The government needs to be bolder when it comes to regulating financial markets. The health of the economy and the public finances depend on it
As we enter 2013, the future of the banking sector in the UK is still the subject of much debate. The Parliamentary Commission on Banking Standards, chaired by Andrew Tyrie MP, published an interim report in December calling for the ring-fencing between banks’ retail and investment banking operations to be ‘electrified’.
While recognising that doing nothing is not an option, the Treasury is reported to be reluctant to go as far as the Commission recommends. It fears that placing too onerous a regulatory burden on the banks could hamper their ability to support the UK’s economic recovery.
How this will play out is hard to assess. Much could depend on whether further revelations, following on from the PPI and Libor scandals, emerge in 2013. If they do, the Treasury is likely to be pushed in the direction suggested by Tyrie.
Ring-fencing retail banking – whether with the addition of electricity or not – would go some way to dealing with two of the three crucial elements of bank reform: reducing the implicit subsidy from the taxpayer to the financial sector and increasing the protection of depositors, borrowers, investors and shareholders from risk.
However, it would do nothing to address the third element: how to reduce the excess economic rents extracted by the sector. This is the missing element of financial reform.
'Excess rents' are the income companies generate above what would result if they were subject to the full force of market competition. Finance is a sector where markets are highly distorted in ways that enable large-scale rent extraction. These excess rents harm other sectors of the British economy by misallocating capital and talent away from other economically productive uses.
Attempts to increase competition in the UK retail financial sector are to be welcomed, but they only address a small fraction of the larger rent extraction issue.
UK retail finance provides only 16% of Barclays’ income, 24% for RBS and 6% for HSBC. The vast bulk of the profits made by the UK’s global banks come from corporate banking, investment banking, proprietary trading and asset management. And it is not just the big multi-business banks who are engaged in rent extraction; there are also issues in hedge funds, private equity and other parts of the sector.
The UK’s large corporations and its institutional investors – including pension funds - are harmed most by these market distortions. They pay the inflated fees, greater spreads, higher interest rates and other charges that they would not have to in a truly competitive, efficient market. They also suffer from a lack of transparency, conflicts of interest, and collusion among providers of financial services.
An example of common practice that leads to rent extraction is the implicit coordination of hedge fund and private equity fee structures. Almost all firms in these sectors charge their institutional clients '2 and 20' – a fee equal to 2% of the assets under management plus a 20% share of any investment gains. Yet studies show only a small number of elite firms produce an investment performance that justifies such fees. High-performing firms earn more, as they should, because their gains are higher. But low performing fund managers can still get rich from fat management fees.
Why don’t institutional investors push back against such practices? Some do fight to get fee discounts, and some very large investors with sufficient power occasionally succeed. But the funds put up a common front of 'this is the standard fee' and a fragmented investor base has little leverage to push back.
How to tackle rent extraction from corporate and institutional clients is not obvious or likely to be simple. More regulation will not on its own do the trick; the governance and compensation practices – indeed the culture - of banks have to change.
As a first step, the government should extend the remit of the Tyrie Commission on Banking Standards to cover rent extraction from corporate, institutional, and wholesale users of financial services.
Britain needs a well-functioning financial sector to provide capital for its businesses and households and it benefits from being the home of a successful financial industry that provides its services to the world. But the sector must succeed on its ability to fulfil those duties well, innovate, and compete – not on its ability to distort markets to extract rents.
Tony Dolphin is the IPPR’s chief economist. A longer version of this post, written by Eric Beinhocker and Tony Dolphin, is published in the latest edition of IPPR’s journal Juncture. IPPR has also recently published a major report on the financialisation of the UK economy: Don’t Bank on It.
