousands to suffer.
One underlying problem (in my view) was the sheer scale of the FCA which meant that it senior executives had very little idea of what was truly happening within their organisation.
It was noticeable that the FCA's Chief Executive, Andrew Bailey, was reluctant to accept responsibility for the organisation's failings. He didn't have a brilliant reputation; he had for instance previously antagonised steelworkers pensioners' representatives by falling asleep when meeting them. But he was to some extent bullet-proof as he had been appointed by Chancellor of the Exchequer George Osborne as someone who was less likely to assert his independence and 'rock the boat' than his tough predecessor Martin Wheatley. Face was saved all round when Mr Bailey left the FCA to become Governor of the Bank of England.
Sadly, though, Martin Wheatley subsequently refused to cooperate with John Swift who was investigating the FSA's handling of the mis-selling of interest rate derivatives from 2001 to 2011- see above for further detail. The failure of these two supposed leaders to account for their decisions left a very bad impression.
The Financial Times Editorial Board commented very sternly:
The collapse of minibond provider London Capital & Finance, and with it £237m of investors’ money, is one of the biggest retail investment scandals in UK history. It is only one of three in the past 30 years where the government has offered special compensation; recognition of the litany of shortcomings that resulted in 11,600 customers, many of them first-time investors and pensioners, facing financial hardship. It is time the government seriously considered, rather than rebuffed, recommendations to prevent future scandals, and future payouts.
The regulatory failings by the Financial Conduct Authority were detailed by Dame Elizabeth Gloster, a former appellate judge, last year. Her inquiry found a risk-averse watchdog that ignored red flags and failed in its duty to protect consumers. But no heads rolled at the FCA — led at the time of the scandal by Andrew Bailey, now Bank of England governor. Instead, the Treasury select committee on Thursday suggested that the watchdog shied away from applying to itself rules it expects firms to follow and which hold senior managers to account. Damning as that is for the FCA, it is the committee’s other findings that may be more constructive.
The “perimeter” dividing what is and is not regulated is a perennial problem, of which the LCF scandal is the latest example. The company was authorised, but the mini bonds it pushed were not. Unregulated products tend not to carry protection from the Financial Services Compensation Scheme. However, small investors saw LCF’s authorisation and assumed their money was safe to plough into what were in fact high-risk, thinly traded products; as did some FCA and FSCS staff. If officials cannot understand the difference, how can everyday investors?
Gloster calls this the “halo effect” — the imprimatur of safety that authorisation confers — which some firms wilfully exploit. The watchdog must now clamp down on the advertising of unregulated products without prominent warnings. The committee wants the FCA to have an official power to recommend to the Treasury changes to the perimeter, set by parliament. A similar call by the committee two years ago was rebuffed by the Treasury. That should be rethought. The government has also ignored pleas by the FCA and the committee — repeated in Thursday’s report — that it include scam advertising in its Online Safety Bill, which requires technology giants to take down harmful content. Many were drawn to LCF by online adverts promising impressive returns.
- This website concentrates on regulation in Europe but it is worth noting that the failure of regulation in poorer parts of the World has caused much tragedy, including many deaths as a result of fires and collapsing buildings following failures to comply with building regulations. (The Rana Plaza disaster in 2013 killed 1,100.) These tragedies demonstrate all too clearly the benefits of ex ante over ex post regulation although under-resourced regulators and corruption all too often lead to very weak enforcement.
- More than 2,800 people in the City of London were paid more than £1m in 2009, according to the Financial Services Authority. Total City bonuses paid in 2007 were around £10 billion, just less than the total of c.£11 billion given to charities each year by all 60 million UK residents.
- Rewards paid to the City of London's highest paid bankers rose by one-third from 2011 to 2012. 2,700 were paid more than £1 million (and an average of £2 million) in 2012. In Germany, France, Italy and Spain there were 212, 177, 109 and 100 respectively.
- The moral hazard associated with institutions being 'too big to fail' is hardly a new phenomenon. The Romans, when ruling Britain, found that they had to bail out publicani and conductores who had bid too much for the privilege of collecting taxes and found that they could not even meet their targets, much less get rich themselves.
- Another nice financial services quote: Barings went broke in 1995 a year after its Chairman told the Governor of the Bank of England that 'it is not actually all that difficult to make money in the securities business'.
- The Centre for Analysis of Risk and Regulation approached regulatory failure in an interesting way when it published its discussion paper Regulation scholarship in crisis? in 2016. Its authors recognised public concern about academia's analysis of the effectiveness of regulation:-
- Philip Aldrick commented as follows In The Times in November 2018:
... the past two decades have witnessed acute and salient crises that might be seen as major challenges to scholarship on regulation. One is that regulated sectors have witnessed considerable crises, especially following the financial crisis since the late 2000s. Other crises involve food, such as the horsemeat scandal which involved mislabelled products, nuclear safety (Fukushima) or mining (River Pike). The question was not whether regulatory scholarship failed to predict these incidents, but whether the literature was pointing to the kind of vulnerabilities that were identified post-crises, and whether existing approaches and theories have proven sufficiently robust to analyse the aftermath of these various crises. In other words, it is worth questioning whether the financial crisis and other crises associated with regulatory failings constituted rude surprises for regulation scholarship.
But CARR went on to be optimistic about the way academia is responding to these concerns - see in particular Martin Lodge's contribution beginning on page 1 of the paper.
Warnings are easy to deliver but worthless if there is no follow-through. It’s a truism that every parent knows, and ignores, but one that the Bank of England learnt the hard way in the financial crisis.
Two years before disaster erupted in 2008, the Bank’s Financial Stability Report identified a severe funding shortfall among Britain’s lenders. Should there be an unexpected shock, it warned, there would be a credit crunch that might wipe out a year’s worth of bank profits and push the country into recession. It was quite a warning, but then nothing until suddenly, in August 2007, the markets froze and overnight the Bank’s worst nightmares were real.
Once the run on Northern Rock was over and the bank nationalisations were complete, the authorities paused to take stock. One of the many regulatory shortcomings that the crisis exposed was the lack of tools that supervisors had to manage the financial system. All they could do was issue warnings, like those in the FSR. Without supporting powers, though, those warnings were as commanding as a whisper in a nightclub.
So the Bank was given a vast array of powers to rein in lending where it saw fit, which it passed to the new financial policy committee. The FSR was to be its flagship publication, but with teeth now to make its warnings bite. Yet, somehow, the Bank seems to have forgotten the first lesson: that warnings are worthless without follow-through. It may have power, but is too timid to use it.
The point was driven home by a report from the International Monetary Fund this week. Britain is not the only country to have adopted new “macroprudential” tools since the crisis. They are widespread and widely used. Just not in the UK.
It had all started so auspiciously. The FPC was formally established in 2013 and the following year took steps to stop the housing market from overheating by setting loan-to-income limits. Banks would be allowed to extend only 15 per cent of new mortgages at multiples higher than 4.5 times a borrower’s income. Affordability checks also were tightened.
Yet even at this early stage, the policy hinted at the FPC’s timidity. The LTI limit was designed as a restraint against rampant house price inflation rather than an attempt to cool the market. In 2014, a quarter of mortgages were on more than four times a borrower’s income. Today the figure is 30 per cent. In aggregate, lending has got riskier. When the LTI limit was introduced, annual UK house price inflation was running at just over 8 per cent. Two years later, the market was still growing at 8 per cent. It was only after the Brexit referendum that prices began to cool.
In Europe, authorities were much tougher. Nineteen countries have loan-to-value caps in place, ranging for the most part between 60 per cent and 95 per cent of the property price. Twelve of those also have some form of loan-to-income limit and most have set a specific objective of “slowing down house price increases”, the IMF said. Norway hit the housing market hard, even targeting a bubble in the capital, with an LTV limit of 85 per cent, stricter LTV restrictions for second homes in Oslo and tight LTI controls. Not the Bank, though. It had no intention of slowing UK house prices, it wanted to stabilise them, and it washed its hands of the London bubble, arguing that policy could not be set regionally.
The new tools work not only by limiting borrowing but also by discouraging lending. If the FPC is worried about particular markets, such as commercial real estate, it can force banks to hold more loss-absorbing capital against those loans. Because capital is expensive, doing so will make banks shift lending to other areas. Again, compared with supervisors in Europe, the Bank has been timid on this front. Norway, Sweden and Croatia have used capital rules to deter both mortgage and commercial real estate lending. Finland, Ireland, Romania, Belgium and Slovenia have cracked down on one or the other. The Bank refuses to use capital adjustments in such a targeted fashion, even though the IMF reckons it should. “Areas of potential vulnerability include the valuation of commercial real estate and to some extent housing,” the fund said in its annual UK economic health check in September, recommending the use of “bank-specific capital buffers”.
Ask the Bank about the FPC’s tools and it will proudly declare that no committee in the world is so powerful. It’s just that it prefers to use warnings to change behaviour, like police threatening to shoot before pulling the trigger. Warnings have slowed ballooning levels of consumer credit, strengthened resilience to cyberattacks and spurred banks into preparing for Brexit. Risky corporate lending is now in the FPC’s gunsights, the Bank says.
At the margin, warnings work today where they did not in 2006 because they can be followed up. But until the Bank pulls the trigger, a suspicion will remain that its powers are just for show. Behind the Bank’s timidity is a fear of picking winners and the political wrangling that would follow. Strict mortgage limits would provoke an outcry from those who found themselves locked out of the housing market by technocrats on Threadneedle Street.
Part of the problem is the FPC’s garbled remit, which runs to eight pages and instructs the Bank simultaneously to “enhance the resilience of the financial system”, “support the economic policy of the government”, promote competition, encourage long-term investment and justify any action it takes that might slow growth. Everything about that is political and none of it is clear. If the FPC is ever to use its powers properly, it needs a clear remit and a popular mandate.
To get that, someone on the committee has to be bold enough to call for tough interventions and demand political support for them. It’s not too much to ask — they have managed it in Europe — but needs to happen soon.
Until then, Britain’s already worryingly high debt levels will continue to creep up, leaving the country more vulnerable to another financial shock than it need be. Warnings alone, as the Bank learnt in 2006, are never enough.