UK: Would criminal law prevent banks taking excessive risks?

On Friday we were yet again reminded of the fragility of the UK financial sector. The Co-operative bank has had its credit rating downgraded to ‘junk’ status by credit rating’s agency Moody’s.

In addition, their CEO, Barry Tootell, has resigned with immediate effect, following his failure to acquire 632 branches from Lloyds Banking Group last month.

Rumours abound that the Co-op will need external funding to shore up its capital defences ahead of new regulatory requirements due to be implemented under the Prudential Regulatory Authority.

With that in mind, this is probably an apt time to be discussing a new criminal law that the banking commission is considering. Dubbed the ‘reckless endangerment’ law, it involves criminal prosecutions for banking executives who wrack up catastrophic losses that pose a risk to the health and stability of the wider economy.

The idea that individual employees are to be held accountable for the triumphs and tribulations of the boardroom is a unique proposition in the UK, but then the current banking system is a unique hybrid of capitalist and state principles: banks compete for private profits but when the foundations crumble the politicos swoop in, all belts and braces, with a blank cheque.

To allow business to carry on as usual is simply not a viable option. The question now becomes: in a world where banks cannot fail in the normal way, how can we effectively regulate against a future crash without seriously damaging the British economy? A criminal law could be one part of a multi-pronged solution.

Critics point out that if such a law comes into play too soon it could starve off a fledgling recovery so implementation needs to be carefully timed. A bigger concern is the long term effect any regulation will have on the profitability of the financial sector and the consequences for GDP. The spectre of diminishing liquidity as bank profits dwindle leads many to reject out of hand a serious overhaul of the financial sector.

The government in particular is caught between a rock and a hard place: reluctant to burden a fragile sector critical to the UK economy, yet they know that they must do something to quell taxpayer indignation or risk a snub at the polls.

Establishing the Parliamentary Commission on Banking Standards has enabled David Cameron to tread water on the issue, quietly postponing any real decision-making until the UK economy is safely on the road to recovery. Yet decisions must eventually be made and it will be a brave government who prioritises a safe, regulated financial sector in the future over short, sharp growth now—hardly surprising when the Chancellor is judged on today’s growth figures and not tenuous future claims to systemic safety.

Many find the prospect of a criminal sentence appealing as it makes bankers directly responsible for their decisions. No longer can a banking executive hide behind the faceless corporate brand. Executive teams will be under pressure to keep a close eye on the wheelings and dealings of their golden boys, or risk being accused as complicit in their reckless decision-making.

And there was certainly plenty of reckless decision-making afoot in the run up to 2008. In the Parliamentary Committee on Banking Standards report into the failure of the bank HBOS, the Committee cites the propensity of HBOS to look for blame for their failures anywhere but in their own backyard:

The repeated reference in evidence to us by former senior executives to the problems of the Irish economy suggests almost wilful blindness to the weaknesses of the portfolio flowing from their own strategy.

An Accident Waiting to Happen: The Failure of HBOS
Of course, a criminal law taken on its own it is not enough. It is however, one element in a raft of measures that include: sensible, absolute capital to debt ratios (as opposed to the tiered structure we are due to adopt under Basel III that is open to manipulation); a complete separation of investment and retail divisions; and a new, much tougher regulatory culture.

Profits will feel the bite and lending may take a hit, although perhaps this is the natural equilibrium our economy needs to find in order to escape from the boom and bust cycle.

The devil will be in the detail. The law needs to be broad by design, for it is the subtle nuances that will demarcate unlucky market twists and sloppy business decisions from dangerous casino-style risk taking. On the flip side, it is that loose, interpretative element that will make this issue so tough for the courts to adjudicate.

In many ways, the success of this law could be in its preventative corollaries—the mere sniff of a prison cell could be enough to give board members a sharp wake up call. Next time, it simply will not be good enough to hold your hands up and whimper that you had no idea what was on your books.

The banks employ some of the best and brightest in the country and the expectation will be that a proportion of those skills will be put to work monitoring the banks long-term financial health and stability and testing their investment assumptions.

The banking sector is the goose that lays the golden egg – and it has bitten us on the nose. We may not be ready to slaughter the goose for Christmas supper, but it might be time to clip its wings.