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Free market on the rocks

Northern Rock bank rescue highlights the need for deeper reforms says Prem Sikka

The state rescue of Northern Rock, a UK bank, again shows that left to itself the corporate world only thinks relatively short-term and is not capable of thinking about the long-term consequences. In pursuit of higher profits and executive remuneration, directors of many banks piled into risky investments. They lent money to people who could ill afford it, often at exorbitant rates. They had discovered the modern Eldorado of the housing market where prices only went up and mortgage payments rolled on. Of course, such is the crisis nature of capitalism, that ultimately all historical trends go awry.

The profit chasing banks learnt little from the 1970s UK secondary banking crash or the 1990s US Savings and Loan (S&L) crisis. The financial regulators excelled at aping the three unwise monkeys and banks developed new financial instruments. The traditional business of lending money to buy property was no longer seen as a long-term ‘investment', but as a short-term ‘transaction' that had to be quickly churned into cash. Why wait for the profit on loans through repayments from the borrower, or possible foreclosure of the underlying property, when large profits could be realised by selling the paper receipts of the mortgage loans and then lending out the proceeds and repeating this process ad infinitum?

Soon hedge funds, insurance companies and pension funds also joined in this frenzy of buying and selling rebundled mortgages and thus spread the impact of an eventual crisis. Thus a secondary market for mortgage loans developed built on the belief that the original loans were virtually default free and in any case the underlying assets (property) could easily be sold at escalating prices. No one cared about the end game of higher interest rates, decline in property values or defaults as the poor continue to become ever poorer. Sooner or later the business model had to hit the buffers and Northern Rock provides an early sign of the turmoil to come, especially if the economic growth slows.

The above is in addition to the usual practices where, in the name of risk management, companies place bets on the movement of interest rates, prices of shares, currency, commodities and anything else. If the gambles pay off banks and their executives strike it rich, and if they don't the value of the bets is zero and someone else, the saver, has to suffer the losses. Company accounts rarely provide any insight into the underlying risks. Shareholders at Northern Rock collected dividends but rarely asked any questions about the bank's investment policies.

Some neoliberals have been too keen to write off the state and portray the markets as self-correcting. At least this bogey can be laid to rest as markets can't regulate, rescue banks, placate worried depositors, stem the queues outside banks, or create institutional structures to promote confidence in capitalism. The Northern Rock rescue again confirms that the state is the ultimate guarantor of capitalism, just as it lubricates the wheels of capitalism through investment in education, healthcare, transport, security services and protection of property rights.

The state's support for Northern Rock and its willingness to guarantee the safety of £35,000 of savers' deposits, rising to possibly £100,000, is good news for many depositors. However, this has also ushered in new moral hazards. Company directors can now indulge in even more reckless policies with the full knowledge that a large part of the downside risk has been passed to the taxpayers. There is no easy mechanism for monitoring the risk seeking behaviour of directors, especially as the UK's banking regulator, the Financial Services Authority (FSA), does not employ a dedicated team of inspectors to regulate banks. Like most companies, banks seek to maximise profits and that may not be in the interests of depositors. The typical tenure of a FTSE100 chief executive is four years, and falling, and the temptation is to maximise remuneration by conjuring up short-term profits. That may not be in the depositors' interest either. How closely would a government want to regulate banks? The past evidence shows that in the face of determined opposition, governments postpone much needed reform.

The Northern Rock episode confirms the usual position where profits are privatised and losses are to be passed to the taxpayer. The taxpayer gets little out of propping up the likes of Northern Rock. Certainly not cheaper mortgages or much needed funding for affordable housing, or even promises of responsible behaviour from banks. If governments underwrite bank deposits then there is little point in letting banks be the intermediaries and make profits from it. The profits should rest with the taxpayers since they will bear most of the risks. Governments should take deposits from small investors and go into the lending business. Yet for ideological reasons, such public policy options are unlikely to be considered.

The Northern Rock episode also raises questions about the governance of banks. The entire system depends on depositor confidence, yet depositors have little say. Under the UK law three parties are directly concerned with the governance of banks. These are directors, auditors and the regulator – the Financial Services Authority (FSA), but none seem to be directly concerned with the welfare of the depositors.

Under the Companies Act 2006, directors are appointed by shareholders and depositors have no say in it whatsoever even though they bear a considerable part of the risks and in the event of a banking failure their financial losses could be as large, or even larger, than those of the shareholders. In general, company directors only owe a ‘duty of care' to other members of the board of directors, company shareholders collectively or the company as a legal person. Directors have a duty to promote the success of the company for the benefit of its shareholders as a whole. They do not owe a ‘duty of care' to any individual shareholder, creditor, employee, pension scheme member or depositor. Success of the company and returns to shareholders might be enhanced by investment in risky portfolios, which might not necessarily be in the depositors' interest.

Depositors do not have any statutory right to receive company accounts, attend annual general meetings, table resolutions or ask any questions. They can risk their money but have no say on how the bank might be governed or whether its resources might be used for genocide, war, or unethical activities.

Bank auditors are of no help to depositors either. Under the Companies Act they are appointed by shareholders collectively, but the reality is that they are hired, fired and remunerated by company directors. Depositors have no say in such matters. Thus they are unlikely to have any recourse against negligent auditors, unless they were wilfully or recklessly negligent. The 1990 House of Lords judgement in the Caparo case stated that neither individual shareholders, nor anyone else, including depositors, could use audit reports or audited company accounts to make any investment decision. In any case, it is extremely unlikely that in the era of electronic transfers of money, banks operating from a hundred or more countries can be audited by any accounting firm. Ex-post audits are of little use and the FSA is unwilling to impose its own auditors to conduct real-time audits. The collapse of the Long Term Capital Management (LTCM) showed that even Nobel Prize winners in economics could not value complex financial instruments. Auditors, bankers and company directors are unlikely to do better.

The third part of the governance architecture is the Financial Services Authority, a statutory regulator of banks and financial services entities. Its objectives include securing confidence in the financial system and the appropriate degree of protection for consumers. The FSA does not appoint bank directors. It does not appoint auditors either though the two parties can meet to discuss irregularities. Neither auditors nor bank directors owe a ‘duty of care' to the FSA. The FSA does not owe a ‘duty of care' to any individual depositor. If the FSA becomes aware of problems at a bank it is not duty bound to inform depositors though it runs a Financial Services Compensation Scheme from which depositors can be compensated for the approved statutory amounts.

For depositor protection to become a central plank of governance of banks, fundamental reforms need to be introduced. Savers at banks and insurance companies should elect directors and have the right to receive information, appoint, fire and question directors. As the interests of savers and shareholders conflict, savers should have the right to appoint their own auditors with a specific mandate to report on the safety of their savings. Directors, auditors and the FSA should owe a ‘duty of care' to savers. Their interests should not be subordinated to the interests of shareholders. These reforms should mark the beginnings of a process that democratises the governance structures of banks and introduces policies for depositor protection.