When firms neglect their reputations we all end up paying an extortionate price

Didn’t high-street bankers selling PPI care about their reputation and the long-term health of their businesses? Not enough

Ben Chu
Sunday 11 October 2015 17:11 BST
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Kevin Spacey and Jack Lemmon as salesmen in the film version of ‘Glengarry Glen Ross’ Moviestore/rex
Kevin Spacey and Jack Lemmon as salesmen in the film version of ‘Glengarry Glen Ross’ Moviestore/rex

Britain’s high street banks have set aside £20bn in compensation for millions of people to whom they sold a generally worthless product called “Payment Protection Insurance” (PPI) in the two decades before the financial crash. And now some are predicting that payouts could rise by a further £15bn. That would take the final PPI compensation bill to £35bn. That’s a staggering sum, equivalent to almost 2 per cent of our GDP this year. What we have here is the price of market failure, the price of asymmetric information.

Why do I want to buy what you want to sell? There might be many good reasons. It’s mutually beneficial to trade, something we’ve understood since Adam Smith’s time. But there are also, sadly, bad reasons. You might know a lot more about the quality of the item than I do and want to profit by offloading it on to me for more than it’s truly worth. In other words, I might want to buy because I overestimate the value of what you’re selling. Information might be asymmetric.

It’s a common, inescapable, phenomenon in markets. And no sector has exploited it for profit as ruthlessly as the banks. The people running our high-street banks were well aware that these newly invented PPI products were overvalued. Why? Because they were so profitable, bringing in upwards of £5bn a year in total for the sector at one stage.

The payout rates were extremely low because of the fiendish way the products were designed. For instance, people who really needed loan payment protection such as the self-employed or those with pre-existing medical conditions couldn’t actually claim it.

As a result PPI policies made the banks far more money than regular car or house insurance products. And frontline sales staff were duly ordered to push them on as many customers as possible whenever they took out a loan or a mortgage. Needless to say the customers didn’t know they were buying a duff insurance product.

It wasn’t just individuals who were victims of insurance mis-selling by the banks. Banks sold small companies “interest rate swaps”. These products would supposedly give firms financial relief on their bank loans in the event that the Bank of England put up interest sharply. But, in the event, the Bank slashed its rates close to zero, and many companies found themselves on the hook for sometimes crippling repayments that they had no idea they might be liable for. Again, the bankers knew more about the product than the customers.

At around the same time, investment bankers sold supposedly more sophisticated wholesale investors “mortgage-backed securities” (MBSs) and “collateralised debt obligations” (CDOs). These products again turned out to be hugely over-priced given their risk.

Did bankers really know they were duff products? Not all, certainly. There is some evidence that the heads of these banks were as clueless as their customers about the dangers of the MBSs and CDOs they were selling. But some certainly did. For instance, Goldman Sachs packaged and sold billions of dollars-worth of CDOs to investors in one infamous incident. Then the Wall Street bank promptly took out a big bet on their price collapsing. They knew more than their customers about the products.

Asymmetric information in some markets isn’t a structural problem. If I buy fruit from a greengrocer that turns out to be rotten, I won’t shop there again. Word is liable to get out and others won’t shop there, either. Eventually, if they keep selling rotten fruit, they’ll go bust.

It’s those markets in which people are selling items just once that tend to be the most ridden with the curse of information asymmetry. In an influential 1970 paper, the economist George Akerlof described the trade in second-hand cars as a “market for lemons”. Sellers of second-hand motors tend to know much more about the car for sale than potential buyers. They know whether it’s a reliable vehicle or one that’s likely to break down (a “lemon”). Buyers know that they’re at a disadvantage, so the general price of all second-hand cars tends to be depressed to reflect this structural disadvantage.

But this has harmful knock-on effects. Because the general price for second-hand cars is depressed, people who have good (not lemon) cars tend not to bring them to market. But people with lemons are obviously still willing to sell. Quality cars are driven out of the market, leaving a lot of lemons. Trading volumes in such distrustful markets tends to be thin and unsatisfactory for buyers and honest sellers alike.

How can we get around this kind of market breakdown brought about by an inequality of knowledge? Concern for corporate reputation has traditionally been one mitigating factor. Good companies didn’t mis-sell because they knew that in the long term, it was bad for business. They didn’t exploit the possibilities offered by asymmetric information because they wanted to maintain a profitable relationship over time. “Don’t sell a guy one car, sell him five cars over 15 years” as one of the salesmen in David Mamet’s play Glengarry Glen Ross puts it.

Didn’t high-street bankers care about their reputation and the long-term health of their businesses? Not enough. They thought they could leave such matters to the public relations teams and advertisers. They were, of course, spectacularly wrong, and their short-termist greed has now destroyed colossal value for their shareholders. They have also corroded trust in high-street banking more generally.

There is no simple way to lift the curse of information asymmetry in markets. But part of the solution must involve addressing the myopic and, yes, predatory culture that prevails in certain corners of the business world.

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