Bankingreform,!andthe importanceofownership:! how ...

Banking reform, and the importance of ownership:

how the way banks are owned affects their behaviour

A thesis submitted to the University of Manchester for the degree of Doctor of Philosophy in the

Faculty of Humanities

2018

Michael Wilkinson

Alliance Manchester Business School People, Management and Organisation

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Table of Contents

ACKNOWLEDGEMENT 5

ABSTRACT 6

LIST OF CHARTS 7

LIST OF TABLES 8

LIST OF STATUTES 9

DECLARATION AND COPYRIGHT STATEMENT 10

LIST OF ABBREVIATIONS 11

CHAPTER 1. INTRODUCTION 12 1.1 INTRODUCTION 12 1.2 PART 1: BANK OWNERSHIP, AND BANK BEHAVIOUR 12 1.3 PART 2: HOW TO EXPLORE OWNERSHIP AND BEHAVIOUR? 15

CHAPTER 2. THE BANKING REFORM AGENDA: PRESERVING THE STATUS QUO 18 2.1 INTRODUCTION 18 2.2 PART 1: THE ‘OFFICIAL RESPONSE’ 20 2.2.1 CONTROLLING THE DEBATE 20 2.2.2 SIR ‘WIN’ BISCHOFF AND BOB WIGLEY – PLEDGING ALLEGIANCE TO THE CITY 21 2.2.3 LORD TURNER – PRESERVING LIGHT TOUCH REGULATION 22 2.2.4 THE BANKING CRISIS INQUIRY – THE WRONG BODY 23 2.2.5 SIR DAVID WALKER – PROTECTING SHAREHOLDER-‐OWNERSHIP 25 2.2.6 SIR JOHN KAY – REFORMING EQUITY MARKETS, NOT OWNERSHIP 27 2.2.7 SIR JOHN VICKERS – PRESERVING UNIVERSAL BANKING 28 2.2.8 PARLIAMENTARY COMMISSION ON BANKING STANDARDS – A MISSED OPPORTUNITY 29 2.2.9 THE COMPETITIONS AND MARKETS AUTHORITY INVESTIGATION–A STANDARD RECIPE? 31 2.3 PART 2: THE WIDER DEBATE 32 2.3.1 WHAT WAS MISSED? 32 2.3.2 CHALLENGING THE ‘OWNERSHIP’ PARADIGM 34 2.3.3 CHALLENGING THE ‘STRUCTURAL’ PARADIGM 35 2.4 CONCLUSIONS 38

CHAPTER 3. ‘OWNERSHIP PRESSURES’: WHAT IT IS, TO BE OWNED? 39 3.1 INTRODUCTION 39 3.2 PART 1: HISTORY 41 3.2.1 THE BIRTH OF THE CORPORATION 41 3.2.2 THE RISE OF THE STOCK MARKET 44 3.3 PART 2: DEFINING CORPORATE PURPOSE 45 3.4 PART 3: THE EMERGING SHAREHOLDER VALUE PARADIGM 49 3.4.1 ENTRENCHING THE PARADIGM 52 3.5 PART 4: THE BACK-‐LASH, AND RISE OF STAKEHOLDER THEORY 53 3.6 CONCLUSION 55

CHAPTER 4. ‘STRUCTURAL PRESSURES’ AND COPING WITH THEM: SURVIVING IN THE ‘WILD WEST’ FOLLOWING THE ‘BIG BANG’ 56

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4.1 INTRODUCTION 56 4.2 PART 1: THE SHIFT FROM INTERMEDIATION TO CREDIT-‐CREATION 58 4.2.1 THE EXPLOSION OF CREDIT-‐CREATION 58 4.2.2 REMOVING CONSTRAINTS ON CREDIT-‐CREATION 61 4.3 PART 2: THE SHIFT FROM PRODUCTIVE INVESTMENT TO PROPERTY-‐LENDING 63 4.4 PART 3: THE SHIFT INTO RISKIER BUSINESS 66 4.4.1 LAX COMPETITION CONTROL 69 4.5 PART 4: THE SHIFT TOWARDS EXPLOITING RETAIL CUSTOMERS 70 4.6 CONCLUSIONS 71

CHAPTER 5. METHODOLOGY 74 5.1 INTRODUCTION 74 5.2 PART 1: THE ONTOLOGICAL AND EPISTEMOLOGICAL FRAMEWORK 74 5.3 PART 2: THE ESSENTIAL INQUIRY 76 5.4 PART 3: THE METHODOLOGICAL FRAMEWORK 78 5.4.1 WHY NOT OTHER METHODOLOGIES? 79 5.4.2 LIMITS OF THE INQUIRY AND METHODOLOGY 80 5.5 PART 4: DESIGNING THE CASE STUDY RESEARCH 82 5.5.1 THEORY 82 5.5.2 CHOICE OF CASES 83 5.5.3 TIME FRAME FOR STUDY 84 5.5.4 DATA AND SOURCES 85 5.5.5 TERMINOLOGY 91 5.6 PART 5: SUMMARY AND CONCLUSIONS 92

CHAPTER 6. ‘OWNERSHIP PRESSURES’ AND BARCLAYS AND LLOYDS 94 6.1 INTRODUCTION 94 6.2 PART 1: DELIVERING SHAREHOLDER VALUE 95 6.2.1 COMMITTING TO THE MARKET 95 6.2.2 EXCEEDING EXPECTATIONS -‐ LLOYDS 96 6.2.3 THE COST OF KEEPING INVESTORS HAPPY – LLOYDS 99 6.2.4 MEETING MARKET DEMAND -‐ BARCLAYS 103 6.2.5 EXCEEDING EXPECTATIONS -‐ BARCLAYS 108 6.3 PART 2: WHEN THE MARKET DEMANDS TOO MUCH 110 6.3.1 LLOYDS’ STRATEGIC BIND 110 6.3.2 DELIVERING VALUE IN A CRISIS – LLOYDS AND HBOS 114 6.3.3 AVOIDING BAIL-‐OUT -‐ BARCLAYS 117 6.3.4 BARCLAYS’ HALO 119 6.4 PART 3: WIDESPREAD MIS-‐BEHAVIOUR, AND THE NEED FOR REGIME CHANGE 120 6.4.1 DIAMOND’S DEPARTURE -‐ AMIDST MARKET-‐RIGGING 120 6.4.2 DANIELS’ DISAPPEARING ACT – BEFORE THE PPI SCANDAL 121 6.5 CONCLUSIONS 122

CHAPTER 7. ‘STRUCTURAL PRESSURES’ AND THE CO-‐OP AND THE NATIONWIDE 124 7.1 INTRODUCTION 124 7.2 PART 1: STRUCTURAL PRESSURES, AND THE CASE OF THE CO-‐OP 125 7.2.1 THE CO-‐OP’S FAILURE 125 7.2.2 THE CO-‐OP’S GROWTH IMPERATIVE 127 7.2.3 GOVERNANCE AND OVERSIGHT FAILURES 128 7.3 PART 2: STRUCTURAL PRESSURES AND THE CASE OF THE NATIONWIDE 132 7.3.1 THE NATIONWIDE’S RESILIENCE 132

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7.3.2 ITS PART IN MIS-‐SELLING 137 7.3.3 ITS MORE TRADITIONAL BUSINESS 138 7.3.4 REINFORCING FUNCTIONALISM 143 7.4 CONCLUSIONS 144

CHAPTER 8. CONCLUSION: ‘OWNERLESSNESS’ MUST BE PART OF THE SOLUTION 146 8.1 INTRODUCTION 146 8.2 PART 1: THE KEY FINDINGS 147 8.2.1 EXTRACTIVE OWNERSHIP IS NOT FIT-‐FOR-‐PURPOSE 147 8.2.2 CHANGING OWNERSHIP IS NOT ENOUGH 149 8.2.3 THE NEED FOR COMPARTMENTALISATION AND FUNCTIONAL REGULATION 150 8.3 PART 2: RELEVANCE AND IMPLICATIONS 151 8.3.1 IMPLICATIONS FOR REFORM 151 8.3.2 INADEQUACY OF CURRENT REFORMS 152 8.3.3 SCOPE FOR DETERMINING WHAT WE WANT FROM BANKS 153 8.3.4 REFORMS UNRELATED TO OWNERSHIP 154 8.4 PART 3: RE-‐THINKING AND RE-‐DESIGNING OWNERSHIP 156 8.4.1 STAKEHOLDER STEWARDS 156 8.4.2 A PROPERLY ‘OWNERLESS’ MODEL 158 8.4.3 AN OWNERLESS NATIONAL INVESTMENT BANK 161 8.4.4 ENCOURAGING RESPONSIBILITY 162 8.5 PART 4: EVALUATION AND CONTRIBUTION 163 8.6 CONCLUSIONS 164

REFERENCES 167 WORD COUNT: 76,834

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Acknowledgement This thesis took many years to bring to completion, and would not have

arrived there at all without encouragement from a range of remarkable people, to whom I really ought to say a word of thanks. Between having the idea which sparked my interest in what became this thesis, back in 2002, and putting a part-‐time study plan into action, in 2010, I was lucky enough to be shepherded towards doing a PhD by an eclectic assortment of bright sparks. Whilst they are too numerous to list here, I am thankful to them for pointing me in the direction of the University of Manchester’s Business School, where I had the good fortune to encounter my eventual tutors, professors Julie Froud and Karel Williams. I doubt there exist any two persons better suited to the task of guiding me through the journey I have taken to write this thesis. Julie and Karel provided me with tireless support and direction as the weeks turned to months and the months to years, whilst I trundled along with my part-‐time writing, also keeping a busy day job. They have taught me more than I could ever thank them for, and lightened my burden no end with their levity and humour. They also put me in touch with some fascinating sorts at Manchester’s CRESC with whom I was very pleased to associate.

I should also like to express some thanks to my examiners for taking up their time and giving me the benefit of their insight and ideas. They helped ensure I left no interesting aspect of this thesis untouched. In the same vein, I should add to that list, Adam Leaver, who chaired my various reviews over the years. Our discussions added depth and dimension to my inquiry.

Last but by no means least, it would be remiss of me not to mention my long-‐suffering, and significantly better half, Vivian, for putting up with my peculiar passion for the subject of this thesis, when I dare say no other sane person would, and for encouraging me to keep going with it. This thesis would not have been written without her, and really it ought to belong to her, but alas, in her honour, I would instead like to dedicate it to our son, Lewin, hoping that one day he might get to write something far better and more meaningful.

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Abstract Despite claims made by the UK Government in 2015 that the process of

banking reform had come to an end, the debate about how to reform banks very much continues. There is now an increasing willingness to question both whether banks should be owned by, and run for, their shareholders, and whether the role they play in creating and allocating credit can safely be left to be determined solely by private interests. Where banking reform goes from here is not entirely certain. It could even be said to have reached something of a fork in the road. The obvious way open to us is to continue down the path forged by the neoliberal agenda, trusting market forces to determine credit-‐creation and allocation, and continuing to champion the banking sector as a sort of national treasure to be preserved in its own right. An alternative course could be to more radically control what banks do, to have more of a say about what activities they should finance more or less generously and to treat the sector not as an end in itself, but more as a means, an essential engine for economic growth which needs to be more carefully controlled and driven.

Whichever way we go from here, the question of ‘ownership’ and whether it needs to be reformed remains relevant. Indeed, it is doubtful whether banks can really be trusted to behave themselves and to serve our interests if the requirement to maximise shareholder returns provides conflicting incentives for them to be reckless, self-‐serving and exploitative. Ultimately, how important the issue of ownership is depends upon how far the way banks are owned drives them to misbehave. This thesis seeks to explore that relationship and its relevance to banking reform. It does so by looking at how pressures arising from the way banks are owned encourage bad strategic decisions and bad behaviours in a number of UK banks. It conducts case studies of two stakeholder-‐owned banks and two shareholder-‐owned banks, and analyses a body of evidence which tends very strongly to suggest that the way banks are owned is indeed liable to contribute towards the adoption of unsafe strategies, and bad behaviours.

The thesis proceeds to argue that we still need to tackle this ‘ownership’ problem which continues to drive much of the dysfunctionality in banking. Fixing ‘ownership’ will not necessarily ensure that credit is created in sensible quantities and allocated in sensible ways where needed in the economy, and it will not be the only reform needed to discourage bad behaviour. It is however a necessary reform, and one which still needs to be made. The entire notion that banks are owned by and should be run for their shareholders needs radically to be reigned in, and we need to be far more experimental and creative in exploring ways of making banks act more like stewards or trustees administering other people’s assets – and in safe and productive ways which are in fitting with the interests of the state, its citizens and tax-‐payers. This thesis explores ways of doing that by making banks more ‘ownerless’, including creating any National Investment Bank, such as that recently proposed by the Labour Party, as a truly ‘ownerless’ institution.

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List of Charts Chart 4.1: Household deposits and loans in % of GDP (1964-‐2009)………………. 59 Chart 4.2: Business deposits and loans in % of GDP (1964-‐2009)………………… 69 Chart 4.3: UK banks lending by sector in £tr. (1986-‐2013)…………………………… 64 Chart 5.1: A ‘research onion’……………………………………………………………………….. 92 Chart 6.1: Lloyds: returns on equity in % (1988-‐20013)………………………………. 96 Chart 6.2: Barclays and Lloyds: returns on equity in % (1992-‐2012)…………….. 97 Chart 6.3: Barclays and Lloyds: return on assets (RoA) in % (1992-‐2012)…….. 98 Chart 6.4: Barclays and Lloyds: total assets in £m (1992-‐2013)…………………….. 99 Chart 6.5: Barclays: assets by business in £bn (1993-‐2012)………………………… 103 Chart 6.6: Barclays: profits before tax by business in £bn (1993-‐2012)……….. 107 Chart 6.7: Barclays : dividend pay-‐out per share (2000 – 2017)……………………110 Chart 6.8: Lloyds: dividend pay-‐out per share (2000 – 2017)……………………….112 Chart 6.9: Lloyds : share price (2008-‐2015)………………………………………………. 117 Chart 6.10: Barclays: equity and liabilities (1993-‐2012)…………………………….. 119 Chart 7.1: Barclays, Lloyds, Nationwide and Co-‐op: total assets in £m (2008-‐2013)………………………………………………………………………………………………………. 133 Chart 7.2: Lloyds and Nationwide: total assets in £m (2008-‐2013)…………….. 134 Chart 7.3: Nationwide and Co-‐op: total assets in £m (2008-‐2013)………………. 134 Chart 7.4: Nationwide’s growth trajectory in £m (1991-‐2013)……………………. 136 Chart 7.5: Top six banks provision for mis-‐selling by category (2010-‐2014)...138

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List of Tables Table 3.1: Historical Trends in Beneficial Ownership by % (snapshots between 1963 and 2010) ……………………………………………………………………………….…………. 45 Table 5.1: Table of data, sources, advantages and disadvantages…………………... 86 Table 5.2: Saunder’s ‘research onion’……………………………………………………………..92 Table 6.1: Lloyds: assets and equity in £m and equity/ assets in % (1988-‐2013)………………………………………………………………………………………………………….101 Table 6.2: Barclays: assets and equity in £m and equity/assets in % (1992-‐2013) ……………….………………………………………………………………………………………………….104 Table 6.3: Barclays book value (as total assets less total liabilities) and market capitalisation (taking average of final month each year) (2003-‐2008) …………..109 Table 6.4: Lloyds book value (as total assets less total liabilities) and market capitalisation (taking average of final month each year) (2003-‐2009)………………………………………………………………………………………………………….113 Table 7.1: Barclays, Lloyds, Nationwide and Co-‐op: total assets in £m (2008-‐2013)...................................................................................................................................................127 Table 7.2: Nationwide’s total assets in £m (1990-‐2014)…………………..……………135 Table 7.3: complaints upheld (July-‐December 2013) ……………………………………138 Table 7.4: Barclays, Lloyds, Nationwide and Co-‐op: % of assets and % of lending composed of deposits (2006-‐2014) ……………………………………………………………..139 Table 7.5: Barclays, Lloyds, Nationwide and Co-‐op interbank assets/interbank lending in % (2006-‐2014) …………………………………………………………………………..140 Table 7.6: Nationwide: amount of assets comprised of mortgages and securities in % (2009-‐2014)………………………………………………………………………………………..141 Table 7.7: Barclays: amount of assets comprised of mortgages and securities (2009-‐2013) ………………………………………………………………………………………………142 Table 7.8: Co-‐op: amount of assets comprised of securities in £m and in % (2009-‐2013)………………………………………………………………………………………………………… 142

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List of statutes Acts of Parliament in England and Wales The Royal Exchange and London Assurance Corporation Act 1719……………….. 42 The Slavery Abolition Act 1822…………………………………………………………………… 39 The Competition and Credit Control Act 1971……………………………………………….61 The Building Society Act 1986………………………………………………………140, 141, 148 The Financial Services and Markets Act 2000……………………………………………… 52 The Companies Act 2006……………………………………………………………………39, 51, 55 The Financial Services (Banking Reform) Act 2013……………………………………… 20 The Co-‐operative and Community Benefit Societies Act 2014 ……………………….159 Foreign statute or statutory instruments The US Foreign Corrupt Practices Act 1977………………………………………………….118 The EU Directive on Takeovers (2004/25/EC)…………………………………………… 51

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Declaration and Copyright Statement

No portion of the work referred to in the thesis has been submitted in support of an application for another degree or qualification of this or any other university or other institute of learning. Note on copyright and the ownership of intellectual property right: The author of this thesis (including any appendices and/or schedules to this thesis) owns certain copyright or related rights in it (the ‘Copyright’) and has given The University of Manchester certain rights to use such Copyright, including for administrative purposes. Copies of this thesis, either in full or in extracts and whether in hard or electronic copy, may be made only in accordance with the Copyright, Designs and Patents Act 1988 (as amended) and regulations issued under it or, where appropriate, in accordance with licensing agreements which the University has from time to time. This page must form part of any such copies made. The ownership of certain Copyright, patents, designs, trade marks and other intellectual property (the ‘Intellectual Property’) and any reproductions of copyright works in the thesis, for example graphs and tables (‘Reproductions’), which may be described in this thesis, may not be owned by the author and may be owned by third parties. Such Intellectual Property and Reproductions cannot and must not be made available for use without the prior written permission of the owner(s) of the relevant Intellectual Property and/or Reproductions. Further information on the conditions under which disclosure, publication and commercialisation of this thesis, the Copyright and any Intellectual Property and/or Reproductions described in it may take place is available in the University IP Policy in any relevant Thesis restriction declarations deposited in the University Library, The University Library’s regulations and in The University’s policy on presentation of Theses. (See:http://www.campus.manchester.ac.uk/medialibrary/policies/intellectualproperty.pdf and http://www.manchester.ac.uk/library/aboutus/regulations)

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List of abbreviations Barclays Barclays Bank PLC BBA British Bankers Association BoE Bank of England CEO Chief Executive Officer CMA Competition and Markets Authority Co-‐op The Co-‐operative Bank PLC Co-‐op Bank The Co-‐operative Bank PLC Co-‐op Group The Co-‐operative Group CRESC Centre for Research on Socio-‐cultural Change EIB European Investment Bank FCA Financial Conduct Authority FSA Financial Services Authority GDP Gross Domestic Product GFC Global financial crisis ICB Independent Commission on Banking ICFC Industrial and Commercial Financial Corporation IMF International Monetary Fund KfW Kreditanstalt für Wiederaufbau LIBOR London Interbank Offered Rate Lloyds Lloyds Banking Group PLC, or, as appropriate, its predecessor

Lloyds TSB PLC, or indeed its predecessor, Lloyds Bank Limited M&A Mergers and Acquisitions Nationwide The Nationwide Building Society PCBS Parliamentary Commission on Banking Standards PLC Public Limited Company PPI Payment Protection Insurance PRA Prudential Regulation Authority RoA Return on Assets RoE Return on equity SME Small and Medium-‐sized Enterprises TBTF Too Big to Fail TSC Treasury Select Committee UK United Kingdom US United States Vickers The Independent Commission on Banking

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Chapter 1. Introduction 1.1 Introduction

This chapter introduces the inquiry made in the thesis, explaining briefly why that inquiry is relevant and how it will be made. It is broken down into two parts. The first explores some of the main literature which argues that the way banks are owned affects their behaviour, and considers why that topic appears relevant for any discussion about banking reform. It considers what inquiries have already been made by others into the relationship between ownership and behaviour, and in view of the evidence uncovered by such inquiries, it explains why further inquiry is still required. The second part then explains how that relationship between ownership and behaviour will be explored and provides an overview of the thesis outlining a brief summary of each of the chapters to follow.

1.2 Part 1: bank ownership, and bank behaviour

How banks are owned and organized has implications for how they behave and perform (O’Hara, 1981; Fama et al, 1983; Rasmusen, 1988; Bøhren et al 2013). Shareholder-‐owned banks, that is to say banks whose shares are publicly traded, tend to be run to prioritise the maximisation of value for their shareholders (Haldane, 2011, 2015; Mayer 2013, pp111-‐115, 144; Black et al, 2015). On the other hand, stakeholder-‐owned banks, that is banks which are either mutually-‐owned by their customer-‐members or owned by co-‐operative societies, tend to return value to a wider set of stakeholders (Coco et al, 2010; Ferri et al, 2010; Bøhren et al, 2012, 2013). Following the financial services reforms in the 1980s which came to be known as the ‘Big Bang’, it was routinely claimed in the UK that shareholder-‐owned banks were more profitable than stakeholder-‐owned banks and behaviourally superior (Cuevas et al, 2006). Many argued that the latter were less competitive than shareholder-‐owned banks and that they only existed due to protectionist regimes (O’Hara, 1981).

The events following on from the global financial crisis (‘GFC’) which began in 2007 and the subsequent banking crisis in the UK have provided ample evidence to undermine these pro-‐shareholder and anti-‐stakeholder claims. Following the failure of many shareholder-‐owned banks and the multiple banking scandals and behavioural problems which subsequently came to light, there has been an increasing willingness to critically question whether shareholder-‐owned banks are fit-‐for-‐purpose and whether they perform and behave better than stakeholder-‐owned banks. It is commonly observed that shareholders tend to be principally concerned with capturing and extracting value through the buying and selling of shares, and consequently that they care more about making short-‐term gains from trading than they do about taking a

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long term interest in and governing the businesses which they notionally own (Kay, 2012, ch.1; Haldane, 2011, 2015; Ertürk, 2015).

An array of academics and policy-‐makers, including some mainstream and influential officials and not least the Bank of England’s Chief Economist Andy Haldane, have argued that the way that main banks in the UK are owned gives them powerful incentives to take excessive short term risks to the detriment of other stakeholders, such as employees, investors, tax payers, and society in general (Mayer, 2013; Haldane, 2015; Black 2015). Shareholder-‐owned banks have not only been criticized for driving risky strategy and behaviour, but also for negatively affecting the role banks play in creating and allocating credit (Haldane, 2015; Turner, 2016, pp109, 172-‐174). Haldane (2015) for example suggests that the net effect of having banks run for their shareholders is that ultimately banks finance the stock market rather than the stock-‐market financing banking. Haldane (2015) observes a series of macro-‐economic trends which tend to indicate that the stock-‐market is a net drain on bank assets, rather than a net contributor : instead of issuing new equity, banks tend to buy back more and more of their shares; and shareholders extract apparently increasing dividends from banks regardless of their performance; whilst at the same time productivity growth is declining, and investment into R & D is declining.

It has also been increasingly argued that stakeholder-‐owned banks are better behaved than shareholder-‐owned banks. Not being expected to return value to their shareholders, it is commonly claimed that they have less incentive to take excessive risks and to adopt unsustainable business strategies and to exploit rather than fostering good relationships with their customers (Allen et al. 1997, 2000, 2004, 2009; Coco et al, 2010; Ferri et al, 2010, 2012; Amess, 2002; Hakenes et al 2009). Comparing return on assets, cost efficiency and their loan quality across 300 European banks, Ferri et al (2010, 2012) found that stakeholder-‐owned banks performed more efficiently in terms of loan losses and cost efficiency than shareholder-‐owned banks and that there was no compelling evidence to suggest that shareholder-‐owned banks behave better than stakeholder-‐owned banks. Their evidence suggested that stakeholder-‐owned banks behaved more prudently and more sustainably than shareholder-‐owned banks across the economic cycle both before the crisis, and afterwards.

There is also another type of ownership model which cannot accurately be described as a stakeholder-‐owned organisation because it is not ‘owned’ by its members, or in more accurate terms it does not have any residual claimants to whom it distributes its proceeds, but instead retains its earnings to meet its social aims. This model of organisation, which is sometimes referred to as a ‘social purpose not-‐for-‐profit’, rather than a ‘member-‐owned not-‐for-‐profit’, is not without precedent in the world of banking. Distinguishing this model from stakeholder-‐owned models, Bøhren et al (2012, 2013) called this type of bank ‘ownerless’ and identified two examples: the Spanish Cajas, and the Norwegian Sparkassen. In both cases, the banks are neither shareholder-‐owned, nor owned by other stakeholders, but have governance regimes which require them to retain their proceeds rather than distribute them directly or indirectly to members and to apply such proceeds to meet their socially-‐oriented banking goals (in relation to the Spanish Cajas, see also Crespì et al 2004). As Bøhren et al (2012, 2013) observed this ownerless model has particularly interesting and positive implications for banking because it appears to be apt to do well in

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sectors where there are high informational asymmetries and customers are vulnerable or liable to be exploited by organisations which would otherwise be run to extract or return profits for their owners (Hansmann, 1980, 1981, 1988). Hansmann claimed that organizations which were not ‘owned’ and which were not run to extract their profits for the benefit of outsiders but which recycled such proceeds by continually applying and re-‐applying them to meet their aims, behaved more responsibly than organizations which in the pursuit of profits for their owners otherwise had incentives to compromise their behaviour (Hansmann, 1980, 1981, 1988).

As for stakeholder-‐owned banks, there was also evidence to suggest that such ownerless banks also perform more sustainably and behaved more responsibly than shareholder-‐owned banks. Comparing the return on assets employed by ownerless and shareholder-‐owned banks, the former were found to have performed and behaved better (Crespí et al, 2004) and both in ‘crisis times’ and ‘normal times’ (Bøhren et al, 2013). Bøhren et al (2013) also considered the disciplining effect of competition in product markets and concluded that shareholder-‐ownership only really presents benefits for governance in inadequately competitive markets and where stakeholder governance is otherwise inadequate as a disciplining force. In other words, it was suggested that in competitive markets, shareholder-‐ownership does not present any benefits in terms of its governance model.

These various claims and counter-‐claims are far from settled but continue to be argued in what is an on-‐going corporate governance debate between shareholder versus stakeholder advocates. We need only look to the failure of the Spanish Cajas or the failure of the UK’s Co-‐operative Bank PLC (‘Co-‐op Bank’) to find some prima facie evidence, which tends to undermine those who advocate universally for stakeholder-‐ownership or ownerlessness. Nevertheless, in the wake of the crisis, there is now what can fairly be described as some very serious doubt about whether the shareholder-‐ownership model is fit-‐for-‐purpose. On the micro and meso levels, there are concerns about whether it encourages mis-‐behaviour and unsafe strategy for banks (Bowman et al 2014; Haldane, 2011, 2015; Mayer, 2013), and on the macro level there are also concerns about whether it encourages harmful and unproductive credit-‐creation and allocation (Turner, 2016, pp109, 172-‐174). There is also a growing body of evidence to suggest that shareholder-‐owned banks perform and behave worse than stakeholder-‐owned or ownerless banks across the economic cycle (Bøhren et al, 2013; Ferri et al 2010, 2012; Birchall, 2014).

At the same time, it is increasingly recognised that the way banks are owned and organized is not an inevitable or logically necessary arrangement, but a political and economic choice, and one which can be changed (Ireland, 2011; Haldane, 2015). Banks, after all, are social constructs, and the form they take is ultimately decided upon by the law-‐makers governing the societies within which they operate (Haldane, 2015). We can construct and regulate banks in ways which ensure, or at least which aim to ensure, that they better serve society’s interests and needs (Haldane, 2015). That being the case, following the crisis, one would reasonably expect there to have been a serious debate and inquiry into whether banks can and should be owned in different ways. What is surprising in the UK is that whilst the debate about how the banking sector should be reformed considered corporate governance issues, there was no

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official inquiry into whether banks should even be run for shareholders in the first place – notwithstanding that the Parliamentary Commission on Banking Standards (PCBS) called for an inquiry into whether banks should be run also in the interest of others and not just for shareholders (PCBS, 2013b, p.344, see also annex 5 ‘bank ownership’). Even amongst academics, that issue has not received a great deal of attention. Whilst there is a vast body of literature addressing how the GFC was caused and making proposals for tackling such causes, there has been far less critical inquiry into the relationship between ownership and behaviour. Save for the statistical analyses performed by Ferri et al (2010) and Bøhren (2013) which compares bank performance across sectors and countries, there appears to have been little attempt within the banking reform literature to compare the behaviour of shareholder-‐owned and stakeholder-‐owned banks. For example there are no case studies, or at least none that are widely published, which compare different ownership models and contemplate how the same affects bank behaviour. This thesis aims to fill that gap. It hopes to contribute to the relatively scarce body of literature that explores the relationship between bank behaviour and ownership.

In the light of recent banking scandals and crises, such an inquiry appears to be more relevant now than ever before. This thesis aims to explore the relationship between ‘ownership’ and behaviour, and to consider whether shareholder-‐ownership is fit for purpose or whether stakeholder-‐ownership or ownerless models might obtain better behaviours. It asks how the way banks are owned affects their behaviour, and conversely how other unrelated pressures arising instead out of the market and regulatory environments within which banks operate also affect bank behaviour. It refers to the latter as ‘structural pressures’ and the former as ‘ownership pressures’, and considers them in connection with differently owned banks. It both explores the relationship between ownership and behaviour and then considers the implications for banking reform and how we should go about thinking about ownership and how we design or might re-‐design what the thesis refers to as the ‘ownership model’.

1.3 Part 2: How to explore ownership and behaviour?

This thesis tries to explore the relationship between ownership and behaviour in the case of four British banking institutions (or technically, three banks and one building society), namely, Barclays Bank PLC, the Lloyds Banking Group PLC, the Co-‐operative Bank PLC, and the Nationwide PLC. The thesis thus considers two ‘shareholder-‐owned’ banks and looks at their behaviour and it considers two ‘stakeholder-‐owned’ banks and considers their behaviour. In each case, it considers how the banks behaved, paying special attention to the strategy or ‘business model’ adopted by the banks, and in other words how they planned their business to generate revenue to more than recover their operating costs. The thesis considers how behaviour and strategy was influenced by the ownership model as opposed to other factors arising out of the environment within which each bank operated.

By adopting a case study methodology, the thesis considers the phenomena of ‘ownership’ and its behavioural implications alongside various claims, such as Hansmann’s claim (1980, 1981, 1988) that social purpose not-‐

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for-‐profits are apt to behave more responsibly and claims made by Kay (2015, pp248, 299) and Turner (2016, pp57-‐60) that banks have departed from the role we need them to play and are creating and allocating credit in ways we need to reign in. By exploring the relationship between ownership and behaviour within a case study framework, the thesis not only considers such behavioural phenomena within the context within which they arise, but allows them to be evaluated in the light of broader questions and claims such as what role should banks be expected to perform, and whether the shareholder-‐ownership model is fit for performing such roles. The thesis thus considers how the ownership model influences behaviour both in real terms, according to existing normative standards, and in putative terms, according to the role many would argue banks should be performing. Conversely, but necessarily, the thesis also explores how other pressures, un-‐related to how banks are owned, also influence behaviour. It identifies how stakeholder-‐owned banks, such as the Co-‐operative Bank, are subject to pressures arising out of the structure of the market environment they operate in and how such pressures also have behavioural implications.

The thesis is broken up into 8 chapters. Chapters 2 to 4 review the relevant literature and seek to frame the inquiry into how ownership affects behaviour within the context of the current reform agenda and the wider debates surrounding ownership and what we want from the banking sector. It does this by first considering how the banking reform debate has been shaped and directed in a way which has avoided any attempt to challenge the ownership paradigm or to revisit the relationship between finance sector, market and state which was brokered in the Big Bang. Chapter 2 charts the ‘official response’ to the crisis and how the same has failed to grapple with these issues. Chapter 3 goes on to explore ownership within the broader corporate governance literature and the shareholder versus stakeholder governance debate. This chapter describes how that debate has evolved over the centuries to reach the point where the shareholder-‐governance paradigm appears conceivably to be losing its grip amidst a barrage of recent criticism and accusations that it is liable to incentivize unsafe strategy, and mis-‐behaviour.

In chapter 4, the thesis considers how other pressures exerted on banks through the structure and regulation of the banking market also drive misbehaviour, and encourage banks to create and allocate credit in ways which are unproductive or unsafe. These other pressures unrelated to ownership are referred to throughout the thesis as ‘structural pressures’. Chapter 4 considers the changes brought about in the Big Bang, and how the settlement brokered between state, market and financial sector caused a shift in the role performed by banks, and how banks have coped with those pressures. In particular, it considers how banks are encouraged to grow to be as big as they can, to exploit their customer-‐base to recover heavy operating costs, and how the resulting dynamics have put pressures on smaller banks making it difficult to compete without also engaging in similar bad behaviours as their larger peers.

Chapter 5 then describes the methodology, clarifying the reasons for selecting the particular banks chosen and justifying the sources of data consulted. It explains that Barclays, Lloyds, the Co-‐op and the Nationwide were chosen because they represent a range of different ownership models, each encountering behavioural problems or issues which were remarkable in their own rights, with three of the banks exhibiting behaviour which can be

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characterised as ‘misbehaviour’ and one bank mostly avoiding allegations of misbehaviour. Chapter 6 then explores Barclays and Lloyds and ownership pressures, and chapter 7 explores the Co-‐op and Nationwide and structural pressures.

Chapter 8 then attempts to draw together the analysis and conclusions, considering what lessons should be learnt from the case studies and what the broader implications are for banking reform and in particular for how we should approach the subject of ownership. Whilst recognising that an ‘ownership fix’ is insufficient to resolve all of the problems in banking, it argues that reforming ownership is necessary to tackle the underlying causes driving much of the misbehaviour in banking. It calls for more functional regulation and suggests we need to be far more courageous in clarifying what we expect of our banks and we need to be both more interventionist in regulating banks to perform such functions, and more experimental in designing new forms of ownership which are fit for performing such purposes. Rather than prescribing how to reform ownership it then sets out an array of options for reducing shareholder primacy, including creating the newly proposed National Investment Bank (the Labour Party, 2017) within an ownerless model.

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Chapter 2. The banking reform agenda: preserving the status quo

2.1 Introduction

‘The laws of power Law 31 Control the Options: Get Others to Play with the Cards you Deal The best deceptions are the ones that seem to give the other person a choice: Your victims feel they are in control, but are actually your puppets. Give people options that come out in your favour whichever one they choose. Force them to make choices between the lesser of two evils, both of which serve your purpose. Put them on the horns of a dilemma: They are gored wherever they turn.’ (Green, 1998, p254) ‘The art of always being right: thirty eight ways to win when you are defeated 18. Interrupt, break-‐up, divert the debate If you observe that your opponent has taken a line of argument which will end in your defeat you must not allow him to take it to its conclusion, but interrupt the course of the dispute in time or break it off altogether or lead him away from the subject, and bring him to others. In short you must effect a change of debate.’ (Schopenhauer, 2004, p79 and p95)

The UK banking crisis, which began in 2007, was part of what was widely

viewed as the worst financial crisis since the 1930s. Some of Britain’s biggest banks were faced with insolvency and collapse, which in turn threatened the functioning of the financial sector and the wider economy. It called for immediate and radical government intervention and on an unprecedented scale to ensure that banks could continue to provide some of the rather basic functions required of them. Several mainstream banks and building societies were bailed out or nationalised, and many more were subsequently propped up by an extensive and prolonged programme of quantitative easing which subsidised bank lending with taxpayer funds. After a crisis of such magnitude, the UK had an opportunity to think about what went wrong with banking, how it could be fixed, and how banks might be reformed and made fit for performing the purposes we require of them.

Ordinarily, one would have expected there to be some fairly quick mainstream discussions about what reforms were required to ensure banks never again hold society to ransom in the same way. One might have expected some radical proposals to have been adopted by government seeking to break up the biggest banks, and create an overall smaller sector, with constraints being placed on the identifiably more harmful and unsustainable financial activities. Instead, what we got in the UK was a rather leisurely drawn out reform debate which spanned several years, and which concluded with a rather modest set of reforms proposals (Woolf, 2014a).

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The ‘official response’ to the crisis – that is to say, the published findings and proposals of parliamentary and government bodies and the various watchdogs, and experts commissioned by government – essentially avoided asking the big questions about what needed to be done to fix banks and make them more fit for purpose. Whilst there was no shortage of reports, the official bodies involved in preparing and publishing such reports tended to focus instead on answering a number of narrower pre-‐determined issues, generally referred to them by government, whose own reform agenda appeared to have been set with a view to preserving the dominance of the financial sector (CRESC, 2009, pp11-‐12; PCBS, 2013b, paras190, 237). Following the first signs of financial crisis, a halo was quickly constructed around the City as the government quickly commissioned and endorsed the findings of Sir Win Bischoff, committing itself first and foremost to a thriving internationally successful City (CRESC, 2009, p18).

As we shall explore in this chapter, any reforms which might threaten such a thriving and successful City were soon marginalised in the reform debate by the ‘official response’. In the sense referred to by Schopenhauer and Greene in the opening quotations at the head of this chapter, the government appeared to ‘divert the debate’ and ‘control the options’, setting the pace and agenda for discussion, which resulted in the reform debate arriving at a modest set of reform proposals. Ultimately, the proposals adopted by Government did not seek to tackle the perverse incentives arising from the way banks are owned, nor did they seek, at least on the national scale Basel III notwithstanding, to radically change the wider structural setting and regulatory environment within which banks operate to encourage them to reduce the amount of unsustainable and risky speculative lending. The ownership pressures and structural pressures which this thesis is concerned with were largely overlooked by the official response.

The purpose of this chapter is to consider the reports and inquiries undertaken in response to the crisis in order to look at how the ‘official response’ to the crisis dealt with the issue of ownership. This chapter considers what the official response was, what issues it considered and why that response failed to question whether banks should be owned in different ways. In explaining how the official response failed to ask the big questions and to tackle what this thesis refers to as ‘ownership pressures’ and ‘structural pressures’ this chapter also sets the scene for the review of the literature into ‘ownership pressures’ in chapter 3 and ‘structural pressures’ in chapter 4.

The chapter is broken down into two parts. The first and biggest part follows the reform debate broadly in chronological fashion. It deals with the official and semi-‐official reports and inquiries which were instigated in response to the banking crisis, such as the reports produced by Bischoff, Wigley, Turner, Walker and Vickers, as well as the various reports by the Treasury Select Committee within its ‘Banking Crisis Inquiry’. It also considers the reports produced later on in response to the public’s reaction to the market-‐rigging scandals which emerged in 2012, chiefly the Parliamentary Commission on Banking Standards report (2013a, 2013b) and later the Competition and Markets Authority (2016) review into competition in the retail banking sector. It describes how the banking reform debate was influenced and even steered by the government, and how the government itself has been in hock to financial

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interests, seeking to preserve light-‐touch regulation and a thriving City by setting the agenda for the debate and defining the issues for determination. It describes how the government stage-‐managed the debate by appealing to authority, appointing its own experts to make proposals on a predefined set of issues, which inevitably sought to preserve shareholder-‐value banking and limited regulation, without disturbing the dominance of the big banks, or breaking up universal banking.

The second part of the chapter then discusses what was overlooked by the official response, namely how banks are owned and how the space within which they operate should be regulated to ensure they meet our expectations of them. Having explained how and why these issues were side-‐lined in the first part of the chapter, there is an analysis of how such ownership and structural issues have been raised at the margins of the debate but in ways which have failed to engage political imagination and enable any meaningful challenge to the status quo, resulting in the banking reform debate missing an historical opportunity.

2.2 Part 1: The ‘official response’

2.2.1 Controlling the debate On 5 March 2015, the Government announced that the ‘banking reform

agenda’ had been completed (H. M. Treasury, 2015). It announced that the implementation of the Financial Services (Banking Reform) Act 2013 represented ‘the final piece of the biggest reforms…’ which, according to Andrea Leadsom then the City Minister ‘mark[ed] the end of a five year process, led by the government, to make the UK banking system stronger and safer.’ (H. M. Treasury, 2015). The Government’s banking reform agenda essentially incorporated some of the proposals made by the Independent Commission on Banking chaired by Sir John Vickers, as well as some of the recommendations of the Parliamentary Commission on Banking Standards. The Government’s reform package comprised a set of measures: re-‐empowering the Bank of England as bank supervisor responsible for identifying and mitigating systemic risks; obliging banks to ring-‐fence the more publicly-‐sensitive parts of their business to protect them in the event of bank failure; encouraging competition by stream-‐lining account switching services; tightening up the approval regime for the appointment of senior bankers and introducing a series of criminal offences to penalize ‘reckless misconduct’ in an effort to improve banking ‘culture’. As far as the government was concerned, the banking reform which they boasted was ‘led by the government’ had officially concluded in 2015, culminating in the 2013 Act coming into force.

That 2013 Act was the culmination of ‘the official response’. It formally put into effect those proposals which were accepted by government and put before Parliament which themselves were made at the conclusion of various inquiries and reports undertaken by those state agencies or appointees commissioned by the government following the banking crisis in 2008. The ‘official response’ to the crisis did not hold a comprehensive inquiry investigating the types of questions

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one would expect to be asked in the wake of the banking crisis such as what went wrong with banking, what do we want banks to do and what reforms are needed to achieve the type of sector we want and to avoid banks failing again.

Instead, as we shall see, the official response essentially delegated the task of policy formulation and inquiry to a number of agencies and experts supposedly independent of government with an emphasis on their familiarity with and experience of the financial industry. This process, which we shall explore more fully below in this part, began in 2008 when the crisis became apparent and lasted for years, until 2016 when the Competition and Markets Authority concluded its review. In 2008, the government asked a City grandee, the former Chairman of Citigroup, Sir Win Bischoff essentially whether he thought it was important for policy-‐makers to protect the competitiveness of the City. Shortly afterwards in 2009, the Mayor of London asked another City man Wigley essentially the same question. The Government then went on to ask the head of the FSA, an institution which itself had been implicated in regulatory failure (Treasury Committee, 2009e, pp3, 13), to inquire into what caused the crisis with a view to considering how regulation should be reformed. It asked another City heavyweight, Sir David Walker to look into corporate governance in banking and what reforms were needed. As well as the various inquiries performed by the Banking Crisis Inquiry by Parliament’s select committee, Parliament asked a number of City figures, led by Sir John Vickers, to make reform proposals for the banking sector generally.

2.2.2 Sir ‘Win’ Bischoff and Bob Wigley – pledging allegiance to the City

In July 2008, at a stage when it was becoming apparent that the UK was entering into a financial crisis, H. M. Treasury asked the former Chairman of Citigroup, Sir Win Bischoff whether he thought it was important for policy-‐makers to protect the competitiveness of the City. Specifically, this enquiry was asked :

‘to examine medium to long term challenges to London’s continued competitiveness in international financial markets and to develop a framework on which to base policy and initiatives to keep UK financial services competitive over the next 10 to 15 years’ (H.M.Treasury, 2009).

Around the same time, the Mayor of the City of London, Boris Johnson, asked another City man what needed to be done to preserve the City’s competitiveness. Bob Wigley, European chair of Merrill Lynch was asked to undertake a ‘review of the competitiveness of London’s financial centre’ (Wigley, 2008, p6). These reviews were asked to consider how to preserve a prominent and thriving City, rather than to make a broader inquiry into what sort of financial sector the UK needed. Unsurprisingly, both Bischoff and Wigley produced reports boasting the importance of the City for Britain’s national economy which suggested that policy-‐makers should be careful not to prejudice its competitive position. Bob Wigley’s report, ‘London: winning in a changing world: review of the competitiveness of London’s financial centre’, published in December 2008, stressed the need for London to compete as the global financial centre, boasting the benefits of its regulatory regime and cautioning against excessive regulation (Wigley, 2008, pp17, 41).

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The Bischoff report ‘UK international financial services – the future’ was published in April 2009. Advocating for the promotion of the City and a balanced approach to regulation it dismissed the need to create narrow banks and rejected outright the notion of completely separating retail and investment banking (Bischoff, 2009, p2). Any reforms, it suggested would have to minimally disrupt the City’s freedom to compete with other global financial centres to be a hot-‐bed for global capital and should have a view to preserving and promoting the City’s success as a global financial centre (Bischoff, 2009, pp38-‐39). It rejected the idea of breaking up universal banks and big banks (Bischoff, 2009, pp2, 21), and instead advocated for macro-‐prudential regulation, regulating capital ratios to manage growth and encourage banks to lend more during downturns and less during economic booms (Bischoff, 2009, p2) and it called for periodic reviews of regulation, and cooperating internationally with others rather than radical regulatory change (Bischoff, 2009, p39).

The apparent aim of the policy being advocated for was not to inquire into what caused the banking crisis and needed to be done to avoid it, or to ask more generally what we want from the sector but rather to preserve the City’s role as a global financial centre. Bischoff and Wigley epitomise a form of regulatory capture with the official response buying into a narrative which was lobbied for by the financial sector (CRESC, 2009, p11). Without even questioning what the financial sector cost society, Bischoff accepted that the City was a large net contributor to gross domestic produce (‘GDP’) and good for the economy (CRESC, 2009, p24). The report was keen to recognise that banks were an important part of the UK economy and very quick to suggest that they should not be treated as any special case but rather approached like any other industry driven by commercial interests (Bischoff, 2009, p23). Bischoff advocated in favour of such laissez faire approach without identifying that banks perform vitally important public functions essential for the running of the economy, and without observing that their shareholders tend to contribute only a tiny fraction of their overall assets.

Before inquiring into what went wrong with banks and how they needed to be reformed, the policy line adopted by the elite position was that regulatory reforms had to be limited to preserving London’s competitiveness. Indeed, any attempt to undertake an official inquiry into the causes of the crisis came after Alistair Darling publicly pledged allegiance to a thriving City. Any doubt about whether the government supported such policy aims were immediately dispelled before the banking reform debate even got started upon the Chancellor of the Exchequer, Alistair Darling, signing up to Bischoff proposals, and co-‐authoring the report (Bischoff, 2009, p2). The Government’s banking reform agenda and policy priorities were thus set, or confirmed, by a City appointee, who whilst independent of government, had very close connections with a City bank who had obvious interests in preserving what Bischoff described as internationally ‘competitive regulation’ (Bischoff, 2009, p37).

2.2.3 Lord Turner – preserving light touch regulation

Having already appointed Bischoff, in October 2008, the Chancellor of the Exchequer Alistair Darling then asked Lord Turner, who was at the time still

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director of the FSA, to consider what regulatory changes were needed, and specifically: ‘to review the causes of the current crisis, and to make recommendations on the changes in regulation and supervisory approach needed to create a more robust banking system for the future’(p5, Turner 2009). The choice of the FSA as agent to review the adequacy of regulation and make proposals for reform was rather peculiar, given that the FSA had been roundly criticised for failing to do its job properly and adequately regulate (Treasury Committee, 2009c, para.63) and therefore arguably had the least incentive to find regulatory failure, or to propose any radical change in regulation. Before the government had debated or proposed how to reform the banking sector Turner was asked to make proposals for reforming the way the sector was regulated and he was asked to do so without being asked to consider what type of banking sector the country needed or wanted. His remit tacitly assumed that we would continue to have the same type of sector as indeed Bischoff and Wigley had already argued for, and the government had apparently committed itself to. Turner was specifically asked to make proposals to enhance the ‘robustness’ of the sector, and not to consider how banking crises might be avoided altogether in the future.

Unsurprisingly, the Turner Review, ‘A regulatory response to the global banking crisis’ did not pin blame for the banking crisis at the door of the FSA. The Turner Review was not heavily critical of the regulatory regime but instead presented the crisis as an inevitable and unavoidable systems failure: an unfortunate combination of complex, but unpredictable macro-‐economic forces playing out within a regulatory climate which had become permissive in reliance on mathematical models (Turner, 2009, pp11-‐22). This explanation criticised excessive faith being placed on mathematical models, but in marked contrast with his later 2016 analysis of the crisis (Turner, 2016), Turner was not scathing of the entire light-‐touch approach of regulators. The cause of the crisis, Turner argued in his review, was the macro-‐economic imbalance caused by the Eurasian savings glut seeking yield in a highly innovative and permissible regulatory environment where trade in complicated financial instruments was rife, and able to cause a critical accumulation, and occlusion, of risk (Turner, 2009, pp11-‐22). This narrative ‘macro trends meeting financial innovation’ (Turner, 2009, p11) had few guilty parties deserving punishment, and no identifiably singular flawed part of the system which could be readily fixed. Turner instead proposed an array of measures. He got behind the proposal for greater macro-‐prudential regulation already suggested by Bischoff (Bischoff, 2009, p2), and canvassed the possibility of regulating financial products, warning of the need to more carefully police shadow banking and cross boarder activities (Turner, 2009, pp7-‐9). He proposed greater capital buffers, closer supervision of credit rating agencies, and reform of director remuneration structures, as well as a more pro-‐active counter-‐cyclical role for regulation (Turner, 2009, pp7-‐9).

2.2.4 The Banking Crisis Inquiry – the wrong body The Banking Crisis Inquiry (BCI) was not an independent commission set

up by Parliament to inquire into what caused the banking crisis and how to avoid it, and consequently it did not produce a comprehensive single report on that

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subject. Rather the BCI was performed by the Treasury Committee (TC), which is one of the House of Commons select committees which had been set up by the House of Commons with the express purpose of examining ‘the expenditure, administration and policy of HM Treasury, HM Revenue & Customs, and associated public bodies, including the Bank of England and the Financial Conduct Authority’ (House of Commons, 2002).

Rather than being tasked with performing a singular comprehensive inquiry, it was free to choose its own subjects of inquiry, as relevant to examining the expenditure of the Treasury and associated bodies. On 25 November 2008, the Treasury Committee announced its intention to launch a Banking Crisis Inquiry, its own terms of reference being to identify lessons that can be learnt from the crisis, specifically with a view to ‘securing financial stability, protecting the tax payer, protecting consumers, and protecting shareholder interests’ (Treasury Committee, 2008a) The Treasury Committee held a series of public hearings predominantly in 2009, in which it heard evidence from a number of different stakeholders, and it consequently produced a number of reports. The first report ‘Banking crisis: the impact and failure of Icelandic banks’ published on 4 April 2009 dealt with problems emerging from the Icelandic banking sector (Treasury Committee, 2009a). The second published on 1 May 2009, dealt with ‘The failure of the UK banks’ (Treasury Committee, 2009b). The third, published on 15 May 2009 considered ‘Reforming corporate governance and pay in the City’ (Treasury Committee, 2009c). The fourth, published on 24 July 2009 considered ‘The international dimension’ (Treasury Committee, 2009d). And the fifth report, published on 31 July 2009 considered more generally ‘Regulation and supervision’ (Treasury Committee, 2009e).

The House of Commons Treasury Committee also undertook various other inquires related to banking reform outside of its Banking Crisis Inquiry, including its report into ‘The Run on the Rock’ published on 26 January 2008 (Treasury Committee, 2008b), its report into moral hazard: ‘Too important to fail–too important to ignore’ which was published on 22 March 2010 (Treasury Committee, 2010), its report on ‘Competition and choice in retail banking’ which was published on 24 March 2011 (Treasury Committee, 2011a) and its report into ‘The Financial Conduct Authority’ (Treasury Committee, 2012a).

The proposals of the Treasury Committee, which were spread across the various reports, are constrained by the practice of making recommendations by unanimity. Whilst able to vent criticism and question witnesses, the proposals were less radical than its inquiry and criticisms. In its second report, ‘dealing with the banks in the UK’, for example, the committee heavily criticized the FSA, the Bank of England, and indeed the government itself for spreading the illusion that banking growth and profitability was sustainable in the long or medium term and also for permitting the culture of ‘easy rewards’ for risky behaviour (Treasury Committee, 2009b, para.17), but it did not go on to make a set of clear and radical proposals for reforming the culture of light touch regulation. In the same report, the Committee rejected the suggestion that bankers were merely innocent victims of unfortunate external circumstance and it explicitly rejected the apologies given by senior bankers during some of the hearings in 2009 as being too insincere and even rehearsed, (Treasury Committee, 2009b, paras.132-‐134). Yet whilst unaccepting of apologetic bankers, its proposals for reform fell

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short of those later proposed by the PCBS which for example recommended the introduction of new criminal offence, and overhauling the approved person regime (2013a, ‘summary of recommendations’). Its analysis was also obscured by being spread over a large variety of reports looking into multiple diverse issues. Instead of producing a singular, definitive report on the causes of the banking crises and the implications for reform, there was a proliferation of analysis across many different reports which watered down what might otherwise have been a more cogent compelling set of proposals.

Whilst considering that there were corporate governance failures (Treasury Committee, 2009c) the Treasury Committee did not question whether banks should be run for shareholder value. In its third report in 2009, on corporate governance, it did not explore how far shareholder value banking contributed to the crisis, but proceeded on the assumption that there had been some form of corporate governance failure, involving a failure of shareholder oversight which called for reform of the corporate governance regime to encourage further shareholder activism (Treasury Committee, 2009c, para.176). It sought to narrow what it presumed to be an agency gap, without questioning whether such agency should exist and in other words whether banks will behave if run primarily for their shareholders.

Although it had identified, in its second report on the failure of UK banks, that building societies tended to be inherently less risky business models than shareholder-‐owned banks (Treasury Committee, 2009b, para63), it did not go on to question either in that report or in its report on corporate governance what the relevance of the shareholder-‐ownership model was to the risks banks took upon themselves. In its report on corporate governance, the Treasury Committee appeared to accept that shareholders tended to vote with their feet, rather than take an active interest in governance (Treasury Committee, 2009c, paras.75 and 176), yet it nevertheless it proposed more of the same corporate governance regime rather than challenging whether shareholder supervision could ever be adequate. In that report the Treasury Committee accepted that shareholder-‐value banking tended to encourage leverage, short termism and excessive risk (Treasury Committee, 2009c, para.167) but it did not question whether banks should be run for shareholder value. The committee argued more had to be done to enhance shareholder activism and indeed, it called for Sir David Walker to look into how that could be done (Treasury Committee, 2009c, paras.75 and 176).

2.2.5 Sir David Walker – protecting shareholder-‐ownership

In February 2009, three months after Turner was asked to report on the cause of the crisis, the Prime Minister, Gordon Brown, then asked another City grandee to look into problems with corporate governance in banking. Just after receiving the Wigley report, Sir David Walker – a man known to have close connections with a number of big City financial institutions, and significant professional and financial interests (Treasury Committee, 2009c, para.161) – was asked to consider the subject of corporate governance in banks and to make proposals for reform (Walker, 2009 pp5, 6, 127). The reasons for Walker’s selection were not published. His explicit terms of reference were which were

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made public are noticeably limited. Sir David was not asked to consider the causes of corporate governance failure and bank failure in general or to make proposals to prevent the same. He was not asked to consider whether the ‘ownership model’ was unfit or another model could be more fit for purpose nor to consider what the effects of banks being shareholder-‐owned had, and how to address them.

Instead the Prime Minister asked Walker specifically to propose measures to encourage ‘greater shareholder activism’ (Walker, 2009, p5). And he was engaged on the assumptions which he explicitly recorded in his report that banks would continue to engage in speculative activities and continue to provide both retail banking services as well as engaging in wholesale and investment banking (‘IB’) activities (Walker, 2009, pp25-‐27). He was further clear that he only intended to propose more soft law reforms which did not require any primary legislation or radical change in the law. As he clarified in his report, he considered proposals on the basis of adding further to the ‘comply and explain’ regime of the Combined Code, which companies voluntarily adhere to. And he was specifically asked to make his proposals on the basis that they would not risk putting UK banks at a competitive disadvantage vis-‐a-‐vis their non-‐UK domiciled competitors (Walker, 2009, pp27, 31). Any discussion about whether shareholder-‐ownership itself provided problematic incentives which needed to be addressed, or on how to address such incentives, was implicitly off-‐limits.

Rather predictably therefore, Sir David Walker’s report, ‘A review of corporate governance in UK banks and other financial industry intermediaries’ published on 26 November 2009, both blamed inadequate corporate governance arrangements for failing to prevent excessive risk-‐taking, whilst proposing more of the same type of corporate governance arrangements which he had found failing, and it did so without questioning whether shareholder value banking encouraged risk or whether shareholder supervision could ever adequately guard against excessive risk (Walker, 2009). Like Bischoff before him (Bischoff, 2009, p23), he treated banks like any other economic venture run for commercial interests. Even though bank capital, unlike the capital of companies operating in other sectors, tends to be composed of only a tiny proportion of shareholder capital, Walker did not differentiation between the ownership of banks and the ownership of any other company. He did not distinguish banking from other sectors of activity by recognising the extent to which banks handle other people’s money nor did he consider the important socially valuable functions banks perform. Unlike John Kay after him, who we shall consider next, Walker did not consider how shareholder value banking caused incentivised for senior management to take risks.

Instead Walker proposed some modest soft law improvements for the corporate governance regime applicable to banks. He proposed tighter controls over risk and pay by non-‐executive directors (NEDs), the introduction of risk committees and risk officers to scrutinise big transactions, the adoption of a stewardship code to encourage greater activism by institutional investors, greater disclosure on pay (for employees earning more than £1m) and more use of deferred or long term (dividend) bonuses – proposals which he himself was noticeably later powerless to implement when he became Chairman of Barclays. His rather inevitable conclusions were to propose more shareholder activism, and to seek to further align the interests of management with shareholders, in

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the expectation that such alignment would lead to more prudent long term management (Walker, 2009, pp14-‐22). Assuming that the failings in corporate governance arose out of inadequacies in the existing corporate governance regime rather than intrinsic problems in the ownership and supervision structure of PLC banks, he proposed more of that soft law regime calling for oversight, rather than thinking about reforming the ownership structure and tackling its adverse incentives. Walker’s entire report was predicated on the assumption that banks would continue to be run for shareholder value; indeed Walker confirmed as much at the start of his report in para.1.1: ‘the role of corporate governance is to protect and advance the interests of shareholders’ (Walker, 2009, p23). Like the Banking Crisis Inquiry (2009c, para.176) Walker’s review presumed there was an agency gap which needed to be narrowed without questioning the logic of having banks act as agents for their shareholders. Walker’s review thus sought to side-‐line from the official response and the wider banking reform debate any question about whether banks should be run for shareholder value.

2.2.6 Sir John Kay – reforming equity markets, not ownership

Kay’s review in UK equity markets, published in July 2012, contrasts starkly with the Walker Review and for that reason it is worth exploring here both out of chronological order and notwithstanding that the review was not limited to reform in the banking sector as it is illuminating to consider the review alongside the Walker review. Asked by the Business Secretary, Vincent Cable, to make proposals for making ‘equity markets’ ‘more efficient’ and less ‘short term’ (Kay, 2012, p7). John Kay reported on a number of issues which were conspicuously absent from Walker’s review. He reported that shareholders are demonstrably failing to govern companies and have little incentive to do so (Kay, 2012, p22); that share ownership is not functioning in accordance with its purpose to provide new sources of investment and that shareholders are increasingly removed from having any supervisory function (Kay, 2012, p32) and that the structure of shareholding favours trading, transactions and intermediation, over long term productive and sustainable investment leading to chronic problems of short termism and under-‐investment (Kay, 2012, p10).

Kay proposed the imposition of fiduciary duties upon financial intermediaries so that they owe duties to investors and those involved in trading and investment to put the interests of investors first (Kay, 2012, p13). He proposed that trading intermediaries disclose their own interests, charges and commissions (Kay, 2012, ch.9); and he called for reporting standards to be improved, and quarterly reporting to be eradicated (Kay, 2012, ch.10). He also called for the incentives of managers and intermediaries to be aligned with more long term value creation in companies through scrapping cash bonuses and delaying equity interests until after directors had exit the company (Kay, 2012, ch.11) and he called for regulators to focus on the interests of investors, not on those of intermediaries and to abandon their reliance on the efficient market theory (Kay, 2012, ch.12).

What is interesting about the Key review is not merely that his proposals in the main went by the way-‐side and were not adopted, but that Kay was given

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scope to inquire into the problem of shareholder ownership in a way which effectively precluded him from introducing the shareholder value critique into the banking reform debate. Kay was given a very limited mandate, being asked not to consider problems caused by shareholders owning companies, but rather problems caused more generally by equity markets and the increasing financialisation and distancing of shareholders. Further he was asked not to consider problems with equity in banking, but generally to undertake an inquiry across all sectors into the functioning of equity markets in the UK. He was thus asked essentially to consider the problem of trading in shares, and not whether there is a fundamental problem with companies being owned by shareholders and run for their benefit. That device, which distinguished between the problem of shareholders trading shares rather than retaining an interest in owning shares, required him to assume that shareholders should own shares and enabled him to critique problems caused by shareholder ownership in only a limited and indirect way. Kay was invited to consider the controversial subject which the official response had otherwise avoided, but in a way which did not risk trespassing upon the modest proposals recommended by Walker. He was asked to consider problems arising through the holding of equities, rather than whether shareholders were fit to govern. Having thus not been asked to consider whether shareholder ownership drives problems particularly in banking, he avoided bringing the ownership issue being any part of the official response.

2.2.7 Sir John Vickers – preserving universal banking

In 2010, a year after the former Chancellor of the Exchequer Alistair Darling had confirmed that there would not be a full separation of retail and wholesale functions (Bischoff, 2009, p2), the new Chancellor of the Exchequer, George Osborne, announced that Sir John Vickers would chair a commission to formulate government policy recommendations for banking reform with a view to :

‘Reducing systemic risk in the banking sector… Mitigating moral hazard … Reducing both the likelihood and impact of firm failure; and… Promoting competition … with a view to ensuring that the needs of banks’ customers and clients are efficiently served, and in particular considering the extent to which large banks gain competitive advantage from being perceived as too big to fail’. (H.M. Treasury, 2010) Vickers was asked to do that ‘with specific attention paid to the potential

impact of its recommendations on… the competitiveness of the UK financial and professional services sectors and the wider UK economy; and Risks to the fiscal position of the Government’ (H.M. Treasury, 2010). Rather than being asked to consider the big questions about what went wrong with banks, what we want from the sector and what needs to be changed to deliver that, Vickers was instead charged with only ‘mitigating moral hazard’, not avoiding it altogether (ICB, 2010a). He was called upon to make proposals which reduce the impact of systemic failure (ICB, 2010a), not to prevent it from occurring in the first place; he was asked to address ‘the competitive advantage from [banks] being perceived as too big to fail’ (ICB, 2010a), rather than to tackle the problems caused by banks being too big to fail and he was asked to consider ways of making banks

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better able to absorb losses and less costly to sort out when they get into trouble (ICB, 2011, p8), not to do whatever was necessary to ensure banks avoided getting into such serious trouble in the first place. The Independent Commission on Banking's chief function, as encapsulated by Sir John Vickers' executive summary, was to ‘insulate essential banking services’, to minimize the damage caused to those essential services, and to the tax payer, in the event of financial collapse but to do so ‘with specific attention… to… the competitiveness of the UK financial and professional services sector’ (ICB 2011, p10). He was asked to make recommendations with specific attention being paid to the ‘complex issue of separating retail and investment banking functions’ (ICB, 2010a) and to make such recommendations whilst also bearing in mind the need for the City of London to remain a thriving financial centre (ICB, 2011, p145), the inference being that intervention should be subordinate to that aim.

Unsurprisingly, Vickers recommended proposals which he had essentially been called upon to make. As Martin Wolf, one of the ICB’s members later clarified (Wolf, 2014a) the ICB recommended the most modest ways of achieving what had been called for. Vickers proposed insulating essential banking functions by ring-‐fencing them, rather than separating them out risky and socially important banking functions. Having been asked to think the unthinkable (ICB, 2011c) Vickers made recommendations to minimally disrupt the status quo. Although Vickers was asked to make recommendations to promote competition, the ICB merely proposed that the sector be referred to the Competition Commission. Rather than making radical proposals to break up banks and reduce their size and dominance in an oligopolistic market, the ICB kicked the issue into the long grass calling for future inquiry by the Competition Commission. Having not been asked to consider how and why bank failure was caused in the first place, and how it could be avoided Vickers made proposals for ameliorative and not radical reform, and did so in a modest way which insulated business as usual, and allowed banks considerable time (8 years) to implement his proposals and a considerable degree of discretion to determine what activities can and cannot be protected and need to be ring-‐fenced.

2.2.8 Parliamentary Commission on Banking Standards – a missed opportunity

Following the market-‐rigging scandal which revealed that banks had submitted false submissions to set the London Interbank Official Rate (‘LIBOR’), a growing consensus emerged that there was a problem within banking and that something needed to be done to change it (Treasury Committee, 2012b). The PCBS was subsequently empowered to investigate the issue of ‘culture’ and to make wide-‐ranging proposals for reforming the banking sector with a view to reforming ‘culture’. Specifically, it was appointed by both Houses of Parliament to consider and report on:

‘professional standards and culture of the UK banking sector, taking account of regulatory and competition investigations into the LIBOR rate-‐setting process, lessons to be learned about corporate governance, transparency and conflicts of interest, and their implications for regulation and for Government policy and to make recommendations for legislative and other action’ (PCBS, 2013b, ‘terms of reference’).

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Properly resourced, the 13 members who employed 19 members of staff

and engaged 14 others outside parliament, including independent counsel to cross examine witnesses, conducted an extensive public inquiry over the best part of a year, which under the glare of public scrutiny and television cameras, heard evidence from more than 250 witnesses. On 19 June 2013, the PCBS published its final report ‘Changing banking for good’ in two volumes (2013a, 2013b) which ran to more than 500 pages and cost more than £850,000 to produce (PCBS, 2013a, annex 1, para.10).

The report made wide-‐ranging recommendations to deal with the problem of ‘culture’ in banking. Its main proposals were: to overhaul the way senior bankers are vetted and authorized; to introduce a clearer allocation of responsibilities; to introduce new criminal offences for reckless banking; to make changes to banker remuneration to align rewards with longer term performance including making greater use of bail-‐in bonds, and claw-‐backs; as well as introducing greater powers for regulators to defer rewards (PCBS, 2013a, ‘conclusions and recommendations’).

Unlike the inquiries before it, the PCBS did not ignore the issue of ownership and how shareholder value banking can provide incentives for bad behaviour. In annex 5, which considered ‘bank ownership’, the PCBS observed how :

‘bank shareholders typically have limited interest in the operation of banks, and tend to place a premium on short-‐term returns’ (PCBS, 2013b, p533).

Indeed, the main report observed how shareholders gave banks every incentive to push for greater leverage (PCBS, 2013b, p154) and as such suggested that they were ill-‐equipped to hold bank boards to account. It also considered that institutional shareholders had incentives to encourage directors to pursue high risk strategies in pursuit of short-‐term returns (PCBS, 2013b, p155).

Nevertheless, the PCBS’s investigation into the relevance of ownership was relatively limited. Focusing instead on the problem of ‘culture’, it considered what Helmke at al (2004) would have described as ‘informal’ institutions, namely banking ‘culture’, ‘standards’ and ‘practices’, rather than seeking to address and contemplate reforming what might be called more ‘formal’ institutions, such as the law of corporate governance or regulation of the sector. The PCBS’s ownership-‐related reforms for example were limited. Having identified how banks have perverse incentives to act for shareholders it merely suggested that government should consult on whether IFI’s should be run not only for shareholders but also for other stakeholders putting ‘the financial safety and soundness of the company ahead of the interests of its members’ (PCBS, 2013b, p344) – a proposal which has not been adopted or taken up. Although the PCBS recognized that problems were caused by banks being run for the benefit of largely disinterested shareholders, who contributed proportionately little to bank assets (PCBS, 2013b, annex 5 ‘bank ownership’), the government was unwilling to adopt any of its proposals to consider reforming ownership incentives, and has instead watered down the validity of this analysis by cherry-‐picking other proposals for adoption, unrelated to ownership.

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This omission represents more than mere oversight and a missed opportunity but suggests a wilful refusal on the part of government to think about any alternative to the shareholder value paradigm of banking (Black et al, 2015). Having effectively shut the door to any debate about removing shareholder value banking by side-‐lining the issue from the official response, the issue was not let in through the back door by the PCBS’s inquiry.

The PCBS was instead asked to consider the problems of ‘banking standards’ and what was widely perceived to be a problem with ‘culture’. ‘Culture’ is a complex concept open to divergent interpretations and meanings. Indeed, it has been described as one of the most complex words to define in the entire English language (Williams, 2014). Presupposing that the banking industry had a problem with ‘culture’, the PCBS was not asked to consider how the way banks are owned created a problem with culture and how such causes might be tackled. As Luyendijk (2015) argues the PCBS addressed the symptoms and not the cause of misbehaviour, like addressing damp from water ingress without fixing the hole in the roof. It addressed the proximate and not the underlying causes of bad behaviour, trying to fix the problem of culture without any mandate to tackle the causes driving such problems.

The PCBS also made its proposals without investigating the causes of the banking crisis or what is needed to avoid future problems, and without considering what reforms are necessary to ensure banks do what we want of them. Indeed, its final report explicitly clarified that it was not making such inquiries:

‘67. A commission on banking standards cannot address the causes of the financial cycle which is, in any case, extremely unlikely to be eradicable. Nor should the recommendations of a UK body be expected to correct, or attempt to correct, all that is wrong in a global industry. However, that does not mean that nothing should be done. A great deal can and should be done to reduce the risk of future crises and to raise standards. There is currently a widespread appetite for measures to constrain the misconduct, complacency and recklessness that characterised the last boom and its aftermath…’ (PCBS, 2014, para.67)

2.2.9 The Competitions and Markets Authority investigation–a standard recipe?

Asked to look into enhancing competition in the retail banking market, and having been prevailed upon also by Vickers to do so, on 6 November 2014, the CMA launched an investigation into retail banking. It produced its final, report, entitled ‘retail banking market investigation’ on 9 August 2016. Unsurprisingly, the CMA found a lack of competition in retail banking. It was observed that the biggest banks enjoy a dominant position in a highly concentrated oligopolistic market with high barriers to entry (CMA, 2016, para.93). Rather than exercising any of its extensive statutory powers for example to break up the banks and reduce their size to reduce their stranglehold or to end free-‐whilst-‐in-‐credit banking, however, the CMA instead proposed a modest set of measures aimed to make it easier for retail consumers and SME’s to change bank accounts and understand what charges they pay banks. The proposals were widely received with criticism for failing to do enough to address competitive failures and for failing to adopt measures others had called for such

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as ending free whilst in credit services, or capping overdraft fees and charges and the report has been widely criticized for not doing enough for consumers or to reform competition (Treanor, 2016).

2.3 Part 2: the wider debate

2.3.1 What was missed? The official response arose in the face of elite political resistance to radical reform of the banking sector (CRESC, 2009, p11). As was made clear by Bischoff, the prevailing political climate favoured reforms which were minimally disruptive and were subordinated to the aim of promoting a competitive City. There was evidence of what Carpenter et al (2004) described as ‘non-‐materialist’ regulatory capture, in other words the sort of cultural or cognitive capture often witnessed around industries that fund powerful pressure groups. Certainly, there was no shortage of lobbying on banking reform. In 2011 alone, the year in which Vickers produced his report, the British Banking Association (‘BBA’) spent £92 million on lobbying government in an attempt to secure favourable policy changes (Mathiason et al, 2012). As its chairwoman, Angela Knight, who ironically argued in 2007 that banks could be trusted in setting the LIBOR rates in 2007 and in 2011 that there was nothing wrong with the way banks had sold customers PPI in 2011 (Bloomberg, 2013), gave over 800 interviews and 1000 speeches in the banking crisis, and was heavily involved in lobbying for the reforms which the banks wanted (Garside, 2012). CRESC in particular discovered that the Bischoff report was produced following consultation with mainly financial actors, with non-‐financial actors being largely excluded (2009, p24).

In this environment of considerable political capture (CRESC, 2009, p11), there was an absence of any radical challenge to the status quo, and as we shall explore further in chapter 4, the political and economic settlement which was brokered in the Big Bang, remained fundamentally undisturbed by the official response. The prevalence of the PLC ownership model, strongly favoured following the Big Bang, was not affected by banking reforms. On the whole the vast majority of banks continue to be run for shareholder value, and the way they are owned and run has not been altered.

Without holding an official inquiry into what went wrong in banking and how it can be avoided, and without having engaged more openly in public debate about what we want our banks to do, it is unsurprising that the Government’s reform agenda has been widely criticized by academics and other commentators as being inadequate (Wolf, 2014a, 2014c, chs8-‐9; Bowman et al, 2014, ch.5; King, 2016, ch.9; Turner, 2016, p240) or representing a ‘missed opportunity’ (Black, 2015). Many feel that the government has not gone nearly far enough to effect needed reforms. Some consider it to be in hock to finance in an elite coalition around banking (CRESC, 2009, pp11-‐14; Engelen et al, 2011, pp14-‐18). What is clear from the main reports produced within the official response is that the government managed to avoid asking the sorts of big questions one would expect, and it appeared to be committed to preserving the status quo.

Unfortunately, the critics of the Government’s position who have generally called for more radical reforms have not emerged in the wider banking

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reform debate with a coherent and unified message and clear voice. Absent from the wider debate has been a dominant Keynes-‐like figure behind whom others could rally and mobilise to challenge the established status quo and call for radical reforms. In the wake of the last depression, Keynes enjoyed a significant public platform. He commanded the respect not only of academics but also of many prominent politicians who were eager to seek his views (Wapshott, 2012, ch.2). After the GFC, there has not been any singular prominent proponent for change, as Keynes was. The picture which emerged instead from the wider reform debate is one of a number of disparate figures and factions raising divergent issues whilst grappling with diverse and complex issues, and lacking any unified movement and coherent voice.

Many (such as Admati et al 2012) have focused for greater capital adequacy, increased fractional reserves and the need to de-‐leverage banks or for banks to take greater equity positions in real estate lending (Mian et al,2014; Turner, 2016, ch.12). Others (such as Wolf 2014a) have called for more radical competition intervention to break up the banking oligopoly to better insulate narrow banking and allow riskier parts of the banking business to safely fail. Others (such as Bowman et al, 2014, p114) have suggested that retail banks should be regulated as utilities with lower expectations on returns on equity. Some have called for greater regulatory powers to control financial activities, licencing financial instruments like dangerous chemicals, or for the simplification of lending products, or to enable losses to be imposed on others in the event of bank failure (Turner, 2016, p173). And others have focused on greater reform of the criminal law, or regulatory powers or reform of the tax system -‐ calling for tax relief for debt to be cancelled (Turner et al, 2010, ch.10) or for tax incentives to be reversed so that equity, not debt is privileged (Haldane 2011) or for the creation of a Tobin-‐style tax on credit intermediation, or indeed for a global tax on wealth (Picketty, 2014).

Out of this diverse assortment of analyses emerge two distinct critiques of the official response, which are relevant to this thesis. Both are more willing to question and challenge the status quo. The first can be characterised as challenging the pro-‐City narrative, namely that banks should be left largely undisturbed in order to perform ‘business as usual’ with only minimal and essential reforms and intervention subordinated to the aim of promoting a thriving City. The second challenges the pro-‐stock market narrative, questioning the dominant assumption that there is no alternative to banks being publicly traded and run for their shareholder-‐owners. We have already explored, in the first part of this chapter, how the government itself claimed to steer the banking reform debate and how these two issues were avoided by the official response, which set the agenda for debate, and marginalised those issues in the way it delegated policy issues to be decided upon by experts, whose proposals were invited through limited, generally leading terms of reference. That the government has been unwilling to consider these two issues critical of the status quo suggests a high level of political and regulatory capture, and a lack of political imagination and productive vision for any alternative experiment to that brokered in the Big Bang (Bowman et al, 2014, ch.5).

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2.3.2 Challenging the ‘ownership’ paradigm

Andy Haldane is perhaps the most dominant figure to emerge in the wider reform debate who has been willing to challenge orthodoxy and question some of the assumptions made by the official response in a way which has stoked interest in more radical reforms from a wider audience than might otherwise have been reached by academics. Widely regarded as a rising star in the Bank of England (see for example : Ralph, 2012 and Cassidy, 2013), Haldane, who became Executive Director of Financial Stability on 1 January 2009 and Chief Economist on 1 June 2014, is an atypical central banker. In October 2012, Haldane spoke out in favour of the ‘Occupy’ movement, whose protesters had camped outside of St. Paul’s Cathedral, arguing that they had been right to criticise the financial sector and that their protest had had an impact in persuading bankers and politicians ‘to behave in a more moral way’ (Kuchler et al, 2012).

Haldane published some radical and controversial ideas in the banking reform debate for example introducing epidemiology as a means of analysing the spread and containment of financial crisis (Haldane, 2009); challenging the orthodox view that banks are net contributories to the economy (Haldane, 2010); and challenging the assumption that banks should be run for shareholder value (Haldane, 2011; Haldane, 2015). Shortly after the publication of Vickers in October 2011, Haldane questioned how banks should be owned in his article ‘Control rights (and wrongs)’ (Haldane, 2011). In that lecture, and his later lecture in 2015 ‘Who owns a company?’ (Haldane, 2015) he challenged the assumption that banks should be run for their shareholders, explaining how shareholders provide only a vanishingly tiny fraction of bank assets. Unlike the official response which marginalised this critique, Haldane explored how shareholder-‐value banking provides perverse incentives for management to take socially excessive risks, dangerously leveraging the bank and becoming ‘volatility junkies’ by engaging in risky business (Haldane, 2011; Haldane, 2015).

That this radical analysis has come from within the Bank of England has lent significant credibility to the stakeholder debate and those who challenge the pro-‐stock market narrative that banks should be run as any other PLC as if owned by its shareholders and for their sole benefit. As we shall explore in the next chapter, prior to the GFC, proponents of stakeholder management theory were very much marginalised and in a minority within the corporate governance debate. The stakeholder debate, which contends that stakeholder-‐owned banks (Ferri et al, 2010) or ownerless banks (Bøhren et al, 2013) are less likely to sacrifice the long term interests of wider stakeholders and less prone to take excessive risks and to adopt unsustainable and dangerous business strategies (Allen et al, 1997, 2000, 2004, 2009) gained prominence following the GFC.

Nevertheless, as we shall see in the next chapter, the balance of political and economic thinking tended to favour shareholder value governance and discounted stakeholder ideas. By differentiating between banks and other sectors of activity, and emphasising how shareholders contribute so little to bank capital, Haldane has helped to tilt the scales in this debate, opening it up for others to credibly argue that banks and IFI’s are not like any other company, and there is accordingly little sense in having them managed as if owned exclusively by shareholders who contribute so little to the colossal amounts of money they

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handle (see for example: Haldane, 2012, 2015; Turner, 2016, pp172-‐174, 245-‐246; Black 2015; and also PCBS, 2013b, para708). Whilst the ownership debate still remained at the fringes of the wider banking reform debate, a loose consensus has now emerged around the idea first that it is better to have a diversity of ownership models and not only shareholder-‐owned publicly traded banks (The Oxford Centre for Mutual & Employee-‐owned Business, 2009; Nissan et al 2009; The Ownership Commission, 2012; Ayadi et al. 2009; Hakenes et al 2009; Llewellyn 2010; PCBS, 2013b, paras343, 356), and also that running banks to achieve shareholder-‐value, and rewarding management for doing so, can provide perverse incentives for banks to misbehave and take on excessive risks (Haldane 2011; Coco et al 2010; Hakenes et al 2009; Coco et al, 2010; Ferri et al 2010, 2012; PCBS, 2013b, paras176, 203, 597, 660-‐666, 684, 703, 708).

But whilst Haldane enjoys a public platform from which he can reach a wide audience, unlike Keynes who was able to disseminate radical proposals as well as analysis, Haldane has been limited in the degree to which he has been able to call for concrete reforms. Being a Bank of England ‘insider’, not enjoying the independence for example which Keynes enjoyed, he has been somewhat constrained in how far he can make radical reform proposals. His connection with Threadneedle Street has inevitably inhibited his ability to call for radical reform. He has been able to produce radical analysis and openly discuss fundamentals but he has not been able to discuss the logic of such analysis and how the same translates into concrete proposals for widespread reform, as taking any radical political position might compromise and jeopardise his independence and that of the Bank of England. The pro-‐stock-‐market narrative was not the only aspect of the official response with which others took issue in the wider banking reform debate.

2.3.3 Challenging the ‘structural’ paradigm

Other academics have questioned the extent of finance’s political and regulatory capture, and whether the political and economic settlement brokered in the Big Bang needs to be re-‐balanced to enable banks better to do what we expect from them. Amongst other literature, chapter 4 explores how pressures are exerted on banks from the structure and regulation of the environment within which banks operate -‐ as opposed to the way banks are owned. Emerging from the wider reform debate, there are really two schools with distinct geographical groupings which have questioned the extent of political capture and considered how the structure of the wider economy and the regulatory environment within which banks operate affects what they do and how they behave. There is the Manchester collective and the London collective.

In Manchester, revolving largely around the Centre for Research on Socio-‐cultural Change (‘CRESC’), a group of Manchester academics and intellectuals have published various materials on banking reform including the 2009 ‘Alternative report on UK banking reform’ (CRESC, 2009), the 2011 ‘After the great complacence’ (Engelen et al, 2011) and the 2014, ‘The end of the experiment’ (Bowman et al, 2014). This collective has been heavily critical of the political and financial coalition around banking, challenging the assumption that banks add value to the economy and calling for more public engagement in the

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debate about reforming the sector (CRESC, 2009, pp5-‐7; Engelen et al 2011, p371). By comparing tax revenues, employment statistics and the benefits of bank claimed wealth-‐creation against the ultimate cost to the public of the bail out and programme of quantitative easing, this collective challenged the pro-‐city narrative, arguing that banks did not add value and are not net contributors to the state but that they exert a disproportionate influence over government policy (CRESC, 2009, p32) and argue that the state’s commitment to a light tough regulatory environment for finance has moved beyond naivety and into the realms of hubris (Engelen et al, 2011, p15). They warned of the politically corruptive nature of finance, providing a compelling narrative about the dangers of alignment between political and financial interests (CRESC, 2009, pp5-‐6) and they reduced down issues in the banking reform debate into political, not specialist and technical, issues (CRESC, 2009, pp9-‐10). Calls for clarifying what we want from banking and regulating their credit-‐creation and allocation functions with such purposes in mind, have been repeated by others such as Turner (2016), and in view of the failure of the Government’s ‘funding for lending’ initiative (Jenkins et al, 2013), many would argue that there are good reasons for trying to set explicit targets and regulating banks to achieve certain levels of funding for certain activities.

The Manchester collective also identified how the underlying structure of banking drives excessive risk-‐taking and inherent financial instability (CRESC, 2009, pp40-‐51; Engelen et al, 2011, pp97-‐187). In ‘The end of the experiment’, it was also critical of the political settlement brokered in the Big Bang with shareholder-‐value banking becoming ubiquitous, arguing that the continuing over-‐commitment to the neoliberal experiment, is evidence of a lack of productive vision and leadership to create an alternative to depart from the light-‐touch regulatory status quo (Bowman et al, 2014, p145).

Revolving around the London School of Economics, another grouping of academics and policy-‐makers have published various materials on banking reform chiefly the 2010 ‘Future of Finance’ report, as well as a mass of scholarly articles including those which have been heavily critical of shareholder value banking (such as Black et al 2015). This collective has been more willing to challenge the orthodox pro-‐City narrative and the assumption that bankers give to society more than they take. Rich in the variety of its offerings and analysis, ‘The future of finance’ brings together an assortment of contributions from an array of academics, commentators and officials including, Adair Turner, Martin Wolf and Andy Haldane. It covers topics such as the need for greater capital reserves and macro prudential regulation (Turner et al, 2010, ch.1); the need for narrow banking functions to be protected (Turner et al, 2010, ch.8); the need to align banker's pay directly with banks' long term performance and the need to regulate the shadow banking industry (Turner et al, 2010, ch.9); the need to create an international financial regulatory architecture through treaty organisations (Turner et al, 2010, ch.10); and the proposal for living wills for banks (Turner et al, 2010, ch.5). This collective was not averse to blaming bankers and regulators for contributing towards the crisis, and to criticise socially useless financial activities such as momentum trading for exacerbating bubbles and asset inflation (Turner et al, 2010, ch3). This collective has also been critical of the politicisation of finance and the political and regulatory capture,

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challenging the claimed value of the City and questioning its disproportionate influence (Turner et al, 2010, ch.2).

Following on from the early work of these two schools, a loose but noticeable consensus appears to have emerged from the wider banking reform debate which is critical of the settlement brokered in the big bang, and its deference and over-‐reliance on economic models and ideas, including the efficient market hypothesis and light-‐touch regulation. The post-‐1980s experiment has come under increasing criticism from a wide range of sources who have variously challenged the assumptions bound up by neoliberalism and chiefly the notion that perfectly functioning and efficient financial markets mean that we can largely ignore the role fractional reserve banks play in creating credit and allocation (Bowman et al 2014, ch.1; Turner, 2016, ch.2; King 2016, ch.1). After concluding his chairmanship of the FSA, Turner in particular became a lot more critical of the political establishment for letting the banking sector go largely unmonitored in creating increasing amounts of credit. He argued that fractional reserve banking is liable to create too much credit and cause economic instability, and that the credit creation function needs to be limited or reigned in (Turner, 2016, ch.9).

Turner (2016, ch.12) further suggested that society had collectively forgotten the realizations made following the Great Depression, and he rehearsed arguments made by the Chicago School, in the first half of the last century in favour of abolishing fractional reserve banking. The Financial Times commentator Martin Wolf also resurrected arguments made earlier in the last century by the Chicago School, for example by Soddy (1926), Knight (1933), Fisher (1936), and Simons (1936), not only warning of the dangers of having the credit-‐creation function run for private interests, but also arguing that fractional reserve banking should be abolished or controlled by the state.

Within this wider debate, many have argued for radical reform contending that more needs to be done if the banking sector is to avoid existing in an unstable relationship with the market for the production of assets with speculative bubbles being followed by collapse, risking destabilizing the whole system (Foster et al, 2009, p16; Turner, 2016, pp172-‐174; Wolf, 2014b). Alternative visions for organising the economy have emerged from this debate. Some envisage greater constraints and control on credit-‐creation by banks (Turner, 2016, pp57-‐60) while others envisage the state playing more of a role in clarifying what functions need to be financed more generously and directing credit towards such investment (Bowman et al, 2014, p6). Many popular politicians have advocated for greater productive investment, arguing that the existing system fails to direct credit towards financing the sorts of capital investments needed to generate additional income to repay existing debts and sustain new ones. Leaders of the Opposition, including Ed Miliband (Eaton, 2012) Jeremy Corbyn (Elgot, 2016), and his rival contender Owen Smith (Stone, 2016), all calling for the creation of a well capitalized national investment bank, similar to that proposed by Keynes and the Macmillan committee following the war (Mayer, 2012). Such bank, the Labour Party suggests (Elgot, 2016), could operate along the lines of the German Kreditanstalt für Wiederaufbau (KfW) or Scandinavian Nordic Investment Bank and in other words be tasked with investing in industry and business to increase productive investment, and subsidised with state funding.

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2.4 Conclusions

Despite many years of inquiries and many volumes of proposed reforms, the banking sector remains largely unreformed, doing much of what it used to do in much the same way with all of the same drivers in play as existed before the banking crisis (Wolf, 2014a, 2014c, chs.8-‐9; King, 2016, ch.9). According to some commentators, banks remain dangerously large, continuing to engage too heavily in speculative activities which are neither sustainable nor socially beneficial but which threaten the stability of the real economy (Turner, 2016, pp172-‐174). They still have every incentive to engage in risky business and to misbehave, to pump out too much credit and to allocate it in unproductive and destabilizing ways (Turner, 2016, pp245-‐246). Having banks run for extraction is thought not only to pose dangers in terms of future crises (Wolf, 2014a, 2014b, 2014c; Turner, 2016, pp173-‐174), but is symptomatic of a broader societal trend which tends to prioritize property wealth over other forms of productive investment (Turner, 2016, pp85, 178) and is liable to lead to further wealth inequalities (Piketty 2014, pp21-‐24).

The official response to the crisis failed to ask how we can reform banks to prevent future crisis and to make them serve the broader needs of our society and in particular the real economy and its need for productive investment. Those two aims – the need to avoid further crisis, and to create a banking sector which does what we need of it – could not be accomplished without fundamentally challenging the political-‐economic experiment in which the UK has been heavily engaged since the Big Bang (Bowman et al, 2014, chs.1, 5). The reluctance to depart from this paradigm and challenge orthodox thinking, notwithstanding the banking crisis and the subsequent banking scandals strongly suggests a lack of any productive vision for an alternative experiment. Those two aims – avoiding future crises and reforming the sector to better serve society’s needs – require us to radically re-‐assess what we want from banks, and how they are owned and how the space within which they operate is structured to help them to perform what we want from them. Those two issues ‘ownership pressures’ and ‘structural pressures’ form the subjects around which the literature is considered over the next two chapters.

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Chapter 3. ‘Ownership pressures’: what it is, to be owned?

3.1 Introduction

‘…ownership is really a misnomer when applied to shareholders. What defines shareholders is not that they own most or all of the company. Rather they ‘own’ least, as residual claimants. Associating ‘shareholding’ with ‘ownership’ thus makes little substantive sense, despite its widespread use in popular discourse. Indeed it is precisely because shareholders own least, not most, that justifies granting them control rights over management in the first place. By vesting control rights in the stakeholder whose claim is riskiest, the firm is immunised against taking too much risk in the first place.’ (Haldane 2015, p14)

As a matter of law, in England and Wales it is not possible for a person to

own land. A person can own title to an estate in land, but not the land itself (Grey et al, 2008, ch.2.2). The above excerpt, taken from Haldane’s lecture ‘Who owns a company?’ (Haldane, 2015) highlights a similar legal distinction in relation to companies. As a matter of law, a person can very well own shares in a company, which are a species of intangible property embodying various control rights including the right to have a company run in the shareholders’ interest (see s172, Companies Act 2006). Whilst shareholders can own shares, however, they cannot own the company itself. Indeed, as a matter of law, a company is a fictional entity with separate legal personality distinct from that of the persons who own shares in it or who direct it (Kelly, 2003). Being a separate person with its own legal personality, it is no more possible for another to ‘own’ it than it is for a person to own any other human being, a practice which has been illegal in Britain since the Slavery Abolition Act 1822.

Since companies in the UK are required by law to act for the benefit of their shareholders (s172, Companies Act 2006), it is nevertheless common to talk about companies being ‘owned’ by their shareholders (Eccles, 2015). Indeed, in mainstream economics and political-‐thinking, companies are commonly described as being owned by their shareholders (Mayer, 2013, pp26-‐31), which is widely known as the ‘agency theory’ of corporate governance (Eccles, 2015), and in consequence it is common also to reason that companies should be run for the benefit of their owners, which is known as the theory of ‘shareholder sovereignty’ or ‘shareholder primacy’ or ‘shareholder value maximisation’ theory of corporate governance (Jenson et al, 1976). As is explained in chapter 5, at 5.5.5, the terminology of ‘ownership’, whilst not technically exact, is employed throughout this thesis as useful shorthand for more readily describing the relationship whereby companies are run for their shareholders, or other members as in the case of building societies. ‘Ownership pressures’ refers to the corporate governance relationship whereby businesses are expected to act in the interests of their shareholders, and in other words being run with a view to making them capital gains in financial markets or indeed paying them dividends.

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The question about corporate purpose and in whose interests companies should be managed remained unsettled for many years and has occupied a vast body of literature on ‘corporate governance’ traversing different fields of social science, including law, accountancy, business, economics, politics and philosophy. Shortly before the GFC, it was widely considered that the debate around corporate purpose had been settled (Kraakman et al, 2000) and that advocates of shareholder governance had won: companies should be run for the benefit of their ‘owners’ (or more accurately, their ‘shareholders’) in priority to others. Advocates of stakeholder governance – who argued that companies should it be run for a wider community of interests, in recognition of the contribution made and risk taken by others involved in the success and operations of the companies, for example their employees, directors, customers, suppliers, lenders, the wider society in which it operates, or even the counter-‐parties with whom it does business – were marginalised by the political and economic consensus which favoured shareholder governance (Kraakman et al, 2000).

As we observed in chapter 2, the official response to the banking crisis presumed that there had been an agency failure, and that it could be fixed by further aligning management duties with the interests of shareholders. The UK’s policy response was for ‘more’ corporate governance or to try to ‘fix’ corporate governance by adding to the body of rules requiring management to act more in line with shareholder interests (Bowman et al, 2014, p129). The official response did not observe how reinforcing shareholder governance conflicted with the interests of other stakeholders and undermined a company’s scope to act more broadly in the interests of others (Meyer, 2013, p115; Haldane, 2015) nor did it even question the ‘ownership paradigm’ and in other words ask whether it made sense to have banks run primarily for their shareholders.

However, what appears to be an entrenched consensus or paradigm is in fact a relatively new development, and is also perhaps more susceptible to change than might otherwise be suggested by the assumptions made by the official response. What has become axiomatic today – that companies should be run in the interest of their shareholders, and that management who do not maximise shareholder value risk being removed, or replaced or the company taken over – was not at all commonplace at all in the mid-‐nineteenth century when corporations were first bestowed with separate personality and limited liability (Ireland, 2007, p5). As we shall explore below, the current shareholder value or ‘ownership paradigm’ – whereby companies are run for their shareholders, and vulnerable to take over if they do not deliver sufficient shareholder value – only really took root in mainstream political and economic thinking in the latter half of the twentieth century. And as we shall explore below, it is also a paradigm which is increasingly challenged, particularly in the context of banking. Indeed, the realisation appears to be dawning that shareholder value governance is causing particularly acute problems in banking (Mayer, 2013, pp128-‐129; Haldane, 2011, 2015; Black et al, 2015).

This chapter considers the ‘corporate governance’ literature and how it has dealt with the issue the thesis seeks to explore namely how the way banks are ‘owned’ affects their behaviour (or more accurately, how the way banks are required to be run in the interests of shareholders, or others, affects their behaviour). The first part briefly explores the history of the publicly traded form

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of organisation charting the creation and evolution of the joint stock company, limited liability, and the development of the stock market. The second part then considers the wider shareholder versus stakeholder debate, and how in the first half of the twentieth century the debate around corporate purpose was adverse to shareholder primacy. The third part then goes on to explain how that debate was eventually settled in favour of shareholder sovereignty and how since the 1960s onwards, the political and economic consensus which emerged and became increasingly entrenched has favoured this ‘shareholder value’ or ‘ownership’ paradigm, effectively treating shareholders as owners and expecting companies to be run for their benefit. The final part then explores the growing resistance to this ownership paradigm, and how its critics have been given a new lease of life.

3.2 Part 1: history

3.2.1 The birth of the corporation

The ability to trade not in one’s own name but in the name of another person, and one who is not actually alive or even a human being but has been entirely made up and is not a person at all, is hardly an obvious or natural concept. Yet, in the business world, that precise device has become second nature, and a way of life, so much so that many would consider it their economic right to conduct their business through a company rather than any form of special privilege. Historically speaking, however, until relatively recently the ability to deflect one’s own liability entirely onto a fictitious person was not available as of right, but was a concession and one only rarely granted (Ireland, 2007, p7). Before the industrial revolution, corporate personality was bestowed on only a few bodies: other than the medieval commerce and merchant guilds, who were able to trade on account of their ‘joint stock’ (hence that term of phrase), joint stock companies had to be created by the Crown or by Parliament and typically were only created to advance foreign trade interests or in order to galvanise investments for large infrastructure projects, such as canal, rail, dock, bridge and gas works (Ireland, 2007, pp4-‐5).

Typically, the early joint stock companies thus performed public functions, one example being the Bank of England, which was set up in 1694 under both a Royal Charter and an Act of Parliament with its purpose being ‘to promote the public good and benefit of our people’ (Haldane, 2015). It was only in the latter half of the nineteenth century when the companies’ acts of 1844 to 1856 were enacted that the joint stock franchise was opened up for all sectors and industries. The origins of the corporation and of corporate purpose thus lie in the public, and not the private, sphere. The modern corporation is a descendant of the old trade and merchant guilds, which were permitted, often with monopoly rights to trade on their own account in their sectors of activity on the back of their members’ ‘joint stock’ (Mayer, 2012, p217).

The early joint stock companies were also generally only temporary affairs: their capital was liquidated and distributed out to members after each voyage or project completed and it was only from 1614 onwards, that it became

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possible for joint stock to be subscribed for a period of a year and only from 1654 onwards, that it became possible to permanently subscribe capital (Mayer, 2012, pp215-‐217). After companies were permitted to trade in their own name, in 1658 it then became possible for those owning shares to trade in those shares (Mayer, 2012, p216) -‐ something which judges were initially reluctant to allow, for example in cases such as Blundell v Winsor (1808) 1 Camp 547 and R v Stratton (1811) 14 East 406. Early joint stock companies were thus limited in number, their shares were not always readily transferrable, and they were not all given limited liability. The right to trade in a separate name was essentially a public concession involving some sort of activity beneficial to the realm. The South Sea Company, and the Bank of England, for example provided public financing for important investments or for national expeditions (Mayer, 2012, p216).

After the collapse of the South Sea Company, the Royal Exchange and London Assurance Corporation Act 1719 which has come to be known as ‘the Bubble Act’ was passed making it illegal to operate joint stock companies without a royal charter or Parliamentary enactment (Mayer, 2012, p215-‐217). The Courts subsequently prosecuted those who attempted to trade on joint stock or to trade shares (Talbot, 2013, pp794-‐795). With the industrial revolution came pressure to repeal the Bubble Act and to extend the corporate franchise (Haldane, 2015). The Crown and Parliament were inundated with applications for joint stock status, having already created all manner of other exceptions to the Bubble Act in order to galvanise investment for new business and infrastructure, in particular the various Canals Acts which were passed in the late eighteenth century, creating corporations to build the canals (Mayer, 2012, p218). Rail, dock, bridge and other infrastructure projects gave rise to similar concessions.

To stem the tide of applications and to reduce state monopoly, parliament made the joint stock company universally available (Mayer, 2012, p218). In 1820 the Bubble Act was repealed. In 1826 ‘Joint Stock’ banks were legalised outside of London (within a 65 mile radius) and in 1833 they were legalised in London (Mayer, p128). In 1844, Parliament passed an act permitting the universal creation of joint stock companies. The same act also removed the 6-‐partner limit on issuing bank notes. Not all agreed with the extension of the joint stock company. Emphatically, Adam Smith disagreed with the use of dispersed-‐ownership joint stock companies, believing they made efficient operations impossible and that they should be reserved only for capital intensive public projects (Smith, 1776, p741; Berle & Means, 1932, p345-‐346). In 1776, Adam Smith argued for a very limited use of the joint stock company:

‘directors of [joint stock] companies… being the managers rather of other people's money than of their own, it cannot well be expected that they would watch over it with the same anxious vigilance with which the partners in a private co-‐partnery frequently watch over their own’ (Smith (1776, republished 1976), p741). With the extension of the corporate franchise, the banking sector changed

from having a large number of small banks dispersed around the country, to having a small number of ever larger banks operating predominantly out of London (Haldane, 2015). In the first half of the nineteenth century there were

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approximately 500 banks (not including the 700 or so building societies), none of which were publicly traded, and most of which had less than 6 partners to avoid the prohibition on issuing bank notes for banks with more than 6 partners. These banks did not have limited liability. By 1843, 100 banks were publicly traded (Haldane 2012).

But in those early days, even with a joint stock company, investors could incur personal liability for losses. With unlimited liability they had every incentive to manage and control the banks diligently: shareholder assets were on the line: if the bank made losses, the shareholders would be personally liable to repay. Managers thus had powerful incentives to be prudent with depositor money and they tended to issue shares only to investors with deep pockets to bear any losses. Indeed, for this reason, William Gladstone who headed up the Treasury Select Committee which recommended the various company acts between 1844 to 1856, argued in relation to companies generally in whichever sector of activity, that shareholders were best placed to govern companies to protect their interests against fraud and misfeasance from those who managed joint stock companies: they had the most incentive to do so (see Ireland 2010, p.7). Adam Smith had also recognized the disciplinary effects of unlimited liability. As well as opposing the use of the company as a separate personality (Smith, 1776, p741) Smith vehemently opposed the extension of limited liability to those owning shares in companies. As Paddy Ireland observed (2009, p5) Smith argued that it was only appropriate to extend limited liability to shareholders in special cases, in particular where non-‐routine works were involved which worked towards delivering an identifiable public benefit, and only where there was unusually high risk such that the amounts of capital required for investment could not otherwise be generated from partnership businesses.

Unlimited liability was not to last for long however. Along with pressures to extend the corporate franchise, Parliament was prevailed upon to introduce limited liability at large. As Haldane (2015) notes, in the early 19th century France had already allowed limited liability for its companies, which had encouraged fears in Britain of capital flight from investors. Economists, such as Bagehot, exploited those fears arguing that unlimited liability also deterred wealthy people from investing in Britain (Haldane, 2015). In 1858 and 1862, limited liability was introduced at large and by 1889, British banks had converted from being mostly unlimited, to being almost entirely limited liability companies (Haldane, 2015). By 1913, the number of banks had reduced from more than 500 less than a hundred years earlier to only 70 (Haldane 2015).

In a short period, banking changed from being fragmented and localised to being highly concentrated, and central to London. Building societies followed a similar trend, declining in popularity, and making way for other forms of savings institute, particularly fractional reserve banks (Talbot, 2010). In 1890 there were more than 2000 societies; by 1920 there were only 1271; by 1950 there were 819 societies; and by 1971 there were 481 (Talbot, 2010, p7). The trend became more pronounced in the later half of the 20th century. Upon being permitted to float on the stock market in the Big Bang, the process of consolidation in the banking market and decline of the building society sector increased (Talbot, 2010; Haldane, 2015). By expanding the joint stock franchise the state took away its monopoly on determining what activities were fit for

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being run by corporations. In so doing, it opened the floodgates of limited liability and separate legal personality to all manner of economic activity subverting what was essentially once a public institution, for private use.

3.2.2 The rise of the stock market

The rise of the stock market was an unplanned consequence of extending the corporate franchise with limited liability (Fergurson, 2008, ch.2). After shares were recognised as legal property capable of being bought and sold, the stock market was permitted to come into its own. It is commonly thought that its birth was not the product of intelligent design or careful planning, but was an unintended and spontaneous reaction to the creation of the company, with its tradable intangible shares (Ferguson, 2008, ch.2). As the stock market grew, shareholders had less incentive to take an interest in the company they notionally ‘owned’ and became more interested in their ability to trade shares for a short term profit. With limited liability, they had zero liability for company losses. If the company’s share value fell, shareholders could readily cut their losses, sell their shares and invest their capital elsewhere. Whilst such capital flight materialises immediate losses, it might prove significantly less costly and more straightforward than having to police against mis-‐management and discover the cause for poor performing share value and then having to exercise control rights and exert sufficient influence over management to govern the company into implementing appropriate corrective measures to improve share value. Conversely, if share value increased, shareholders could capitalise on any gains quickly by selling their shares and even if they retained them, they had little incentive to investigate the soundness of the business operations as there is no need to fix something which is working. Whilst management was expected to act in the interests of shareholders, shareholders were thus incentivised to care less for the company’s long-‐term success.

As trading on the stock market grew, the ownership of public companies became increasingly ‘disinterested’ in the long term and more interested in short term trading (Ireland, 2010; Mayer, 2012). Shareholding became more dispersed and removed from the company as intermediary trading and investment funds got in on the action (Kay, 2012). Whilst individuals owned roughly half of the traded companies in the UK in the 1960s by 2010 they owned near to 10% (see Table 3.1 below). Direct institutional shareholding also declined. Whereas pension funds used to own a large proportion of shares, their stake is now dwarfed by comparison to intermediary trading and investment funds (see Table 3.1). In 1990, pension funds used to own roughly half of the traded shares in the UK yet by 2010, they owned as little as 15%. The time horizon for shareholding also decreased (Kay, 2012, ch.2). Average shareholding fell from 6 years in the 1950s to less than 6 months in 2012 (Haldane, 2011).

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Table 3.1: Historical Trends in Beneficial Ownership by % (snapshots between 1963 and 2010)

(Source: The Kay Review of UK Equity Markets and Long-‐term Decision Making, Final Report, p 31, citing data collated from the Office of National Statistics) Historical Trends in Beneficial Ownership (Percentage Held) 1963 1975 1981 1991 2001 2008 2010

Rest of the world 7 5.6 3.6 12.8 35.7 41.5 41.2 Insurance companies 10 15.9 20.5 20.8 20 13.4 8.6 Pension funds 6.4 16.8 26.7 31.3 16.1 12.8 5.1 Individuals 54 37.5 28.2 19.9 14.8 10.2 11.5 Other 22.6 24.2 21 15.2 13.4 22.1 33.6

3.3 Part 2: Defining corporate purpose

With the ownership of companies becoming increasingly dispersed, disinterested and short term (Mayer, 2012; Haldane, 2011; Ireland, 2010), the logic of having companies run solely for their shareholders began to be questioned and by an array of academics, commentators and policymakers, who throughout the course of the twentieth century and in diverse fields of social science variously questioned and criticized shareholder sovereignty, arguing that running companies for the benefit of shareholders encouraged unsafe and reckless behaviours. Following the last depression, for example, in a widely publicised work entitled ‘The modern corporation and private property’ Berle and Means (1932, republished 1968), observed the danger of management running companies in the interests of shareholders as such prioritisation essentially benefitted investment banks, who facilitated much of the short term trade in shares on the stock market.

Berle and Means (1932) argued that companies were not actually ‘owned’ by their shareholders, but were separate entities pursuing a community of interests and they suggested that companies should not be conceived of as private property owned by their shareholders and it was wrong to think of the company as capable of being repackaged into parcels of intangible property which could simply be owned and traded (Berle et al, 1932). They instead postulated a different conception of the company entity and one which better reflected the community of individuals contributing to its overall wealth and success. Berle (1954), in particular, saw directors as ‘administrators of a community system’, and not merely as fiduciaries that acted for shareholders. In his conception, a company was more than a private affair but some form of community institution (Berle et al, 1932; Berle 1954).

This ‘communitarian’ or ‘stakeholder’ conception gained wide support in the early part of the twentieth century. In the USA, Dodd (1932) advocated that directors should owe duties not only to shareholders but also to employees, consumers and society as a whole. And at the end of the 20th century, Porter (1992) and Blair (1995) continued to argue that companies are made up of a community of human stakeholders, and that they ought accordingly to be run in the interests of the wider set of stakeholders who also contributed to generating

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profits. Blair (1995) argued that we needed to devise a system of compensation for wider firm-‐specific contributions beyond those made by shareholders.

The logic of shareholder value governance was thus by no means universally accepted, and communitarian or stakeholder ideas of governance gained support in the UK as well as in the USA. Parkinson (1993) and John Kay (1995) were critical of companies subordinating the interests of stakeholders such as employees, the local community, and company creditors to the short-‐term interests of shareholders, particularly where the same could harm the long-‐term interests of the company. They advocated for a ‘stakeholder’ system of governance, whereby companies would consider all of their stakeholders' interests. And more recently, Mayer (2013, pp111-‐115, 144) very forcefully criticised the shareholder value governance model for encouraging an extraction of value from the company for the benefit of shareholders and at the expense of other creditors and stakeholders. In pursuing shareholder value governance, the corporation places the stakes of other parties, who also invest in and contribute to the corporation at risk in order to extract returns on their equity, creating what Haldane called frictions and tensions (Haldane, 2015; Haldane, 2011).

These criticisms are by no means new developments. As Paddy Ireland observed (2009, p14) in the inter-‐war years, Keynes (1936, chapters 12 and 24) was critical of social interests being subordinated to shareholder interests. Whilst shareholder value and productivity might sometimes coincide with these broader public aims, Keynes observed that there was :

‘no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable’ (Ireland 2009, p14, citing Keynes, 1936). Keynes’ objection was that prioritising shareholders could undermine

other corporate purposes, such as promoting a sound long term business, meeting the needs and interests of customers and society and keeping employees in jobs. Keynes (1936, chapters 12 and 24) observed how the value of shares was not an accurate reflection of the soundness of a company's underlying business. Market value often differed from a company’s book value. Although share value is a specific measure, it is determined by competition and trading in a parallel market, according to the interests and beliefs of persons generally far removed from the company who do not necessarily have much knowledge at all about its underlying fundamentals. Shareholders are typically ‘in’ the stockmarket, not ‘in’ the company, to make money. Keynes famously likened share value to a beauty contest: the judges chose the value of contestants not by considering the model's intrinsic beauty but by thinking about how others may view the model's beauty, and often based on speculation or hearsay about what others like and how they appreciate beauty.

Even before Keynes, Veblen (1904) described a disconnect between what is good for shareholders and what is good for society and the wider community of stakeholders. He warned of a depletion of productive resources, with management putting otherwise what could be useful capital at risk or applying it in ways aimed to keep shareholders happy and not to achieve productivity (Veblen, 1904). He witnessed that management, in order to satisfy short term shareholder demands, had incentives to cut costs to the detriment of the long term viability of the business often disinvesting the business of valuable assets.

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Froud et al (2006) also observed this phenomenon of ‘hollowing out’ of businesses, observing in the case of GM Motors the phenomenon of value transfer, whereby management effectively exploit other creditors for the benefit of shareholders. And in the case of banking, Engelen et al (2011) observed how shareholder value banking provides incentives for management to borrow significant amounts from creditors, to leverage the balance sheet in risky and potentially unsustainable ways (Engelen et al, 2011, pp158-‐172). In more colourful language, the former member of the Independent Commission on Banking, Martin Wolf (2012) likened the process of dis-‐investment caused by shareholder value governance to ‘the larva of a spider wasp eating out its host’. Jenson et al (1976) described the process whereby management increases company risk in a manner which transfers value to shareholders as ‘risk shifting’. They criticised the corporate governance bias towards shareholders over other debt holders observing that where a company relies on debt, shareholders stand to gain far more than debt-‐holders by the company pursuing high risk strategies because they have zero downside risk whilst having potentially unlimited upside gains (Jensen et al, 1976). In other words, shareholders have more to win from successful risk-‐taking and less to lose from unsuccessful risk-‐taking encouraging companies to become what Haldane later called ‘volatility junkies’ (Haldane, 2011).

Others have criticized shareholder value governance for providing incentives for management to not only cut costs but to perform macquillage, to make companies look a lot more attractive than they really are by constructing exaggerated narratives to manipulate investor perceptions to keep share value high (Kelly, 2003). Shareholder value governance is also criticised for enhancing inequalities. There is a significant body of recent literature documenting the contribution of shareholder value governance towards inequality. Saez (2003, p32) for example argues that the ‘working rich’ have now replaced individual investors at the top of the income distribution chain in the United States getting richer whilst other labour is becoming more impoverished – a trend which Piketty (2014) agrees manifests itself across capitalist democracies (Piketty, 2014). The proceeds of commerce, it is suggested, are being redistributed away from labour and into financial capital causing increasing inequalities in income (Ireland, 2009; Piketty, 2014).

Shareholders have benefited from this new class of elite ‘working rich’, who also reap the rewards of helping shareholders in what has been called an ‘unholy alliance’ of interests between the working rich and the ‘rentier’ class or owners (Ha Joon Chang, 2011, pp11-‐23) which favours capital over labour and exacerbates income inequalities (Piketty, 2014; Dumeril and Levy, 2004). In Marxist terms, ‘the capitalist class’ has expanded to include elite management or it has formed an alliance with it and the elite management no longer represent the workers but have betrayed the ‘labour class’ ; provided management continues the extraction of value for owners, this class of ‘working rich’ are welcome to join in the riches of the capitalist classes (Ireland, 2009).

Ireland (2009) argues that it is no accident that the shareholder value model has come to serve the interests of a new wealthy elite. He argues that the shareholder value model ‘is not an efficient arrangement, but rather a power relationship that is a particular (societal) way to design a corporation’ (Ireland: 2009, p.4). Whilst shareholder value governance is dressed up as an obvious,

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logical, even an inevitable arrangement, it is, says Ireland a political compromise which favours the investor and his agent: ‘Elite power has been dressed up as efficiency’ (2009, p.28). The shareholder value model is a product, not of intelligent design, but of economic power (Ireland, 2009, p.4). Haldane (2015) seemed to agree with that analysis by recognising that companies are mere ‘social constructs’ and how they are owned and run is not inevitable, but a political decision, and one which can be changed.

The shareholder value model has also been critiqued for being based on false principles. As Haldane observed in the opening passage at the start of this chapter, the belief that companies are ‘owned’ by their shareholders is not correct. It is not possible for anybody to own a company, which is its own person (Kelly, 2003). The question which instead needs to be asked is what do shareholders deserve, bearing in mind the amount of their contribution and the risks they take. As Haldane (2011) and Kelly (2003) point out the contribution made by shareholders can be extremely limited whilst their right to have companies run for their benefit can be unlimited. Shareholders also have diversifiable risk, which calls into question the logic of rewarding shareholders above all others, especially those who cannot diversify their risk: unlike employees whose contribution is tied to the company, shareholders can diversify their risk by investing elsewhere (Haldane, 2015).

That is not to say that shareholders do not make any contribution. They undoubtedly bear considerable risks: as Ferguson points out, one in ten publicly traded companies in the USA disappears each year, and most firms eventually fail: of the 100 largest companies trading in 1912, 29 were bankrupt by 1995, 48 had disappeared and only 19 were still in the top 100 and in the UK, 30% of tax registered businesses disappear after three years (2008, p350). Clearly shareholders risk their investment, and provide direct investment upon subscribing their shares.

In many industries, however, shareholders are not the main risk-‐takers and they contribute far less in terms of risk and even financial investment than others. It is argued therefore, for example by Blair (1995), that the contribution made by shareholders does not justify companies being run exclusively in their interests, often at the expense of other (sometimes more significant) contributors and risk-‐takers. Shareholders are not the only parties with firm-‐specific contributions and which stand to lose in the event of failure; at any one time, there will be a number of employees, suppliers, and customers who have all contributed to a company’s success and who will stand to lose in the event of failure. If shareholders do not stand to lose the most if the company fails, why is it, Blair asks rhetorically, are they entitled to have the company run almost exclusively in their interests?

Shares furthermore retain potentially perpetual (and unlimited) rights to extract profits from the company in the future. The time horizons for those privileges may bear no correlation at all to the direct contribution initially made to the company. A shareholder’s right to extract wealth from a company lasts forever, whereas their contribution is often limited in both time and amount. According to Veblen (1923, republished 1945) and Tawney (1921), share ownership does not lead to productivity. It contributes little, if anything, to the actual assets of the company. The vast majority of shares are generally bought in the stock market from other shareholders, and not upon company offering. They

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are second hand, third hand or might be ten-‐thousandth hand and any investment made by later shareholders goes to the benefit of previous owners and is not any direct contribution made towards the company.

Whilst the trading in shares might have indirect benefits for a company such as maintaining a high share price, thus promoting its brand and reputation, and enabling it to raise other finance, after the initial subscription, secondary trading in shares provides no direct contributions, leading some to suggest it is analogous to the contribution a man makes to a motor company by buying a twenty year old car from a second hand car dealer (Kelly, 2003).

Kelly (2003) compares the unlimited extractive rights to the rights of the aristocracy under a feudal system. Aristocrats generally inherit all of their privileges as a result of some ancient predecessor having made a contribution to the Crown in centuries gone by. Their contribution is historical whilst their extractive rights are perpetual. Keynes (1936) described this historical contribution as being ‘functionless’ (Ireland, 2009, p.9), and Tawney (1921) goes so far as to call it positively ‘parasitic’: future shareholders take all of the profits without providing any contribution; they retain rights of extraction despite owing no responsibilities to the company and making no on-‐going contributions. After their initial offering, they are simply takers. Similarly, for Tawney (1921) shareholders ought instead to be treated like secured creditors, rather than proprietors.

3.4 Part 3: the emerging shareholder value paradigm

Notwithstanding the body of intellectuals who argued for a stakeholder conception of corporate purpose, the political-‐economic consensus which emerged at the end of the 20th century very much supported the agency view of the company, that is to say that the company is owned by its shareholder; and the obvious corollary was that the company should be run in the interest of such ‘owners’ (Friedman, 1970, p54; Hansmann et al, 2001). Indeed, this conception of corporate purpose has not only become most popular but has become enshrined legally, and subsequently reinforced by economic forces and political trends, particularly those emerging from the 1960s onwards, as neoliberalism came to dominate political and economic life (Ireland, 2009). In 1962, when Friedman argued that the company was an ‘instrument of the shareholders who own it’ (the agency theory) (Friedman, 1962, p.135) and that the role of the company’s management was to keep the share price high for the shareholder (the shareholder value theory) (Friedman, 1962, p133) he did so against a body of academics who favoured the stakeholder conceptions of corporate purpose (Ireland, 2009).

Nevertheless, the agency theory and the shareholder value theory soon became mainstream orthodoxy, encouraged by advocates of the efficient market theory who sought to justify shareholder value governance not as a matter of ownership rights and property law, but as a matter of economic efficiency. The efficient market or efficient allocation theory of finance posited that in perfect financial markets, the share price of a company would reflect its underlying profitability, leading to an efficient allocation of society's resources through the instrument of financial markets (Turner, 2016, pp37-‐38). In efficient markets,

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companies need not worry about how to serve their multiple stakeholders, and can instead focus exclusively on maximising returns for their owners. Indeed, in order to help make markets efficient to gain access to the capital they need to survive and thrive, it was argued that, companies should focus only on their owners. As Friedman famously put it:

[T]here is one and only one social responsibility of business -‐-‐ to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud. (Friedman, 1970, p54)

Provided that markets within which companies operate are themselves competitive and companies governed to perform optimally for the benefit of their owners, the value of their shareholding should reflect the soundness of the business and capital markets could efficiently allocate resources where justified (Turner, 2016, pp37-‐38).

This ideology provided businessmen, economists and politicians with a complete scheme with which they could view, debate and plan the political economy. Owing to economic successes in the UK and USA particularly in the early 1990s, the agency and shareholder value conceptions of corporate purpose, which were central to this efficient market hypothesis, were increasingly viewed as inevitable or logical or even productively superior (Hansmann et al, 2002; Haldane, 2015).

This hypothesis quickly became widespread not only within neoliberal political orders in the west but also within economies touched and concerned by them, because the World Bank, the Organisation for Economic Cooperation and Development, the European Union and the Washington Consensus all tended to advocate for the expansion of capital markets with competition policy as a means of encouraging efficient markets and companies having access to capital and governed by shareholder value (Turner, 2016, pp136, 141, 143, 150).

A wider ideological consensus began to emerge particularly in countries dominated by neo-‐liberalism supportive of the idea that companies should be run for their owners (Ireland, 2009). Proponents of stakeholder governance were increasingly marginalised, in the face of an increasingly popular shareholder value ideology. Jenson, who had previously criticised the corporate governance bias towards shareholders (1976), began to advocate for a longer term form of shareholder governance, arguing that it was impossibly difficult for management to maximize returns in more than one dimension, and that purposeful behaviour required them to pursue a single-‐valued objective, which stakeholder governance failed to provide (2001). Even Hansmann, who had been a strong advocate for non-‐profits in particular (1980, 1981, 1988) famously declared that it was ‘The end of history for corporate law’ (Kraakman et al, 2000). Just a few years before the financial crisis, Hansmann and Kraakman argued not only that that the shareholder value model of corporate governance had won out over any other model but also that it was productively superior.

Other economic forces, and particularly the growing market for corporate control, reinforced shareholder value governance. Since share value can directly affect a company’s ability to raise capital in financial markets, there are incentives for management to enhance its value. If share value is not as high as it

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can be, a company prejudices its ability not only to raise finance but also risks being taken over by outsiders who can promise shareholders they will make them more money.

The rise of the takeover and leveraged buyout market inevitably have added pressures on management to cut costs, to undertake restructuring and to take other, sometimes radical, measures to sustain and improve share value (Glynn, 2006, p.58). Since the early 1980s, the number of hostile takeovers, particularly in the US and the UK, has risen dramatically. In 1990, for example, in the US, one third of the Fortune 500 companies were targeted for hostile takeovers (Kelly, 2001, p.55 citing Whitman, 1999). And in the UK, some four-‐fifths of equity capital is thought to be directed not to new investment in companies but into taking over existing companies (Mayer, 2012, p138).

Whereas subscribing shares was initially concerned with providing capital for a company, the trend in the last century has been to shift focus away from productivity and towards buy-‐outs. Mayer cites a prime example (2013, pp132-‐135). The company that was to become 3i namely the Industrial and Commercial Financial Corporation (ICFC) was set up following the war in 1945 as ‘a company to devote itself particularly to the smaller industrial and commercial issue’ namely to plug the ‘Macmillan gap’ and shortfall in investment from banks and the stock market (Mayer, 2013, p133). The Bank of England and the main clearing banks subscribed capital and became its shareholders. The capital was to be used to provide productive investment. Whilst it was successful in discharging its aims and investing in small businesses, it was nevertheless floated in 1994. The BoE and clearing banks sold their shares on the stock market and with new ownership, it subsequently changed its operations from investing in SMEs into buying out other companies. To satisfy the extractive demands of its owners, 3i subverted its productive investment function and like most private equity businesses, focused instead not on starting up new businesses but funding the hostile takeover of existing business, which encouraged management to commit themselves to enhancing share value, or risk compromising their ability to raise finance, or being taken over by others.

Rightly or wrongly (and many commentators, such as Attenborough (2009), argue wrongly) the law in England and Wales also developed to explicitly support the agency and shareholder value conceptions of corporate governance. Directors of a company are now under a legal duty to act in the interests of the shareholders. Indeed section 172 of the Companies Act 2006 provides shareholders with a right to take directors to court if they fail to so act. Whilst directors can take into account other considerations such as the long term interests of the company, the effect of any decision on employees, or creditors or the local communities, those other considerations are secondary and subsidiary to shareholder interests: insofar as they conflict, the duties owed to shareholders should prevail. As well as being able to take directors to court shareholders have other rights to ensure their interests are prioritised: they can appoint and remove directors (see ss154-‐169, Companies Act 2006), change the company objects and decide what business the company will transact (s21a, Companies Act 2006), or adjust the company's capital structure (ss641 and 716, Companies Act 2006), or agree to a management takeover or even to dissolve the company (see ss21a, 154-‐169, 641, 716 of the Companies Act 2006, and the EU Directive on Takeovers (2004/25/EC). Thus the law, and not only economic forces and

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political trends have all lent support to the shareholder value conception of corporate purpose. It is not entirely surprising therefore that the government’s response to the GFC did not begin by questioning whether the orthodox position was problematic.

3.4.1 Entrenching the paradigm The entire debate about whether banks should be run in the interest of

their shareholder ‘owners’ was avoided by the ‘official response’ which as we saw in chapter 2, was concerned to preserve the status quo by making ameliorative, rather than radical, proposals for reforming how banks are owned and ran. The official response essentially called for more ‘corporate governance’ rather than to question the paradigm, which thus re-‐asserted the ownership claims of shareholders and sought to further empower shareholders as stewards (Talbot, 2013; Bowman et al, 2014, p129).

The official response, epitomized by the Walker Review, blamed inadequate corporate governance, and in particular an agency gap, whilst advocating for more of the same soft law governance regime aimed at narrowing the agency gap that had already failed. Although Walker sought to differentiate between ‘Banks and Other Financial Intermediaries’ and other listed companies by seeking to add to the body of soft law regulating financial institutions (Walker, 2009), such differentiation should not be over-‐stated. The UK Combined Corporate Governance Code after all is still essentially an advisory regime, and one which still expects all companies in the UK to act primarily in the interests of their shareholders, whose interests are often prone to being short-‐sighted. Banks may well be subject to additional corporate governance requirements, as well as other forms of regulation imposed either domestically by legislation such as the Financial Services and Markets Act 2000 or by international treaty such as Basel III, which regulates capital quality and adequacy. Nevertheless, like any publicly limited companies in any other sector, in the UK, banks are all expected to deliver shareholder value. As Froud et al (2009, p40) observe, the stockmarket does not differentiate between companies acting in different sectors. They are all on the stockmarket and subject to meeting its demands. If they cannot meet the stockmarket’s demands for shareholder value, they should leave (2009, p40).

Furthermore, as has been widely observed banking regulation, like the regulation of other sectors, also subscribed to the ideology of efficient markets believing that being efficient financial markets would correct themselves and could be governed adequately by competition law without the need for significant state regulation and supervision of economic activity (Engelen et al. 2011; Bowman et al 2014, ch.1; Turner, 2016, ch.2; King 2016, ch.1).

The official response thus did not mark out banks for a different type of corporate governance treatment. As was clarified by Walker it wholeheartedly embraced the agency and shareholder value models of corporate governance (Walker, 2009, p23, para.1.1). It simply sought to narrow the agency gap and to broader shareholders’ time horizons. Institutional shareholders were encouraged to engage more actively as stewards (Kay, 2012) and modest steps were taken to ensure banks vet the competence of senior management and

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further checks were proposed for approving the ‘compensation’ of senior management (PCBS, 2013a, ‘conclusions and recommendations’; PCBS, 2013b, p155). In short, these reforms overlooked and ignored the ‘communitarian’ and ‘stakeholder’ ideas about governance and pre-‐supposed that banks should continue to be run in the interest of shareholders.

3.5 Part 4: the back-‐lash, and rise of stakeholder theory

More recently, a growing body of intellectuals have become highly critical of shareholder value governance in the context of banking and more willing to question the sense in having banks owned for shareholder value, arguing that this ownership model negatively affects how banks behave, making them more prone to misbehave and to adopt excessive risks, to pump out too much credit and to become difficult for society to trust (Haldane 2012, 2015; Brummer, 2015, p144; Wolf, 2014c, chs6-‐7; Black et al, 2015; Turner, 2016, pp172-‐174, 245-‐246).

Before the crisis, commentators on corporate governance tended to view corporate purpose and governance issues on an abstract plain removed from the specific nature, and context of the banking market. They tended to advocate for a universal system of governance applicable across all sectors and activities (Mayer 2013, p190). There were a few exceptions. Adams and Mehran (2003) for example argued that there was a difference between the governance of banks and non-‐financial firms and Macey et al (2003) observed how the state is a large stakeholder in the governance of banks by virtue of subsidising banks. They suggested that the directors of banks should be subject to special fiduciary duties to ensure the on-‐going soundness and solvency of their business and not merely that things are run for the shareholders (Macey et al, 2003). These critiques were however in the minority and the majority of corporate governance commentators treated all sectors the same.

There are however a number of obvious differences between banks and non-‐financial firms which are relevant to the issue about how they are owned and in whose interests they should be ran. The biggest difference is perhaps that banks are granted privileges by the state to perform functions which are at least partly public in nature. As is explored in the next chapter at 4.2.1, banks do not merely redistribute the existing money supply, but in fact create colossal amounts of credit. By doing so they extend the existing money supply. The state’s ability to honour its promise to pay the bearer of any bank note a certain sum in value is thus directly affected and can be undermined by banks extending the supply of money. Since they are bestowed with such privilege and perform functions which are public in nature, there is reason to question whether banks should be run entirely along private lines.

Another big difference is that banks are leveraged in a different order of magnitude to non-‐financial firms. Whereas non-‐financial firms tend to be debt-‐financed in the order of around 40% of their balance sheet, banks tend to be leveraged to the tune of 90% or more (Haldane, 2011, citing the Federal Reserve Bank of New York Staff Report, June 2011, p3). The injustice which Blair eloquently complained of, relating to shareholders having all the control whilst contributing only a fraction towards the success of the company, is magnified acutely in the context of the banking firm. As Haldane (2011) observed,

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shareholder capital constitutes a ‘vanishingly small fraction’ of a bank’s total assets and typically less than 5% in most countries, and in the UK as little as 2.5%. Jensen and Meckling’s argument (1976) that shareholder value governance can unfairly privilege shareholders at the expense of debt holders and other contributors, has special significance in the context of banking, where shareholders contribute as little as 2.5%. In that context, shareholders enjoy what Haldane called an ‘equity dictatorship’ (Haldane, 2011).

It has also been observed how shareholder value governance has led to disinvestment in banking. Since the 1980s there has been a ‘one way street’ in terms of dividend payouts. Whereas previously payouts would fluctuate up and down depending on profitability, dividends have generally only increased and so too has the practice of buying back shares (Haldane, 2011; Haldane, 2015). The predisposition of banks to debt-‐finance is not incidental to their business models but an essential ingredient. Whereas firms in other sectors might occasionally leverage to raise needed finance, leveraging for banks is an intrinsic part of their functioning: their legal status and definition as a ‘bank’, depends upon them taking deposits, and usually other subordinated debt, in reserve for their lending. Leveraging is not so much optional, as a necessary component of their business.

Banks in the UK are also publicly subsidised. The government, the taxpayer, and thus society at large, are all stakeholders in the banking business. The government not only provides insurance for depositors, which is paid for by tax payers, but it has an interest in ensuring the integrity of the payment system and the general health of the economy and consequently will not let banks fail in any way which jeopardises such public interests. Even if a government is not legally bound to bail out a bank in the event of insolvency, in reality, for economic reasons, it has little choice. This too big to fail (“TBTF”) subsidy is not merely theoretical but as was proven by the various rescues, and bailouts as well as the Government’s programme of quantitative easing is very real problem. The TBTF subsidy also makes lending to banks more attractive for other institutions as they are unlikely to default which in turn reduces the cost of inter-‐bank lending and helps to contribute towards bank leveraging.

The implicit TBTF subsidy also encourages banks to take on risks. With the ability to privatise gains and socialise their losses, banks can afford to take risks they might not otherwise contemplate. As Haldane (2011) puts it, the state subsidy, combined with cheaply leveraged capital, turns banks into ‘volatility junkies’ Shareholder-‐centric governance leads to a transfer of risk to wider society and can be what Haldane considered a recipe for ‘super-‐charged risk-‐shifting’ (Haldane, 2011). The TBTF subsidy makes it difficult to price risk and can lead to excessive risk-‐taking and credit creation during upswings, whilst also contributing to excessive caution and a credit crunch during the downswing (Haldane, 2015). Risk-‐shifting results in two-‐sided deadweight costs, for creditors and for the macro-‐economy (Haldane et al, 2015). Shareholder primacy has led to frictions between the company and other stakeholders which need to be managed (Haldane 2015).

Banks have also become incredibly large, complex and opaque institutions making it difficult for directors to comprehend or control what is going on. The opacity of their business poses implications for governance. Banks may become too big to manage along private lines as private companies.

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As a result of these differences, it appears that the realisation is now dawning that shareholder value governance is posing particular problems for banking (Mayer, 2012; Haldane, 2011; Haldane, 2015; Black et al, 2015). Whilst this represents a significant development within the shareholder versus stakeholder debate, as we saw in the last chapter, the ‘official response’ and reform agenda overlooked this issue – an omission which is startling given that banks perform functions of significant public importance, and their ownership models are ultimately only ‘social constructs’ which we have the power to change (Haldane, 2015).

3.6 Conclusion It seems that several key figures in the banking reform debate accept that

shareholder value governance can cause particular acute problems in banking (Haldane, 2011, 2015; Turner, 2016, pp173-‐174, 245-‐264; PCBS, 2013b, paras.666-‐708). Save for the few studies referred to in chapter 1 (Ferri et al 2010, 2012; Bøhren et al, 2012, 2013), there is still very little inquiry into whether banks would behave better if they were capitalised without any shareholder funds or governed not for the benefit of their ‘owners’ (or shareholders). There appears to be greater scope now than before the crisis to contemplate governance-‐related reforms requiring banks to act in the interests of other company stakeholders such as bondholders, depositors, borrowers, and employees and external stakeholders, such as the government as lender of last resort and society at large.

The PCBS’s recommendation (2013b, para.708) for a Government consultation about amending s172 of the Companies Act 2006 ‘to prioritise financial safety over shareholder interests in the case of banks’ was a step, albeit a small one, in the right direction. However, it came too late in the day, when the impetus for reform had waned, and it was easily overlooked by Government. The main issues this thesis seeks to explore – namely, how ownership affects behaviour, and what the implications are for reforming the way banks are owned -‐ have still not been given the treatment they deserve by the ‘official response’ or within the wider banking reform debate, which has only recently opened up and been more admitting of stakeholder arguments.

The behavioural implications of ownership will be studied more closely in chapters 6, and 7 before discussing their implications in chapter 8. Before doing that, it is necessary first to consider in the next chapter what other factors, unrelated to the way banks are owned, also influence and impact upon behaviour and strategy.

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Chapter 4. ‘Structural pressures’ and coping with them: surviving in the ‘wild west’ following the

‘Big Bang’

4.1 Introduction The political and economic experiment commonly referred to as

‘neoliberalism’ changed the frame within which banks operate. It affected what they could do and how they could do it. De-‐regulation became a key policy plank of this experiment as minimal state intervention was seen as a way of attracting foreign investment and pushing for growth of the City of London as a global financial centre (Turner, 2016, pp88-‐93). The corollary for the wider real economy was a process of de-‐industrialisation, which combined with a reduction in real interest rates, resulted in reduced margins for banks to make profits from traditional intermediation between household savings into business lending (CRESC, 2009, p40; Turner et al, 2010, p50).

As well as re-‐shaping the structure of the wider economy and space within which banks function, the state also exercised direct ‘structural power’ by altering the structure, rules and regulation of the banking market itself in a series of the changes which came to be known as the ‘Big Bang’ (Strange 1988, p131). The removal of restrictions on credit and the introduction of a new light-‐touch regulatory regime made way for the radical growth of universal banking and the drastic expansion of credit-‐creation, particularly in property lending and riskier, wholesale, IB and speculative activities (Turner 2016, pp88-‐90). There was an homogenization of the ownership landscape across the banking sector as all manner of business assimilated one another adopting the PLC form and becoming increasingly mimetic in ramping up the volume of their borrowing and lending, and seeking to recover their costs from sales to customer (Bowman et al, 2014, pp90-‐94).

The net effect of the changes brought about in the Big Bang was that banking organisations becoming increasingly responsible for serving their private interests and responsibility for acting in the public interest was externalized to the regulators, whose job it became to police against bad behaviour. This predicament resulted in what Luyendijk called a culture of ‘amorality’ as bankers felt no moral compunction for their behaviour and how it affected others provided it was not illegal, or liable to being caught (Luyendijk, 2015). It inevitably also led to failure, as regulators having limited manpower and resources and being in many ways removed from the internal dealings of banks, were unable to police banks perfectly to ensure good behaviour (Bowman et al, 2014, p129). Their own responsibility for determining what banks did and how they did it was limited both directly by the specific changes made in the Big

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Bang, and indirectly by the increasing faith being placed by the state in free market forces (Turner, 2016, ch.6). The spread of free market ideology resulted in less attention being paid by regulators in to how much credit was being created by banks and where it was being allocated to (King, 2016, ch.2-‐4; Turner, 2016, ch.6).

Ultimately how much credit is created and where it is directed to, are questions which fall to be determined by political decision and can be influenced by the exercise of state power (Strange 1988, pp24-‐25). Credit can be directed in ways which help society or which are useless or even harmful to it. As we saw in chapter 2, the big political questions about what we want banks to do and what reforms are required to ensure they deliver on those expectations were largely avoided by the elite-‐driven banking reform debate. The official response did not contemplate revisiting the settlement reached in the Big Bang, for example by questioning what activities we need banks to finance more generously or to finance less, and whether, to that end, the current relationship between the state, market and financial sector needs to be re-‐addressed and re-‐balanced .

However, as on the micro-‐level, where the lesson being learnt seems to be that it is unwise to treat a banking organisation like any other capitalist enterprise and to have it owned in the same manner, so too on the macro-‐level it seems that the realization is dawning that it is unwise to treat the banking market like any other market and to leave the fate of credit-‐creation and allocation to unbridled market forces (CRESC, 2009; King 2016; Turner 2016). It is now increasingly argued that left to their own devices, banks will create too much of the wrong sort of credit, financing debt-‐fuelled consumption, or competition for locationally scarce property resources, thus causing property price inflation and instability; rather than allocating credit to useful investment which generate the additional wealth needed by society to repay its debts, banks instead tend to finance unproductive activities, particularly property which fuel dangerously unstable economic cycles and pose a burden to society (CRESC, 2009, pp40, 44; Turner, 2016, pp172-‐174, 245-‐246).

This chapter explores the structural pressures which have been exerted on banks by the market and regulatory environment within which they operate. It does this by exploring the main changes in the banking business model over the past 40 years and considering how structural pressures influenced such changes. The chapter is broken up broadly into four parts, each looking at a significant shift within the banking business. The first part considers how the Big Bang ushered in a permissive regulatory regime which encouraged banks to leverage to gargantuan sizes and to move away from traditional intermediation. The second part then considers the increased allocation of credit to property-‐lending. It describes how the regulations restricting property lending were removed in the Big Bang and how at the same time changes in the wider market economy reduced the scope for making profits in traditional intermediation. It describes how, in this environment, banks inevitably sought out other sources of profit, and exploited new opportunities which were made possible in the Big Bang chiefly in property speculation (CRESC, 2009, p40).

The third part then considers the shift towards universal banking and its increasing dependence on risky IB operations. Having de-‐compartmentalised the financial market and liberalized trading rules, the state cleared the path for banks to adopt a universal model and to engage in large-‐scale wholesale and IB

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operations. The growth of universal banking, also gave rise to another structural pressure, at least for smaller banks. It describes how the dynamics of an increasingly oligopolistic banking market put pressures on smaller banks to act mimetically or take risky steps to gain market access and to compete. A fourth trend concerns the emergence of a selling culture within retail banking. This part describes how banks were subject to pressures to exploit their customers and to make money out of them in order to recover the costs of their branch networks and maintain expensive free-‐whilst-‐in-‐credit services (Bowman et al, 2014, p104). These dynamics encouraged banks to shift away from being servant and intermediary and witnessed banks becoming increasingly independent and in it ‘for themselves’ (CRESC, 2009, p42).

4.2 Part 1: The shift from intermediation to credit-‐creation

4.2.1 The explosion of credit-‐creation The standard text-‐book definition of what banks do tends to overlook

their function in creating credit, suggesting instead that their main function is to act as intermediaries allocating redundant capital from existing savers into productive investment by lending to borrowers (Jakab et al, 2015; Turner, 2016, pp57-‐60). This narrative suggests that banks merely redistribute a money supply which already exists, and implies that they perform some form of social good by allocating existing un-‐used capital to needed investments, leading to growth and increase of commercial activities. But that description fails to explain how banks by lending more than they have, in fact create credit and extend the money supply. Since banks are required to keep in reserve only a tiny fraction of the amounts they lend, and since they have an almost unlimited capacity to borrow and to lend more, they play a leading role in creating credit. Whilst they are no longer able to print their own money in this country, they create it electronically, which has the same effect in extending the money supply; and indeed the vast majority of money in circulation is created electronically in this way (Turner, 2016, p58).

In the last half century, the amount of credit created by banks has increased in staggering quantities. In the 10 years between 1997 and 2007, there was an increase in the money supply from £750 billion to £1700 billion, most of which is thought to have been caused by bank lending (New Economics Foundation, 2012, p47). In the decade which led up to the global financial crisis of 2007-‐2008, private credit grew at a rate of roughly 10% per year resulting in Britain’s banks lending so much that their balance sheets eventually exceeded the nation’s GDP by more than five times (Turner, 2016, p51). This increase in credit contrasts markedly with half a century ago. Back in 1964, the balance sheets of UK banks constituted only 35% of GDP and Government debt was only 39% of GDP (Turner, 2016, p51). As can be seen from Charts 4.1 and 4.2 below, households tended to deposit a lot more than they borrowed, typically depositing as much as 40% of GDP and borrowing as little as 14%, whereas the corporate sector borrowed slightly more than it deposited – borrowing 13%, and depositing 8%.

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Chart 4.1: Household deposits and loans in % of GDP (1964-2009)

(Source: Turner et al, 2010, p56, citing Bank of England as the source of data)

Chart 4.2: Business deposits and loans in % of GDP (1964-2009)

(Turner et al, 2010, p57, citing Bank of England as the source of data)

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By 2007, there is a very different picture. Whilst bank balance sheets

tower over GDP, being 500% bigger, households borrow more than they deposit, typically borrowing 76% of GDP and up to 95% of GDP if secured lending is taken into account, which is not otherwise shown on bank balance-‐sheets (Turner et al, 2010, p17), a significant increase from the 14% borrowed in 1964. And in 2007, they deposited 72% of GDP which whilst more than the 35% deposited in 1964 is less than the amount (76% or 95%) which households borrowed (see Charts 4.1 and 4.2 above). In other words, whilst in 1964 there was a surplus of capital which could be allocated to borrowers, which came from households depositing more than they borrowed, by 2007 there was no such surplus. Instead, where there used to be funding for traditional intermediation a funding gap has emerged. Clearly, the modern banking business model is thus no longer rooted in intermediating between household deposits and business borrowing, and textbook suggestions to the contrary are misleading (Jakab et al, 2015; Turner, 2016, pp57-‐60).

Instead of sourcing funding from household deposits, banks now fund their lending, or rather the fraction of their lending which they are required to keep in reserves, from wholesale, and typically inter-‐bank, borrowing. This shift has been underscored by an increase in often complex securitisation. Banks have moved away from retaining loans on their balance sheets, as assets, in favour of adopting an ‘originate and distribute’ model whereby securitisation provides the mechanism to bundle up their loans and sell them on typically to those that were able to secure cheap finance, often secured against the securities being purchased. By clearing these assets off their balance sheets in this way, banks have been able to grow their fee income and interest income whilst enhancing their capitalised balance sheets, thus generating additional funds which banks can also re-‐lend.

To appreciate just how much money banks borrowed in wholesale markets, it is useful to put the UK’s £1,200 billion bailout into perspective: the entire bail out in 2009 represented just 75% of what UK banks lent to finance in the very same year (CRESC, 2009, p45). Thus, at the aggregate level, we can see a shift from a business model grounded in the relationship between households and companies, and in its place an increase in credit creation dependent upon increased amounts of wholesale borrowing and securitisation (Turner et al, 2010, p17).

The structural pressures encouraging this radical change in activity were brought about by a deregulation on bank lending. The banking sector’s capacity to create credit is limited first by the rules which regulate how much banks have to keep in reserves, second by the rules which place restrictions on the quantity and type of credit which banks can create, and third by the lending opportunities available to banks. In terms of the first two types of restrictions, as we shall explore below the last fifty years have seen significant reductions on constraints and a general de-‐regulation of limits on the type and amount of credit banks can create. At the same time, there has also been a broader change in the structure of the wider economy, which has undergone a process of de-‐industrialization, whilst the state pushed for growth of the City of London and foreign investment.

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As a result of these changes, banks have been able to lend a lot more and they have been less restricted in what types of credit they can create. At the same time however they have had fewer opportunities to make profits from productive investment and they have thus had to look elsewhere to make profits from other areas of activity favoured by state policy, and in particular two areas considered below: the state’s encouragement of home ownership, which found expression through increased property lending, and the state’s ambitions to cultivate a thriving internationally competitive financial centre in the City, which was translated through into greater wholesale and IB activities (Moran, 1991, p124).

4.2.2 Removing constraints on credit-‐creation In the first half of the 20th century, the UK like most other developed

western political economies restricted credit-‐creation and compartmentalized finance into different regulated activities. Before the big Bang, real estate lending was heavily regulated, and pre-‐dominantly performed by building society lenders (Moran, 1991, p16). The Competition and Credit Control Act 1971 abandoned any quantitative constraints on credit creation, removing any restrictions on the amount of lending banks perform. In the Big Bang in the 1980s the constraints on bank mortgage lending were removed entirely and the different types of finance were de-‐compartmentalised, with banks and financial service providers being encouraged to compete in one another’s field to undertake previously protected and separately regulated domains of activity. These changes essentially permitted banks to engage in all manner of activity, to create as much credit, of whatever type, they wanted. It also led to the creation of ever more complex and sophisticated IB instruments, operations and markets and the growth of increasingly lengthy and complex chains of activity (Turner et al, 2010, p14).

At the same time, the requirements for banks to hold capital in reserve were weakened. Historically, the Bank of England – the lender of last resort, ultimately responsible for paying out in the event of bank failure – kept a cautious eye on bank behaviour to ensure that they had adequate reserves to prevent bank runs and to mitigate damage in the event of bankruptcy. It had power to insist upon minimal capital requirements, and to call in and itself hold bank capital in reserves to cope with any failure. In the last half century however, the Bank of England has abrogated this function of taxing banks for rainy days in favour of minimal international standards set by Basel and in doing so it has become less concerned by domestic balance sheets and the credit being created by UK banks, and instead of paying keen attention to how much credit was being created and what it was being applied to the Bank of England has instead focused predominantly on monetarism and the control of inflation (King, 2016, ch.5; Turner, 2016, ch.6).

This diversion of focus and abrogation of responsibility for credit-‐creation marked a shift away from the previous political-‐economic order, which was noticeably more cautious about how credit was being created and allocated. After the last depression, economists and academics had widely warned about the dangers posed by banks pumping out too much credit and fuelling

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unsustainable asset price bubbles, which were liable to burst. Between 1929 and 1933, economists of the Chicago school, including Irving Fisher, Frank Knight, Henry Simons, even called for an end to fractional reserve banking, or rather they called for banks to hold in reserve a 100% fraction of their lending (Turner, 2016, p188). Frederick Soddy (1926) argued that banks should not be freely licenced to create credit because by doing so they extend the money supply and thus affect society’s purchasing power. Soddy argued that the state needed to reclaim and control this function, and constitutionalise how it was to be exercised – arguments which have been given renewed force by movements such as Positive Money (Douglas, 2015) and by economists and even mainstream financial commentators such as Turner (2016) and Wolf (2014c).

The Chicago economists not only advocated in favour of abolishing fractional reserve banking insisting that the government should direct credit-‐creation but also argued that state printed fiat money or helicopter money was preferable to letting fractional reserve banking create purchasing power in ways which were controlled by the free market (Turner, 2016, p188). Whilst these post-‐depression economists did not succeed in abolishing fractional reserve banking or getting states to control or constitutionalise such functions, there was a lot more caution and concern, before the Big Bang, about how much credit banks were creating. Even the economists who were relied upon by the proponents of neoliberalism, such as Milton Friedman, Wicksell, and Hayek warned of the threats posed to financial stability by banks creating too much credit (Turner, 2016, p189). Friedman in particular had argued that in deflationary times it was desirable for the state to create credit (Turner, p188; Friedman, 1948, pp245-‐246). Wicksell also argued that credit needed to be constrained. As well as setting the rate of interest in line with the natural rate of interest, Wicksell prescribed government control of credit creation arguing that banks should be required to hold a substantial fixed proportion of their money liabilities as liquid reserves at the central bank, a requirement which central bankers, in their pursuit of free market thinking, since ignored (Turner, p59).

And more recently, economists such as Minsky (1991) warned vociferously about the dangers posed by banks pumping out too much credit and engaging in ‘speculative’ and ‘ponzi lending’. Stability was undermined, he warned, by having a monetary economy run by financial institutions whose capitalistic aims were liable to cause markets to be flooded with credit (Minsky, 1991).

Instead of keeping an eye on credit creation and bank reserves, the Bank of England transferred its banking oversight functions to the Securities and Investment Board, an early incarnation of the FSA, or today’s PRA and FCA – an institution which was not expected to act as lender of last resort and thus arguably never had the right incentives to guard vigilantly against over-‐extension of credit. Having transferred its oversight functions to another regulator and placed its faith in Basel to set international standards to regulate capital reserves, the Bank of England prioritised its focus on monetarism, concerning itself more with inflation than bank balance sheets (Turner, 2016, p242). Whilst the Basel framework attempts to regulate the quantity and quality of capital retained by banks, and thus to put some limits on the amount of credit which banks can create relative to their capital, and to do so in a clear and universal way, the amount of capital required to be kept in reserve under Basel

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has been widely and heavily criticized as being too little, and governed by the principle of the lowest common denominator (Admati et al, 2013, ch.11).

The Basel regime also places no constrains whatsoever on bank size. Provided banks keep sufficient risk weighted capital, there are no limits on the scale and scope of banking. To reign in their capacity for credit-‐creation, many economists argue that banks should hold two or three times as much as at present and at least 20% or 30% capital in total against their liabilities (Admati et al, 2013, ch.13) – far short of the 100% called for by the Chicago school after the last depression.

The Basel framework, which has a sophisticated regime of risk weighting capital and liquidity requirements, can furthermore be gamed by banks able to shift assets and liabilities off balance sheet (Ertürk, 2015). Basel II for example allowed credit derivatives to reduce balance sheet risk. Banks thus bought credit default swaps to shift risks, supposedly, off their balance sheets, whilst in effect taking positions which overall enhanced volatility across the sector. And banks gamed the rules in other ways. With many transactions classed as off-‐balance-‐sheet, banks had every incentive to develop those lines of business. Lending to government for example was classed as risk free under Basel I thus requiring no capital reserves to support that lending. Lending to private companies on the other hand required around 8% capital reserves (Ertürk, 2015). Lending to other banks was classified as low risk, and was thus encouraged. Interbank lending thus grew exponentially, and by 2007 it constituted a massive 25% of bank lending.

Without high capital adequacy standards, banks will play a significant role in creating credit. The less banks have to keep in reserve as a fraction of their lending, the more they can lend. Able to hold less or less quality capital in reserve, banks have therefore ramped up the scale and scope of their activities, whilst at the same time the Bank of England was unconcerned with increasing bank balance sheets. According to Andy Haldane, before the crisis less than 2% of BoE time was spent discussing the activity of banks, the regulation of which had been passed over to the FSA (Turner, 2016, p20). Economists even removed bank balance sheets from their risk models: the ‘Dynamic Stochastic General Equilibrium models’ employed by economists completely ignored the destabilizing role banks played acting as creators of credit (Turner, 2016, pp170, 246).

4.3 Part 2: the shift from productive investment to property-‐lending For more than half a century, private credit has grown at a faster rate

than GDP and by and large that credit has been pumped not into productive investment but mainly into real estate lending. Most of the lending undertaken by banks has contributed towards either debt-‐funded consumption or competition between borrowers for the ownership of locationally desirable, already existing, real estate properties (Jordà et al, 2014; Turner, 2016, p246). In complex roundabout ways, banks have effectively become real-‐estate lenders either directly through retail banking or in circuitous routes through wholesale inter-‐bank lending and IB operations (Turner, 2016, p66; Jordà et al 2014).

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Between the mid-‐1990s to 2007, the share of bank lending which was allocated to manufacturing fell, in relative terms, from 7.9% to 1.6% and there were similar trends in agriculture, construction, retail and distribution (CRESC, 2009, p44). Since the mid-‐1980s, productive investment has essentially plateaued and lending to real estate, insurance and inter-‐bank lending has increased (see Chart 4.3 below). By 2007, 25% of bank lending went to finance; 40% was comprised of real estate and less than 2% went to manufacturing (CRESC, 2009, pp44-‐45). Before the last depression, in the 1920s, real estate lending averaged less than 20% of bank liabilities, whereas by 1970, it was around 35% and by 2005, it was nearly 60% (Jordà et al, 2014; Turner, 2016, p67).

Chart 4.3: UK banks lending by sector in £tr. (1986-2013)

(Source: Turner et al, 2010, p57, citing Bank of England as the source) In 1970, the value of the nation’s wealth, which is mostly attributable to

the value of real property, was approximately three times the nation’s income whereas by 2010 it was nearly six times the nation’s income (Turner, 2016, p67). Housing wealth was 120 % of national income in 1970 and 371% in 2010 (Turner, 2016, p67). In mature, developed cities, rising property prices are attributable not to new construction, which would employ and reward labour and the human endeavour involved in selling materials for construction, but increases in value in the underlying land. 80% of property price increases in the UK were increases in the value of the land and only 20% was attributable to new construction and developments (Turner, 2016, p68.). Whereas the supply of land, especially in good locations, is scarce, the supply of credit is practically unlimited. In other words, if the supply of credit increases, so too will the price of land. Lending against real estate thus creates asset price inflation, generating a

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self-‐reinforcing cycles of credit supply, credit demand and asset prices inflation – a bubble which eventually bursts.

Changes in regulation, chiefly the removal of the restrictions on property lending and credit creation, and the lowering of capital adequacy standards, have not been the only structural pressures driving real-‐estate lending. Property lending has also been encouraged by political attitudes and also by another type of structural pressure emerging from the real economy. As we have explored above, back in the mid-‐1960s, when households deposited more than they borrowed and businesses borrowed more than they deposited, there was a place for high street and commercial banks to make money from inter-‐mediating funds between household deposits and lending to business. In this environment, typically high national interest rates encouraged household savings and gave scope for retail and commercial banks to make a profit on the spreads between savings and lending. A desire to lower national interest rates put downward pressure on the high street banks’ ability to take a cut from intermediation.

Selling credit secured against property thus became the basic, low cost, low risk business line for mainstream banks. Compared to lending working capital to manufacturing firms, property lending was unproblematic and provided security which in a period of rising property prices offered banks the appearance of safety without any of the high costs and due diligence involved in business lending. Mortgages and secured lending which had been sold to customers, could also be repackaged and sold again on wholesale markets fusing wholesale and retail banking together in what CRESC described as ‘a giant transaction generating machine with mass marketing of retail products providing the feedstock for proprietary trading in wholesale’ (CRESC, 2009, p40). The result of removing restrictions on the quantity of and type of bank lending, and eradicating scope for margin in intermediation, was the relentless rise of real estate lending, which funded unsustainable property prices, and ultimately contributed towards unsustainable asset price rises.

Property lending was also encouraged by widespread faith in free market forces. As the external structure of the real economy witnessed a process of de-‐industrialisation, fewer opportunities for productive investment were presented. The secondary banking crisis in the early 1970s is a case in point. As Reid (1988) observed, the root of this crisis was the nation’s bias for property lending, and the lack of productive alternatives in the real economy. In a de-‐industrialised and globalized economy, where manufactured goods are more cheaply sourced elsewhere, property speculation was an easier bet for banks than investment in the real economy.

In the secondary banking crisis in the early 1970s small lenders bet on rising property prices particularly in London. A large number of smaller ‘secondary’ banks invested heavily in property lending aiming to capitalize on rising housing prices in the late 1960s and early 1970s. These banks relied heavily on borrowed money, and engaged in what Minsky described as ‘Ponzi lending’ -‐ their profits were dependent on continuing house price rises, which in turn were dependent upon more lending and more finance being available. A downturn in the housing market together with interest rate rises, and other economic shocks popped the bubble and left many ‘secondary banks’ holding security worth less than the loans which were supposedly secured. This crisis might have served as a precursory warning to the global financial crisis, warning

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about how gains from real estate lending can be illusory, and unstable and how real estate lending can pose dangers to the economy. However the Bank of England did not come out of the secondary banking crisis being distrustful of real estate lending or with a new eagerness to help direct bank credit into productive investment.

Instead, the Bank of England fell in line with free-‐market thinking, and wanting to avoid micro-‐managing bank lending it developed a distrust of managing small banks having bailed out some thirty smaller banks in that crisis (Reid, 1988). Notwithstanding the persuasive arguments advanced by economists throughout the 20th century that the government should have a hand in guiding and constraining credit-‐creation, the state instead sought to create a more unified market economy, leaving the determination and allocation of credit-‐creation almost entirely to free market forces.

4.4 Part 3: the shift into riskier business

Almost universally, there has also been a shift in the banking business model towards increased IB, with the profitability of banks becoming increasingly dependent upon their engagement in wholesale and IB operations (Bowman et al, 2014, pp90-‐94). Of the Big Five, all bar Lloyds, have radically grown their wholesale and IB operations following the Big Bang (Fallon, 2015, p56). The universal banking model that emerged involved banks engaging in a wide variety of operations, not least mergers and acquisitions (‘M&A’) and the types of complex property instruments which underscored banking’s shift into property-‐lending described above. Having generated fees on retail property loans, banks then repackaged them and sold them on in wholesale markets, taking a ‘clip’ at every stage of the chain and upon each transaction (CRESC, 2009, p44). Since the Big Bang there has been a radical growth in complex securitization and a proliferation of complicated instruments -‐ such as mortgage backed securities, interest rate derivatives, foreign exchange swaps and commodities futures and oil futures. In terms of M&A, banks not only financed M&A in other sectors but also engaged in it themselves, and in the process they accumulated often large amounts of intangible assets onto their balance sheets in the form of goodwill, which can be terribly difficult to value. The profitability of many of these operations, like with competition for locationally scarce properties, depended upon continued, and ultimately unsustainable levels of, liquidity and demand for credit, as well as consistent valuations. When demand, asset prices, or liquidity fell, those operations became less sustainable.

In the decades leading up to the GFC, inter-‐bank lending significantly increased. It largely financed IB operations and contributed to the growth of a complex inter-‐dependent global credit-‐intermediation system. At the same time, the treasury departments of banks grew exponentially. Whereas these used to be small, service departments, very much reactive in nature, responding to bank deficits or surfeits by borrowing or lending on the inter-‐bank markets, they turned into large profit centres in their own rights (Turner, 2016, p96). These departments did not previously require large numbers of highly paid traders to undertake their book-‐balancing. By the 1990s, however, these departments had become pro-‐active in their approach to making profits and they were manned by

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armies of dealers who were invariably sited on the same floors of banks as traders, and they were paid handsomely to transact in all manner of financial instruments giving rise to a complex mesh of intra financial system claims and obligations (Turner, 2016, p96).

There were various structural pressures contributing towards this shift into IB operations. The Big Bang essentially let loose a lot of non-‐British actors and significant foreign capital hungrily searching for yield (Moran, 1991). In 1979 exchange controls were abolished and foreign investment and participation was encouraged through the progressive dismantling of foreign exchange controls after 1979 (Moran, 1991, p10). Fixed commissions and interest rates were abolished, exposing traders and lenders to competitive pricing and selling practices by new entrants (Moran 1991, p10). A process of de-‐compartmentalising finance followed, as regulatory burdens were removed and barriers opened up. In the early to mid 1980s there was a wholesale dismantling of protectionist measures. The state removed: restrictions on price competition, fixed interest rates, fixed commissions on the sale of securities, the prohibition on foreign enterprise participating in securities, and the restrictions on domestic businesses operating in other types of business (Moran 1991, p10).

After 1983 there was also a phasing out of price competition on the stock exchange, the prohibitions on firms acting as principles and brokers were abolished and the restrictions on stock market companies being owned by foreigners was abolished (Moran, 1991, p10). There was also a radical change in the way firms could be owned. Foreigners were permitted to own shares, to trade on the stock exchange and to take over British companies (Moran, 1991, p10).

The British securities industry thus became increasingly exposed to competition and was no longer a protected domestic arena. The signal went out that all were welcome to compete in IB and London was open for business. The state broke down the compartments between finance, and retail banks moved not only into mortgage-‐lending which was formerly the domain of building societies but also into securities and IB. The former cartel, operating around the stock market which had been insulated from competition, was broken up and what was largely an inward-‐looking merchant banking sector was exposed to new competition (Moran, 1991).

Prior to the Big Bang takeover by foreign enterprise was prohibited, the ownership of shares by foreigners was constrained, there were high barriers to entry to the securities and banking markets by both foreign and domestic enterprises and domestic competition was also constrained by restrictions on price competition, such as minimum commissions, and with fixed interest rates set on loans and deposits, and there was hostility towards new products and innovation (Moran 1991, p9). Before the 1980s the elite finance capitalists had thus developed their own operations and regulation largely removed from the attentions of the state (Moran, 1991, p9). These elite interests were largely insulated from intervention by the state which viewed the task of understanding, let alone regulating, these activities as mystifying and best left to those whose familiarity and expertise lent themselves to understanding complexity (Moran 1991 p18). New technological advances and regulatory reforms in other countries also opened the way for more global operations and gave way to new trading behaviours, even creating new markets (Moran 1991, p12). New

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competition brought about innovation, which led to the creation of new products and markets:

‘There is in turn an intimate connection between intensified competition and the drive for innovation, because the creation of new financial instruments or trading practices is one of the most effective ways of securing a competitive advantage… In recent decades this ingenuity has stretched beyond the invention of particular contracts to the creation of whole markets. Two of the most dynamic are in financial derivatives and Eurocurrencies….’ (Moran 1991, 10-‐11) The Big Bang also gave banks incentives to incorporate as PLCs, which in

turn encouraged risky behaviour. National championing of the City as the destination for foreign investment opened up new access to capital for banks. By permitting foreign ownership of shares and breaking up the old stock market oligopoly, causing an explosion of investment in the stock market, the PLC – able to quickly raise equity – became the main ownership structure for banking businesses (Moran 1991, p12). Formerly closely owned private companies and partnerships, which used to risk their own funds gave way to ever-‐larger PLCs (Moran 1991, pp12, 68-‐69), whose traders could gamble with other peoples’ money.

As we explored in chapter 2, since increased borrowing does not prejudice a bank’s ability to return value to shareholders, banks were encouraged to increase their asset base thus increasing their scope for lending and fee generation. Even only marginal or nominal returns made on increased lending, enabled banks to boost the returns on the tiny amounts of equity they retained. Banks were thus encouraged not only to leverage to great heights but also to take large risks for small returns on their assets (CRESC, 2009, p44) becoming what Haldane (2011) called ‘volatility junkies’. This propensity for both growth and risk was also encouraged by the implicit state subsidy underpinning banks solvency: whilst the state becomes a significant stakeholder in banks, their implicit subsidy all the while encouraged banks to take risks which imperilled that stake-‐holding, engaging in risky operations for relatively low returns on assets, in order to return value to shareholders knowing the state would not allow bank losses to result in insolvency (Haldane, 2015).

Political championing of banking giants and a big city also encouraged the growth in IB operations. The state, whose central bankers were already distrustful of smaller banks (Reid, 1988), cheered on the growth of financial giants by pushing for foreign investment and growth of the City (Moran, 1991, p124). The state’s experimentation with free market ideology undermined its incentives and capacity to monitor and control IB operations. Believing that financial and macroeconomic stability flowed from low and stable inflation, policy makers and central bankers encouraged the deepening of financial markets, leaving bank activity to free market forces. The International Monetary Fund’s (IMF) Chief Economist assumed risk had been more safely dispersed through the system and that the IMF could ignore much of the details of the financial system (IMF, 2006; Turner, 2016, p170). Innovations which increased liquidity or made it easier to hedge against risks, were deemed desirable – despite the fact that they made it simultaneously easier for economic agents to take positions in other words to place bets which could radically increase the

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volatility against which such innovations were attempting to hedge (Turner, 2016, p194).

Rising economic wellbeing, albeit illusory and founded upon unsustainable conjunctural upswing, confounded the delusion that markets could be left to run free, and that the banking market did not require careful oversight. The President of the American Economic Association, Robert Lucas in 2003 declared: ‘the central problem of depression prevention has been solved’. In 2006, like Gordon Brown who famously later declared there would be no return to boom and bust (Summers, 2008), the IMF declared that free financial markets had brought about ‘increased resilience of the financial system’ and considered that ‘banks may be less vulnerable today to credit or economic shocks’ (IMF, 2006).

4.4.1 Lax competition control As was observed by the Parliamentary Commission on Banking

Standards, the state’s minimally interventionist and light-‐touch regulatory approach was not only concerned with direct regulation, but also influenced competition policy (2013b,p160). Provided the banks did not collude, the state was happy for banks to grow to dominant sizes and the market to concentrate into an oligopoly without much competition control (PCBS, 2013, p160, paras152, 167, 309-‐313, and 334). These banking giants became increasingly insulated from competition by challenger banks as the banking market consolidated resulting in significant barriers to entry and creating an effective oligopoly with significant competitive advantages for the big dominant banks (PCBS, 2013b, paras.167, 309-‐313, 334).

Benefitting from their more lucrative IB operations, the biggest banks could afford to keep large and costly branch networks and could afford to maintain free-‐whilst-‐in-‐credit banking services. The high operating costs and need for a branch network disadvantaged smaller banks forming something of a barrier to entry which insulated the bigger players from retail competition (CRESC, 2009, p51). These dynamics inadvertently discriminated against smaller more conservative banks such as the Co-‐op, which lacked the branches to compete against the Big Four in the domestic retail market (Bowman et al, 2014, p94). The smaller banks that depended on others for clearing services were put to further disadvantages by having to pay high costs for such clearing services and by the relatively higher cost of deposit insurance (PCBS, 2013b, paras.309-‐314, 334).

Mutuals and building societies operating not in pursuit of high shareholder value thus found it more difficult to do well because they lacked the crossover subsidy from wholesale and IB and they did not enjoy the incumbent positions of having large branch networks. They tended to make lower net interest margins (CRESC, 2009, p52) and being building societies were limited in how they could grow their assets and what new business they could transact. They consequently found it more difficult to grow their assets and branches on the scale required to compete with bigger retail banks. The growth of banking conglomerates thus created:

‘an unlevel playing field which systematically disadvantaged mutual and smaller firms [who also] pay higher costs of deposit insurance and all smaller banks are handicapped by the requirement to buy clearing services from an existing clearing bank. The

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incumbent major PLC banks are protected by their branch systems which are both barrier to entry and a basis for cross selling to a customer base which is still more likely to divorce than to switch current account provider’ (CRESC, 2009, pp7-‐8). The consequences of this oligopoly are that the Big Four were able to

restrain competition by smaller competitors, who were forced, by these diverse structural pressures, to follow their lead by adopting the same behaviours and business practices in order to survive.

To make matters worse, the competition authorities have allowed many large-‐scale mergers within the banking market. Since the 1990s there has been a significant consolidation and increase in size of banking companies. Indeed, the EU second banking directive 1989 encouraged universal banking and was permissive of growing national banking champions to compete on the global scale. Whilst the CMA 2016 report recognises the stranglehold enjoyed by large banks on the retail market, it has not made any inroads into breaking up this oligopoly. Competition law is supposed to police not only against anti-‐competitive agreements between firms and abuses of dominant positions, but also to encourage competition between competitors, and to protect smaller firms from unfair competition. As Craig and Duburca put it:

‘efficiency is not the only goal of competition policy. A second objective [is] to protect… smaller firms from large aggregations of economic power, whether in the form of the monopolistic dominance by a single firm or through agreements whereby rival firms coordinate their activity so as to act as one unit’ (2008, p951). In a banking market which is highly concentrated where the dominant

players are over-‐leveraged and better-‐subsidized by dint of being too big to fail, pressures are brought to bear on smaller peers, and new entrants, who have incentives to mimic the behaviours of the less ethical banks, becoming exploitative and adopting excessive risks in pursuit of growth and market access.

4.5 Part 4: the shift towards exploiting retail customers Whilst the Big Bang de-‐compartmentalised finance, it did not break up the

oligopoly of the large high street banks, and it did not regulate how retail banks served their customers. At one and the same time the Big Bang permitted high street banks to engage in new and other areas of banking, but also exposed them to new risks and potentially new competition thus incentivizing them to generate income from less traditional lines of business. Retail banks found themselves pitched side by side with all manner of other financial businesses in essentially the same race and prone to the same urgent need to re-‐think how to exploit new opportunities to cover their costs and keep ahead of the competition. For retail banks, these costs were particularly high, and necessarily so.

In retail banking, market share very closely correlates with the size of a bank’s branch network. To retain and increase market share, retail banks are forced to retain and even grow their costly branch network (Bowman et al 2014). Although most banks tried to move away from branch banking and to usher in a new system of internet banking, those endeavours largely failed and

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still today the extent of a bank’s branch network largely determines their market share. For example the big four retail banks– Lloyds, the Royal Bank of Scotland, HSBC and Barclays – now control, as a result of their effective strangle-‐hold on retail branches, more than three-‐quarters of Britain’s personal current accounts (Competition and Markets Authority, 2016).

Retaining this branch network is all the more costly for retail banks when the current paradigm retains expectations for free-‐whilst-‐in-‐credit banking services. The delivery of these two costly products –branches and core banking services – if they are to be delivered free of charge, place considerable strain on retail banks to cover costs in other ways (Competition and Markets Authority, 2016; Bowman et al 2014, p94). Along with secular low interest rates ultimately destroying margins in traditional intermediation (CRESC, 2009, p40), these pressures have forced banks to exploit their branch networks as sales-‐points for selling other services (CRESC, 2009, pp40-‐42).

Universally and regardless of their ownership model, retail banks have responded to these pressures by aggressively selling, even mis-‐selling products to their customers (Bowman et al, 2014, p11; CRESC, 2009, pp50-‐52). Branches have become selling points not only for mortgages and property-‐backed loans, but also for other products which can be sold profitably to customers including pensions, and insurance products, and not least PPI, and interest rates swaps – often products which customers have no need for. In turning banks into selling points, a deal-‐making and sales-‐oriented culture has emerged in retail banking, adopting the same incentives more typically found in IB such as incentivized targets, and bonus and commission schemes (CRESC, 2009, p51; Parliamentary Commission on Banking Standards, 2013b, paras.116, 119, 519, and 536).

This shift into sales-‐dominated retail behaviour is a part of what CRESC (2009, p42) characterised as the shift into becoming ‘giant transaction making machines’ where banks take fees on a large volume of transactions, ramping up the scale and scope of their retail activities often to feed wholesale lending and borrowing (CRESC, 2009, p42). Retail banks have thus shifted away from being cautious intermediaries serving the interests of their customers, and have increasingly become self-‐serving, often exploitative, in it ‘for themselves’ (CRESC, 2009, p42; Engelen et al, 2011, p159).

In addition to the pressures arising from needing to recover high branch costs in a low interest environment, there is another structural pressure incentivizing this shift in business model. Fee-‐generating products are generally not risk-‐weighted under the Basel regime and they can therefore be sold in large volumes without requiring capital reserves and they thus do not disturb bank equity, meaning that their sales enhance returns on equity (Ertürk, 2015).

4.6 Conclusions The main structural pressures considered in this chapter have arisen as a

result of the changes brought about in the Big Bang. With the onset of neoliberalism, responsibility for industrial policy and planning was increasingly abrogated in favour of free market forces, and the real economy underwent a process of de-‐industrialization. We witnessed how within that climate banks

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were forced to seek out profits from new and untraditional sources. So long as the broader structure and regulation of the economy remain unchanged, the structural pressures considered in this chapter are liable to remain in play.

It was observed in this chapter that an increasing number of academics and policymakers have argued for radical change, seeking to revisit the relationship struck between finance, market and state in the Big Bang. Many have argued that credit-‐creation and allocation cannot sensibly be left to be determined by free market forces, and that the state needs to exert greater control over these functions (Wolf, 2014b, 2014c; Turner, 2016, p109). It is increasingly also argued that we need to decide what activities we want banks to finance more generously, or not to finance, and to adjust regulation to achieve such ends (Bower et al, 2014, p6; Turner, 2016, pp193-‐195). Some have argued that regulation needs to ensure that credit is directed to finance more useful capital investments capable of producing the additional wealth required by society to repay our debts (Turner 20156, pp61-‐63; Kay 2015, pp428, 299).

Whilst calls for greater productive investment have found favour amongst some in the Labour Party, resulting in a recent manifesto pledge to capitalise a large National Investment Bank (Labour Party, 2017), they have not impacted upon the government reform agenda, which remains stubbornly committed to the same political-‐economic experiment the state has been invested in since the 1980s (Bowman et al, 2014, p13; PCBS, 2013b, paras.190, 237, 247). Still captivated by free-‐market ideology and lacking any alternative vision in a productive economy, the state seems to suffer from something of an ‘inertia of faith’, held captive by delusional beliefs that credit-‐creation can be best determined by private competition and that any economic failure is merely a result of inadequate execution of that policy (Bowman et al, 2014, ch.5; Turner, 2016, p100). As we observed in chapter 2, the reform agenda has completely ignored calls which challenge the ideological status quo. The official response was explicitly committed to making London the epi-‐centre of global finance (PCBS, 2013b, para.237) and did not consider what types of activities the UK needed to be more generously financed by banking. It went about implementing reforms which minimally disrupt the banking sector’s free scope for credit-‐creation and allocation.

Consequently, without changing the structure and regulation of the broader economy, the same structural pressures are likely to encourage banks to engage in the same dangerous activities which led to the financial crisis and which are likely to lead to further crises (Wolf, 2014a, 2014b, 2014c, chs8-‐9; Brummer, 2015, pp299-‐301; King, 2016, ch.9; Turner, 2016, ch.12). The main drivers which encouraged the global financial crisis in the first place remain in play : banks are still too big, their remuneration system and shareholder value governance continue to provide incentives to leverage, engage in excessively risky business, they consequently have every incentive to exploit their customers, and to pump out too much credit and to allocate it in unproductive ways and ways which are liable to cause unstable cycles (Turner 2016, pp173-‐175, 245-‐246).

A lot of the structural pressures considered in this chapter are indiscriminate to ownership forms – they encourage bad banking regardless of how banks are owned. Before exploring in more depth how ownership pressures influence behaviour in the context of the case studies performed by

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this thesis, the next chapter will consider more carefully how ownership pressures can be distinguished from structural pressures so that the former can be more closely analysed.

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Chapter 5. Methodology 5.1 Introduction

This chapter aims to clarify how the thesis has addressed the overarching thesis inquiry, namely how ownership affects behaviour. It is clear from the preceding chapter, that ‘ownership’ is not the only phenomenon influencing bank behaviour and that there are all sorts of ‘structural pressures’ arising from the market and regulatory conditions within which banks operate which also affect their behaviour. Differentiating these different behavioural drivers and distinguishing their various effects presents some significant methodological challenges. The purpose of this chapter is to clarify and justify what methodology will be adopted in this thesis and particularly in the following empirical research chapters to explore the relationship between ownership and behaviour in banks.

The chapter is broken down into five parts. The first part begins with a reflection on epistemology and ontology, and clarifies what epistemological and ontological stance is adopted by the thesis. The second part then clarifies what inquiry is being made by the thesis and what the main thesis questions are. A third part then explains what methodological framework is being adopted in order to perform such inquiry, clarifying what conceptual structure will be used to gather and analyse the data and materials. This part also discusses why such methods are considered appropriate. A fourth part then contains a more specific discussion about how the research is designed, discussing in particular what cases have been chosen, what sources and data will be explored and why. This part also clarifies the lexicon and terminology employed throughout the thesis. Finally, the fifth, concluding part summarises the research strategy adopted and it justifies the choices made in the research depicting the same diagrammatically in a ‘research onion’ made popular by Saunders et al (2007). This part thus summarises why the thesis has adopted a social ontology and critical-‐realist epistemology, and chosen to perform an exploratory case study using quantitative and qualitative data of a primary and secondary nature.

5.2 Part 1: The ontological and epistemological framework The way we think of the world (ontology) influences: what we think can be known about it (epistemology): how we think it can be investigated (methodology) and the kind of theories and knowledge claims we think can be constructed about it (Fleetwood and Ackroyd, 2005)

As Fleetwood and Ackroyd (2005) observe, how we think about reality

affects what we can understand about it, and how we can go about investigating it. Ontology, that is the philosophical study of the nature of reality, beings and their relationship, is regularly concerned with questions about what entities or systems exist or can be said to exist and how such entities or systems may be grouped, and related within an hierarchy, and subdivided according to their similarities and differences (Fleetwood and Ackroyd, 2005). This thesis adopts a

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‘social ontology’ (Archer et al, 1998). It recognizes that banks are social constructs (Haldane, 2015), and the form that they take and how they are regulated, are not inevitable arrangements but rather settled upon through the exercise of state power. What society can create, can also be changed, and in ways which aim to obtain behaviours more beneficial for society (Bourdieu, 1977; Hurrelmann, 1988; Hurrelmann, 2009; Haldane 2014).

Within that framework of beliefs or ‘social ontology’, the thesis then adopts an epistemological approach of ‘critical realism’ (Bhaskar, 1978). Bhaskar’s ‘critical realism’ explores the interface between the ‘natural’ and ‘social’ worlds, by combining a transcendental realist theory of science with a critical naturalist social philosophy of social sciences (Bhaskar, 1986). Whereas the essential premise of ‘realism’ maintains that there is an independent reality of being which transcends the relative bounds of human knowledge and interaction, ‘critical’ natural philosophy recognizes that studying the human world is fundamentally different from studying the natural world and calls for the adaptation of different strategies (Bhaskar, 1979).

Critical realism does not require a constant conjunctive relationship between events in order to establish causal relationships, but seeks instead to identify causalities at the level of generative mechanisms, recognizing that there is or may be greater flux in the social world than in the physical one, and that individuals who inhabit social structures can themselves reflect upon and change their behaviour (Bhaskar, 1979). The Bhaskarian approach is essentially non-‐reductivist. It acknowledges the enormous complexity of the world, and rather than seeking to reduce any exploration into a single hermeneutic, it combines together different ways of looking at things, providing a variable appreciation of both ‘realism’ and ‘critical’ inquiry (Bhaskar, 1986).

This epistemology is particularly appropriate for approaching an inquiry into the different drivers affecting bank behaviour and the particular relevance of ‘ownership’ related drivers. Any inquiry into bank behaviour is necessarily complicated by the highly structured and stratified nature of banking, which involves huge social constructs organizing vast numbers of human agencies, run and regulated according to different and differing aims, values and rules. Critical realism is commonly considered to be apt for performing inquiring into events and circumstances which are themselves the result of multiple generative mechanisms (Denmark et al, 1997). Not only are banks large and complex, but the object this thesis wishes to study namely ‘behaviour’ or rather ‘mis-‐behaviour’ is itself largely irreducible, as it arises out of the relationship and interplay between various conditions, structures and generative mechanisms, and not merely the condition of ‘ownership’.

Adopting a social ontological belief and an approach of critical realism provides the thesis with the best tools to explore the relationship between ownership and misbehaviour. Such ontology and epistemology allow this subject to be approached holistically without calling for the arbitrary application of singular hermeneutics to define the transcendental reality of social structures, our experience of them and the empirical layer of perceived reality.

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5.3 Part 2: The essential inquiry

Before considering and justifying the choice of methodology, it is necessary first to clarify why such inquiry is being performed and what specific questions will be asked. As was touched upon in chapter 1, the motivation for writing this thesis stems from an interest in stakeholder governance and more particularly the type of social purpose not-‐for-‐profit which Hansmann considered back in the 1980s (1980, 1981, 1988) and which more recently Bøhren et al described as ‘ownerless’ organisations (2013). Hansmann claimed that organizations which were not ‘owned’ and which did not distribute their proceeds to outsiders or to members but which recycled such proceeds by continually applying and re-‐applying them to meet the organizations’ aims, behaved more responsibly than organizations which were owned by outsiders as their interest in extracting profits provided incentives for them to compromise their behaviour in the pursuit of profits (Hansmann, 1980, 1981, 1988).

Hansmann considered also a particular type of stakeholder model which was not owned by and for the benefit of its members, but which was run for the benefit of its social purposes, and he argued that social purpose non-‐profits were better placed to operate in sectors where there is scope for the pursuit of profit to otherwise lead to exploitation for example where customers are in a position of vulnerability or where the trader enjoys a disparity of power because of informational asymmetries relating to their products or services (Hansmann, 1980, 1981, 1988). He argued that such organizations are apt to perform social purposes and can make a better and more efficient allocation of resources towards meeting such aims because they prevent profits being distributed to owners and require them instead to be dedicated to meeting the organizations’ aims. Hansmann’s claims (1980, 1981, 1988) became all the more topical in the wake of banking failures and the global financial crisis when regulators, politicians and commentators increasingly began to observe that banks had behaved badly (PCBS, 2013a, 2013b; Brummer, 2015). This behavioural deficit was not simply about the ways they had treated their customers, but also involved a departure away from the role many expect banks to perform in providing productive investment and into unproductive and harmful investments which have helped to cause or contribute towards economic problems and ultimately posed costs for the tax-‐payer (Turner, 2016, pp172-‐174, 193-‐199, 245-‐246).

The inquiry motivating this thesis was thus concerned with whether banks would behave better if they were not shareholder-‐owned but were more like the social purpose not-‐for-‐profits Hansmann considered, or what Bøhren et al (2013) more recently called ‘ownerless’ organizations. The need for such inquiry was made greater by the absence of any serious attempt in the banking reform debate to think about ownership issues. As we explored in chapter 2, the banking reform debate, which was largely an elite-‐driven affair, was seemingly intent on preserving the status quo and the power of the City, and it tended to avoid the subject of ‘ownership’ altogether. This omission was somewhat startling, especially since, as we have learned in chapters 1 and 3, it is now

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increasingly recognized that shareholder-‐owned banks tend to pose serious problems in terms of behaviour and performance. In the UK, the mainstream banks are all shareholder-‐owned and in other words their shares are publicly traded. There are no examples on the high street of any ownerless banks or what might otherwise be referred to as ‘social purpose, not-‐for-‐profit’ banks. It would be extremely difficult therefore to perform an inquiry into whether such model would behave better than differently owned banks because there are no subjects to study, or at least not in this country, and it is difficult to consider how an ownerless bank might behave in a vacuum.

In banking, there are what Bhaskar referred to as many other ‘generative mechanisms’ which also influence behaviour. Indeed, what emerged from the literature reviewed in chapter 4 was the clear realization that structural pressures arising from the market and regulatory environment within which banks operate can also have a strong bearing and influence on bank conduct. Recent history has shown that serious behavioural issues have arisen in stakeholder banks which are apparently free from the types of ownership pressures explored in chapter 3. It is necessarily difficult to differentiate these different drivers influencing behaviour and to consider their various affects. Nevertheless, stakeholder banks which encountered or avoided behavioural problems and which were apparently free from ownership pressures presented obvious opportunities to inquire into how ‘structural pressures’ as distinct from ‘ownership pressures’ affected behaviour.

Because there are no ownerless banks in the UK, the thesis inquiry has necessarily been broadened to consider the relevance of ownership in stakeholder-‐owned and shareholder-‐owned banks. This thesis seeks in general terms to explore the relationship between the ownership of banks and their behaviour. It questions whether other ownership models other than the shareholder-‐ownership can encourage more desirable behaviours in banks, and it inquires into the relationship between ownership and behaviour whilst considering how conduct is also influenced by other drivers or ‘generative mechanisms’, and in particular the sorts of structural pressures identified in chapter 4. The thesis tries to look at how bank behaviour is affected by pressures arising from the way banks are owned (which are referred to as ‘ownership pressures’) whilst also bearing in mind how such actions can be affected by pressures which arise in other ways unrelated to how banks are owned out of the structure of the market and regulatory environment within which banks operate (which are called ‘structural pressures’).

The thesis therefore addresses three questions. The first two are primary questions concerned with exploring the drivers of mis-‐behaviour, while the third question is a reflective follow-‐up question intended to explore the implications of the earlier analysis: (1) how does the way banks are owned affect their behaviour? (2) how do other pressures arising out of the market and regulatory

environments within which banks operate affect behaviour? (3) what are the implications for banking reform, in particular in terms of

ownership?

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5.4 Part 3: The methodological framework This thesis adopts a case study methodology to inquire empirically into

behavioural phenomena within a number of existing mainstream UK banks. It seeks to explore how behaviour is affected by ownership pressures arising from a bank’s ownership model and how behaviour is affected by other structural pressures unrelated to ownership. It tries to do this by studying a selection of banks which can be described as having different ownership models, and whose behaviour has been remarkable in different ways.

It is considered that a case study methodology is particularly apt for exploring the issues in this thesis for three reasons. First, how ‘behaviour’ is affected by different influences is largely irreducible phenomenon. The extent to which different drivers cause different behaviours cannot readily be separated out from one another, and measured in isolation. The case study methodology permits an holistic approach where multiple different generative mechanisms need to be considered. Case studies are generally considered to be useful for conducting empirical inquiries into phenomena within a real-‐life context where it is difficult to separate out certain phenomena or to distinguish what causes such phenomena from other causes (Yin et al, 1984, p23). For example, they are a useful way of studying phenomena and their causes within social constructs (Yin, 2014). Whereas experiments call for phenomena to be isolated from the context within which they arise and can focus on only a limited number of variables, a case study allows an inquiry into phenomena within a real life context where it is not possible or easy to isolate the same from their context (Yin et al,1984, p23).

Second, this methodology permits a theory-‐exploring framework, and is not limited to testing a singular proposition. Whereas quantitative research methods are limited in how they can provide holistic and in-‐depth explanations for behavioural problems, case studies permit greater flexibility in how data and sources can be evaluated against different claims and theorems (McDonough et al, 1997). The case study methodology is extremely flexible in the way cases can be structured to develop, explore and build theories (Yin, 2014). Case-‐study research can involve multiple case studies, and importantly it can benefit from the prior development of theoretical propositions (Yin, 2014). In other words, case studies need not be limited to testing fixed propositions but can be useful for exploring and building on existing theories and narratives, and developing new theories or narratives alongside existing ones.

This method thus appears apt for the inquiries made in this thesis, whose questions cannot be precisely answered in quantifiable terms but call more generally for discursive and qualitative explanation. The underlying claims which the inquiry seeks to test – how the shareholder-‐ownership model drives behaviour, and how stakeholder-‐ownership models might encourage better behaviours – have already been made by others, and are incapable of being proven or disproven in absolute terms. Rather they call to be explored within an holistic approach alongside other and conflicting claims and ideas. The case study allows these questions to be explored alongside other claims and ideas including the claim that shareholder-‐owned models provide more effective governance regimes than stakeholder-‐owned models, or indeed Hansmann’s

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claim (1980, 1981, 1988) that a social-‐purpose not-‐for-‐profit which does not have owners is better at encouraging sustainable behaviours.

The case study methodology thus allows this thesis not only to bear in mind Hansmann’s claims about social purpose not-‐for-‐profits being more responsible in sectors of activity where customers might otherwise be vulnerable to being exploited by profit-‐maximising incentives (1980, 1981, 1988), but also to considers the claims made by Kay (2015, pp248, 299) and Turner (2016, pp61-‐63) about banks failing to perform the credit-‐creation and allocation functions we should expect of them. As well as considering the effects of ownership on behaviour, the thesis can thus contemplate the broader philosophical questions about what role we want banks to play in credit-‐creation and allocation and to consider whether the shareholder-‐ownership model is consistent with such aims. It permits an inquiry into how the ownership model of banks affects and influences their behaviour both in actual terms, and in terms of the behaviour and functions we might wish banks to perform.

Third, the case study methodology is flexible in how it allows use of data from disparate and overlapping sources. This flexible framework allows different data to be accumulated around different complex issues; this also makes triangulation possible from different sources. By including both quantitative and qualitative data, case studies allow behavioural phenomenon to be observed more closely to their context and more completely (Tellis, 1997).

In summary, this methodology permits an in-‐depth insight into the relationship between ‘ownership’ and behaviour. It considers different types of ownership models which exist, or could be created, and how ownership affects behaviour both in practice and in terms of the behaviour and functions we might wish banks to perform. At the same time, the limits of the case study methodology need to be acknowledged. Such methodology is commonly criticized for lacking rigour and giving way to biased views which influence the direction of findings and conclusions (Yin et al, 1984, p21). It is also often criticized for considering too small a pool of subjects (Tellis, 1997). As Yin put it: ‘How can you generalize from a single case?’ (Yin et al, 1984, p21). Many case studies also suffer from being long-‐winded and produce massive amounts of documentation, especially when they are conducted in fields where there is a danger of data not being managed or organized systematically (Yin, 1993).

Nevertheless, the advantages far outweigh the disadvantages so far as this thesis is concerned, especially since many of the problems with case studies can be overcome in the way that the research is designed (Yin et al 1984; Yin, 1993, 1994). As Hamel et al (1993) observe the problem of bias can be guarded against by setting suitable parameters, picking an appropriate selection of cases and establishing an objective research framework within which to analyse findings.

5.4.1 Why not other methodologies? An alternative to performing case study research, which was considered

but dismissed, was to undertake statistical analysis of financial data relating to bank performance in order to compare how banks with different ownership models have performed over time. Another approach might have been to

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imaginatively model data based upon how banks would be expected to perform and behave if they had different ownership models. Yet another, very different, approach might have been to engage in a more abstract political-‐economic and philosophical inquiry into corporate governance and the shareholder versus stakeholder debate.

Of these alternative methodologies statistical analysis and comparison was the most attractive alternative. The other method, data-‐modelling, necessarily entailed levels of speculation and guesswork which risks detracting from the meaningfulness of the research. And research into the field of corporate governance and the stakeholder debate has already been undertaken at great lengths by a great number of scholars, and is likely to harden into more claims or counter-‐claims than uncover any meaningful data. On the other hand, a statistical analysis and comparison of financial and performance data from across a range of banks with different ownership models could possibly yield a lot of meaningful data, and it might also permit investigation into other types of ownership models, not existing in the UK, including the types of ‘ownerless’ model discussed by Hansmann (1980, 1981, 1988) and Bøhren et al (2012, 2013) such as the Spanish Cajas or the Norwegian Sparkassen.

As was identified in Chapter 1 however, such research has already been performed by others, and not least Ferri et al (2010, 2012). It also poses its own methodological complications involving as it does the performance of banks across different markets, countries, and regions with different regulatory, economic, linguistic, legal and political environments. Such a comparison would also be limited to considering the ownership models which actually exist, whereas a case study methodology allows the flexibility to contemplate other ways of owning banks and even to conceive of legislating new models into creation. It is possible for example to conceive of a bank that does not distribute its profits to its owners or indeed its members, but which applies its profits to continually perform its investment aims and purposes. Whilst the Spanish Cajas, and the Norwegian Sparkassen, are manifestations of such ownerless banks (Crespí et al, 2004; Bøhren et al, 2013), they are limited in scale and the area of their activities and there are many conceivable variants for creating other ownerless models to perform different banking functions.

The case study approach was thus preferred over a statistical comparison not merely because the former avoids the difficulties involved in comparing data from banks across different markets, jurisdictions and regulatory environments but also because that methodology is flexible and pragmatic and allows for in depth analysis whilst permitting theory exploration and development. In short, it permits the thesis to inquire concretely into how certain banks have performed whilst allowing it also to contemplate how other ownership models might be created to overcome problems encountered by the banks which it explores.

5.4.2 Limits of the inquiry and methodology The line of march taken by this thesis is concerned first and foremost with

the effects of ownership, and hence its focus is on how banks with different ownership models have actually performed and behaved. Whilst the thesis bears in mind ownerless forms of organisation (Hansmann 1980, 1981, 1988; Bøhren

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et al, 2012, 2013), it does not seek to consider the array of ownerless banks currently in existence, such as the Spanish Cajas, whose failures tell a wholly different story to the UK banks (Trenlet, 2012), which would call for another type of inquiry. Instead, the thesis recognizes that the task of re-‐engineering how banks are owned is open-‐ended and that changing the current ownership model is possible, but it does not seek to tackle questions about how a new ownership model should be designed or how such bank would be created and capitalized. Its focus is on how ownership pressures affect behaviour and how they can be addressed, rather than on how banking organisations should necessarily be designed.

Further this thesis does not pretend that it is capable of proving in absolute terms that misbehaviour is in fact caused by the way banks are owned or that any one ownership model is behaviourally superior to another. It would not be possible, even by increasing the number of case studies to prove behavioural causalities conclusively because an exploratory case study cannot be used to prove or disprove. Moreover, there are obvious limits to how far generalizations can be made from only a limited sample of cases. Causalities are necessarily complex and the methodology adopted by this thesis is unlikely to prove in absolute terms that mis-‐behaviour is necessarily caused by ownership pressures as opposed to other factors. Banks are huge organisations involving vast number of human agencies, pursuing many different aims and interests within complex hierarchical, management and regulatory environments; relationships are partly about perception and politics and they often have to be observed through proxies, not directly. Rather, having identified ownership pressures and structural pressures as drivers which can influence behaviour the thesis instead seeks to explore how they do so, by considering relevant evidence which tends to suggest that behaviour is or is not affected by such influences.

The focus of the thesis is also directed on the importance of ‘ownership’ on behaviour, rather than other factors. Whilst it is necessary to distinguish other structural pressures which also influence behaviour, these are secondary concerns, arising necessarily in order to explore the relationship between ownership and behaviour. Therefore, the thesis does not set about cataloguing, exploring and attempting to measure all of the possible structural pressures. Had the thesis been interested in exploring the impact and behavioural affects of monetary policy, or regulatory reform, or capital adequacy requirements, the research would have been designed in different ways. Furthermore, the thesis is not concerned with the adequacy of the various reform measures which have been taken, particularly relating to capital reserves and capital adequacy, which have been the subject of other inquiries. As such, it does not apply statistical analysis or modelling which would be required to stress test the lending and borrowing platforms of differently capitalized banks.

The case study methodology is also necessarily limited by the types of sources of data available. The different sources each have their limitations. In the cases studied in this thesis, a variety of sources will be called upon including academic publications, official inquiries, commentary from financial commentators and journalists, and statistical data collected from third party analysts, official sources as well as from banks, and from popular business books. The limits and advantages of such sources shall be discussed in more detail below.

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5.5 Part 4: Designing the case study research

5.5.1 Theory According to Yin (1994, p20), the main components for designing case

study research involve clarifying what questions are being asked, what propositions or theories (if any) are being advanced, what materials or units are being analysed and why, and how such materials should be interpreted and analysed to connect with those questions and propositions. In short, the research needs to be designed so that the questions being asked can be appropriately explored within a framework, which considers relevant materials and allows for the materials to be analysed in a way which connects with the questions. As Thomas (2011) puts it, the ‘case’ is the ‘subject’ of inquiry and a class of phenomena which provides the frame for the inquiry or ‘object’ within which the study is conducted and which helps to illuminate and elucidate matters.

To adopt Thomas’ terminology, the ‘subject’ of inquiry in this thesis will be the banks which are chosen to illustrate a range of different ownership models and behavioural phenomenon. The cases have been chosen as instances of what Thomas calls a class of phenomena to provide an analytical frame or ‘object’. Each of the cases involve instances of identifiable behaviour which is the ‘object’ being studied. In other words, the ‘subject’ is the different types of bank with their different ownership models, whilst the ‘object’ or ‘analytical frame’ within which the study will be conducted and the questions asked is the instances of different types of behaviour which, as we shall see, appear more broadly to represent examples of ‘good behaviour’ or ‘bad behaviour’.

Chapters 6 and 7 provide an analysis of four different banks: three examples of banks which have ‘misbehaved’ or demonstrated some notable form of ‘bad behaviour’ and one bank, or more accurately a building society, which has apparently behaved better than its peers and which cannot fairly be characterized as behaving badly. These four cases are coupled in pairs and considered together over two chapters, each chapter considering two banks whose ownership models closely resemble one another. So, Barclays Bank PLC forms one case, and is paired with the Lloyds Banking Group PLC in chapter 6, which is concerned with shareholder banks and how ownership pressures affected behaviour in those cases. Chapter 7, then considers two banks which can be classified as ‘stakeholder banks’ The first is the Co-‐operative Bank PLC, which before the majority of its shares were sold to third parties in 2013 was entirely owned by the Co-‐operative Group, which is a co-‐operative society or specific type of mutual organisation. And the Co-‐op Bank is paired with the Nationwide Building Society, which is still a mutually owned building society, owned by and run for the benefit of its members.

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5.5.2 Choice of cases Barclays and Lloyds were chosen not because they are outlier examples of

shareholder-‐owned banks but rather because they are illustrative more generally of the big banks in the UK whose shares are publicly traded and whose behaviour has been criticized in recent times. Both Barclays and Lloyds failed in different ways, but both told a variant on the same story that is shared by many mainstream banks, about management being encouraged to adopt risky strategies and (explicitly or implicitly) to tolerate mis-‐behaviour in order to meet objectives.

Both Barclays and Lloyds are historically and economically significant institutions and both are thoroughbred examples of shareholder-‐owned banks. Each developed risky business strategies and has been found to have misbehaved in other ways. Barclays, for example, courted widespread public controversy not only for isolated incidents of misbehaviour, such as LIBOR and other market-‐rigging, but was also criticized for developing a highly leveraged investment banking business model, which risked failing in economic terms, as it was overly-‐dependent upon non-‐traditional and unsustainable sources of income, and was thus badly suited to cope with the global financial crisis and also with the subsequent and still prevailing environment of low interest rates. Lloyds was also criticised not only for specific instances of misbehaviour, in its case embarking upon industrial scale mis-‐selling of products to its customers as well as market-‐rigging, but also by developing a business model which was dependent on making large acquisitions and which ultimately had to be bailed out by the Treasury in the banking crisis.

As for the stakeholder-‐owned banks, the Co-‐op and the Nationwide were chosen as cases because they were obviously relevant to the inquiry both because they had different ownership models and because they each behaved in ways which called out for further investigation. The Co-‐op bank was not owned by shareholders seeking to capture and extract value by trading shares in capital markets. It was owned by the Co-‐op Group which had no interest in trading shares for capital gains. Nevertheless it still developed a very risky business model, pursuing an unrealistically acquisitive strategy, similar to that witnessed in the case of Lloyds, albeit on a much smaller scale. This strategy ultimately caused its ‘failure’ and its need for third party bail out. As for the Nationwide, whilst not technically a bank, the Nationwide has performed the functions more typically associated with retail banking, and presents itself as a worthy case for exploring in this thesis not only because it has a stakeholder-‐owned model and operates in an environment where there are no other banks with such model, but also because, perhaps uniquely, the Nationwide performed well following on from the crisis, avoiding much of the allegations of ‘failure’ and ‘misbehaviour’ which were levelled at other banks. It thus presents an interesting outlier choice of case and useful comparator.

The cases were chosen, at least in part, with a view to guarding against pre-‐conceptions and bias. The shareholder-‐owned models were not radical examples of failure, such as the Northern Rock, or RBS, but were more representative of the experience had by the big banks in the UK. Similarly, the choice of stakeholder-‐owned banks included an obvious case of failure namely the Co-‐op Bank, which could have been overlooked had the thesis been intent on

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arguing that stakeholder-‐owned banks are behaviourally superior to shareholder-‐owned banks. Instead, it was chosen with a view to exploring the reasons for failure in a case where ownership pressures were apparently absent.

5.5.3 Time frame for study The empirical research into these four cases considers them over

different time spans. It would be arbitrary and unrealistic to consider them all over the exact same period, as their different notable incidents of ‘behaviour’ or ‘misbehaviour’ developed in different ways and at different times. The time-‐spans adopted have been chosen to provide sufficient insight into the incidents of ‘behaviour’ which are studied. In the case of Barclays and Lloyds, for example, these cases have been considered in the period leading up to and following on from the banking crisis and following on from the crisis until there was regime change amongst senior management.

These cases are considered for a period of some decades leading up to the crisis during which time their individual business models were developed. Since most of the revelations relating to misbehaviour for both of these banks followed the crisis, such as market rigging and mis-‐selling, they have been studied right up until relatively recently when there was a change of top management. It has also been appropriate to study these banks for some time following the crisis as their failing behaviour continued and was compounded by their inability to recover. The behavioural and performance problems which were remarkable for both Barclays and Lloyds consisted both of the difficulties they encountered during the crisis and their inability to recover from the crisis in a low interest or no interest conjuncture.

As such, Barclays is studied during the period between 1992 and 2013 and Lloyds between 1988 and 2013. Since the development of the respective business models within these banks revolved significantly around one central personality -‐ Bob Diamond in the case of Barclays and Brian Pitman for Lloyds – it has been appropriate to study these cases over the course of their careers. Heavyweights in their own rights, these individuals are commonly considered to have delivered transformative success and defined the strategy and business models for which their banks became known (Fallon, 2015). They not only created huge reputational success for themselves but also came to characterise or personify the dominant force for their bank’s business strategy. The research into Barclays and Lloyds thus aims to chart the transformation of the business models within those firms essentially by following the careers of those individuals. It is also appropriate to consider Barclays and Lloyds alongside one another to make comparisons with how their strategy was being perceived by analysts and translating through into share price.

In the case of Lloyds, it was appropriate to extend the period of inquiry beyond Pitman’s retirement right up until the crisis when Lloyds failed most significantly, and still further beyond the crisis because of the incidents of misbehaviour and scandals which emerged in 2012 and 2013, and not least in connection with market-‐rigging and PPI and other mis-‐selling sagas. For Barclays, the behavioural issues were primarily concerned with the bad strategy involved in building up a business model which was too dependent upon

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unsustainable sources of liquidity and funding, and which resulted in Barclays having a significant capital deficit, which in turn meant that Barclays had to be rescued in its own way by hurriedly raising unorthodox funding. The behavioural issues of interest also included miscellaneous incidents of misbehaviour throughout the bank, such as : the questionable way in which Barclays raised funds to plug its capital shortfall, particularly from Qatar; its involvement in rigging markets such as LIBOR; the part it played in mis-‐selling products to its customers which they had little or no need for; as well as incidents of money laundering (Mollenkamp, 2010) and allegations of tax evasion, or unethical attempts to avoid tax (Leigh et al, 2012).

For Lloyds the behavioural issues of interest mainly also revolved around its risky strategy in diverting business away from traditional retail banking functions and becoming aggressively acquisitive, resulting in Lloyds taking on bad assets, including HBOS’ bad loans, which eventually required the state to bail it out; as well as other incidents of miscellaneous misbehaviour including : rigging markets; engaging heavily in mis-‐selling; and also engaging in money laundering (Mollenkamp, 2010).

Unlike Barclays and Lloyds, the strategies and business models for the Co-‐operative Bank and Nationwide Building Society revolved less evidently around any one central figure. The Co-‐op suffered a collective failure of governance, and so the relevant period of study cannot chart the career of any one individual. Its failure also came much later than the crisis, unfolding in 2012 and 2013, with reports and inquiries being produced afterwards. Similarly the successes of the Nationwide are not attributable to one dominant personality, but to organic growth and traditional prudent business whose management was not in the hands of one figure but a collective with multiple, changing personalities.

It was appropriate to study the Co-‐op therefore in a more recent period, from the 2000s onwards and to go beyond the crisis, in order to take into account the reports and inquiries published after its failure in 2012 and 2013. The Co-‐op was thus studied from the start of the millennium up until 2016, which is when the inquiries were published. As for the Nationwide, its resilience and stability has been proven over a longer period of time. Since the Nationwide’s growth and success has been organic, it has been appropriate to study it over a longer period of time, namely since the late 1990s until 2014. Unlike for Barclays and Lloyds which were considered alongside one another to make appropriate comparisons, the behavioural problems in the Co-‐op and the success of the Nationwide are quite distinctive and these cases are therefore presented in turn.

5.5.4 Data and sources

The research questions call for a wide variety of data to be consulted. Set out below in table 5.1 is a table showing the different types of data consulted as a part of the empirical research. The table identifies what each source was consulted for, where it was found, what typical types of data were consulted, and also comments upon why such data was considered to be beneficial for the inquiries being made, and conversely how the same was considered to have draw-‐backs.

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Table 5.1: data, sources, advantages and disadvantages

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What data? What relevant for?

Where sourced?

What typical sources?

Advantages Disadvantages

1. Sales-‐side analyst reports

-‐Ch.6: the inquiry into ownership pressures for shareholder banks

-‐management communications to investors

-‐Thomson One Banker

-‐Online

See references in chapter 6 for fuller details; typically consulted large IB reports, for example:

-‐Deutsche Bank

-‐Morgan Stanley

-‐Société Générale

-‐Bear Sterns

-‐Credit Suisse

-‐JP Morgan

-‐good for figures, graphs and tables

-‐source of investor relations data and communications

-‐way of gaging investor attitudes to management

-‐enables comparison to be made with business model changes to gage how investor demands were received

-‐unavailable for stakeholder-‐owned banks

-‐irrelevant therefore to the structural pressures inquiry

-‐potentially biased as IB’s disclaim opinions and state may have vested interests

2. Broadsheet financial commentary and banking journalism

-‐chs.6-‐7: ownership and structural pressures inquiries

-‐Thomson Reuters

-‐In print

-‐Online

See references in chapters 6, 7 for fuller details; commonly:

-‐The Financial Times

-‐The Times

-‐The Telegraph

-‐The Mail

-‐The Guardian

-‐The Independent

-‐Easily accessible and readily searchable

-‐Good coverage of banking scandals and behavioural issues

–good coverage of shareholder owned banks

-‐sometimes a source of insider insights

-‐sometimes shallow reporting, sensationalising scandals, and lacking analysis

-‐coverage of stakeholder banks particularly lacking in analysis

3. Official and semi-‐official reports and inquiries into the banking crisis and certain banks

-‐Both pressures inquiries

-‐Bank misbehaviour generally

-‐The failure of the Co-‐op

-‐Misbehaviour in Barclays and Lloyds

-‐Parliament

-‐HM Treasury

-‐The different government departments or agencies

-‐Online

See references in chapter 2 for more details; main examples:

-‐IBC (2012)

-‐PCBS (2013)

-‐CMA (2016)

-‐Turner review (2010)

-‐Kay Review (2012)

-‐Salz review (2013)

-‐Kelly (2014)

-‐often analytically rigorous and detailed

-‐good source of figures tables and graphs

-‐easily accessible and searchable

-‐Potential for bias in appointments

-‐Potential for bias in terms of reference

-‐Potentially supporting existing elite agenda

-‐Haphazard and idiosyncratic in coverage of only some issues and some of the cases

4. Academic -‐inquiry into -‐Online See references in -‐often analytically -‐Often providing an

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journals and commentary

ownership pressures

-‐inquiry into structural pressures

-‐all of the cases

-‐Thomson Reuters

-‐Library

chapters 1, 2, 3 and 4 for more details; examples:

-‐Moran (1991)

-‐Ireland (2009)

-‐CRESC (2009, 2011)

rigorous

-‐more comprehensive coverage of ownership and corporate governance issues

-‐easily accessible and searchable

-‐good source of figures, tables and graphs

outsider perspective, lacking insider insight

5. Bank performance data, annual reports and annual or quarterly accounts

-‐All four banks studied

-‐ownership pressures: source of investor relations data and communications

-‐checking for asset growth, M&A, RoE, RoA, earnings ratios

-‐Bankscope

-‐Online

-‐The websites for all four cases

-‐Their annual reports

-‐Good source of figures, tables and graphs

-‐data from audited accounts

-‐Not specific to any of the inquiries

6. Popular business and finance books

-‐ownership pressures inquiry

-‐structural pressures inquiry

-‐all four cases

-‐Amazon

-‐libraries

-‐book stores

See references for chapters 3 and 4 for fuller details; examples:

-‐Admati et al (2011)

-‐Mayer (2013)

-‐Brummer (2015)

-‐Wolf (2014c)

-‐King (2016)

-‐Turner (2016)

-‐Kay (2015)

-‐Good source of insider insight

-‐potentially unbiased, lacking apparent agenda (unlike analyst reports)

-‐coverage haphazard and not comprehensive

-‐data sometimes highly subjective and lacking analytical rigour

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Although there were three thesis questions (see 5.3 above), the third

question was evaluative in nature, and consequently it was really the first two questions which called for primary empirical research. The sources and data available for those two inquiries varied considerably.

5.5.4.1 … for the ownership pressures inquiry

The empirical research into ownership pressures in shareholder banks had two slightly different aspects. It considered how the business model and strategy employed by Barclays and Lloyds was fashioned by investor demands, and how such pressures more generally influenced other incidents of misbehaviour. The main empirical research focused more upon the strategy and business models that developed within the cases studied, rather than on the multiple and miscellaneous incidents of misbehaviour that emerged. Strategy is an ordinary every day work connoting high level decision-‐making made for long term or overall gain. Whilst there are different definitions for a ‘business model’, at its most basic, it describes how an organisation recovers its operating costs and makes profit and in other words how it creates value and makes money (Osterwalder et al, 2009). The research aims to consider how changes in strategy and the business model were influenced by ownership pressures. These strategic changes at the level of the firm are often easier to study than specific incidents of bad behaviour occurring within firms, as there is typically more data readily available. Specific incidents of misbehaviour can be difficult to investigate because of a lack of evidence. Such incidents are often not detected or proven by regulators. Accordingly, the research into incidents of misbehaviour more generally relied heavily upon the official and semi-‐official reports and inquiries and their findings, including the Salz report (2013) or the FCA report on Libor-‐rigging or the PCBS report into banking standards. As for the research into strategy and business models particular attention was paid to growth in bank size, M&A activity, RoE, and RoA during the relevant time periods (identified in 5.1(c) above).

Using the bank performance data identified in row 5 of table 5.1, which was typically taken from Bankscope or from the bank’s annual or quarterly reports, the empirical research focused particularly on the two things typically called for by investors, namely increased earnings and growth. Special attention was paid to how banks sought to deliver high returns on equity and also greater profits by asset-‐growth and increasing the volume of the underlying business transacted.

RoA and RoE were considered to be useful ratios because they often provide an indication about how well management is using, respectively, total assets or equity to generate profits. In other words, they can reveal something about how efficiently profits are being generated relative to the total assets available to a bank or relative to the amount of money shareholders have invested.

As is identified in row 1 of table 5.1, to inquire into how ownership pressures caused changes in strategy, sales-‐side analyst reports were consulted for Lloyds and Barclays, and in particular those produced by the main

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investment banks such as JP Morgan, Credit Suisse, Deutsche Bank, and the others set out also in row 1 or referred to in chapter 6. This data was checked for investor communications or demands made on management, and also compared with the performance data, which had been analysed to consider the changing business models in Barclays and Lloyds. Such comparison was made as a way of assessing whether and how far investors were receptive to the strategy and business models being developed in Lloyds and Barclays and reflexively how their demands were being accommodated by those banks and their changing strategies and business models.

Other data was consulted to explore statements made by the banks relevant to shareholder pressures and in relation to wider instances of misbehaviour. Journalism and financial commentary as well as popular business books (rows 2, and 6 of table 5.1) were a good source of information about how management both in Lloyds and Barclays felt the need to satisfy investor demands, and about how they variously misbehaved. The two popular books written on Barclays and Lloyds provided good ‘insider’ insight into management decisions and the affects of investor demands. Banking journalism and official reports proved to be a useful source for types of misbehaviour such as PPI selling or LIBOR-‐rigging.

5.5.4.2 ….for the structural pressures inquiry

Since the inquiry into structural pressures was confined to looking at the

two stakeholder banks, the sources of data available for shareholder banks were of limited or no use. There were no sales-‐side analyst reports. The data and sources identified in rows 2 to 4 were the main sources consulted for the research into structural inquiries. Performance data, banking journalism, official reports and academic commentary were analysed for information about bank strategy and business models, again with particular attention being paid to performance indicators such as assets growth, M&A, RoE, and RoA. These sources of data (rows 2 to 4 of table 5.1) were checked also for information about other behavioural issues beyond the strategy and business models.

These sources were also analysed with a particular view to considering the types of structural pressures identified in chapter 4, and in particular what might be described as the ‘scale requirement’, ‘obesity problems’ and ‘peer pressure problems’ which are driven by high operating costs in retail banking, an effective oligopoly in the retail banking market, and the TBTF state subsidy.

The official and semi official reports, and academic commentary (rows 3 and 4 of table 5.1) were particularly relevant sources for the structural pressures inquiry in considering both the failure of the Co-‐op (Kelly, 2014), and issues of competition in retail banking (Competitions and Markets Authority, 2015). As is explained in row 3 (table 5.1), there were no official reports into the Nationwide, and accordingly performance data and the Nationwide’s own publications, particularly reports, as well as banking journalism, were consulted for information about strategy and business model.

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5.5.4.3 The benefits and limitations

The limitations, drawbacks and benefits posed by each source of data,

varied widely from source to source. Table 5.1 identifies more fully what were considered to be the main benefits and draw-‐backs for each source of data. The sales-‐side analyst reports (row 1) were a useful source for quantitative data, figures, tables and charts. They were also a good source of information for investor-‐management communications, clarifying what targets had been set, delivered upon or missed. Whilst lacking ‘insider’ information, they were much closer to the proverbial action than academic commentary, and benefited from extensive and up close performance analysis. The qualitative opinions expressed in those reports were perhaps less reliable as each report explicitly disclaimed liability for opinions and explained they might have vested interests which would conflict with objective analysis.

The financial commentary and banking journalism (row 2) was also more proximate to the business and less removed than academic commentary. It thus benefitted from anecdotes about internal goings-‐on within the organisations. The banking media provided good coverage of failures and scandals, such as the problems arising in the Co-‐op or the market-‐rigging for Lloyds and Barclays or PPI mis-‐selling sagas for all of the banks.

The official reports (row 3) responding to the banking crisis and different incidents of misbehaviour also proved to be a good sources of information for misbehaviour particularly for the Co-‐op (Kelly, 2014; FCA, 2016), and Barclays (Salz, 2013). The inquiry performed by these different reports was limited however in how far it connected with the ownership and structural pressures inquires performed by this thesis.

Whilst the academic commentary (considered in row 4) connected more with the ownership and structural pressures inquiries, this source of data was distanced from the internal culture within organisations. The performance data (row 5) was also largely numerical in nature, and did not explain the personalities, and sense of association or even mission within the culture of each bank.

There was something of a perceived gap in the data therefore in terms of insider insight. This was not necessarily overcome by the official inquiries, banking journalism or analyst reports, but it was compensated for by some of the popular business and finance books consulted. These sources (row 6) provided insights into Barclays (Weyer, 2000) and Lloyds (Fallen, 2016) and the Co-‐op (Brummer, 2015) as well as perspectives from central bankers (King, 2016), regulators (Turner, 2016) and other policymakers, involved in formulating banking reform agenda (Wolf, 2014c). Whilst this source of data was haphazard as regards which cases it spoke to and about what issues, it was advantageous in that books were apparently written without any obvious motive or agenda – something which cannot necessarily be said for the analyst reports (row 1).

5.5.5 Terminology Finally, this thesis has chosen to explore the above questions in the

manner described above, whilst employing the terminology of ‘ownership’

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rather than ‘governance’. It refers to the ‘ownership model’ rather than the ‘governance regime’ and to ‘ownership pressures’ as opposed to describing the incentives driven by ‘shareholder sovereignty’ or ‘shareholder primacy’ or ‘shareholder value maximisation’. The reason it has chosen to adopt such terminology is twofold. First, ‘ownership’ is useful shorthand for describing governance phenomena which can be cumbersome to explain. ‘Ownership pressures’ is a more pithy way of describing the corporate governance relationship whereby businesses are expected to act in the interests of their shareholders typically by paying down dividends or being run with a view to making capital gains in financial markets.

Second, such terminology, whilst technically inexact, is in common usage within the corporate governance literature and it helps to emphasise the thinking bias and conceptual errors made by treating shareholders as analogous to owners. Whilst banks or companies are not technically owned by anybody, it is common in political and economic thinking to conceive of and treat shareholders as ‘owners’ (Haldane, 2015, p13; Mayer, 2013, pp26-‐31; Eccles, 2015) – a misconception which is reinforced by the extensive rights shareholders are given to control companies. By employing such terminology it draws attention to that thinking error and helps to emphasise the illogicality in treating shareholders like owners and having banks run entirely in their interests. By adopting such terminology, the thesis underlines the question whether shareholders are treated like owners, and whether they should be treated in that way.

5.6 Part 5: Summary and conclusions Saunders et al (2007) famously depicted a ‘research onion’ showing diagrammatically the different available categories of research philosophies, strategies and methodologies. That research onion is shown in chart 5.1 below.

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Chart 5.1Chart 5. 1: A ‘research onion’

(Source: Saunders et al (2007), p52)

Of the available categories, the table below clarifies the choices of philosophy, approach, strategy and methodology adopted. Table 5.2: The different levels of Saunders' research onion Onion layer

Description of layer Chosen category

1. Research philosophy and epistemology

Social ontology and a critical realist epistemology

2. Research approach Inductive 3. Method of research Quantitative and qualitative research 4. Research strategy Case study (exploratory) 5. Time horizon Longitudinal 6. Types of data Primary and secondary data It is clear from the above discussion in part 1 that a social ontology adopting an epistemological approach of critical realism seems apt for the inquiry made by this thesis. And it is apparent from the above discussion and in particular that contained in part3 that a case study methodology seems appropriate for studying ownership pressures and the behaviour they encourage. Such phenomena are largely irreducible and incapable of being isolated from the context within which they arise where multiple other generative mechanisms are also in operation. Whilst this methodology has well-‐known limits being concerned with only a limited number of cases, it is hoped that the parameters set by the research design discussed above, and the selection of cases, is sufficiently objective and robust to guard against bias. It is also hoped that the wide range of sources used, whilst imperfect each on their own, taken together provide enough data to undertake meaningful analysis and identify useful and interesting findings. Following the empirical research into shareholder banks and their behaviour in chapter 6 and stakeholder banks and their behaviour in chapter 7, the findings made in those chapters will be analysed and evaluated in chapter 8 in which the discussion about the importance of ownership and its behavioural implications will be discussed further.

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Chapter 6. ‘Ownership pressures’ and Barclays and Lloyds

6.1 Introduction As we saw in chapters 2 and 3, in the wake of the UK banking crisis, it

became increasingly apparent that banks had taken on too many risks, and had misbehaved. As chapter 2 outlined, there was no shortage of journalistic and academic commentary covering the various banking scandals and incidents and allegations of misbehaviour and malfeasance, and there has been no shortage of proposals for reform. What was surprisingly absent from the reform debate was any official inquiry into whether the existing ownership model drives mis-‐behaviour – an omission which is rather astonishing in the light of the claims made by advocates of stakeholder governance, namely that shareholder-‐owned banks tend to encourage strategies which prioritise short term returns at the expense of their customers and long term stability. This chapter looks more closely at how the shareholder ownership model, that is to say the PLC whose shares are publicly traded affects the strategy and conduct of banks. In doing so, it explores the ‘ownership pressures’ described in chapters 3 and 5, and explores the first of the primary research questions, namely: how bank behaviour is affected by the way a bank is owned. The following chapter will then inquire into behavioural implications of the ‘structural pressures’ which were described in chapters 4 and 5 and that chapter will consider the second of the primary research questions, namely how far behaviour is affected by structural pressures regardless of how a bank is owned.

This chapter explores how ownership pressures make demands for profits in the two ways considered in chapter 3 and 5 namely by calling for high returns on equity and greater asset-‐growth by increasing the volume of underlying business transacted. It considers the demands placed on management for earnings and growth and how they were responded to, and it considers other incidents of misbehaviour and whether ownership pressures acted as drivers or restraints. As was explained the last chapter, particularly at 5.5, it seeks to explore these issues by considering sales-‐side analyst reports produced by large investment banks, and accessed through Thomson Reuters, as a sort of proxy for gaging investor demands. It draws upon this data as well as the performance data gathered from Bankscope and annual and quarterly reports, and the financial and banking media to consider how the different business models in the case of Lloyds and Barclays were developed and how ownership pressures drive behaviour. The chapter charts the different periods when the respective business models were developed within the two banks, following the career rise of their respective chief executives Bob Diamond and Brian Pitman.

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The chapter is broken up into three parts. The first part explores how both Pitman and Diamond sought to satisfy market demands and how their banks developed distinct business models as a way of keeping investors happy. The second part then explores the strains which developed when the business models proved unable to meet the market’s demands, which in the case of Lloyds arose before the credit crunch and banking crisis. For Barclays, these strains appeared later and this part therefore charts Barclays performance for some years after the crisis. The third part charts how banks performed and how analysts perceived them right up until the period when there was effectively a ‘regime change’ across British banks following the LIBOR-‐rigging scandal and the multiple incidents of misbehaviour and banking scandal which emerged in 2011 and the years which followed.

In the case of Lloyds, the chapter looks initially at the strategy developed under the leadership of Brian Pitman whilst he was CEO between 1984 and 1997 and later chairman of Lloyds between 1997 and 2001 and it continues to chart ownership pressures on Lloyds and resulting strategy following Pitman’s departure, through the acquisition of HBOS in 2008, and right up until the departure of Eric Daniels in 2011. In the case of Barclays, the analysis covers the business model developed during Bob Diamond’s rise to high office between 1997 until his resignation from Barclays in 2012.

6.2 Part 1: delivering shareholder value

6.2.1 Committing to the market Although Pitman and Diamond rose to prominence in Lloyds and Barclays

in different decades, they had one thing in common. Both publicly promised to deliver what the market called for, and were explicit and outspoken about their commitment to delivering ‘shareholder value’. In his 17 years as CEO of Lloyds, Pitman made repeated reference to that commitment, insisting that his priority was to enhance earnings per share, to deliver returns on equity significantly higher than Lloyds’ cost of capital and to double the share price every three years (Preston, 2010; Fallon, 2015, pp8, 25). In 2010, almost a decade after leaving high office in Lloyds, Pitman re-‐confirmed this article of faith: ‘Well, nobody is a greater believer in shareholder value than me’ (Preston, 2010; Future of Banking Commission, 2010).

Similarly, Bob Diamond also ran Barclays to achieve high returns for shareholders and he was publicly explicit about that aim. Those companies that do not dedicate themselves to maximising shareholder returns, he warned, got left behind and risked being taken over (Baker et al, 2011). Barclays’ annual reports regularly pledged to deliver high shareholder returns and even in 2010, after a year of very poor performance, Barclays promised its shareholders in its annual review that it would deliver 15% RoE (Barclays, 2010, p12). The importance of RoE was reaffirmed by Diamond in 2011:

‘return on equity is the financial measure that correlates most closely with shareholder value, so it’s extremely important to us and it’s extremely important to our shareholders’ (Barclays, 2011, p3).

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6.2.2 Exceeding expectations -‐ Lloyds In the 1990s, both Barclays and Lloyds pursued a regime of cost-‐cutting,

and retrenching their foreign operations – a strategy which worked particularly well for Lloyds, which was keen to build up its UK-‐based business. In the late 1980s and 1990s, in accordance with Pitman’s stated aims Lloyds trebled in market value approximately every three years, which won favour for Lloyds amongst analysts and investors (Fallon 2015, p14). Barclays did not prove to be as popular in the same period (Weyer 2000). Despite delivering routinely high returns on equity, often even in the order of 20% (see Chart 6.1 below), analysts commonly complained about Barclays being capable of doing more, and still having ‘cost-‐cutting potential’ (Collier, 1998, p1). Lloyds, which was regularly achieving returns on equity in excess of 30%, and rarely dropping below 20% (see Charts 6.1, and 6.2) and which was also making marginally higher returns on its assets than Barclays (see Chart 6.3) won greater favour with the analysts in this period than Barclays. By the mid to late-‐1990s, a noticeable consensus had emerged amongst analysts who warmed to Pitman’s self-‐styled image as a ruthless cost-‐cutting capitalist (Preston, 2001) and they regularly encouraged investors to ‘Buy!’ Lloyds stock (see, for example Collier et al, 1998), some reporting Lloyds’ stock as ‘Best in market’ (see Collier et al, 1999, p1).

Chart 6.1: Lloyds: returns on equity in % (1988-20013)

(Source: Bankscope) Key: Lloyds shown in blue

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Chart 6.2: Barclays and Lloyds: returns on equity in % (1992-2012)

(Source: Bankscope) Key: Barclays shown in blue; Lloyds shown in red.

Chart 6.3: Barclays and Lloyds: return on assets (RoA) in % (1992-2012)

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Key: Barclays shown in blue; Lloyds shown in red.

Pitman managed to deliver high returns on equity whilst retrenching operations and focusing on building up UK retail banking, whilst also eschewing IB and wholesale operations. In later years, Pitman was boastful about his strategic aversion to wholesale and IB activities, congratulating himself on the wisdom of his caution and criticising his competitors for being imprudent by engaging so heavily in speculative lines of business whose success depended on high levels of liquidity (Preston, 2010; Future of Banking Commission, 2010). Before the Future of Banking Commission, Pitman claimed that unlike his competitors, he had not been motivated by short term rewards but had tried to make money for shareholders ‘over the long term’ and out of ‘narrow banking’ (Preston, 2010; Future of Banking Commission, 2010), rather than out of wholesale and speculative activities. It is true that under Pitman’s leadership, between 1984 and 1997, Lloyds’ business focus narrowed and Pitman was openly sceptical of the exciting, new-‐fangled derivatives and securitization which was being embraced by Lloyds’ competitors, such as the Midland, Natwest, and Barclays (Preston, 2001). Pitman focused instead on building up domestic retail banking services – pushing for more market share locally and seeking to achieve economies of scale by making customer-‐focused efficiencies (Fallon 2015, pp9, 17).

The boasts Pitman made to the Future of Banking Commission about making long-‐term strategic decisions and wisely avoiding risky activities tell only part of the story inasmuch as they suggest, first, that Pitman did not succumb to the short term demands of the stock-‐market and, second, that his cautious conservatism came about through wise long-‐sighted decision-‐making. Pitman’s dislike of new and risky banking activities was not arrived at through far-‐sighted wisdom or indifference to stock market demands but rather as a result of past bitter experience. Pitman’s distrust of new risky activities came about as a direct result of having explored other unorthodox banking activities in the past, and having very spectacularly failed (Preston 2012). Lloyds had been very heavily involved in sovereign lending in the late 1970s – loans which Pitman had personally signed off (Preston 2012).

The South American banking markets massively underperformed and those loans were ultimately defaulted on. Pitman played a major part in the various IMF bail out deals in South America, particularly for the Mexican banks and was personally involved in cutting their losses and writing off loans he had signed off (Preston 2012, p16) causing huge losses for Lloyds and its shareholders, the effects of which were still being felt in the 1980s (see the negative returns on equity in the 1980s, Chart 6.1 above). Pitman later confessed that had the full extent of those losses been known to the public, Lloyds would almost certainly have gone bust, but as it happened it managed to avoid that fate as the accountancy standards of the time were far more lax, and the Bank of England was willing to give Lloyds a chance to recover (Preston 2012, p16).

Whilst it is true that Pitman, and his successors eschewed IB and avoided engaging in derivatives and speculation (Fallon 2015, pp175, 179), it is not true to suggest that he, and his successors, did not take huge and risky gambles with Lloyds in other ways. Although Lloyds managed to deliver extremely high returns on its equity and on its assets in the 1990s, Lloyds was soon lagging in

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size. Its competitors, including Barclays, had built up significantly bigger businesses and engaged in greater volumes of work (see total assets in Chart 6.4 below). By the early 1990s, Barclays was roughly three times Lloyds’ size in terms of assets and had set itself on a steep growth trajectory. In line with his earlier commitments to create shareholder value, Pitman recognised that he needed to deliver not only high returns on equity, but also asset growth (Fallon 2015, p17). But Pitman’s options for bulking up on assets were rather limited. Pitman’s strategic aversion to wholesale and IB really left Lloyds with few options for growth. Whilst Pitman’s competitors were bulking up on cheap borrowing and making returns in derivatives and securitisation, there was only so much scope for growing Lloyds’ market share in domestic retail banking.

Chart 6.4: Barclays and Lloyds: total assets in £m (1992-2013)

(Source: Bankscope) Key: Barclays shown in blue; Lloyds shown in red

6.2.3 The cost of keeping investors happy – Lloyds In order to keep up with competitors and retain market favour, Pitman

had to do more than merely driving efficiencies and focusing on domestic retail operations. He also needed to grow Lloyds’ assets. Having cut back overseas operations, and declined to grow IB, Pitman’s only option for doing that was to make Lloyds radically acquisitive. As it happened, Pitman was in a prime position to embark in M&A and conduct hostile takeovers (Preston, 2001). Having become CEO at Lloyds in 1984, just before the Big Bang, Pitman had witnessed first hand the growing market in M&A and leveraged buy outs

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(Preston, 2001). Being at the helm of a large bank gave him ready access to cheap finance. In the 1980s and 1990s, Pitman’s plans to grow domestic retail became necessarily more takeover-‐focused therefore. He set about garnering a reputation for himself as a master of M&A (Preston, 2001), aggressively picking fights with bigger competitors with a view to taking them over: in 1984, he tried, unsuccessfully, to acquire the RBS; in 1986, again unsuccessfully, he went for Standard Chartered; and in 1992, he tried and failed to acquire the Midland Bank.

According to Preston (2001) whilst these attempts were unsuccessful, they had a positive impact on Lloyds’ perception in the eyes of shareholders and investors on the stock market. By the early 1990s analysts routinely perceived Lloyds as having considerable takeover potential, encouraging people to ‘Buy!’ Lloyds stock. Having failed to make several sizeable acquisitions in the 1980s, his chance came in the 1990s when there was a wave of de-‐mutualisations in the UK building society sector. In the mid-‐1990s Lloyds completed a spree of significant acquisitions, substantially consolidating Lloyds’ position in the UK banking sector, and radically increasing its branch network. Lloyds acquired the Cheltenham & Gloucester in 1995 and then, almost doubling the size of its branch network, the TSB in the same year (although the merger was complicated and did not complete until 1999).

After the wave of de-‐mutualisations was over, Pitman looked further afield both to European banks, and other financial propositions. In 1999, by which stage Pitman had become Chairman, he acquired the insurer the Scottish Widows, making Lloyds the first mainstream retail bank in the UK to acquire an insurance company. Pitman’s strategy shifted focus slightly as he declared his desire to turn Lloyds into a one-‐stop shop for banking and insurance services, akin to the continental ‘bancassurance’ model. Setting the scene for later pressure selling to customers and mis-‐selling financial products, this acquisition put Lloyds into a position where it was able to offer its own pensions, mortgages, insurance policies, tax and investment advice, unit trust and financial planning all under one roof and across an extensive branch network up and down the country.

By pursuing his strategy of building a domestic bancassurance business and engaging heavily in M&A, over the course of the 1990s, Pitman almost trebled Lloyds’ assets (see Chart 6.4 above) for a time significantly narrowing the gap in size between itself and Barclays. By 1997, when Pitman stepped down as CEO, Lloyds had a market value of £42 billion, forty times its value when Pitman had taken over, and four times what it had been in 1992 (Fallon 2015, p26; see also Chart 6.4 above and table 6.1 below). The stock market value of Lloyds had shot from £1bn in the 1980s to over £40bn by the late 1990s and Lloyds became known as ‘a cash machine’ (Down, 2000, p1). As can be seen from Chart 6.1 above, in 1997, the year when Pitman became Chairman, Lloyds was delivering 38% RoE and by the end of the 1990s, it was still routinely beating 25%. By 1999, it reported having a return on equity which was three times its cost of equity (Collier et al, 1999). And by the end of that decade, for many analysts Lloyds was still ‘Best in market’ (Collier et al, 1998, p1; and Collier et al, 1999, p1).

With such high share prices, and market popularity, Pitman was able to take huge personal rewards, at least relative to others at the time. In 1995, the

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year Lloyds acquired TSB, Pitman took home £571,383 which was 28% more than his previous year (Preston 2012, p45). Whilst that might seem low to the bonus pool created in Barclays in the decade, which saw Roger Jenkins take more than £40m in 2005 and Bob Diamond take home more than £60m in 2009 (Treanor, 2010a), it was a lot higher than what other banking bosses were receiving in the UK at the time, and made him the highest paid commercial banker in the UK (Fallon 2015, pp15, 318).

Pitman’s combination of conservative retail banking combined with his talent for deal-‐making and desire to build up a bancassurance model proved to be a winning formula – at least as far as the market was concerned. He broadly met his aim to double his bank’s stock market value every three years (Fallon 2015, p14). His popularity was won not just by ‘safe banking’ or focus on building up domestic services, however, but mainly by risky deal-‐making and through some colossal acquisitions. Contrary to his later claims about pursuing ‘long term shareholder value’ and ‘narrow’ banking (Future of Banking Commission 2010), Pitman was not immune to the short term demands of the stock-‐market, but was compelled to take huge gambles to achieve growth. As proved to be the case a decade later with the Co-‐op’s troublesome Britannia acquisition, or with RBS’ acquisition of ABN Amro, M&A is inherently very risky business, and misplaced assumptions, miscalculations or misjudgement can prove to be ruinous – as may indeed have been the case had Lloyds later succeeded on its ambitions to acquire Fortis or Northern Rock.

In Lloyds’ case, its growth in assets also teetered upon a tiny amount of equity. As is evident from Table 6.1, the amount of Lloyds’ equity was negligible – at times only 2 or 3%.

Table 6.1: Lloyds: assets and equity in £m and equity/ assets in % (1988-2013)

(source: Bankscope)

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1988 51,834 3027 5.84

1989 57,542 2532 4.40

1990 55,202 2441 4.42

1991 51,306 2642 5.15

1992 62,937 2870 4.56

1993 71,636 3233 4.51

1994 73,200 3835 5.24

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1995 101,487 3430 3.38

1996 109,744 3781 3.45

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2000 140,762 11,422 8.11

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2005 311,621 11,620 3.73

2006 345,664 12,476 3.61

2007 353,543 13,439 3.80

2008 436,191 9,572 2.19

2009 572,980 13,713 2.39

2010 1,008,732 47,732 4.73

2011 988,366 51,273 5.19

2012 952,463 46,984 4.93

2013 862,004 44,086 5.11

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6.2.4 Meeting market demand -‐ Barclays Lloyds was not alone in developing a risky business model in the way it

pushed for growth. As can be seen from Chart 6.4 above and Table 6.2 below between 1992 and 2001, Barclays also grew rapidly, more than doubling its assets. As can be seen from Chart 6.5 below, Barclays did this chiefly by growing its IB operations and in particular those performed by Barclays Capital. Having joined Barclays in 1996 as Head of ‘Global Markets’ in Barclays’ investment banking business, BZW, Bob Diamond quickly moved up the ranks within a year becoming Chief Executive of Barclays Capital – the parts of BZW’s debt business which Barclays had not sold to Credit Suisse. He set about building Barclays, and more specifically Barclays Capital, into a key player in global investment banking. Having to compete with IB giants such as Morgan Stanley, JP Morgan and Goldman Sachs, Barclays had a long way to catch up however. At the end of the millennium, Diamond took advantage of cheap lending in increasingly liquid markets, and built up Barclays IB operations by recruiting heavily from the US and London, poaching ‘talent’ from other banks with the promise of high salaries and fixed bonuses, setting up an equity based ownership plan and bonus pool for ‘key employees’ at BGI and Barclays Capital in 2000 (Salz 2013, para.4.12), sowing the seeds for later scandal and public indignation for huge bank bonuses.

Chart 6.5: Barclays: assets by business in £bn (1993-2012)

(Salz, 2013, 4.12, collating data from Barclays accounts 1993-‐2012)

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By the turn of the millennium, Diamond had managed to build up a significantly large asset base around wholesale and IB: and Barclays was delivering consistently high returns on equity (see Chart 6.2 above, and also 6.8 below). The analysts were not quickly won around however. Despite delivering consistently high returns on equity for example nearing 20% towards the start of the millennium, Diamond did not commonly find favour amongst analysts, who tended to report Barclays’ hangover of its poor performance in the early 1990s, when it had to set aside £4bn for losses incurred in 1991 and 1992 (Salz 2013, para.4.7). In the early part of the millennium, despite impressive growth and returns (see Charts 6.2 above, and also Table 6.2 below), analysts commonly, but inaccurately, predicted relative decline or modest growth at best. Several advocated investors to sell, for example ING, who suggesting that Barclays recent returns and impressive performance ‘simply looks wrong’ (Helsby, 2002, p1).

Table 6.2: Barclays: assets and equity in £m and equity/assets in % (1992-2013)

(source: Bankscope using available Local GAAP, unqualified annual reports)

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Year (Y/E 31/12) Assets (M£) Equity (M£) Equity/ass

ets (%)

1992 157917 5878 3.72

1993 163159 5885 3.61

1994 159363 6490 4.07

1995 164184 7370 4.49

1996 180321 7587 4.21

-‐-‐1997 226427 7903 3.49

1998 212366 8113 3.82

1999 246748 8830 3.58

2000 30747 14782 4.81

2001 348436 14613 4.19

2002 395727 15306 3.87

2003 435296 16768 3.85

2004 513875 19172 3.73

2005-‐ 924170 24243 2.40

2006 996503 27106 2.62

2007 1227583 31821 2.72

2008 2053029 43574 2.59

2009 1379148 58699 2.12

2010 1490038 62641 4.26

2011 1563402 65170 4.20

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2012 1488761 59923 4.17

2013 1312840 63220 4.82

Barclays quickly outpaced these early pessimistic predictions. In 2003,

Diamond launched the ‘Alpha plan’ aiming to double its revenue every four years (Salz 2013, para.4.15). He recruited a very close-‐knit and hierarchical leadership team, including his later most-‐trusted lieutenants, Rich Ricci and Jerry del Missier. Together they encouraged a culture in the bank which was results-‐focused and which heavily rewarded success (Salz 2013, para.8.22). According to Brummer (2015, p277) between 2002 and 2009, Barclays paid out an average of £170 million per year in bonuses to a changing group of around 60 people. In 2003, the group’s pre-‐tax profits rose to a respectable 20% and Barclays delivered 22% ROE (see Chart 6.2 above). Having distributed more than £6 billion in dividends and having spent more than £3 billion in share buy backs between 1995 and 2003, Barclays could not help but attract market attention. At the time, in 2003, the share which was soon to rise stood at 350p.

By the end of 2003, growing favour for Barclays began to emerge amongst analysts, with those at Credit Suisse, and Bear Sterns persuading investors to ‘Buy!’ (Lever et al, 2003 ; Cummings et al, 2003) and others such as Morgan Stanley advocating shareholders to at least ‘Hold’ Barclays’ stock (Down et al, 2003a). Barclays subsequently ramped up its assets (see Chart 6.5 and Table 6.2 above) largely through the increased volumes of IB work being undertaken by Barclays Capital, which started to make huge profits (see Charts 6.5 above and 6.6 below).

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Chart 6.6: Barclays: profits before tax by business in £bn (1993-2012)

(Source: Salz, 2013, 4.12, collating data from Barclays accounts) The group’s share price steadily rose. In 2004, it breached 500p and

safely made it beyond 570p by the end of the year, leading Deutsche Bank to pass favourable comment encouraging investors to at least ‘hold’ (Lord et al, 2004b). From there on in, support for Barclays seemed to harden. Credit Suisse routinely encouraged investors to ‘buy’ considering, in the first half of 2004, that Barclays would ‘outperform’ the market (Lever et al, 2004a) and reporting towards the end of the year on how Barclays Capital ‘opens up new revenue pools’ (Lever et al, 2004b, p1).

With much of the group’s assets being tied up in the IB operations being performed by Barclays Capital, which were all ran by Bob Diamond (see Chart 6.5), it was not long before Barclays Capital and Bob Diamond attracted particular attention (Lever et al, 2005). In 2004, it was reported that Diamond narrowly missed out on the CEO role, in favour of Varley. Whilst Varley stayed on as CEO until 1 January 2011 when he was succeeded by Diamond, he gave Diamond huge responsibility for managing Barclays IB, appointing him as ‘President’ of the Investment Banking Group in 2005.

A series of acquisitions took place in 2004 and 2005, which caused Barclays market share and global and product reach to grow further. Investor confidence followed suite, as Barclays continued to ‘outperform’ largely through growth in IB operations, which were funded by borrowing at low interest rates in the increasingly liquid capital markets prevailing in the early 2000s. Whilst

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before 2005, the two biggest earning businesses in Barclays were Barclays UK retail and its corporate division, from 2005 onwards, the biggest single earner and biggest in terms of assets was Barclays Capital (Salz 2013, paras.4.26, 5.12; see Charts 6.5 and 6.6 above). Under Diamond’s supervision, Barclays IB operations grew rapidly and by 2006, nearly half of Barclays revenues were being geared towards capital markets, with Barclays Capital earning more than any other business (see Charts 6.5 and 6.6 above).

6.2.5 Exceeding expectations -‐ Barclays The analysts predictions in the early part of the 2000s about lacklustre

performance from Barclays were consistently out-‐performed (see for example Helsby et al, 2002). Analysts such as those at Credit Suisse began to note that Barclays was ‘out-‐performing the market’ (Lever et al, 2003, p1) and had ‘Good Momentum’ (Kambo et al, 2004, p1). By the mid-‐2000s, a growing consensus emerged amongst analysts who regularly sang Diamond’s praises, and routinely touted Barclays’ stock, encouraging investors to ‘Buy!’. By 2005, the share price breached 650p and analysts commonly touted Barclays stock, for example with Credit Suisse advocating investors to give Barclays ‘Wholesale support’ (Lever et al, 2005b).

According to Salz as Barclays grew and the source of its income originated from ever more complex investment banking activities, something of a cultural change was taking place internally in Barclays, and the risk-‐taking mentality which pervaded in investment banking began to spread (Salz, 2013, paras.2.11-‐2.13, 3.21). That same trend was observed more generally by the PCBS in relation to Britain’s biggest banks, including not only Barclays and Lloyds. Having become too big to manage (PCBS 2013b, para.84) UK banks generally permitted the ‘culture’ of banking to be corrupted, with banking standards and duties to customers giving way to risk-‐taking and reward-‐seeking (PCBS, 2013b, paras.116, 119) – a development across the sector which was being reinforced by perverse remuneration structures, and sales target (PCBS, 2013b, paras.203, 416, 519, 536, 597 and 784).

Those problems within the culture of banking, and the radical growth of IB, were not raised as concerns by the analysts, who on the whole, appeared unconcerned by the fact that Barclays was delivering low returns on its assets (see Chart 6.3 above). As can be seen from Chart 6.3 above, Barclays typically made less than 1% profits on its assets and in 2006, 2007, and 2008 respectively, its RoA was as little as 0.46%, 0.36% and 0.21%. In the same period, there is an absence of concern expressed amongst analysts about whether Barclays’ viability was dependent upon unusually high levels of market liquidity. As table 6.3 shows, in the years leading up to the GFC, the market valued Barclays in a significantly higher order than its net value.

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Table 3.3: Barclays book value (as total assets less total liabilities) and market capitalisation (taking average of final month each year) (2003-2008)

(source: Orbis-‐banker)

Year Book value (£m) Market value (£m) Market

value/Book value (in %)

2016

64,441

37,904

59%

2015 60,631 36,785 61% 2014 61,657 40,173 65% 2013 61,082 43,820 72% 2012 59,863 32,125 54% 2011 65,110 21,477 33% 2010 62,581 31,874 51% 2009 58,639 31,496 54% 2008 43,514 12,842 30% 2007 31,775 33,303 105% 2006 27,072 47,382 175% 2005 24,243 39,497 163% 2004 19,172 37,691 197% 2003 16,768 32,557 194%

Leading up to the crisis, it seems that there was no alarm expressed amongst analysts about whether liquidity and demand for Barclays IB products might dry up. As chart 6.7 shows below, Barclays increased its dividend payments during this same period. Whilst the dividends continued, analyst remained supportive and unconcerned by Barclays’ business model or by its valuation exceeding its book value. Shortly before Gordon Brown declared ‘there would be no return to boom and bust’ claiming that banks had managed to transform risk and remove it from the sector, in 2008, Morgan Stanley analysed the widespread growth in wholesale capital markets and concluded that growth was a result of structural, and not ‘cyclical’ factors (Haynes et al, 2008) which was a sign of the times, when irrational exuberance, and the transformation myth appeared to be widespread.

Instead, Diamond’s business model, albeit heavily dependent upon revenue from Barclays Capital which in turn relied upon high levels of liquidity and demand for IB products, was commended by analysts. Bear Sterns considered the IB ‘sector [was] leading growth’ and that Barclays would ‘outperform’ (Patel et al, 2007, p1). With its consistent year on year growth, analysts continued to favour the Barclays business model. In 2007, Barclays was Deutsche Bank’s ‘top pick of the year’ (Napier et al, 2007a, p1) and it encouraged investors to ‘buy’ (Napier et al, 2007b). By the summer of 2007, when the prospect of acquiring ABN Ambro was announced, market confidence in Barclays was still high, even when the deal fell through, and the share price fell to 678p, analysts such as those at JP Morgan continued to advise investors to ‘Hold’,

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suggesting Barclays has ‘solid organic momentum despite ongoing uncertainty around ABN’ (Antunes et al, 2007, p2).

Chart 6.7: Barclays : dividend pay-out per share (2000 – 2017)

(Source : Barclays) As can be seen from table 6.3 above, in the mid 2000’s, the market placed

a far higher value on Barclays than the net value of its assets, and sometimes twice as much. Leading up to the crisis, Barclays market value was worth significantly more than its book value.

6.3 Part 2: When the market demands too much

6.3.1 Lloyds’ strategic bind The analysts and stock market were not as warm to Lloyds throughout

the 2000s as they were to Barclays. Lloyds soon reached something of an impasse, finding it difficult to keep the analysts happy and to deliver the high levels of RoE and growth, which the market appeared to be calling for. Between the start of the millennium and 2006, Lloyds fell from being the biggest bank in terms of market capitalization to being the fifth biggest. In 2000 and 2001, Lloyds attempted to take over the Abbey National, but the merger was blocked by the Competition Commission. The positive sentiment previously expressed by

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analysts towards Pitman in the 1990s soon dried up after he was replaced by Peter Ellwood as CEO in 1997, notwithstanding that he became Chairman. By the turn of the millennium, analysts such as those at Morgan Stanley openly called for greater growth : ‘the landscape is changing… the main battleground will be for income growth… revenue growth will be the key to differentiation’ (Down et al, 2000, p1).

Despite still achieving high RoE (see chart 6.1 above), Lloyds found itself incapable of delivering huge growth, and consequently Ellwood came under heavy fire. In an interview in 2001, he commented about how shareholders were ‘worried’ and how having only recently inherited a legacy with very limited scope for M&A in the UK, he was already being given the message from investors that it was now his ‘last chance’ (Davidson, 2001). In 2001, perhaps realising that his strategy had ran its course, Pitman resigned as Chairman, having been CEO between 1983 and 1997, and Chairman between 1997 and 2001. Pitman had been skilful in fine-‐tuning Lloyds into an efficient banking machine, and growing its balance sheet through some risky and aggressive deal-‐making, but in what was already a rapidly consolidating banking market, Lloyds had little further scope for M&A in the 2000s, at least in the UK.

After the failed Abbey National bid, Ellwood opted not to bid for the Woolwich, preferring instead to bid for Scottish Widows. And, after Barclays acquired the Woolwich, growing its own branch network from 1718 to 2,120 branches, there were few potential acquisition targets left for Lloyds. Ellwood and his successors instead had to explore potential mergers abroad (Davidson, 2001), and they contemplated being adventurous like HSBC, Citibank and Barclays by looking to acquire banks in Africa, the Far East and South America (Fallon 2015, p130). They scouted, unsuccessfully, for a ‘merger of equals’ on the continent looking to big continental banks, such as Fortis and even ABN Amro, Credit Agricole, BBVA, BNP Paribus, Commerzbank and the German Postbank (Fallon, pp133, 411). If Lloyds was to keep up with its fast growing competitors, it either needed to make a huge acquisition, which was a rapidly diminishing option, or ditch its aversion to derivatives and grow its wholesale and IB activities.

Unable to get out of that strategic bind, and apparently buckling under shareholder pressure Ellwood took early retirement at the age of 60:

‘Peter Ellwood retires from Lloyds TSB with more detractors than supporters. The share price has halved since his acquisition of Scottish Widows in 1999; profits are down, bad debts are up. Oh, and the dividend is under threat’ (The Guardian, 2002). His successor, Daniels (CEO between 2003-‐2011), and the Chairman that

soon succeeded van den Bergh, namely Victor Blank (Chairmen between 2006-‐2009) were all caught in the bind: unable to make a success of Pitman’s strategy, but unwilling to abandon the model which had worked so well previously, and which distinguished Lloyds from more risky investment banks.

Throughout the early 2000s, the analysts continued to make demands for greater growth, routinely commenting for example that Lloyds could do more. Deutsche Bank, for example, bemoaned the lack of growth suggesting it had ‘unexploited corporate arms’ (Lord et al, 2004a). Compared to Barclays, which was starting to gain stock market favour by 2004, Lloyds was not maximising its

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‘leverage potential’ (Lord et al, 2004a). Morgan Stanley lamented that Lloyds was ‘Still underweight?’ and suggested ‘Recovery won’t be easy!’ (Down et al, 2003a). Their unrealistic demands for more growth were hard to satisfy. Despite delivering consistently high RoE, even of the order of 30% in 2003, the analysts called for more growth. According to the Independent (Griffiths et al, 2002) the City was ‘underwhelmed’ by Daniels who was ‘under pressure to put his foot on the accelerator for growth’.

Resisting calls for greater securitization, in October 2003, Daniels unveiled Lloyds’ plan to re-‐invigorate the core UK franchise. He sold off Brazilian and New Zealand and South American assets. Whilst the share price subsequently increased by 5%, it was outperformed by others in the sector, chiefly Barclays and those who had invested heavily in wholesale derivative and securitisation operations. Daniels sought to sweeten shareholders by increasing their dividends and Lloyds began to pay down unusually high dividends to enhance shareholder loyalty. As can be seen from Chart 6.8, Lloyds consistently paid a high dividend in the years leading up to the crisis.

Chart 6.8: Lloyds: dividend pay-out per share (2000 – 2017)

(Source : Lloyds)

Despite consistently high dividends, analysts remained sceptical. In fact with such high dividends factored into shareholder returns, Lloyds was actually performing above par by comparison with its competitors. In 2004, Société Générale reported that Lloyds had delivered 34% RoE, when accounting for dividends, but nevertheless it still advocated investors to ‘sell’, suggesting that Lloyds was in a dire position : ‘Sustained growth will need real Daniels magic’ (Erskine et al, 2004, p1). As can be seen from Table 6.4, Lloyds’ market value exceeded its book value by a significant order. When comparing table 6.3 (above) with table 6.4 (below), it is clear that for a period leading up to the crisis Lloyds’

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market capitalisation exceeded its book value by a significantly higher margin than Barclays.

Table 6.4: Lloyds book value (as total assets less total liabilities) and market capitalisation (taking average of final month each year) (2003-2009)

(source: Orbis-‐banker)

Year Book value

(nearest £m) Market value (nearest £m)

Market value/Book value (in %)

2016

47,034

44,616

95%

2015 47,353 52,153 110% 2014 49,990 54,116 108% 2013 44,086 56,295 128% 2012 46,984 33,705 72% 2011 51,273 17,804 35% 2010 47,732 44,725 94% 2009 13,713 32,327 236% 2008 9,572 7,526 78% 2007 13,439 26,656 198% 2006 12,476 31,980 256% 2005 11,620 27,336 235% 2004 12,783 26,468 207% 2003 12,669 25,056 198%

In 2005 and 2006, Lloyds’ market capitalisation was comfortably more

than double its net assets. Yet around the same time, the analysts became more critical of Lloyds’ strategy. Deutsche Bank, for example, became openly hostile towards Lloyds’ aversion to securitisation:

‘Turnaround potential exists…significant opportunity exists for Lloyds TSB to leverage a strong market share in lending and basic banking products in the W& IB [wholesale and IB] division into higher fee and less capital intensive products‘ (Napier, 2005, p1). Whilst others had profited hugely from funding and selling mortgages

adopting an ‘originate to distribute’ model to capitalise upon property price increases particularly at the start of the millennium, Lloyds resisted market demands and continued to shun subprime lending (Fallon, p150). Unlike Barclays (see Chart 6.6 above), staple retail banking represented more than half of the bank’s earnings. Despite market pressure to engage in securitisation and ramp up IB, Daniels continued in Pitman’s footsteps. He was sceptical about the selling and funding platforms needed to gear up the balance sheet through IB, and unwilling to risk Lloyds’ reputation with its clients (Fallon pp151-‐179). Such

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prudence doubtless came at a personal cost. Daniels could probably have done better personally had Lloyds engaged in IB. Whilst he was paid between £1.8m to £2.8m in 2007, Bob Diamond made £20m in bonuses alone in that year, and Barclays Capital distributed £500m in bonuses to a pool of senior management (Fallon, p152).

Withstanding powerful contrary incentives and strong market pressure, Daniels ordered his executives to avoid securitization altogether (Fallon p154). In 2006, Lehman brothers’ Jeremy Isaacs made a direct approach attempting to persuade Daniels to get into subprime to pump more volume out of its already efficient machine (Fallon 2015, p155). Internally, Lloyds’ own mortgage division also sought to persuade Daniels to adopt the Northern Rock model (Fallon 2015, p156), and in 2007, Lloyds faced the prospect of shareholder revolt and potentially buy out thereafter. Robin Saunders approached the Chair of the Victor Board, seeking a 10% share issue in favour of a consortium of backers, mainly middle eastern, who she had interested in the proposition on the basis that Lloyds would engage wholesale in subprime adopting an ‘originate to distribute’ model akin to the Northern Rock (Fallon 2015 pp158, 160). Daniels flatly declined the proposal (Fallon 2015, pp161, 162).

Whether, in a different conjuncture, Lloyds could have continued to resist the market’s demands for securitization is uncertain, but has to be doubted. Had the banking crisis and global financial crisis not subsequently unfolded, Lloyds could well have been a takeover target itself for a less cautious buyer looking for growth. What is clear is that Lloyds was under immense pressure to ramp up the volume of its sales and without engaging in IB that provided pressures for Lloyds to generate revenue from its customers, including through the mis-‐selling of PPI. Daniels continued Pitman’s bancassurance model, and reigned as CEO during the period when most of Lloyds’ PPI mis-‐selling took place (Osborne 2013). He not only later sought to justify PPI, denying any mis-‐selling, but was also a strong proponent for high interest rates and charges for overdraft facilities, arguing that high risks entitled banks to higher charges, an argument which was accepted in litigation (Fallon 2015, p129). Whilst Daniels managed to resist calls to engage in sub-‐prime he was forced to take Lloyds into more pressurised sales, seeking to maximize profits from selling product to its own customers, often products which they had little need for, such as PPI. All the while, Lloyds looked around for further acquisitions, and whilst the Competition Commission had threatened to block any further takeovers in an already largely consolidated market, things changed in the autumn of 2008.

6.3.2 Delivering value in a crisis – Lloyds and HBOS

The market’s demands for earnings and growth had led Barclays to contemplate taking over ABN Amro in 2007, which would have been a disastrous move (Robbins 2009), and Lloyds to look far and wide for merger options. Having considered and approached various continental and foreign banks, including BBVA, ABN Amro, BNP Paribus, Commerzbank, Germany’s Postbank and America’s Washington Mutual (Fallon 2015 pp144, 411, 412), Lloyds’ appetite for M&A was widely known. In 2006, Blank discussed taking over HBOS and even met with Andy Hornby to discuss the possibility (Fallon 2015, p138).

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In 2007, after the Northern Rock defaulted on repaying its short term lending, due to a decline in sub-‐prime origination and securitisation, Lloyds offered to acquire the Northern Rock, subject to the Bank of England providing short term lending to help Lloyds plug Northern Rock’s funding gap (Fallon 2015, pp184-‐185). The Bank of England refused and a run on the Northern Rock followed on 13 September 2007.

To the excitement of commentators and analysts, rumours spread that Lloyds might subsequently take over the failing Alliance & Leicester or Bradford & Bingley (Fallon 2015, p211). Commentators were enthusiastic about opportunities for consolidation for example with Murden advocating ‘Now is the time for banks to go bargain hunting’ (2008). Believing there was opportunity to be found in the chaos, however, Daniels and Blank held out for a bigger prize, which eventually came in the form of the failing HBOS, which threatened to collapse and cause widespread economic upheaval. A deal which would have been impossible when Hornby and Blank met in 2006, moved to becoming a possibility and then as banking crisis unfolded, became increasingly inevitable resulting in the government suddenly confirming that it would waive competition rules to allow the merger in September 2008.

By the summer of 2008, the FSA policy vis-‐à-‐vis HBOS was to encourage and facilitate a merger with a stronger bank (Fallon 2015 p233). HBOS, which had announced in February 2008 that it held £6.3 billion, nearly a tenth of its assets in high-‐risk assets, posed a liability the government could ill-‐afford to bear. Lloyds by contrast had only limited exposure to sub-‐prime assets: it wrote off a mere £200 million on 11 December 2007 (Monoghan 2013). Both banks endured losses in the banking crisis, but Lloyds was in a far stronger position. Even though on 30 July 2008, Lloyds’ profits were down 70% and it had realized £585m of losses attributable to the credit crisis (Monoghan 2013), HBOS was in a far worse predicament. In a single day on 17 September 2008, HBOS share price halved in the first hour of trading (Monoghan 2013).

Over September and October 2008, Lloyds performed hurried due diligence but it was impossible to value HBOS in what was a collapsing conjuncture. The £1.7 billion which Lloyds had forecast for HBOS impairments in September was revised up to £2.4 billion in October and revised again to £6bn in the following month as Lloyds revised up its estimates about whether there would be a 1 in 15 year recession to a 1 in 25 year event, and not knowing that it was dealing with the worst recession since the great depression, closer to a 1 in 100 year event (Fallon 2015, pp294, 344, 406).

The Government added incentive for Lloyds to buy HBOS, informing Lloyds in a series of emergency meetings that it would need to be bailed out even if it did not take the deal and then rapidly changing the terms on which bail out would be provided. On 2 October 2008 (the Monday), Lloyds was told it needed to take £1.5 bn of government money if it did not merge with HBOS, which was revised up to £3bn by 6 October 2008 (the Friday), £4bn by 7 October (the Saturday) and on 8 October 2008 (the Sunday) Lloyds was told it would need £7bn (Fallon 2015, p327). The Treasury and the Bank of England told Lloyds that it needed to take £7bn of government money if it was a standalone bank, which would result in Lloyds being 42.5% government-‐owned, or only £5.5bn if it merged with HBOS, which would result in 43.5% government-‐ownership.

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The Government’s intervention was perceived at least by Daniels as arm-‐twisting and strong-‐arming him into the HBOS acquisition (Fallon 2015, pp321-‐328; Dey 2009). If Lloyds was having to be bailed out, as well as RBS, Daniels wanted assurances that others, particularly Barclays, were also being required to take government capital, and he felt misled by the Bank of England who told Daniels that Barclays was also in the Treasury in other rooms having other talks, when Barclays had in fact avoided taking the ‘queen’s shilling’ (Fallon 2015, p315-‐335).

Although Blank subsequently boasted about the merger, it was arrived at through extraordinary risk and at extraordinary cost. Lloyds, which had prided itself on being a solid proposition and had been disparaging of the riskier funding platforms operated by its more reckless peers, had to be bailed out by the state who dictated the terms of such intervention. It was subsequently precluded from issuing dividends without Treasury approval and, in due course, required to buy back £1 billion worth of preference shares and to sell off more than 600 branches. Far from being seen as the saviour which prevented the UK economy being plunged into recession, Lloyds was merged with HBOS, a bank which itself had recklessly over-‐extended itself by pursuing a policy of growth at all costs (Brummer, 2015).

The terms of the deal were also questionable. As the subsequent House of Lords inquiry discovered, the impairments on HBOS’ balance sheet, proved to be greater than contemplated in October 2008 (Fallon 2015, p409). For example, its exposure to the downturn in the Irish and Australian construction industries proved to be more extensive than anticipated (Fallon 2015, pp346; 344). Lloyds had made provision for impairments of the order of £23 billion in 2009, most of which was for HBOS liabilities, but the full extent of those liabilities was thought to exceed 40 billion (Fallon 2015, p409). Lloyds consequently made huge losses in 2009, and was not able to return to profitability until 2010. As is demonstrated in Chart 6.9 below, its share price crashed in 2008, with recovery slow and limited since then.

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Chart 6.9: Lloyds : share price (2008-2015)

(source: BBC) The HBOS acquisition appeared to be the logical consequence of Pitman’s

strategic choices. Lloyds was essentially left with no choice but to take a deal with HBOS which was something of a ‘shotgun wedding’, ministered by the state, to marry a good bank with what would have otherwise been a huge liability for the state. The subsequent reaction to the deal, provided further proof of the market’s demands for growth. Despite the unknown liabilities in HBOS and losses which would eventually follow, the market favoured the deal. The crashing share price soon stabilised (see Chart 6.9 above) and would have likely fallen much farther had the merger not gone ahead. Indeed, the implications of the merger on its share price appeared to be tangible. In a single day, doubts about the deal’s feasibility caused the share price to plummet by 15%, from p242.25 to p237.5 (Fletcher 2008). The balance of opinion amongst analysts favoured the merger. Société Générale advocated investors to ‘hold’ (Lee et al, 2008, p1) and UBS revised ‘sell’ to ‘neutral’ (Curran et al 2008, p1). Whilst some questioned Lloyds’ capacity to finance the acquisition and the sense of making the deal in the middle of the banking crisis (see for example, White 2008), analysts tended to be keen on the merger, enthusiastic about asset growth, increased business and economies of scale (see for example Lee et al, 2008 and Curran et al, 2008).

6.3.3 Avoiding bail-‐out -‐ Barclays

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After the run on the Northern Rock, Barclays also faced huge liquidity problems. Unable to settle its day-‐trading debts, it was forced to borrow £1.6 billion from the Bank of England sterling standby facility. The path which Diamond had led Barclays down meant that it was heavily reliant on liquidity to fund huge volumes of wholesale and IB business. When the liquidity dried up in the credit crunch, Barclays developed a gaping capital shortfall. John Varley, Barclays’ Chairman, considered the prospect of nationalization to be completely unpalatable and Roger Jenkins, one of the biggest beneficiaries of the bonus pool set up by Diamond (who was thought to have earned between £40m and £75m in 2005, was tasked with raising finance from the Middle East to avoid bail out (Fallon 2015, p318). In a funding episode which was later called into question and alleged to have involved bribery and back-‐handers (Brummer, 2015, pp72-‐73), Barclays managed to raise £7.3bn to meet what was required by the FSA. In June 2008, Barclays called upon Qatari backers to invest £2.3bn to support a £4.5bn share issue and in October 2008, in response to the UK government announcing that Barclays needed to raise more capital, it unveiled terms for a fresh £7bn capital injection from Qatari and Abu Dhabi investors to boost its balance sheet. To the chagrin of some of its institutional shareholders, who argued that they had pre-‐emption rights, existing shareholders were left out and Barclays raised a total of £12 billion from Middle East investors, paying some £400 million in ‘commissions’ or ‘kick-‐backs’ to do so, and in one kick back alone, the former model-‐cum-‐financier Amanda Staveley, is said to have received, through her company, a £40 million ‘introduction fee’ (Brummer, 2015, pp72-‐73). Being forced to raise capital at such short notice put Barclays at a huge disadvantage. It issued equity at a 40% discount on market value, as opposed to the 8.5% discount which had been offered to Lloyds by the Treasury (Fallon, 2015, p320), and it resulted in Barclays becoming 16% owned by new middle eastern investors.

Although that funding spree later subjected Barclays to serious investigation – not only by the FCA and FSO but also by the Securities and Exchange Commission for breaching the US Foreign Corrupt Practices Act 1977– the market appreciated that Barclays had avoided the stigma of being bailed out and had plugged its own capital hole without government meddling. Whilst the share price of both Barclays and Lloyds fell radically in the banking crisis, amongst the analysts, Barclays’ popularity remained largely intact. The credit crunch and run on the Northern Rock did not seem to tarnish Barclays’ reputation. Deutsche Bank continued to encourage investors to ‘buy’ suggesting that ‘BarCap and BGI fears are overdone’ (Napier et al, 2007c).

Despite the economic down turn, like Lloyds, Barclays sought to create an opportunity out of the crisis by building up Barclays’ assets. In 2008, Barclays had continued its foreign M&A spree, not least buying Russian (US$745 million) and Pakistan banking assets (US$100 million) (Barclays, 2008). Most significantly, having bid for the Lehman Brothers brokerage in a deal which was eventually quashed by the regulators, thus forcing Lehman into bankruptcy, Barclays managed to pick up Lehman stock at fire-‐sale prices – $1.75 billion (Salz 2013, para.4.24). Just two days after the Lehman bankruptcy, it was reported that Diamond had picked up ‘the crown jewels’ of the brokerage, leaving behind most of the toxic assets, and getting most of IB business, three of its buildings including the iconic New York building and some 10,000 staff (Fallon 2015,

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p268). Having tried unsuccessfully to takeover Lehman Brothers before it was declared bankrupt, which probably would have been ruinous for Barclays which had not anticipated the £100 billion in liabilities which later materialized on Lehman Brother’s balance sheet (Fallon 2015, p268), Diamond turned what he himself perceived to be a failure into victory. He got the best bits of Lehman brothers which had been worth £40 billion on the stock-‐market a year earlier, for less than two billion (Fallon 2015, p268).

Chart 6.10: Barclays: equity and liabilities (1993-2012)

(source: Barclays annual reports)

6.3.4 Barclays’ halo The analysts roundly applauded the acquisition and continued to

advocate the purchase or retention of Barclays’ stock. In 2008, whilst predicting extremely low RoE, analysts still considered Barclays posed an attractive long term investment. Deutsche Bank enthused investors to ‘Buy!’ throughout 2008 (Napier et al, 2008a, Napier et al, 2008b, Napier 2008c), as did analysts at Morgan Stanley who considered the stock to be ‘overweight’ (Hayne, 2008). Despite the global financial crisis, there was very little concern expressed amongst analysts about the business model Barclays had developed. There was an absence of any suggestion that Barclays had contributed to its own liquidity problems by ramping up its IB operations, and on the contrary, analysts continued to encourage such strategy. For example, as Barclays Lehman’s stock doubling down on its IB operations, Deutsche bank considered Barclays had availed itself of a good ‘restructuring opportunity’ (Napier et al 2008a).

In the years which followed, although analysts became increasingly critical of the extent of Barclays' leveraging. Nevertheless, analysts roundly applauded the appointment of Bob Diamond as CEO in 2010 (Treanor, 2010b), and whilst the consensus to buy Barclays stock had diminished, the market

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continued to express favourable sentiment towards Barclays throughout 2011 and 2012, notwithstanding the more contrary view emerging in public perception.

6.4 Part 3: Widespread mis-‐behaviour, and the need for regime change

6.4.1 Diamond’s departure -‐ amidst market-‐rigging Diamond had proven to be extremely skilful playing to the market’s

demands, but he did not prove to be as deft at managing his public perception. A fracture appeared between his reputation amongst investors and his reputation with the wider public. In 2009, when Barclays sold BGO to Black Rock Inc, Diamond extracted a £23 million bonus, taking home nearly £70 million in compensation for the year. Whilst the market, the analysts and shareholders were content with Diamond, such that he was the only and obvious choice for CEO when appointed in 2011 (Salz 2013, para.4.16), his humungous ‘compensation’ packages did not endear him to the public, whose indignity was given expression by Lord Mandelson’s suggestion that Bob Diamond represented the ‘unacceptable face of banking’ (Collins 2011).

Diamond’s suggestion shortly after being appointed as CEO in 2011 that ‘the time for banker-‐bashing [was] over’ misjudged the public mood and attitude towards banks (Treanor 2013a). His attempt later in that year to justify himself by writing an article in the Guardian about why he felt ‘Banks would be good global citizens’ (Schäfer 2013) was not enough to save his public perception. As he later admitted ‘I think that the anger against banks and bankers particularly in the UK was deeper than I realised’ (Schäfer 2013). On 30 June 2012, the FSA announced that Barclays had admitted to rigging LIBOR rates, and was to be fined £290 million (FSA, 2012). It was revealed that on numerous occasions, and in ways which were widespread, systematic and condoned by senior management, traders at Barclays Capital had rigged LIBOR rates to maximize their own returns, generally with a view to enhancing their own bonuses (FSA, 2012).

LIBOR is a benchmark rate for interbank lending set by bank submissions. In December 2008, the British Banking Association’s Angela Knight, had defended bank involvement in setting the rate, claiming that they could be trusted (Bloomberg, 2013). On the contrary, between 2007 and 2009, Barclays had understated the bank’s borrowing costs to the city committees to pretend that its creditors had more confidence in the bank than was actually the case and on numerous occasions had adjusted their submissions to enhance their bonuses (FSA, 2012). In short, Barclays had been dishonest with their submissions in order to distort and manipulate markets and rates for their own gain. Having been trusted with setting the LIBOR rate, Barclays was found to have abused its privilege.

The consequence of this malpractice went beyond a mere fine for Barclays, and the others involved (which is what Diamond might have expected when Barclays owned up to its involvement). In an unprecedented move for recent times, on 2 July 2012 the Governor of the Bank of England, summoned the Chairman of Barclays, Mr Agius to his office and essentially asked the Chairman

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to resign and to go away and think about whether confidence could be restored if Bob Diamond remained CEO(Brummer 2015, p147; Treasury Select Committee, 2012). On 3 July 2012, Bob Diamond, albeit incredulous at the Bank of England’s request, handed in his resignation and the Chairman, Marcus Agius, and Chief Operating Officer, Jerry del Missier followed suit (Treanor, 2013a).

In response to public outcry at LIBOR-‐rigging, Barclays subsequently arranged for an independent review into its banking practices by Anthony Salz. The Parliamentary Commission on Banking Standards was also empowered to investigate what was perceived to be a failure in banking standards and culture. The misbehaviour in Barclays and Lloyds was not limited to making dishonest submissions and rigging-‐LIBOR. The findings of the PCBS, which are explored in more detail in chapter 2, at 2.2.7, suggested that the culture at the heart of banking in Britain’s major banks, and not only Lloyds and Barclays had deteriorated, with professional standards giving way to risk-‐taking and reward-‐seeking behaviour (PCBS, 2013b, paras.597).

Bankers had compromised standards of expected behaviour, to exploit their often vulnerable customers (2013b, paras.416, 519, 536) and management had not only turned a blind eye to incidents misbehaviour (2013b, para.784). There were widespread and perverse incentives encouraging misbehaviour in banks (2013b, para.203) and governance structures which were inapt to ensure responsible behaviour, giving a veneer of orderliness to cover up the lack of control and understanding (2013b, para.684).

6.4.2 Daniels’ disappearing act – before the PPI scandal After losses of £11 billion were realized in 2009, investors lost confidence

in Blank and he stepped down on 17 May 2009 (Monoghan 2013). Seeking to ride out the storm, and following a further issue of shares to the government in 2009, which realized £5.7 billion in investment, Daniels stayed on until Lloyds returned to profitability in 2010 (Monoghan 2013). On 20 September 2010, he announced he would stand down. Whilst Daniels had managed to guide Lloyds through the aftermath of the HBOS acquisition, he could not avoid the oncoming scandal of PPI mis-‐selling. Shortly afterwards, and having sold 40% of all PPI policies, Lloyds was found to be the biggest offender in what soon became the biggest mis-‐selling saga in banking history (Monaghan 2013).

In 2011, the banks lost their judicial review of the FSA’s decision to uphold mis-‐selling complaints (Weardon, 2011). The British Banking Association’s Angela Knight, had played a prominent role in denying any wrongdoing in mis-‐selling PPI, and the BBA had intended to continue the fight and appeal the decision (Garside, 2012). Ironically, both Barclays and Lloyds broke ranks with the BBA and accepted the validity of the ruling, exposing Angela Knight, who resigned the following year, to public criticism (Garside, 2012). Daniels avoided the costly consequences. PPI mis-‐selling claims were estimated to be worth in the order of £40 billion, easily dwarfing any other mis-‐selling scandal. All of the banks (the Co-‐op, and Nationwide included) appeared to have played their part in selling PPI, but Lloyds took particular criticism. Even in dealing with its PPI claims, for a time, Lloyds was found to have acted unreasonably by denying any liability on any case, regardless of merit (Monaghan 2013).

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And the mis-‐selling culture did not stop at PPI. Interest rate swaps, premium bank accounts and various other products were also allegedly mis-‐sold and both Lloyds and Barclays settled investigations and proceedings in connection with the sale of interest rates swaps (Monaghan 2013). Lloyds was also implicated in the on-‐going FCA GRG investigation into GRG and it may well be concluded that Lloyds along with RBS and GRG purposefully colluded to destroy otherwise viable small businesses in order to pick up their assets as was suggested by Tomlinson (2013). It also inherited a dubious legacy from HBOS, which had operated various schemes of fraud against their customers, leading to later class action (Treanor, 2017).

Also whilst Barclays was first in the line of fire for rigging LIBOR, it was not alone. Lloyds also rigged LIBOR and was fined £226 million for its part (Treanor 2014). Amongst other things, Lloyds was also found to have purposefully manipulated rates in order to reduce the fees payable for its emergency lifeline in the financial crisis and was obliged to repay the Bank of England £6 million (Treanor 2014).

6.5 Conclusions What emerges from looking closely at Lloyds and Barclays over a

prolonged period is a story of two formerly conservative and cautious banks being led into riskier and unsafe activities in an effort to keep their share price high and their stock desirable to investors. Having followed the rise of both Pitman and Diamond through the 1990s until long after the banking crisis unfolded when both banks were implicated in multiple scandals and allegations of misbehaviour, it is evident that investor demands have had an influencing role upon the development of their business models, and the findings of the many inquiries would tend to suggest that these pressures have also encouraged misbehaviour and standards to be compromised.

Demands for earnings and growth saw both banks depart from traditional lines of retail business, radically ramp up the scale of their activities and engage in riskier behaviours. The pressures exerted on Lloyds led it to pursue risky M&A and in the case of Barclays they led it to develop a business which relied on transacting huge volumes of wholesale and IB business, which in turn were dependent upon potentially unsustainable demand and liquidity.

As those banks grew to gargantuan sizes, and focused on keeping investors happy by delivering earnings and growth, it seems that such ownership pressures also encouraged the cultivation of reward-‐orientated, risk-‐taking cultures tolerant of misbehaviour and willing to compromise standards (2013b, para.203, 597, 784, and 836-‐838). In the light of findings made by the PCBS, it is widely considered that in addition to developing risky business models, the culture in both Barclays and Lloyds degenerated, becoming tolerant or encouraging of misbehaviour, with a results-‐driven, profit-‐oriented mentality typical of investment banking spreading and prevailing in those banks (FCA, 2012; Brummer, 2015, ch.5; Salz, 2013; and Fallon, 2015; PCBS, paras116-‐119). As those banks were submitting dishonest LIBOR submissions and mis-‐selling products to their often vulnerable customers (PCBS, 2013b, paras519), investors were calling upon them to further enhance their earnings and growth; rather

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than discouraging misbehaviour their demands encouraged irresponsibility, and they were wholly unsuitable to effectively govern standards of behaviour (PCBS, 2013b, pp176, 660-‐668).

Without addressing how the incentives for risk-‐taking are driven by ownership pressures in the first place, it seems doubtful whether the banking reforms implemented in the UK and aimed at fixing ‘culture’ can ever really succeed. Whether or not removing ownership pressures will avoid unsafe business, and misbehaviour, is something which the next chapter, which is concerned with structural pressures and stakeholder models, can consider further.

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Chapter 7. ‘Structural pressures’ and the Co-‐op and the

Nationwide

7.1 Introduction

The two cases explored in chapter 6 suggested that much of the dysfunctionality in banking is driven by banks being run for shareholder value. Ownership pressures encouraged the adoption of risky business models and the development of internal cultures which tolerated or encouraged risk-‐taking and misbehaviour. This chapter considers how other pressures, unrelated to ownership, also influence bank behaviour. It pays particular attention to the structural pressures discussed in chapters 4 and 5. In particular, it has regard to the ‘scale requirement’ whereby banks need to achieve economies of scale to meet high operating costs, and to grow large branch network in order to achieve market access. It also bears in mind how banks are encouraged to be mimetic and to engage in similar behaviours, by the heavy operating costs involved in branch banking and maintaining free-‐whilst-‐in-‐credit banking services.

These structural pressures are explored by looking at two non-‐PLC banks, the Co-‐op bank and the Nationwide. Those cases are considered with a view to understanding how structural pressures affected their behaviour, how far they contributed towards the failure of the Co-‐op and how they encouraged the Nationwide to avoid the types of misbehaviour which others were implicated in. By looking at two stakeholder banks where the ownership pressures considered in the last chapter were absent, it tries to gain a closer understanding of how far such structural pressures drove bad strategy and mis-‐behaviour.

As discussed in chapter 5, this chapter draws mainly on financial media and performance data for the two cases studied with a view to exploring what led to the failure of the Co-‐op, and conversely in the case of the Nationwide how failure was avoided. It studies those cases over slightly different time spans. The focal point for the Co-‐op was its failure in 2012 and 2013, whereas the resilience and stability of the Nationwide could be observed over a much longer timeframe. The Co-‐op is thus considered between 2005 and 2015 in other words from pre-‐crisis times through the banking crisis right up until just after the Co-‐op’s failure when the various inquiries and reports into that failure were published. The Nationwide is considered over a slightly longer period of time namely between the end of the 1990s and 2014 in order to get a longer-‐term picture about its stability. The performance data for the Nationwide was thus considered from the late 1990s until 2014. Since the behavioural issues in the Co-‐op and Nationwide were very different, unlike Barclays and Lloyds which could be considered alongside one another, the two stakeholder banks are analysed separately.

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The chapter is thus broken down into two parts. The first considers the case of the Co-‐op, a bank which was until 2013 owned by the Co-‐op Group a co-‐operative society owned by its members. This first part is set out into three sections. The first describes how the Co-‐op failed and moves on in the second section to discuss how structural pressures were influential, especially the Co-‐op’s own ‘scale requirements’. The third section then considers governance failures, and the part played not only by incompetence amongst the Co-‐op Group and the Co-‐op bank’s managers, but also by hubris more broadly amongst the regulators, financial media and even politicians who all seemed to encourage the Co-‐op’s radical push for growth.

The second part then considers the Nationwide and how it avoided failure, scandal and the sorts of allegations of misbehaviour commonly made against its peers. It explores how it developed a more conservative business model, considers how it was also involved in mis-‐selling PPI, and considers also how its regulation has encouraged its more orthodox and conservative business model.

7.2 Part 1: structural pressures, and the case of the Co-‐op

7.2.1 The Co-‐op’s failure

In a prolonged advertising campaign spanning years after the banking crisis, the Co-‐op bank marketed itself as the go-‐to ethical bank claiming to be ‘good with money’, suggesting it was not only ethically good but also competently good at handling other peoples’ money. That claim was soon rubbished by subsequent events. On 21 March 2013, it was reported that the Co-‐op had realised losses in the order of £673 million arising out of its Britannia merger. On the same day, its claim to be ethically good with money was undermined by its announcement that it needed to budget a further £150 million to compensate customers for past PPI mis-‐selling (Neate, 2013).

The extent of bad debts stemming from the Britannia loan book eventually rose to £14.5 billion, creating a £1.9 billion capital hole which the Co-‐op Group could not afford to fill, even after selling its insurance and asset management arms (Treanor, 2014a). Its Chief Executive, Barry Tootell, quickly resigned, and on 24 April 2013, the Group’s chairman Peter Marks, publicly admitted that the Co-‐op Bank was in no position to bid for Project Verde, the 632 branches being divested from Lloyds (Neate 2013). Moody’s down-‐graded the Co-‐op’s credit-‐rating to junk status, and the Coop had to suspend its corporate lending and sell off 8% of Britannia’s loans (Neate 2013).

In a time of crisis, when one might look to a company Chairman to steady the ship, the Co-‐op’s Chairman, Paul Flowers, was caught buying illegal drugs (Craven, 2013). The Co-‐op Group, which had itself been on a dash for growth, demonstrated by its expensive acquisition of the Somerfield supermarket chain, was not in a position to help, and instead, two American hedge funds, Aurelius Capital Management and Silver Point Capital, bought up the majority of the Co-‐op’s bonds, later agreeing to convert such large amounts of debt into equity, for a

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70% stake in the bank. The result was that the Co-‐op Group become a minority shareholder initially with 30% and subsequently 20% shares (Scuffham 2014).

In short order, the Co-‐op lost its long-‐standing status as a member-‐owned bank, made a mockery of its ‘good with money’ claim, and fell into the ownership and control of the US hedge funds that bailed it out. Although the Co-‐op bank tried subsequently to preserve its brand as an ethical Co-‐operative, having incorporated its ‘ethical charter’ into the company constitution, there was an exodus of customers with almost 40,000 customers leaving the bank and switching their accounts (Goff, 2014). Amidst public outcry and confusion as to how the Bank could have got itself into such trouble, various official inquiries were launched into the Bank’s failure. The Treasury, the Prudential Regulation Authority, the Financial Regulation Council as well as various Parliamentary select committees conducted investigations. It is clear from the result of their inquiries that the Co-‐op had not been ‘good with money’ and its stakeholder-‐ownership had not precluded it from adopting the sorts of risky strategies and behaviours, which were common for shareholder-‐owned banks.

The Co-‐op was lambasted for having a governance structure which was ineffective and management who were unqualified and inept (Kelly 2014; FCA 2015). The Co-‐op avoided being fined, and was issued with a public censure by the FCA and PRA whose joint investigation was critical of the Co-‐op’s governance and management (FCA 2015). It accused the Co-‐op of failing to be transparent, concealing information, and misrepresenting and misleading the public and regulators about its capital position. The FCA and PRA (2015) found that in the year ending 31 December 2012, the Co-‐op wrongly declared that adequate capitalisation could be maintained or was available to cover regulatory requirements. In fact, the FCA found that the Co-‐op Bank did not have sufficient capital to meet requirements and concluded that there was no reasonable basis to justify the Co-‐op Bank’s belief to the contrary.

Furthermore, the FCA considered that the Co-‐op’s management had adjusted monthly impairments to achieve targets over-‐riding the risk-‐grading which would ordinarily be applied to the loans the Co-‐op inherited from the Britannia merger in order to improve perceptions about the bank’s capital adequacy position. And like Britain’s other mainstream banks which were accused of cultivating cultures that were too tolerant of misbehaviour (PCBS, 2013b, paras.116, 119, 176, 203, 519, 597, 784, and 836), the Co-‐op bank was also found by the FCA and PRA to have fostered a culture which prioritised its short-‐ term financial position at the cost of taking prudent and sustainable actions for the longer term (FCA 2015, para.1.76).

The report criticised management incompetence, exemplified by Paul Flowers’ evidence at a Treasury Committee hearing that the Co-‐op had only £3bn in assets when it had over £40 billion (Treanor, 2013b). The Co-‐op’s governance structure was found to be unfit for purpose with senior management being incapable of scrutinising the merits of the Britannia deal and running a large bank (Kelly 2014, FCA, 2015).Populated by place-‐men and political appointments both the management and the board were not qualified to assume significant financial and commercial roles (Kelly 2014). The set-‐up in the Co-‐op, as Brummer (2015, p16) put it, had management ‘on top’ and advisers ‘on tap’, and was not fit to provide the scrutiny, oversight and checks needed to ensure that the right decisions were made if and when advisers got things wrong.

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The Co-‐op’s failure raises important questions not only about management competence and governance but also about what drove a small stakeholder bank to seek to grow so radically and in such short succession

7.2.2 The Co-‐op’s growth imperative

The Co-‐op had spent the late 1990s and early part of the millennium focusing on building up orthodox banking services, rolling out new products such as premium accounts linked with insurance products, the smile credit card, and its internet and telephone banking services. By the mid-‐2000s, the Co-‐op bank was still modest in size compared to other UK banks and it had less than £15 billion in 2008 (see table 7.1). Table 7.1: Barclays, Lloyds, Nationwide and Co-op: total assets in £m (2008-2013)

(Source: Bankscope, using IFRS unqualified accounts with y/e 31.12 for each of the banks save for Nationwide, using available accounts with y/e 04.04)

Barclays Lloyds Nationwide Co-‐op 2008 2053029 436191 201093 14964 2009 1379148 572980 190497 46138 2010 1490038 1008732 187699 43581 2011 1563402 988366 194988 48935 2012 1488761 952463 189318 49772 2013 1312840 862004 188889 43396

As far back as 1992, the Co-‐op committed itself to pursuing an ‘ethical'

banking policy. Whilst ethical banking may have many different meanings, in the Co-‐op’s case it branded itself as an alternative to shareholder-‐run banks, offering to bank not in self-‐interested ways, but for the benefit of its customers, investing in accordance with its ethical policy informed through customer feedback in order to promote various social and environmental aims (the Co-‐operative Bank, 2010, pp1, 3).

But this strategy to corner the ethical banking market did not deliver growth on the scale needed to give it the market access its peers enjoyed. Prior to merging with the Britannia the Co-‐op had only 90 branches, and even post-‐merger in 2014, it still only had 342 branches, whereas the Nationwide had 800 and Lloyds had 2,875 branches (Jones 2012). Even after the merger, in 2008, the Co-‐op had only a 2% share of the retail banking market, whereas Lloyds had 30% and the Nationwide’s had 7% (Jones 2012). The Co-‐op’s scope for achieving growth was very limited. The retail banking market was characterised by customers reluctance to switch between banks and a stranglehold by the biggest banks over current accounts, with the big four providing 77% of personal accounts and 85% of SME business accounts (Independent Banking Commission 2011). Furthermore, in retail banking, a bank’s market share correlates closely with the size of a bank’s branch network, which are costly to operate (Bowman et al 2014,p94).

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To deliver growth on a radical scale in such a market, the Co-‐op needed to do more than capitalise on its ethical credentials, which is something it had been doing since 1992. Drastic steps were needed if the Co-‐op was to become a ‘challenger bank’ to the big four. It radically needed to grow its branch network. Having sought to distinguish itself from shareholder banks and proclaimed itself as ‘good with money’, the Co-‐op could hardly try to fund building such branches by engaging in the types of securitization and IB the Northern Rock and other demutualised societies had capitalised on. The only obvious alternative was to try to make a sizeable acquisition, which it did in 2009 when it merged with the Britannia adding : £35 bn in assets to its own £15 bn, 254 branches to its 90 branches, and 2.8 million customers to its 50,000 customers. The merger with the Britannia in 2009 in fact created a bank with £43 billion in assets, 300 branches, and more than 3 million customers and it enabled the Co-‐op to position itself as a challenger bank, and to put itself in the running for taking on the 632 branches being divested from Lloyds.

In July 2011, just two years on from the merger, the Co-‐op set itself up as a serious contender to take over the Lloyds branches. Were it to succeed in doing so, it would have resulted in the bank having 1,000 branches and in other words 10% of the UK branch network, serving 11 million customers and having a 7% share of the UK retail banking market (Jones, 2012). Given the Co-‐op’s need to grow its branch network, the prospect of both merging with the Britannia, and taking over Lloyds’ divested branches must have been extremely attractive for the Co-‐op’s management.

As the next section shows, management incompetence and governance failures played a key part in causing the Co-‐op’s fateful acquisition of the Britannia. But what is interesting about the Co-‐op is that its progression towards its own failure was somewhat pathological: it was driven down a perilous path by its manifest need to gain market access, which required it to achieve radically greater scale. Furthermore, and as the next section shall explore, the Co-‐op’s management was clearly not alone in failing to foresee problems with its capital adequacy and the Britannia deal. Its advisers, auditors, accountants, as well as the regulators, and financial commentators who approved its growth all failed to foresee troubles before the Co-‐op’s 2012 crisis unfolded.

7.2.3 Governance and oversight failures

7.2.3.1 Immediate oversight failures

Whilst the Co-‐op Bank was considering acquiring the Britannia, the Co-‐op

Group, which wholly owned the bank, was committing its own resources to expanding its supermarket business, having paid £1.57 bn to take over Sommerfield (BBC, 2008). By the time the Co-‐op encountered its own capital shortfall in 2013, the Group had just moved into expensive newly built headquarters. It was neither in a position to provide assistance financially, nor was it governed in a way which was fit to supervise and oversee the activities of the Co-‐op bank (Myners, 2014, ch.1). Although shareholders may have more of an interest in trading their shares than taking a long term interest in governing

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the companies they own, capital market actors, such as analysts and financial media, provide a lot of analysis and scrutiny of company activities. In the case of the Co-‐op, whose shares were not traded, there was not only an absence of such analysis but furthermore a labyrinthine management structure, made up mainly of ‘placemen’, which was not fit to provide long term oversight and governance of the Co-‐op Bank (Myners, 2014, ch.1). When it came to the Britannia acquisition, there was thus an absence of analysis and a failure of oversight by the Co-‐op’s Group. It is clear in retrospect that the Britannia’s mortgage book and commercial loans were wildly over-‐priced in the merger, and the Co-‐op’s management failed to value the assets and foresee likely delinquencies (Kelly, 2014). The mispricing of Britannia’s assets, and the subsequent writing down or writing off of bad loans, was the main cause for the Co-‐op’s subsequent failure, although various operational and integration costs, not least in respect of IT infrastructure and provision required for PPI, also contributed towards the Co-‐op’s subsequent capital shortfall (Kelly 2014; Treasury Committee 2014). The Co-‐op’s board believed its management had performed appropriate due diligence and stress-‐testing, and that they had made a prudent allowance against future impairment of the more risky assets in the form of a Fair Value Adjustment (Murray, 2014). Unlike other M&As where goodwill proved to be the riskiest asset and most difficult to value, goodwill does not appear to have been a large part of the deal. As the transfer of engagement did not involve a direct payment of cash consideration (other than the maintenance of Britannia customer rewards and the payment of their fees for joining the Co-‐op), there was no amount directly payable for Britannia’s goodwill. In any case, Britannia’s goodwill was only a fraction of its total assets, being valued at £194.8 million in 2009. The Britannia appears to have written that off as a part of the deal, and the Co-‐op appears only to have capitalised £600,000 on its accounts for goodwill as a result of the deal (Co-‐op, 2009, p3, p132). The writing-‐off of goodwill by the Britannia does not necessarily mean the goodwill disappeared however, as it may well have influenced, in an indirect way, the amount the Co-‐op was willing to pay for the Britannia’s other assets. But by far and away, the riskiest part of the Britannia’s assets was its corporate loan book, and in particular the commercial real estate lending, which according to Kelly was vastly over-‐valued, with only the most cursory of due diligence being performed (Murray, 2014; Kelly, 2014).

7.2.3.2 Wider oversight failures

The Co-‐op bank’s management, and the Group which was criticised for

not keeping better watch on management, were not alone in failing to spot the risks. Criticism can also be levelled against the Co-‐op’s advisers and its auditors as well as the regulators who waved through the Britannia deal. The Co-‐op’s auditors, KPMG, who were paid £1m to audit the merger (Tyrie 2014), did not doubt the pricing of assets. Despite later claiming to have conducted ‘thorough’ due diligence (Brummer 2015, p5), it transpired that KPMG had not even inspected Britannia’s loss-‐making corporate loan book, which was one of the biggest factors contributing to the Co-‐op’s subsequent capital shortfall (Brummer 2015, 2015, p5). KPMG subsequently denied being responsible for

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performing due diligence alleging that the Co-‐op bank was responsible for its own due diligence, notwithstanding their earlier claim that their due diligence had been ‘thorough’ (Brummer 2015, p5).

The Co-‐op’s investment bankers, JP Morgan, who were paid £7m to assist in the merger (Tyrie 2014) also advised that that the deal was ‘fair’ and its commercial and strategic logic was ‘compelling’ (Brummer 2015, p6), and they told the board that the due diligence ‘exceeded that normally undertaken for listed companies’, a claim which must be doubted if nobody had scrutinised the commercial loan book (Brummer 2015, p6).

Had due diligence been performed properly, it should have been reasonably apparent that the Britannia was overpriced (Kelly, 2014). Unlike Lloyds’s difficult task of valuing HBOS hurriedly, it was not a complicated problem to value the Britannia’s loan books. As the Kelly Report (2014) noted, the commercial loans were not complex syndicated loans, but a few dozen loans on shopping centres and office developments. It should not have been difficult to spot that there were a small number of large commercial loans which were outside of the Co-‐op’s traditional risk appetite, and which had the potential to materialise significant impairments if property prices fell, which they were liable to do in 2009. It should also have been evident that the Britannia had been over-‐extending itself on home loans for some time including providing some self-‐certifying mortgages, whose average quality must have been at least questionable, not being as good as the loans the Co-‐op made (Kelly 2014). But it seems that the obvious question about what the quality of Britannia’s loan book was, was not discussed by anyone, including the Co-‐op’s advisers.

The Co-‐op contemplated litigation against both KPMG and J P Morgan (Chu, 2014). However, no formal legal proceedings were brought, but that is not to say that the same were not confidentially compromised in an unreported settlement. Without official findings about whether the Co-‐op was responsible for its due diligence, it is difficult to say for sure whether its advisers were necessarily negligent. But what is clear is that there was an absence of internal expertise and a failure on the part of management to adequately perform due diligence (Kelly, 2014; Murray, 2014). Although the Co-‐op Bank had expertise ‘on tap’, it did not have it ‘on top’, and instead was instead populated by placemen, wholly unsuited to the task of spotting what were widely considered to be vastly over-‐valued assets (Brummer, 2015, p16).

7.2.3.3 hubris everywhere -‐ the financial media’s failure

There was also an absence of analysis amongst the financial media. On 12

October 2008, just 4 days after the UK Government had announced its £850 billion pound bank bail out programme, the mainstream financial press all announced that the Co-‐op and Britannia were in merger talks to create a super-‐mutual. In mid-‐January 2009, the necessary legislative instrument, the ‘Butterfill Act’, was passed. On 21 January 2009, the Co-‐op and Britannia announced their agreement to merge, subject to approval by regulators and mutual members. On 29 April 2009 Britannia's members voted overwhelmingly in favour of merger. On 24 July 2009, the merger was approved by the FSA, who had conducted its own audit approving the deal. And on 1 August 2009, the merger finally took

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place. Within that chronology, there were three events which ought to have raised serious concerns about the deal. The first occurred at the start of 2009, when the Britannia reported problems in 2008 blaming rising bad debt, as a reason for profits falling from £50.5m to £31.2m. The second was in February 2009 when Moody and Fitch downgraded the Coop’s credit rating to ‘negative’ because of fears of it taking on a legacy of debt from the Britannia. The third occurred in March 2009, when Britannia reported 92% losses for the full 2008 year.

Notwithstanding those warnings, it appears from a review of broadsheet financial commentary, including the Financial Times, the Telegraph and the Guardian, over that same period of time that not one financial commentator questioned the prudence of the deal. On the contrary, the broadsheet commentary appeared to report favourably on the news of the merger, re-‐publishing what looked like it might even have been the Co-‐op’s own press releases. Commentators typically only reported on the beneficial features of the deal. On 12 October 2008, when the announcement first broke, the broadsheets were boastful about the possible creation of a ‘Super Mutual’ with 9 million customers, 12,000 employees, over 300 branches and £70 billion worth of assets under management. On 21 January 2009, when the merger announcement was made the financial press provided remarkably similar coverage to one another about the beneficial details of the proposed merger, suggesting that there was scope for a mutual to succeed in the crisis where PLCs failed. The FT headlined with ‘Britannia and Co-‐op merge into “super-‐mutual”’ (Croft, 2009) and the Guardian went with the remarkably similar ‘Britannia and Co-‐operative to create £70bn “super-‐mutual”’ (Collinson, 2009). The former suggested the Co-‐op was in a ‘safer haven’ (Croft, 2009) and the latter commented upon the trend for consolidation likely continuing amongst mutuals (Collinson, 2009).

A review of the broadsheet newspapers in this period suggests that not one commentator raised concerns about the deal– which is surprising given that it took place at the height of the crisis in something of a free falling economic conjuncture, when regulators were requiring banks to hold increasing amounts of capital. Instead, the press appeared to share the Co-‐op’s optimism and enthusiasm for the deal and did not raise concerns; that position appeared to prevail even after Moody and Fitch’s decision in May 2009 to downgrade the Co-‐op’s credit rating from ‘stable’ to ‘negative’. Even following the Britannia’s announcement in March 2009 about its 92% losses, commentators did not seriously challenge the merger or argue that it looked unsafe. The Financial Times did not retract its view that the Co-‐op was a ‘safer haven’ but went on to award the Co-‐op the Financial Time’s ‘Sustainable Bank of the year award’ (the Co-‐operative Bank, 2010, p.3).

7.2.3.4 Hubris – in political circles

Ironically, the success of the Co-‐op’s ethical branding campaign may well

have encouraged political support for the merger. Having capitalised on its distinct member-‐owned structure free from shareholder pressures and its ethical brand (the Co-‐operative Bank, 2010, pp3, 5), the Co-‐op had smoothed the path for others to accept its claim that the merger would create a super mutual

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and ethical alternative to shareholders. Its success in moulding the public’s perception into believing that there could be a ‘a new era dawning for the financial services market’ (the Co-‐operative Bank, 2010, p.5) with a place for a ‘super-‐mutual’ may well have encouraged complacency more broadly amongst politicians. There was no resistance to the merger reported from any of the political parties. Many politicians favoured the Co-‐op’s radical push for growth. George Osborne welcomed the Co-‐op’s bid for project verde heralding:

‘a new banking system for Britain that gives real choice to customers and supports the economy. The sale of hundreds of Lloyds branches to the Co-‐operative creates a new challenger bank and promotes mutuals’ (Trotman 2012).

The regulators were similarly apparently supportive of the Co-‐op’s push

for growth, notwithstanding that the FSA had secretly identified the Britannia as a building society which needed to be rescued knowing that without a merger, the Britannia might need bailing out (Brummer 2015, p5). The FSA permitted the deal to proceed without full due diligence being performed, and they subsequently allowed the appointment of the Reverend Flowers as Chairman in 2010 – a person who was subsequently found to be ‘not suitably qualified for the role of chairman’ (Kelly 2014).

In this climate of encouragement, where the apparent mentality of the herd favoured the creation of an ethical challenger bank and where the Co-‐op’s strategic growth imperatives had been set by structural pressures beyond its control, the willingness of the Co-‐op to take on assets outside of its traditional risk appetite and to try to put itself in the running for project Verde is not entirely surprising. Whilst the Co-‐op provided misleading information and unreasonably prolonged what were unrealistic expectations, its ambitiousness in the first place was a natural consequence of needing to get market access, and the Co-‐op’s governance structure was not alone in failing to keep such ambitions in check: the shareholders of all failing shareholder banks also provided inadequate oversight. What is clear in the case of the Co-‐op is that, however owned, the problems of over-‐ambition and hubris still need to be checked.

7.3 Part 2: structural pressures and the case of the Nationwide

7.3.1 The Nationwide’s resilience Whilst the Co-‐op pushed for radical growth in unsafe ways, the

Nationwide got through the financial crisis, whilst growing only modestly, and whilst also delivering award-‐winning retail banking services. Like the Co-‐op, the Nationwide was free from the types of ownership pressures observed in chapter 6 in the cases of Barclays and Lloyds. Although the Nationwide had issued some limited equity, it was never ran to deliver as much value as possible for its shareholders, and, as we shall see, it found ways to issue equity which necessarily limited returns and shareholder rights.

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The Nationwide was also not subject to the same structural pressures which drove the Co-‐op’s over-‐ambitiousness. By 2008, in terms of its size, the Nationwide was already well established in UK retail banking being five times the size of the Co-‐op, and a quarter the size of Lloyds. As can be seen from Table 7.2 below, the Nationwide had £189 billion in assets compared to the Co-‐op’s £43 billion post-‐merger and Lloyds’ £862 billion. Before Lloyds acquired HBOS, Nationwide, with its £178 billion in assets, was just shy of being half as big as Lloyds which had £436 billion in assets (see Table 7.1 above and Charts 7.1-‐7.3 below).

Chart 7.1: Barclays, Lloyds, Nationwide and Co-op: total assets in £m (2008-2013)

(Source: Bankscope, using available IFRS unqualified accounts)

Barclays

Nationwide 0

500000

1000000

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2008 2009 2010 2011 2012 2013

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Lloyds

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The co-‐op

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Chart 7.2: Lloyds and Nationwide: total assets in £m (2008-2013)

(Source: Bankscope, using available IFRS unqualified accounts)

Chart 7.3: Nationwide and Co-op: total assets in £m (2008-2013)

(Source: Bankscope; using available IFRS unqualified accounts)

Nationwide’s size came with significant market access and market share.

The Co-‐op only had 90 branches prior to the Britannia merger and only 342 branches with a 2% share of retail banking market afterwards, in 2012, the

0

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Nationwide already had over 800 branches and 7% of the market which was half as many as Barclays’ 1625 branches, and nearly a quarter of Lloyds’ 2,875 branches (Jones, 2012). Because the Nationwide already had a lot of branches and a significant market share, it did not suffer from the same growth imperative which drove the Co-‐op’s acquisitiveness.

Whilst the Nationwide was free from the types of ownership pressures we saw were exerted on Lloyds and Barclays and free from the types of structural pressures exerted on the Co-‐op, we can see that it developed a more conservative business model. Its business model was neither dependent upon making huge acquisitions, nor on transacting huge volumes of wholesale and IB business relying upon wholesale funding.

That is not to say however that the Nationwide was adverse to risk-‐taking and M&A. The Nationwide is the product of scores of acquisitions: its website suggests it has acquired 172 building societies and other businesses in nearly two hundred years (Nationwide, 2015). In 2006, it took on its largest acquisition in the form of the Portman Building Society. According to Bankscope, before being acquired, Portman had assets of the order of £21bn. After the crisis unfolded, the Nationwide then picked up the Derbyshire and Cheshire Building Societies which according to Bankscope had combined assets of nearly £12bn. In short succession, between 2006 and 2008, the Nationwide thus grew by more than £30 billion through sizeable acquisitions, but such assets still represented less than a fifth of Nationwide’s total assets (see Table 7.2 and Chart 7.4 below). Table 7.2: Nationwide’s total assets in £m (1990-2014)

(Source: Bankscope; amalgamating available GAAP and IFRS accounts: GAAP unqualified accounts y/e 04.04 for years 1990-‐2005; IFRS unqualified accounts for y/e 04.04 for years 2006-‐2014) YEAR MILLIONS

1990 26647.1 1991 31124.9 1992 34119.0 1993 34996.0 1994 35423.4 1995 35742.2 1996 37600.9 1997 40292.2 1998 46522.6 1999 52052.0 2000 62612.2 2001 69576.8 2002 73044.6 2003 83946.0 2004 99645.5 2005 109674.3 2006 118228.3 2007 132695.2

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2008 178482.1 2009 201093.0 2010 190497.0 2011 187699.0 2012 194988.0 2013 189318.0 2014 188889.0

Chart 7.4: Nationwide’s growth trajectory in £m (1991-2013)

(Source: Bankscope, amalgamating available GAAP and IFRS accounts: GAAP unqualified accounts between y/e04.04 for 1990-‐2005 and IFRS unqualified accounts for y/e 04.04 for 2006-‐2014)

Whilst the Nationwide’s growth was significant in the decade leading up to the financial crisis, its growth was not dominated by M&A, and what M&A the Nationwide engaged in was not significant when compared with the M&A activity at both Lloyds, and the Co-‐op. The Britannia had more assets than both of Nationwide’s two biggest acquisitions combined. In relative terms, the Nationwide’s M&A was thus incremental, and not transformative like that of Lloyds or the Co-‐op. As can be seen from Chart 7.2 above, before HBOS appeared on Lloyds’ radar, Lloyds only had £436 billion in assets, which is slightly more than twice as many assets as Nationwide. Through the single acquisition of HBOS, Lloyds more than doubled its size, and for the briefest of periods entered the £1 trillion club (see Table 7.1 above). The Co-‐op’s M&A was even more radical relative to its size. The Co-‐op had only £13 billion in assets when it acquired the Britannia which had £37 billion in assets. Prior to the Britannia acquisition, the Co-‐op was less than a tenth the size of the Nationwide (see Chart 7.3 above). By making that one acquisition, the Co-‐op was able to grow three-‐fold and become the Nationwide’s nearest rival, in terms of size, allowing it to be championed as a challenger bank in UK banking (see Charts 7.3). Unlike the Co-‐

Nationwide

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op and Lloyds, the Nationwide did not bet the proverbial house on a single, potentially catastrophic, deal. And unlike Lloyds and the Co-‐op, the Nationwide did not make any large acquisitions after the financial crisis and banking crisis had developed.

7.3.2 Its part in mis-‐selling The Nationwide not only embarked upon M&A like other retail banks, but

it also engaged in mis-‐selling PPI and interest rate swaps (Osborne 2013). However, the Nationwide was not as heavily involved as other banks in selling PPI. Its was responsible for mis-‐selling only a tiny fraction of the total PPI mis-‐sold : see Chart 7.5 below which compares the role of different banks in mis-‐selling PPI over a four years period between 2010 and 2014. As can be seen from Chart 7.5, both in actual terms and in relative terms in proportion to their retail assets, Barclays and Lloyds played a far bigger role in mis-‐selling PPI. As at 20 September 2012, the Nationwide accounted for only 1.3% of the total mis-‐selling amongst banks compared to Lloyds’ 40% (Collinson, 2014). That the Nationwide was involved in mis-‐selling PPI might tend to suggest that an absence of ownership pressures is not a guarantee for good behaviour, at least not when it comes to competing in what was a developed product market when banks are under pressures to recover heavy operating costs (Bowman et al 2014).

On the other hand the fact that the Nationwide was less heavily involved in mis-‐selling PPI than its peers, might even suggest that it was subjected to less pressures to exploit its customers, than those exerted on its peers. Data relating to the handling of PPI complaints also indicates that the Nationwide may have been less aggressive in selling such policies. As at March 2014, of the 6,436 complaints made against the Nationwide, only 10% were upheld, which is significantly smaller than the 77% of the 36,506 complaints upheld against Barclays (Collinson 2014). There is also evidence to suggest that the Nationwide’s reputation with its customers was better preserved: in 2013, the Nationwide was complained about less than the other major financial institution in the UK (see Table 7.3). In 2012, Nationwide came 3rd in a JD Power review of customer services amongst banks, and was rated 9th out of 28 banks in the review of customer satisfaction amongst 28 banks conducted by Which? (Jones 2012). Although the Co-‐op beat the Nationwide, coming 2nd in both surveys, the Nationwide was ahead of Lloyds and Barclays, which out of 28 banks surveyed in the Which? survey came 25th and 20th, respectively (Jones 2012).

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Table 7.3: complaints upheld (July-December 2013)

(Source Collinson, 2014, citing the Financial Ombudsman) Most complained about financial institutions Bank Number of

complaints (01.07.13-‐31.12.13)

Percentage upheld

Lloyds TSB 40,500 54%

Barclays 36,506 77%

Nationwide 6,436 10%

Chart 7.5: Top six banks provision for mis-selling by category (2010-2014)

(Source: Treanor, 2015, referring to Standard & Poor’s)

7.3.3 Its more traditional business

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Nationwide’s growth appears to have been organic and not radical or sporadic. As can be seen from table 7.2 and chart 7.4 above, at the start of the millennium, Nationwide’s assets were just over £62bn, and they had more than tripled over the period leading up to the end of the 2014 financial year growing to £190bn. Of the £130bn increase, it appears that a little more than £30bn can be attributed to M&A and the lion’s share arose from originating new lending to borrowers, which as we shall see below, was comprised mainly of lending secured against properties. Nationwide’s funding also appears to have been relatively conservative. As can be seen from table 7.4 below, in the year ending 4 April 2014, 79% of Nationwide’s funding came from deposits. By comparison, looking back over the last 5 years, generally less than half of Barclays’ total assets have been contributed by depositor funds and the figure is slightly more than half for Lloyds. On the other hand like the Nationwide, the Co-‐op has sustained a high proportion of depositor funding. In that respect, Nationwide and the Co-‐op more closely resembled the paradigm model of an orthodox retail bank, intermediating between small savers and borrowers, whereas Barclays and Lloyds departed from such role.

Table 7.4: Barclays, Lloyds, Nationwide and Co-op: % of assets and % of lending composed of deposits (2006-2014)

(Source: Bankscope)

YEAR

Barclays % of assets made up of deposits

Lloyds % of assets made up of deposits

Nationwide % of assets made up of deposit

Co-‐op % of assets made up of deposit

Barclays % lending made up of deposits

Lloyds % lending made up of deposits

Nationwide% lending made up of deposits

Coop % of lending made up of deposit

2006 -‐ 57.51 72.66 81.67 -‐ 86.99 114.02 86.99 2007 -‐ 59.83 69.34 87.60 -‐ 86.84 122.30 86.84 2008 -‐ 51.21 66.96 84.30 -‐ 88.64 111.13 88.64 2009 48.03 40.88 -‐ 75.88 116.86 107.29 NS 107.2

9 2010 43.57 55.86 -‐ 81.11 117.01 104.58 NS 104.5

8 2011 45.54 60.25 -‐ 81.10 115.54 94.60 NS 94.60 2012 48.95 65.33 73.09 79.43 100.08 92.41 101.98 92.41 2013 52.84 71.49 74.57 82.19 94.03 94.77 105.68 94.77 2014 79.88 102.85

The Nationwide thus achieved more organic growth by undertaking more traditional lending and borrowing and without ramping up its assets like Barclays, or others banks such as the Northern Rock who fuelled the production

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of large volume low quality securities through use of wholesale funds (see table 7.5 which compares the percentage of assets made up of interbank lending for different banks). When inter-‐bank lending, and the market for selling securities, dried up in the credit crunch, Nationwide was not directly imperilled but had developed a safer business model built upon depositor funding and mortgage lending (see table 7.4 above). By focusing on retail services and savings product, Nationwide managed to build up a high quality asset base, as well as developing a lower risk profile on its funding base. It built up its depositor base, whilst also growing its funding and lending. Table 7.5: Barclays, Lloyds, Nationwide and Co-op interbank assets/ interbank lending in % (2006-2014) YEAR Barclays:

% Interbank assets/ interbank lending

Lloyds: % Interbank assets/ interbank lending

Nationwide : % interbank assets/ interbank lending

Co-‐op Interbank assets / interbank lending

2006 -‐ 109.32 49.04 195.12

2007 -‐ 87.64 42.58 182.07

2008 -‐ 60.81 49.58 142.01

2009 46.88 125.31 38.67 29.29

2010 40.88 59.17 25.11 81.47

2011 47.63 80.20 212.65 60.75

2012 60.23 200.23 104.40 52.72

2013 77.01 195.48 128.16 57.82

2014 -‐ 205.99

Building society-‐specific rules encouraged Nationwide’s stable funding

and lending platforms. Section 7 of the Building Society Act 1986 requires the funding platform of a building society to be composed of at least 50% of funds provided by individual members. In turn the Nationwide has powerful incentives to encourage individual deposits from its members. Non-‐retail sources, particularly borrowing from wholesale markets, cannot form more than 50% of a building society’s funding therefore (although the Treasury does have a power, which has not been exercised, to increase this proportion to 75%.). Nationwide

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has thus had limited scope to resort to wholesale funding. In fact wholesale funding has constituted considerably less than the 50% available to it (see table 7.4). Of the wholesale funding which Nationwide has raised, much has been raised to meet capital adequacy requirements, rather than funding core aspects of its business, and a significant proportion of that funding has been longer term, maturing in over one year, rather than being short term roll-‐over borrowing. In each of the last three years shown, unlike the Co-‐op, Barclays and Lloyds, Nationwide has also borrowed less than it has lent on interbank markets (see table 7.5).

Nationwide has not only developed a lower risk funding profile, but has also stuck to originating more traditional, low-‐risk, lending. The majority of Nationwide’s assets are, and were at the time of the crisis, comprised of loans fully secured against residential properties. Indeed, at least 75% of Nationwide's business assets (but not its total assets) have to be comprised of mortgages in order to comply with the Building Society Act 1986 (as amended). Section 6 of the Act provides that at least 75% of the ‘business assets’ must be loans ‘fully secured against residential property’. Nationwide’s role in mortgage lending is thus much higher, proportionately, than any of its other larger banking peers and consequently its assets are of a good quality. Of its ‘total assets’, between a fifth and a quarter is held in securities, and even less was held by the Co-‐op (see tables 7.6 and 7.8 below). Barclays, by comparison has almost two-‐thirds tied up in securities, and only a tenth or so in residential mortgages (see Table 7.7). Unlike Northern Rock which operated an ‘originate to distribute’ model, Nationwide did not engage originating high volume sub-‐prime lending with a view to off-‐loading such assets in more profitable sale of securities.

Nationwide has had a securitisation programme, but securitisation necessarily represented only a small part of its business. As there is no restriction on what categories of asset Nationwide can hold in the remaining 25% of ‘business assets’ Nationwide could have engaged in securitisation more heavily, but it appears from the absence of such activity that the Nationwide has never been incentivised to engage in securitisation. Unlike most of its peers, therefore, Nationwide managed to stick to more orthodox lending originating quality secured lending and generally only used its securitisation programme to sell off mortgages in order to free up capital to manage funding, and liquidity issues, and not to fund key parts of its business. Table 7.6: Nationwide: amount of assets comprised of mortgages and securities in % (2009-2014)

Nationwide’s asset base : comparing the composition of residential mortgage lending and securities (Source: Bankscope, using available IFRS accounts) YEAR Residential

mortgage Total assets (£)m

% asserts comprised strictly of residential mortgages

Total securities

% comprised in securities

2009 112959.0 201093.0 56% 48447.0 24%

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2010 109721.0 190497.0 58% 46743.0 25% 2011 104960.0 187699.0 56% 44982.0 23% 2012 104599.0 194988.0 53% 51995.0 27% 2013 109969.0 189318.0 58% 42884.0 23% 2014 119084.0 188889.0 63% 39607.0 21% Table 7.7: Barclays: amount of assets comprised of mortgages and securities (2009-2013)

(Source: Bankscope)

YEAR Residential mortgage

Total assets (£)m

% asserts comprised strictly of residential mortgages

Total securities


2009 110605.0 1399428.0 8% 752313.0 54% 2010 123995.0 1536290.0 8% 857138.0 56% 2011 133516.0 1602603.0 8% 908183.0 57% 2012 171272.0 1515163.0 11% 884014.0 58% 2013 149974.0 1345833.0 11% 763517.0 57% Table 7.8: Co-op: amount of assets comprised of securities in £m and in % (2009-2013)

(Source : Bankscope)

YEAR Total assets (£m)

Total securities (£m)


2009 46138.8 8041.6 17%

2010 45581.3 6055.2 13%

2011 48955.6 5921.5 12%

2012 49772.8 8072.4 16%

2013 43396.1 5173.3 12%

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7.3.4 Reinforcing functionalism

Nationwide thus developed a less risked business model, and it did so whilst also having to pay proportionately higher costs than its larger peers via the government deposit holding scheme, and without having the same access to equity funding as its peers. Proportionately Nationwide has to pay greater amounts to the Financial Services Compensation Scheme (FSCS) than other banks as the FSCS levy is proportionate to the amount of savings held by a bank regardless of how safe the bank’s lending practice is. Nationwide, the UK’s second largest savings provider, has had to pay a heavy toll therefore notwithstanding that it originated higher quality mortgage lending than a lot of its peers. In that connection, the levy had the effect of penalising safer lenders and encouraging reckless lenders as those engaging more heavily in sub-‐prime origination, such as the Northern Rock, holding less in savings, were not required to pay as much as the Nationwide (Weardon, 2009).

In addition, as a mutual, Nationwide has been limited in the way it can raise equity to provide it with capital. Section 8 of the Building Society Act 1986 prohibits a building society from accepting corporate bodies as shareholders; and funds raised from individuals must be in the form of shares or current accounts. In order to meet rising capital adequacy standards, Nationwide issued £500m of core capital deferred shares (CCDS) in November 2013. Such shares rank behind all other forms of subordinated debt, and are thus last in line to recover in the event of insolvency. They also have weaker control rights than regular equity. Regardless of how many shares are owned, an investor holding CCDSs will be a single member of the organisation only entitled to cast one vote. Whilst the shares were valued as producing a 10.5% yield, their maximum yield is also capped at 15%. According to Nationwide’s treasury division director Andy Townsend, the shares were purposefully designed to make it clear to shareholders that they should not expect unlimited upside: ‘The purpose of the cap was to make it clear that the introduction of this new class of security was not a suggestion to holders to influence Nationwide to move to a profit maximising model’ (Caiger-‐Smith 2013).

Given the more demanding capital adequacy standards, future share issues may prove to be popular. Nationwide will not only have to pay a heavy toll to the FSCS proportionate to its savings, but may also have to de-‐leverage to increase its capital. Since savings constitute liabilities, not assets, and its main line of business – mortgage lending – does not free up adequate capital to de-‐leverage, the issue of CCDS and other subordinated debt may become necessary. The 2013 CCDS issue certainly helped boost Nationwide’s leverage ratio, increasing its available capital as a percentage of its assets. With weightless voting rights and capped dividends, and only limited scope for trading such shares (Nationwide not being listed on the stock-‐market) such shares are unlikely to subject management to the types of ownership pressures exerted on publicly traded banks. Nationwide has also confirmed that it has no intention of being a regular issuer. For the time being therefore, CCDS are more akin to bonds than regular equity and are unlikely to jeopardise Nationwide’s mutual status. Whilst Nationwide has been forced to deleverage, it did not realise a deficit on the same scale as the Co-‐op, nor did it require government bail out like

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Lloyds or help from middle eastern investors like Barclays. What is also impressive about the Nationwide is that it has managed to

develop a safe business model whilst also retaining only a very modest interest in its assets. Like many other banks, its equity, was extremely small compared to other assets, typically no more than 5%, but unlike other banks those who held such equity were not treated like owners, and were not entitled to have the Nationwide run just for their benefit. A less risky strategy was encouraged in the Nationwide therefore, whose ownership model limited ownership pressures and whose external regulation required it to stick to more conservative lines of retail banking.

7.4 Conclusions What emerges from looking at the case of the Co-‐op is the lesson that an ownerless bank can be driven to behave in similar ways to banks whose ownership is publicly-‐traded, to seek radical growth in unsafe ways and to foster a culture focused on short term performance where misbehaviour is tolerated. The Co-‐op’s desire for growth came about not from ownership pressures nor from management avarice, but rather from competitive pressures exerted on it as well as smaller banks by the structure and dynamics of the banking market. Unlike Lloyds, where the driver of failure was hard-‐wired into its ownership design, the Co-‐op was locked into its own perilous path by its need to gain market access through extending its branch network. Whilst its management proved to be utterly incompetent and its governance structure ineffectual at keeping its greed in check, the Co-‐op was not alone in being over-‐optimistic, and complacent if not outright blind to a collapsing conjuncture : the major political parties, the regulators and even the public seemed to have bought into the Co-‐op’s claim that a new era of ethical banking was dawning. The story of the Co-‐op suggests that re-‐designing an ownership model to remove ownership pressures is unlikely in itself to guarantee stability and success, and that account needs to be had to the structure and market environment within which banks operate and the pressures arising from operating in such space.

By contrast, what we witness in the case of the Nationwide, is that the problems of greed and hubris are less present. The ownership pressures which governed Barclays and Lloyds were not present and the structural pressures which governed the Co-‐op were not material, mainly because the rules designed to regulate Building Societies ensured the Nationwide stuck to performing orthodox retail banking functions. The freedom and temptation to deviate from these functions, made possible for most banks by the Big Bang was not an option for the Nationwide which remained a building society, and remained subject as such to regulation requiring it to perform certain functions. Such functional regulation kept the Nationwide in its compartment of activity and acted as a countervailing force against the structural pressures which might otherwise have pushed it into riskier behaviours. The case of the Nationwide suggests that ownership and structural pressures can be moderated and accommodated, by ownership models which limit the extractive demands placed on management, and by regulation which prevents banks from departing from their regulated

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retail functions and engaging in more riskier behaviours. The following chapter will consider how this might be done.

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Chapter 8. Conclusion: ‘ownerlessness’ must be part of

the solution

8.1 Introduction

This chapter analyses the key findings of the preceding empirical chapters and discusses their relevance and implications. It is organised into four parts. The first identifies the key findings and, in succession, argues first that these findings suggest that the current ownership model is not fit-‐for-‐purpose and must be reformed; second that an ownership ‘fix’ is unlikely to solve all of the problems in banking; and third that there also needs to be greater compartmentalisation of banking functions and function-‐specific regulation of activities within those compartments. The cases of Barclays and Lloyds both suggested that the shareholder-‐value ownership model is liable to demand too much from the banking business, driving mis-‐behaviour and unsafe strategies and encouraging banks to depart from traditional low profit, and what many would consider to be more socially desirable, behaviours.

On the other hand, we witnessed in the case of the Co-‐op that an absence of any shareholder-‐value ownership does not, by itself, protect against other structural pressures which can also drive bad behaviour and strategy and what was suggested by the case of the Nationwide, was that banks are less likely to misbehave where their functions are clearly compartmentalized and their regulation aimed at enforcing functionalism within those discrete compartments. Indeed, the Nationwide provided something of a back-‐to-‐the-‐future story demonstrating that the most responsible and resilient business model was that which was changed the least in the Big Bang. Having not demutualised and floated on the stock market, the Nationwide remained subject to building society regulation whose focus on the Nationwide’s different compartmentalized and clearly defined activities, reinforced sensible behaviours and provided safe-‐guards against the kind of misbehaviours which saw other banks becoming un-‐stuck.

Having explored the key findings in the first part of the chapter, the second part then discusses the relevance of these findings to the thesis inquiry, comparing the direction of the official ‘reform agenda’ with the implications from the thesis findings. This part criticises the absence of any discussion in the official response about the need for ownership reform. At the same time, we note that the status quo ante is not set in stone and a new political debate appears to be opening up as politicians and intellectuals from diverse walks of life advocate new forms of banking which play more of a role in creating productive investment. This part of the thesis recognises that there are a host of different reforms required in banking which are un-‐related to the issue of ownership, and which call to be considered outside of this thesis.

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Rather than indulging in any detailed discussion of those issues therefore, the third part of the chapter instead focuses on how we should now think about the way banks are owned and how we might seek to re-‐design their ownership model. This part makes proposals bearing in mind both the apparent absence of political will to consider the issue of ownership in post-‐crisis reform, as well as emerging political calls for greater productive investment. The argument which evolves out of this part is that unless we challenge and displace the prevalent assumption that banks should be run as if owned by shareholders, we are unlikely to ensure that banks behave responsibly and perform what can be considered to be more socially desirable behaviours. It is argued in this part that we need to be far more courageous not only in clarifying what we expect of our banks but also in being experimental in designing new forms of ownership which seek to remove or mitigate ownership pressures. Different ways of experimenting with ownerlessness are then explored including preparing plans for converting banks which are nationalised or bailed out in the future and creating any National Investment Bank, such as that currently proposed by the Labour Party (2017) with an ownerless model to ensure that it can effectively dedicate its assets to perform productive investment.

It is argued that if we want to seriously pursue greater productive investment in the wider economy by instituting some form of National Investment Bank, how such a bank is owned is important, if it is to avoid the fate of 3i (Mayer, 2013, pp132-‐135), or the Green Investment Bank (Kollewe, 2017). The fourth and final part then considered the findings and implications in the light of the motivations which initially prompted this thesis, evaluating what practical and academic contributions are made by this thesis inquiry in connection with the subjects of banking reform and ownership more generally.

8.2 Part 1: The key findings

8.2.1 Extractive ownership is not fit-‐for-‐purpose The evidence uncovered by chapter 6 strongly suggested that the

demands placed on management by the stock market, shareholders and investors in the cases of both Barclays and Lloyds played a significant role in influencing and shaping strategy and behaviour. Both Bob Diamond and Brian Pitman vowed to return shareholder value to investors, and with their reputations and compensation packages being affected by their ability to do that, they both had vested interests in succumbing to pressures to deliver double digit returns and grow their banks’ profits. Barclays, formerly reputed for being a conservative retail bank of a respectable Quaker lineage, essentially doubled down on its investment banking operations, raising questionable funding in doing so. Following Bob Diamond’s 2003 Alpha Plan there was a pronounced, one way trend, to ramp up its IB and international operations, and to depart from its lower yielding domestic retail functions – a trend which became apparently irreversible following the Lehman Brother’s acquisition in 2009. Whilst profitable during the economic upswing, when liquidity dried up, these IB

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operations proved costly and difficult to sustain and resulted in a significant capital shortfall which was only plugged by raising colossal amounts of equity from private investors in the middle east in hurried and highly questionable fashion.

As for Lloyds, which was also previously considered to be a safe and reliable retail business, it was taken into riskier and riskier deal-‐making as the stock-‐market and its cheerleaders called upon Brian Pitman and his successors to deliver not only returns on equity, but also radical growth. Pitman’s aversion to investment banking meant that Lloyds could only satisfy these demands through making ever bigger and riskier acquisitions. Having tried unsuccessfully to acquire RBS in 1984, Standard Chartered in 1986, and the Midland Bank in 1992, Pitman took advantage of the de-‐mutualisations in the 1990s and made a spree of sizeable acquisitions, and in particular, the Cheltenham & Gloucester in 1995, and the TSB in 1995. These additions, together with other acquisitions which were considered to be complimentary for banking such as the Scottish Widows in 1999, consolidated Lloyds’ position as a dominant bank in the UK retail sector. Whilst this M&A trebled Lloyds’ assets in the 1990s, it left few options for further growth in the millennium. This made the eventual HBOS acquisition increasingly inevitable, and also put strain on management to ramp up Lloyds’ retail assets through in-‐branch sales.

In slightly different ways therefore the cases of both Barclays and Lloyds provided examples of shareholder-‐value driven ownership models demanding more from the banking business than could be safely delivered, and not only during times of economic growth and high liquidity, but also during recession. The efforts of Bob Diamond’s successor to ‘fix’ the culture in Barclays were singularly incapable of resisting shareholder demands to return to ‘business as usual’, as was demonstrated by the way ‘Saint Anthony’ was quickly derided and mocked, and subsequently ousted to be replaced by another maverick investment banker. Whilst successive CEO’s of Lloyds publicly resisted calls for Lloyds to ramp up its own IB, senior management within Lloyds came under immense pressure to achieve high earnings and growth in other ways. As well as engaging in dubious retail mis-‐selling on an industrial scale, it proceeded with its risky growth strategy which at times saw Lloyds even contemplating taking over the Northern Rock and ABN Ambro – acquisitions which would have proved disastrous (Fallon, 2015 p112).

Barclays and Lloyds not only adopted dangerous strategies but, as was also observed in chapter 6, they also cultivated cultures which celebrated greed and recklessness and encouraged the pursuit of profits at the expense of their customers. As the Parliamentary Commission on Banking Standards discovered (2013b, paras116, 119, 416, 519, 536, 597, 836-‐838), the win-‐at-‐any-‐cost mentality typical of investment banking spilled over into other departments within UK big banks and these other departments came under pressure to take advantage of their customers, in some instances gulling, swindling and cheating them in doing so. Both Barclays and Lloyds manipulated markets and mis-‐sold products to the very people they were supposed to serve, selling an array of over-‐priced financial products to customers who generally had no real need for them.

It is furthermore telling that Lloyds and Barclays were not the worst offenders and were not even extreme examples of banks with shareholder-‐value

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ownership models developing bad behaviour and strategies. Quite the contrary Barclays and Lloyds appear to be rather representative. They provide two variants on the same story which seems to have been told by the rest of the UK’s big banks, whose ownership models have demanded more growth and earnings from the banking business than could safely be delivered. Northern Rock, the RBS and even HSBC provide other examples of banks which went awry in their own way. Northern Rock built up a business model dependent upon the sale of sub-‐prime derivatives which was no longer sustainable when demand for their product and inter-‐bank lending dried up. RBS engaged recklessly in M&A and IB encountering problems similar to those of Lloyds and Barclays. And even HSBC engaged in money-‐laundering operations apparently on an industrial scale across multiple jurisdictions.

Whilst these banks call for their own studies of misbehaviour, the findings of this thesis would tend to suggest that they all probably developed their own peculiar problems for the same reason : their ownership model demanded double digit returns and asset growth on a scale which could not safely be delivered, at least not by operating solely within the retail compartment of banking, or without taking on extraordinary risks.

8.2.2 Changing ownership is not enough

The case of the Co-‐op proved that ownership pressures were not the only forces driving management to take on excessive risks. What was suggested by that case is that even if ownership pressures could be removed entirely, the other types of structural pressures considered in chapter 4 can still drive bad strategy and mis-‐behaviour. As we witnessed in chapter 4, the high operating costs in retail banking, together with fierce product competition for example to deliver free-‐whilst-‐in-‐credit banking services, provides powerful incentives for retail banks, especially smaller banks, to act mimetically : to adopt the same business model as their PLC competitors. All banks were encouraged, to become more ‘universal’ in their offering, to engage in the same lines of business, to use their branches as sales points to recover costs, and thus to view customers as sales opportunities and profit sources in their own right. Because market share still correlates closely with the size of a bank’s branch network, success in retail banking inevitably depends upon banks having lots of branches. These dynamics can provide powerful incentives for smaller banks, like the Co-‐op, to grow larger branch networks, regardless of the bank’s ownership model.

In the case of the Co-‐op we saw a tragedy if not an outright horror story being played out. A self-‐styled ethical bank, free from the types of ownership pressures exerted on Lloyds, found itself behaving in essentially similar ways, and then suffering from the consequences of such recklessness. Any argument that the Co-‐op’s stakeholder-‐ownership removed incentives for misbehaviour were seriously undermined in 2012 when £14.5 billion worth of bad debts opened up on the Co-‐op’s balance sheet, stemming mainly from its Britannia acquisition. The Co-‐op’s accountants and auditors and the regulators who approved the Britannia deal failed to spot the risks with the Britannia deal, but ultimate responsibility for that oversight lay with the Co-‐op’s board. Its governance structure permitted decisions to be taken essentially by prominent

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figures within the Co-‐op’s parent group, who were ‘placemen’ and unqualified to manage a bank (paragraph 203, TC Project Verde 2015). The Co-‐op’s management failed to spot the bad commercial loans on the Britannia’s loan book during the due diligence which was undertaken prior to acquiring the Britannia. That failure was compounded by the Co-‐op’s unrealistic ambitions in putting itself in the running subsequently for Project Verde and the acquisition of the 632 branches being divested from Lloyds.

All this suggests a failure in the Co-‐op’s governance system, which was inadequate to restrain the Co-‐op’s recklessly acquisitive ambitions. But the Co-‐op’s greed for growth came about from its strategic imperatives which were set not by management but by the marketplace within which it found itself. Having eschewed risky and unethical business, and having opted to operate a bancassurance type-‐model mainly within the retail department, the Co-‐op had little choice but to seek to radically grow its branch network if it was to succeed in UK banking. Its best, if not only, opportunity for doing that was to take over the Britannia, and to try to put itself in the running for the 632 Lloyds branches being sold off in Project Verde. If the Co-‐op had not ventured for such radical growth, its prospects otherwise of succeeding in retail banking, and establishing itself in what is a costly and competitive market would have been very poor, especially since it had confined itself to ethical banking.

Although the Co-‐op’s peculiar governance system was found wanting, so too was the governance system of all PLC banks which, as we saw in chapter 2, was accused of being ineffectual and incapable of reigning in recklessness and greed. In other words, the Co-‐op’s governance system was different, but it was not alone in failing: the governance system of all ‘owned models’ had also failed, thus suggesting governance problems in both shareholder and stakeholder models. And as chapter 7 also demonstrated, non-‐profit ownership models could succeed as in the case of the Nationwide’s governance system which was not called into question.

8.2.3 The need for compartmentalisation and functional regulation

The Nationwide provides something of a success story. Unlike the Co-‐op, or Lloyds or Barclays, it managed to steer itself on a far safer course essentially by remaining within the compartmental limits of its traditional banking activity. The irony of the Nationwide’s success is twofold. First it had the business model which changed least in the Big Bang, and second it managed to deliver better banking services than most of its peers and in a more sustainable and cautious manner without actually becoming a bank, all the while remaining a building society. Indeed the Nationwide provided a back-‐to-‐the-‐future story about the most resilient and successful bank being the one which was least primed for change in the Big Bang. Although it was only a building society it was able to undertake the more traditional functions typically associated with fractional reserve banking, namely taking deposits and lending to businesses and households in less risky ways than its peers. It did not try to become a go-‐go bank, demutualising and embarking on the ‘originate to distribute’ business model of some of its peers. It pushed instead only for modest growth by acquiring other building societies in a piecemeal, organic manner. And unlike

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Barclays and Lloyds and indeed the many other demutualised building societies, the Nationwide did not seek to leverage in dangerous ways, nor did it cultivate the results-‐orientated and greedy culture we saw developing in Barclays and Lloyds. The Nationwide instead stuck to more traditional banking services all the while delivering respectable albeit more modest returns on equity of around 5-‐10%.

In the case of the Nationwide, the absence of an extractive ownership model was combined successfully with other internal and external governance factors which mitigated the effects of other structural pressures. Like the Co-‐op the Nationwide was subject to structural pressures to grow, but being more than ten times as large as the Co-‐op (before 2009), its growth imperative was not nearly as pronounced as for the Co-‐op. Nationwide was five times as big as the Co-‐op (even after the Britannia merger), and was nearly half the size of Lloyds (prior to the HBOS acquisition). Having gradually acquired almost two hundred building societies over its two hundred year history, the Nationwide already had an extensive branch network reaching across the country. Being a regulated building society, its capacity for financing any radical acquisition was also significantly more limited than the Co-‐op bank. Although it was not precluded from making acquisitions, a combination of prudent management, and functional regulation restrained how much it could borrow, thus limiting the scale on which it could pursue growth. The Nationwide did engage in the same product markets as its peers, and in particular (mis)selling PPI. The extent of Nationwide’s mis-‐selling however was miniscule by comparison to other PLC banks, especially Lloyds.

Whereas other banks were criticised for exploiting their customers for their own advantage, following the crisis the Nationwide won accolades for serving its customers’ needs through delivering award-‐winning services, and creating innovative competitive retail products. Its devotion to its depositor-‐members was positively reinforced by the rules regulating building societies which limit the amount of wholesale funding building societies can raise (up to 50%) and insist upon lending being originated from more traditional, low-‐risk activities (at least 75% mortgages). Whilst the various banking acts passed in the big bang caused banks to become risky self-‐interested extraction machines, the building society rules kept building societies within their compartments of activity, encouraging them to become archetypal fractional reserve intermediaries allocating loan resources by traditional retail banking criteria. The Nationwide was kept within its compartment of regulated activities by functional regulation. The Nationwide’s sustainability story thus reflects the way its stakeholder model insulated it from ownership pressures and also how a series of other conditions protected it from structural pressures.

8.3 Part 2: relevance and implications

8.3.1 Implications for reform The key findings from the empirical research performed in chapters 6 and

7 suggest both that the prevalent ownership model is liable to demand more

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than can be safely delivered by the banking business and that it makes little sense for banks to be exposed to such demands, especially given that banks are expected to perform a lot of what are essentially low yielding activities. Shareholder-‐value ownership provides pressures for banks to act in self-‐interested, exploitative and risky ways. It is not well suited for businesses whose primary function is to manage other people’s money, especially if we expect such money to be allocated in certain ways for example to meet the needs of businesses and the broader economy.

The inevitable implications arising from this are that our law-‐makers and regulators need to be far more interventionist in three respects: first in determining what role we expect banks to perform; second by being more experimental in designing how banks are owned to help them perform such role; and third by being keener to regulate them in ways which also aim to help them perform such role. Without changing the underlying ownership structure of the PLC, and without clarifying what we want from banks, the relentless expectations of investors are likely to drive banks to further mis-‐behave, to take bad decisions and to apply investment in ways which do not necessarily benefit society. If banks continue to be owned in ways which provide incentives for them to be self-‐interested, exploitative, and reckless with other people’s money, the overwhelming likelihood is that there will always be a pervasive culture of greed and irresponsibility in them, and regulators will pursue an impossible task in seeking to make them behave more responsibly.

The demands of shareholder-‐value, combined with the structural pressures considered in chapter 4, are also liable to encourage banks to engage in activities which are harmful or of little benefit to society or which deviate wildly from the more socially useful functions we might want them to perform (Brummer, 2015, p144; Turner, 2016, pp61-‐63, 173-‐174, 245-‐246). If we want banks to originate lending which benefits society and is not useless or harmful to society, it seems that we really need to go further in defining what economic activities we expect banks to finance more generously or not to finance and we need to keep banks, or parts of them, within the compartments of prescribed activities which we require them to perform and then to regulate them to stay within those compartments.

8.3.2 Inadequacy of current reforms The UK’s post-‐2008 financial crisis reform agenda has not gone nearly far

enough in articulating what we want from banking or in ensuring ownership and structural pressures are tackled and managed to help banks meet these needs. As we saw in chapter 2, the Government’s reform package consisted mainly of requiring banks to hold slightly more capital and to ring-‐fence only the most publicly-‐sensitive parts of their business to protect the same in the event of bank failure. It was a feeble attempt at compartmentalisation, which was less radical than reforms in other countries. Notably, in the USA, the Dodds-‐Frank act sought to end the too big to fail subsidy to protect American tax-‐payers and prevent any future bail outs, and it did so by instituting a radical overhaul of the regulatory regime providing extensive powers for new regulators to break up banks if needs be, but critically to prescribe how activities were to be performed.

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Although banks were not broken up, the new regulatory regime imposed limits on the activities banks could engage in and required regulators more carefully to monitor and control how they performed such activities (Paletta, 2010).

In the UK, the ‘official response’ did not engage in the sort of philosophical inquiry one might have expected about what we require from banks as the quid pro quo for bailing out the banks and for giving them a licence to create credit in the first place. We did not grapple with the ‘ownership’ issues explored in chapter 3, nor did we seek to revisit and rebalance the relationship struck between the state, market and financial sector in the Big Bang, which was discussed in chapter 4. Instead, the official response sought to preserve finance as a sort of national protected treasure. As we saw in chapter 2, this ‘halo’ which has been constructed around the City of London has made it extremely difficult for politicians to resist the demands of the finance industry or to be radically interventionist.

8.3.3 Scope for determining what we want from banks

As was observed at 4.2.2 banks create and allocate colossal amounts of credit, and they are hugely privileged in being licenced to do so. Having bestowed that privilege upon them, the state has something of a right, if not also a vested interest, in having more of a say in determining what activities are financed, or need to be financed more generously. Although the Government’s reform agenda did not break ground in radically defining what we want from the banking sector, it seems that there is increasing political willingness to revisit the settlement struck between state and the financial sector in the Big Bang.

As we observed in chapter 4, it has certainly become common for a range of intellectuals, academics and policy-‐makers to argue that credit-‐creation and allocation should not be left to unbridled market forces (see CRESC, 2009, pp40, 44; King 2016; Turner 2016, pp61-‐63, 174; Kay 2015, p248). It is commonly claimed that rather than allocating credit to the type of productive investment society needs to repay its debts and to grow sustainably, banks instead tend to finance unproductive activities, particularly property which fuel dangerously unstable economic cycles and pose a burden to society (CRESC, 2009, pp40, 44; Turner, 2016, ch.10).

As a result many now argue that banks should be limited in how they create and allocate credit. Many argue that the state needs to limit fractional reserve banking by requiring radical more reserves or by having more of a role in determining where credit is to be allocated. Wolf (2014b, 2014c) suggests fractional reserve banking should be abolished altogether. Others advocate that we need more credit allocated into wealth generating capital investments to meet the needs of the real economy. For example, Kay, and also Turner, argue that as well as requiring banks to operate the payment system and allocative channel, what we really need them to do is to allocate credit to finance useful investments to generate the additional wealth needed to sustain and repay society’s debts (Kay, 2014, p299; Turner, 2016, pp61-‐63). They were not alone in calling for greater productive investment from banks. Whereas previously calls for the state to control or influence the direction of investment capital seemed anathema, the pendulum appears to be swinging the other way.

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Before the crisis, there was a widely held and firm belief amongst many popular commentators that unrestrained free market capitalism had irrevocably worked its way into every aspect of life (Perry, 2000; Klein, 2007; Pickett et al, 2009, Tisher, 2009; Mount, 2010). The political-‐economic consensus appeared to be intolerant of critics of free-‐market ideology and there was little place for those who advocated for greater state intervention in directing the creation and allocation of credit. After the crisis, however, there has been something of a political shift against neoliberalism and growing disenchantment with the economic status quo has been widely expressed not only through anti-‐capitalist protests and demonstrations such as the Occupy movement, but also through a range of popular commentary (Mason, 2015; Mazzucato, 2013; Jacobs et al, 2016) as well as parliamentary representatives.

Political parties of all colour have sought to market themselves to those ‘left behind’ or ‘just about managing’, promising to create an economy which works for all (the Guardian, 2017). Cameron’s aim to create ‘capitalism with a conscience’ (Elliot, 2009) has been pursued by the conservative party whose 2017 manifesto rejected free market capitalism clarifying ‘we reject the cult of selfish individualism..’ and ‘We do not believe in untrammelled free markets’ (Conservative Party, 2017). Recognizing a place for state regulation and the need to limit executive pay and asset-‐stripping by foreign investors, the Tories have promised to put workers first, even going so far as to suggest reforming corporate governance to give employees a place on the board of companies (Conservative Party, 2017). The Labour party, who have gained in popularity on a platform which promotes forms of nationalisation, have also promised to put workers first, and reign in excessive pay and the excesses of the City of London, as well as promising to create a National Investment Bank to promote more productive investment (Labour Party, 2017).

After the financial crisis, and the long period of no growth, free-‐market ideology thus appears to be losing ground. In this climate, the inevitability of free market forces that characterised Naomi Klein’s Shock Doctrine (2007) is far less apparent. It is not entirely certain that free market ideology will continue to determine how banks create credit and what activities they finance. Indeed, there appears to be far greater scope now than before the crisis for more radically intervening in banking by determining what activities we want banks to undertake and finance. This is unlikely to happen however as long as our law-‐makers continue to see the finance industry as a sort of national treasure which needs to be preserved in its own right rather than as a means to growing the real economy and an engine for growth which needs to be controlled.

The obvious implications from all of this are that we still need to go a lot further in clarifying what functions we expect banks to perform and which activities we expect them to finance more generously, and that question would be best resolved before addressing how banks are owned and regulated.

8.3.4 Reforms unrelated to ownership Notwithstanding the absence of clarity about what we want banks to do,

there are some broader lessons to be learnt from the empirical research unrelated to ownership. The clear lesson from the Nationwide appears to be that

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retail functions may be better performed, and banks themselves more resilient, when there is greater compartmentalisation and functional regulation. Such functional regulation would inevitably call for a more radical and interventionist approach from our regulators, not only in defining what we want from banking, but also in identifying and tackling the structural pressures which work against achieving such aims. There are reasons to believe that such radical interventionism may one day be feasible, and not only because of the changes in the political climate described above. The more radical approach of Dodd-‐Franks to functional regulation provides a useful precedent. If other regulators in other countries become more interventionist, the UK may follow suit. Also the failure of the Government’s ‘funding for lending’ initiative (Jenkins et al, 2013) also provides good reasons for trying to set explicit targets for regulating banks to achieve certain levels of funding for certain activities.

Whether or not we determine what role we want banks to play, it seems that some structural pressures will need to be tackled come what may. Without breaking up the strangle-‐hold the big banks enjoy on the retail banking market, for example, we are unlikely to weaken the structural pressures discussed in chapter 4, and in particular the growth imperative we witnessed for smaller banks such as the Co-‐op and the pressures driven by high cost and product market competition which encourage banks to become mimetic in their offerings and activities.

All of this would tend to suggest that we need to be more sensitive to the problems faced by new entrants and smaller banks, particularly those seeking to perform ethical and low yielding activities within retail functions. Whilst the Co-‐op was forced to acquire branches, the biggest banks that dominated the personal and SME account market were able to divest themselves of branches. That the big banks retain such competitive advantage over smaller banks in the retail market still appears to be unfair, and there are good reasons to suggest that competition regulation needs to go further to reduce the dominant position of big banks or alleviate the pressures suffered by small and ethical retail banks to mimic their less ethical peers. Had the CMA instead proposed ending the free-‐if-‐in-‐credit paradigm, or sought to impose limits on target returns on equity from certain utility functions it would no doubt have reduced pressures on banks to seek to deliver earnings and growth in unsafe ways. The growth imperative might also be reduced if access to the payment system could be provided on terms which are not biased in favour of bigger clearing banks, as was suggested by Philip Augur (2016).

As things stand, banks remain over-‐leveraged and too big to fail, endangering the taxpayer and putting unfair competitive pressure on smaller banks that do not benefit from the cheap borrowing rates available to these overly subsidised giants. Retail operations have not been properly separated from the rest of the riskier activities performed by banks. If we are to prevent banks from imperilling tax-‐payers in the future, the sector as a whole needs to be radically descaled, and broken up to allow for parts to safely fail without having to resort to the lender of last resort for a bail out. The obvious way of achieving that would be to break up and separate narrow and wide banking activities into separate entities and to put an end to universal banking. If that is not to be done, then we at least need to find ways of discouraging banks from leveraging

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themselves so significantly, as otherwise banks will always have incentives to become too big to fail.

The suggestions for banks to radically increase their equity (Admati et al 2012) or to radically increase their capital reserves paid up to central banks (Turner, 2016, ch.12) are sensible ways of discouraging banks from leveraging themselves so dangerously. The proposals of Mian and Sufi (Mian et al, 2014) to simplify property lending and Turner’s suggestions to regulate loan to value ratios also appear appropriate, as do proposals to introduce credit limits on certain lending activities (Turner, 2016, p176). As well as implementing greater capital requirements, and other tax reforms might also assist in descaling the banking sector. A credit intermediation tax for example similar to that initially proposed by Tobin might reduce transaction generation and thus likely reduce leverage. Other taxes might also be experimented with, especially taxes which end preferential treatment of debt over equity (Haldane 2012; Turner, pp191-‐192; Boon and Johnson, 2010) or even wealth tax (Picketty, 2014).

It is impossible to provide a comprehensive list of all of the reforms required to fix all of the problems in banking beyond ownership and to discuss their merits, here. The task of defining what functions we expect our banks to finance more generously, and how to go about regulating them to deliver such aims, are issues which really call for further study, particularly around the issues of capital reserves, leverage, separation of functions, and tax treatment. It would significantly exceed the scope of this thesis to attempt to treat such subjects or to venture further from the primary focus, which must return to the issue of ownership. What appears to be clear from the findings in this thesis is that we would likely benefit from more functional regulation spelling out more clearly what functions we expect banks to perform and regulating them with a view to addressing the structural pressures which work against banks meeting such expectations.

8.4 Part 3: re-‐thinking and re-‐designing ownership

8.4.1 Stakeholder stewards

In view of the above findings, it makes little sense to give shareholders all of the rights of control over banks. As Haldane (2015) commented in the quote set out at the start of chapter 3, it is erroneous to conceive of banks as being ‘owned’ by shareholders at all, and it is consequently wrong to treat shareholders as owners. Whilst shares themselves can be owned, banks themselves cannot, but are separate persons composed of a community of interests. And whilst shareholders contribute some capital to banks and take risks in doing so, banks tend to handle a lot more of other people’s money, who also run risks. The logic of having banks run entirely for the benefit of their shareholders, when they only contribute a tiny fraction of a bank’s assets and do not bare all of the risks, makes very little sense in this context. Instead, it is logical to think of them, as indeed Berle and Means did, as being ‘stakeholder’ or ‘ownerless’ institutions, subject to a community of interests. Once conceived of in this way, it makes far more sense to expect those who control banks to act more

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like trustees handling other people’s assets, or as professional bureaucrats stewarding assets in which society has some vested interests.

The main implication of this thesis is therefore that we need to stop thinking of banks as being ‘owned’ and shareholders as ‘owners’, and we need to devise ways of ensuring banks are run not only in the interests of shareholders but more broadly in the interests of other stakeholders. It is difficult to reign in ideas about ownership when banks are run for their shareholders who are given other rights to govern and control management. We therefore need to find ways to design the ownership model in order to limit the rights of shareholders and to make such rights consistent with their actual contribution, and less liable to conflict with the interests of other stakeholders. We also need to recognise that if we continue to have banks run primarily for shareholders, there are likely to be serious adverse implications in terms of their behaviour going forwards.

Fortunately, there are a plethora of ways of reducing shareholder rights and re-‐designing the ownership model. The obvious starting point would be to reform directors’ duties. One possibility is that suggested by the Parliamentary Commission on Banking Standards (2013b, para.708) namely to remove shareholder primacy in the case of banks and to expand directors’ duties to ensure the long-‐term financial ‘stability and soundness’ of the bank. Another possibility would be to pursue Mayer’s proposals (2013, p201) to create trustees within the board owing duties to promote and protect the corporation’s particular states values and principles.

Designing and experimenting with different corporate purposes and testing their governance and behavioural dynamics really calls out for a collaborative process requiring input from different fields of social science, including business, economics, law and perhaps also politics and accounting. It is not entirely clear which fields of social science would need to be engaged in such process, and the methodology would likely be disputed. Certainly it would be beyond the scope of this thesis to attempt to prescribe a singular type of reform or ownership design in order to fairly balance the different interests in banks and enable them to act in ways which meet our expectations of them.

The best that this thesis can perhaps attempt to do is to advocate for greater experimentation in looking for ways to reduce shareholder rights and make those who run banks act more like stakeholder stewards or trustees acting for a wider group of interests than just shareholders. In that connection, it is a shame that the PCBS’s recommendations for a government consultation about directors’ duties in banking (2013b, p344, para.708) has fallen by the way-‐side. A sensible opportunity for progress has been missed.

Changing the statutory duties of directors is not the only way of weakening the ownership paradigm, and there is plenty of scope for experimentation in ways of reducing shareholder rights and enhancing stakeholder rights. Options include : re-‐designing financial instruments to reduce the rights bound up in ‘shares’, or alternatively spreading about control rights by distributing them also to depositors, bondholders or those drawing salaries in companies, who might have employee representation on the board. Shares are already capable of being designed in ways which limit control rights. They can reduce control rights, for example, by having different tiers of shareholding with different associated rights. As Haldane pointed out (2015) there are already a

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plethora of ways of structuring and re-‐purposing shareholding so that shareholders or some classes of shareholders have fewer control rights.

Those shares with the most control rights, which could for example be called ‘tier 1’ or ‘trust’ shares could be held by specially-‐selected individuals, or groups, on trust either for the benefit of other stakeholders or for some defined purpose for example in accordance with explicit values or principles. In other countries, employee representatives hold a proportion of shares and have representatives on the governance board. In the case of banks, a proportion of shares might be held by employees who are tasked with regulatory compliance, or by other representatives, including those employed by or more closely affiliated with regulators such as the Bank of England. In such an example, ‘tier 1’ or ‘trust’ shares might be privately held and in other words incapable of being publicly traded, or they might be held for a certain number of years.

In the UK the Charity Commission already has supervisory and oversight powers not only for charities but also for other forms of community interest or social purpose companies. There is no reason why the ownership or transfer of such key controlling shares could not be more carefully monitored or controlled by the Commission or another public body which could be empowered to act as a check against the sale of such rights for short term profit and to ensure that those control rights are owned by parties who are well placed to exercise such rights in the long term interest of banks. Other tiers of shares might then be publicly traded but endowed with lesser control rights or time-‐limited control rights or rights which are suspended upon given events, for example such as where the Bank of England issues certain warnings. Different categories of shares might have different dividend rights for example with core controlling ‘tier 1’ or ‘trust’ shares having zero scope for yielding dividends and other tiers having limited or conditional scope for yielding dividends. Alternatively, shares might be accompanied not only with rights but also with liabilities for example to ‘bail in’ capital in determinate quantities in determinate circumstances when a bank is failing or risks failing. There is also good reason for experimenting further with conditional or contingent liabilities, ‘bail in’ shares or shares with limited rights.

In these different ways, the extractive capacity of share ownership might be reduced or abated over time and shareholder control rights could correspond more proportionately with the amount of contribution made and risk taken by them. Another way of re-‐designing the ownership model, or governance regime, might involve removing shareholders from the equation altogether. As Ireland (2008, 2009) and more recently Haldane (2015) observed, there is no logical or necessary reason why organisations need to be owned whether by external owners, or indeed members. Banks are social constructs which can be made in different ways (Haldane, 2015).

8.4.2 A properly ‘ownerless’ model This thesis has observed with particular interest, the special type of

stakeholder model which has no owners who can call for the proceeds of its business operations to be distributed. Those organisations operate not to benefit their members or outside owners but rather to serve their own predetermined

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purposes (Hansmann, 1981). Such genuinely ‘ownerless’ or ‘social purpose not-‐for-‐profit’ models have interesting potentially very positive behavioural implications for banks (Bøhren et al, 2013). By design, their assets and proceeds are ‘locked’ from distribution and must be applied to meet defined aims. In other words they recycle their earnings. Proceeds which would otherwise be distributed to owners, are thus available to be applied for further investment. In theory, therefore, an ownerless bank would be in a better position to serve the persons or purposes it aims to finance than a shareholder-‐owned bank, because it would not distribute profits, whether through dividends to shareholders or through compensation beyond reasonable remuneration to management.

In the UK, there are already plenty of legal forms of incorporation in which an ownerless model could be created. An ownerless bank could even be run through a regular limited company, provided its constitution was modified : to fix its social purposes; to preclude its shares from being traded or drawing dividends; and to preclude distribution of earnings to managers beyond what is reasonable remuneration. The Co-‐operative and Community Benefit Societies Act 2014 has created other forms of incorporation to assist in entrenching these aims. ‘Community Benefit Societies’ or ‘Community Interest Companies’ both afford opportunities to entrench an organisation’s social aims, and to prevent assets from being distributed to owners or to management, beyond what’s considered reasonable remuneration.

There are also plentiful examples of ownerless organisations in existence in the UK which are more akin to a trust or public institutions. There are also ownerless banks in other jurisdictions, including the Norwegian Sparkassen and the Spanish Cajas (Crespì et al, 2004; Bøhren et al, 2013), although as we explored in chapter 5, these models do not necessarily make for easy comparisons, at least in the case of the Cajas, as their own behaviour calls for investigation in its own right (Trenlet, 2012). There are also various public international organisations, such as the European Investment Fund and European Investment Bank, which also operate in ways which constrain distribution to their owners and allow them to recycle and dedicate their proceeds into meeting their entrenched social aims. More parochially, in the UK, the Charity Bank locks its assets from distribution, and applies them to invest in charities. There is also a social investment fund in the UK called ‘Big Society Capital’ which was set up in 2012 and capitalised with an initial fund of £600 million, which invests in to the ‘social sector’ (O’Donohoe, 2014).

Anybody seeking to design an ownerless bank might wish to consider these different examples. However, they are not the only, or indeed the best way, for designing an ownerless bank, and each of those examples pursues different purposes. The Norwegian and Spanish banks for example play a particular role in regional development rather than performing productive investment nationally (Bøhren et al, 2013). The European Investment Fund and European Investment Bank on the other hand are international organisations and are not fractional reserve deposit taking banks. They tend to prioritise infrastructural projects and raise money in capital markets by going into joint ventures with other financial institutions, rather than dedicating just their retained earnings (Lankowski, 1996). Similarly, the Charity Bank and Big Society Capital are not deposit-‐taking fractional reserve banks. The former pursues extremely social aims by assisting mainly charities and the latter is partly externally owned with

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40% of its shares being owned by four of the high street banks namely Barclays, HSBC, RBS and Lloyds (O’Donohoe, 2014).

Any attempt to design an ownerless bank would need not only to find ways of restraining assets from distribution, but also to entrench the bank’s purposes. Following on from the above discussion, and that in chapter 4, Kay’s list of banking functions might provide a helpful starting point. According to Kay banks perform socially helpful functions in allocating financial capital to meet the borrowing needs of households and businesses, helping them to understand financial risks and manage their finances across life-‐cycles as well as providing productive investment to meet the needs of the real economy (Kay, 2015, p299). All of these activities involve handling other peoples’ money in often routine transactions, where an absence of incentives for risks might foster more prudence care and trust. Certainly, there appears to be a perceived funding gap in terms of productive investment, with many commentators and politicians calling for greater investment in wealth generating enterprises (Turner, 2016; Eaton, 2012; Elgot, 2016)

Whatever expectations and purposes we decide upon, in order for banks to be able to deliver upon them, particular attention will need to be paid to the cost of capital. Unlike a PLC any ownerless bank would be limited in its ability to raise capital from the issue of regular equity. Any new bank would thus need to have sufficient capital, or access to capital, to be insulated from the problems which surfaced in the case of the Co-‐op. Since retail banking still requires costly high street branches, an ownerless bank might need to be capitalised initially with sufficient own resources to have a sizeable share of the current account market. Alternatively, other ways of providing access to capital could be explored. Our national government might consider pledging capital to such bank, as was the case with the EIB (Lankowski, 1996).

Alternatively, we might allocate funds from redundant bank accounts, as currently flow into Big Society Capital (O’Donohoe, 2014), or we could allocate capital from other redundant sources such as those which currently pass to the state bona vacantia when a person dies without any next of kin or will disposing of their assets. Alternatively, the state might explicitly guarantee the performance of our new bank’s obligations, as the Nordic states do with the Norwegian Investment Bank, thus enabling the bank to access cheap capital (Nordic Investment Bank, 2017). The Bank of England might provide preferential lending as a quid pro quo for dedicating its proceeds or parts of its proceeds to providing productive investment in the real economy. Alternatively, it might seek to raise equity by offering limited returns, as experimented with by the equity issue granted by the Nationwide (Nationwide, 2017).

Creating any new bank would likely encounter significant political obstacles and require significant political will. In the current conjuncture, it may be infeasible to convert all of the UK’s retail banks into ownerless banks, but significantly more feasible to convert those banks which have to be bailed out or nationalised in the future. Certainly, to provide for that eventuality if nothing else, there is good reason to engage in further discussion and experimentation about creating more ‘ownerless’ forms of banking, to remove or reduce shareholder rights and to spread oversight and control rights around to others who are better placed to ensure they behave more responsibly and invest more productively.

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8.4.3 An ownerless National Investment Bank

It may also be feasible to create the national investment bank which is currently proposed by the Labour Party in a form which is ownerless. Recent leaders of the Opposition, including Ed Miliband, Jeremy Corbyn, and the leader contestant Owen Smith, have all proposed creating a national investment bank to undertake more productive investment (Eaton, 2012; Elgot, 2016). In the current environment of low growth, it is entirely feasible that political will for creating such bank may bear fruit. Such banks have fared well in other countries. In Germany, the state-‐owned KfW development bank is still serving its post-‐war purposes and making considerable productive investment to this day (Carrington, 2012), and in Scandinavia, the Nordic Investment Bank operates across various states to make investments into businesses (Skidalsky et al, 2011).

If such a bank were created in the UK, there would be good reason to design its ownership model in a way which locked its assets from distribution and dedicated them to investment purposes. Indeed, unless such a bank were created in this way, its purposes might be compromised by extractive demands of shareholders, as was the case with the last national investment bank created in the UK, and more recently the case with the Green Investment Bank (Kollewe, 2017).

In his critique of shareholder governance, Meyer (2013, pp132-‐135), explored the case of the ICFC which later became known as 3i, and the reasons for its changing role. Following the great depression, in 1931, the Macmillan Committee proposed the creation of the Industrial and Commercial Financial Corporation (ICFC), which was eventually created after the Second World War. Keynes, who sat on the committee, was a prominent advocate for a new bank to perform productive investment. Set up in 1945, the ICFC was capitalised with £15 million and charged, as its namesake suggests, with the purpose of providing productive investment to small industrial and commercial businesses. A sister fund was also set up also in 1945 called the Finance Corporation for Industry, with the purpose of providing finance for larger industrial companies. Both were intended to plug what was called the ‘Macmillan gap’ namely the lack of sources of capital for medium sized firms which banks were failing to provide.

Those funds were not designed to be ownerless. Their constitutions did not entrench their aims in irrevocable ways, nor constrain their shares from being traded and their assets from being distributed to outsiders. Eventually, its shareholders sought to raise more equity and floated the company on the stock market. Having merged with its sister company in 1973, eventually becoming ‘Finance for Industry’ the company floated on the London Stock Exchange in 1994. Following floatation, it then changed its name to 3i, and was ran for the benefit of its shareholders who themselves were typically interested in profitably trading its shares, 3i moved away from pursuing productive investment. Having become more value driven, it shifted into more profitable activities. Since the 1980s, and leading up to its floatation, the firm became increasingly involved in private equity, and financing management buyouts, in other words funding corporate raiders in their endeavours to take over other

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companies. The organisation which should have been value creative ended up operating in the market for corporate control, effectively disciplining the management of other companies to work more efficiently for the benefit of their own shareholders.

Some argue that the UK Green Investment Bank is likely to go the same way (Kollewe, 2017). Having been mostly sold to external investors, many fear that its green agenda will be undermined by more profit-‐oriented aims. Time will tell whether the retention of some shares by government suffices to protect and promote those greed aims.

These precedents provide cautionary tales for those who create any new National Investment Bank. If societally important functions are to be protected from ownership pressures, such bank would do well to be designed with an ownerless model. Had the ICFC been less dependent on equity for investment, for example had it been endowed with more capital, or licenced to act also as a fractional reserve bank to also take deposits, or indeed given the benefit of redundant assets such as those in dormant bank accounts, or perhaps some of the assets which pass bona vacantia, it might have still served its original aims of productive investment today. Instead, however, its assets were not protected from distribution, and it was able to distribute its proceeds and cede control to those in whose interest it was eventually run for. Had the ICFC been ownerless over time, without distributing proceeds to members, it may well have grown in size and economic power and might have been in a better position to offer finance for productive investment.

8.4.4 Encouraging responsibility Ownerless banks also pose benefits in terms of enhancing standards.

According to Hansmann (1980, 1981, 1988) having no scope to distribute surplus proceeds to outsiders, and being required to apply such proceeds to meet its aims, the not-‐for-‐profit model puts a check upon profit-‐seeking incentives and is a recipe for more responsibility. Without incentives for irresponsibility there is arguably less need for external regulation and potentially also scope for cultivating better standards from counter-‐parties.

At present, as we explored in chapter 4, the responsibility for promoting public good is not placed within the sphere of private institutions, and it seems almost inconceivable therefore that banks might ever work to enhance standards within those they have dealings with. As we observed at 4.1, following the Big Bang, banks become increasingly responsible for serving their private interests and less responsible for the morality of their behaviour which tended to be externalized. This predicament resulted in what Luyendijk called a culture of ‘amorality’ within banks and led to inevitable failure as regulators, whose job it became to police against bad behaviour, faced an impossibly difficult task. Run purely along private lines for extraction, our current banks are largely absolved of responsibility for their actions – anything goes, provided what they do is not illegal, or not likely to be caught (Luyendijk, 2015). Banks do not have incentives to behave themselves, let alone to encourage better behaviour from their counterparties.

If banks were purpose-‐built to perform socially beneficial investments with their assets being locked and dedicated to meeting those purposes there

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would potentially be scope to condition better behaviour from those they invest in by requiring them to respect certain rights or undertake and honour certain obligations. Indeed, freed from extractive ownership pressures large international banks, such as the European Investment Bank, already practice a form of loose conditionality, not only by vetting the social and environmental practices of those they invest in (many of whom are outside of the EU) (Lankowski, 1996), but also by extracting contractual agreement from such borrowers to abide by the acquis communautaire, and in other words to abide by the entire gamut of EU social, environmental and employment protection legislation (Wilkinson, 2005). Although in practice, such clauses are not enforced in private law by the EIB, in theory they could be, and it is not impossible to imagine a world where our future financial institutions are owned and organised in such ways that they are so limited in pursuing their own self-‐interest that they instead seek to use their economic power for public good by conditioning better behaviours in those they invest in.

8.5 Part 4: evaluation and contribution The inquiry made in this thesis was really motivated by an interest in

Hansmann’s claims (1980, 1981, 1988) and in particular the idea that banks might behave more responsibly and invest more productively if they were not run for shareholder-‐value, but were instead run as social purpose non-‐profits. The idea of having an ownerless bank recycle the proceeds of its investments and continually apply them to making productive investments whilst fascinating appeared to be unexplored by the official response to the global financial crisis, which lacked any will to challenge or even question the existing ownership paradigm, and seemed intend to assume that banks should be treated, at least notionally, as if they were owned by their shareholders.

We have since witnessed how the banking reform debate has moved on and how what were previously marginalised criticisms of shareholder-‐value banking have moved more into the mainstream. As we witnessed in part 4 of chapter 3 (3.5), there is now a nascent but important branch of corporate governance literature which appears to be growing in influence and which is critical of the ownership paradigm at least in banking. Whereas previously the balance of opinion seemed to weigh strongly in favour of shareholder-‐value governance and across the spectrum whatever the industry of activity, after the crisis, at least as far as banking is concerned, the scales seem to have tilted. Significant inroads have now been made into exposing the illogicality of having banks run as if owned by their shareholders and the political-‐economic consensus appears to have weakened both on the micro-‐level where shareholder-‐value banking has been criticised even by central bankers such as Andy Haldane, and also on the macro-‐level where the wisdom of leaving credit-‐allocation to free market forces has been questioned by former regulators such as Turner (2016) or prominent commentators such as Wolf (2014c).

The implications of this thesis speak to those two issues : how companies are and should be owned and governed, and what we as a society need from them. The conclusions are that banks should be treated not as if owned by their shareholders but in a way which is more consistent with the reality that banks create and allocate huge amounts of credit and as a society we have a vested

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interest in ensuring such credit is allocated in helpful and not harmful ways. It is hoped that the thesis might add to what is now a growing and important body of literature which is both critical of shareholder-‐value banking, and which is keen to reform banking to ensure that the credit it creates and allocates is directed more usefully into productive investment.

It is also hoped that the means of diagnosis as well as the prognosis might prove of relevance and use to others. The taxonomy employed by this thesis deliberately emphasised the concept of ‘ownership’ in preference to other more exacting terms such as ‘shareholder value’ or ‘governance’. Whilst the latter may have been semantically more accurate in describing governance phenomena, the former is more emotive and helps to emphasise one of the key implications of the thesis namely that we need to try to find ways of structuring and regulating banks which recognise that banks are not in fact owned by shareholders. This thesis chose to refer to the ‘ownership model’ rather than the ‘governance regime’ and to employ the semantics of ‘ownership’ because such terminology was useful shorthand and also provided a conceptualisation which helped to emphasise the illogicality of treating shareholders like owners.

As well as adopting the language of ‘ownership pressures’ and ‘ownerlessness’, the thesis also described the pressures arising from the market environment within which banks operate as ‘structural pressures’. This term was not employed as a means of encapsulating all other phenomena which might impact upon bank behaviour under one heading. Rather, it made conceptual sense to consider external pressures arising out of the space and environment within which banks operated as such factors were logically distinct from internal pressures arising out of the way the governance structure regulates how banks are ran. This terminology might be criticised as lacking in precision and it might also have required repeated exemplification and illustration throughout the thesis. But, it was nevertheless useful as a way of conceiving of other influences on bank behaviour. It is hoped that this kind of conceptual distinction and use of terminology might prove useful for others in distinguishing governance and ownership issues and as a means of conceiving of and exploring the other dangers, limitations and opportunities arising in the market and regulatory environment within which banks operate.

8.6 Conclusions

Until now, the halo which was constructed around finance following the Big Bang has made it difficult for politicians to resist the demands of the finance industry. This has meant that the reform package implemented in the UK has preserved the City as a sort of protected national treasure, rather than seeking to fix banking to make it serve the economy’s needs. As the economy proves increasingly prone to low productivity, short-‐termism, and the problems of boom and bust, there may well be greater willingness than before to contemplate more radical ways of making banks behave more responsibly and invest more productively. Those seeking to dislodge neoliberalism and replace it with an economic system which creates and redistributes wealth more sustainably and equitably may have more political opportunity to do so now than before the crisis.

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Despite Government claims that the banking reform agenda has come to an ‘end’ (H. M. Treasury, 2015), the debate about how to reform banks still continues. There is now increasing willingness to criticise the structural and ownership paradigms entrenched since the Big Bang and to look for ways to make banks serve our broader economic needs. Where banking reform goes from here has reached something a cross-‐roads: we can continue along the same path opened up by the neoliberal agenda, championing the City of London as a key industry in itself, and trusting free market forces to determine how credit is created and allocated; or, the state can take more control of credit-‐creation and allocation by determining what sectors and businesses are to be financed more or less generously; or, we might take the middle path by being more watchful of the City’s credit-‐creation, and at the same time take steps to ensure there is greater investment into wealth producing activities for example by creating a National Investment Bank, as proposed by the Labour Party.

Whichever route is taken, ‘ownership’ still matters. If we want to address the fundamental structural incentives which drive bad behaviour and which encourage credit to be allocated in harmful or unhelpful ways, then the underlying ‘ownership’ problem needs to be tackled. Fixing ‘ownership’ will not necessarily ensure that credit is allocated sustainably where needed in the economy and it will not be the only reform needed to ensure that banks behave themselves. But the findings of this thesis strongly suggest that this is nevertheless a necessary reform, which still needs to be made. Whether or not we see the finance sector as an essential engine for economic growth, as a means to an end rather than a protected industry in itself, we need to address the ownership dynamic which appears to be driving much of the dysfunctionality and irresponsibility in banking. External regulation is unlikely ever to be adequate in ensuring responsible behaviour and helpful productive investment if at the same time as policing against misbehaviour banks are given incentives to act in reckless, exploitative and self-‐serving ways.

In whose benefit banks are run, is thus something which needs to be re-‐visited and re-‐vised. We need to arrest all notions that banks are owned by their shareholders. They are not. And we need to modify the requirement that banks should be run primarily in their interests, because that arrangement is liable to jeopardise other interests which need also to be protected. We instead need to be far more experimental and creative in exploring ways of making banks act more like stewards or trustees administering assets in which we all have some vested interest.

As was explored above in 8.3 and 8.4, there is not only increasing willingness to contemplate more radical ways of making banks behave more responsibly, but there are also a range of options for tackling the ownership problem. As well as re-‐defining in whose interest banks are run, a whole host of other initiatives could be explored including : drawing up the blueprints for converting into an ownerless banks any bank which is nationalised in the future; or designing an ownerless model for any newly created National Investment Bank, such as that currently proposed by the Labour Party. If the examples of the Green Bank and 3i are not to be followed, any National Investment Bank which is created, would do well to have an ownership model which protects it from shareholder governance and which enables it to dedicate its assets to productive investment and to entrench such purposes.

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Whilst truly ‘ownerless’ models remain untested in the arena of UK banking, there appears to be every reason for trying to experiment with them, especially since there is considerable scope in banking for assets to be dedicated for investment in socially desirable ways. Indeed, the idea of having an ownerless bank constantly recycle the proceeds of its investments into further productive investments, may well form a component of some new economic system seeking to create and redistribute wealth more sustainably than under the current neoliberal order.

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