Replies to bloggers from Matthew Hancock on banking

Last week John reviewed our new book Masters of Nothing, and he has invited us to reply to the comments left on the site.


We’ve found that you keep learning about a book you’ve written after you’ve written it, thanks to the comments of others, and the discussion it provokes, so we are grateful to everyone who put fingers to keyboard.


One of the reasons we wrote this book is because we wanted to provoke a discussion that was largely absent before 2008, a discussion about the way our financial markets behave, and the need for regulators to look to the big picture, instead of huge piles of box-ticking rules.


The discussion under John’s review is wide-ranging, informed and insightful. One of the key themes that emerged was the importance of competition within the financial system. Nearly all comments agreed that a more competitive banking industry would go a long way towards averting future systemic crises. There was also a broad consensus on the principal that market discipline must be restored – that banks should be allowed to fail without disrupting the wider economy.


We agree. More competition is crucial. But we would add an important qualification.


Groupthink, the herd mentality and our impulsive inclination to buy into ‘get-rich-quick’ stories, mean that large numbers of smaller financial institutions are just as capable of getting swept up in bubble manias as their global counterparts. People behave differently in groups than as individuals: that’s a fact of life.


The best defence against such complacency is not only downsizing or ring-fencing, but a culture of responsibility amongst the senior management of major financial institutions. This points to stronger boards, a regulator prepared to challenge irresponsible behaviour, and the ultimate sanction of prosecution for those executives who imperil our economy.


Several readers argued that in a free market the composition of a board, or the compensation package of a senior executive is the business of shareholders alone. Conversely shareholders and not taxpayers should absorb the consequences of banking failures.


Yet there’s a reason the state stepped in to save banks: when the whole financial system, and so whole economy  was put at risk. So the taxpayer is on the hook – whether we like it or not. 


All too often in recent history shareholders have not made it their business to assess the effectiveness of their executives, or the true nature of so-called ‘incentive’ packages. The structure of modern shareholding, which conveys a disproportionate influence on huge institutional funds, often means individual shareholders are ill-equipped to provide this kind of oversight. This is a market failure, which is why we call for the greater professionalisation of non-executive directors, who need both the time, the expertise and the incentives to hold the executive management to account.  


Several comments, which throw light on some of the most interesting issues, deserve a more specific response.


‘Major Loophole’ made an argument that we strongly identified with, suggesting that in the late 1990s the ‘old hands’ of local branches came to be dominated by ‘younger, less experienced ‘bean counter’ style managers,’ who ‘crucially, were given lending targets, the meeting of which, of course, led to qualifying for our old friend—the bonus.’


Such perverse incentives were a key aspect of the crash, but Major Loophole hints at a more fundamental problem with modern finance: a detachment from the society it serves. Too few decision-makers at the height of the boom questioned the wider consequences of what was effectively financial pollution.


Robert K wrote: ‘the idea that a rule-maker should control waves of waves of optimism and economic greed is silly.’


We agree. One of our central arguments is that you cannot legislate human nature out of existence.    The cycles of euphoria and panic – and the asset bubbles they generate are an inherent part of capitalism. What we suggest instead is that both policy and economic thought should be shaped in a way which takes account of human nature. We know, for example, that there can be no risk-aversion without fear, and we have to bear this in mind when we think about incentives. Similarly, we know that there is a relationship between testosterone and risk-taking, and this needs to be considered when we think about the role of women in finance.


Ralph Musgrave picked up on the role of the Bank of England’s new Financial Policy Committee:


‘The idea that the Bank of England should have the “the authority and the power to be able to tell a large bank that its strategy is too reckless…” is naïve. Various regulators had that power prior to the crunch, but they just got swept along with the irrational exuberance.’


This is a question we deal with at length in the book. It’s absolutely true that the regulators got caught up in what Alan Greenspan labelled ‘irrational exuberance’: the euphoria of the bubble. As we argue in our chapter on regulation, the FSA’s failure was a failure of institutional culture, in which box-ticking and the rulebook came to replace big-picture thinking and personal initiative. We need instead a regulatory institution capable of offering both a big-picture view of the UK financial system, and a culture of discretionary decision-making, so that the regulator is always one step ahead of those who game an abuse the rules. The Bank of England is well placed to provide these two things. But crucially, regulators themselves will inevitably fail, so the system needs to be structured so regulatory failure doesn’t bring the whole economy crashing down.


Finally ‘lifelogic’ asked ‘Who, on earth, has ever though that people behaved rationally?’


In a word: economists.



  1. Rebecca Hanson
    September 22, 2011

    I’m enjoying this book. I find it a great relief that forensic, as opposed to axiomatic, economics is alive and well.

    My father was a forensic economist. He spent his career trying to have economics degrees rewritten and redesigned to ensure student learned to tune into and interpret emerging situations, to properly see human behaviour and to respectfully question preconceptions given to them by others.

    He set up practical degrees in economics and business management and spent many, many hours on the phone to businesses sorting out gap years for students.

    I was worried forensic economics was as dead as engaging with reality is in education policy and am deeply relieved to see that it is not.

  2. Nick
    September 22, 2011

    a detachment from the society it serves.


    They don’t. They serve the shareholders. If the is also inline with the customer so be it. If its not, the competition kills them off. You’ve fallen for the socialist trap that everything is there for the government’s requirements

    As for what to do with the banks.

    First, dispose of Vince Cable. He’s a disaster.

    Second, cut regulation, particularly for new entrants. Why should it cost 50K plus to set up a friendly society?

    Three stop the government from borrowing and spending so much. They are sucking up the funds. They have driven interest rates down. Look at ‘twist’ in the US and the effect on bank stocks.

    Cut the penal taxes on banks. It only prevents them building up capital. It also sends the message, don’t invest in banks, because governments will steal the profits.

    And don’t whatever you do give idiotic civil servants a commercial lending bank to play with. [Unless you get the unions to invest all their members pensions with the bank. That way the unions are dead – forever]

    And stop fighting the last war. It’s history.

    The next war, is the disaster when governments default. If you take 50% off banks capital (remember you’ve forced them to loan to governments), you will wipe out the ability to loan any more money for a long time.

    1. Major Loophole
      September 23, 2011

      “As for what to do with the banks. “………

      A couple of years ago during a meeting with my ‘business manager’ at my local market town’s (pop. circ 30k) branch of *******bank (doesn’t matter who it was), where the front of house ground floor area was five times oversized for the activity it accommodates, I found myself needing a pee. I was shown to the staff loo somewhere way back in the bowels of the building and a couple of floors up. The place was all but empty. It’d probably had ten times the numbers of staff in the past, but now just empty offices and open space.

      Perfect, in other words.

      In the case of RBS, then, we could let the non-taxpayer shareholders keep all their business and clobber and operating stuff in return for us 80% shareholders taking what was their buildings. They will become a leaseholder on, say, 10-20% of the area of the building on the same terms as the other 4/5/6/ or so new local friendly society (or other) type banks and compete for business in the same way as Chinese fast food stalls in a mini-mall.

      Non-taxpayer owned banks should not concern us for now. In time the new guys will deal with them anyway, partly because they won’t be able to afford their own high street premises: structural costs in excess of those of your competitors are fatal in the long term. Costly prime space demands to be used efficiently.

      As you say:

      “Second, cut regulation, particularly for new entrants. Why should it cost 50K plus to set up a friendly society?”

      ……or some other model of financial operation. I’m not against friendly society/mutuals by any means but we don’t know what else people might think up: payment by mobile phones is already up and running and very cheap; who knows what type of financial services might arrive and thrive.

      RBS would get its lease at a discount; the new ones theirs at market prices, (the cost of the lease sitting in the balance sheet as an asset and perhaps forming part of the capital ratio).

      This would not return all the taxpayers’ investment in RBS’s shares, but we’re not getting our money back on those anyway so hey ho. As you say, ..”stop fighting the last war. Its history.”

      Cashing in our stake in RBS will not be possible until after the final chapter of the crash and returns to taxpayers from lease sale proceeds should not and need not be rushed, after all, we’ve already lost the investment and any cash is a plus from where we really are as opposed to where some mythical balance sheet imagines we might be.

      This would allow time to set up some very basic regulation and control safeguards for the new operators and allow them time too to attract the necessary investment. If their idea doesn’t work and their business model fails—depositors money would be insured—then there’s still a valuable lease to sell to someone else through the normal channels with a liquidation. The space is still there for someone else to have a go.

      As JR repeatedly reminds us, competition is necessary, not just desirable.

  3. Lindsay McDougall
    September 22, 2011

    If you just let the failed banks crash and burn, you will get your downsizing, your greater competition, your greater responsibility automatically. Regulation and bail outs are the problem, not the solution. Did Darwin live in vain?

    1. lifelogic
      September 23, 2011

      Darwinian evolution also explains the existence of protected parasites too. Such as many of the arms of the state organisation that are so close to killing their victim.

      We should not underestimate what can be achieved by better shareholder control systems and encouragement/protection for whistle blowers. Many in the banks knew and understood exactly what was going on as is clear. Some whistle blowers were fired or sidelined for pointing out the problems.

  4. forthurst
    September 22, 2011

    Had he been clever Greenspan would have realised that it was his policies at the private secret Fed which cause the ‘irrational exuberance’; that is, unless as is customary, he was not explicitly setting the Fed’s policies to coincide with the financial interests of Wall Street rather than his nominal responsibility to set interest rates and promote policies which would prevent the formation of asset bubbles.

    No discussion of banking should be undertaken without a clear understanding of the role of massive financial fraud originating from mis-sold mortgages in the USA and the evidence that was extracted from the private secret Fed by Congress as to the disbursements that had been made to whom under TARP and TARF and charged to the American people.

    Blaming testosterone is far too simplistic; why not focus on the consequences of psychotropically generated reality and the tendency of people with low IQs and obnormally high self-esteem to put themselves forward as Investment bankers.
    The sort of people who can take down banks can take down any organisation, like UK plc in the case of the Labour Party, if they are allowed anywhere near the levers of power.

    As to the vunerability of smaller financial institutions, that surely is a matter of their focus of operations not their size?

    Clearly our banks have let us down; they are far too introspectively concerned with selling each other sophisticated financial instruments than doing what they have been licensed to perform. Maybe we need to look at the Bank of North Dakota, how it was set up as a protection against Wall Street spivs and how it successfully weathered the recent financial turmoil in which the spivs managed to lose everyones’ shirst but their own.

  5. Cllr Andrew havery
    September 22, 2011

    I think we are getting there. I urge you to consider
    1 boom and bust, to some degree is integral to our system as growth does not move up in straight lines
    2 great regulation is sadly impossible. We tried the experienced bankers model and it didn’t prevent bcci. We then tried the thousands of staff, tens of thousands of pages of regulation model, and we are where we are. It is because even if you believe in theory that multiplying the number of regulator by ten is a good thing there aren’t enough clever people on the planet to do the job. I know- I was a banking compliance officer and the greatest service I performed was when a senior banker talked rubbish and the FDA accepted it and lapped it up I explained to his boss or more usually his boss’s boss the risk he was causing us
    6 I also need to point out that for all sectors when the Market is moving up you want optimises as executives. The pessimists get sacked as they underperform the optimists. In periods of downturn the control and risk guys get hired which is great for me but let’s face it they’ll be the wrong guys if against the odds we have an upturn

  6. Richard
    September 22, 2011

    “Yet there’s a reason the state stepped in to save banks: when the whole financial system, and so whole economy was put at risk. So the taxpayer is on the hook – whether we like it or not.”
    Im not so sure this is right, if Governments had held their nerve and explained to some panicing deposit holders that they would get decent compensation and perhaps even offered to improve on the cover the scheme provided, whilst saying boldly that failing banks will have to go into administration, would the eventual results have really been any worse than the mess we have now?
    We now realise that the “lame duck” policy of the seventies where near bankrupt companies were propped up at great expense by the Government to “save jobs” was an expensive failure.
    Are we now not just repeating this same policy but with much larger sums of money in the financial sector?

  7. Anoneumouse
    September 22, 2011

    You know it’s time to stock up on the rice and beans when the political bankers start to bleat.

  8. stred
    September 22, 2011

    Good to know that your blog is read and answered. Perhaps the authors would make responsible future governors of the BoE.

  9. lifelogic
    September 22, 2011

    Economist may think that but Engineers certainly do not think they are logical most of the time after all they but lottery tickets and put wind turbines on their houses and do almost anything for a pretty blond with a smile.

    “Similarly, we know that there is a relationship between testosterone and risk-taking, and this needs to be considered when we think about the role of women in finance.”

    Indeed there is endless evidence that women and men are different (though overlapping) in everything you care to measure. That is why the equal pay agenda is so absurd. At GCSE women beat men in everything by quite a margin – save additional maths I notice.\

    You book is pretty good and sensible really but it is hard for MPs to be too honest or even lightly honest though.

    Also I recommend Matt Ridley’s “the rational optimist” (to cheer you up with all this gloom about) also “Adapt”, by Tim Harford and “the God Delusion” and anything else by Richard Dawkins. The God delusion is one of the funniest books I have “read” in ages actually I had it in the car on CD but had to be careful not to laugh too much and crash.

    1. lifelogic
      September 22, 2011

      When I say the equal pay agenda is so absurd – I just mean that you cannot expect woman to do the same jobs or earn the same as men – they make their own choices and compromises just as men do. To go around saying their are only x% of MP.s or work as Engineers or as oil rig workers or refuse collectors and then say this is clearly due to discrimination is pure nonsense – just for silly programs like women’s hour, Polly Toynbee or Harriet Harman and not a remotely intelligent argument. I am quite sure most woman with their good GCSE’s can see this quite clearly.

      Gender neutral insurance is even more insane another back door EU tax – but Cameron likes it – it seems.

    2. lifelogic
      September 23, 2011

      People behave as there evolution has programmed them to behave. This behaviour might well be inappropriate for the new environment in which they find themselves. A spider will still spin a web – even if their are no flies to catch but not for very long.

      The young have been programmed by evolution often to do as they are told by their elders – as that way they avoid being killed or punished. Hence the desire of religions and similar to indoctrinate when young.

      Technology has changed hugely and bombard people with much misinformation with a view to selling people something duff investments, cosmetics, miraculous perfumed deodorants, over expensive trainers, lottery ticket and endless other things. Government do the same sort of misleading too a great deal.

      So they may behave logically in some ways but often logically for a different environment that no longer exists and having been given a duff map by the media, parents and similar to “help” them.

  10. Dai
    September 23, 2011

    Perhaps your analysis of the problems of group behaviour in financial institutions is seriously limited. You suggest shareholders should act more actively as sensible monitors of institutional behaviour. Share holdings are managed by fund management companies who enjoy the same group behaviour characterstics as managers of financial institutions. The economic impact of similar group behaviour also occurs outside financial and share management institutions. In the nineties the cash rich, stodgy GEC-Marconi was destroyed by ambitous and extremely silly deals carried out by its management, who were encouraged and bullied into doing so by the company’s shareholders, the fund management companies who were themselves under pressure to obtain shareholder performance. All went for the then “fashionable solution” and will do so again. Bond management groups I suspect would also come under the same umbrella. Perhaps you need to analyse a wider group to come up with solutions. I suspect it will boil down to relying on honest men and women. Politicians anyone?

  11. Denis Cooper
    September 23, 2011

    “All too often in recent history shareholders have not made it their business to assess the effectiveness of their executives, or the true nature of so-called ‘incentive’ packages. The structure of modern shareholding, which conveys a disproportionate influence on huge institutional funds, often means individual shareholders are ill-equipped to provide this kind of oversight. This is a market failure, which is why we call for the greater professionalisation of non-executive directors, who need both the time, the expertise and the incentives to hold the executive management to account.”

    But this approach of placing greater reliance on better non-executive directors has already been tried and failed.

    Checking back, in 1992 there was the Cadbury Report:

    which harped on about the importance of non-executive directors, and I think there may have been another similar report as well.

    The core of the bonus problem is not so much the sums involved, but the structure of the bonus schemes to reward performance over timescales which are short compared to the typical economic cycle.

    Non-executive directors have not and will not solve that problem, because either they themselves are part of the short term bonus culture, or they are chosen with a view to their names lending an air of respectability to the board but with little risk that they may offer any effective challenge to the executive directors.

    Shareholders have not and will not solve that problem, because the dominant shareholders are institutional investors who are probably operating similar short term incentive schemes themselves.

    So the problem can only be solved by an outside agency, which really means by Parliament imposing change through the law.

  12. Susan
    September 23, 2011

    Economists expect people to behave rationally, really, I would have thought it was politicians that made that assumption otherwise the banking crisis would never have occurred. Economists actually expect people to act irrationally that is why they are there. However it would be very difficult to build economic models on the basis that people will act unreasonably in a given situation.

    Furthermore, the BOE has been, and is part of the problem in this crisis and is therefore not part of the answer. The crucial point is that the FSA as regulator failed, however even they gave Gordon Brown warnings about the state of the banks, which was ignored by him. Banks need better regulation not more.

    I also dispute your belief that the banks could or would bring the economy crashing down. If failures in the banking system were handled in the right way this would not occur. It is language such as this that incties the public and loses confidence both in our banking system and economy.

  13. RDM
    September 23, 2011

    I agree mostly with the comments about the Book, but can’t help thinking that a competitive banking system alone will not solve our problem. It will help, no doubt!

    As a Technology Contractor for more then 10yrs, I do not except that banks are helping technology startup companies. A technology startup would require a 1(2) year holiday (min) before it could make any repayments, the development time!

    To develop an idea you need more then an unsecured (£25k) loan! And what fool would what a Business Angel, VC, involved, or allow a bank to put a charge on your home?

    Surely we have entered the “Information Age”, the Risk is attached to the idea and the skill of the developer! If we are going to start generating wealth, within high value added industries, then aren’t banks going to serve the needs of Technology Developers?

  14. lojolondon
    September 25, 2011

    Ralph Musgrave is totally wrong IMHO.

    As has been documented several times previously, here and in many other pages, the previous government intentionally split the BOE into three, set up two new organisations filled with cronies, de-regulated vital areas of banking laws, and then told all three parties to regulate the sector with a ‘light touch’.

    This was accomplished by G Brown. He is also responsible for the US catastrophe, as US banks pointed to the light regulation in the UK and the need to be competitive as reasons for Clinton to repeal the Glass-Steagall Act of 1933, which led directly to the problems they have there right now.

    It is like getting a bunch of children in a room, tell them there are no rules, they can do anything they like and then blame the children when they are getting hurt and things are getting broken. I use this example explicitly because we all know that at some point the parent will have to step in, clear up and patch up, but even so, there are things that will be broken that can never be replaced.

    Because the buck stops with the taxpayer, the government has a duty to protect us and itself. It is noticeable that COMMONWEALTH COUNTRIES, ALL WITH BANKING LAWS BASED ON BRITISH REGULATION FROM THE LAST CENTURY HAD NO EXPOSURE TO ANY BANK FAILURES. None.

    We do not need to spend a long time or a lot of money or ask a lot of experts their opinion, that is the Labour way. The tory way is to dismantle the FSA etc, revert to the BOE, re-instate the laws that served us so well for hundreds of years, as soon and simply as possible. It should be possible to achieve this in, say, a week, with a massive net saving, and improved protection for taxpayers.

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