A year-end is always a good time for reflection. And as 2015 draws to a close, it is an opportunity, after a year of considerable central bank activity which many expect will culminate in a US interest rate increase later this month, to reflect on the state of the global banking system.
One thing is abundantly clear. More than 7 years after the collapse of Lehman Brothers, which initiated the banking crisis that rocked the world economy, and nearly 5 years after then Barclays chief executive Bob Diamond’s comment in January 2011 that “the time for apologising is past”, the banks are still no closer to redeeming themselves in the public eye. Their reputation remains firmly in the mire, as the misdemeanours they are accused of and the fines they have to pay for past transgressions mount to extraordinary levels. And with criminal charges and court cases for rate-fixing and market malpractices continuing to make the headlines, nobody in the banking sector can say with any confidence when the assault on past practices and the accusations of past immoralities and illegalities will start to end.
But if the process of looking back and holding the banks to account for past activities seems endless, a potentially more concerning feature of modern banking is the continuing struggle to establish a sound basis for banking regulation going forward. Seven years on from the crisis, the landscape for banking regulation is still a battlefield between the regulators on the one hand and the banks and wider financial system on the other. Regulation has never been more onerous, intrusive and extensive, yet few people in either the authorities or the financial sector really believe that the raft of new laws has made the financial system any more secure.
Major questions in the financial system are unanswered – the role of non-banks such as insurance companies and asset managers and how they should be regulated, the functioning of markets when liquidity is in short supply, the interaction between very active central banks and the markets. The goal of globally consistent regulation remains distant, with the US and Europe pursuing very different approaches despite the best endeavours of the Financial Stability Board to co-ordinate regulatory activity. Indeed the European Union cannot even agree on simple features such as a Eurozone-wide common deposit protection scheme for weak banks or a common resolution system for failed banks.
But behind all these, there are two questions which are seldom explored but which – with the luxury afforded by an end-year reflection – deserve greater consideration. What if the mass of regulation which has been enacted since the crisis is not so much the solution to banking’s problems of stability and acceptability to the public but exacerbating them? And what if the challenge is not to make the current structure of banking safe and acceptable (whatever that means), but to find a better structure altogether?
Laws and regulations have an interesting property, which is that the overall effect of a body of laws cannot be determined by looking at the separate effects of individual laws in isolation and then trying to sum them. Indeed, it is quite possible for each individual law or regulation in a set of laws to have a positive effect in isolation, but the sum effect of the whole body of the laws to be negative. And this is particularly true of laws and regulations which try to change attitudes: as actors respond to the incentives and restrictions of the laws, their reaction to other parts of the law is changed. This feedback effect can make predicting the consequences of any new law very difficult and the results of a new law sometimes counter-intuitive.
In the case of the banking system, there are increasing signs that this has happened. Regulators have watched with growing disappointment how the banking system has reacted to every new regulation with increasingly ingenious attempts to get round it. Banks appear to be ever more precise about obeying the letter of the law (those swingeing fines for breaking the rules do have some effect), but ever more cavalier about ignoring the spirit of legislation.
This is not entirely surprising. The body of legislation that applies to the financial system is now so large, so complex and so intrusive, that no sensible banker will rely on his or her own judgment in determining what is a proper way to conduct business. Every single move is checked with the compliance department, every initiative is tested against all the various regulations. And this breeds an atmosphere in which the moral test between the “right” and “wrong” way to conduct business is completely subordinated to the legal test between the “allowed” and “not allowed”.
In short, banking is so keen to determine what it can do, ie what is permitted or forbidden within the law, that it increasingly no longer bothers to ask itself whether it should. “If it isn’t illegal then it must be OK” runs the mantra, and any sense of a moral basis for the conduct of business has largely evaporated. And the result is that finance risks moving beyond being a moral business, or even an immoral one; it is now far too often a business without any moral basis at all.
This is not what the regulators intended. Their aim has all along been not just to make banking safer, but also to make it more acceptable, perhaps even honourable in the eyes of the general public. This is behind all the exposés of past moral lapses, and the drive to put legislation in place to make sure that they cannot be repeated. But the damage has been done; as Winston Churchill once remarked, “If you make ten thousand regulations you destroy all respect for the law”. And unmaking the regulations will not recreate respect for the underlying principles the regulators are trying to promote.
This is where the second question comes in. Increasingly some commentators are beginning to ask whether the current structure of banking is inherently unmendable, and whether a more radical rethink is required. And the element of modern banking that they tend to focus on is the limited liability structure of the banks.
We are so used to the concept of the public company, with shareholders as owners, a board of directors as executive management and limited liability for both that we have perhaps forgotten that it is an artificial construct designed to solve specific problems.
The more natural structure of business in the early days of capitalism was the entrepreneur, personally liable for all debts he incurred: it was felt that this was the only way to keep business honest and under the control of the owners of enterprises. This structure however proved inadequate when faced with the need to raise very large sums of money for the infrastructure projects of the Victorian era – mainly the railways – and successive Companies Acts in the UK between 1844 and 1862, and similar legislation in other countries, made it very much easier to create limited liability companies. Without this, it is doubtful whether the railway systems of the world would ever have been built.
But the move to limited liability was not universally popular. As an early critic of limited liability, Edward Cox, observed in 1855, “He who shares the profits of an enterprise ought also to be subject to its losses … limited liability is founded on the opposite principle and permits a man to avail himself of acts if advantageous to him, and not to be responsible for them if they should be disadvantageous; to speculate for profits without being liable for losses”. And in particular, it was recognised that some professions carried such a heavy responsibility to society that they should not be allowed the protection of limited liability.
Thus it was that doctors, dentists, accountants, lawyers, insurance underwriters, stockbrokers and various other professions were denied the right to incorporate with limited liability: it was deemed that the need to keep them honest was so important that they should not be offered the chance to escape the full financial consequences of their actions. And in their number were investment bankers: the old accepting houses and merchant banks in the UK and the traditional investment banks in the US remained partnerships with unlimited personal liability.
Finance has long struggled to escape this onerous regime of personal responsibility, but for most of the last 150 years society held firm. The American investment banks Goldman Sachs and Morgan Stanley, for example, only managed to incorporate as limited liability companies in the last years of the 20th century. And for some of the financial system’s critics, the connection between this and the explosion of risk-taking that led to the financial crisis just 10 years later is not entirely a coincidence.
Cox’s observation 160 years ago that limited liability “permits a man to avail himself of acts if advantageous to him, and not to be responsible for them if they should be disadvantageous” is almost exactly echoed by the sentiment today that in the financial crisis bankers were able to “privatise profits but socialise losses” – that is, keep any gains from their activities but leave society to finance any losses. It is perhaps not entirely surprising that the solution the Victorians agreed on, ie keeping bankers honest by forcing them to accept much greater, perhaps even unlimited, personal liability, is once again being actively discussed.
 In the House of Commons, 3 February 1949
 For an extended discussion on this topic see, for example, “The End of Banking” by Jonathan McMillan