Restoring trust in finance: Competition or moral motivation?

Blogpost: Alexandra Zeitz, St. Antony’s College, University of Oxford

Speaker: Gordon Menzies, University of Technology, Sydney (with Donald Hay and Thomas Simpson)

Chair: David Vines, Balliol College, University of Oxford

Banking suffers from a trust problem. A post-crisis YouGov study found over 70% of respondents agreeing that “Banks aren’t doing enough to get us out of this economic crisis which they helped cause”. In his PEFM seminar in Michaelmas term, Gordon Menzies (University of Technology, Sydney) presented research on the means of restoring trust in banking, arguing that greater competition alone cannot increase public trust in banks. Instead, Menzies argued that bankers’ motivations must be addressed; in order for banks to earn stakeholders’ trust, they must invest in ethics education and professionalization as measures to encourage moral motivation.

Banking did not always have the distrusted reputation it has today. Menzies began his presentation with a history of late 19th to mid-20th century “gentlemen bankers” in Britain. These bankers enjoyed a well-respected reputation for conservative and reliable banking based on personal relationships and close knowledge of their customers. Bankers’ pay was moderate, and the business was not characterized by the cross-selling and conflicts of interest that are now pervasive. 

This all changed with “Big Bang” deregulations in the late 1980s. Menzies pinpointed these reforms in financial markets as leading to changes in British banks’ motivations and behavior. Risk-taking increased rapidly, as did bankers’ remuneration. This risk-taking on its own is not morally objectionable, as Menzies pointed out. Bankers’ behavior can be thought of as a “right to be rogue,” a right purchased with the high returns acquired through risky investments. Investors and customers may countenance rogue behavior as long as it yields them substantial returns. 

The future of banking and the role of challenger banks

Blogpost: Alexandra Zeitz, St. Antony’s College, University of Oxford

Speaker: Cyrus Ardalan, Chairman, OakNorth Bank
Chair: Alexandra Zeitz, St. Antony’s College, University of Oxford

The banking sector in the UK is undergoing a transformation. In 2010, the Bank of England issued the first new banking license in one hundred years to Aldermore. From 2013 to 2016, 14 new banks have received licenses, and there were reports in mid 2016 that a further 20 new banks had applied for licenses. This proliferation of new “challenger banks” is reshaping the financial landscape in Britain.

Cyrus Ardalan, formerly Barclays Vice Chairman (Investment Banking), is the new Independent Chairman of OakNorth Bank, a challenger bank specializing in financing to small and medium-sized enterprises (SMEs). In his presentation at PEFM this term, Ardalan gave an insider’s perspective on the changes in the British banking sector and gave his explanation for the rise in challenger banks, which he chalked up to regulatory changes and technology shifts. 

The British banking sector remains highly concentrated. The “Big Five” banks (HSBC, RBS, Barclays, Santander, Lloyds) control 90% of the market in personal banking, corporate financing and SME lending. Nevertheless, challenger banks are reshaping the landscape. These include larger challengers such as Clydesdale and Yorkshire, TSB, and Handelsbanken, which in many cases are longer established and have relatively large portfolios of loans. Smaller challengers such as OakNorth, Metro, Aldermore and Shawbrook received their licenses in the more recent profusion of banks. Retailers offering financial services, such as ASDA, M&S or Tesco, are also challenging the dominance of the Big Five, but are not “challengers” in reshaping the model of banking, according to Ardalan. 

A pragmatic approach to reform of banking governance and culture

Blogpost: Alexandra Zeitz, St. Antony’s College, University of Oxford

Speaker: John Mellor, University of Leicester

Chair: Adam Bennett, St. Antony’s College, University of Oxford

What does it take for a bank to be well governed? In Michaelmas term, PEFM hosted John Mellor of the University of Leicester for a seminar on reforming banking governance and culture. Mellor’s headline argument was that the quality of bank governance is directly shaped by a bank’s culture, which in turn is defined by the purpose or objective that the bank sets itself. He used case studies of three well-known banks, Nationwide, Rothschild, and Barclays, to illustrate the determinants of high and poor quality bank governance.

While it is oft discussed, Mellor suggested that bank governance is in fact poorly understood. He argued that analysis of bank governance must begin with the bank’s board of directors, since the directors hold ultimate responsibility for the bank’s conduct. Governance, from the bank’s board downward, is influenced by both internal and external factors. Internally, bank governance is shaped by the ownership of the bank, its business model and history, while important external circumstances are the competitive and political environment and the structure of regulation. 

Ethics and cultural assimilation in financial services

Ivaylo Iaydjiev (St Antony’s College, Oxford)

Speakers: Alan Morrison, Saïd Business School, and John Thanassoulis, Oxford-Man Institute, University of Oxford

Chair: Natalie Gold, King's College London

With a string of scandals in finance in the last few years, it is not rare to hear people lamenting the decline of ethical behavior in the industry, including the Archbishop of Canterbury and Pope Francis. In their new paper, Alan Morrison and John Thanassoulis want to go further and understand the causes behind the many failures.[1] Drawing on the use of contracts of finance and their role in incentivizing certain behavior and fostering a culture, they present an elaborate model of cultural assimilation in a professional services firm.

The starting point for their argument is the moral dilemma that bankers face in acting on behalf of their clients. In considering the trade-offs of actions that are simultaneously harmful to the client and profitable to the company, traders are likely to be affected by cultural standards and the tone from the top. The question then becomes how performance pay affects such decisions and why a principal might decide to create a less ethical culture. Their model includes two versions of the actors, one based on a utilitarian Benthamite conception that focuses on increasing the aggregate welfare surplus, and the other based on Kantian duty ethics that consider actions separately from their context. 

Managing Complexity—Economic Policy Cooperation After the Crisis

G. Russell Kincaid (St. Antony’s College, Oxford)

Speakers: Tamim Bayoumi, Deputy Director, International Monetary Fund (IMF); Fred Bergsten, Senior Fellow and Director Emeritus, Peterson Institute for International Economics; Heidi Crebo-Rediker, Senior Fellow, Council on Foreign Relations; and Vitor Gaspar, Director Fiscal Affairs Department, IMF

Moderator: Kemal Dervis, Vice President and Director, Global Economy and Development, The Brookings Institution

According to Mr. Bayoumi, this new book adopts a Cubist Approach to analyzing economic policy cooperation. Like the art school, the 12 chapters in Managing Complexity—authored by various academics and practitioners, including two current PEFM Associates—do not depict the subject from a single vantage point, but provides multitude perspectives to picture all the intricacies. This event, was held at the Brookings Institution in Washington DC on May 16, followed similar presentations earlier in 2016 at Chatham House and in Shenzhen, China at a conference on global financial governance. The book’s main thesis rebuffs the “benign neglect” approach to policy cooperation owing to new challenges posed by interlinked financial stability and the “new normal” economic environment.

Fred Bergsten endorsed strongly the message that the benefits from policy cooperation are far greater in tough times—a point made in the chapter by David Vines—seeing a need to ensure that cooperation frameworks are in place and ready to respond promptly—like fire fighters. He added that having more policy issues on the table helps by opening up more trade-offs and allowing more avenues to a successful conclusion. He stressed the importance of inclusiveness—having all the policy actors at the table, in particular emerging market economies such as China. 

Continuing the latter point, Ms. Crebo-Rediker emphasized the complex interactions from spillovers and spillbacks especially from capital flows, resulting from our ever more multi-polar global economy. In this connection, she recommended the four chapters on policy responses to the crisis. She highlighted the important cautionary lessons in the chapter on the euro-area responses, which was accurately subtitled “A Case of Too Little, Too Late” written by an insider, Fabrizio Saccomanni.

What they do with your money: Does the finance industry do its job well?

Ivaylo Iaydjiev (D.Phil. Candidate, St Antony’s College, Oxford)

Speaker: David Pitt-Watson, London Business School
Chair: David Vines, Balliol College, Oxford

What does the financial industry do with your money? That is the misleadingly simple question that motivates David Pitt-Watson’s new book (co-authored with Stephen Davis and Jon Lukomnik). Given the large amounts of fees we pay in transparent or often less so ways to financial professionals, this is a particularly pertinent question. More broadly, it invites us to step back from the complex and technical details that dominate everyday financial news and revisit how we think about the role of the financial system and its contribution to society. 

Mr. Pitt-Watson examines in his talk whether the financial industry does its job well, and his conclusions are not particularly optimistic. Intriguingly, he decides to tackle the question by first reconnecting financial activity with its initial purpose. As he aptly points out, there is a voluminous literature on what financial institutions exist, but it tends to proceed by assuming that the existence of such institutions must serve a purpose, and then deducing what that purpose might be. Instead, it is necessary to be clear on what the original purpose is and work out the institutions from there.

For Mr. Pitt-Watson finance serves four key purposes, largely in line with the academic literature. The first key function is the safekeeping of assets, especially money. In turn, this is central to the second function – transaction-processing, or reducing the costs of financial exchange. The third function is the sharing of risk through the provision of insurance, which however does not reduce the aggregate amount of risk. Finally, the financial system’s most important purpose is to intermediate funds from savings to investment. 

These four functions demonstrate that finance does indeed have a socially beneficial purpose. However, he is careful to point out that this purpose relies on technical knowledge as much as on trust in the institutions and financiers themselves. When knowledge and trust are combined with a sense of purpose, the results can be transformative. Therefore, finance is key to our economies, to opportunities for social mobility and development, and to addressing our current challenges.

Financial Reform in Turkey: Responses to Past and Current Crises

Alexandra Zeitz (St Antony’s College, University of Oxford)

Speaker: Gazi Ercel, Former Governor of the Central Bank of Turkey
Chair: Nicholas Morris, St. Antony’s College, University of Oxford

How to prevent cycles of financial crises in emerging market economies? What interventions and reforms can stabilize and strengthen these economies in the aftermath of a financial crisis? Drawing on his extensive experience in Turkey, Gazi Ercel, former Governor of the Central Bank of Turkey, shared his insights on financial crises and reform in a PEFM seminar in late April, stressing the importance of reducing political uncertainties and ensuring post-crisis reforms are carried through once economic conditions improve.

Examining the record of financial crises in Turkey in the last four decades, Ercel identified common causes. In almost all crises the country has faced in recent history, public sector deficits had expanded, which provoked investors to withdraw short-term capital and in turn plunged the economy into crisis. For instance, Ercel attributed the inflows of large volumes of short-term capital in the lead up to the 1978-1979 crisis to a positive World Bank report. When these investors abruptly and rapidly withdrew in light of worsening public sector imbalances, the country experienced its worst foreign exchange crisis in three decades.

Domestic political economy, especially the pressure for a rising public sector wage bill, is at the root of the persistent public deficits that prompt financial crises, argued Ercel. The instability of Turkish politics exacerbates this problem, disincentivizing fiscal discipline as governments seek to maintain their hold on power.

In addition to identifying these Turkish political dynamics, Ercel argued that the particular causes of financial crises in emerging economies are distinct from those in developed economies. While industrialized economies are more likely to experience crises in their capital markets, emerging economies are frequently hit by debt crises. Emerging markets are likely to have weak and unsophisticated banking sectors, which may cause fragility, while instability in developed economies stems from the complexity and lack of transparency in banking sectors.