Ben Chu: Only structural reform will clean up our unsound banking system

Outlook John Maynard Keynes nailed it 83 years ago. As the great economist wrote: “A sound banker, alas, is not one who foresees danger and avoids it but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.”

This Keynesian principle is the reason the menu of sanctions directed against today’s “unsound” financiers, as proposed yesterday by the regulatory authorities at the Bank of England and the Financial Conduct Authority, is unlikely to deliver the hoped for results.

One of the consultation documents suggests senior executives could face criminal prosecution if they take a “reckless” decision causing a financial institution to fail. But how does one prove recklessness? Granted, in the sorry cases of the managements of Co-op Bank or Northern Rock one might have a chance. But what about the Royal Bank of Scotland’s disastrous decision, under the leadership of Fred Goodwin, to acquire ABN Amro in 2007? Recall that Barclays was bidding for that prize too. Under those circumstances would the executives of the successful bidder be prosecuted and the top brass of the other institution let alone? That doesn’t sound very legally sound.

And consider the reckless decisions by senior UK bank executives to slash their capital buffers to tiny wafers in the years before the crash. Would they be prosecuted under the new regime if their institutions failed? If so, what about the management of US and European banks who followed precisely the same strategy? In practice, those bankers who are reckless in the herd, foolish in a conventional way (as described by Keynes), can be reasonably confident of avoiding prosecution.

The proposed fresh restrictions on bonuses are also deeply unconvincing. The consultation proposes a clawback of bonuses over seven years where there is “reasonable evidence of employee misbehaviour or material error”, or “if the firm or the relevant business unit suffers a material failure of risk management”. But, again, one doesn’t need to be a £1,000-per-hour City lawyer to see the point of legal contention. Define “reasonable”. Define “material failure”.

The presumption that this new sanction would have any bite hinges on believing bank executives possess, or can be shown to possess, a high level of knowledge about what is taking place in their institutions. Recent years have shown these sprawling financial empires are simply too vast and complex to be overseen in this way.

Ultimately, attempts to regulate banks into good behaviour are doomed to failure. And the threat of legal sanction is always going to be blunt except in clear-cut cases of fraud such as the rigging of interest rates. The proposed bonus rules, which would merely add further complexity to an already mind-bendingly complicated pay system, are an especially poor idea because they will make transparency over banks’ remuneration worse, not better.

Behaviour is determined by incentives and opportunities. And the screaming requirement is for radical structural change that will shift those incentives and diminish the opportunities for the sort of behaviour that has destroyed banking’s reputation. The goal should be to create a financial ecosystem where executives have no expectation whatsoever of a public bailout in bad times. This means going far beyond the “ring-fence” between retail and investment banking being pursued by the Coalition, and implementing a straightforward split of the universal banks. It means a cap on the size of the balance sheets of individual institutions relative to GDP. Further, the authorities should find ways to force investment banks to convert into risk-sharing employee partnerships as the price of operating in Britain. This is the only way of lifting the curse of “too big to fail” and cleaning up the industry.

These structural changes would, finally, break the political power of big banks. And be in no doubt that this power still exists. Do not be fooled by the breast-beating of the British Bankers’ Association yesterday at the proposed new bonuses regime. The seven-year restriction on payouts is weaker than the full decade proposed by Parliament’s Independent Commission on Banking last year. One can see the hand of the banking lobbyists clearly here. Even after the deluge of scandals, financiers are still influencing the scope and scale of regulatory reforms behind the scenes.

Here, then, is a simple test that people can apply: if a politician or a regulator pushes a structural overhaul of the industry with a view to transforming the incentives of financiers, they can be considered to have understood the lessons of the great financial crash. If, on the other hand, they talk earnestly about curbing bankers’ behaviour through complex new rules, but propose to leave the existing industry structure in place, they have, alas, learned nothing.