The Banking Industry's Biggest Problem isn't Bonuses or Market Share
Last Friday, in another of those agenda-setting speeches for which he has rightly become famous, Ed Miliband took on the biggest of what he describes as "the broken markets" in the UK economy – the financial market.
Taking his "cost of living crisis" theme to another level, the Labour leader emphasised that the issue is not just about oligopolistic firms fleecing their customers; it is also about the lack of jobs with decent wages that can support decent standards of living. The problem with the British banking industry, Miliband pointed out, is not just about the concentration of financial power in the personal account market, but also in the business loan market.
According to Miliband's analysis, the dominant banks are not lending enough to small and medium-sized enterprises because they form a cosy oligopoly (controlling 85% of small business lending) that does not want to take any risk; enterprise loans are inherently riskier than mortgage and personal loans. Given that small businesses create most jobs in the UK (as they do in all countries), lack of finance for them is limiting the creation of decent jobs. The solution, he argued, is to introduce more competition into the small business lending market by capping the share of individual banks.
This proposal has caused much controversy. However, one thing is certain: it is going to be slow-acting. It may be years before proper "challenger" banks emerge, given the time necessary for the review by the Competition and Markets Authority – which takes over the roles of the Competition Commission and Office of Fair Trading from April – and for the process of selling branches.
But there is a quicker and simpler solution to this problem. It is for the government to use its ownership of two of the big four banks, RBS and Lloyds, to direct more lending to small businesses. Thanks to the bailout following the 2008 financial crisis, RBS is 81% owned by the government. This means it can tell RBS what to do. It also owns 33% of Lloyds, and while this does not give it a total control over the bank, it is well above what is normally considered a "controlling stake" in an enterprise.
Now, if you can basically tell two of the four largest banks what to do – say, to increase lending to small businesses – why go through the rigmarole of calculating their market shares and forcing them (and the other two) to sell off some of their branches?
The usual refrain is that Westminster cannot make RBS and Lloyds do things differently because, in order to survive, these banks need to behave like other competitors: generating as much profit and paying their staff as much.
This argument may be right if the existing business model of British banks and other financial companies is fine. But it is not. It is a business model that has caused the biggest financial crisis in 70 years and created imbalances and inequalities that threaten the future viability of the British economy. The fact that the political class, including Miliband himself, cannot even imagine state-owned banks ditching such a model is a testimony to the power of the financial industry lobby.
From the day when RBS and Lloyds were bailed out, the Labour government was at pains to emphasise it would run them along the same lines as before nationalisation. The only thing for which Labour and, subsequently, the coalition government have used the government's dominant shareholding position has been to restrain bonuses. But this is really missing the point.
The problem with bonuses in the financial industry is not about their levels – if someone makes a huge contribution to the economy, he or she should be richly rewarded. The main problem is that these bonuses are given to people for doing the wrong things well – things that harm the economy in order to enrich the shareholders, the top managers of banks and other financial firms.
So the real question is how we make banks and other financial firms pursue the right goals, rather than how much people should be paid, whether in bonuses or salaries. And the only way to make them pursue different goals from those they pursue now is to change the rules of the game.
Unfortunately, few regulations have been introduced since the crisis that have materially changed the goals of financial companies. The result has been "business as usual".
All those complex and risky financial products that were at the centre of the 2008 financial crisis – such as mortgage-backed securities, collateralised debt obligations, credit default swaps and other financial derivatives – are back in vogue again.
The credit rating agencies, whose incompetence and cynicism in rating those financial products has become legendary after the crisis, are still operating in the same way.
Thanks to Help to Buy, the mortgage-lending market is nearly back to its old self. Now you can get loans that are 95% equal to the value of the house – not quite the 125% you could get before the crisis, but nearly there.
In the absence of measures to encourage longer-term shareholding – for instance, by granting more votes or tax advantages – short term-oriented shareholders are still reigning supreme, putting pressures on banks to generate short-term profits, whatever the consequences.
The main problem with the British financial industry is not the level of bonus, or even the concentration in the banking sector; it is that the industry is pursuing goals that are detrimental to the long-term economic viability of the country, in the process enriching only a tiny minority and sapping human and financial resources from the rest of the economy.
Unless those goals are changed through better regulation, the industry will remain harmful to the rest of the economy, whatever we do about bonuses and market concentration.
Ha-Joon Chang is a Senior Research Associate with the Center for Economic and Policy Research.