BankingFutures Consultation Document by Meteos

BankingFutures Consultation Document An Invitation to Rebuild a Healthy Banking Sector for the UK

Leadersâ&#x20AC;&#x2122; Quest is a social enterprise that works with global leaders from all sectors to create a more inclusive and sustainable world. We are passionate about the role of business as a force for social good â&#x20AC;&#x201C; alongside delivery of financial performance. Through our work, we challenge and support individuals to explore purpose and implement meaningful change in their organisations. Meteos is a not-for-profit company that undertakes cross-sector, multistakeholder dialogues. Our dialogues, focused on finance, health and the environment, provide a forum for senior figures in the corporate sector, civil society, public sector and investment worlds to share different perspectives on the major trends that will shape market, regulatory and societal outcomes in coming years.

Executive Summary n UK banking is undergoing a process of profound reform, which offers a unique opportunity to undertake a systemic rethink about what society wants and needs from our banking sector. n Leaders’ Quest and Meteos have convened thoughtful, principled bank leaders with investors and sector experts to catalyse a vibrant public consultation on what is needed to rebuild a healthy UK banking sector. The BankingFutures Group* has produced this public document of its initial conclusions for consultation with all banking stakeholders. n The Banking Futures consultation document will be the subject of roundtable discussions from June to October 2015, to bring in additional stakeholder views. The process will culminate in the publication of a public report in December 2015. n The roundtable dialogues will largely be focused on two fundamental underpinnings of any country’s financial system: the appetite for risk within the system, and how value generated by the banking sector should be measured and distributed.

Introduction from Leaders’ Quest and Meteos The UK banking sector is undergoing a process of profound reform designed to de-risk the banks and address serious and egregious misconduct. This reform process offers a once-in-a-lifetime opportunity to undertake a systemic rethink about what we want from our banking sector. A healthy banking sector is critical to address today’s economic challenges, while supporting government commitment to other initiatives, including protection of society’s most vulnerable members and de-carbonising the economy. Defining this healthy banking sector is a collective responsibility and gives rise to the need for vibrant public debate. To this end, Leaders’ Quest and Meteos have convened a group of senior banking insiders, investors and sector experts to catalyse and support a process of public consultation. The banking sector has a tremendous amount to do before it regains societal trust. It is important, however, to recognise that reform is a cultural challenge as well as a regulatory one. Cultural change cannot be imposed from the outside and requires the buy-in of all stakeholders, including the leadership of banks now and in future. It is therefore important to engage thoughtful, principled bank leaders in debates about how to restore a safe and stable financial system. The BankingFutures Group has produced this document as an invitation to engage in debate about the nature of the banking sector the UK wants and needs. It summarises the perspectives of a group of banking insiders and as such reflects their concerns and focus, though it should be noted that they were not always in agreement with each other. But this is only a starting point. The document is an invitation to others to bring their perspectives to the table. It will be the subject of a number of roundtables held for, and in partnership with, bank stakeholders from June to October 2015. Based on these consultations a final document will be produced before the end of 2015.

* The BankingFutures Group is made up of senior bank executives, institutional investors and banking experts, participating in a personal capacity. While members fully support the objectives of the initiative, they do not necessarily endorse all the views and conclusions expressed in this document. See Participant List in the Appendix.

Request for Engagement from the BankingFutures Group We, the BankingFutures Group, believe that banks exist to serve the economy and acknowledge the need to reintroduce and firmly reinforce this sense of purpose. We recognise that the financial crisis of 2007/8 – in which the banking sector played a pivotal role – was at the expense of social value. We are grateful for the role British taxpayers played to support the financial system at that time of crisis. We understand that societal expectations of banks have recently changed irrevocably, and that we need both to adapt bank culture and improve conduct in response to this new reality. We are committed to bringing our own individual leadership to bear on those parts of the system we can influence now and in the future. We fully acknowledge the role played by the banks in the 2007/8 financial crisis, but because we believe the underlying causes to be systemic, we understand that we cannot solve these problems alone. We are committed to working constructively with the architects of reform – and particularly regulatory authorities – in their efforts to inclusively rebuild a healthy banking sector. Consequently, we invite other stakeholders in the financial system – including bankers, investors, regulators, government, customers, civil society and academics – to engage with us in a public consultation about what we collectively want for the UK banking sector. The BankingFutures Group

The Background to BankingFutures Eight years on, the consequences of the most recent financial crisis continue to unfold. Though the exact cost is impossible to quantify, in 2010 the Bank of England estimated that solely in terms of output loss to the world, it represented up to US$200trn.ii The impacts of reforms to protect society and prevent such a crisis ever happening again are also becoming clearer. The British banking sector is changing, and perhaps irrevocably. The financial crisis in the UK led to a wholly understandable and rapid response by regulators to try to ensure taxpayers would never again be on the hook. Initially the regulatory focus was on the reduction of total risk in the sector. A second wave of regulation focused on conduct and included bank

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fines for a range of crimes and transgressions and the introduction of criminal liability for institutional failure. The reform agenda is seeking two things: for banks to take less risk, and to share more value with society. The BankingFutures Group supports both of these objectives. The process of sector reform is also giving rise to fundamental questions about what kind of banking system the UK needs.

The Fundamentals – Value Generation and Distribution, and Risk Profile The BankingFutures dialogue is an invitation to join the discussion about what a healthy banking sector in the UK looks like and how it should serve customers and wider society. To help define this requires stakeholders to come to mutually

acceptable understanding and agreement on two fundamental underpinnings of any financial system: how value generated by the banking sector can be understood and measured and how it should be distributed amongst stakeholders; and the risk profile the UK wants its banks to have. To understand how value generated by banks could and should be distributed is complex. After the financial crisis, many argued that the banks and their investors had disproportionately benefited at the expense of others. In response, BankingFutures is proposing a rethink on the entire subject of how value from the sector is generated, measured and then shared amongst customers, shareholders, taxpayers, Inland Revenue, society and employees. The document outlines a number of questions that could help with

this definition, and with how transparency and accountability on value can be improved. The need to understand the risk profile the UK wants its banks to have is also complex. The risk appetite of banks has implications both for individual depositors and more significant risks to the financial system, resulting from cumulative risk profile of the sector as a whole. Understanding risk is made more urgent because it is already rapidly dispersing across the financial system. As banks reduce their exposure, leverage is moving into other institutions (e.g. insurance companies, asset managers) and unregulated new areas of shadow banking. As before the crisis, it is important to recognise who is carrying risk and what is their ability to understand and manage it. Given the size of the banking sector relative to the rest of the British economy, it is important to understand the macroeconomic risks and benefits to the economy of international banking services, and what these mean for other bank stakeholders. The document explores these risks and poses a number of questions designed to help unpick the UK’s risk appetite.

A Healthy Banking Sector in the UK The BankingFutures Group believes a healthy banking sector in the UK should be capable of performing multiple functions with honour and probity. These include services to retail customers: financing

of mortgages, provision of payments services, helping people to plan pensions and travel abroad for work and holiday. It would also continue to place greater emphasis on providing services to small and medium-sized enterprises. It would extend financial services to people underserved today, and accelerate the transition to a low-carbon economy. A healthy banking sector would also permit the UK to continue to occupy its dominant place in the global financial system, with a banking system that operates worldwide, and where the UK regulator retains an important seat at the international regulatory table. It would do so in a way that is appropriately de-risked. In a healthy banking sector, leadership would prevail over a culture focused on the purpose of the sector to serve the real economy over the long term. Relationships with customers would be characterised by banks upholding a duty of care through the provision of products, services and advice. Relationships with regulators would be respectful, open and transparent. The sector would attract investors seeking stable and attractive capital returns over the long term. It would be held to account by a population with higher levels of financial literacy.

Kick-Starting the Debate – Areas of Contention The BankingFutures Group sees it as reasonable and

necessary to deal with the risks that emerged during the financial crisis. Given its definition of a healthy banking sector for the UK, the Group is concerned about the changing profile of the UK banking sector to a more regulated, domestic industry. It is concerned about the effect on the economy of the potential loss of international banking services in the UK. Other stakeholders, however, believe this change to have created a safer banking system which is worth any such losses. This divergence of views warrants serious and public discussion. The BankingFutures Group is apprehensive that reforms designed to improve conduct and address incentives – particularly the Senior Managers Regime – are disincentivising qualified people from assuming or remaining in senior leadership roles in banks – particularly Non-Executive Directors. Others believe these specific measures to govern conduct to be wholly necessary, and furthermore that the substantial remuneration changes have not gone anything like far enough. This too merits debate. The Group is worried about what they perceive as a failure to evaluate which reforms are proving effective before introducing others, as well as cumulative regulatory overload. Others believe this is simply the banks resisting regulation, and some even argue that bankers are happy with the reforms because they constitute a barrier to new entrants. Finally, the Group has some concerns that some reforms may prevent shareholders from

getting enough information to understand the capital position of banks. Others see the same reforms as appropriately addressing conflicts of interest within the asset management industry. All these points are worthy of dialogue. These points of divergence â&#x20AC;&#x201C; and others which will be raised by stakeholders in the course of the consultation â&#x20AC;&#x201C; are exactly what the roundtables are designed to explore, and

are part of the balanced and public debate needed to inform the rebuilding of a healthy banking sector.

The Transition To demonstrate its commitment to action, not just words, the BankingFutures Group identified some steps that could be taken to transition to the banking model described above, which ideally would be spearheaded by Treasury-led government policy

that defines a viable long-term economic strategy for the UK: 1. The introduction of an active programme of public engagement in defining risk appetite and value distribution. 2. A commitment to take active steps to simplify and reform remuneration. 3. The creation of a Cross-Banks Ethics Group. 4. The introduction of cultural performance metrics.

Conclusion BankingFutures invites all stakeholders to engage in this project. This document seeks to provoke an informed and respectful discussion about what we, as a society, need from the banking sector amongst the widest possible range of stakeholders. We believe this informed perspective provides us with our best chance of achieving the outcome we all need. Please join the conversation.

Leaders’ Quest and Meteos Introduction The UK banking sector is undergoing a process of profound reform, driven by a desire to ensure that the British taxpayer is never again called on to provide emergency scaffolding for a collapsing financial system.

The social consensus in support of bank reform offers an opportunity to de-risk the banks and to address serious and egregious misconduct. And it goes further. The appetite for reform also provides a once-in-a-lifetime opportunity to provoke a systemic rethink about what we need and want from our banking sector. BankingFutures is designed to grasp that opportunity. It is co-convened by two not-for-profit entities, Leaders’ Quest and Meteos, seeking to bring to bear their skills and experience to facilitate a holistic, systemic and balanced dialogue on how to rebuild a healthy UK banking sector.

We are doing this because of the vital importance of the banking sector to the real economy. Eight years on from the financial crisis, the UK economy remains weak. Despite a return to growth, gradual increases in earnings, rising employment levels and household consumption, vast challenges remain. Productivity remains perplexingly low; earnings rises are not flowing through to the under-30s; and inequality in Britain is the worst in Europe. A healthy banking sector is critical to address these economic challenges, while simultaneously supporting government commitment to a number of other important initiatives, including protection of society’s most vulnerable members and de-carbonising the economy. Defining this healthy banking sector is a collective responsibility. At present, plans for reform are well-rehearsed by regulators, by banks and in the financial media. To address the systemic causes of the crisis, however, requires more.

Despite the huge responsibility of the banks, they were not alone in causing the crisis. Investors, regulators, policy-makers and customers all played a role. A systemic solution to the banking crisis needs to address the roles of these others, as well as the bankers. Second, there are communities and issues that remain underserved and under-represented in current debates. It is important that reformers take steps to encourage their active representation. Finally, although the scale of the crisis and the depth of its economic consequences have had the effect of de-legitimising bankers from contributing to its solution, it is important to recognise that reform is as much a cultural challenge as a regulatory one. Cultural change cannot be imposed from the outside – it needs the buy-in of all stakeholders. This includes the leadership of banks now and in future. Yet, while the sector is feeling so besieged there is little incentive for thoughtful, principled leaders to lift their heads above the parapet to engage in this debate. The absence of the perspective of experienced bankers in attempts to restore a safe and stable financial system could have unintended and potentially damaging consequences for the design of policy and regulation, and – in the long-run – for the wider economy. The consequences of this would be a disservice to the society the system is there to serve.

This impasse must therefore be broken. There are risks involved in the engagement, but any reputational concerns should pale into insignificance in the face of the greater risk of presiding over a restructured system that is not fit for purpose. Reform that does not draw on the expertise of progressive, experienced bank executives is unlikely to be any more durable than a solution that does not understand the needs of vulnerable customers or which fails to tackle long-term challenges such as climate change. To catalyse debate about a healthy UK banking sector, Leaders’ Quest and Meteos have convened the BankingFutures Group of senior bankers, investors and sector experts. The Group is a self-selecting group of forward-thinking individuals committed to contributing to positive reform and willing to engage with critics and stakeholders of the sector. They participate in a personal capacity.

Over a period of 12 months, the Group has met to develop this document, which is designed to kick-start a process of public consultation. As a diverse group, its views were not always aligned. It did not, for example achieve consensus on how to approach executive compensation. Despite this, the document is the product of the sort of collaboration, healthy debate and mutual respect that we will seek to repeat in upcoming stakeholder roundtables. The document is structured as follows:

n Introductions: Project Convenors and Request for Engagement from the BankingFutures Group n Section One: The Background to BankingFutures – The Financial Crisis and its Regulatory Consequences

n Section Two: The Fundamentals - Value Generation and Distribution, and Risk Profile n Section Three: A Healthy Banking Sector in the UK

n Section Four: Kick-Starting the Debate – Areas of Contention n Section Five: The Transition – Progress Milestones

The consultation document is an invitation. It will be the subject of a number of roundtables held for and in partnership with bank stakeholders from June to October 2015. Having tested its ideas and assumptions, the BankingFutures Group will respond by producing a revised version of the document and incorporating lessons they have learnt into their work practices. Our intention is to produce the final version before the end of 2015.

Sophia Tickell and Anne Wade Co-Directors, BankingFutures

Request for Engagement from the BankingFutures Group We – the BankingFutures Group – are a group of senior individuals from some of the largest banks present in the UK, experienced fund managers, and governance and sustainable finance experts.

We recognise that the banking sector has unique and special responsibilities given its pivotal role in the economy over the long term. We believe banks exist to serve the economy and we acknowledge the need to reintroduce and firmly reinforce this sense of purpose. We affirm the importance of delivering shareholder value, but believe the focus on short-term returns to have failed to deliver this outcome. Furthermore, we recognise that the financial crisis of 2007/8 – in which the banking sector played a pivotal role – was at the expense of social value. We acknowledge and are grateful for the role British taxpayers played to support the financial system at that time of crisis. As a result, we understand that societal expectations of banks have recently changed irrevocably, and that we need both to adapt bank culture and improve conduct in response to this new reality. We hope to make a unique contribution to other initiatives on banking reform by seeking collaborative solutions to the challenges that continue to face the financial sector. We believe these challenges to be systemic. Although we fully acknowledge the role played by the banks in the 2007/8 financial crisis, we believe other factors – investor demands, loose regulation and monetary policy, accounting changes and customer behaviours and expectations – also created the conditions for what happened. In seeking a systemic approach difficult challenges facing the sector must be tackled. The issues of executive remuneration and culture, in particular, need to be addressed to rebuild trust.

We are committed to bringing our own individual leadership to bear on those parts of the system we can influence now and in the future. At the same time, because we believe the problem to be a systemic one, we understand that we cannot solve these problems alone. We are committed to working constructively with the architects of reform – and particularly regulatory authorities – in their efforts to rebuild a healthy banking sector in ways that involve people from all parts of the system. Consequently, we invite other stakeholders in the financial system – including bankers, investors, regulators, government, customers, civil society and academics – to engage with us in a public consultation about what we collectively want for the UK. The BankingFutures Group

The BankingFutures Group is made up of senior bank executives, institutional investors and banking experts, participating in a personal capacity. While members fully support the objectives of the initiative, they do not necessarily endorse all the views and conclusions expressed in this document. See Participant List in the Appendix.

Section One The Background to BankingFutures The Financial Crisis BankingFutures takes place at an important moment. Eight years since the most recent financial crisis began, its consequences continue to unfold. Although the exact cost is impossible to quantify, in 2010 the Bank of England estimated that solely in terms of output loss to the world, it represented up to $200trn.ii For the UK alone, it is estimated to have led up to £7trn in lost output.iii It wasn’t until 2014 – seven years after the crisis first hit – that the British economy grew to its pre-crisis size.iv The causes of the crisis were systemic. They were driven in part by what turned out to be over-confidence in the ability of the market to assess and manage risk, and right itself accordingly; and in part by changes in culture and management in the banking sector. The move to universal banking, coupled with a surge in global liquidity, afforded far greater institutional appetite for the origination, distribution and holding of risk assets. This coincided with the advent of unprecedented modelling and structured finance capabilities, which contributed to changes in perception, distribution and management of risk across the system. In turn, this exacerbated a cultural sea change already

taking place in the sector towards an intense focus on profits at the expense of more traditional risk management. On the wholesale side, traditional banking activities were brought into the trading room, while in retail, banking products were treated as commodities to be insistently marketed to the public, sometimes without due care as to purpose and suitability. Furthermore, a low interest rate environment and adjustments to compensation structures and levels, combined with these changes to transform banks’ strategies. The traditional ‘buy and hold’ approach was replaced by an ‘originate and distribute model’,v which played a significant part in the deterioration of underwriting standards and asset quality. Bank boards, executives, regulators, academics and investors became increasingly convinced that risk could be sliced up and managed in such a way as to radically diminish its impact, while insufficient attention was paid to those voices urging prudence. Monetary policy also played a significant role; arguably being too lax in the run up to the crisis and too tight as it unfolded. And while easy access to credit was good for governments wanting to counter income inequality and encourage home ownership;

for a public happy to reap the rewards of cheap credit; and for investors also seeking to disguise risk and benefiting from staggering returns, there was little pushback. The end result was a huge, opaque and poorly understood build-up of risk and who held it. Despite the systemic nature of this risk, in the ensuing crisis it was poor behaviour at a number of institutions, the high pay of individual bankers, the belief that banks had ‘optimised’ the system, and their apparent lack of accountability that led to the perception that the catastrophic economic consequences for millions of people was disproportionately the fault of the banks. Society demanded that something must be done.

The Regulatory Consequences… The result was a wholly understandable and rapid response by regulators to try to ensure that taxpayers would never again be on the hook. In the UK, the initial regulatory focus was on reducing perceived total risk in the banking sector. This meant the introduction of new liquidity, capital and leverage requirements, increased depositor insurance, measures to ensure banks are better placed to absorb losses, and measures to restructure the

banking sector. This has not only reduced risk for taxpayers, it has also shifted risk to investors, particularly as they are uncertain as to the regulatory end point of incoming legislation. This has led to a higher cost of capital for banks. A second wave of regulation has focused more clearly on longer-term structures to support bank resilience. Efforts include introducing ring-fencing of ‘core banking activities’ (retail and commercial) from investment banking activities, holding senior executives to greater account, and focusing on incentives. Conduct moves have included bank fines for a range of crimes and transgressions, some of which took place after the banks had been bailed out and problems were known; including the rigging of Libor, foreign exchange market manipulation, and mis-selling of Payment Protection Insurance. It has

seen the introduction of criminal liability for institutional failure and the Senior Managers Regime (SMR) – which holds senior bank executives and some senior non-executive directors to a ‘Presumption of Responsibility’, and demands evidence of oversight to show that ‘reasonable steps’ have been taken to prevent, stop or remedy breaches. These combined measures are seeking to reintroduce clearer responsibility, greater accountability and good conduct at the heart of banking. They form part of on-going Recovery and Resolution Plans designed to allow the regulators to understand recovery plans if a bank is at risk, and how the banks propose to resolve problems if those plans are not deemed adequate. Ultimately, they are designed to contain the consequences of bank failure so that taxpayers aren’t called upon

again to shore up the banks in a crisis. The Treasury Select Committee has emerged as an important new actor in this area. It is not only UK regulation that affects banks operating here. They are also subject to EU regulations, supervised by the European Central Bank and the European System of Financial Supervision (formed in 2011), and also the three global bodies working to coordinate global regulatory standards: the Bank for International Settlements, the Basel Committee on Banking Supervision, and the recently fortified Financial Stability Board. UK bank operations in other countries are also subject to the corresponding national regulatory requirements, and in some financial centres, such as New York, to requirements of municipal authorities.

Section Two The Fundamentals – Value Generation and Distribution, and Risk Profile Reform of UK banking offers a unique opportunity to undertake a systemic – and publicly debated – rethink about what we as a society want and need from our banking sector. On the one hand, improved riskmanagement, protection of taxpayers and consumers, and a fairer distribution of value is desirable. So too, on the other, are the benefits that accrue to the UK as a global hub for international trade and capital flows, capable of financing its globally-focused economy and multinationals. There are judgements to be made about how and when the benefits relating to different choices outweigh the costs to society. In listening to the public discourse and evaluating the response, the BankingFutures Group considers the reform agenda essentially to be asking for two things: first, for the banking system to create more value for society; and second, to take less risk. To understand the shape of the sector capable of delivering these outcomes, BankingFutures has created a framework for debate around these two fundamental questions. The first question relates to how value generated by banks can be understood and measured, and how it should be distributed amongst their many

stakeholders. The second relates to the risk profile the UK wants its banks to have.

Value Generation and Distribution To understand how value generated by the banking sector could and should be distributed is complex. After the financial crisis, many argued that two stakeholders – the banks and their investors – had disproportionately benefited at the expense of others. In response, BankingFutures is proposing a rethink on the entire subject of how value from the sector is generated, measured and then shared. Value generation can be broken down into component parts, including an understanding of value contained in the service to the customer, value to shareholders, value to the taxpayer, value to the Inland Revenue, value to society (including services offered to the economy and underserved communities) and value obtained by employees. Banks contribute to value generation in the real economy through loans and the creation of credit. This money is used to finance new capital investment projects, pay for consumption, and to finance the purchase of existing assets, such as property.

A key challenge is to ensure that banks are incentivised to lend to the real economy (stimulating credit generation beyond today’s heavy focus on real estate investment) and in ways that ensure that small and mediumsized enterprises (SMEs) are able to obtain appropriate credit. Banks also generate value within the financial system via wholesale banking services. These include helping clients (from governments to corporates and financial institutions) to raise new finance in primary capital markets. Investment banks also provide liquidity in secondary markets, facilitate securities lending transactions and provide financial markets infrastructure services, such as clearing and payment services. Although these sources of value generation are well articulated, there is less consensus over how value should be measured. Should this be based on contribution to GDP, accounting profit, total shareholder returns, dividends, on the risk managed, or on productivity? Moreover, while there was once consensus that a more developed financial sector would always lead to increased economic prosperity, a growing number of influential voices are questioning whether this assumption is robust.

Understanding the answer to these questions is important for taking the next step on deciding how any value generated should be distributed amongst bank stakeholders and what the mechanisms of transfer between them should be. Value distribution today lacks sufficient transparency and accountability. A number of questions need to be answered: 1. How should value be understood and disaggregated to reflect value obtained by various bank stakeholders? How should the costs of any value generated be factored into calculations of fair distribution? 2. How are customers to understand whether they are getting value for money? Related to this is the thorny question of free banking. It is poorly understood that in order to limit the losses on ‘free’ products (e.g. cashpoint services) charges are levied elsewhere (e.g. the bulk of overdraft charges are paid by the poorest in society). 3. The sector is now held increasingly responsible for multiple issues, including big societal issues such as financial illiteracy and inequality. What is a reasonable scope of the value we can expect the banking sector to generate? 4. What is the role of the Central Bank’s monetary policy in distributing value from banks to society (e.g. today interest rates benefit borrowers and penalise savers)?

5. What are the appropriate remuneration structures for banks and their employees to signal reward for how value is generated, as well as what value is generated? 6. Are shareholders getting a fair return for the risks they assume? Is a higher regulatory risk, which raises the cost of capital, perversely likely to encourage more risktaking? 7. Calculating all the above is predicated on confidence in the numbers. What is needed to create confidence that accounting treatments reflect the true value being created?

Risk Profile The second fundamental challenge is to understand what risk profile the UK wants its banking sector to have. As was seen in the crisis, the risk appetite of banks had implications for individual depositors (which were largely mitigated by government underwriting) and more significant risks to the financial system, resulting from the cumulative risk profile of the sector as a whole. The need to understand the risk profile the UK wants its banks to have is made more urgent because risk is already rapidly dispersing across the financial system. As banks reduce their exposure, leverage is moving into other institutions (e.g. insurance companies, asset managers) and unregulated new areas of shadow banking. As prior to the crisis, it is important

to recognise who is carrying risk at any moment in time and their ability to understand and manage risks. Given the size of the banking sector relative to the rest of the British economy, and the fact that it was the systemic risk that caused the damage, a good starting point is to understand the macroeconomic risks and benefits to the economy of international banking services and what this means for other bank stakeholders. During the crisis of 2007/8, the macroeconomic risks posed by investment banking were manifest. They include complexity, which even to this day makes it difficult to understand the assets on the balance sheet; interconnectedness, which means that insolvency problems can become contagious very quickly; and size, which means that distress of a major investment bank can result in dramatic withdrawal of market-making and financial infrastructure services very quickly across the financial system. It is clear in the public discourse – and in the regulatory response – that the level of risk held prior to the crisis was intolerable. Indeed, some UK banks were insolvent. What is less clear is whether the changes made since have achieved the desired outcomes. To understand the risk profile that the UK requires of its banks and the sector as a whole means answering some of the following questions:

1. What is a reasonable burden of risk-sharing amongst different stakeholders with wholly different understanding of risk? Which risks should investors bear? Which risks customers? For example, retail depositors may be indifferent to the risk profile of their bank because their deposits are by underwritten by government. Equity investors and regulators, on the other hand, want to understand a bankâ&#x20AC;&#x2122;s risk appetite. 2. Is the UK moving towards a more domestic-focused regulated banking sector, and if so what would be the real risks to growth and

productivity of losing UKbased international banks? If the costs are too high, how can this outcome be avoided? 3. Is the economic and social utility of the sector to the UK challenged by having a high percentage of foreign owners who may not share the same policy agenda, risk appetite and/or values? If so, what can be done about this? 4. Is the sector really too big for the economy, and if so, what are the risks involved? 5. New businesses and financial product offerings are emerging in the, as yet, largely unregulated shadowbanking sector. They may be

delivering unique, useful and exciting products, but they may also be highly risky. This also applies to peer-to-peer lending. Do the people whose money is being invested understand the risks they are taking, and if not, how should this be managed? What are the greatest risks posed by shadow banking, and how should they be addressed? 6. What is the best way to understand and manage non-financial risks facing the banks, including IT infrastructure, reputation, conduct and the risks to the natural environment? 7. What is the time horizon on which we are evaluating risk?

Implications Finding answers to these questions is important. The definition of risk profile for the sector, and how value is measured and distributed, will in turn define the kinds of banks the UK will attract and support. It is also important because today the problems of the past are dominating the present and blotting out the future. This means that banks have not been thinking as creatively as they should about a range of pressing, but slower-burn issues: the impact of technology, and social, economic and environmental challenges.

Section Three A Healthy Banking Sector in the UK That a healthy banking sector is critical to the real economy is self-evident and never more so than now. The banking sector oils the wheels of any economy. It should play a subsidiary role, in service to the financial needs of households and businesses. In the UK it has also played a critical role in serving the country’s international aspirations. A healthy banking sector will be needed to strengthen the UK economy, particularly given the size of the sector relative to the rest of the economy. All agree on this point. There is less consensus, however, on how big it should actually be. Likewise, views on the component parts of a healthy banking sector – resilient enough to withstand shocks while taking well-informed and well-judged risks – are also less aligned.

In an ideal world, banking reforms would end up with a sector capable of performing multiple functions with honour and probity. These would include the provision of (improved) services to retail customers: individuals, households and SMEs. The sector would continue to finance mortgages, and help people to make payments, plan pensions and travel abroad for work and holiday. It would help encourage savings to overcome the UK’s current position of having the lowest savings rate in Europe. It would also continue to place greater emphasis on providing loans and other financial services to support SMEs (where the value generated exceeds the cost). In addition, reforms would help it extend financial services to the significant numbers of people underserved by the

sector today and accelerate the UK’s fulfilment of its commitment to transition to a low-carbon economy, particularly via efficiency requirements on residential mortgages. Optimally, the reforms would also create a risk profile for the sector that permits the UK to continue to occupy its dominant place in the global financial system, with a banking system that operates worldwide and where UK regulators retain an important seat at the international regulatory table. Below, the BankingFutures Group has attempted to articulate what a healthy UK banking sector, capable of delivering these outcomes, would need to look like. It is divided into purpose, leadership, culture, incentives and key relationships with stakeholders.

The Purpose of Banks The purpose of banks is to serve the real economy over the long-term: n

Supporting macroeconomic well-being.

Providing access to finance.

Allocating capital in ways that supports economic development, encourages environmental stewardship and fosters innovation.

Being a safe and responsible custodian of clients’ money.

Providing reliable and fair payments services to households and businesses, to enable them to transact efficiently.

Prudently extending credit to support sustainable economic activity undertaken by people, SMEs, large corporates and financial institutions.

Helping households and businesses understand and manage risk, e.g. through access to savings products that help customers achieve their financial objectives.

Undertaking transparent, prudent and efficient financial intermediation in support of the range of financial activities.

Running commercially successful, risk-adjusted businesses.

Providing advice to customers on interest rate and currency risk.

Bank leadership to achieve these goals is characterised by: n

Active reinforcement of the idea that banks exist to create economic value for society, and create long-term shareholder value in the process of delivering that economic value. This will require leadership to articulate a vision for sustainable profitability, and signal a shift away from a focus on short-term profit-maximisation at the expense of other considerations.

A comprehensive and holistic understanding of all risk – financial, technical, conduct and compliance – being managed by the bank.

A commitment to strategic planning that captures future risks and opportunities arising from changing client demand, including for environmentrelated products.

A commitment to serve by demonstrating, in leadership statements and day-to-day engagements, humility and a more conciliatory approach to stakeholders.

Management of the importance of compliance with the spirit and letter of regulations. This means signalling that sound and prudent banking should take priority over profit opportunities from regulatory arbitrage, and zero tolerance of optimising regulatory loopholes.

The institution of – and requirement of staff to demonstrate – a duty of care, particularly to clients with less financial literacy than themselves. Placing strong emphasis on personal responsibility and accountability for actions and behaviours in the bank and throughout the wider banking system, at the same time as maintaining a collegiate approach to decision-making. Willingness to stand up against unfair or improper practice in the bank and wider sector.

The appropriate remuneration, incentive and compensation structures to achieve this: n

Remuneration should reward the delivery of real and enduring value for customers and society. This will then result in sustained returns for shareholders.

Reinforce the banks’ purpose and reflect the culture of service to the well-being of the client by, for example, aligning incentives with providing appropriate, wellpriced solutions for clients.

Reward performance that achieves an appropriate balance between risk-taking and prudence, ensuring that the pursuit of short-term profits does not conflict with the bank’s stability objectives.

Are transparent, straightforward and easy to understand.

Are aligned across bank divisions and appropriate to the profitability of each division and the bank as a whole.

Are aware of and take into consideration new societal expectations.

The desired bank culture overseen by these leaders is: n

Underpinned by an understanding of the banks’ purpose to serve the real economy over the long term, consistently expressed in leadership statements, in day-to-day transactions and in performance management.

Characterised by simplicity rather than complexity.

An environment in which employees are encouraged to seek help and guidance from their superiors, seeking to ensure issues are escalated quickly.

Balanced to allow staff to exercise accountable, individual discretion whilst complying with bank and regulator rules.

Supported by improved accountability functions within banks, such as whistle-blowing mechanisms.

Stakeholder Relationships: How We Can Work Well Together As the banking crisis was a systemic failure, future risk management has to address how all stakeholders can contribute to a healthy banking sector. Below, we make a first attempt to identify how some of the key stakeholders would be working in a well-functioning system.

Customers and Citizens Retail Customers – Individuals and SMEs There is no hard and fast rule about where a retail customer ends and a wholesale one begins, but the term retail customer here refers to individual clients of the banks, and also small and some medium-sized companies. When the relationship between retail customers and banks is working well:

Work with others to ensure that access to financial products is extended to currently underserved individuals and communities.

Extend credit to SMEs whose businesses have been appropriately understood and risked.

Uphold a duty of care to all clients, particularly more vulnerable customers, where there is a mismatch in their level of expertise and that of the banks. Provide the appropriate point of customer contact – online, in branches – to reflect diverse customer preferences, particularly for elderly or lowincome clients. Create appropriate products for clients, which are sold judiciously in clients’ interests not just the banks’.

Protect the deposits of individuals and small businesses from riskier investment banking activities.

Wholesale Customers – Large Corporates and Financial Institutions Investment banks offer wholesale clients a range of high-level financial services, which facilitate capital transfer across markets to help fund business activities, and finance infrastructure and other capital intensive development. When the relationship between wholesale customers and banks is working well: n

Banks offer the full range of services needed for a healthy economy, e.g. raising debt and equity, bond issuance, share sales, Initial Public Offering (IPO) services, derivatives, risk management solutions and international payment services.

Banks accept that they have responsibility for their clients’ best interests, and task themselves with always behaving as such.

Banks manage market conduct to be free of conflicts of interest between different branches of the investment bank, and particularly in proprietary trading in conflict with customers’ interests.

Proprietary trading, in its various guises, is managed in such a way to ensure that it does not threaten the deposits of people and small businesses.

Customers and Citizens: n

Banks: n

Are permitted to give advice and appropriate product guidance to their clients, provided that this is adequately regulated.

Ordinary citizens and people who run businesses have a deeper understanding of the financial system. Customers are sufficiently well advised/educated to make appropriate decisions about financial products for them and assume responsibility for their choices.

Consumer groups engage with banks about what products customers want and need.

Consumer groups engage in discussions with the regulator about the right balance between consumer protection and allowing banks to provide advice.

Citizens and government engage in constructive debate about finance, the role of banks, financial risk and how value should be distributed.

Government Government is one of the banksâ&#x20AC;&#x2122; most important stakeholders due to its role in framing the banksâ&#x20AC;&#x2122; social contract via regulation and policy, and because government is a major client. The relationship between regulators and banks is currently highly strained. The banking sector has played a major contributory role to this situation through taking an adversarial approach to regulation and regulators, and in some cases engaging in illegal activities.

Banks and regulators engage in regular, respectful dialogue, characterised by more public expressions of respect. The relationship is depoliticised, open and transparent. It is characterised by a desire to collaborate.

The tensions between government objectives to promote the financial sector and consumer safeguards are well balanced.

There is global harmonisation or cooperation between countries and regulators.

There is a degree of regulatory standardisation to ease transaction cost, while permitting national differences.

Banks and regulators are both accountable to specific and clear objectives.

Banks are sufficiently trusted for regulators to be confident that they do not need to micro-manage internal bank functions.

When the relationship between banks and government is working well: n

The statutory objectives of regulators are extended to consider the best interest of the full range of stakeholders, including those of the customer.

Government: n

Successfully promotes financial literacy and understanding of the role of the financial system in society.

Coordinates approaches to legislation and regulation of the financial system to ensure coherence across the whole.

Moves to ensure that the regulatory regime is as independent from political debates as possible.

The Regulator: n

Provides clarity about when and how regulatory decisions will be made to allow banks time to prepare appropriately.

Takes the views of bank executives into consideration in the drafting of new regulation, such that unintended consequences are understood and minimised.

While maintaining independence and avoiding inappropriate influence, the regulator and banks take concrete steps to enhance mutual understanding.

Banks: n

Acknowledge the enormous responsibility exercised by regulators in issuing bank licences.

Take active steps to comply with the spirit and legal requirements of regulations and assume a policy of zero tolerance of optimising regulatory loopholes.

Introduce improved internal accountability functions, such as whistle-blowing mechanisms.

Investors

Banks:

Have a deep understanding of bank operating models, and specifically of how banks are making money from their clients and customer base. Investors communicate to banks when their actions and businesses are not understood, and require them to explain.

Signal to government their interest in a predictable, longterm approach to regulation.

Disclose to their clients and the general public how they are exercising their stewardship duties to deliver long-term, sustainable value creation – and engage with beneficiaries on strategies to deliver healthy banking.

Communicate realistic expectations of sustainable returns to investors. n

For commercial entities to deliver long-term, sustained profitability and dividends to shareholders as well as social benefits, investors need to acknowledge the need for prudent behaviour at banks. The existing relationship between banks and investors could be improved if UK banks were able to attract an investor base that matched its calls for more stability in returns and focus on long-term value creation, and which demonstrates greater tolerance for the impact reform might have on performance in the short term.

Provide simple, clear and transparent reports that give investors an accurate and detailed understanding of the underlying business and financial position. n

Provide clarity about the business models – and how they relate to one another – upon which banks’ plans to generate returns will be based. n

Investors: n

Communicate their views to management about what will create long-term value for the sector, to ensure that such views are aligned with management plans to deliver stakeholder, as well as shareholder, value.

Demonstrate willingness to accept short-term costs for longer-term value creation, and patience with changes to business models that are currently not serving the customer well and hence undermining longer-term value.

When the relationship between banks and investors is working well: n

The sector appeals to investors seeking attractive and stable capital returns over the long term. Investors actively engage with bank management teams and boards on strategy, transparency, accounting and remuneration.

Section Four Kick-Starting the Debate – Areas of Contention The BankingFutures Group accepts the need to deal with the risks that emerged during the financial crisis. It sees such steps as reasonable and necessary. Given its definition of a healthy banking sector for the UK, the Group believes that recent reforms may be generating additional risks of their own for the economy that merit discussion. Although not an exhaustive list, some of these issues are outlined below as a way to trigger debate. These points of divergence – and those which will undoubtedly be raised by other stakeholders – are exactly what the BankingFutures roundtables are designed to explore, and are part of the balanced and public debate needed to inform the rebuilding of a healthy banking sector. The first is the risk that moves towards a more regulated, domestic industry – a wholly understandable response to the crisis – could potentially lead to unintended negative impacts on the overall economy. Historically, the UK has occupied a dominant place in the global financial system. This competitive model has provided financial services for UK

multinationals and international clients, as well as to domestic businesses and customers. In addition, it has spawned a significant professional services infrastructure in London – e.g. legal, accountancy – to support that global industry. It is important to evaluate and prevent associated risks of a potential shift of global financial services away from the UK. How should this be done? The second, related risk is that some reforms are undermining confidence that fair treatment under the law is a fundamental cornerstone of the UK. As this is a prime reason for people choosing to do business here, some members of the BankingFutures Group genuinely fear that the UK may lose its international banks as a result. It is important to explore this risk and evaluate the costs of this happening, not just in terms of lost tax revenue and loss to the knowledge economy, but also its impact on the UK’s voice in international regulatory debates. The Bank of England was an early and fast mover in regulatory reform. If its reforms have indeed solved many of the critical challenges of banks

being ‘too big to fail’, then the UK arguably may now be one of the safest global financial centres, making it possible for it to retain its strong international influence as a global hub. The third is the thorny issue of executive compensation. Members of the BankingFutures Group expressed a variety of views on this topic. These range from those who advocate a simple salaried system aligned to public sector pay levels, reflecting a perception that taxpayers will inevitably again be called on to shore up the sector in crisis. At the other end of the spectrum are those who believe the sector can only thrive if incentives remain exceptionally strong. Where there was broad agreement, however, was that remuneration should primarily be a matter for boards, not regulators. In particular, some in the Group expressed concern that reforms designed to improve conduct and address incentives – particularly the Senior Managers Regime – are disincentivising people, particularly non-executive directors, from assuming or remaining in senior leadership roles in banks. It is important

to come to agreement on the implications of this; and if it matters, how can it be avoided?

requirements on banks, and streamline these requirements as much as possible.

The fourth relates to regulatory coordination. In contrast to capital flows, payments services and cash, which are moving increasingly freely across the globe, regulation in most countries is increasingly national. Within each individual jurisdiction, regulators have worked to make their own banking systems safer. From the perspective of banks â&#x20AC;&#x201C; already conducting their own internal reform processes â&#x20AC;&#x201C; the resulting regulatory requirements can seem uncoordinated, or even chaotic. This raises the question of whether global bodies charged with coordinating international regulatory activity should give greater consideration to the cumulative impact of their

Fifth, the pace and volume of new requirements makes it difficult to evaluate which reforms are proving effective. It is important to decide how this can be assessed. What can be done to prevent new requirements from creating a barrier to new entrants, or affecting the ability of the banking sector to serve customers, including SMEs, both of which would run counter to government aims of encouraging greater competition in the sector and a thriving SME sector? Sixth, is the question as to whether reforms are preventing shareholders from getting enough information to permit them to understand fully the capital position of the banks in which they may invest.

The legitimate desire of regulators to address potential conflicts of interest within the asset management sector may run the risk of reducing the ability of shareholders to exercise appropriate oversight of banks. What is the best way to ensure that banks are both accountable to regulators and to their shareholders, who have much to lose from bank failure? All these questions highlight the fact that the crisis and its consequences are leading to wider questions about the optimal shape of the overall banking ecosystem. BankingFutures hopes to make a contribution to debates about what is the right balance of different banks with different business models to serve the widest possible range of customer needs.

Section Five The Transition In an ideal world, the transition to the banking model described above would be spearheaded by government policy that defines a viable long-term economic strategy for the UK. This would include clear statements about how the banking sector could support the strategy. In addition, the policy would be an opportunity to provide a concrete steer on the UK’s risk appetite and what it wants to see in terms of the measurement and distribution of value generated by the banks. With the clarity of purpose provided by such a strategy, the pathways to achieving it should be clearer and the much-vaunted goal of ensuring that revenue flows from banks to government are generated by profitable business taxes, rather than fines, will be achieved. Such a transition will not be easy and will not happen overnight. The systemic nature of the challenge means it will be work in progress for a considerable time to come. Nevertheless, there are a number of steps that can be taken to get things moving today, in ways that contribute to building confidence between stakeholders in the banking sector and signalling progress towards the desired future.

Milestones Milestone One – Defining Risk Appetite and Value Distribution The views of a wide range of banking stakeholders will be critical to defining the characteristics of a banking sector that meets all their needs. The first milestone is therefore an active programme of engagement between the banks and their core stakeholders. Progress against this milestone will be the BankingFutures roundtables held for – and in partnership with – banking stakeholders, e.g. investors, regulators, customers, civil society and academics as a contribution to such a programme. Milestone Two – Compensation Despite a significant amount of work already being done to address societal and market concerns about inappropriate or excessive compensation, this continues to be a source of mistrust of bankers. From a senior banker perspective, current remuneration packages (that combine salary, nonpensionable fixed pay, cash bonus, shares that cannot be sold, restricted shares, clawback mechanisms) have become so complex that they are almost incomprehensible.

A milestone could therefore be to take active, public steps to address these concerns further by: n

Significantly simplifying remuneration structures.

Linking compensation and promotion directly to customer experience.

Disclosing significantly more information about compensation both inside banks, to encourage good performance, and externally for public review.

Agreeing that bonuses should be paid after taxes and financing costs have been paid on profits (post EVA ) – rather than simply on revenues – in order that bonuses reflect the true value created by different divisions within each bank, and by the bank as a whole.

Progress against this milestone would include increased disclosure on pay, including explanation of how compensation is directly linked to the financial health of each institution; more informed debate on the merits of compensation such that society better understands and accepts the basis for pay levels; more constructive debates on compensation between the investment community and boards; and retention of bank staff due to perceived fairness and transparency.

Milestone Three â&#x20AC;&#x201C; Cross-Banks Ethics Group Reforms are underway in all banks to improve culture, values and focus on customer needs. However, they are difficult for outsiders to understand and evaluate. A third milestone could therefore be for banks to create a Cross-Banks Ethics Group comprised of senior representation from each bank. The remit of this group would be to identify, monitor and make public progress against ethical milestones that have been designed with civil society input. The activities of the group could be evaluated through public customer satisfaction scores of different banks, held by a publicly-focused institution

such as the Financial Conduct Authority, monitoring customer experience. Progress against this milestone could be measured in levels of trust shown in banking surveys; increased customer satisfaction; a fall in complaints to the financial ombudsman; and an increase in the amount of voluntary self-reporting on breaches from within the sector. Milestone Four â&#x20AC;&#x201C; The Introduction of Cultural Performance Metrics Many banks are already introducing new performance metrics to supplement existing performance evaluation and support culture change. However, they are poorly understood by external bodies.

A fourth milestone could therefore be the introduction and monitoring of performance metrics that reflect the sectorâ&#x20AC;&#x2122;s changed approach to culture and values. Such metrics would be applicable across the sector, could be integrated into investment analysis of banks, drive compensation, and should be well aligned with government policy. Progress against this milestone could be measured against the degree to which values and culture become part of investor valuation of banks; a shift in compensation within financial organisations away from simply profit and efficiency towards values, corporate citizenship and economic goals.

Conclusion The Invitation

It is incumbent on leadership across the financial system and beyond to pull together to create a banking sector capable of underpinning economic prosperity and contributing to demonstrable social and environmental value, which in turn creates longer-term value to all stakeholders. An evaluation of the impact of current banking reform initiatives is part of that process. So too, is the need to think strategically about what we need the sector to do to support underserved communities and address long-term challenges, such as climate change. BankingFutures is an invitation to stakeholders to engage in discussion about these issues and to share your perspectives on the possible futures for UK banking. The project requires new ways of working together, and more frequent and transparent dialogue. Bringing together the widest possible range of perspectives on what we, as a society, want from the banking sector is our best chance of achieving the outcome we all need.

Appendix BankingFutures Working Group James Alexander Head of Equities Research

M&G Investments (May 2002 - May 2015)

John Flint

Chief Executive, Retail Banking and Wealth Management

HSBC Holdings Plc

Kirt Gardner

Chief Financial Officer Wealth Management

UBS

James Garvey

Managing Director, Head of Capital Markets

Lloyds Banking Group

Jessica Ground

Global Head of Stewardship

Schroders

Andy Griffiths

Executive Director Senior Advisor

Investor Forum Corsair Capital

Matt Hammerstein

Head of Client and Customer Experience, Personal and Corporate Banking

Barclays

Stephen Jones

Chief Financial Officer

Santander UK

Natasha Landell-Mills

Head of ESG Research

Sarasin & Partners

Stuart Lewis

Chief Risk Officer and Member of the Management Board and Group Executive Committee

Deutsche Bank

Glen Moreno

Chairman

Pearson, Virgin Money

Nick Robins Co-Director

Inquiry into the Design of a Sustainable Financial System, UNEP

Simon Samuels

Independent

Consultant

Helen Wildsmith Head of Ethical & Responsible CCLA: Specialist investment Investment management for charities, faith organisations, and local authorities

The BankingFutures Team

Marloes Nicholls

Lead Researcher & Project Manager BankingFutures Programme Manager, Finance Meteos

Sophia Tickell

Co-Director Partner

BankingFutures Meteos

Anne Wade

Co-Director Partner

BankingFutures Leadersâ&#x20AC;&#x2122; Quest

Notes

i Andrew G. Haldane, The $100 Billion Question, BIS Review 40/2010, p. 2 ii Andrew G. Haldane, The $100 Billion Question, BIS Review 40/2010, p. 2 iii Ibid., p. 2 iv http://uk.reuters.com/article/2014/07/25/uk-britain-economy-growth-idUKKBN0FU0R120140725 v This refers to a shift in practice over the last 20 years towards banks creating, or originating loans, and then selling/distributing them to third parties.This contrasts with a more traditional model in which a bank creates a loan and holds it on its own balance sheet to maturity.

info@bankingfutures • www.leadersquest.org • www.meteos.co.uk © Leaders’ Quest, Meteos, June 2015 This report was printed using waterless ink and recycled paper by Seacourt, an environmental printing company that uses renewable energy and ethical funding to produce zero waste products.