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Business as Usual

Has anything really changed in the financial world?

When the full extent of the credit crunch of 2007 became clear, many expected it to herald a new era. The market ideology had failed and changes were inevitable. Governments had to pull the financial sector back on the rails, which caused the worst recession since World War II. It seemed unthinkable that the fundamental flaws in the system would be left untouched after such a catastrophe. A bit over three years later and with most of the dust cleared up, evaluation of the resulting differences in the financial sector can commence. Unfortunately, in most respects it seems to be business as usual.

Since 2007, governments have certainly attempted to get a tighter grip on the financial sector. Despite the please of banks, sober analysis made it clear that a crisis of this depth is seldom self-correcting. New regulations have been installed to increase political supervision over the banks and insurance companies. Countries such as France, Lithuania, the United Kingdom and Portugal have announced far-reaching changes in their supervisory structure. Almost all member states plan a larger involvement of the central bank in controlling the national financial sector. Existing supervisory structures are now consolidated and entrusted with more responsibilities.

On the EU level, there is consensus regarding the establishment of a European Systemic Risk Board and three new supervisory agencies for the banking, securities and insurance sector. The EU has also begun the application of a new round of stress tests on the banks. These tests aim to verify whether or not the banks are armed against economic calamities, like a new plunge of the real estate market or an unstable euro. Failing the test can allow governments to restructure and recapitalise the banks. All this supervision will have to ensure that derailments in the sector are noticed before they get out of hand.

Yet the installation of the new policies on national and international levels cannot be completed overnight. One of the more optimistic deadlines for the completion of the new structures is 2018, a date at least partially the result of Europe’s current need to focus all of its energy on rescuing monetary unity. Thorough reforms require some stability and such peaceful times are nowhere in sight for the time being.

The additional supervision is of course much detested by most of the banking sector. The banks promised self-correction and internal policy change, dismissing state control as ineffective and harmful interference. Many observers believed that short-term profit and irresponsible attitudes were a direct cause of the crisis; it was hoped that the collapse of the financial system would bring its main players to their senses and encourage the sector to adopt more responsible, self-regulating policies. However, there seems to be little reason for optimism. Regulatory arbitrage is still popular. Banks avoid new national and international regulation by transferring some activities to countries where the regulation on that specific activity is less heavy. Despite the number of new rules on the table, many banks still try to find legal loopholes and backdoors to undermine their effectiveness. The incentive for banks to play this game is too high and that of government officials to prevent it is too low.

Regulation by supervisory institutions is one side of the coin, the practical application of these is the other. Regulatory bodies must have a firm backbone if they want to function effectively. They must be completely independent from the sector, as well as from the political agenda. Not an easy feat especially with mounting pressure and though governments may seem tough now, when employment is at stake the temptation to give banks a break is substantial.

There is also the question of the bonus culture. Demonised as one of the great aberrations in the financial sector, the astronomical rewards for well-performing staff have long been under heavy attack. Excessive risks and illusionary profits generated higher bonuses than the long-term vision. The sector attempted to prove that regulation in this issue was unnecessary by substantially limiting bonuses themselves or by postponing them to more prosperous times. Several CEOs even refused their bonuses or had them frozen until their results would prove to be sustainable. Today, however, bonuses are soaring again. The Royal Bank of Scotland (RBS) announced that it has reserved 1,1 billion euro for bonuses this year; remarkable as the bank reported a loss of 1,3 billion euro in 2010 and was one of the main beneficiaries of the bail-out in Britain. Continental banks have not made their bonuses public yet, but ING, for example, has already announced that it will start up the bonus system again for the first time since the crisis, despite still owing billions to the Dutch state.

The sector itself naturally argues that large bonuses are vital for its revival. Rewarding talented people for their performance is necessary to keep them aboard. Without bonuses, they claim, profits would decrease and that would prevent the banks from paying back their debt to the state. Yet in New York, bonuses are 9% lower than they were last year. Simultaneously, salaries have gone up by an average of 6%. This suggests that banks are focusing somewhat more on stable rewards for their well-performing staff and less on the short-term profit generation. Observers can only hope that the European financial market will follow this example.

Still many remain sceptical about the sector’s ability to change. The Bank of England’s governor Mervyn King warns that the focus on short-term profit has already been reinstated and his accusations did not meet many objections outside of the sector. The bail-out has strengthened the conviction that banks are too important to go bankrupt. The problem of some banks being ‘too big to fail’ has not even begun to be addressed. This of course brings about a feeling of invincibility. Risks can be taken without too much to lose simply because the state has proven it will intervene when things turn really ugly. All in all, the repercussions for the failing banks have not been very worrisome for them. In a world that revolves around incentives, the banks have not received enough of them to substantially change their policies.

Since the banks themselves have not done enough yet to regain the trust of the population, there is still a long way to go and hurdles still to be faced along the way. The current hope among those observing the sector is that the increased supervision will be effective in avoiding a second crisis. Yet the sector still has many weak spots to worry about - soaring oil prices could provoke inflation, which would likely provoke the central banks to increase interest rates, and this could easily destabilise some of the weaker banks. Judging by such forecasts, it is fair to assume that the appropriate time to resume handing out big bonuses has not arrived quite yet.

by Gioele De Cort