Capital ravings

Vickers: 8 reasons why the banks' arguments are wrong

2011-09-05T10:23:00.000-07:00

It’s only a week to go before Sir John Vickers publishes the ICB’s final report on bank reform and the debate is heating up spectacularly. The banking lobby has gone into spin overdrive and is pumping out arguments against change in various newspapers, on the BBA blog and behind closed doors to government officials, including David Cameron it seems. At the same time, a few brave City figures like David Pitt-Wilson are putting the other side of the argument.

An unfortunate side-effect of this activity has been to anchor the public debate firmly around the ICB's remedy of ringfencing, which was already a compromise on the original proposal of structural separation. This shift is partly a result of George Osbourne's Mansion House speech in June (see earlier post) and partly a result of recent bank lobbying. Like it or not, it means we are now discussing whether to compromise on a compromise.

Luckily, the arguments against separation and against ringfencing are nearly identical and can be rebutted just as easily. In the article below, replace "inside or outside the ringfence" with "utility or casino bank" and the arguments work just as same.

If the anti-ringfence arguments are sufficiently discredited when the ICB launches its report on Monday it will be much easier to move the debate back to separation, although the politics still look pretty challenging.

It is surprising that any politician would want to resist a set of relatively mild bank reforms after the biggest financial crisis for 80 years and a deep recession. The fact that David Cameron is having reform jitters shows just how good the industry is at talking people round in private. Whether it can do so in public and avoid either ringfencing or separation will depend on the quality of its arguments, so let's see how many of them stand up.

Here are eight arguments against bank reform culled from the weekend press and eight rebuttals.

Bank argument: Higher equity and ringfencing (or alternatively, the separation of "utility" from "casino" banks), will increase the cost of bank capital and this will hurt the economy.

Rebuttal: Higher equity capital requirements should in fact reduce the aggregate cost of equity and debt funding for banks because it reduces their overall long-term risk (the so-called Modigliani-Miller theorem).

In addition, higher equity buffers increase systemic stability, which further reduces risk and bank funding costs.

Transitioning to higher equity would not have to cause deleveraging in the real economy if banks are made to move slowly by retaining earnings and deleveraging their wholesale assets first.

Banks inside the retail ringfence (or "utility" banks under a full separation scenario) will have an explicit state guarantee and a slightly higher capital requirement, which should make their cost of funding lower than now. This will benefit the economy because most SME lending is done through retail banks. It will also make it easier for retail banks to fund themselves in the wholesale markets if they need to, as their risk profile will be better.

Banks outside the ringfence (or "casino banks" under full separation) will have a higher cost of capital as their subsidy is removed, but this will have limited impact on the real economy because the majority of investment bank assets are non-productive, meaning they are mostly financial or property -related. The different funding costs at retail and investment banks are likely to cause capital to move from the financial into the real economy.

The current subsidy to banks creates hidden “tail risk” for the UK’s sovereign rating. Removing the public subsidy from investment banks through any reform will reduce the chance of a speculative attack on UK government debt if the economy deteriorates, as most economists now predict it will.

Bank argument: UK banks will face a competitive threat as will the future of London.

Rebuttal: The best way to protect London’s long-term future is to improve the stability and function of its banks, not to subordinate these qualities to profitability or short-run returns on equity.

Bank argument: The global economy needs global banks.

Rebuttal: Ringfencing will not prevent banks from offering international corporate banking services. Global corporates managed fine in the stable era of Glass-Steagall and are likely to benefit if ringfencing reduces “financial bundling”, which drives a lot of excess bank profits.

Bank argument: Corporates will move their accounts to foreign banks if ringfencing or separation pushes up lending costs.

Rebuttal: Corporate lending should become cheaper if this relatively uncomplicated activity is left inside the ringfence (or "utility" bank) because it will be expressly guaranteed and better capitalised than now. However, if it is outside (or in a "casino" bank), commercial lenders will need to become more competitive by offering a better service and lowering their own funding costs through safer, higher equity funding. If banks are unwilling to do this, or they do it but they still lose corporate lending business, that means, by definition, that the business they are losing was only won in the first place because of the UK taxpayer subsidy to bank capital. Since the benefit of this subsidy falls privately and often abroad but the cost is public (and very high if it ever endangers the UK’s sovereign rating), losing this business may well be a net gain for UK taxpayers. In any case, if public subsidies are to be provided for corporate borrowing they should be explicit and targetted.

Bank argument: Banks will move abroad, eg HSBC to France.

Rebuttal: Healthy democracies do not make policy by blackmail, but if banks want to move they must first find a host country that is free from sovereign exposure, willing to risk its sovereign rating and willing to subsidise the bank’s capital. Good luck to them.

Bank argument: The bulk of UK bank assets are foreign anyway. The UK’s domestic bank sector is no bigger than that of Spain or Norway.

Rebuttal: This is irrelevant. UK taxpayers can be on the hook for the overseas assets of UK domiciled banks just as they are for domestic assets, as we saw with Lloyds/HBOS and RBS.

Bank argument: Ringfencing will destroy the value of taxpayer stakes in RBS and Lloyds.

Rebuttal: On average, banking crises cost the economy around 3% of GDP, or more than £40bn each year, according to the Independent Commission on Banking. The combined equity value of RBS and Lloyds is around £35bn, less than a single year of this burden. Ringfencing would help RBS and Lloyds to lend more to the real economy leading to higher tax revenues, and the value of the taxpayers' stakes would likely recover in the longer run anyway, once the banks were recapitalised and rehabilited.

Bank argument: Universal banks are more resilient in a crisis.

Rebuttal: In fact the opposite is true; a universal bank only needs one rogue unit to get into trouble and the entire business can become insolvent. The more units a bank has, the greater the chance that one of these units will get into trouble. And the bigger the overall bank, the greater the systemic damage if this happens. This is exactly what happened with RBS and AIG. As in many areas, systems made up of lots of different units are generally more resilient than those with fewer, similar units.

Ringfencing as a laboratory experiment

2011-09-02T05:01:00.000-07:00

The banks are predicting doom if ringfencing comes, saying their inability to lend will stifle growth and it will all be the government’s fault. The government’s reaction in the short-term, I hope, will be to call their bluff and do it anyway. Let’s see – it’s only ten days to go before the ICB publishes its final report.

But what happens a bit further down the track?

According to Martin Wolf’s latest piece, the UK may already be locked into its longest depression for a century. He says a structural decline in output could condemn us to low growth and low productivity for years.

What do you think the banks will say in 2013 if, as Wolf predicts, the economy is sick as a dog?

I guess we can expect a chorus of “I told you so” from the bank lobby, followed by indignant demands to repeal ringfencing – which won’t be fully implemented by then anyway – together with any other reforms the banks don’t like.

It’s easy to imagine politicians supporting this as they start to see a 2015 election dominated by the economy. Voters, confused and worried about their jobs, will go along with them.

This would be a complete disaster, a victory for Voldemort. Today's lack of growth has its roots in a financial system that actively channelled capital away from productive activity. Reform is a vital part of recovery, even if it takes time to get right and to work through the system.

The recent credit bubble focussed almost entirely on property and financial assets, the least productive parts of the economy. The most productive parts, the unglamorous non-financial companies (the ones that create most of the jobs and exports), have been starved of growth vitamins for years thanks to the flawed Basel regulations and a culture of short-term, transaction-led banking.

Meanwhile on the demand side, pension funds and saving accounts have been raided by market volatility and low interest rates, both triggered by the financial crisis and sucking further life out of the economy.

Given this background, any future attempt to roll back financial reforms because of economic failures caused by the financial system itself would be extremely foolish.

But the financial lobby thinks far ahead and is already preparing to do exactly this, leaving a trail of high-profile warnings such as John Cridland’s “barking mad” comments (apparently made without irony).

If the government is to sidestep this trap it will need a counter-factual: something to show what would happen to the economy, or at last to productive lending, if we don’t adopt ringfencing.

Luckily, we have the US. Its political elite rather likes universal banks and is not about to ringfence them. The progress of its banks in the next few years will provide an interesting comparison.

However, the US and UK economies are too different for this to make policy. We need a British laboratory experiment.

Here’s an idea – let’s apply the ringfence to the whole banking sector apart from one UK universal bank, perhaps a certain state-owned one. Then let the reforms rip and see how all the banks fare as our 100-year depression unfurls.

My bet is that most of today’s big UK banks will adapt pretty quickly to ringfencing. They will build capital, their wage bills will fall and their aggregate funding costs (debt and equity) will fall as they become safer, more self-sufficient and less dependent on the UK's sovereign rating. They may have a couple of lean years in terms of returns on equity, but once the uncertainty goes and they have built their reserves I would expect their lending figures in 2013 to no longer be a source of shame.

The experimental bank, unreformed and still trading off its retail deposits, might look rather sickly in comparison. And if it isn't, well at least we’d know the truth.

Riot reading

2011-08-16T02:59:00.000-07:00

Handy guide to the week's riot writing: eight explanations and eight excellent riot commentaries from the press/blogs. What am I missing?

Why the riots happened
This list has been looted from various articles in the UK press in the last week, the best of which are mentioned below:

1. Absent fathers, gangs, knives, blacks, whites, chavs, Grand Theft Auto

2. Compensation and entitlement, frustrated consumerism

3. Unemployment, lack of opportunity, abandonment, austerity

4. Breach of social contract by elites in finance, politics, media and police

5. Market and social individualism, wealth inequality, Tories

6. Multiculturalism, moral relativity, New Labour

7. Decline of religion and morals, lack of responsibility

8. Educational failure, indisciplined schools and homes, inability to articulate

Eight smashing riot commentaries

1. How did England's cities become engulfed in a Lord of the Flies nightmare? Toby Young, Telegraph 11 Aug 2011

Moral relativism is to blame, not gang culture

“the prevailing orthodoxy that’s taught in our schools and universities is that one set of substantive moral values is no better than any other and to claim otherwise is to risk appearing racist or sexist.

… as we witnessed in England’s cities earlier this week, moral relativism does not lead to peace, love and understanding but to a kind of Hobbesian nihilism…

Perhaps the root of the problem is the progressive Left’s conviction that mankind is essentially good. After all, if you think human beings are fundamentally benign and altruistic, then failing to teach them about right and wrong isn’t going to pose any major problems. They’ll just get along regardless. But the lesson of Lord of the Flies is that this is sentimental and naive.

Released from the bonds of civilisation, human beings will quickly descend into cruel, atavistic creatures who pursue their own selfish interests at the expense of everyone else’s.

They were just ordinary people who’ve been insufficiently socialised, members of all communities and none. What they lack isn’t material wealth or meaningful employment, but a moral framework that enables them to see that smashing shop windows and setting fire to cars – and stealing – is wrong

2. The moral decay of our society is as bad at the top as the bottom, Peter Oborne, Telegraph 11 Aug 2011

Blames elites in politics, media, police and business for setting a bad example. More than 4000 online comments so far

“ I believe that the criminality in our streets cannot be dissociated from the moral disintegration in the highest ranks of modern British society. The last two decades have seen a terrifying decline in standards among the British governing elite. It has become acceptable for our politicians to lie and to cheat. An almost universal culture of selfishness and greed has grown up. It is not just the feral youth of Tottenham who have forgotten they have duties as well as rights. So have the feral rich of Chelsea and Kensington.

The rioters have this defence: they are just following the example set by senior and respected figures in society. The culture of greed and impunity we are witnessing on our TV screens stretches right up into corporate boardrooms and the Cabinet. It embraces the police and large parts of our media. It is not just its damaged youth, but Britain itself that needs a moral reformation.

3. Bankers and rioters share a common impulse, Michael Meacher Left Futures blog 15 Aug 2011.

Blames breach of social contract at all levels, profound changes needed

“The concept of a social contract and a moral responsibility to each other was discarded as old-fashioned, and replaced by dog-eats-dog mentality, a ruthless and uncaring individualism. The results, as we now see, were inevitable. That system is now facing terminal collapse at all levels. There will be no sustainable reform till the tensions and contradictions in the system as a whole are tackled.

That is the semi-revolutionary challenge for the decade ahead.

4.One law for the rich and another for the poor? Jon Snow, Chanel4 Snowblog 15 Aug 2011

Blames rising inequality in incomes and justice

“There is a sense in Britain too of a widening gap in both wealth and law – that there is a that there is one law for the elite and one for the poor. Take the MPs’ and Peers’ expenses scandal. A tiny handful of the expenses abusers have gone to jail. The vast majority have been allowed to pay stuff back or retreat to the political undergrowth. How many of the looters will be allowed to bring their plasma screens and running shoes back in return for their freedom?

No British banker is in jail for what happened in 2008.

Disconnect is the order of our massively interconnected day. Condemning and jailing the looters is one thing. Trying to identify the nature of their disconnect is another. Damning and punishing the faceless hoody comes a lot easier than seriously challenging the faceless banker who broke our economy, or the politician who thieved in our own Houses of Parliament.

5.London’s Rioters Are Thatcher’s Grandchildren: Pankaj Mishra Bloomberg 12 August 2011

Blames market individualism

The illusion that the nation could be saved only through immersion in a self-stabilizing market economy hardened into a revolutionary ideology, embraced by both major parties, that has shaped today’s Britain. If Tony Blair and David Cameron are “sons of Thatcher,” the rioters of today are the grandchildren…

Margaret Thatcher, who famously proclaimed“there is no such thing as society,” rapidly privatized state-held assets. She decimated many public services that tended to the most disadvantaged and vulnerable people in Britain. More importantly, Thatcher abandoned the idea of full employment -- a precondition of the welfare state.

The enduring effects of this radical socioeconomic engineering are now visible in the U.K., not least in some of the world’s highest levels of inequality.

as the riots revealed, the police cannot perform their Hobbesian task of staving off the brutish state of nature if there are not enough informal keepers of public order such as intact families, not to mention bus conductors, park keepers and truant officers.

British conservatives today speak a lot of the Big Society. But they remain blind to how a culture devoted to social and economic individualism undermines the traditional institutions that they pay ritual obeisance to, such as marriage.

6. Britain's liberal intelligentsia has smashed virtually every social value, Melanie Phillips, Daily Mail 11 Aug 2011

Blames liberal policies, rise of single parent families, woolly education theory and multiculturalism, victim culture, lack of religious codes.

“David Cameron is commendably talking tough: but will he have the stomach for tough action?

Will he, for example, remove the incentives to girls and women to have babies outside marriage? Will he dismantle the concept of entitlement from the Welfare State? Will he vigorously enforce the drug laws? Will he end the kid-glove treatment of ‘victim groups’, and hold them to account for their behaviour in exactly the same way as everyone else?

Repairing this terrible damage also means, dare I say it, a return to the energetic transmission of Biblical morality.”

7. Big Brother isn’t watching you, Russell Brand, Guardian 12 Aug 2011

Young people have no privileges or opportunities and politicians do not represent them. We should care for them more.

I found those protests exciting, yes, because I was young and a bit of a twerp but also, I suppose, because there was a void in me. A lack of direction, a sense that I was not invested in the dominant culture, that government existed not to look after the interests of the people it was elected to represent but the big businesses that they were in bed with.

Amidst the bleakness of this social landscape, squinting all the while in the glare of a culture that radiates ultraviolet consumerism and infrared celebrity.

I remember Cameron saying "hug a hoodie" but I haven't seen him doing it. Why would he? Hoodies don't vote

If we don't want our young people to tear apart our communities then don't let people in power tear apart the values that hold our communities together.

8. London Riots Were Bonfire of Consumers’ Vanities: A.A. Gill Bloomberg 12 Aug 2011

Blames the lack of other bad news. Superficial but entertainingly, poetically written.

“We were lulled and gulled and played for fools, beginning to think we could be winners”,

“Capitalism had flaunted a crass and insistent consumerism in front of this generation, while ensuring they could never be part of it. The answer to this was apparently more opportunities, more jobs and more investment. So the cause was filthy capitalism, and the answer was more filthy capitalism.”

FT letters 12 Aug 2011 Reflection of a dysfunctional society

From Dr Rowan Watson.

Sir, We woke up on Monday morning to hear on the one hand that there were riots and looting in London, and on the other that the average pension of a company director was as much as 29 times that of employees. As we see horrific images of smiling rioters with looted television sets under their arms, we may imagine that, for a time at least, they are as happy as those contemplating six-figure pensions. Might we hope that the happiness of both groups is tinged with a feeling that their position is a reflection of a dysfunctional, not to say amoral, society?

Rowan Watson,

And finally, the Economist puts it in perspective with a retrospective of English riots since 1600, courtesy of Geoffrey Pearson's 1982 book "Hooligan: A History of Respectable Fears".

Werner-nomics (or how to turn debt into jobs)

2011-08-11T11:40:00.000-07:00

After my last post on stimulating growth, inspired by the riots, I stumbled across an article on the q-finance website by Richard Werner, the rebel economist from Southampton University. As a layman’s introduction to his ideas on credit and economic growth, it was pretty thought provoking.

Werner is a heterodox (as in, not orthodox) economist whose theories on credit creation and money are proving a major challenge to mainstream economics. He invented the term “quantitative easing” while working on the Japanese banking crisis in the 1990s and his book “New Paradigm in Macroeconomics” has been hailed as a classic in the making. Despite his dubious choice of words, he recently become a Qualified Member of Finance Watch and seems to be working hard to live up to his 2003 Davos billing as a “Global Leader for Tomorrow”.

Here is a summary of the article and a few thoughts about what it could mean for growth:

Werner says mainstream, or neoclassical, economics relies on theories of equilibria and perfect markets that can never exist in real life because of shortages of information, time and money. In most real markets, “short-side” economics prevail, in other words the most constrained side of the market determines the volume of transactions. This confers huge market power on corporate bureaucrats who decide how much to produce. They make decisions for their own benefit not society’s, so the invisible hand does not deliver the social benefits predicted by Adam Smith.

When this is applied to banking, where 95-98% of credit creation is done by private banks, the result is over-lending in booms, under-lending in busts and credit allocation with no regard to growth. This leads to consumer price inflation when credit is used to finance consumption, and asset price inflation when credit is used to fund transactions that do not contribute to GDP, such as those involving real estate and financial assets.

This is what happens now and explains our recurring financial crises and poor economic outlook. It should be contrasted with a situation - which does not yet exist but Werner wants to bring about - in which credit is created mainly for productive use. In his view, if credit were used only to fund activities that contributed to GDP, then it should lead to non-inflationary growth.

Werner’s proposal is to restrict banks so they can only create a tiny amount of "non-GDP" credit, less than the increase in aggregate credit, ie if total credit in the economy increases by 10%, then unproductive loans should make up no more than 10% of the total.

But central banks have apparently ignored Werner’s calls to monitor and control the proportion of GDP vs non-GDP lending by private banks, presumably leaving that to Basel rules and banks themselves. And in times of crisis central banks have relied on interest rate reductions, which are useless because growth depends on the availability of credit not its price, and QE which has failed because it has been used to buy gilts instead of going into the productive economy.

Werner's advice in times of crisis is for central banks to create new money and use this to de-zombify failed banks by acquiring their non-performing loans and buying new bank equity. This would allow failed banks to lend again without increasing national debt.

Commentary

Overall, it seems intuitively right that some markets fail to serve society because of “short-side” volume constraints that confer excess power to special interests. This seems especially so in finance, supermarkets, energy and utilities where scale economies and barriers to entry are high and producers find it easy to capture the market for their own benefit.

In more fragmented industries - such as personal services, web-design, media, local retail, small scale construction and maintenance - the market seems to work much more as it should, as producers respond both to demand and competition from rival producers.

Government intervention therefore seems more appropriate at a strategic, industrial level, either to address specific cases of market capture, such as in finance, or to favour industries where positive social externalities are ignored, such as job creation, food or energy security, carbon reduction, environmental protection, skills development and R&D.

As Werner says, the self-regulation approach to financial markets based on mainstream economic theory has been discredited by events but is not yet dead in policy makers' minds. His argument is worth making over and over until it replaces the Washington Consensus. Vested political and financial interest will make this a long and difficult shift, but Werner’s ideas on credit creation could play a key part in getting the message across.

There are a few problems, or at least unanswered questions, in the article.

First, with defining GDP. For example, lending for consumption, which Werner says is unproductive and inflationary, is hard to distinguish from lending to support the retail sector, which contributes to GDP. And lending for financial and real estate transactions produces revenue that is part of the finance sector’s contribution to GDP. The boundaries would always be contested, and there is a growing view that GDP has serious shortcomings as a measure of well-being.

Second, is sovereign debt a GDP or a non-GDP activity? Private bank holdings of sovereign debt are a major threat to stability in the Eurozone and a significant source of funding for overstretched governments. If they were considered non-GDP, how would governments replace the funds they currently get from private banks (at near-zero cost to the banks, thanks to Basel risk weight rules)? A serious transition plan would be needed.

Similarly, a huge portion of current private bank assets are “non-GDP” financial and real estate assets. Restricting these to the level of aggregate credit growth, which could be a tiny fraction of the current total, would be hugely dislocating and would need another serious transition plan.

Finally, the idea of Werner-style QE, where central banks create money to rehabilitate zombie banks so they can lend again, looks horribly difficult to implement. It is only worth doing if those banks can be trusted to lend productively but current bank rules ignore productivity completely, focusing mainly on default risk instead. Changing the consensus view might take a generation. Meanwhile, zombie recapitalisations would be seen by the right as unacceptable nationalisation and by the left as unacceptable bail-outs. None of this is easy to achieve.

But perhaps the sea change in regulatory thinking is not so far away. Regulators are already looking at ways to reduce systemic risk with capital surcharges based on size and interconnectedness, among other factors. The Bank of England has considered variable risk weights on certain assets (eg mortgage securities) for the same reason. It would be a short step to extend this thinking to include economic productivity and easily justified if you consider economic failure also to be a systemic risk.

A more extreme approach would be to fully nationalise credit creation in the central bank. This would give central banks full control over the money supply and could be advantageous if inflation becomes a major concern, as seems likely after previous rounds of QE. A quota of new money could be set centrally, with private banks bidding to distribute the new credit. Distribution would still need to be directed to gain the best possible growth benefits, perhaps using the productivity-based capital requirements approach outlined above.

A less interventionist approach would be simply to replace existing capital requirements with a strict overall leverage ratio for banks, who would then be free to create credit where they like regardless of risk and productivity. Banks would set interest rates and lending conditions to maximise profits, automatically channelling credit to the highest returning ventures.

The danger here is that banks might favour high-risk high-reward ventures at the expense of all other businesses, for example lending to financial engineering and leveraged speculation but not to SMEs. If we accept Werner’s view that policy should favour productive over unproductive credit, a tougher approach is called for.

In conclusion, while some of his policies raise questions, Werner's theory about credit sets up a much-needed debate about how credit should be allocated in the economy if we want it to help rather than hinder economic life.

Growth pains

2011-08-08T06:31:00.000-07:00

Violence among unemployed north Londoners, panic in the financial markets, teetering public debt – the UK is really missing economic growth. It seems we need a hit of good economic news quickly, before things turn even uglier.

But before grabbing the economic morphine of QE and tax cuts, shouldn't we check if they will actually improve the way we use our resources, rather than merely expanding credit and inflating asset values?

Vince Cable has called for QE and tax cuts, which could help if they increase the amount of real work going on in the economy, an outcome that could take years to come through.

Let's be optimistic for a moment and assume we are able to wait that long. What policies could be introduced now that would bring real growth, including jobs for the disaffected and tax revenues for the deficit, in the future?

• Instead of printing money to buy gilts, the government could break with tradition and print money to spend on energy and transport infrastructure. This would maintain demand now and, crucially, improve industrial productivity in the future. It would be more constructive, in every sense, than the Bank's current preference for buying gilts, which merely pumps liquidity into zombie banks.

• If the government wants to limit its money printing, it could make strategic use of existing budgets to subsidise R&D in our pharma, renewable energy and high-tech sectors, just as the US used decades of military spending to build a global semi-conductor industry (see brief and very readable Ha-Joon Chang article, item five)

• Instead of cutting taxes indiscriminately, the government could offer bigger tax breaks for businesses that invest in capital equipment ahead of depreciation, that provide lifelong staff training and that retain apprentices. Similar investments paid off handsomely in Germany but they took 20 years to come through.

• We could fill skill gaps in the workforce by making strategic changes to the national curriculum, for example promoting sciences or skills for the workplace.

• We could make consumer spending less of a rollercoaster for retailers, who employ one in every 10 UK workers, by reducing people’s dependence on cyclical consumer credit and promoting effective savings and current accounts. State controlled banks RBS and Lloyds and the Post Office would be excellent places to start.

• The Bank of England could be smarter about the way it implements Basel bank capital rules so it promotes lending to real businesses instead of “low-risk” financial assets (as argued here before). And financial regulators could rescue commodity markets from hot money flows, which push prices up and down irrespective of real economic demand (the FT's Edward Hadas explains why this is so damaging), and stimulate private investment by doing the same with capital markets.

There is plenty that could be done to promote growth. Sadly, many of the policies above would be either opposed by strong vested interests or would take longer than one election cycle to complete.

Summer riots and market meltdowns make it tempting to look for a quick fix but a problem that has taken years to create needs years to resolve. The question is - have we got the nerve and the patience to see it through?

What’s missing from Cameron’s public services white paper

2011-07-11T19:01:00.000-07:00

Private equity firm Blackstone escaped most of the blame for Southern Cross’s demise on Monday (see previous post How Blackstone made its £600m from Southern Cross) but the techniques it used to make its windfall raise serious questions about whether private equity firms are appropriate owners for public service providers.

The questions are relevant now because David Cameron has just published his White Paper on public service reforms, detailing plans to open nearly all public services to the private sector – schools, hospitals, rehabilitation, childcare, council services, visa application centres etc - with virtually no safeguards against financial engineering or against brave new social enterprises being swamped by big business (see Peter Holbrook's post).

The White Paper has some good suggestions, such as allowing social enterprises, charities and employee-led mutuals to compete for services whose provision had grown stale under the state.

But it contains big contradictions, mostly relating to the role of the private sector and highly relevant to private equity. Here are some suggestions for making it safer.

Ironically, the paper was launched on the same day that struggling Southern Cross threw in the towel and said it would hand control of its care homes to its landlords (the second time in a little over a decade for some of its homes). With this fresh in mind, here are some of the contradictions in the paper:

- After mentioning the government’s “huge respect for public service ethos”, the Paper says that ownership models do not matter. But the form of ownership is a big factor in corporate culture and in determining whether staff are motivated by money or by something else. Is this just lip service?

- It says public services must be sustainable in the longer term but calls for more innovation in financing public service providers. If innovation means turning assets and income streams into huge one-off payments for private equity firms and other financial engineers, as we saw with Southern Cross, it will not be very sustainable.

- It says providers will be encouraged to use a new register of public assets to “make innovative proposals for the better use of publicly owned assets”, but does nothing to stop private firms from simply selling public assets, or using them for complex and ultimately costly asset-backed financing.

- It denies any ideological preference for either sector. It then derides public provision as "take what you're given" and "Whitehall knows best" but fails to mention any of the downsides of the private sector, such as the extra cost of paying dividends and the extra risks of bankruptcy. Brushing these under the carpet does not seem very impartial.

- It sets out to reduce bureaucracy and improve quality using “payment by results”. This is bound to skew the delivery of services towards easily quantifiable targets, such as number of visas processed or hours of care invoiced, and ignore qualitative aspects such as providing correct information to visa applicants or ensuring that care-givers give quality care that recipients really appreciate. It replaces the unselfish ethos of public service and quality with a self-interested focus on bureaucratic box-ticking in order to get paid.

- It will create a continuity regime for failing providers with few comebacks for failed management, which risks creating another industry prone to moral hazard and bail-outs.

Keep the financial engineers out

The best argument for allowing private equity to get involved with public service provision is that it might bring new capital. This is true, but if much of it leaves in the form of windfall payments, it rather undermines the industry's case. If much of it is transferred from public stakeholders, such as customers and taxpayers, it is untenable.

The next best argument is that private equity could turn around failing providers or fund new entrants. These are useful functions and do not rely heavily on financial engineering as a source of profit, making them suitable for venture capital rather than LBO houses.

The government recognises some of the problems. The white paper says there is a need for regulators to ensure financial management and robustness, while the Department of Health is proposing insurance bonds for care home operators to fund continuity of care in a failure. But it's not enough.

To capture the benefits of private sector involvement safely, the White Paper needs a few basic safeguards:

- a ban on extractive financial engineering (eg by hidden increases in operational leverage)

- strict limits on financial leverage

- restrictions on the sale or mortgaging of public assets, including the use of opco-propco structures

- personal liability for failing directors, including professional bans and civil and criminal liability for the worst offenders

- a continuity-in-failure regime that avoids moral hazard by haircutting debtors and clawing back excess profits

- overriding corporate objectives with a statutory public service delivery obligation.

How Blackstone made its £600m from Southern Cross

2011-07-11T18:17:00.000-07:00

Five years before Southern Cross failed, private equity firm Blackstone owned the company and its main freeholder for two years in which time it engineered a profit of £600m - pretty impressive given that the UK care home group had annual operating cashflow of only £50m. Blackstone has faced accusations of profiteering and worse ever since.

This post tries to explain how Blackstone made its money and where it really came from.

The background

Southern Cross was a care home “opco”, paid by local authorities to run care homes for about 31,000 elderly people. It leased most of its buildings from specialist landlords including the company formerly known as NHP, the largest of SC’s “propco” freehold owners. NHP was unusual as it also owned its own “opco” Highfield, inherited in the late 1990s when some previous care home tenants went bust in a previous round of financial engineering.

Blackstone bought both SC and NHP in 2004 in a pair of separate, leveraged buyouts that cost it £162m for SC and £950m for NHP. It made a few internal changes, such as transferring Highfield from NHP to SC, installing en-suite bathrooms in some of the bedrooms and refinancing both companies via massive offshore debt structures.

In 2006, it listed SC on the stock market for around £500m and sold NHP to RBS for £1.15bn. Its profit on the two deals was £600m, made up of £400m from SC and £200m from NHP.

After Blackstone left, SC’s new management expanded the company extremely quickly, taking Blackstone's methods to new extremes and adding some tricks of their own. When rates of bed occupancy fell and rents carried on rising, SC could no longer pay its rent. SC’s share price collapsed almost to nothing and its landlords including NHP (now owned by the Qatari sovereign wealth fund) started a long and messy round of negotiations, ending with the transfer of care homes from SC to its various landlords as going concerns.

Blackstone's original "buy-and-build" strategy has ended with SC being fragmented among 80 landlords.

SC made 3000 staff redundant and promised its anxious elderly residents that they would not be left in the street, a promise it has so far kept.

How did Blackstone make its money?

From my own research, Blackstone appears to have earned its windfall using these four financial engineering techniques:

1. First, Blackstone adjusted the operating leases between leaseholder and freeholder, both of which it owned. It extended any leases under 20 years to 25-30 years and replaced any RPI-linked and turnover-linked rents with a fixed annual ratchet. In the booming conditions of the time, this reduced SC’s short-term costs but restricted its longer term flexibility, since rent increases could not be reduced in down years. Another change (I don't know if this is down to Blackstone or someone else) was to prevent any rent review until 2020. This last change massively complicated negotiations with the landlords when the business eventually collapsed. Overall, the lease changes boosted the gearing capacity and therefore the resale value of NHP when it was in Blackstone's hands.

2. The second technique was to gear up. In round numbers, Blackstone contributed only £60m of its own equity for SC and £200m for NHP, around 20% of its total investment. The rest was borrowed, allowing Blackstone to gear its equity return 5x, in effect pocketing much of every pound of debt that the operating companies paid off.

3. The third was tax planning. Since debt interest is a tax-deductible, the large amounts of debt meant SC and NHP paid little or no UK non-payroll tax. If this had been equity finance, any dividends would not have been tax-deductible and the tax bill would have been far higher. The structure effectively forced the UK taxpayer to subsidise the deal. Further tax avoidance measures included a mind-boggling web of offshore holding companies and a technique of providing equity in the form of tax efficient “deep discount bonds”. These measures are widely used in the private equity industry to avoid tax.

4. The last and biggest technique was multiples arbitrage. Blackstone paid around 6x EBITDA for the care homes in 2004 and sold them for 9x in 2006. It could do this because it was packaging smaller care homes into a larger network that was visible to institutional investors, who were in the grip of a property mania at the time. No doubt many regretted it later.

Where did the money really come from?

Blackstone’s strategy was to capture for itself the nominal rise in value of a group of real estate assets. Assuming a typical 2 and 20 fee structure, staff at Blackstone are likely to have shared a £125m bonus for doing this, and transferred the remaining £475m gain to their investors.

Market theory holds that fund managers are rewarded for the social and economic value they create by directing capital to its most productive use. Their rewards represent a slice of the additional return that the capital earns from new marginal production and therefore commensurate with the social and economic value added. That's the theory, anyway.

In this case, Blackstone’s profit was earned from changing asset values. It can best be described as a transfer from people that owned the assets at other times, not a reward for boosting productivity.

If anything, it may have diminished productivity by leaving the care home group heavily mortgaged and its managers focussed on caring for debts instead of residents. The result: higher bankruptcy risk, lower long-term capital investment and a shoestring budget for residents and nursing staff.

Even the £475m profit booked by Blackstone’s investors is hard to count as a social gain: most of it was simply shuffled from one set of institutional investors to another. Despite huge fees taken on the round trip, the net amount of institutional funding for the care homes industry hardly changed.

Blackstone did not trigger the failure of Southern Cross, which was carried over the edge by its subsequent management. The private equity group apparently "feels terrible" about what happened but has denied doing anything irresponsible.

Despite this reassurance, the fact is that over the ten years that include Blackstone and subsequent management, Southern Cross grew markedly less resilient. In 2001-2004, bed occupancy and rent cover averaged around 87% and 1.2x, levels the business was comfortable with for several years. Fast forward to 2011 and ratios were very similar at 85% and 1.2x but the business failed, with financial conditions now deemed “impossible”.

It is difficult to prove empirically who profited from this fall in resilience, but the question lingers like a bad smell. Either way, the prospects for future health privatisations are not good.

What is clear is that Blackstone succeeded in capturing all the asset price inflation of care homes that it owned only fleetingly, using elaborate financing and good timing to squeeze past and future asset price gains into its pocket, helped by lease alterations and leverage. Blackstone was smart enough not to cripple the operating company and to sell before the bubble ended but when subsequent, less-disciplined managers continued with the same financing techniques, the money machine inevitably collapsed.

So where did the money come from? Some came from taxpayers via the subsidies on debt, some may have come from squeezing operating margins but it seems most of Blackstone’s windfall came at the expense of other investors and creditors. Tough luck, you might say, that's how the market works and how we reward entrepreneurs for creating value. Unfortunately, even Blackstone agrees that, of all the things it did, earning £600m by making Southern Cross a better care home operator is not one of them.

ICB submission

2011-07-05T03:40:00.000-07:00

Click "Read more" to see the full text of my submission to the Independent Commission on Banking

Greg Ford is editor and research manager at the think tank Re-Define. This submission represents his personal views.

Consultation question 1.1

Do you agree with the general position set out in this Interim Report?

I agree with much of the analysis but feel the ICB’s general position on reforming the UK banking sector does not go far enough.

I would prefer full separation of retail and investment banks, much higher equity capital in all banks, more balance sheet disclosure, and incentives on banks to self-shrink and self-resolve.

In addition, I believe the ICB should consider the use of leverage ratios instead of risk asset ratios as a primary tool for prudential regulation of banks. Other measures the ICB could consider or recommend for future assessment include the abolition of debt interest deductibility for tax purposes, a more purposive regulatory regime and a policy to position London as a global centre of excellence in sustainable finance.

Underlying my submission is a belief that banks and the financial system should not in general profit from public subsidy or moral hazard, should have as their primary objective the tasks of bringing capital into productive use and helping business to cope with risk, and should operate where possible in an undistorted, unsubsidised and competitive market.

Consultation question 2.1

Do you agree with the analysis set out in this chapter?

Yes, although I think paragraph 2.4 defines the functions of the financial system too narrowly.

Instead of “lending to households, businesses and governments”, I would prefer “bringing capital into productive use” as this recognises the benefit of allocating bank credit to where it can do the most economic good. This sorting process is a central function of capital markets and should be made more explicit in the ICB’s analysis.

Consultation question 3.1

Are there other reform initiatives, beyond those set out in Chapter 3 and Annex 5, which you consider it essential for the Commission to examine further?

There are four other areas of reform that I would like to bring to the ICB’s attention as it prepares its final report:

1. risk weighting reform

2. debt interest deductibility

3. purposive regulation

4. making London a centre of sustainable finance.

1 Risk weighting reform

“Recent history suggests that risk weights have done a poor job of assessing how much capital should be held against assets. … These points argue against relying on a minimum capital ratio to RWAs alone.” (ICB interim report, 4.27 and 4.28)

Summary of idea

Risk weights proved themselves an ineffective tool for prudential regulation. They are a (i) flawed concept that (ii) failed to ensure enough loss-absorbing capital or flag problems in advance of the financial crisis, they have (iii) allowed banks to disguise historically high levels of total leverage, and (iv) have distorted the allocation of credit within the economy to perceived-as-low-risk investments at the expense of risk enterprise and economic growth.

The easiest way for the ICB to address these flaws would be to recommend a simple leverage ratio at a level high enough that the Basel commitments on risk assets become redundant.

Problems with risk weighting

(i) Flawed concept

Perceived risk is not the same as real risk. As Per Kurowski, former World Bank director, wrote recently in an open letter to new IMF boss Christine Lagarde[1]:

Currently the “capital requirements for banks” are set by discriminating between borrowers based on their “perceived risk of default”, mostly as perceived by the credit rating agencies. More perceived risk, more capital, and vice-versa.

But, this is not logical, given the fact that regulators need not concern themselves much with the risks that are perceived, but should concern themselves mostly with the risks that are not perceived.

There has never, ever been a financial crisis resulting from excessive lending to what is perceived as “risky”. Apart from cases when fraudulent behaviour was present, they have all resulted from excessive lending to what is perceived as “not-risky”. Just look at the current crisis, 100% caused by leveraging the perceived as "not-risky" and then discovering these, later, as being “very-risky”

And it is also not logical, given that those perceived as “risky” are already compensating the capital accounts of the banks by means of paying higher risk-adjusted interest rates.

Since crises arise only when supposedly-safe assets turn out to be dangerous and not the other way round, risk weighting by definition will not catch the next crisis. It is more likely to accelerate the next crisis, by incentivising banks to disguise risk. This happened with sub-prime and is happening again with sovereign debt. The head of Swiss Re’s investment office wrote in last week’s FT:

The explosion of sovereign debt in several advanced economies is one of the more visible issues and calls into question the wisdom of regulatory incentives that encourage investment in so-called “risk-free” assets, which we now know to be an illusion...

The incentives for investing into sovereign bonds are being increased exactly at a time when interest rates are still very low and rate volatility is set to increase, exposing financial markets to the risk of global capital misallocation.[2]

Rather than increasing bank safety, risk weighting appears to reward banks for disguising risks and for engaging in capital arbitrage instead of traditional risk assessment.

(ii) Insufficient capital, poor indicator of trouble

The bail-out is proof that the system of risk weighted capital requirements failed to ensure that banks had enough loss-absorbing capital to survive a banking crisis. Looking at only one area of difficulty, the Bank of England found that trading book losses were up to six times greater than pre-crisis trading book capital, and that overall capital ratios would have needed to be up to 2.5 percentage points higher to accommodate this model risk[3].

The Basel committee has since adjusted trading book requirements but this retrospective approach is not a long-term solution: it will always leave regulators one step behind the next crisis. It also assumes that regulators can gauge future risk, something even the market struggles with.

This backward-looking system explains why most of the banks that got into trouble had adequate capital according to Basel rules at the time. Risk-weighted capital requirements turned out to be a poor indicator of trouble, leading the Bank’s Andrew Haldane to conclude:

“Regulatory capital ratios do about as well in predicting crises as a coin toss”[4]

(iii) Disguises high total leverage

Risk weighting has allowed banks to disguise high levels of absolute leverage by letting them reduce risk assets as a proportion of total assets while still complying with regulatory standards. Barclays’ total assets today are nearly four times its risk weighted assets. This means that despite holding a safe-sounding 10.8% in Core Tier 1 equity, well above the new Basel minimum, its entire shareholders equity would be wiped out by a 2.8% fall in total assets.[5]

As the ICB points out in Box 1 of its interim report, Basel III would still allow leverage of nearly 30x and a safety margin of only 3.5% of total assets, even assuming risk assets increased to half of total assets.

This is less than the rate of non-performing loans among UK banks after the crisis. A year after Lehman Brothers collapsed, non-performing loans at European banks jumped to an average of 4.9% of total loans, according to the IMF[6]. A year later in the UK, they reached 6.1% of total loans, according to PwC[7]. These are averages, so the figures at the worst hit banks could be much worse.

Apart from allowing too much absolute leverage, the risk weight regime has grown too complex to be useful. It allows banks to escape effective supervision, as most large banks set their own risk weightings using the Internal Ratings Based Approach. For a regulator to check a large bank’s risk weightings, it may have to assess several million separate calculations, the Bank of England has noted. The resulting freedom and subjectivity means that the same asset can be weighted anything from 30% to 189% by different banks, according to a recent spot check by the FSA.

The variation has given rise to calls for harmonisation of risk weighting methodology across banks and countries but this would only fix one symptom among many and would the bigger problem of resource misallocation unfixed.

(iv) Distorting the allocation of credit within the economy

Just as risk weighting helped to disguise large increases in overall bank leverage during the boom, it has forced rapid real economy deleveraging in the bust, hurting the most productive parts of the economy first. BBA data from 2007 to date shows that lending to private non-financial companies, which includes SMEs and businesses that lack credit ratings and therefore attract a high risk weight, fell off a cliff after the crisis, relative to other forms of lending (see chart).

This can be partly explained by falling demand but it does not explain why business lending fell so much more than other lending measures. Since banks set the terms in most lending markets, it cannot be ruled out that the drop off follows a deliberate policy of tightening terms in specific markets in order to economise on bank equity and preserve double digit returns on equity. Business loans typically attract high risk weights, while consumer credit and mortgages can access lower risk weights through securitisations.

The most recent BBA data shows the trend continuing, with May 2011 lending to private non-financial companies falling £2.5bn, while mortgage lending was up £1.2bn.[8]

Newspapers have criticised banks on their front pages for failing to lend to SMEs but on other pages carried stories of acquisitions with debt financing measured in billions, such as Blackstone’s planned leveraged acquisition of a £1.4bn debt portfolio from RBS, the two secondary private equity buyouts from PAI to BC Partners of Gruppo Coin for €1.3bn and of SPIE to CDR for €2.1bn, and Apax Partners €1.2bn takeover of Takko from Advent International.

While banks have focussed on lending to relatively less productive sectors, such as real estate and LBO finance, they have dismantled the financial and branch infrastructure needed for traditional small business lending, despite the higher lending margins available. This is because the wide variation in gearing of different assets under the risk weight system has made capital intensity the dominant factor in lending decisions. The government’s aims of re-balancing the economy away from financial services while stimulating an SME-led jobs and growth recovery look unachievable as long as this bias continues.

Reforming risk weights

The case for reforming the risk weight regime is strong and has supporters from many quarters. However, there are strong barriers to reform and there is no consensus on what should replace the current system. This section looks at (i) the barriers and (ii) some proposals.

(i) Barriers to reform

The first barrier is that countries running budgets deficits such as the UK and US benefit from the zero-weighting of their sovereign debt. The Treasury will naturally be wary of actions that might disrupt the gilt market or raise national borrowing costs. Risk weight reform would therefore need an impact assessment and a careful transition plan. Any increase in national borrowing costs caused by banks demanding a higher return on sovereign debt will be offset by the likely fall in national borrowing costs as banks are weaned off state subsidies, including the subsidy that state-guaranteed banks earn when lending to the government via zero-weighted gilts.

Secondly, bank shareholders and staff benefit substantially from the higher leverage and freedom possible under the risk weighting system and will resist any reform strongly, for example by demanding global implementation or threatening to leave the UK. Counter-arguments include that the UK’s financial sector could end up attracting more capital under risk weight reform if it were seen as developing an expertise in undistorted credit assessment and if its capital were seen as correctly priced, self-sufficient and not linked to the UK’s fiscal health. Arguments about unilateral implementation should be no different from the “Swiss finish” or the ICB’s ringfencing proposals.

Thirdly, the reform could interact with other developments that impact bank treasuries, such as the growing reliance of banks on secured repo funding or higher margin requirements for OTC derivatives as they are brought on-exchange. A transition plan would therefore need to coordinate with other reforms.

Fourthly, many senior regulators and academics including at central banks have spent years refining the risk-weight system and may feel they have a vested interest in its survival. A public debate could help to challenge views in this area. The academic case for reform has already been well made by Martin Hellwig of the Max Planck Institute in his July 2010 paper “Capital Regulation after the Crisis: Business as Usual?”[9], the business case by James Ferguson of Arbuthnot Securities[10], former World Bank director Per Kurowski has been campaigning for risk weight reform for years through his blog[11], ThomsonReuters blogger Felix Salmon and the Economist have both advocated it in recent articles[12]. It would be very helpful if the ICB also endorsed this as an area for discussion.

Fifth, abandoning risk weights may encourage banks to pile into risky assets in pursuit of higher interest margins, with possible adverse consequences for systemic risk. But as long as they do so within a prudent overall leverage ratio, and as long as there is sufficient balance sheet disclosure for regulators and the market to assess risk and the formation of bubbles, this should not make banks any more dangerous than they are now. In fact, instead of being incentivised to accept risk and then hide it, as now, they would be incentivised to become more expert at assessing credit risk on their own (ie without Credit Ratings Agencies) and matching it with appropriate collateral and interest rate conditions.

If this measure were accompanied by better balance sheet disclosure, banks would be kept in line by their own investors. This process would encourage the market for bank capital to evolve to allow investors to choose between banks with higher and lower risk lending strategies, a development that would improve diversity.

(ii) Alternatives to the current risk weight regime

A transition away from risk weights to an alternative system would be difficult in the short term, especially during the Eurozone sovereign crisis, but in the longer term could have profound benefits for the stability and function of the financial sector and the economy as a whole.

There seem to be two approaches suggested so far. One is to aim for the eventual abolition of risk weights in favour of a simple leverage ratio for prudential purposes, accompanied by a switch from Basel-led risk assessment to old fashioned risk and reward credit assessment, all subject to investor discipline backed by balance sheet disclosure. The transition could be done by lifting risk weights as a proportion of total assets until they reach 100%, or by lowering leverage ratios until risk asset based ratios become redundant, which might be less confrontational to the Basel committee. Changes would need to be implemented gradually to avoid over-rapid balance sheet restructuring and integrated with new rules on collateral etc.

The other approach is to retain risk weights but adapt them to reflect macroeconomic, social and environmental and other policy risks. This raises interesting political questions about how best to use regulators to implement policy goals outside of their core area.

Here is a sample of proposals for risk weight reform from different ends of the political spectrum:

Right wing think tank Reform favours leaving credit assessment to the market and adjusting capital requirements only for macro or idiosyncratic risk:

Regulation and government guarantees have not, in the historical long term, made banks one iota safer. They have merely mollycoddled and confused. Fifty or even twenty five years ago all almost certainly had higher capital levels; not because regulators demanded it, but because the market did.

Regulators should be able, more precisely, to adjust banks’ capital requirements to the stage of the economic and credit cycle (i.e. build up capital in the good times) or to the strategy of an individual bank (i.e. requiring more capital to cover new probably illiquid types of investment which are not yet “in the rules”).[13]

James Ferguson, chief strategist at Arbuthnot Securities, wrote that risk weighting is a flawed concept and suggests more power for regulators to probe banks’ capital decisions:

There’s a logic flaw at the very heart of the whole RWA concept… Taken to its logical conclusion, the capital to risk-weighted asset ratio should, therefore, be very high (perhaps even 100%) yet the BIS and US minimum requirement is 8%. Capital should equal the likely loss in the event of default, so why such a low ratio was acceptable has never been adequately explained.

Regulators should be impelled to explain why they support banks capital and risk-weighting decisions and be encouraged to offer alternatives capital ratios under differing assumptions[14]

Friends of the Earth has written that risk weights distort capital allocation and proposes that social and environmental criteria be included in risk weights, with capital surcharges used to punish behaviour with negative externalities:

The Basel Capital Accord… favoured global financial conglomerates and their financial innovations at the expense of other traditional financial actors.[15]

Banks should be required to integrate social and environmental sustainability criteria in their credit risk assessment system. Specific and penal capital requirements should be considered for banks providing credit to companies grossly violating environmental and human rights standards, as well as for banks financing other investors that invest in such companies, such as private equity funds. Banks exposed to, or financing, commodity, credit and foreign exchange derivatives trades, as well as any kind of OTC derivatives, which have no hedging purposes and stimulate excessive financial speculation, could be required to hold specific and penal capital requirements, especially in times of high volatility and high prices.[16]

Whatever the preferred option, there is a case for risk weighting to answer. The ICB should use its final report to acknowledge this and either propose reforms to the way risk weights are used or recommend a detailed follow up investigation by another body.

2 Debt interest deductibility

The tax preference for debt over equity funding has contributed to excessive leverage and fragility in the capital structures of many firms and acted as a tool for transferring wealth from taxpayers to financial engineers, especially in private equity. As Lord Turner has pointed out, it has also contributed to confusion between the private interests of banks and the public interests of society in any discussion of what is the socially optimal level of bank capital.

Equalising the tax treatment of debt and equity could fund a corporation tax decrease to 17%, according to calculations by Andrew Lillico at the Policy Exchange[17], which could spur corporate investment.

Commentators have been calling for this reform for some time, with the FT’s John Plender writing last year:

A failure to address this very large distortion, which affects most of the larger developed economies, means the tax system is at odds with policy initiatives that seek to promote financial stability. It is a fundamental and destabilising flaw in the post-crisis financial architecture.[18]

Such a far-reaching move may need international coordination (it would certainly be opposed by the industry on level-playing-field grounds) but placing it on the ICBs agenda would be a good first step, especially as part of a discussion about socially optimal levels of bank equity.

3 Purposive regulation

If the calls from Lord Myners and others for a Royal Commission into the causes of the financial crisis are successful[19], the investigators should look at the general level of dysfunction in the financial industry, of which the 2008 crisis was merely the culmination (see appendix Re-Define doc “That other financial crisis”).

One proposal that an enquiry could examine is to create a new power for regulators to investigate financial dysfunction.

The recession will end up costing far more than the 2008 crisis because parts of the financial system have evolved in a way that leaves them unable to perform their core economic functions of resource allocation and risk management, among other things.

Where an industry area has obviously failed - as with SME lending, PPI, or under-performing pensions - intervention is easy to justify. But where it merely bumps along without crisis, incurring hidden economic costs and possibly storing up hidden risks while contributing little economic value, regulators have no general right to act outside of competition, consumer and certain other areas of law.

The idea of purposive regulation is to expand a regulator’s scope to include monitoring the underlying economic function of the firms it is regulating. It could work by creating a power for regulators to investigate evidence of market dysfunction such as high prices or wages and then act or make recommendations based on the cause (eg poor regulation, tax distortions, macro-liquidity, market structure, oligopoly, agency incentives, information flows etc).

If the rules and structures that emerge from this approach fell outside the regulator’s direct powers it could still make recommendations to other bodies, such as the competition commission or legislators. The outcome would tend to realign the City with the needs of the real economy and provide London with a competitive advantage over financial centres in Asia and elsewhere, since customers would be more protected from market capture.

The approach could lean against practices that impose costs without bringing economic benefits, such as high frequency trading or dividend tax arbitrage. It would entitle regulators to ask basic questions such as “who benefits from this activity and who bears the cost” and to correct market failures early on.

Examples of areas where purposive regulation could make an immediate impact include the possible restoration of the broker/jobber distinction in capital markets, supported by different regulatory regimes and pay structures to remove conflicts of interest between client and trader, as argued recently by the FT’s John Gapper.[20]

4 London as a centre of sustainable finance

Part of this approach could include replacing any duty to promote London with a duty to promote sustainable finance in London.

Bodies such as the CityUK, the ICB and the FSA (under its outgoing mandate), have duties to consider or promote the competitiveness of London as an international financial centre. This controversial requirement is a kind of extreme financial mercantilism that disregards external costs even when they fall on the UK. It is frequently used by the bank lobby to fight reforms.

The government is now considering how far to include a similar duty in future regulatory legislation. This presents an opportunity to replace the duty to promote London at all costs with a duty to promote sustainable finance in London.

By positioning the City as a centre for sustainable finance - meaning finance whose returns can be sustained over the longer term by the real economy growth it facilitates - the City could attract more stable capital inflows and wind down its involvement with the type of leveraged, speculative trading and extractive financial engineering that characterise the City today.

In employment terms, this may mean replacing, for example, derivative traders moving to Asia with new specialists in London who could become world leaders in green finance, GDP bonds, execution only trading, venture and growth capital, traditional risk lending etc.

This back-to-basics approach would be attractive to politicians and provide an alternative strategy for a financial industry facing tougher regulation and foreign competition.

Consultation question 4.1 and 4.2

Should systemically important banks be required to hold more equity than Basel III requirements? If so, how much?

Should UK retail banks be required to hold more equity than Basel III requirements? If so, how much?

The ICB should recommend far higher equity capital for both systemically risky and retail banks.

The proposed 10% ratio of tangible common equity to risk assets represents only 2-3% of total assets, assuming the proportion of risk assets to total assets currently typical among UK banks. The proposed rate is lower than the average rate of non-performing loans among European banks following the crisis, which ran at 6.1% of total assets in 2009, according to PwC.[21]

Barclays’ £392bn of risk assets are only a quarter of its £1,492bn total assets, according to its last interim statement. Barclays could satisfy the ICB's requirement with only £39bn of core Tier 1 equity, still only 2.6% of its balance sheet. The headline 10% ratio is therefore an optical illusion, providing only a fraction of the protection needed.

It seems sensible that the ICB should aim at least for the 17-20% level recommended by David Miles[22], a level calculated to be socially optimal given the high economic costs of bank crises.

The industry’s argument that this is costly and damaging for the real economy have been comprehensively dismissed by Stamford academic Anat Admati in the 2011 paper “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive”[23], which, among other things, analyses the deliberate confusion created by banks between the private interest of banks and the public interest.

Admati writes that banks could easily build capital on their own through retained earnings and mandatory equity issuance. In her view:

Bank equity is not socially expensive, and high leverage is not necessary for banks to perform all their socially valuable functions.

FSA Chairman Lord Turner summarised Admati and Miles, saying:

The costs of higher bank equity requirements are lower and the economic benefits considerably higher than many participants in this debate – from the banking industry but also from public authorities – have in the past assumed.[24]

The IMF and bank lobby both argue that higher equity capital would mean reducing dividends, raising lending margins or deleveraging, all of which harm the economy. But their argument misses the most obvious solution – that banks simply issue new equity. In a May 2011 working paper [25], the IMF excluded equity issuance from its model on the feeble grounds that it felt banks would view the “dilution of existing shareholder rights as a last resort measure". The ICB should not accept reasoning based only on bank preferences.

Institutional investors have lobbied against higher bank capital to avoid dilution and loss of dividend income. This is fair comment but should be seen in the context of a longer transition plan. The short term outlook of many institutional fund managers (often incentivised on a quarterly or annual basis) has become such a barrier to long-term planning that the government has set up the Kay Review to look at investment in UK equity markets and its impact on the long-term performance and governance of UK quoted companies. Institutional investors should see higher bank capital as a longer term opportunity to invest in bank debt and equity at much better risk-adjusted returns than are currently available, assuming fewer bank crises over the longer term.

The CBI and industry have also objected to higher bank capital in case it reduces bank lending[26]. This should be seen in the light of other reforms that could increase business lending, such as risk weight reform (see section 3.1 above) and mandatory new equity issuance at banks.

The obvious way of implementing higher capital without hurting lending is to require bankers to be paid in new equity when their remuneration is above a certain level, eg a certain multiple of average earnings, until the desired capital has been built.

Over time, this could transfer bank ownership gradually to bank staff, moving banks closer to the partnership style of ownership that many had before becoming joint stock companies. Bank culture and risk management are likely to improve as a result.

Alternatively, mandatory equity issuance could be designed to include dividends so the balance of ownership between existing shareholders and staff does not change.

A further twist would be if bank staff with especially high risk profiles, such as traders, were paid with double or treble liability equity, as suggested by economist Axel Leijonhufvud in the recent Good Banking summit in London. This would lower the bank’s funding costs, while other equity holders and taxpayers would benefit from a reduction in asymmetric risk-taking at their expense.

Bankers including Jamie Dimon have warned that excessive capital regulation could force banks to shed assets, triggering another spiral of deleveraging and tipping the economy back into recession.

This need not be the case. Standalone investment banks that retain earnings or pay their higher-earning staff in new equity for a year or two could quickly build up capital, removing any urgent need to shrink balance sheets. Basel III capital ratios will not fully apply until 2019, so there is plenty of time. Of course, banks would not do this voluntarily, but that is why we have regulators.

A transitionary risk-weighting regime could also help minimise the economic impact of a move to higher capital by reducing the equity required for small and medium business lending relative to lower risk-weighted lending (see section 3.1).

A final comment is that global SIFI surcharges, as agreed by the BIS recently, must be set at punitively high levels to counter the increased subsidy that banks would gain from G-SIFI status with its guarantee of a bail-out.

Consultation question 4.3

Do you agree that bank debt should be made more loss-absorbing using some or all of contingent capital, bail-inable debt and/or depositor preference? If so, which of these tools do you support and how should they be designed?

Bail-ins, cocos, depositor preference and bank resolution are all welcome but significant problems exist with each, making them less effective than a simple combination of structural separation and socially optimal (ie much higher than now) levels of equity capital.

The “bailing in” of bank creditors barely happened in the last crisis for reasons of complexity that have since become worse. Complex inter-bank relationships exist from treasury to repos to swaps and derivatives, syndicated lending, structured credit, equity finance, trading, collateral and custodial arrangements etc. These areas are not known for their transparency and fear of contamination will always risk a domino effect if a bank is left to fail, unless structural and strong equity capital remedies are adopted.

Secondly, not all types of debt can be bailed in. There is little point bailing in central banks or holders of secured repos and other secured debt, while unsecured creditors would likely challenge any bail-in, especially in cross-border cases. These all make bail-ins slow, difficult and less effective at stopping contagion than a bail-out with public money.

CoCos are an interesting source of loss-absorbing capital. Andy Haldane calculated[27] that if half the bonuses and dividends paid in the run up to the crisis had been in contingent capital instead of cash, UK banks would already have had the £70bn in extra loss-absorbing capital they needed to raise as a result of the crisis.

The ICB’s interim report was lukewarm on CoCos because they are vulnerable to speculative attack and might be difficult to sell. But if banks were forced to part-pay their high rollers and shareholders in CoCos that might help while reducing moral hazard by forcing bank staff to “eat their own cooking” if things turned out badly, to use Andrew Haldane’s words.

An even better solution than CoCos, however, would be to pay staff bonuses in new equity until David Miles-levels have been raised.

Resolution plans are also worthwhile and the European Union and FSB are working on these now. However, the politics of cross-border burden sharing seen in the Eurozone crisis suggest there is much work to do before they will offer a reliable source of protection. For now, structural separation and higher equity seem much safer tools for addressing the too-big-to-fail problem.

Consultation question 4.4

In relation to structural reforms to promote stability, do you agree that the Commission should focus its work on a UK retail ring-fence?

No, I think full structural separation is a simpler, more effective and fairer solution.

Ringfencing will continue the state subsidy for bank capital, something considered inappropriate in most other industries. The subsidy is measured in tens of billions, depending on methodology, and helps to fund the bonus culture, as RBS chief executive Stephen Hester admitted to the Treasury Select Committee recently.

Ringfencing will let investment banks profit directly from government-backed retail deposit insurance, to the extent that surplus capital moves over the wall. The more capital crosses the wall, the greater the subsidy and the greater the inter-connection between bank subsidiaries, which will further increase the chances of rescue and therefore the subsidy.

The subsidy is not free to taxpayers. Cheaper bank capital means more expensive government debt, as the ratings agencies have made very clear in countries with over-developed bank sectors such as Ireland, and with Greece.

There is a further cost from ringfencing in credit misallocation. The best way to turn retail deposits into small business loans – the area where they might produce the most economic growth and employment - is to leave them in a retail bank that actually lends to small businesses. If surplus retail capital is transferred into investment banks it is likely to end up backing assets with low risk weights that are by definition less economically productive. This further reduces the case for allowing subsidised bank capital across the ringfence wall.

One argument for leaving the banks alone is that separation of any kind would decrease the value of state owned bank RBS, denying taxpayers a profit when this rescued lender is sold back to the market. This argument fails to compare the huge value of RBS to the economy as a functioning bank with its relatively limited value as a one-off asset for sale.

A second argument is that ringfencing would increase the cost of credit to large corporates if they were excluded from the retail part of the bank, as they could no longer access the subsidised, retail deposit-backed credit that universal banks now offer. This is true, but neither a ringfence nor complete separation would stop the government from providing capital subsidies to large corporates directly, if that is what an elected government chooses to do. In fact, this would be a more targeted and democratically accountable way of subsidising big business than using banks as opaque intermediaries.

A third is that cutting off investment banks from subsidised capital would encourage them to adopt riskier behaviour to maintain their current double digits returns on equity. Such a danger would recede quickly if the ICB were to recommend higher equity capital.

Both ringfencing and separation would make the state guarantee of retail banks explicit, which brings dangers for retail banks too, as Jeremy Warner of the Telegraph wrote:

If everything within the ringfence is deemed utterly safe and guaranteed by taxpayers, it won’t be long before bankers find ways of exploiting this public subsidy with ever more high-risk forms of conventional lending.[28]

This makes it even more important for the ICB to recommend a low leverage ratio for retail banks to shut down any risk weight-driven arbitrages. It should also impose tough restrictions on retail bank activities: the government guarantee should come with strings attached.

The chancellor George Osborne has spoken about what he calls the “British dilemma” that strong financial services benefit the UK as long as they don’t bankrupt it. His backing of ringfencing goes part-way to solving that dilemma but this should not stop the ICB from going all the way in its final recommendations. A clean, structural remedy that could be implemented decisively and forgotten about is far preferable to a behavioural remedy with blurred definitions that invites never-ending regulation and continuous arbitrage.

Making investment banks rely on their own unsubsidised capital - as they did before the advent of Basel, deposit insurance and universal banking - would be the ultimate expression of free market capitalism and the ancient spirit of the City of London. It would help investment banks to end their period of regulatory uncertainty and build sustainable, self-sufficient business models that the public and industry could support.

If enforced separation proves politically difficult after Mr Osborne’s public support for ringfencing, the ICB could consider creating incentives for universal banks to break themselves up, probably using capital surcharges or balance sheet taxes.

Consultation question 4.8

Do you agree with the Commission’s assessment of the impact on the competitiveness of the City and the UK economy of the reforms? Can you provide further data and analysis in this area?

See “London as a centre of sustainable finance”, above.

APPENDIX

That Other financial crisis

Sony Kapoor, Re-Define Managing Director

A crisis can manifest itself in the form of a short and intense burst or it can unfold over a long time. While the present financial crisis has been spectacular in its speed and apparent size, a much bigger more insidious and harmful financial crisis has been brewing.

Background

Making cost estimates for the financial crisis is fashionable, in particular if your number is higher than others that went before. From the direct cost of bailing financial institutions to the total estimated costs that include the deterioration of fiscal balances and the opportunity costs from lost growth estimates vary from 1%-2% of GDP to 25% of GDP or more.

While these calculations are no doubt important for public policy I believe that this approach to measuring the seriousness of problems afflicting the financial sector is limited. An excessive focus on this approach can lead to serious policy mistakes and lost opportunities.

It would not be too unfair to say that the primary, if not sole, focus of the extensive regulatory reform agenda in the EU and beyond is crisis avoidance. We have catalogued the various causes of the crisis on a piecemeal basis and are trying to use a tick mark approach to ensure most of these are addressed.

We have embarked upon the biggest most ambitious program of reform of the financial sector without having ever asked basic questions such as 1) what the financial sector is meant to do 2) whether it was doing this job well and 3) if this was not the case then what corrective measures could be applied using the window of opportunity provided by the crisis.

We have crisis myopia where the single minded focus on the crisis has crowded out any positive vision of what a good financial sector ought to look like. It has prevented us from pausing to map out what the supposedly well-functioning financial sector that is supposed to emerge from this reform process ought to look like.

The reform process in the EU is being led with some zeal by teams of people drafting detailed regulations with little time for the big questions or the vision thing. They are obsessed with making sure that what led to the crisis does not happen again.

The real costs of a malfunctioning financial system

The implicit underpinning of this approach is that all was well before the crisis. That if only we are able to prevent the recurrence of another crisis, the economy would prosper and finance would be doing its job.

the real long-term costs of a malfunctioning financial system have arisen not during war-time (the financial crash) but during peace time when the financial sector was apparently working well. I believe that these costs are far bigger and far more serious than even the high end estimates of the costs of the crisis.

These costs arise when the financial sector fails in its assigned role of supporting real sustainable growth in the economy through 1) facilitating price discovery 2) ensuring the efficient mobilization and allocation of resources 3) providing opportunities for effective risk sharing 4) acting as a shock absorber for the real economy 5) and the provision of access to suitable credit, savings and investment products for economic actors.

For example, a financial system that impeded proper price discovery can send erroneous price signals to the economy and lead to suboptimal investments. These have a large opportunity cost.

Problems with the time-horizon of financial sector actors and misaligned incentives can cause the financial sector to misallocate resources away from high return investments into wasteful investments that have a lower economic return.

The financial sector can and does, often as a result of implicit public subsidy and the asymmetry of information push risk away from entities most competent to handle and absorb it towards public entities as well as unsophisticated economic actors least capable of managing and absorbing such risks.

The real economy is cyclical and has strong inertia so the virtual financial sector which can at least on paper adjust faster has a significant shock absorption capacity. At least that is the theory. In reality, the financial sector has often acted as an amplifier and even a source of shocks to the real economy imposing significant economic costs.

The financial sector is supposed to increase welfare through improving access to credit, savings and investment products for economic actors. However, the financial market remains far from complete, many economic actors still lack access to financial product and appropriate products are often not matched with the right economic actors. All of these reduce potential economic welfare.

Suffice to say that the economic and welfare costs of a malfunctioning financial system are much larger than even the largest cost estimates that show up in a crisis. Most of the time, a sub-optimal financial system will simply chug along imposing large opportunity costs on the economy without necessarily blowing up.

Instead of waiting for the financial sector to blow up again, we urgently need to use the current spate of financial sector reforms and regulations being enacted in the EU to rejig the design of the financial system so it fulfils the tasks expected of it and to improve its functioning. The political window of opportunity for financial reform will close soon again.

[1] http://subprimeregulations.blogspot.com/2011/07/letter-from-citizen-to-mme-christine.html

[2]Guido Fuerer, 3 July 2011 http://www.ft.com/cms/s/0/e7de2a88-9cbc-11e0-bf57-00144feabdc0.html#ixzz1R8mk6kyx

[3] January 2011 speech “Capital Discipline” p.6 http://www.bankofengland.co.uk/publications/speeches/2011/speech484.pdf

[4] Haldane, “Capital Discipline”

[5] £392bn risk assets/£1,492 total assets x 10.8% Core Tier 1 = 2.8%, source Barclays Q1 2011 Interim Statement

[6] IMF Global Financial Stability Report 2010, table 9 http://www.imf.org/external/pubs/ft/gfsr/2010/02/index.htm

[7] PwC European outlook for non-core and non-performing loan portfolios 2011 http://www.ukmediacentre.pwc.com/imagelibrary/downloadMedia.ashx?MediaDetailsID=1914

[8] http://www.bba.org.uk/media/article/may-2011-figures-for-the-main-high-street-banks

[9] http://www.coll.mpg.de/pdf_dat/2010_31online.pdf

[10] “The Gathering Storm”, Chapter 1 What Went Wrong?

[11] http://subprimeregulations.blogspot.com/

[12] http://blogs.reuters.com/felix-salmon/2010/09/15/the-biggest-weakness-of-basel-iii/ and http://www.economist.com/blogs/freeexchange/2010/09/basel_iii

[13] Nicholas Boys Smith, “A Dangerous Consensus”, Sep 2009 http://www.reform.co.uk/Research/ResearchArticles/tabid/82/smid/378/ArticleID/932/reftab/82/t/A%20dangerous%20consensus/Default.aspx

[14] “The Gathering Storm”, Chapter 1 What Went Wrong?

[15] “In 2011 European decision makers can make banks sustainable” http://www.foeeurope.org/finance/sustainablebanks-2011.pdf

[16] “Seven steps to make banks sustainable” http://www.foeeurope.org/finance/sustainableCRD-2011.pdf

[17] “Taxation, Growth and Employment, 2010 http://www.policyexchange.org.uk/images/publications/pdfs/Taxation__Growth_and_Employment_-_March__10.pdf

[18] “It is time to stop punishing prudence”, John Plender FT, 25 march 2010 http://www.ft.com/cms/s/0/ad563496-37af-11df-88c6-00144feabdc0.html#axzz1R7V80Bec

[19] “Sir John must take his chance to repair the banks”, Paul Myners and Neal Lawson, 3 July 2011 http://www.ft.com/cms/s/0/747d7652-a5a4-11e0-83b2-00144feabdc0.html#axzz1R7V80Bec

[20] “The price of Wall Street’s black box” 22 June 2011 http://www.ft.com/cms/s/0/fe7aaec6-9d00-11e0-8678-00144feabdc0.html#axzz1RDrHp74o

[21] PwC European outlook for non-core and non-performing loan portfolios 2011 http://www.ukmediacentre.pwc.com/imagelibrary/downloadMedia.ashx?MediaDetailsID=1914

[22] External MPC Unit Discussion Paper No. 31 “Optimal bank capital” Jan 2011 http://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdf

[23] http://www.coll.mpg.de/pdf_dat/2010_42online.pdf

[24] March 2011 speech, “Leverage, Maturity Transformation and Financial Stability: Challenges Beyond Basel III” http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2011/0316_at.shtml

[25] “Macroeconomic Costs of Higher Bank Capital and Liquidity Requirements” http://www.imf.org/external/pubs/ft/wp/2011/wp11103.pdf

[26] http://www.cbi.org.uk/ndbs/press.nsf/0363c1f07c6ca12a8025671c00381cc7/63f05d3426953b97802578c3004ccefe/$FILE/CBI%20response%20to%20the%20ICB%20interim%20report%20-%20July%202011.pdf

[27] “Capital Discipline” Jan 2011 http://www.bankofengland.co.uk/publications/speeches/2011/speech484.pdf

[28] 15 June 2011, http://www.telegraph.co.uk/finance/comment/jeremy-warner/8578201/Will-keeping-bankers-apart-put-an-end-to-bail-outs.html

Retail ringfence is not good enough, George

2011-06-17T08:50:00.000-07:00

George Osborne sounded the death knell for enforced full bank separation this week at the Mansion House dinner, when he gave full – and premature – backing to the ICB’s interim recommendation for retail ringfencing.

It was bad news for taxpayers and the economy, but all is not lost. There are three steps the ICB can still take.

But first, a quick look at why ringfencing is not as good as full structural separation.

Ringfencing will continue a large part of the state subsidy for bank capital, not something one can imagine Osborne choosing to do in any other sector. The subsidy works by artificially lowering banks’ cost of capital and is worth tens of billions of pounds to the banks each year (up to £100bn at its peak after the crisis, according to the Bank of England). It helps fund the bonus culture, as RBS chief executive Stephen Hester admitted to the Treasury Select Committee recently.

Full structural separation would have denied investment banks the benefits of government-backed retail deposit insurance but ringfencing will let some slip through, since it allows surplus capital to cross the wall, subject to a 10% capital minimum. The more capital crosses the wall, the more the subsidy. And as this increases retail and investment banks will be more intertwined, which increases the subsidy even more as it makes a rescue more likely and further lowers the cost of capital.

While this is good for bankers, the costs will still fall on taxpayers and the wider economy. There is both a direct cost as the subsidy to bank capital increases the government's own cost of borrowing, and an indirect cost as retail-backed credit is gobbled up by the financial industry instead of being deployed where it can create the most jobs and growth.

Osborne and the ICB are aware of the subsidy but still back the ringfence, citing some of the industry's favourite arguments to do so.

One of these is that universal banks can use retail despoits to economise on equity, which lets them pump more credit into the economy. For the economy to really benefit, though, this credit must be used in the right way. Ideally, it would be available directly to businesses, especially the small and medium sized firms that create most of the country’s employment. Applying it to real estate securitisations, leveraged trading and various other investment bank businesses is less fruitful - for the economy at least - and can even be disastrous, as with sub-prime.

The best way to turn retail deposits into small business loans is to leave them in a retail bank that actually lends to small businesses. If surplus retail capital is transferred into investment banks it is likely to end up backing assets with low risk weights that are by definition less productive.

Osborne has pinned his career to the recovery of the economy but appears blind to these points. Instead, no doubt after strong lobbying, he is giving a thumb’s up to the ringfenced, but still universal, bank model, as if the long period of financial stability when retail and investment banking were kept entirely separate never happened. Those hoping for a return to Glass-Steagal will be sorely disappointed.

Just in case he changes his mind, a transition to separate banking need not be too painful. Bankers like Jamie Dimon like to warn that excessive regulations will force banks to shed assets, triggering another spiral of deleveraging and price falls and tipping the economy back into recession. This is a real risk but only if the transition is mismanaged.

For example, standalone investment banks that retain earnings or pay their higher-earning staff in new equity for a year or two could quickly build up capital, removing the need to reduce balance sheets in a hurry. Basel III capital ratios will not fully apply until 2019, so there's plenty of time. Of course, banks would not do this voluntarily, but that is why we have regulators.

Osborne made much of what he called the “British dilemma”, namely that strong financial services benefit the UK but might also bankrupt it. His response of mild intervention seems aimed at keeping the banks in the UK and on his side if the economy turns down. A braver response would be a radical, structural overhaul of the sector in which financial firms are regulated according to the real function we want them to perform, backed by a responsible transition plan.

Making investment banks rely on their own unsubsidised capital - as they did before the advent of Basel, deposit insurance and universal banking - would be the ultimate expression of free market capitalism, quite a legacy for a Conservative chancellor. If the free market gurus are right, the lack of subsidy should make the UK’s investment banks the best in the world.

More of a worry is that ringfencing makes the state guarantee of retail banks explicit. As Jeremy Warner of the Telegraph has written: "If everything within the ringfence is deemed utterly safe and guaranteed by taxpayers, it won’t be long before bankers find ways of exploiting this public subsidy with ever more high-risk forms of conventional lending."

This makes it even more important that the ICB recommends a low leverage ratio for retail banks. Suggestions of 10% of risk assets will not help if retail banks switch into lower risk assets such as sovereign debt and AAA bonds, unless they are either banned from such loans, quite a prescriptive remedy, or have a tough total asset ratio enforced. The government guarantee should come with strings attached.

However, it is hard to imagine Osborne changing course on ringfencing now - the coalition has flip-flopped on too many other things - but that shouldn’t stop the ICB from taking the few steps still left open to it.

These include:

• developing the most robust retail ringfence imaginable. The tougher the better: if it leads some banks to break themselves up voluntarily, so much the better;

• toughening its stance on capital ratios (see previous post);

• introducing leverage ratios as the main prudential control on banks. More on that to follow…

Will ICB proposals on bank capital keep taxpayers dry?

2011-05-15T15:44:00.000-07:00

Problem: The ICB proposals for bank capital are too low and plans for debt bail-ins and resolution plans too weak to protect taxpayers from the next bank crisis.

Solution: Double the capital requirements by earnings retention and paying bonuses in equity, or opt for full structural separation.

Apparently, breaking up the banks is too difficult and too expensive.

That was the disappointing conclusion from the Independent Commission on Banking’s interim report, published last month. Instead of true structural reform we got a mish-mash of compromise remedies, such as higher capital, debt bail-ins, resolution plans, a retail ringfence and branch disposals.

Will these be enough to save taxpayers from a soaking next time the banks crash?

The short answer is no. As the ICB collects responses by 4 July, here are a few thoughts on why – as things stand - taxpayers are still in for a drenching as well as some recommendations for the ICB's final report.

Capital

Capital is what keeps banks solvent when loans stop performing and have to be written off. Ideally, there's enough capital to handle losses in a financial crisis, like a sea wall in a storm.

And journalists such as the FT's John Plender think another storm is not far away.

The ICB proposes lifting banks’ core Tier1 equity capital from pre-crisis levels of around 2% to 10% of risk assets. This is a five-fold increase - but do not be fooled.

The trick is in the definition of assets. The ratio applies to risk assets which are smaller than total assets, typically a quarter to half the size. This means the new capital barrier is really only 2.5 to 5% of total assets.

This is less than the rate of non-performing loans at UK banks after the crisis. A year after Lehman Brothers went bust, non-performing loans at European banks jumped to an average of 4.9% of total loans (table 9, IMF). In the UK, they reached 6.1% of total loans in 2010 (p.8, PwC, April 2011). These are averages, so the figures at the worst hit banks could be much worse.

Non performing loans are not the same as actual losses but they are only a step away. What this means is that if the last crisis happened all over again but with UK banks holding the ICB’s minimum capital, the sector's capital could still be washed away. And even if it weren't, any significant erosion could leave banks unable to make new loans for some time, harming the productive the economy.

The point here for the mathematically minded is that while the headline capital ratio (the numerator) has increased, the figure it applies to (the denominator) is still very small.

In the run-up to the crisis, banks found ever smarter ways to shrink this denominator so they could grow returns on equity (a measure that determines banker's pay, among other things) despite low interest rates. Chart 7 from this Bank of England speech gives a neat illustration of the trend, with the coloured dots climbing further uphill every year.

The ratio of risk assets to total assets got smaller and smaller until it shrank the effective capital barrier to a tiny sliver of total assets. Even now, Barclays’ £392bn of risk assets are only a quarter of its £1,492bn total assets, according to its last interim statement. Barclays could satisfy the ICB's requirement with £39bn of core Tier 1 equity, still only 2.6% of its balance sheet.

The headline 10% ratio is therefore an optical illusion, providing only a fraction of the protection needed.

Bank of England guru David Miles, a former chief economist at Morgan Stanley, believes the socially optimal level of bank capital is at least 17-20% of risk assets, nearly double the ICB’s figure. To keep taxpayers dry in a really big storm, they should be as high as 50%, he calculated.

The ICB knows this. It admits that 10% of risk assets is a minimum and says “a case could quite easily be made” for going higher (para 4.34). So why hasn't it?

Debt bail-ins

The cynical answer is that the ICB is trying hard to stop banks from leaving the UK. A slightly less cynical one is that bank equity is expensive. That argument was given the lie both by David Miles, above, and Stamford Universsity's Anat Admati and Martin Hellwig of the Max Planck Institute, in a paper called "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive".

FSA Chairman Lord Turner summarised their findings:

"the costs of higher bank equity requirements are lower and the economic benefits considerably higher than many participants in this debate – from the banking industry but also from public authorities – have in the past assumed."

So another explanation of the 10% is needed. The ICB's next argument is that when equity runs out, debt will take over with creditor bail-ins or Cocos.

But “bailing in” bank creditors is not so easy. It barely happened at all in the last crisis, when regulators avoided it for fear of pushing other banks into insolvency.

Inter-bank exposures are famously complex, ranging across treasury and repos to swaps and derivatives, syndicated lending, structured credit, equity finance, trading, collateral and custodial arrangements etc. These areas are not known for their simplicity and transparency.

Unless bank structures are dramatically simplified, regulators and markets will always fear a domino effect.

Second, not all types of debt can be bailed in. Thanks to the Eurozone crisis, several European banks count the ECB among their biggest creditors. There’s little point bailing in central banks as that's just a public bail-out by another name. Bailing in holders of repos and other secured debt is no easier because of legal barriers, and even unsecured creditors can be relied on to challenge a bail-in, especially in cross-border cases. This means bail-ins are slow, difficult and less effective in a crisis than a bail-out with public money.

The ICB looked briefly at whether contingent capital or “CoCos” could automate the process (CoCos are debt that converts to equity at a certain price and trigger). But, it was so worried about CoCos’ vulnerability to speculative attack and the difficulty of finding people to own them that it seems to have given up on the idea.

This is a shame because the Bank of England’s financial stability chief is a big CoCo fan. Andy Haldane calculated that if half the bonuses and dividends paid in the run up to the crisis had been in contingent capital instead of cash, UK banks would have had £70bn in extra loss-absorbing capital in 2008, roughly the amount they had to raise as a result of the crisis.

Even better, if banks were forced to part-pay their high rollers and shareholders in CoCos, they might behave better as, in Haldane’s words, staff would have to “eat their own cooking” if things turned bad.

Sadly, there’s no such recommendation in the ICB’s report.

Resolution plans

The ICB's next hope is with bank resolution plans. These are instructions drawn up in advance to help regulators take over a failing bank and settle its affairs at minimal loss to the taxpayer quickly, maybe even over a weekend.

Speed is the key here, since any delay could trigger a market panic.

The problem is that few people think they will work. The idea that executives in a failing investment bank would leave neat little “read me” folders about their disasters seems far-fetched to start with. But even if they were forced to, regulators would still struggle to allocate international multi-billion dollar losses at speed; they would need political agreement on how to share fiscal budget-altering losses between sovereign countries.

The politics of the Eurozone crisis and the USD 1bn plus Lehman’s litigation show how easily the prospect of big losses can put things into slow motion. But even if loss-sharing were agreed in advance there is nothing to stop political leaders from changing their minds in the heat of the moment. It's hard to believe that any amount of preparation could make cross-border bank resolution a reliably fast and certain process.

The G20’s Financial Stability Board and European Commission are exploring loss-sharing protocols but if they don’t completely succeed (and one feels it could be a doomed mission), maybe UK taxpayers should not place too much faith in resolution plans.

ICB must get tougher

The ICB has a few other remedies to explore, some relating to liquidity, others to shadow banking, market infrastructure, ringfencing, competition and possibly remuneration, but the key to keeping taxpayers feet dry is having enough capital to absorb losses.

Unfortunately, the ICB has proposed capital below the level of bad loans in the last banking crisis, and half the level that the Bank of England considers socially optimal. This is like building sea defences below the high tide mark.

Its suggestions for debt bail-ins and resolution plans may act as a layer of sand-bags on top but, as the FSB and ICB have both admitted, these too can be washed away in a storm.

FSA chairman Lord Turner agreed in a recent speech that capital levels should be twice as high as the ICB's proposal, but feared it would be impossible to get there without crashing the economy. He may have been reading this alarmist paper published this month by the IMF's Scott Roger and Jan Vlček in May, which estimated that 2% more bank capital would cost the economy 1% of GDP, rather higher than previous estimates.

These calculations were based on a simplified "closed economy model" and subject to a long list of theoretical assumptions about monetary policy, implementation period, lending spreads, dividends, liquidity requirements etc. The paper's authors admit that it has many limitations, including the failure to consider that banks might hold anything other than risk-free government debt or that they may simply issue new equity, on the grounds that "banks may consider equity issuance, and the dilution of existing shareholder rights, as a last resort measure". Plus, equity issuance didn't fit the academic model.

Previous estimates of the cost to the economy of higher bank capital put the cost far lower. In reality, the cost of building bank capital will fall where politics directs it, and banks have a vested interest in arguing that it should fall on the general public.

Stamford academic Anat Admati, reckons that banks are made of tougher stuff and could easily build capital on their own through retained earnings and mandatory equity issuance. In her view:

"bank equity is not socially expensive, and high leverage is not necessary for banks to perform all their socially valuable functions".

The ICB might take her recommendations a stage further and require under-capitalised banks to pay bonuses in new equity until higher capital levels are met, a much neater solution than CoCos.

Wherever you stand on the question of what effect higher capital might have on the real economy, the inescable fact for the ICB is that 10% is still far too low.

ICB head Sir John Vickers was the first to admit that his interim proposals are a compromise. His team is under huge political and lobbying pressure to spare banks from the toughest reforms, especially meaningful structural reform. His final recommendations are not due until September but if he really doesn't want taxpayers to pay for the next banking crisis, his proposals will have to get a lot tougher.

At half time it’s KONP 1 – Cameron and Lansley 0

2011-04-06T19:44:00.000-07:00

The government yesterday said it was in listening mode over health reforms, a significant victory for all the Keep Our NHS Public, Save Our NHS, NHSDirect Action, Health Emergency and other campaigners fighting its health reforms.

But the Health and Social Care Bill is not dead yet and there is plenty more lobbying to do. Thanks to this government pamphlet and Andrew Lansley’s own patchy media performances on Wednesday, there should be some easy wins ahead for the campaign...

First, let’s look at Lansley’s interviews. He told Radio 4’s PM interviewer, Eddie Mair (click here, from 10 mins to 22 mins, with Mair asking if Lansley would resign around 21 mins) that health professionals and the public agree with the principles and policies of his reforms, and are worried only about their implementation.

This is simply wrong. Medical and public opposition is centred on fears about opening up the NHS to private competition, a matter of principle not implementation. Lansley can ignore it all he likes, but it's the biggest barrier to his reforms and it’s still there.

Funnily enough, Lansley made a similar slip in his earlier myth-buster document (myth 4), when he argued that the reforms did not count as privatisation because the NHS would still be publicly funded, even if the providers were now private. Obtuse or dishonest? You decide.

Next, Lansley told Newsnight’s Gavin Esler that the BMA supports GP commissioning. Let’s look more closely at this claim: the BMA is in favour of more clinical commissioning but has serious doubts whether GP commissioning is the right way to do it (see BMA's response paper):

The BMA has consistently argued that doctors and other clinicians should have much greater autonomy and flexibility to shape services for their patients...The BMA believes successful [GP] commissioning will only be achieved if consortia are able to draw on the expertise of other clinicians...GP-led consortia will also require significant support from managers and other non-clinical staff

It is true that GPs are queuing up to join pathfinder consortia but that is because they have to avoid being disadvantaged, most of them don't actually support the reform. A few do, perhaps inspired by the financial opportunities, but according to this Royal College of GPs survey , more doctors think GP commissioning will fail to achieve the government's aims. As the BMA said, joining a pathfinder is no more a sign of approval than passengers jumping into a lifeboat is an approval of their ship sinking.

Lansley then told Esler he wants to slash a third off NHS administration costs by handing commissioning to doctors. The implication is that we must choose between administrators doing it badly or doctors doing it well. This is a false choice: GPs will have to hire ex-PCT staff, so quality and overall staff levels can only change so far. The best that can be said of the change is that it might bring a one-off benefit if GPs leave the worst administrators behind.

Lansley's war on managers is simplistic, you cannot just wish them away. Better to improve them than remove them. Also, the clinical/admin divide apparently provides a source of productive tension in well-run hospitals that would be lost under his reform.

Lansley spoke of clinical-led commissioning and patient choice as the heart of his reform but has not explained why it should be GPs and not other doctors in the driving seat. Why not take a mix of doctors across specialisms? (this may now happen as the BMA wanted, according to the FT).

And instead of turning GPs upside down, why not simply appoint more doctors to PCT boards? Making GPs join large consortia will probably reduce diversity and choice, at least as far as choosing a GP is concerned. The policy looks self-defeating.

What about David Cameron's arguments? He promised to stop private companies from cherry-picking services and leaving NHS hospitals with the dregs. Doing this while leaving "any willing provider" in place is contradictory.

If the aim is to create a market for health services, it will only work if buyers and sellers can act in their own interests. Private firms will naturally want to cherry pick, as will charities and NHS units – since they are all competing for the same revenue. Rules to stop cherry-picking will stop the market from being a market and add red tape; it’s hard to see the point of it.

The first draft of the Bill sheds some light on this – it originally allowed for price competition, taking us firmly into the realms of US-style health provision. Mercifully, this was removed in the government’s first small U-turn on the Bill, but the “any willing provider” rule is still there in all its cherry-picking glory.

If the government wants an element of internal competition, it already has it from the reforms brought in by Labour. Instead of trying to marketise things further, it could look at ways to improve public sector provision through new ownership models, such as social enterprises that reinvest profits in their community, as proposed by Cameron's favourite Tory think tank, ResPublica in its report, The Ownership State.

Next, Cameron says that the status quo is not an option. This is his biggest area of personal risk as the claim is dubious, ties him to bold reform and makes it harder to ditch Lansley and his troublesome Bill.

So why is status quo not an option? The NHS is famously in constant evolution, patient satisfaction is a near record high and health outcomes are on an upward trend, all for lower expenditure than any other developed country: the status quo actually looks pretty good. As these Financial Times and Guardian editorials say, the reforms are fixing a problem that doesn’t exist.

The pamphlet puts it down to funding: it says Lansley's reforms are needed because demographic changes and rising treatment costs will squeeze the NHS budget.

But this is a funding not an operational problem. Funding the health needs of an aging society will need a mix of fiscal and other policies that focus on where the money comes from. Lansley’s reforms are operational and look only at where the money goes to (which happens to include private providers such as Lansley benefactor Care UK).

In fact, GP commissioning and private provision are likely to increase pressure on funding by adding transaction costs and reducing the NHS’s scale economies: countries that share our demographic outlook but not our universal health provision spend 1-4% of GDP more on healthcare. Like us, they also have aging populations and are probably looking at the UK as a model to bring their costs down!

If the biggest challenge is funding, Cameron is talking to the wrong person. He should be speaking to George Osbourne about economic growth and reworking inheritance tax rules to fund end-of-life care.

Meanwhile, to keep the best bits of Lansley’s reform without ruining the NHS (and possibly his own career), here’s what Cameron should do next:

abandon the Bill completely,
appoint someone to explore fiscally-based long-term funding options for end-of-life care,
put more doctors on the existing commissioning structures,
make PCTs smaller, more local and more accountable,
consider letting NHS units adopt social enterprise models,
promise to protect the NHS’s integrated, public provision model.

These small changes would make the NHS safe again for the Tories and would not need a Lansley Bill. In fact, they would not need Andrew Lansley at all.

Ladbrokes this week shortened the odds on the health minister being the next to leave the cabinet from 10-1 to 5-1 and today to 4-1. Put your bets on before it gets to evens!

Alternatives to the Lansley plan

2011-03-21T12:56:00.000-07:00

One of the problems for those of us that oppose Andrew Lansley’s health reforms is that it’s hard not to sound negative. “Kill the Bill!” is not a constructive slogan. "Here's a better one!" might be more effective.

We need an alternative but most people (like me) haven’t a clue where to find one. Apparently, there are pretty good health systems in France, Holland and Switzerland, even the US system has its good parts. A cursory look at these - courtesy of good old wikipedia - throws up a few ideas about what kind of NHS we might ask for instead.

The main finding is that all those systems cost a lot more than the 7.7% of GDP we're used to paying. The chart above shows how cheap the NHS is compared to other systems (click here for more data).

Another is that no one has really cracked the problem of getting the efficiencies of competition without paying for profits and suffering from cherry picking, monopolies and other market failures. In general, the more competitive systems seem to cost more overall, which must be a puzzle for economists.

Here's what a few of the alternatives look like, in ascending order of cost, and some features we might look to adopt from them for ourselves.

The Netherlands

The Dutch split their healthcare into immediate and long-term chronic care with different funding systems for each.

Immediate care, such as for broken legs and curable sicknesses, is funded by compulsory, strictly regulated private insurance that costs each adult around EUR 100/month (children go free). This takes care of nearly half the nation’s health costs and reduces the nation’s tax bill accordingly.

Long-term and chronic care, which includes care for the elderly, is funded from general taxation and accounts for around a quarter of total health spending. The remaining quarter is funded by a mix of other taxes and private insurance.

Dutch health insurers are not supposed to make a profit on their compulsory health policies and must offer a defined package of cover. Despite this they still manage to compete and keep costs low. They must also charge the same premium to everyone and not turn anyone down on the basis of age, gender, lifestyle etc. To make this non-discrimination work, a government agency redistributes premium income between insurance companies behind the scenes, using a formula that slightly favours riskier people to counter the natural bias against them.

The system is complicated and not free of complaints but, at only 8.8% of GDP, is significantly cheaper than the French and Swiss systems. In UK GDP terms, it is around £10bn more expensive than the current NHS.

France

The French have a centrally funded universal healthcare system similar to ours but better. It is reckoned to be the best in the world and has the lowest mortality rates. It costs a pricey 9.7% of GDP and rising – a full 2% more than the UK. Bringing NHS spending up to French levels would cost GBP28bn, in UK equivalent terms. Clearly this is not the direction of travel, despite the government’s liking for French health statistics, but gives an idea of what we'd need to spend if we stick with the same system as now.

Switzerland

As you would expect, the Swiss have an intricate, expensive and very reliable system ~~made entirely of chocolate~~. Like the Dutch, it is based on compulsory insurance but covers acute as well as long-term care and carries an insurance excess of around EUR 600 a year to discourage use, especially among the poor. Despite that it costs even more than the French system, at 11.2% of GDP the most expensive in the developed world after the USA.

Swiss adults must pay up to around EUR 300 a month (Swiss taxes are low so it's not so bad) and pay an excess every time they use a service up to the cap, which can also vary depending on the insurance policy. The excess means users think twice before seeing their doctor as every visit generally ends with an invoice. There is “any willing provider” style choice of private and public service providers. Insurance companies are privately owned but cannot make a profit on basic policies (they can sell upgrades for those wanting a private room and flowers by the bedside). The state picks up the premiums for those on low incomes.

If the next set of reforms after Lansley’s is to bring in universal compulsory health insurance, this could be the system we end up with. In overall cost terms, it would be equivalent to increasing the NHS budget by £50bn.

USA

The US system is the free market end point, with the world's best doctors and shiniest equipment and costs to match. We should be either copying it or avoiding it like the plague, depending on your politics. Its two defining features are insurance and litigation.

Truly private health insurance is costly. According to the annual reports of two randomly selected US health insurance companies, Emblem Health and Coventry Healthcare, around 89% and 85% of premium income is paid out in medical benefits, respectively. In other words, these private insurers add 11-15% to basic healthcare costs just to cover their own admin and profit.

As insurance goes this is actually not bad – I'm told some types of insurance eat up to two thirds of premium income in costs - but 11% of a national health budget is still a huge, huge number. If insurance companies are to be part of the funding solution, they will clearly have to be non-profit insurers, as in the Netherlands and Switzerland.

A financial consequence of moving the NHS budget out of the exchequer is that private insurers will need assets capable of generating £100bn a year or more. This is a whole new asset management industry, great news for beleaguered financial workers and probably the stock market too.

The other big cost is medical litigation. Medical malfeasance, or rather its avoidance and management, adds around 10% to US health spending, according to this 2006 study by PwC. The extra costs are mainly legal fees and damages and so-called “defensive medicine”, where doctors request clinically unnecessary tests to make the insurance companies feel better.

Clearly we don’t want that here. One of the reasons the UK suffers less from litigation culture is that we have a good safety net in the NHS and welfare state. Judges are less likely to award sky-high damages when other sources of reparation are available, especially if the defendant is a public service. Sadly, this approach is already being eroded by small-time litigators and the compensation culture. As austerity shrinks the welfare budget and the NHS is privatised, the worry is that health providers will increasingly be seen as deep pockets for litigators.

If you add up the 10% cost of dealing with medical malfeasance, the high medical salaries and profit margins of private medical companies (which our coalition government estimates at 14%), the 11-15% admin and margin costs of insurance industry, it is a miracle that the US can afford healthcare at all. The fact that it spends “only” 14.6% of GDP on health looks like a triumph of the free market until one remembers that the UK spends only half as much and that US healthcare is, by a country mile, the worst value in the world (that chart again).

Aging populations

All these systems face the common problem of aging populations. In addition to the demographics, people are living longer and families are increasingly sending their elderly relatives to care homes, which increases costs further.

Raising the retirement age seems a fair response to increased longevity and this is already happening via annuity rates and changes to pension schemes. The rising use of care homes reflects a wide variety of cultural, moral and economic changes, from family and cultural traditions to ideas of obligation between generations and changes in lifestyles and asset values.

It is hard to imagine the state taking a position on the home vs. residential care debate (although it has an opinion on marriage) but it needs to plan for costs whoever provides the care. This probably means tax credits for families that look after their elders at home and changes to inheritance tax and capital gains taxes. The key point is that reforming the NHS is not a cure for rising elderly care costs; this will need strong fiscal and social measures.

Of the systems above, the Dutch seem to have the cleanest split between funding for long-term and acute care. This financial flexibility may grow more useful as the gap between them opens up.

Distributional justice

Like finance, medicine is full of informational asymmetries and displaced risks. The difference is that medicine – under the NHS - has strong institutional ethics and a public service ethos. Lansley's reforms could undermine these and their role in making the NHS a moral community, since, as Adam Smith warned, markets cannot be relied on to create a moral community.

To know if this risk is worth taking it would help to agree on what we want out of a modern NHS. We didn’t have much of a debate about the NHS before the last election but we really need one as the distributional ethics of universal health provision seem to be changing fast, especially regarding acute versus long-term care funding.

Events such as the housing and financial booms, credit crunch, recession, education costs and pension reforms have changed the way wealth is distributed between generations and the obligations felt between young and old. It has also seen dramatic increases in wealth inequality, changing the way people feel about their obligations to the state and each other.

Health and social care reform assumes some level of agreement about these. A debate would have helped build consensus on new problems, such as whether illegal immigrants should be entitled to long-term care or just A&E, whether people whose houses doubled in value should have the same subsidy for end-of-life care as those who don’t own a home, whether the wealthy should be allowed to contract out of the NHS or made to keep a vested interest, whether health can be judged purely by cost or also by Cameron’s index of wellbeing, and how the financial crisis has changed our view of free markets and public service, to name a few.

New forms of ownership

A debate could also explore whether new forms of ownership might be more appropriate to public service delivery than private firms. One of the leftwing's worries about "any willing provider" is that health services could become dominated by companies whose interests, by definition, are not the same as the public's.

Matt Leach, associate director at "Red Tory" think tank ResPublica, explains the dangers.

"With cherry picking, you risk costs being left with the state. With monopoly you risk long term exploitation of market position to the detriment of other local players and the procuring agency. Parts of the public sector may favour large scale contracts for reasons of perceived ease of bureaucracy, monitoring, etc, but at a long term financial, social and delivery cost."

ResPublica's idea is for new types of social enterprises to take on the work. In a report on this idea, entitled "The Ownership State", ResPublica director Philip Blond, writes:

We propose a new model of public sector delivery, in which services are provided by social enterprises led by frontline workers and owned by them and the communities they serve. These new social businesses would exchange economies of scale (which are all too often illusory) with the real economies that derive from empowered workers and an engaged public."

The idea is being championed by Tory MP Chris White, whose private members bill Public Services (Social Enterprise and Social Value) Bill 2010-11 is making its way through parliament just behind Lansley's NHS reforms.

White's Bill defines a social enterprise as "a business that acts for the benefit of the community and whose profits are for the greater part reinvested for that purpose in the business or in the community."

It also proposes a social value test in which those engaged in public procurement must consider the impact of contracts on economic, social and environmental wellbeing - a change of thinking for most private contractors.

If so much of the opposition to Lansley's reforms stems from the conflict between private profit and public service, the easiest escape for the government is to redefine AWP so it excludes or severely limits private NHS provision and promotes social enterprises instead.

Conclusions

A national debate and comparison with the health system of another country would have been an obvious and honest way to approach NHS reform but - no such luck.

In the meantime here are a few things we can learn from a quick look at our neighbours' health systems in case we have to decide quickly what we want instead of Lansley's reform:

Health systems in other developed countries all cost more than the current NHS
Any reform will therefore increase either taxes or private health insurance premiums
Litigation and insurance inflate costs massively but can be kept lower if the system is designed upfront to control them
Non-profit competition works for insurance, maybe it would for core health provision too
Swiss style “excess” insurance is incompatible with the NHS principle of “free at the point of care”
French health standards require French levels of spending
The Dutch system is relatively good value and seems flexible in dealing with rising long-term care costs, perhaps we should look more closely
Rising care costs for the elderly will require fiscal, not NHS reforms
Successful health reform needs an updated consensus on matters of distributional justice
Banning (or severely restricting) private NHS provision while promoting social enterprises would create competition without the ill effects of privatisation

UK politics and the AV: time to consider mini-referenda

2011-02-25T05:55:00.000-08:00

A likely outcome of the Alternative Vote system, subject of the upcoming May referendum, is that it would push election campaigns further into the centre ground as MPs try to widen their appeal.

This raises the risk of rogue governments adopting policies for which they have little mandate, as with the UK coalition’s post-election lurch to the right, and raises the question whether AV on its own is enough. Perhaps it should be followed by other democratic reforms, such as mini-referenda?

In 2010, David Cameron campaigned on a safe middle platform but once in office revealed a different face. After the election, we discovered that his policy lab had stitched together a body of old Friedmanite ideas on small government and marketisation, as if they hadn't noticed the financial crash.

Cameron and George Osborne prepared us for cuts in the name of deficit reduction but never mentioned their plans to kill off providers of the “social commons” such as day care centres for the elderly and citizens advice bureaus, or to turn the NHS into a private market and do the same with other public services.

Now there is little the electorate can do, apart from hope the Lib-Dems pull the plug after the May council elections.

How does this relate to AV? The worry is that AV might encourage more of this type of behaviour. MPs in search of second choice voters will have to appeal to a broader range of opinion than they do now, making them unlikely to campaign on unpopular policies. This will increase the temptation to play nice at the hustings then reveal a Frankenstein policy after polling has finished.

AV is a big step forward but perhaps it needs buttressing with other electoral reforms.

Given the heightened political awareness of the moment, why not use new technology to introduce mini-referenda on topics such as Lansley’s NHS reforms? This would modernise politics and help to keep rogue governments in check.

Critics will say that referenda make it harder to adopt tough but necessary changes, such as tax rises, and encourage populism at the expense of minorities. But this depends entirely on how they are used. For example, mini-referenda could be reserved only for high-impact national policies that did not appear in a manifesto, or their use could be subject to approval by a constitutional court.

The current whipping system means that defeat on any landmark Bill risks triggering a vote of confidence in the whole government. Not surprisingly, this is pretty rare and the fear of it explains many current undemocratic practices (such as MP and former GP Sarah Wollaston being told not to criticise the NHS Bill despite sitting on the Bill scrutiny committee). A mini-referendum could act as a pressure valve and help governments to adjust their course as they go.

World events show how quickly democracy is evolving. Britain's unique parliamentary system is the result of centuries of improvements, but whatever the result of the AV vote our system should keep pace too.

Youth unemployment: another misguided case of ‘leave it to the market’

2011-02-23T05:30:00.000-08:00

Alice Roosevelt Longworth once joked that “the secret of eternal youth is arrested development”.

That certainly resonates with me but if Teddy Roosevelt’s eldest daughter was right, today’s school leavers should remain young for a very long time. Those hoping to develop into employees face the toughest job market since most of them were born.

The TUC’s February Labour Market Report shows youth unemployment approaching one million. A quarter of these are considered long-term unemployed having been without work for longer than a year, the highest level for seventeen years.

According to the TUC’s blog, one of the first things the government did when coming into power was to cut the Future Jobs Fund introduced by Labour and replace it with nothing. Is this another case of mistaken reliance on markets?

The FJF was originally designed to get young unemployed people without skills into steady work by subsidising a 6 month placement at a sympathetic employer who would leave them with a reference, skills, confidence and the motivation to enter the long-term workforce. It was like a cross between a youth centre and a temp agency, offering something constructive to do to fill the void after full time education at a time when there is precious little else.

It didn’t work for everyone. One FJF worker, Becky Jarvis, wrote in a blog comment that she received no training on her placement and failed to find a job afterwards, despite writing 100+ applications. She said her employer used her as free labour and when she complained refused to give her a reference. She felt she would have been better off without the scheme.

That's hard to know. What's clear is that half of those who did an FJF placement claimed benefits the month after they finished, a statistic that David Cameron used to justify binning the Labour scheme.

This seems rash when you consider that the other half appear to have found work in less than a month – a big win by any standards – and no one had waited to see how the other half fared in the longer-term. Unfortunately, the coalition canned the entire scheme before longer term data had been collected. The Department for Work and Pensions stats only go up to month 7, ie the month immediately following the end of a 6 month placement.

Statistics aside, Becky Jarvis’s experience contains an insight into how the scheme should not be run. Having a subsidised quasi-job is bound to be depressing if your employer treats you as charity and refuses to give the training and respect that a regulator staffer would receive. There is clearly room for improvement.

But should FJF have been scrapped when it was?

According to the TUC, the scheme was abandoned before its longer-term effects were known, before initial feedback could be used to improve outcomes (such as requiring employers to provide training), and nearly 18 months before a replacement scheme could be implemented. Meanwhile, the economy is still shaky and youth unemployment rising. The answer is clearly no, it should not have been scrapped without a decent replacement.

The government’s new welfare reforms involve a Universal Credit designed to close the benefit trap that discourages people from working part-time. This might end up replacing publicly-funded FJF placements with real part-time jobs, which would cost less and encourage self-reliance; overall a great idea.

As an alternative to FJF, however, it is not enough. It assumes there will be jobs. Even where there are, it will push people towards unskilled work rather than the training opportunities they might have got under a properly run FJF. And it will do nothing to help tough cases such as those lacking the ability or confidence to hold down even part-time work.

Rather than scrapping the scheme, why not use the early results to improve it in imaginative ways? It could have been expanded into a wider apprenticeship scheme with incentives for employers to make FJF positions permanent or to provide training and skills; it could have been linked to the voluntary sector and even the Big Society.

But the coalition has opted for a market-based remedy again. As with the NHS and public service reforms, it is easier to abdicate responsibility for problems - such as what to do with unskilled people when there are no new jobs - than to fix them.

The premature cancellation of FJF seems more callous now in light of the unemployment figures. With no replacement scheme, weak economic growth and an acute shortage of commercial apprenticeships, today’s school leavers must be looking forward to casting their first vote.

More NHS materials

2011-02-17T07:02:00.000-08:00

Unison, the health workers union, takes apart the government's myth-buster document (see earlier posting For and against NHS reform - in their own words) in a response called "Rebutting the rebuttals"

Sample letters to write to MPs and GPs, and other Unison docs here

Survey by the Royal College of General Practitioners, which finds that a majority of GPs oppose the marketisation of the NHS and fear the reforms will cause "irreparable and irreversible damage to the NHS."

Follow the legislative progress of the Bill through the committee stages. Only two more committee meetings after today's, scheduled for 1 and 3 March.

Excellent article on Channel 4 website by junior doctor on likely effect of the reforms "NHS surgeon: Lansley reforms are a 'phony revolution'"

NHS price competition – what the academics think

2011-02-10T18:57:00.000-08:00

Here are some links to academic research on the effects of price competition on healthcare. You probably know the conclusions already but here they are spelled out with links to the relevant research papers and the dangerous parts of the draft Bill.

Also, some handy resources for NHS campaigners:

Blog from the The Centre for Market and Public Organisation (see two excellent recent posts from Carol Propper, The Health Bill, the NHS and the facts and Price competition to be (re)introduced in the NHS
Appleby’s BMJ article questioning the government's use of stats
A collection of quotable soundbites from LSE and other health economists
Another blog like this, with summaries and links to academic evidence
BMJ editorial on the dangers of structural reorganisations
Ben Goldacre’s Guardian Bad Science column that reviews the evidence for reform (full of links)
The BMA (doctors’ union) statement against "always damaging" price competition
Richard Taylor’s proposal for a new political party - NHS Concern - to turn the May council elections into a referendum on health reform
Blog from health think-tank Altarum Institute against price competition

Now for the nitty gritty...

What happens when patients choose on the basis of quality alone?

Competition on quality

Researchers in 2000 looked at heart attack data in the US and found that fixed-price competition among Medicare providers "unambiguously improved social welfare" (Kessler, D. P. & McClellan, M. B. (2000). Is hospital competition socially wasteful? The Quarterly Journal of Economics, 115, 577-615).

A UK study, however, found that in the 1990s competition based on loosely fixed prices made heart attack survival rates worse (Propper, Burgess and Gossage (2003). Competition and Quality: Evidence from the NHS Internal Market 1991-1999). During the period in question, prices were negotiated annually in block contracts. They were tightly regulated but still left room for some surreptitious price competition.

A different UK study looked at competition under fixed prices and found again that competition improved heart attack survival rates (Cooper, Z. N., Gibbons, S., Jones, S. & McGuire, A. (2010). Does hospital competition save lives? Evidence from the NHS patient choice reforms. LSE Health Working Paper – 16. London, London School of Economics).

Together, these studies suggest that the more fixed prices are, the more lives are saved when hospitals have to compete on non-price factors such as quality of service.

Whether heart attack studies are the best way to assess general healthcare is an open question (most patients don’t choose where to have a heart attack in advance) but nevertheless, heart attack mortality seems to have become an accepted yardstick for assessing hospital outcomes.

Andrew Lansley even used it for his headline statistic that British heart attack victims were worse off than their French counterparts (although his statistic has since been condemned in the British Medical Journal for ignoring the trend of strong improvement in UK heart disease and cancer outcomes).

Broadening the scope from heart attacks, another recent paper looked at a whole range of quality measures and found that fixed-price competition caused significant improvements in overall mortality and reductions in length‐of‐stay without increasing expenditure per patient (Gaynor, Moreno‐Serra and Propper (2010) Death by Market Power; Reform, Competition and Patient Outcomes in the National Health Service).

Researchers also looked at ways to measure “efficiency”, using the pre-surgery length of stay for hip replacements as a proxy. They concluded that fixed-price competition caused hospitals to shorten the pre-surgery length of stay, ie become more efficient (Cooper, Gibbons, Jones and McGuire (2010). Does Hospital Competition Improve Efficiency? An Analysis of the Recent Market-Based Reforms to the English NHS, CEP Discussion Paper No 988).

The idea of efficiency in healthcare is a little tricky (how do you measure health with a calculator?) but it seems uncontroversial that a degree of competition would make hospitals run a little tighter. There is plenty of evidence that fixed-price competition does exactly that.

Competition on price

Andrew Lansley’s reforms, however, introduce price competition. The coalition has kept this fact quiet but it's there in black and white in the draft legislation.

Sections 103 and 104 of the draft Health and Social Care Bill provide for the regulator to set maximum prices as well as fixed prices:

103 (1) If a health care service is specified in the national tariff, the price payable for the provision of that service for the purposes of the NHS is—
(a) the price specified in the national tariff for that service, or
(b) where the national tariff specifies a maximum price for that service, such price not exceeding that maximum as the commissioner and the provider may agree.

The NHS Operating Framework for 2011/2012 shows how this would work in practice, stating at paragraph 5-43:

“One new flexibility being introduced in 2011/12 is the opportunity for providers to offer services to commissioners at less than the published mandatory tariff price, where both commissioner and provider agree. Commissioners will want to be sure that there is no detrimental impact on quality, choice or competition as a result of any such agreement.”

This is the beginning of price competition in the NHS. What you would expect next is for providers to cut prices at the expense of quality, especially for procedures where it is hard to judge the outcome. It turns out this is exactly what the data prove.

In an important 2002 research paper, (Propper et al. (2004) Does Competition Between Hospitals Improve the Quality of Care? Hospital Death Rates and the NHS Internal Market. Journal of Public Economics, 88, 1247-1272 ), Carol Propper found that when competition is payer-driven, in other words when it is based on price, it leads to higher death rates:

[previous research shows that] under certain conditions it can be shown that payer-driven competition may bring about reductions, rather than increases, in quality (Spence, 1975, Dranove and Satterthwaite 1998).

Our results support the hypothesis that where quality signals are weak or noisy, the impact of competition is to reduce rather than increase quality. Five years or so after the introduction of the internal market the linear relationship between quality and competition is negative. Hospitals located in more competitive areas have higher death rates.

There is apparently some US research that shows price competition can improve outcomes but Propper did not find this result in the UK.

Indeed, other US research backs up her paper, finding that the introduction of hospital price competition was associated with an increased mortality rate among uninsured New Jersey heart attack patients (Volpp et al (2003) Market Reform in New Jersey and the Effect on Mortality from Acute Myocardial Infarction).

The US seems to have learnt this lesson, making its over 65s health service Medicare run on a strict fixed-price system.

Andrew Lansley has not. His Bill - as it is currently drafted - will create a national health market with increased private sector provision and price competition. The evidence says this will be a costly and dangerous mistake.

Save the NHS, push for limits on private health provision

2011-02-01T04:08:00.000-08:00

Here’s an idea to stop the government from gutting the NHS - push for an amendment that limits the percentage of the NHS budget that GPs can farm out to the private sector.

An unexpected champion for this might turn out to be David Miliband, who landed one of the few real blows on the government’s health reform plans in yesterday’s Commons debate.

Speaking from the back-benches during the Health and Social Care Bill’s second reading debate, the elder Miliband accused the government of burying what he called the biggest change in the Bill: the introduction of price competition.

Miliband mentioned some LSE research (which I will post here if I track it down) that competition on quality improves health outcomes but competition on price and quality together makes things worse.

Andrew Lansley, the Health Secretary who had been defending his Bill quite well until then, had no answer. He muttered something about price caps and party politics and quickly moved on.

Miliband’s question is a good one - if the evidence shows that a key part of the reform is going to make things worse, why do it? And how did price competition get so buried in the details that MPs and the public have hardly noticed it?

The answer may lie in how the Bill was presented. A House of Commons research paper mentions fears about privatisation in such a cursory manner, you could be forgiven for thinking it was the view of a few nutty extremists. It reads: “Some respondents, particularly trade unions representing NHS staff, argued that the White Paper reforms threatened the core principles of the NHS and that they would open the door to much greater private sector involvement in the NHS" (page 8).

The same paper cites polling evidence that only a quarter of the public think the reforms are a good idea. The other three quarters of the population cannot all be healthcare union members; perhaps some of them will speak up too.

It also emerged in the debate how expensive private provision could be. The Bill's impact assessment has pencilled in a 14% premium for private healthcare providers, a brand new deadweight cost. On a back-of-the-envelope calculation, the NHS only has to lose one patient in 14 to private firms for that premium to wipe out all the £5bn administrative savings the government expects over the next five years.

In fact, private providers are likely to be far more successful in winning market share. If they capture half the NHS’s £100bn+ annual budget, private company shareholders would end up costing taxpayers £7bn extra every year, or 56,000 nurses in political currency. Not very austere.

Shadow health minister John Healey did a reasonable job of attacking the Bill, saying it would “drive free market ideology into the heart of the NHS”, become “the PM’s biggest broken promise” and replace the public service ethos of the NHS. But he is badly held back by his party’s own moves towards privatisation when it was in power.

Inevitably, MPs passed the vote last night with 321 ayes to 235 noes, a majority of 86. Only the Lib Dems can overturn that, which they won't as it would end the coalition.

The best way forward now is to fight for amendments that remove the price competition rules and set limits on the size of public sector provision. The time is now to ask MPs to push for these changes as the Bill heads to committee and report stages after yesterday's vote.

Tellingly, when Lansley was asked how big the private sector might become under his reform, he said he had no idea. A tight statutory limit, for example capped at 5% of the NHS budget, would keep it in check.

Caveman economics

2011-01-31T01:54:00.000-08:00

Caroline Spelman got duffed up on the Today programme this morning over her plans to sell-off the nation’s forests. “You’re going to have to back down on this, aren't you?”, asked nature-loving interviewer, John Humphrys.

We can only hope he’s right. But whatever happens to our woods, Spelman’s justification for the sell-off highlights a worryingly backwards approach to economics from the government.

Officially, the problem with forests is that their custodian, the Forestry Commission, is also the country’s biggest logger and therefore has a conflict of interest. I had no idea this was a problem but presumably it could be dealt with by splitting the Forestry Commission’s logging activities into a separate entity, without a mass sell-off.

The leap to privatisation appears to come from a Conservative ideological preference in favour of private ownership and fundamentally free markets. It probably helps that forestry is one of the fastest growing alternative asset classes and the Treasury is short of money, but a sell-off seems out of all proportion to the problem.

This 1980s-style love of free markets also lies behind the planned NHS reforms. David Cameron writes in today’s Times that the NHS “will sicken” if it is not reformed to meet funding and demographic challenges. That’s true, but why is privatising the provision of NHS services the answer? All the evidence points in the opposite direction; that private provision will increase costs and reduce quality. When the NHS needs more funding and better management, the government deliver a red herring. The NHS reforms seem to be another case of ideological piggy-backing.

To be fair to the government, there is a deficit to reduce and it is true that most things work better under private ownership. But not everything...

Railways, defence, financial regulation, fish quota management, strategic oil reserves and national health, are some of those that don't. What they have in common is that they all provide a public good, something with a high social value but no market price.

This is not news. A whole branch of economics is devoted to solving the “tragedy of the commons”, in which self-interested individuals rush to deplete shared resources. National woodlands are an almost perfect illustration.

The government could recognise this without resorting to modern-day enclosure. It could work up some practical solutions, such a better management systems for the NHS or a better structure for the Forestry Commission. Instead it is playing the economic caveman and hoping the market will take of the commons. It won't.

For and against NHS reform - in their own words

2011-01-30T15:13:00.000-08:00

UPDATE: New book due out in April "THE PLOT AGAINST THE NHS" by Colin Leys & Stewart Player, promises to expose the creeping privatisation of the NHS. A previous Colin Leys book "Market Driven Politics: Neoliberal Democracy and the Public Interest" (reviewed in detail here) concluded that the marketising of health and public broadcasting was "incompatible with democracy and, in the long run, with civilised life."
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The government's disastrous Health and Social Care Bill has its second reading in parliament tomorrow, Monday. There will be a debate and a vote, after which the Bill can proceed to the committee stage and be picked apart clause by clause by MPs on the health committee.

Under "read more" below you will find two documents that set out the cases for and against.

The first is a government Q&A note written to help health ministers defend the Bill against its many critics. In an Orwellian flourish, the questions and answers are referred to as "myths and facts" (my favourites are Myths 4 and 10, so brief, so flimsy).

The second is a briefing note prepared by Unison, the public service trade union, challenging specific clauses in the Bill. If you don't want to read the whole document, a summary of Unison's main arguments is here.

GOVERNMENT Q&A DOCUMENT [note, a point-by-point rebuttal by Unison of the claims in this document can be found here]

Modernising the NHS: the Health and Social Care Bill

1. Summary

The Health and Social Care Bill will modernise the NHS to give every patient the best
chance of surviving an illness like cancer, and the best quality of life if they have a
long-term condition like diabetes.

We want the NHS to be there for everyone, free-of-charge, and based on need

and not ability to pay. That is why we are increasing spending on the NHS above

inflation year after year - something that Labour opposes.

Our ambition is simple – to deliver care for patients which is the best of

anywhere in the world, on the NHS. Despite the best efforts of staff, the NHS does

not achieve this now:

• Someone in this country is twice as likely to die from a heart attack as someone in

France

• Survival rates for cervical, colorectal and breast cancer are amongst the worst in

the OECD

• Premature mortality rates from respiratory disease are worse than the EU-15

average

That is why we need to modernise the NHS. Our plans:

• Cut managers, waste and bureaucracy, and give extra money to front line

services to pay for things like the Cancer Drugs Fund, which is already giving

hundreds of patients access to the drugs they need.

• Give control over NHS services to frontline doctors and nurses and take it out

of the hands of ministers and managers, so that patients get the best possible care.

• Give local communities powers to stop forced and unwanted closures of A&E

and maternity services.

• Inject real democratic legitimacy into the NHS for the first time in almost 40

years through the creation of Health and Wellbeing Boards, which will drive the

integration of health and social care.

• Focus the NHS on the results it actually delivers for patients by allowing the

best people – whether from the public, independent or charitable sectors – to

deliver the care which patients need.

Because we are handing over power to patients, frontline doctors and nurses, and

local communities, we will be able to make £5 billion of administrative savings

over the coming years – all of which we will plough straight back into patient care.

This is equivalent to over 40,000 extra nurses, 17,000 extra doctors or over 11,000

extra consultants every year.

2. How will care improve?

The Coalition’s plans to modernise the NHS will give patients the best-possible care,

on the NHS.

• When a local hospital feels that they can provide diagnostic tests more

conveniently to patients in the community, they will be free to do so.

• If local GPs see that there is a significant need for physiotherapy services in their

local area, they will be able to organise local clinics for their patients – rather than

giving them a default option of having to travel to a hospital miles away.

• When a GP feels that a patient with serious diabetes is in danger of not managing

it effectively, they will be able to make sure the patient has the support to remain

independent – preventing unnecessary emergency admissions to hospital.

• When frontline nurses feel that they can deliver better care to autistic children in

partnership with a local charity, they will be free to make this happen.

• When a local community decides that they want a new health clinic or walk-in

centre, their local council will be able to work with the local NHS to help achieve

this.

3. Our modernisation plans in detail

The Coalition Government’s plans will modernise the NHS:

• The power and responsibility for decisions about NHS services will be transferred

into the hands of doctors and nurses at the frontline, instead of remote

organisations few people have heard of. This means that the NHS’s money will no

longer be spent by ‘Primary Care Trusts’, but instead by groups of GPs working in

partnership. And it will mean that hospitals and other health services become

‘Foundation Trusts’, which are free from central government interference.

• To prevent political micromanagement, which has damaged patient care,

responsibility for overseeing the NHS at the national level will be passed to an

independent NHS body – the NHS Commissioning Board. This will stop

politicians constantly interfering in the NHS. And we will do away with the topdown

targets which do not improve care. We will instead focus on what matters to

patients the results and quality of care. This means whether they survive cancer,

whether they get seen when they need to be, and whether they are supported to

remain in work.

• To give local communities more power, we will establish health and wellbeing

boards in all local councils, with the responsibility of planning local services,

jointly with the NHS and social services. These boards will publish a new ‘health

and wellbeing strategy’, setting out the ways in which local NHS and social

services will be improved in every local area.

• To give patients more power, we will allow them to choose to be treated anywhere

they want which meets NHS standards, so long as the treatment doesn’t cost more

than it would do on the NHS. This means that charities and social enterprises will

be able to provide services to NHS patients, free of charge, either together with

the NHS or on their own. It also means that the private sector will be able to

provide NHS services free-of-charge, and we will establish a strong economic

regulator to make sure that no-one is behaving unfairly. Any decision about where

to be treated will be for the patient himself or herself, in partnership with their

doctor, and as now no-one will pay for their NHS care.

To help patients and GPs decide where the best services are, we will give everyone

more information about the quality of care each hospital and health service delivers.

And we will establish a powerful new watchdog – HealthWatch – which will make

sure that patients’ views about their local NHS and social services are listened to.

Myths

Myth 1 The NHS is being cut.

Fact

We are increasing the NHS budget above inflation year-after-year – something which

Labour opposes But this does not mean that we can continue to put up with inefficient

services, because of the rising demands on the NHS due to an ageing population and

better technologies. That is why we are modernising the NHS – but any savings we

make will be ploughed straight back into patient care.

Myth 2 The changes weren’t in either of your parties’ manifestos

Fact

They were in both the Conservative and Liberal Democrat manifestos.

The Conservative manifesto (p. 46) promised that GPs would be given control over

the health service budget. The Conservative manifesto (p. 45) promised that every

Trust would be made a Foundation Trust. Both the Conservative (p. 27) and Liberal

Democrat (p. 42) manifestos promised that new social enterprises would be created to

deliver NHS services. The Conservative (p. 45) and Liberal Democrat (p.42)

manifestos promised that all types of providers – NHS, voluntary, or independent

sector – would be free to deliver NHS services. An independent NHS Board was

promised in the Conservative manifesto (p. 46). Scrapping central, politicallymotivated

targets was promised in both the Conservative (p.46) and Liberal Democrat

(p. 42) manifestos. Cutting back on unnecessary administrative costs was included in

both the Conservative (p. 46) and Liberal Democrat (pp. 40-41) manifestos.

Myth 3 The NHS doesn’t need any change.

Fact

Someone in this country is twice as likely to die from a heart attack as someone in

France. Survival rates for some cancers are amongst the worst in the OECD.

Premature mortality rates from respiratory disease are worse than the European

average. The number of managers in the NHS doubled under Labour, and productivity

went down year-on-year.

Myth 4 These changes represent the privatisation of the NHS.

Fact

We will never privatise the NHS. The NHS will always be there for everyone who

needs it, funded from general taxation, and based on need and not ability to pay.

Myth 5 Private hospitals will take over the NHS.

5

Fact

We want patients to be able to choose to be treated wherever they want to be –

whether it’s an NHS hospital, or one in the voluntary or private sectors. This is

because more choice and more competition will lead to benefits for patients. But we

don’t want to set a target for the amount of private sector involvement in the NHS –

unlike Labour – and unlike Labour we won’t pay the private sector any more than we

would pay the NHS. And we will establish a powerful new regulator to enforce these

rules.

Myth 6 GP consortia will be forced to use the private sector

Fact

It will be up to GP consortia to decide their own arrangements.

Myth 7 Every NHS service will need to be competitively tendered.

Fact

Our plans for ‘any willing provider’ are precisely the opposite. Competitive tendering

means identifying a single provider to offer a service exclusively. ‘Any willing

provider’ means being clear that a service needs to meet NHS standards and NHS

costs, and then allowing patients to choose themselves wherever they want to be

treated. It is designed to avoid the need for costly tendering processes, unlike

Labour’s ‘independent sector treatment centres’.

Myth 8 The policy of price competition in the NHS will lead to a “race to the

bottom” on quality

Fact

Patients won’t know how much a service costs, because NHS services are free at the

point of use. Patients will therefore choose to be treated at the highest-quality

provider. There will be competition on quality, not price.

Where prices can be reduced, in agreement with both frontline GPs and with those

offering the service, we will allow it in certain cases. This is the policy Labour set out

in 2009, when in government (Department of Health, NHS Operating Framework

2010-11 (paragraph 3.44), 16 December 2009).

Myth 9 Introducing competition will destroy integrated care

Fact

Allowing patients to choose the best care package for them, in consultation with their

doctor, will drive integration. And there is nothing in our plans that will stop GPs

working with clinicians from hospitals – or to stop hospitals working with other

6

hospitals – to plan ways in which patient care can be improved. Indeed, the Health

and Social Care Bill creates a new duty to promote integration.

Myth 10 Private providers will just cherry-pick the easiest cases, undercutting

the NHS

Fact

The less complex the procedure, the less someone – including in the private sector –

will be paid. Unlike Labour, we will not rig the market in favour of the private sector.

Myth 11 The NHS will cease to be a single, national organisation.

Fact

The NHS has never been a single, national organisation. It has always been made up

of hundreds and thousands of different organisations and individuals – many of them

from the independent sector – providing care free at the point of use and based on

need and not ability to pay. This will not change.

Myth 12 These changes will cost £3 billion

Fact

The one-off cost of our changes will be £1.4 billion, of which £1 billion are the costs

associated with reducing the size of the NHS bureaucracy – a reduction that is needed

to honour both parties’ promises to reduce the cost of administration in the NHS. As a

result, the changes will pay for themselves within two years, and go on to deliver £5

billion of savings over this Parliament.

Myth 13 Waiting times will increase.

Fact

We are not removing any guarantees which benefit patients. That’s why we’ve

retained the cancer waiting time targets. It’s why we will ensure that patient

experience is central to how we measure NHS performance. And it’s why we’ll allow

patients to choose where to be treated, which will drive improvements in quality and

waiting times. But when a quarter of patients with cancer are diagnosed only after an

emergency, it’s not enough just to focus simply on waiting times. That is why we’re

focusing on the actual results which matter as well, like survival rates from cancer.

Myth 14 These changes will lead to a postcode lottery.

Fact

Clear national standards of care will be set, so patients can be confident that –

wherever they are treated – NHS care will be of the same high standard, wherever

they live.

7

Myth 15 These aims could have been achieved by putting GPs on PCT boards

Fact

This would have simply allowed an additional layer of NHS bureaucracy to continue.

We inherited 151 PCTs and 909 ‘practice-based commissioning groups’. Our changes

are simplifying this system, cutting its costs and bringing it closer to patients.

Myth 16 Doctors and nurses will be turned into accountants.

Fact

Frontline doctors and nurses will not be turned into accountants. They will bring

clinical leadership into the NHS. They will be given all the support they need to help

them take decisions in the best interests of their patients, so that they have even more

power to do what they do best: caring for patients.

Myth 17 These plans will result in the closure of hospitals.

Fact

There are no plans to close hospitals. Indeed, our plans will prevent the kind of topdown

closures Labour made without reference to local communities. And our changes

will make the NHS more efficient by cutting back on bureaucracy, ensuring that every

penny spent in the NHS is spent where it should be.

Myth 18 GPs do not want to do the job you are asking them to do.

Fact

In just 12 weeks, GPs covering over half of the country have come together in groups

to lead our modernisation. They have come forward voluntarily, more than two years

before the formal handover of responsibility takes place in April 2013. This

demonstrates the enthusiasm among frontline GPs to take advantage of the

opportunities our modernisation plans offer.

Myth 19 These changes are a revolution.

Fact

Our proposals are an evolution of plans which governments of all parties have

introduced over the past twenty years. Giving power to GPs has been around for the

last two decades, with Labour setting up ‘practice-based commissioning’ when they

realised that abolishing GP fundholding was a mistake. Foundation hospitals, and

allowing patients to choose where to be treated on the NHS, have been ideas in the

NHS for the best part of a decade.

Myth 20 This is a huge, top-down reorganisation.

8

Fact

We’re moving away from top-down organisation and control. We’re removing targets

that tie up NHS staff in red tape and we’re getting politicians out of decision-making.

We’re removing whole tiers of management that sit above doctors and nurses and

instead giving them the power to decide what’s best for their patients. We’re giving

patients more choice and control over their care, rather than managers telling them

what they get. Our changes are about simplifying and modernising the NHS; not topdown

change.

Myth 21 No-one has been consulted on these plans.

Fact

We received over 6,000 responses to the consultation on our plans, and we have

modified our plans accordingly. For example, we have introduced the programme of

GP ‘pathfinder’ consortia.

Myth 22 Primary Care Trust commissioning is in ‘meltdown’

Fact

More than 50,000 people are currently employed in NHS commissioning. We are

clear that we want to reduce this number, but we are doing so in a carefully-planned

manner. We are implementing our plans through a clearly-defined transition process,

over a period of over two years. This process involves the creation of ‘clusters’ of

PCTs, which will step back from commissioning as and when GP consortia are able to

move into their place.

Myth 23 Patients with rare conditions will suffer, because GPs don’t know

enough about them

Fact

Like now, the care of people with rare conditions won’t be commissioned by GPs, but

by national experts in these conditions.

Myth 24 GPs will be made responsible for the rationing of NHS care

Fact

GPs are already responsible for taking decisions about NHS expenditure – when they

tell a patient that they do not need a medicine; when they decide to prescribe a drug;

and when they decide to refer a patient. But because they aren’t responsible for this

expenditure at the moment – only for the decision – the Primary Care Trust has to

‘second-guess’ the decisions taken by all their GPs before deciding what services

need to be offered. This means that the system is more complicated than it needs to

be. As the NHS Confederation has said, the move to ‘GP consortia’, “presents

9

significant opportunities to improve quality, efficiency and value for money in the

healthcare system”.

Myth 25 No-one will be in charge

Fact

Ministers will remain fully accountable to Parliament for the way in which the NHS’s

money is spent. But local services will be shaped to meet local needs through GP

practices working together, rather than imposed by a Primary Care Trust.

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THE CASE AGAINT: UNISON'S RESPONSE

Health and Social Care Bill: Second Reading, Monday 31 January 2011

UNISON Parliamentary Briefing

The huge Health and Social Care Bill confirms the Conservative–led government’s determination to reduce the NHS to little more than a brand name to be attached to a range of competing service providers.

The plans came out of the blue, completely overturning the government’s promise of “no more top-down reorganisations”, and represent an ideological attempt to put the pursuit of profit above the interests of patients. Reform should be gradual, it should build on what is current best practice, and it should have a strong evidence base. The Bill allows for none of these. The government’s plans will be wholesale and untested – a radical departure from what has gone before. It is therefore no surprise that the Bill has attracted unprecedented criticism from all parts of the health service.

The NHS always needs to keep improving, and all the evidence shows that it is getting better with the most recent British Social Attitudes survey finding that satisfaction with the NHS hit an all-time high in 2009. David Cameron may think the NHS is “second rate” – as he let slip in an interview on 17 January – UNISON thinks it is second to none.

UNISON is the major union in the health service and social care sector. We represent more than 450,000 healthcare employees and 300,000 social care employees employed in the NHS and local government, and by private contractors, the voluntary sector and GPs. Our members are nurses, student nurses, midwives, health visitors, healthcare assistants, paramedics and ambulance staff, occupational therapists, operating department practitioners, cleaners, porters, catering staff, medical secretaries, clerical and admin staff, pharmacy technicians and scientific staff, and primary care staff.

This briefing outlines UNISON’s concerns that the whole future of our National Health Service, with a genuine public service ethos and improving levels of healthcare for patients, is now at risk with instability and full-blown competition introduced at a time of unprecedented financial pressure.

1. THE NEW NHS: AN UNFETTERED COMPETITIVE FREE-FOR-ALL

Clause 52 establishes that the first duty of Monitor, the foundation trust regulator, will in future be to “promote competition”. Later in the Bill, Clause 104 even suggests that Monitor could vary prices “in relation to different descriptions of provider” which implies that Monitor could decide to provide extra incentives to bring new private operators into a market by insisting that commissioners pay them a preferential price. Clauses 60-68 demonstrate the government’s ideological determination to force through competition for its own sake, with virtually no reference to boosting choice or to attempting to enhance the quality of service. The repeated references to the Competition Commission and the Office of Fair Trading are completely at odds with a public health service that must be treated as distinct from the likes of the privatised utilities.

Commissioners will in future have to encourage “any willing provider” to deliver services to patients, which will destabilise NHS providers and potentially create a larger role for private healthcare companies. And Clauses 15 and 60 refer directly to compliance with EU legislation, which would give the Secretary of State legislative backing to enforce EU competition law. Once services are commercialised and put out to tender it is virtually impossible under these rules for them to be taken back into a public sector health service.

The lack of accountability in the move to commissioning consortia remains deeply worrying given that these organisations will be responsible for handling up to £75-80bn of the NHS budget. The fact that the door is open for consortia to spend some of this money on “commissioning support” from organisations such as American multinational United Healthcare and management consultants KPMG is the clearest sign of NHS money bleeding out of the system.

The Bill’s impact assessment even speaks in glowing terms of Compulsory Competitive Tendering, despite the proven failure of this approach in the NHS: CCT was introduced for hospital cleaning in the 1980s. The result was that the cost of cleaning was always put before quality and infections such as MRSA shot up.

• Will a market in health providers have the same dysfunctionality of many other markets: a desire for easy profits and the avoidance of some clinical procedures where the margins are lower?

• How will the public sector ethos be maintained when the NHS is merely a brand name and it makes no difference whether health services are provided by the private or the public sector?

2. PRICE OVER QUALITY

Clause 104 unequivocally introduces price competition into the NHS as it refers to the use of “maximum prices” allowing companies to undercut prices in order to enter markets. This could happen with private companies offering “loss leaders” to gain a foothold before expanding to the detriment of NHS providers.

All the evidence from the USA and from the failed English experiment with price competition in the 1990s demonstrates that allowing providers to compete on price leads to the quality of service deteriorating.

There is a consensus across the political spectrum that price competition would damage patient care. Zack Cooper, a pro-market health economist from the London School of Economics, states that “every shred of evidence suggests that price competition in healthcare makes things worse, not better”. Carol Propper from the University of Bristol has produced research on the 1990s experience that shows that in areas where price competition was used patients were more likely to die after an admission following a heart attack. In her opinion the government is “potentially endangering patients’ lives”.

Even NHS chief executive David Nicholson, in giving evidence to the Public Accounts Committee, agreed that such a move was “extremely dangerous”. Moreover there is no recognition in the Bill, as there was in the Department of Health’s most recent Operating Framework (December 2010), that at the very least commissioners would want to ensure there was no detrimental impact on quality.

• What evidence is there that competition on price rather than quality will deliver benefits for patients?

• Will safeguards be introduced to stop quality of care being compromised by cost cutting?

3. PRIVATE PATIENTS PRIORITISED

Clause 150 removes the cap on both the amount of private healthcare services a foundation trust can provide and the amount of private income it can derive from this. A foundation trust paid for by public money and staffed by doctors and nurses trained through the public purse could decide that its business case was best served by increasing private sector income.

There is currently a cap on private sector income – at the level it was at when foundation trusts were established and more recently set at 1.5% for mental health foundation trusts. The purpose of the cap is to stop hospitals from pushing NHS patients to the back of the queue. In the new cut-throat system, hospitals are likely to prioritise those that bring in extra income over free NHS patients.

Reassurances about the need for foundation trusts to reinvest their private patient income in improving NHS services have been inadequate, and plans for foundation trusts to keep separate accounts listing their private income and their NHS income are so far only referred to in the Bill’s impact assessment, rather than being formally legislated for.

• In the brave new NHS, will foundation trust chief executives be tempted to prioritise those that give them extra money over free NHS patients?

• What reassurance can be given that the removal of the private income cap will not lead to hospitals pushing NHS patients to the back of the queue?

4. MASSIVE INSTABILITY

The NHS is under huge pressure to produce £20 billion of “efficiency savings”. Now is not the right time therefore to embark upon the largest structural reorganisation in NHS history that involves scrapping two entire layers of the NHS structure – primary care trusts and strategic health authorities – and putting power in the hands of untested and largely unaccountable commissioning consortia.

This is also likely to create a postcode lottery in which geographical variation will increase with a lack of local and regional oversight to ensure the consistent quality and availability of care. Safety could be compromised as well: there are major question marks as to whether the new commissioning consortia and the arm’s length NHS Commissioning Board will be able to take care of crucial issues like resisting a swine flu pandemic in the way that the NHS has been able to in its current form.

Clause 148 confirms that the borrowing limits on foundation trusts are to be removed, raising the likelihood of hospitals getting into financial difficulty. And there will no longer be a fall-back option of bankrupt hospitals returning to the NHS as Clause 158 repeals this aspect of existing legislation. Instead hospitals can be sold off to other bidders, including private companies, and only those services “designated” as essential will have to be provided elsewhere – the interpretation of which is open to question and can be challenged by providers at tribunal if they wish to rid themselves of providing a particular service.

• Are Ministers, MPs and most importantly patients ready to see hospitals fail and postcode lotteries increase?

5. LACK OF DEMOCRATIC ENGAGEMENT AND TRANSPARENCY

Clause 178 established the new Health and Wellbeing Boards, but for them to express real democratic accountability, UNISON believes that a majority of the Board should be elected councillors (rather than “at least one” as currently stated). The make-up of the Boards includes a role for directors of children’s services but not for representatives from education, which is an oversight given the idea of the Board is to join-up services across areas. The Boards also lack the input of trade union representatives, which would be a way of ensuring that the staff voice is heard. There are further question marks about the power that can be exercised by the Boards that can only “encourage” the integration of services and joint working (Clause 179) and consortia only need to have “regard to” local health and wellbeing strategies (Clause 178).

In terms of transparency, Clause 67 states that companies can “exclude from publication… commercial information” which will damage the proper scrutiny of new providers. These concerns are mirrored elsewhere in the Bill, with all appointments to key bodies being made by the Secretary of State and likely therefore to be politicised – in contrast to Andrew Lansley’s claim to be taking politics out of the NHS. There is no provision for patient, public or staff reps on key bodies such as the NHS Commissioning Board.

• Will measures to hold commissioning consortia to account be strengthened?

6. NHS STAFFING ISSUES

The Bill’s impact assessment makes clear that there will be more than 20,000 redundancies across the health service as a result of this reorganisation. This represents a personal tragedy for those affected and also a colossal waste of talent and resources at a time the NHS can ill afford it; redundancy payments alone will total £1bn.

Staff transferred to commissioning consortia will be at risk that their new employer could move to change their pay, terms and conditions unilaterally. Whilst Transfer of Undertakings (Protection of Employment) regulations protect terms and conditions at the point of transfer, existing law provides for subsequent changes for an “economic, technical or organisational reason”. Whilst UNISON would oppose such moves, transferred staff could have the terms of their transfers unraveled after the fact, with consortia able to vary the terms of a transfer after it has taken place. The impact assessment also suggests that Monitor could be used to dilute the value of NHS pensions in an attempt to level out market “distortions” between the NHS and private companies. Such a leveling down would be entirely the wrong way to go and would be another example of the government attempting to crowbar in an artificial role for the commercial sector.

7. TRANSFER OF REGULATION OF SOCIAL WORKERS

The Bill heralds a significant change for social workers who are currently registered with the General Social Care Council (GSCC) but in future will have to register with the new Health & Care Professions Council. This means that the right of appeal will be to the High Court rather than the current Care Standards Tribunal. This is a detrimental change which is causing great disquiet among social workers because permissible grounds for appeal are much narrower and less responsive to the complexities of social work cases. Pursuing an appeal will become more expensive and risky.

UNISON is very concerned that the new system will reduce access to justice as parties have to instruct barristers or solicitors with higher rights and social workers pursuing appeals run the risk of having costs awarded against them. The current Care Standards Tribunal system has proved itself to be accessible, efficient and cost effective in ensuring fair outcomes for social workers.

UNISON is therefore calling for the current appeal arrangements to be retained. Social workers are also concerned that the change means a more than doubling of the annual registration fee. UNISON is calling for subsidy of the fees, for them to be phased in, and for a pro-rata fee rate for part-time staff. The changes only apply to social workers in England registered or eligible to register with the GSCC. This is potentially very problematic as Scotland, Northern Ireland and Wales will continue to operate the old Codes of Practice and with the lower fee level. There are many questions about portability of registration when social workers move around the UK. UNISON wants to ensure that in addressing these, there are not unreasonable barriers to social workers’ mobility.

Conclusions

• The US-based Commonwealth Fund demonstrated recently that the NHS is the most equitable health system and the only one where a patient’s income does not determine the quality of care they receive.

• Spending billions on an untested, undemocratic and unnecessary reorganisation is the wrong treatment at the wrong time.

• Combined with the real budget restrictions already being implemented, patients are facing a perfect storm that threatens our NHS – an NHS that the public continues to cherish and trust.

CONTACT: if you require further information or would like to meet, please contact:

• Guy Collis, UNISON: tel: 020 7551 1503, e-mail: g.collis@unison.co.uk

• Steve Barwick, Connect: tel: 020 7222 3533, e-mail: steve@connectpa.co.uk

Unhealthy NHS reform

2011-01-19T09:33:00.000-08:00

The UK coalition government today introduced its Health and Social Care Bill 2010-11 to parliament for first reading. In its short life so far this Bill has, to quote Malcolm Tucker, been about as popular as a turd on a trampoline. The cross party Health Select Committee described it as inefficient, risky and a hand-grenade thrown into the system, and newspapers reported mass public concern including a petition that's gained 10,000 signatories already.

Officially, the Bill will let GPs, with their detailed knowledge of local patient needs, decide how resources are spent instead of primary care trusts. So far so sensible, but something sinister lurks alongside, which the government sweetly calls “liberating the provision of NHS services”.

In translation, this means allowing private companies to replace NHS providers if they can beat them in competition. Care will still be free, but the providers may answer to shareholders not voters.

This is where the problem lies: universal healthcare and the pursuit of profits often pull in different directions. Yet despite this obvious fact the Bill puts private provision at its centre. Private healthcare outside the NHS is one thing, but inside the NHS it makes for trouble:

1. Private companies need to make a profit, which adds to costs. With no profits (or insurance companies and lower transaction costs) to fund, the NHS for all its failings is one of the cheapest health providers in the developed world. The UK spends only 8% of GDP on health to cover its entire population, compared with 15% in the USA to cover only a third of its population. It's hard to see how adding a margin for NHS providers will make the budget go further.

2. Competition inside the NHS will likely lead to hospital closures, causing either concentration or capacity reduction. This means either fewer people will be treated or facilities will become bigger and less local. Private providers will encourage this to capture more business, undermining the NHS objective of universal local healthcare provision.

3. Health facilities, like schools, are valuable community resources. If they underperform, they should be improved, not driven out of business.

4. Private companies, which lack a public service obligation, will be free to cherry pick higher margin services and the best staff, hollowing out the NHS to leave a two-tier national health system and diminish the NHS's prestige.

5. Centres of excellence, such as teaching hospitals, could pass from public to private ownership, severely distorting research priorities. The public health agenda will go the way of big-pharma.

6. Health facilities that fall into private hands could become prey for one-off financial engineering. I can already imagine the private equity sale-and-leasebacks and dubious outsourcing contracts (for a description of how this has already played out in the US, including shocking and life-threatening cuts in service, see "Doctoring Customer Servicer", chapter three of Josh Kosman's "Buyout of America").

7. Private health provision will undermine the NHS’s vocational ethos, which provides job security to staff, a rational training and career path and a strong culture of public service. The NHS has taken generations to build and is admired in the international medical world; we should not be so casual with its culture.

The GP reform also faces practical difficulties:

1. How will local GPs decide on strategic national matters, such as preparing for epidemics or prioritising expensive treatments for rare conditions?

2. Administrative savings could be modest if GPs have to employ managers to help with their new burden.

3. GPs will spend less time in the surgery and more in budget meetings.

4. GPs have already complained that budgets will create conflicts with clinical judgement that could undermine patient/doctor trust.

Finally, the whole Bill lacks political legitimacy as it was not clearly flagged in the Conservative or Lib-Dem election campaigns.

The Lib-Dem manifesto is pretty clear, pledging on page 43 to "end the current bias in commissioning towards private providers." That sounds like the opposite of the current Bill, perhaps we can put that U-turn down to coalition politics.

The lack of Conservative mandate is more worrying. Hidden in the 17th point at the very bottom of the Conservative manifesto healthcare webpage is a reference to "greater involvement of independent and voluntary providers". There is no mention of "private providers", "profit" or "abolition of primary care trusts" and nothing to suggest such an extreme subversion of NHS principles as today's Bill. The scale of philosophical change implied by private provisioning makes this sneakiness particularly bad.

I think it's fair to say that the electorate has been hoodwinked.

The leg-up for the private medical industry is particularly suspicious given the £750k campaign contributions it reportedly made to the Conservatives before the last election.

There must be other ways to increase GP influence without sacrificing national health to profit-maximisation. As the Health Select Committee said in its response to the reform, we should have had a debate about the proposal and its alternatives before starting the legislative process.

Today is only the first reading, there is still time to write to your MP...

Bonuses: disclosure is not the only weapon

2010-11-30T16:26:00.000-08:00

What happened: Chancellor George Osborne decided not to implement UK bonus disclosure rules proposed by Sir David Walker. The rules would have forced banks to disclose in anonymous bands how many employees earned more than £1 in a year.

What it means: 2010 bonuses for UK banks will be paid without the new disclosure rules. Shareholders will not be able to challenge boards on staff pay. Public outrage, already heightened by austerity measures, will be less than it might have been, but meaningful reductions in bank pay and reform of risk-inducing compensation practices will be delayed.

What happens next: Osborne will write to European finance ministers to seek European agreement on bonus disclosure. He will find a willing audience on the Continent, especially France, but less likely in the US. The result may be European disclosure rules next year or later, watered down by the UK to compete with Wall Street. In the meantime, banks are raising basic salaries to compensate for lower bonuses.

Comment: Few people now doubt that high financial sector pay was central to the financial crisis; it feeds asymmetric risks, encourages economic rent-gouging and has contributed to the under-capitalisation of lending banks. Sir David Walker's disclosure rules were supposed to help shareholders control financial pay but now Osborne has back-tracked it is worth asking - would they have been enough, and what other options are there?

Telling shareholders how many millionnaires were created each year would help shareholders if they can react. They need separate and binding shareholder votes on compensation policies but the Walker proposals only go some of the way there. Walker planned to allow only 25% of shareholders to oust the remuneration committee chairman and reject the risk report, but do not provide for separate, binding votes on specific compensation policies.

Secondly, total employee compensation is already disclosed and has not helped much so far. Citigroup shareholders, for example, saw bank employees last year walk off with a quarter of the bank’s core equity value in pay while shareholders got nothing. Perhaps well paid shareholders felt uncomfortable challenging pay, or (more charitably) did not care as long as other quarterly returns were good and their funds were not lagging their peers. Either way, shareholder engagement and incentives need to be much better for disclosure to work.

Thirdly, bank pay is only half the problem. Hedge funds and private equity firms share a revolving a door with banks and have a strong cultural influence on banker pay.

These alternative investment fund managers (AIFMs) are not subject to the same shareholder and regulatory pressures, they are answerable only to their investors and there is no limit on their pay once their performance hurdle is reached.

Some argue that high pay in the private equity sector comes largely at the expense of Limited Partners (per Peter Morris) and other stakeholders in investee companies (per Josh Kosman). Some argue that a good portion of hedge fund earnings come from fees or are transferred from more patient capital via arbitrage and volatility strategies (Paul Woolley).

If these markets were efficient, investors should notice this and either disinvest or demand lower fees. But they don't because (i) there are too many informational barriers for the market to 'clear', eg poor disclosure means investors struggle to attribute IRR at PE funds, or the market makes it impossible to work out how an investor's allocation of funds to HFs might increase volatility and lower returns on the rest of their portfolio, and (ii) many AIFMs have delivered strong performance despite the crisis, and (iii) AIFMs give the appearance of portfolio diversification.

As a result there is little downward pressure on hedge fund and private equity pay. Tackling bank pay on its own will drive more people into the shadows of AIFMs, where tackling pay via regulation will be much tougher thanks to the common view that AIFMs did not contribute to the crisis.

Other measures

Luckily, Walker's disclosure of bank pay is not the only tool in the box. Others include absolute bonus caps, the raft of measures proposed by the G20 and FSA (such as clawbacks, paying in equity and spreading payments over time), breaking the link between pay and return on equity, and eradicating monopoly profits.

Taking these in turn, the most radical is absolute pay caps, which would pose an almost existential threat to much of modern finance. With disclosure off the table for now, caps are the nuclear option that cannot be ignored. But they are hard to calibrate, they undermine freedom of contract and invite avoidance, especially as Wall Street will never adopt them. They have high campaigning value in raising deeper questions about finance and making other reforms palatable by comparison but have little regulatory support so far.

The G20 measures can mostly be dismissed as “something-must-be-dones”. Equity and staggered pay were already in place at Lehman Brothers, JP Morgan before the crisis, while clawbacks have limited deterrent effect as they affect only bad trades by known culprits.

Attacking the link between pay and ROE may be more fertile ground. Remuneration consultants say that in the end the different bonus measures at the top all boil down to returns on equity, an internal accounting measure. Perhaps shareholders should demand that pay be linked to better measures of shareholder return, such as long-term dividend and share price performance.

Banking profits (before leverage) are driven mainly by lending margins, trading profits and advisory fees. Since each of these markets suffers deep inefficiencies, reducing the monopoly profits would also lower ROE, and therefore bonuses.

In lending, the current fractional reserve banking model gives banks a high degree of control over where credit is created, encouraging them to push credit to parts of the economy where bank ROE can be maximized even when lending has little economic benefit, as with some securitised real estate lending. Basel capital rules exacerbate this through risk weightings, while allowing banks to gear up and turn relatively modest interest spreads into fat ROEs of 20-30%, even during historically low interest rate periods.

As the crisis showed, neither of these is particularly good for banks or the economy, although they are excellent for bonuses. If wider bank reforms address these, they will help reduce bank pay.

It's not all about lending, however, and trading and advisory profits are also part of the equation. Trading profits have soared in recent years on volatility, complexity and volume (Paul Woolley again), while advisory margins are protected by a double layer of agents in the form of executives and shareholders and no disclosure rules. To the extent that these feed into ROE, capital market and advisory reforms will also help bring down financial pay.

Plenty of other policies might be worth considering too, from clamping down on the use of tax havens to mask pay levels, to monitoring pay ratios in non-financial sectors in order to compare them with finance. Others might include cultural measures to replace the role that bonuses play in motivating financial workers, reversing the “headhunter ratchet” by requiring recruitment agents to be paid by shareholders instead of executives, and reforming nomination committees to include workers and shareholders as is common elsewhere in Europe.

UPDATE 30 Jan 2011: It's catching. A PwC survey has found that asset managers are demanding higher pay because banks have increased salaries to avoid bonus taxes:

Many banks are reported to have sharply increased base salaries to limit the effect of higher taxes on bonus payments and restrictions on the proportion that can be paid in cash.

This has forced asset managers to follow suit, according to a survey of 22 houses conducted by PwC. "Ultimately asset management and banking share much of the same talent pool and new hires expect base salaries to be aligned".

Basel 3 may hold the key to monetary reform

2010-11-15T18:02:00.000-08:00

If radical monetary reform is too much too soon, perhaps a little-discussed part of Basel 3 holds the answer.

Monetary reform is rapidly gaining the public’s interest, something the Basel rules on bank capital adequacy have never quite managed. But perhaps Basel has a special role to play in helping monetary reform come of age.

Calls for monetary reform are being led by a small band of unorthodox economists whose ideas are catching on in these austerity days.

At its heart is the realisation that today's money is in fact credit, or debt, and it is mostly created by private banks when they add digits to people’s bank accounts.

As a plethora of online presentations explain (type “how banks create money” into google), it’s illegal to print bank notes but not to create digital credits – the online equivalent - as long as you’re a bank and you follow the rules.

This is how fractional reserve banking works in a digital age but the realisation has potentially big implications for politicians fighting deficits and stagflation.

Before the financial crisis (and since), banks pumped money into the economy by creating a lot of credit, for example gearing up on asset-backed securitisations and leveraged loans. This created profits for the financial sector through commissions and by gaming capital rules to drive up returns on equity and therefore bonuses. Not all the lending was helpful, as the mortgage foreclosures in the US testify.

Monetary reformers argue that by allowing only the government to create money, lending of dubious economic value could be reduced and the power of money-creation wielded by the financial industry returned to the people. National deficits could be tamed more quickly and real economic activity boosted without always having to maximise returns on bank equity first.

Instead of financing secondary private equity buyouts or sub-prime mortgage-backed collateralised debt obligations, the credit system would fund job creation, innovation and production.

This is exciting and revolutionary but getting it done would be like turning a fleet of super tankers in the fog.

First, someone has to make the case for what many would consider economic heresy. This is beginning to happen with big names such as Paul Tucker and Martin Wolf commenting openly about how private banks create credit.

Then, some workable policy ideas have to be developed. A host of campaigners such as Ellen Hodgson Brown and the nef’s Josh Ryan-Collins are working on this, with Hodgson Brown suggesting that the near-bankrupt state of California could solve its problems by creating a state-owned bank, as has been done successfully in North Dakota.

Campaigners would then need to explain to businesses why the government would do a better job than the current crop of private bankers, and convince politicians that nationalising credit creation is not the economics of soviet Russia.

I’ll leave that to them but assuming they can, now seems like an excellent time for a monetary experiment, with several private banks in state hands after the crisis. Unfortunately, sensible proposals such as the nef’s call for RBS to be turned into the Royal Bank for Sustainability have made little headway.

This illustrates the biggest impediment, political economy. No private industry has ever given itself up for voluntarily nationalisation, which is what this reform really means. Natural monopolies like railways fought tooth and nail against nationalisation in the last century; it’s hard to imagine today’s politically connected banks handing over the keys to the Treasury, barring a bigger financial catastrophe than the last.

So here’s how Basel 3 could help monetary reform to make its own case, without any financial revolutions or crises.

Imagine a spectrum with full monetary reform at one end, in which only governments can create credit, and the current system at the other, in which banks create money where they like, subject only to central banks’ distant attempts to direct lending through interest rates and the capital adequacy rules.

An intermediate step would be to let governments alter the Basel risk weightings to suit their own national economic and industrial policy.

At the moment, risk weightings are determined by an opinion – not always reliable – about how risky an asset is (a concept that is itself deeply flawed, see here for further reading). If a ratings agency or the bank’s internal risk managers think a loan is “safe”, then the loan is assigned a low risk weight, say 20%, which reduces the capital held in reserve against the loan. But if the loan is deemed to be dangerous and weighted at 100% the bank must hold five times as much capital to make the loan.

This means banks create credit where they can get low risk weightings, such as AAA sub-prime debt and monoline-insured ABSs, and not where they might earn high interest margins and hopefully create jobs, such as small business lending or trade finance. The current system almost has an in-build discrimination against economically useful lending.

To kill two birds with one stone, campaigners need to persuade the government to override Basel-approved risk weightings on certain types of lending to suit their own, specific policy goals. Interventions would need parliament approval and be communicated along with the policy goals, such as boosting green investment or helping businesses in a certain sector or region.

Banks would still be the ones creating the credit, deciding interest rates and other conditions, but they would be influenced by the logic of national economic interest instead of flawed and complicated capital rules with no obvious link to economic outcomes.

There would need to be accompanying reforms, in particular a tough overall leverage ratio to prevent excessive risk build-up, and a mix of structural separations and resolution plans to manage contagion and bailout costs if a bank were to overdose on juicy, patriotic greentech loans and get itself in trouble.

It could be introduced in just a few sectors at first, until banks and businesses see the effect. Once people start to see the benefits and note the absence of soviet gulags, it might be possible to have a wider debate about where the power to create credit should lie in a modern, democratic economy.

How to get banks lending to SMEs

2010-10-06T15:01:00.000-07:00

David Cameron enjoyed his swipe at the banks today, using his speech at the party conference to lambast them for not lending to small and medium sized enterprises. He wants the economy to get moving despite huge public spending cuts and said he’s fed up with banks not doing their bit. Sadly for us, lending targets and prime ministerial taunts won’t help, even if they are fun.

How about some other options; couldn't we harness some of the billions the Bank of England is creating through quantitative easing to lend to SMEs? And what about the new Basel 3 rules, they must have something to offer?

First QE, or the Bank of England's creation of £200bn to buy gilts. It's the official response to our flagging economy but doesn't seem to be refreshing the economic parts that need it. Why not?

I'm no banker but from what I've read, the cash injected by QE is meant to boost the reserves of commercial banks so they can lend more and then lend again against the newly created deposits. This “deposit multiplier” acts like Red Bull on the economy, with each new deposit backing a new loan and each new loan creating another deposit. But when banks are short of capital, as now, they’ll either hoard money or lend it to higher rated borrowers, such as ABS-merchants. Which means the money’s not being lent to productive borrowers and doesn't stimulate many SMEs.

QE's other effect is to lower bond yields, which helps investment by making it cheaper to raise capital. But the effect is always limited by investor appetite and that's the other problem: selling low-yield securities to fund growth in a near-recession is a thankless task.

The sickness of banks and the economy are not the only limits on QE’s power as a stimulant. Like Red Bull, QE gets less effective the more you use it. It distorts the gilt markets, causing the Bank of England to start buying 3 year gilts after its 5 year purchases started to wear thin (para 15). And they both store up nasty headaches, in QE's case in the form of inflation or contraction of the money supply when the Bank’s growing pile of gilts is sold back to the market.

If all the newly-created QE money were lent directly to small businesses instead, things would be much simpler. The cash wouldn’t get trapped inside banks or credit securitisations, and instead of a deposit multiplier we’d have a demand multiplier, where money lent to SMEs would be spent on their salaries and suppliers, who would spend it on salaries and suppliers, who would spend it on... and so on until the economy starts breathing again.

Unfortunately, central banks are not allowed to print money to fund deficits, which is how this would look to outsiders. They are allowed to create money to chase deflation, which leaves us stuck with QE and, at the other end of the clogged plumbing, a SME sector still starved of credit.

Basel 3

A different approach would be to change how we implement risk-weightings in the Basel capital adequacy rules. Under the draft Basel 3, banks must increase the amount of regulatory capital they set aside to 7% of risk-adjusted assets. While the headline is good, it's only half the equation; risk-weightings are just as big an influence on how banks lend.

To illustrate, AAA-rated asset backed securities, like some of the toxic rubbish that caused the crisis, have a 20% risk-weighting, meaning a bank has to hold 7% of 20% in capital, or 1.4% of the value of the asset. This means a bank can gear up 71.4 times on these assets and earn 36% return on equity (assuming 0.5% margin).

SMEs, on the other hand, carry a 100% risk weighting, meaning the bank has to hold 7% of the full amount. This allows it to lend only 14.2 times its capital and earn 7% return on equity.

Lending to SMEs may well be five times riskier than buying AAA-rated asset backed securities (or not), but banks already know how to handle that through interest and other terms. The quantity of each they can hold, however, and the return on equity, is set by Basel.

Former World Bank director Per Kurowski has been arguing for years that the Basel system is flawed for this reason, since it encourages banks to load up on debt they think is safe, and when it turns out not to be we have a crisis (interestingly, sovereign debt is still in the safe category).

Kurowski has been promoting his message doggedly with letters to the FT and his entertainingly blunt blog. His message is slowly being heard (see here for Felix Salmon's latest) but so far not in Basel.

Kurowski proposes gradually equalising the risk weightings until there is no longer a regulatory incentive for banks to favour one asset class over another, and leaving banks to manage their exposure through interest and lending criteria, which they do already.

If David Cameron is serious about SME lending, he could do a lot worse than take Kurowski’s idea a step further and push for risk weightings to be set with the real economy in mind, instead of an out-of-date statistical view of which assets are risky.

By turning risk weightings into a policy tool, Cameron could make it cheaper and more profitable for banks to lend to productive businesses and less profitable to stuff their balance sheets with CDOs. He would boost SME lending more than any amount of QE or bank lending targets.

Market fundamentalists won’t like this but it’s not as radical as it sounds. We already use price interventions to change market outcomes on alcohol, tobacco and carbon fuels. We subsidise venture funding and R&D with tax breaks and corporate investment with capital allowances. We accept that pollution should be taxed, and the Bank of England’s Andy Haldane has asked openly whether finance’s “negative externalities” should be dealt with the same way.

In a recent white paper, the Treasury listed variable risk-weights as one of the macro-prudential tools it expects the new Financial Stability Committee to use to control the economy:

"Variable risk weights: This would involve raising capital requirements against specific types of lending. If the authorities felt financial institutions’ exposure to a certain asset class was too great, they could try to discourage it in this way, (page 16)"

You might question how a regulator would ever know the correct risk-weighting for SME lending but this misses the point: banks could lend as much or as little as they like, on their own judgement and on their own terms. All the regulator would be doing is adjusting the reward they end up with, like any government tax or subsidy.

There's a risk of arbitrage if risk-weights differ between countries, but we seem to manage other cross-border differences OK and there'a substantial upside if it can be made to work. Risk-weightings could be lowered in downturns and lifted in boom years. They could become a lever of industrial policy to boost lending in sectors with high-growth or structural change, and dampen it in sectors that are oversupplied or in the grip of a bubble.

In a covert way the existing Basel rules do this already by favouring investment banks over commercial banks. Worse, they do it by referring to ratings agency instead of deliberate, democratically chosen economic policy. Time for a re-think?

A suggestion for commodity hedging

2010-08-22T12:03:00.000-07:00

Problem: influx of assets into soft commodity derivatives is increasing volatility and imposing costs for producers and food companies.

Solution: treat commodity hedging as a utility public service. Financial players would state their purpose as hedgers or speculators, with different regulatory regimes applying to each. Regulators could vary the mix and capture rents for the public benefit.

In early 2008 the price of wheat more than doubled, shooting food prices up around the world. But when wheat prices leapt 50% this summer after crop failures in Russia, bread makers had learned their lesson (according to this FT article from 6 Aug) and were well hedged. Food prices shouldn’t be quite so volatile this time.

Thanks to the banks writing socially-useful commodity futures, thousands of farmers can insure against price falls when the harvest is good, and food companies (and ultimately consumers) can insure against price rises when crops fail.

Agricultural hedges are usually written over 12-18 months, long enough to cover a season of bad weather but short enough for underlying demand changes to feed through, for example so population changes can still drive agricultural land use.

In steady years, the hedgers earn a margin for their role as insurers, which they squirrel away against bad years more easily than a farmer or baker could. Theoretically, as more of both sides of the market become hedged, the smaller the net risk for hedgers in the middle and the cheaper their services should become.

So why is commodity hedging still so profitable? The Armajaro STS Commodities Fund, which “invests in liquid exchange traded commodity derivatives”, makes 25% a year for its investors. Perhaps that’s because it is one of the funds managed by “Chocfinger”, aka the GBP 3.4m a year commodity trader Anthony Ward, who cornered the cocoa market earlier this year.

The huge recent influx of money into commodity ETFs and commodity hedge funds is clearly having an effect. Deutsche Bank estimates that commodity investments in the US doubled in 2009 to more than $22bn, or $73bn if you include precious metals.

This has a range of ill effects. In the words of Paul Woolley, of the LSE's Centre for the Study of Capital Market Disfunction: "Before the middle of the last decade the prices of individual commodities could be explained by the supply and demand from producers and consumers. With the flood of passive and active investment funds going into commodities from 2005 onwards, prices have been increasingly driven by fund inflows rather than fundamental factors. Prices no longer provide a reliable signal to producers or consumers. More damagingly, commodity prices have a direct impact on consumer price indices and the role of central banks in controlling inflation is made doubly difficult now that commodity prices are subject to volatile fund flows from investors."
In other words, when the balance of speculative and commercial investors gets out of kilter, prices don’t behave as they should. In trader-speak, rising future prices create “contango” losses for ETF investors as monthly contracts are rolled over, or “backwardation” if it goes the other way.

Farmers aren't interested in such jargon. They see that high prices hurt consumers and low prices hurt growers. High volatility hurts them both and, as it's a zero-sum game, speculative profits must come from farmers or bakers somewhere along the line. So what is the policy response?

One idea is to tax short-term contracts, as Angus Cunningham proposes with his differentiated speculative Financial Transactions Tax, or dsFTT. This serves as a proxy for speculative activity, on the basis that if producers normally use 12-18 month contracts, anyone trading a 1-week or 1-month futures contract is probably a speculator.

That may often be the case with securities, but agricultural commodities are a bit different. If a producer needs a short-term contract there’s a good chance he really needs it: perhaps a food company extending its hedge as prices spike, or a farmer trying to secure a minimum price for an unexpectedly big harvest as prices fall away. For soft commodity derivatives, a FTT on short-term contracts could have a nasty side-effect of penalising producers, making it less effective as a speculative curb and hard to implement.

Another approach is to limit the ratio of hedging derivatives to the underlying commodity on a one-to-one basis, on the grounds that any excess hedging must be speculative. However, a simple correlation may be unrealistic since some hedges will never be exercised, while outputs will always differ from expectations. It’s also hard to make sure that the right people buy the hedges; if speculators corner the market in futures before producers get a chance, any limit would be self-defeating.

A third option is simply to tax all derivatives as part of a general financial transaction tax, as proposed by the Robin Hood Campaign. This could raise large sums from farmers, food companies, consumers and speculators alike. It would dampen speculation a bit, but its non-discriminating nature means it could end up mostly as a tax on food and farming.

A fourth option is the utility-style regulation mentioned at the top of this post. The idea is to put all commodity derivatives on exchange and issue licenses to financial players, who must opt to be either hedgers or speculators, with different regimes for each.

Hedgers could write as many contracts as they like provided their profits stay within a set percentage of turnover, as with water companies and electricity suppliers. Their profit could be set at a fixed percentage of the value of contracts written (set to give a fair return on capital but no more), with any surplus taxed at a 100% marginal rate. This would set an upper limit to the amount society needs to pay for price stability in commodities that are prone to weather disruption.

To maximise their profits, hedgers would need to contract with as many producers and users as possible, spreading their protection from price shocks as far as possible. In return, hedgers might be asked to maintain a low ratio of derivatives to underlying commodities, and accept duties towards producers and consumers such as equality of treatment and fair dealing. They would have a clear economic purpose in providing price stability and spreading risk, at a reasonable cost. Any behaviour inconsistent with that could lead to them losing their hedger's license and being re-categorised as a speculator.

Speculators would be allowed to operate freely, writing contracts for anyone in any quantity just as they do now. However, they would be subject to a new financial transaction tax that licensed hedgers would be exempt from, and they would have to buy their speculator's licenses at auction. They might also be given higher capital and margin requirements to reflect systemic risk.

The idea would face a few difficulties: speculators could register offshore; putting commercial OTC contracts onto exchanges would increase producers' margin costs; laissez-faire and vested interests could make implementation difficult; a new regulator might be needed and might set the hedging profit level badly; and regulation could cause a disruptive outflow of commodity investments.

But it would have advantages over the current system. If price volatility increases, the regulator could simply bump up the FTT until the level of speculative trading falls back to a suitable level. Meanwhile, speculators' profits would be taxed through the auction process, returning economic rent to the public purse. And traders would still be free to trade as boring hedgers or high-rolling speculators, as long as they accept the risks and duties of each.

Stock exchanges: stop the robots

2010-08-20T04:29:00.000-07:00

Regulators must stop the robots from ruining our stock exchanges, according to democrat Senator Ted Kaufman.

In a 5 August letter to SEC chairman Mary Shapiro, Kaufman warns that some algorithmic trading harms long term investors and dominates the equity markets in a way that brings no social utility. He describes some murky algo practices such as trading on advance information about other people’s orders, collecting unearned liquidity rebates and unnecessary intermediation, to support his case.

The Senator has picked up a useful ally in Gillian Tett, who used her FT column today to back his call for a review of high frequency trading. Tett explains his argument that the benefits of the narrow spreads which high frequency trading supposedly brings may be outweighed by hidden costs, leaving only a “thin crust” of liquidity that evaporates in bad times, as with the flash crash of 6 May.

In an separate but related story, the paper reports that two day-traders in Norway were indicted on charges of market manipulation after they stumbled across – and exploited - a trading pattern that tricked programme trading computers into raising their prices. Despite the breach of market rules, plenty of people cheered the duo for beating the machines: “Robots are designed to push the market but when someone pushes the robots it is suddenly a criminal offence,” was one comment on a Norwegian chat forum, according to the report.

Behind both these stories lies an unease about the growing dominance of robot trading. While not quite an android invasion, the increasing use of computers to arbitrage short-term price anomalies is a sinister development whose effects are not well understood. But it accounts for nearly 70% of US equity trading, making it an important source of revenue for stock exchanges.

As with all arbitrage, programe trading is useful up to a point. Price discovery, an appearance of liquidity and narrow spreads are seen as good for markets. But they shouldn't be confused with the equity market’s primary function of allocating capital to the most productive use. Common sense says that if the market were made up entirely of robots chasing price anomalies, it would not do its job very well.

Similarly, the experiences of the 6 May flash crash and before that the sub-prime sell-off, LTCM and Black Monday tell us that an appearance of liquidity from computerised trading is not the same as a truly deep market of buyers and sellers with different views.

The danger is that if robot trading ends up undermining investors’ confidence in the market, it will frustrate the market's core functions of providing a mechanism for collective investment in large undertakings (capital formation), and attracting long-term investors for that purpose. There is already evidence that equity investors are preferring bonds and commodities, with US equity mutual funds reporting net redemptions in July, for example.

Kaufman proposes a number of technical fixes, such as charging high frequency traders per message rather than per trade (some apparently send 100s or 1000s of buy and sell messages for every order filled, sometimes to "spoof" other algorithms), and a number of regulatory fixes including an emphasis on deeper, less fragmented markets. He doesn't mention the obvious solution of a transaction tax, but perhaps he's just being politic, since Geithner unfortunately rejected FTTs in the US last year.

Algo trading raises a similar concern as passive and active fund management, where some fear that the growth of low-cost index funds will smother the market's ability to pick winners and allocate capital effectively. Computer trading and passive funds direct huge quantities of dumb money without contributing much to asset allocation. But while the fund market can correct itself (active funds simply lower their prices and raise their game until they are competitive again), once robots have smothered the market like pondweed there's not a lot other investors can do to fight back.

We shouldn't forget that stock exchange executives need to make a profit too and keep their companies strong in a consolidating sector, hence their recent investments in HFT and dark pools. But to survive in the long-term, many years after Xavier Rolet steps down as CEO of the London Stock Exchange or Reto Francioni as head of Deutsche Bourse, exchanges need to deliver first and foremost for the equity market.

A quick look at Deutsche Boerse's website illustrates the problem. It lists its core values as integrity, transparency, precision, reliability, innovation and a focus on the needs of customers, investors and staff. These are fine values but it's strange that efficient capital formation is not among them.

It looks like we'll have to rely on regulators like Shapiro to save exchanges by making them perform their core economic function first, and make an honest profit - with or without robots - second. Like utilities, they are part of the infrastructure of finance. We readily accept that private water and energy companies serve us better when they compete within profit and capex limits set by public regulators. Why should stock exchanges be any different?

Update 23 August: This FT article reports that stocks are not responding as they ought to earnings news as macro-investing and programme trading have increased. Stocks in the S&P 500 are 60-70% correlated to each other today, up from 30% in the 1930s, making the ancient art of stock picking relatively pointless, at least until certainty returns to the market.

Appropriating or creating, economists must tell us which is which

2010-08-18T07:53:00.000-07:00

John Kay returns to one of his favourite topics in today’s FT: the Robber Barons of the Rhine, who in the 13th century charged illegal tolls on cargo passing their stretch of the river. Old-school baddies like Werner von Bolander and Philip von Hohenfels, who lived in fabulous castles and plundered their neighbours, are a colourful metaphor for modern finance, which Kay uses to make this point:

"The distinction between the creation and the appropriation of wealth – between those who add value to the cargo and those who help themselves to a fraction of it as it sails by – is vital, if not always clear. But our ability to recognise it will determine, not just the fate of individuals, but the future of modern capitalism."

When Adair Turner suggested there might be good finance and pointless finance, he was probably thinking of this. Despite the City's appalled reaction, many people felt they knew exactly what he was on about.

Kay’s distinction between “brigandry and productive business” exists and has been tackled before without resorting to communism, despite the theoretical difficulties.

He mentions the gilded age when powerful industrialists transformed the US economy. Rockefeller and Vanderbilt ran monopolies that would be declared illegal and broken up today. For regulators in the 1900s, when transport and industry lifted millions out of poverty, tackling appropriation in the oil or railroad businesses probably seemed as hard as taming finance does now.

Kay says that in today's world the courts must decide who is a brigand or a criminal, as they did with Jeff Skilling and Conrad Black. He is half right; courts apply and interpret law, but most primary legislation comes from a democratic discussion of facts and evidence. If we want to tighten the rules against financial appropriation, we first have to look under the bonnet of the City and see where, exactly, it’s happening.

There have been some good initiatives. The Independent Banking Commission is looking at bank structure, and whether bank customers and clients are efficiently served, while groups such as the ABI are calling for underwriting and M&A fees to be scrutinized.

But many areas of wholesale finance have escaped a thorough check-up: high-frequency trading, cross-border transfer pricing, dividend arbitrage, leveraged recaps, commodity speculation, sell-side research, and many others. No one doubts that these are complex and well-paid activities, but does anyone know who really benefits from them and whether they are, on balance, worth their salt?

It's not a simple question. A post on Kay’s article asks whether an investor in a stock would be a creator or appropriator, if it depends on whether the company is Walmart or a small start up, on the expected risk and return or whether the investor is passive or active?

A meaningful look under the bonnet might ask who is dealing with whom, their motivation, the real costs and who bears them, the benefits and how are they distributed. Is there a risk or a cost to society, does it benefit the economic good enough, perhaps through price discovery and liquidity?

Of course it's a difficult and time-consuming analysis and is not generally done, unless there has already been a failure such as mortgage-backed CDOs. If it is done, the inevitable mix of good and bad outcomes makes a policy response difficult.

But moving to a more creative economy means facing these difficulties. It needs rules and regulators willing to tackle appropriation with tools that fit the task, such as taxes designed to limit activities to a certain size.

These are not radical suggestions, as Tony Jackson pointed out in an excellent column on commodity speculation on Monday:

“We need speculators, but only up to a point. Too much, and there may be a case for throwing some sand in the works…There are plenty such tools in financial regulation, from raising reserve requirements to banning naked shorting. And to be sure, not all of them work …But as Keynes almost put it, if feeding the world becomes the byproduct of a casino, the job is likely to be ill-done.”

To avoid this gloomy picture, we need better tools for financial regulation, and to design and apply these tools we need better evidence about how and where financial appropriation occurs.

Who is going to provide it? Bankers and other market participants are generally too partial, customers too ill-informed or unsophisticated, and regulators mainly concerned with existing rules. Government might not back it, despite pre-election promises, if it saw uncomfortable conclusions ahead (what if we discovered that the City, sometimes described as the biggest offshore centre in the world, mainly benefits the UK at the expense of other countries?).

John Kay has proposed a royal commission. This would bring scrutiny into murky parts of the sector but a one-off investigation would only hold the tide for so long.

In my view, the analysis of financial activity as wealth creating or wealth appropriating, something Kay says is vital to the future of modern capitalism, should be a mainstream and continuous branch of economics.

The really interesting question is why it isn't already.

Update on Global Bank Levies

2010-06-15T12:14:00.000-07:00

Problem: several different bank taxes have been proposed but none have been implemented, partly as there is confusion about what each should be for

Suggested approach: widen the debate to publicise all the benefits of each tax, then push for internationally coordinated asset levies together with national taxes on bank profits and selected financial transactions.

Since the last post here on this hot topic, two major developments have moved the debate a long way forward. The IMF has proposed two new bank taxes: a Financial Stability Contribution and a Financial Activities Tax, and a popular movement aimed at funding development (the Robin Hood campaign) has pushed financial transaction taxes onto the international agenda.

At the end of this month in Toronto, G20 leaders are likely to discuss global levies and transaction taxes, despite opposition from host country Canada and others. Germany, France , the UK and USA are keen for a bank levy on assets. No consensus exists on profit and transaction taxes.

So what’s on the table?
(22 June update - UK has introduced an asset levy and said it will consider a profits tax).

The IMF’s Financial Stability Contribution (FSC) would pre-fund a resolution authority. It would be levied on balance sheet and maybe off-balance sheet assets, and perhaps adjusted to reflect those assets’ contribution to systemic risk. In Obama’s version, it would be used to repay TARP money. In the IMF’s version it would build up over 5-10 years to create a fund (eg GBP 60bn in the UK) for use in combination with a resolution authority to wind up failing banks without taxpayer funds. The resolution regime would put bank creditors on the hook after equity holders, while funds from the FSC would finance the wind down of third party contracts. Together, they should lessen moral hazard and reduce the chance of taxpayers funding a future bail-out. After the FSC fund is built up, the tax could be continued as a general taxation measure.

The IMF’s Financial Activities Tax (FAT) would tax bank profits and remuneration, acting as a kind of value added tax on financial activity. The IMF argues that it could also be a proxy for taxing rents in the sector in order to reduce its size, and would reduce moral hazard by lessening the individual incentive to make big bets. The IMF’s proposal at present covers banks only and not private investment funds (ie hedge funds).

An interesting variation on the FAT is to treat any financial remuneration above, say 10x average national earnings (ie GBP 200k in the UK), as part of the bank’s taxable profit. The idea proposed in a paper by Tax Research could become a tool for reducing inequality in all sectors, and would improve shareholders’ powers of stewardship by making them more aware of ultra-high remuneration, since they would have to pay tax on it.

A Financial Transactions Tax (FTT) would work like a turnover tax and could be implemented on all types of securities at different rates. Originally proposed by Keynes and then Tobin as taxes on equities or forex to curb speculative short-termism and volatility, there is today no consensus about which securities would best be taxed, at what rate and for what the proceeds should be used. Instead there is a plethora of partisan and theoretical arguments for and against, mostly from the development and banking lobbies. What is clear is that the tax is now on the agenda as never before.

To fill the gap in evidence, Neil McCulloch of the Institute of Development Studies at Sussex University will shortly publish a neutral paper, entitled “The Tobin Tax – A Review of the Evidence”, which reviews dozens of research papers, sifting the empirical date on transaction taxes collected so far. He made four interesting discoveries:

First, FTTs do little to curb volatility and actually increase it if set too high. Those wanting to throw grit in the wheels of speculators therefore need to use other tools.

Second, FTTs could be implemented nationally without everyone rushing to Bermuda (“migration”), since today's technology and central settlement make central collection easy. He concludes that international agreement on FTTs is therefore not necessary, despite the bank lobby's argument, as migrants would have to pay the tax wherever they are.

Third, FTTs could raise significant revenue, as much as GBP 7bn in the UK on forex alone. His mid-range assumptions were elasticity of 0.6, a 20% avoidance rate and that the taxes are set at 10% of transaction costs for each type of security (eg, if equity trading costs are 3%, the tax would be 30 basis points, or only half a basis point for securities with low transaction costs such as currencies). Globally, FTTs on all securities would raise far more than GBP 100bn annually. This makes them a material revenue raiser for deficit-burdened countries and development aid alike.

Lastly, the final incidence of FTTs is broadly progressive. According to two studies, FTTs would fall mostly on hedge fund investors, bank employees and pension savers (IPPR p19 and Sony Kapoor) but the evidence is mixed and the only safe conclusion is that they are likely to end up with owners of capital, making them more progressive than income tax and VAT.

The IMF decided not to sponsor FTTs on the ground that they don’t reduce systemic risk, which was its primary mandate and is better met with the FSC and FAT. However, they were sympathetic to the idea and expressly left the door open for others (such as France and Germany) to pursue it.

The Panic tax is a leftfield proposal also from Neil McCulloch of the IDS takes inspiration from mechanical engineering to suggest a variable FTT that bites only in times of panic, aiming to curb herd behaviour and sudden swings.

Opponents of bank taxes cite the failure of a high FTT in Sweden, which at 1-2% merely drove the market to London. Recent proposals use much lower percentages. Other arguments against include a reluctance to use up political capital agreeing international taxes, doubts about the capacity of the financial sector to generate so much tax without unexpected economic consequences (this has some merit, although there is little said about the opportunity economic cost of leaving things as they are); horror at the admin burden (although additional tax reporting on a transaction level would give regulators more data on market activity including bubble formation), and that capital rules and living wills are far better ways to address systemic risk than taxes.

Finally, comes the argument from Josef Ackermann that FSC+FAT+FTT+Basel3 = too much cost for banks to bear, so lending and economic growth will suffer. This also has some merit and suggests that taxes should be implemented incrementally and reviewed regularly.

Making sense of the proposals requires some understanding about of the purposes of each tax. Most contributors to the debate are interested in one or more of the following:

1. to repay past and future bail-out and recession costs (according to the IMF, the financial crisis cost the G20 countries a cumulative loss of output equal to 27% of GDP. In the UK, that is a staggering GBP 325bn)

2. to reduce the likelihood of future crises

3. to tackle rent-capture and shrink the financial sector

4. to curb short-termism and speculation

5. to raise revenue, eg for deficit reduction or overseas aid

So far, my guess is that an FSC would deliver 1 ,2 and 5; a FAT would deliver on all five, and FTTs would deliver all apart from 2.

The problem for reformers now is that while everyone wants to recoup bail-out money (1), avoid further disasters (2) and raise more tax revenue (5), not everyone agrees that financial markets need fundamentally fixing to address rent-capture and short-termism (3 and 4).

These two late-comers to the reform debate are now on the agenda as explicit goals for certain reformers. Until now, concern about rent-capture surfaced during the UK’s general election as bonus rage and led to a one-off tax but was never taken seriously in the City, where the free market still reigns, just about. Concern about short-termism has been bubbling away for some time, from outcry over the Cadbury/ Kraft deal, to this hard hitting statement last September from Warren Buffet and a host of luminaries at the Aspen Institute, but has not yet been centre stage in financial reform.

Neither issue has been a priority for the G20, which is focussed on disaster prevention, or the UK (at least until Vince Cable landed at the Treasury). There was concern about them in Brussels, which drafted the Directive on Alternative Investment Fund Managers, but only since the IMF started referring indirectly to them in April are they hitting the G20 agenda.

Reformers have more tools to play with than just capital requirements and living wills, but must be realistic how many of these can be implemented. If one assumes that all are necessary for the sector to return to function, reformers must decide which they want to promote first.

Reluctance from Canada, India and others is understandable and means national implementation should take precedence, for example with FTTs, where central settlement addresses the threat of migration. FTTs could be implemented in the UK gradually at a low rate on selected securities, increased as their incidence and effect is understood.

Update 22 June: One in the bag, one on the way - UK chancellor George Osborne today announced a levy on bank balance sheets (excluding Tier 1, retail deposits govt bond backed repos and tax assets), which will coordinate with levies in France, Germany and the US. He is also working on a FAT, having endorsed the IMF's approach. "We are exploring the costs and benefits of a Financial Activities Tax, on profits and remuneration, and we will work with international partners to secure agreement," he said.

Conflicted credit ratings

2010-06-10T07:15:00.000-07:00

Problem: ratings agencies conflicted by their issuer-pays business model

Solution: fund agencies through a levy on security purchases, distributed according to demand

The conflict that ratings agencies have between offering objective advice and being paid by issuers has inspired a number of proposals.

Most recently, the head of European credit research at Schroders, D. Patrick McCullagh, suggested that investors pay their investment managers to assess credit quality as part of buy-side research, consistent with the caveat emptor principle, with the cost picked up as a management fee borne by investors, in whose interests the rating is conducted. But is it the best solution?

The Schroders idea would eliminate third party ratings agencies completely by moving the function in-house (toss them out like a "torn, charred and mangled" comfort blanket, in the words of the Schroders’ guy). This would not, however, eliminate the potential for conflicts of interest, since buy-side analysts will still be exposed to price incentives, just as agency analysts were by their close relationship to issuers. When a security is on the cusp of a downgrade, buy-side analysts will have obvious incentives to protect their own investors, and colleagues holding the security in their fund.

This is the same problem that McCullagh pointed out about another reform idea proposed by academic Larry Harris, which was that ratings agencies should be paid according to the performance of the securities they rate (similar to yet another idea that agencies take subordinated tranches of each security they rate in order to have “skin in the game”). Under both these proposals, agencies would be still be loathe to issue a downgrade, since they would take a hit on their own earnings.

Another problem with the Schroder’s suggestion is that in-house research would create more management fees at the expense of end-investors, creating a huge duplication of effort and cost if each buy-side house had to fund its own research team.

(These funding proposals, by the way, are completely separate from sensible suggestions to unburden ratings from their regulatory roles under Basel and SEC rules)

A third funding solution that McCullagh mentions is to leave ratings to independent agencies such as Egan-Jones that charge investors by subscription. This at least removes the conflict of interest. The downside is that it keeps ratings behind a paywall, restricting the distribution of key credit information.

A better answer is for the ratings agencies to stay independent and be funded from an industry levy on credit purchases, as with stamp duty on UK equities, under the control of a central body. Quality could be maintained by allowing the agencies to compete, with their revenue controlled by the central body to reflect investor demand and feedback.

This would limit the duplication of work while allowing competition on quality. It would avoid keeping ratings behind a paywall and put the analysts safely at arm’s length from both sell- and buy-side pressures.

The idea could apply equally well to equity analysis, which is famously skewed by bank relationships and brokerage favours.

Capitalism and the stable state

2010-06-09T09:12:00.000-07:00

Problem: economic growth + population growth + finite resources = crisis, somewhere along the line

Solution: reduce the aggregate requirement for economic growth by enabling businesses to profit from resource reduction instead of top line growth

As any school-kid knows, capitalism rewards individuals for making and selling things. To form capital and reward entrepreneurs there must be constant economic expansion. Business schools teach that growth is an elixir for turning ambition into production and ultimately wealth. This is so widely accepted it is part of our identity. Meanwhile, the human population continues to grow in all but the richest countries, while demand for natural resources is growing so fast that some are bound to run out. What gives?

If the problem looks like this:

Economic growth + population growth + finite resources = crisis

then the next question must be what can change. Natural resources are finite, no arguing with that. Population growth is changeable, but usually in response to multiple circumstances or force and out of reach for any (democratic) leader. That leaves economic growth.

So far things have not been too bad. Environmental damage must be seen in the context of the billions of people lifted out of poverty. Future generations will expect the same, rich and poor alike.

We may one day find the marginal cost of producing certain raw materials too high to justify using them in the same way. For example, oil may one day become too expensive for people to run petrol cars and the rare earth metal neodymium too expensive for people to buy electric cars (good news for bicycle makers) or to make batteries for throw away gadgets. In both cases, market forces will simply abandon the unsustainable and we will move on, with any depleted resources being consigned to history with the dodo.

This is fine as long as the depletions don’t create “systemic risk” in the way we live and feed ourselves. Assuming this is not the case, or that ecologists will tell when it happens (ahem), the problem remains that as each resource is depleted we will have to settle for lower economic growth or fewer people, or both. Logically, this is inevitable. The timing and manner of arrival of the change are anyone’s guess but may depend on the pace of technology and the impact that human activity and the environment have on each other. One hopes the transition will be peaceful and slow.

To help make it so, there is one part of the equation worth looking at again: the need for economic growth. The movement for Steady State Economics, advocated by the New Economics Foundation (nef) and inspired by former World Bank economist Herman Daly, are chief proponents. A report called "Growth Isn't Possible" by the nef policy director Andrew Simms proposes switching to a non-growth economy. Borrowing from the world of ecology, he rejects the Darwinian analogy of economic competition in favour of more stable systems found in nature, such as symbiosis, collaboration, co-evolution and diversity.

He says the result could be called “dynamic equilibrium”, in which economic effort is directed at being better instead of bigger, collaborative not combative, making the same with fewer resources instead of always making more.

Sounds great, but is it a bit utopian?

Simms believes that some fundamental assumptions about the economy could, if we really wanted, be changed. These include the idea that public finances should assume economic growth, that stock markets need companies to be progressively more profitable, and that our credit economy needs economic growth to support interest payments. “These things are the result of cultural and political choices, which can, if necessary, be changed in the light of necessary and urgent circumstances,” he writes.

His suggestions on how to achieve this are not always compelling. Simms argues that quantitative easing and bank bail-outs prove that governments can create money anytime; a view that takes no account of inflation. Similarly, his notions that public services could be co-produced with the public, or that highly progressive taxation would lessen the need for growth-oriented saving products, are way too optimistic about human nature. His point, recycled from Herman Daly, that a non-growth economy could achieve full employment by replacing machines with human labour is plain scary. Dark satanic mills, anyone?

Some ideas, though, are worth dwelling on. A shorter working week to tackle overwork and unemployment would be a relatively small cultural change and would free up time for people to “do things for each other, and reduce the need for paid services”. It might not work for everyone but as a principle, who wouldn't want to work less and chat more? Switching some business activity into alternative forms of ownership, such as mutuals and co-operatives, would also be consistent with a no- or low-growth outcome. Finally, alternatives to normal money could be explored for different types of exchange, such as time-banks or non-interest loans for public infrastructure projects.

While some of these ideas might work, I struggle to imagine a world without economic growth. There is no serious alternative yet to our growth-led economic infrastructure and no better mass motivation for putting food on other people’s tables than profit. I could imagine, however, a world with less growth or in which profits could be earned other than by consumption pumping.

Perhaps we could use the tax system to reward entrepreneurs for saving resources as much as from exploiting them, or create financial incentives to generate the same output with less material.

Business efficiencies, for example in manufacturing, are normally captured by producing more for less, the more the merrier. Since businesses concentrate on sales as well as margin growth, efficiency gains alone cannot be relied on to save the planet.

Reversing this means overturning some common assumptions. People might be rewarded for what they don’t use instead of paying for what they do; just as electric cars in London don’t pay the congestion charge, consumers could pay more VAT on goods with non-biodegradable packaging than on goods without, and so on. Or corporate tax rates could be linked to the volume of raw materials consumed or pollution emitted, and taxes at large companies linked to growth as well as profit; both of these would reward innovations that reduce resource consumption and encourage savers to invest in industries with the most potential to cut their inputs.

Admittedly, these interventions are only fiddling with the edges but they might start to change attitudes to growth, without anyone going back to the mills.