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In a recent letter from one of the largest UK banks to SME customers unsecured loans are offered at 8.75%. Cheap funding from the FLS leaves a net margin of around 7.25%. If you set aside £3 of capital to support the loan and earn £7.25 that’s a 242% raw capital return. Adding an additional 2% administration cost still leaves 175% ROC. Clearly things aren’t this simple. SME lending is risky. Unsecured SME lending is worse. A 5% default rate coupled with a low recovery would just about clean out the margin. However two questions prevail. Is a 33 times leverage ratio excessive? Is the lending rate representative of the risks involved? Whilst (1) is the subject of disagreement between banks and regulators (2) is largely ignored. What’s clear is that the FLS does have a cost. It transfers wealth from savers to borrowers by keeping money rates beneath where they would otherwise be. However if that benefit is largely swallowed up by banks the desired effect on economic growth is blunted. Loan pricing therefore becomes a monetary policy issue. I suspect we will hear more about this in the months to come.

The customer is not always right but the way you handle complaints says a lot about your business. Last May the Financial Ombudsman Service published figures showing: Over 508,881 new cases 49% of cases led to compensation for customers Four of the UK’s largest banking groups accounted for 62% of all complaints. This is an appalling record but at the same time presents one of the big four banks with a huge opportunity. A chance to show they are different. And the easiest place to start would be on clearing up the current mess effectively. What does this mean?A proper complaints handling process that has: Senior management who are ultimately responsible Trained staff that know what they are talking about A single point of contact for the customer Proper records Key performance indicators that are applied Escalation processes that work Management information that reaches the Board This isn’t rocket science, it’s important and it’s personal. Customers will accept mistakes happen provided they are properly resolved. If not the brand value is further eroded. Of course this isn’t the end of the matter. In wholesale markets operational weaknesses can be cleared up quickly. The usual method is for the regulator to threaten to stop a bank from dealing. This works wonders. Boards should note stopping new retail business could be the FCA’s alternative.  And it too would work wonders.

Forecasting is a major pastime in financial markets. Economic indicators are pre-estimated. Company results are projected. Macro indicators are anticipated. This has huge entertainment value and when the outcome is unexpected prices change. But can forecasting affect the future? Some central bankers think it can. But to think like this you need to be an elephant. Let’s put it in perspective. If you are told interest rates will remain low for years to come will you borrow and spend more? Your action will probably depend on whether this is a fact or a prediction. Does your view change when you realise this is not the analyst speaking, it’s the elephant? And the elephant can stay in the room for a very long time? For elephants this is both an exciting and dangerous game. Objectives can be achieved with little more than well-chosen words. But the room for error is limited and the cost can be high. If things go wrong and ratings, Sterling and Gilts fall there is a real effect and monetary policy must alter. But the elephant can’t move without damaging trust. Perhaps therefore it is better to stay with the old method. That is to indicate where you stand on inflation but to side step when you feel it is appropriate. This too can damage credibility but at least it’s consistent. After all it’s how the UK has always dealt with excessive post war leverage.

On 1st April 2013 prudential regulation came under the responsibility of the PRA. This covers 1,700 firms with resources focused on category 1 and 2 firms. It’s at an early stage but you have to ask whether there are going to be significant changes and whether they will affect you. From the speeches and documents released it seems that the PRA would like to alter things. Although the crisis is far from over, (rates at 0.50%), groundwork is being prepared to move forward. My guess is we are moving to a more qualitative regime backed up with quantitative analysis. It is this human content that is both interesting and difficult. From what I see the PRA is gearing up to engage Boards on a host of issues concerning structure, reporting, observation, feedback and accountability. Indeed the precursor document published in the BEQB Q4 2012 mentions some of these concerns. They include vulnerability of the NII, awareness of creating systemic risk and transparency of structure. All this should mean good governance will count. Whilst regulatory reporting and peer group analysis will remain an important regulatory tool more will be asked about the medium term health of firms. Are you viable? Are returns sufficient? Are earnings of quality? Where are you going? Of course kicking the tyres in this way presents management with a challenge but just how far is the PRA prepared to go? That is not clear. I suspect that if the PRA doesn’t like what it sees it will stifle the firm either by way of prohibition or by more subtle increases in capital and liquidity. And that’s the risk for boards - you simply can’t grow your business.

Be careful what you wish for. Bankers have for the past five years wanted less regulatory interference. But in a badly damaged financial system this was wishful thinking. Regulators and politicians just couldn’t take the chance of a major bank failure leading to systemic melt down. The liquidity and capital rules just reflected this zero failure regime. But now it’s going to change. Why? In hindsight regulation has been too punitive it’s stopped banks from lending. This is the legacy we currently live with. But political pressure is being brought to bear in order to get the real economy moving. It’s also recognised that failure can be constructive provided the taxpayer doesn’t foot the bill. Provided the authorities think the probability of systemic failure is negligible banks will be allowed to fail. When and where the first failure will occur is anyone’s guess but you have to think it will involve a small player first. The G-SIFIs turn will come later when regulators are confident that their structure can be effectively taken to pieces without endangering the rest of us. In part this is a return to banking as it used to be. But there will be safeguards. Board accountability will be re-enforced. Reporting will be comprehensive and accurate. Resolution will work. The subtle shift from zero bank failure to zero systemic failure has important implications for those of us who work in or around financial markets: Risk levels will be allowed to increase but not to the levels of 2004-7. If you don’t like this then banking probably isn’t for you; Failure to have a credible resolution plan will lead to dismemberment; Board challenge will replace tick box regulation; Unsecured credit exposures to banks are highly undesirable; As is operational reliance on any one party; Failed regulatory reporting will incur big fines; System providers will gain from the infrastructure spend. The debate on the EU and banker’s bonuses is all part and parcel of this shifting process.  Embracing free market thinking that would let badly run firms fail without taxpayer bailouts would surely provide bankers with the best argument for paying bonuses. It’s a pity but we aren’t there yet but I sense that’s where we are going. The problem for bankers is that the implied credit guarantee is major part of the revenue stream. Until then EU legislators will press their case.

The great experiment called QE is about reducing leverage through the devaluation of money. The main thrust is to make sure that real interest rates are negative throughout the curve. This favours borrowers over investors. What’s frustrating for the central bank is that monetary policy appears to be nearing its limits. Enter the next phase, broadcasting the fact that negative rates are here to stay. Market stability and confidence are improved by certainly of intention and we reach “escape velocity”. A consistent medium term policy stance is helpful but the problem with this message is it’s asymmetric. We just hear that it’s more of the same. The best made plans (especially in economics) have a habit of failing to ignite. So what happens then? We just don’t know. The Bank intends to anchor rates low. But what would happen if any of the following events (which have occurred to the UK economy at least once since 1970) happened again? UK credit deteriorates badly; The US comes out of recession fast and hikes rates; Sterling collapses; UK inflation takes hold. Does the planned policy continue? Hardly, these scenarios aren’t mutually exclusive and if the central bank decides to target rates it will lose control of other variables. Political considerations would force change. QE would end but how we don’t know. Convincing markets (and consumers) that a retro rocket exists that could be fired should we need to jettison QE would go a long way to improving confidence. Unfortunately on this mission the engineers seemed to have overlooked this. Let’s hope “escape velocity” isn’t terminal.

The recommendation by the ONS not to alter the calculation of RPI for index linked products is common sense. This is good news for both investors and the Treasury. Investors had bought RPI protection and it was disingenuous to consider that the index should be recalculated on any other basis. Not least because the motivation to re-calibrate the calculation appears to have been driven by the Treasury’s desire to cut financing costs. A laudable objective but in this case one that could have backfired badly. The effective reduction in coupon and principle repayments would have damaged trust in UK government debt. This would have gone against every sound practice in bond markets and would have achieved only short term gains at the expense of increased future financing costs. Whilst investors should feel happier it does leave a bad taste. There appears to have been genuine support at senior levels to rebase linkers and this affected their trading price. In the future could a cash strapped Treasury re-float the idea? Maybe.  There are now to be four different measures of inflation in the UK. In this respect investors should be aware they are running short option position. Out of the money for the moment but who knows what will unfold in the future? This whole saga around linkers leaves me with a worrying thought. The linking issue has been around for over a year. Why didn’t the Treasury bury it long ago? It’s as if Noddy was in charge. Grade C.

Bond investors accept credit and market risk but one thing that’s far less easy to stomach is unilateral changes to terms and conditions. And from what I see that’s what could happen in the index linked gilts market. Linkers are adjusted by the Retail Price Index but proposals may mean that the RPI is replaced with a Consumer Price Index. The CPI rate is about 0.5%-0.90% lower than the RPI. If it went ahead this is a materially adverse change for holders of linkers. There are two issues. Is the CPI a better measure of inflation? Debateable but statisticians seem to be of the opinion that that it is. Should existing RPI linked gilts be re-linked to CPI? Clearly not. Investors have bought these bonds in good faith and expect the UK Government to act in a similar manner. Not restructure the debt post issue. Changing the linking is tantamount to cutting the coupon and reducing the par redemption amount on a conventional Gilt. Countries that restructure debt do so because they are forced to do it. It amounts to sovereign default. If the UK government follows this path it sends a very poor message to investors. It means that Gilt holders are taking on more risk than they thought. Could HMG undermine investors again? Probably. Indices used to calculate payments need to be transparent and not subject to manipulation otherwise mistrust reigns. It’s ironic that commercial banks received a hammering on Libor fixing wasn’t that to do with manipulation too? Do you think we would be discussing this if CPI exceeded RPI? No. It’s all about reducing debt servicing costs. This is short sighted. As we know yields rise with uncertainty and that’s what will happen. Far from cutting costs it will add a risk premium to the whole Gilt market. The solution? Outstanding debt should retain RPI as it is currently calculated even if CPI is adopted elsewhere.

Back in the 1990s a bank was getting a difficult time from the regulator. The regulator didn’t have the same muscle as today but it could still restrict activity. Did the bank improve its risk control? No. The regulator was enticed to join the bank and the bank was off the hook. Maybe a good solution then, but now? I think not……. The regulatory system is being used as a stepping stone for bankers. This is dangerous. It damages wider trust and doesn't make banks safer. In these difficult times some resourceful bankers are using the regulator as an employer of choice. In a world of risk this is eminently sensible for them but not for the rest of us. As we know bankers follow the money so when things change will they stay or will they go? In the meantime you have to ask whether their judgement in a regulatory capacity will be truly impartial or whether it will be influenced by their peer group aka network (which incidentally includes trade bodies and lobby groups) and also where they aspire to be in the future. The risk of having a foot, so to say, in both camps needs to be averted.  It is a conflict of interest. Furthermore that’s not the end of the story. As regulation becomes more complex fewer people understand it. Regulators become the experts in a field where they make the rules. Large banks then hire them to exploit the very rules they have created either by technicality or latterly by “regulatory facilitation” (knowing how the regulator works and who makes decisions). This is a conflict of interest. It benefits the large at the expense of the small and encourages complexity above pragmatism.  Reduced leverage not regulatory arbitrage makes banks safer. But here is the real damage. Ask the man in the street and he can’t understand why since 2008 many more of those in charge (and that includes bankers, regulators and auditors) haven’t been shown the exit.  And he certainly can’t understand why more bank directors haven’t been banned or faced criminal prosecution. It’s not just the cost of bank bailouts. It’s PPI, swaps, payment disruption, Libor and RBS. His simple understanding of finance tells him it’s the Old Boy network. Does it matter? It depends on the importance you place on money. Chipping away at trust is corrosive. Sound money requires a sound banking system. That’s one that’s trusted by everyone. Preventing the regulatory system from being a stepping stone in banking careers would be one measure that would help to restore lost faith. We aren’t in the ‘90s.

On 12th July 2012 the Bank of England released a study on Quantitative Easing, (The Distributional Effects of Asset Purchases).  The paper, requested by the Treasury Committee concedes that QE has had a distributional effect benefiting wealth holders. It also points out: “Without the Bank’s asset purchases, most people in the United Kingdom would have been worse off. Economic growth would have been lower..….” “By pushing up a range of asset prices, asset purchases have boosted the value of households’ financial wealth ……” You could be mistaken that the only thing required to solve the country’s problems was more QE. Can any organisation be seen to have an unbiased view? Or should some of the report be taken with a pinch of salt? The report takes a snap shot of QE. In my opinion this is misleading. It fails to mention what QE may lead to and this will have future costs and benefits. After all forward looking analysis is regularly used by proponents of QE. When interest rates are pushed well below their long term norm you can’t help but feel that QE may lead to some unforeseen consequences that could in the future haunt us. One such consequence is what I call the solar panel problem. In the summer a colleague kitted out his house with solar panels. He explained the expected lifetime saving to his electricity bill exceeded what he could get in a bank. (The project IRR exceeded his ISA rate). At the same time he acknowledged that solar panels weren’t very efficient and he was doing this because interest rates were derisory. He had decided to invest in something that normally he wouldn’t have touched. If you extend this to other aspects of the economy investment now seeks a home at rates that normally wouldn’t get financing for the levels of risk involved. House buyers pay reduced mortgage rates. Companies borrow at very low cost. Governments contemplate borrowing more because the funds are so cheap.  So far so good. Perhaps the only person who is worse off is the cash based saver. But hold on is it that simple? In normal times my colleague wouldn’t buy solar panels. But his action now has the direct effect of investment being made in something that normally would be considered unproductive. Is this good? Furthermore is it in the long run interest of the economy that uneconomic companies who would go out of business but for the unprecedented low interest rates continue to plod on? (Similar questions have been recently raised in the Sunday Press and by the venture capitalist Jon Moulton). Are we in danger of creating an economy condemned to low productivity, low growth and low wages? With the worst recession since the ‘30s is the surprising rise in employment (and fall in productivity) the first sign that QE has unintended consequences? However unpalatable markets are, deliberately altering prices by direct intervention leads to future difficulties whether they are ones of misallocation or inability to fool all the people all the time.  Therein lies the danger that the Bank at some future point can’t keep rates low leading to accelerated rates of insolvency and foreclosure. No wonder commercial banks won’t lend. This is serious stuff and I’m sure the Bank considers it. So why pronounce QE as a success when the experiment has much further to run?

The financial crisis had many perpetrators but now this is about to change. In future there will be one that gets blamed. Since 2007 we have been trying to find out, with little success, who is guilty for the mess we are in. Is it bankers, regulators or politicians? The story was complex and complexity hides the truth. According to today’s FT the combined regulatory penalty that 12 global banks now face as a result of manipulating Libor is $22 billion. Why didn’t we see fines and sanctions of this scale earlier? It’s my bet that the collateral damage would have carried out more than bankers and as they say turkeys don’t vote for Christmas. But now it’s different. With Libor you can see what’s been going on and so far there’s no one else to blame but bankers. What used to be a game played out between the big boys has questioned their honesty and integrity. Make no mistake this is a systemic issue. Heaven help the banks if the regulators find evidence of a cartel. You also have to wonder whether market rigging went a lot further. Who knows? If this behaviour was mirrored elsewhere it could affect just about every financial index and market. One thing is for certain it’s "drains up" time for regulators. Who could blame them? As some dealers would appreciate when there’s nothing to lose and a lot to gain you do it in size. More bodies down there? I for one wouldn’t at all be surprised.

Barclays £59.5m fine rests on two aspects of Libor “fixing”: Profit. As Trader B explains: “I really need a very very low 3m fixing on Monday – preferably we get kicked out. We have about 80 yards fixing for the desk and each 0.1 lower in the fix is a huge help for us. So 4.90 or lower would be fantastic”. And Perception. “just set it where everyone else sets it, we do not want to be standing out”. What’s to blame? Apparently “Culture”. But maybe, just maybe, there is a little more to it than meets the eye. Knowing the difference between what is right and what is wrong and then applying it is critical. In this way nefarious behaviour by dealers, operations and management is less likely. How and why has this been forgotten? Furthermore segregation helps combat bad behaviour and fraud. Does it need re-enforcement? There’s a word for all this it’s “competence”. Perhaps it’s been overlooked. But that’s not all. Bad things will happen. In banking, money has changed personal behaviour – not always for the better.  It's time the personal risk/reward ratio was recalibrated. How quickly could that change culture? With the CEO out and the SFO in we may be about to find out.