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Amazon vs Hachette and the future of book publishing

First published on Huffington Post on 20 August 2014

Amazon’s dispute with Hachette could have consequences none of us ever dreamed of. As a society, we must be careful we do not sleepwalk into a situation we later come to regret – a world where publishers are marginalised and authors simply self-publish on Amazon. Readers will despair: lower quality books and a dearth of new, original creative writing.
Amazon is trying to control the price of eBooks. Hachette believes that is the publisher’s prerogative. Since May 2014, Amazon has forced the issue by using underhand negotiating tactics – it stands accused of deliberately disadvantaging Hachette books by removing the pre-order button, by disqualifying Hachette books from Amazon’s normal discount rates and so on. The outcome of this dispute will ultimately shape the future of publishing.

Technology companies always market themselves as the good guys
When it comes to technology companies like Amazon, there is often a presumption of innocence. They stand on the side of the consumer, lowering prices and changing our lives for the better. To a large extent that is true. But disruptive technologies always come at a cost – whether it’s lower quality, lower security, greater invasion of privacy or something else.
Take VoIP (voice over internet protocol). Internet voice calls are now the norm. VoIP technology is cheaper than the old circuit-switched technology they replaced but the sound quality is inferior, the connection is less reliable, eavesdropping is more commonplace and emergency calls are not guaranteed.

Take mobile banking. It has transformed our lives in terms of ease of use. But what are the risks? If the UK’s banking system is crippled by a large-scale cyber-attack the result could be a run on banks. Or worse, total economic collapse. Living standards may fall much faster and further than they did in the aftermath of the 2007/8 financial crash.

Disruptive technologies often replace something great with something cheaper. But, often, there are unintended side effects. Suddenly, when you assess the potential downside of a disruptive technology, the whole cost/benefit equation changes. We may come to regret a technology that we found so useful only months earlier.

The book publishing industry is going through just such a technological disruption with eBooks.

Amazon is leading the charge. The end outcome is hard to predict because technology is moving so fast.

EBooks themselves have only been around for ten years. Today they represent almost 15% of the global book market estimated to be worth $110bn, the remainder being print books. Yet print book sales are falling and eBooks are taking over.

With a 60% market share in eBooks, Amazon is poised to re-shape the book publishing industry in its own image, almost certainly destroying the traditional publisher’s business model in the process.

To survive, Hachette and other traditional publishers are going to have to learn to live with Amazon. The eBook market and Amazon’s dominance of it is here to stay. The question is what the rules under which this new market operates are.

Do Amazon and Hachette operate on a level playing field?
Amazon portrays itself as a consumer-friendly corporation dedicated to lowering book prices. Its real aim, of course, is to grab a larger share of the profits from the global book publishing industry for itself.

Commercially, this aim is laudable. There is nothing wrong with negotiating hard with one’s suppliers. But it’s one thing to apply pressure on your suppliers to secure a better outcome in a negotiation. And quite another to manipulate the market in order to achieve your aims.

If Amazon is able to suck out the lion’s share of the profits from the book industry on fair commercial terms it should be allowed to do so.

The question is whether Amazon is operating on a level playing field with opponents like Hachette.

Some of Amazon’s alleged tactics come close to what I would call market manipulation. Discriminatory pricing of Hachette books is one example. In the financial services industry, market manipulation is a criminal offence punishable with a prison term. Yet, internet companies like Amazon rarely seem to face the full wrath of regulators.

Regulators can fix this problem
Regulators by definition are a backward looking beast.
When it comes to disruptive technologies like digital publishing platforms, regulators are always behind the curve. They can take years to figure out how to regulate a newly created market like eBooks. By the time they finally get a grip on the issue it could be game over for the traditional publishers.

Moreover, regulators are loathe to be seen to be tampering with internet business models lest they be accused of clamping down on innovation or freedom of speech or the usual defences espoused by technology evangelists.

The real issue is that regulators are incapable of keeping pace with technological change. The result is that internet companies are getting away with murder.

Here are four examples of how internet companies have long been running rings around regulators.

First, there is the tax avoidance issue. Internet companies aggressively avoid both sales taxes and corporation taxes by creating complex corporate structures with tentacles in tax havens. Amazon, Apple, Google and Facebook all fall in this category.

Second, there is the issue of adherence to public broadcasting rules. Restrictions on broadcasting sex and violence apply to traditional broadcasters like television and radio, but not to internet companies. Even where online companies are clearly breaking the law – say with child pornography – law enforcement agencies tend to be slow to act.

Third, there is data privacy. Technology companies like Facebook and Google regularly breach Europe’s data privacy rules with almost total impunity, judging by the size of their fines.

Finally, there are a host of new online products that appear, at first sight, to be illegal – such as Bitcoin or Aereo – to which regulators are often slow to respond. Consumer protection suffers as a result.

When it comes to the book market, there are also growing signs that regulators have lost control. As a result, technology companies like Amazon are getting away with things that we would normally expect regulators to stop.

Here are three examples where regulators seem to have acted in a counter-intuitive manner:

First, there is the battle between Hachette and Amazon: Whilst Amazon is free to negotiate, there are clear signs that the technology company is engaging in abuse of market power. Regulators should be in a position to stop this.

Second, there is the case brought by the US Dept. of Justice against Apple for colluding with publishers to keep book prices high. Yet, Apple’s market share in eBooks was negligible at the time the case was brought. So why did the authorities not wait until Apple was a significant market power before launching the case?

Third, there is the issue of copyright infringement by Google. Google Books has been blatantly infringing copyright for a number of years by copying books with a view to profiting from their part-publication without author approval. This is theft (or piracy) by any legal definition. Yet regulators seem both powerless and reluctant to stop it.

By contrast, regulators often apply the full force of the law to the traditional publishers.

The sensible response from the Big Five publishers — Penguin Random House, Macmillan, HarperCollins, Hachette and Simon & Schuster — to the threat from Amazon would be to jointly develop their own competing digital platform and then to set wholesale prices for their books. Amazon would be free to purchase at that price or not. Consumers would have a choice of where to buy their books from.

But the problem with this kind of response is that it would almost certainly fall foul of the anti-competition authorities.

That’s a shame because there are tried and tested models for regulating industries undergoing root and branch re-structuring in other sectors.
In the UK telecoms sector, for example, BT held an effective monopoly on fixed broadband infrastructure, partly a legacy of privatisation. But the regulator agreed with BT a structure whereby BT can still own 100% of its assets in an autonomously run company called Openreach. BT Retail, together with rivals like Vodafone, TalkTalk and others then rent out BT Openreach’s infrastructure at wholesale rates agreed with the regulator.
Given our experience with the telecom industry, it does not appear beyond the capability of regulators to devise a similar system for the eBook market. That would allow the publishers to set up a rival platform to Amazon without being deemed to be acting in an anti-competitive manner.

What does it all mean for authors if Amazon wins?
In the short term, this is bad for Hachette authors like me who are being discriminated against by Amazon’s alleged dirty tactics.
In the longer term, everyone will lose.

Authors will lose as Amazon squeezes publishers’ profit margins. Squeezing them too hard will mean publishers may reduce author royalties and may be less inclined to take a risk on new authors. Ultimately there will be a loss of author talent and the reward for writing creative original content rapidly diminishes.

Readers will lose because they will see lower quality books, less original content and the loss of talented authors from the profession.

Amazon’s argument is that the opposite will happen. Amazon’s ecosystem makes it easier for anyone to become an author – they are heavily promoting self-published authors – giving everyone a voice. Traditional publishers are no longer required, argue Amazon, because they are just overpaid middlemen in an era when authors can simply publish directly online with Amazon. But Amazon’s argument merely validates my thesis that the quality of books will fall.

Anyone buying a book on Amazon can see the difference in quality between a book published by a traditional publisher and a self-published book. Authors at traditional publishers go through five or six gruelling editing rounds. Each time the book is improved. Publishers act as a gateway to quality reading.

But while publishers’ reputations depend on quality, Amazon’s focus is on volumes.

Regulators need to ensure a book industry which has a healthy dose of both quality and quantity by ensuring that all players operate on a level playing field.

Time is ticking buy. Regulators are in danger of missing the boat. By the time they finally get a grip on the issue, there may be no publishing industry to regulate.

Capping banker bonuses misses the point

First published on Huffington Post on 6 March 2013

Brussels is wrong to cap bankers’ bonuses, just as it was wrong to propose a financial transactions tax a few months ago. Its thinking, however, is along the right lines; having failed to manage their businesses responsibly, bankers need to be kept on a tight leash.

Under the current regulatory system, banks have been run almost entirely for the benefit of their employees. Important stakeholders such as the bank’s owners (shareholders), their customers (depositors and borrowers) and their guarantors (tax payers) are treated with disdain.

Any other industry that had caused economic damage on the scale that the banks had caused in the last few years would bow their heads down in shame and take a lesson in humility, espeically when it comes to pay.

Bankers refuse to accept responsibility for the mismanagement of their assets. Governments, by continuing to stand ready to bail them out, have ensured that banks have little incentive to reform the dubious practices that got us into this mess. Unreformed, banks are likely to stumble into another financial crisis, the bill for which will land on hard pressed taxpayers again.

The bonus culture was one of the three main causes of the 2007 financial crisis. By creating a “heads I win, tails you lose” environment, bankers were encouraged to take excessive risks with depositors’ money. Moreover, bonuses were paid on the back of profits which turned out to be fictitious because they were early estimates of gains on longer term transactions. These estimates turned out to be heavily biased, because the people calculating the gains were the same people who stood to benefit from them.

The second cause of the financial crisis was moral hazard. This refers to the situation where bankers know that they can gamble away our money, because the government will always be there to bail them out if they lose. Whereas the bonus culture allowed individuals to operate under a “heads I win, tails you lose” culture, moral hazard allowed banks themselves to operate under the same culture, ensuring that the normal rules of capitalism did not apply. Most markets are balanced by greed and fear. The problem with moral hazard is that it eliminates the fear, whilst fuelling the greed.

The third cause of the financial crisis was conflicts of interests. Investment banks act in their own interests rather than their clients’ interests. Some of these conflicts have manifested themselves in misselling, market manipulation, money laundering and fraud investigations. One of the biggest conflicts of all is how universal banks handle depositors’ money. Whilst most depositors expect their money to be invested in safe assets, bankers are incentivised to invest these deposits in risky assets, because risky assets generate higher returns – and therefore higher bonuses.

Governments looking to fix the banking sector need to tackle all three of these concerns simultaneously if they are serious about containing the next financial crisis.

Universal banks need to be split into retail banks and investment banks. The retail sector would have deposits guaranteed by the government; but the investment sector – which would not be allowed to take deposits – would have no such protection.

In addition, the investment banking sector would have to follow the Basel III guidelines on capital adequacy with immediate effect – rather than the leisurely 2019 timetable set out by the Basel Committee. The Vickers Report, commissioned by the British government, suggested a ring fencing of these two banking activities, but that leaves too much discretion to management. A full split would be cleaner, provide more accountability and would go some way to solving each of the three structural problems mentioned above. Moral hazard would be eliminated from the investment banking sector by this structural split. As a result, bonuses for investment bankers would be moderated. And the biggest conflict of all – bankers using deposits as cheap money to gamble with – would be outlawed.

Investment banks would then be free to pay whatever bonuses their shareholders sanction, subject to some sensible rules along the lines of the following:

No individual banker should get paid more than the CEO of the bank, whose remuneration should be sanctioned by a majority of shareholders.
Bankers’ bonuses should follow the norms of best practice performance appraisal processes, namely they should be based 50% on individual performance and 50% on the bank’s performance. That implies bonuses would be severely curtailed where a bank is loss making.
A “systemic banking crisis insurance fund” should be set up by the regulator with every retail bank, investment bank, hedge fund and shadow bank contributing an annual premium based on the size of their assets.
No bonus pool would be authorised by the banking regulator unless the bank has first:
(a) met the Basel II capital adequacy requirements
(b) made a profit after paying its annual premium to the systemic banking crisis insurance fund
(c) paid off all outstanding taxpayer bailout funds
Bonuses for investment bankers should be paid in the form of shares to be taken upon retirement.
Bonuses for retail bankers, given the job security effectively provided by a tax payer guarantee, should be capped at twice their salary and should also be taken in the form of shares upon retirement.
The standard argument used by bankers against keeping their remuneration on a regulatory leash is that banks need talent to prosper and talent needs to be rewarded. But this rationale ignores the nature of banks in the wider community.

Banks don’t sell cars or iPods or hamburgers. Banks sell trust. You go to a bank; you hand over your money; and you trust that the bank will look after it. Forever. When you’re in the trust business, you have to act honourably. And honour simply doesn’t sit comfortably with short-termism and greed. So to those people who say that we need to reward talent with multi-million dollar bonuses, I say you’re hiring exactly the wrong kind of talent.

UBS Trading Scandal: right verdict; wrong man

First published on Huffington Post on 23 November 2012

The blame for Britain’s biggest ever banking fraud has been pinned squarely on the shoulders of a one man. Meanwhile UBS, the Swiss bank that uncovered trading losses of US$2.3bn and veered close to bankruptcy as a result, has been painted the victim. But whilst Kweku Adoboli, the Ghana-born trader who perpetrated the fraud, undoubtedly deserves to go to jail, the real question is how such a crime could happen at one of the world’s leading investment banks and why no one higher up the chain of command is facing criminal charges.

Adoboli’s scam started in 2008. He exceeded his $100m daily trading limits and invented fictitious trades to hide his losses. Remarkably, UBS claims that it only discovered the true extent of the risk exposure they faced from his unauthorised trading activities in the summer of 2011. By August 2011, the bank’s risk exposure had ratcheted up to almost $12bn – enough to bankrupt it – but its back office was still blissfully unaware of its full magnitude. How can a fraud on such a scale go undetected for three years? And if it did, why has UBS’s trading licence not been revoked by the Financial Services Authority on the grounds that is its managers are not fit and proper to supervise trading activities of this kind?

Five years ago, Societe Generale revealed a similar trading fraud, disclosing losses of €4.9bn. The French bank too blamed these losses on a single rogue trader, Jerome Kerviel. In their defence statements at their respective trials, both Kerviel and Adoboli alleged that senior management knew what was going on at their trading desks. Both men also claimed that their bosses actively encouraged risk taking and sanctioned rule breaches when they judged them to be profitable, only to make scapegoats out of these junior traders when the losses spiralled out of control. Both banks vehemently deny that.

Banks are custodians of our money. We expect them to have watertight controls. If several staff collude to evade a bank’s internal controls, frauds are always possible. But those controls should be sufficiently robust – and involve sufficient segregation of duties – that a single person acting in isolation could never be in a position to perpetrate a fraud on this scale.

Most bankers will tell you the controls in place are fine. The problem is the culture prevalent at leading investment banks. This bonus-driven culture raises a number of concerns: how effectively are these controls executed; which departments wield the greatest influence within the bank; when are controls overruled and by whom; are shareholders’ – and deposit holders’ interests – foremost in the minds of senior management.

Banks, like all commercial businesses, have to balance making money on the one hand with managing risk on the other. But the bonus culture that has gripped the global investment banking sector over the last two decades has skewed that balance. Moral hazard (which refers to the concept that bankers will continue to take excessive risk as long as they know that the government will always be there to bail them out) creates further imbalances. And the conflicts of interest that are associated with investment banks’ activities – many banks have been fined for putting their own interests ahead of their clients’ interests – sways the balance even further away from sound risk management towards profit maximisation.

Front office staff – the traders – are charged with making money, whilst back office staff – the risk managers, operations managers and compliance managers – are tasked with monitoring risk. Tensions between the front office and back office can be high. Power struggles are commonplace.

It is inconceivable that mangers higher up the chain of command were unaware of the levels of risk taken on by traders like UBS’ Adoboli or Societe Generale’s Kerviel. Today’s high-tech trading floors have real-time monitoring systems. Typically, within a matter of hours, staff in the operations department would be aware of the trades and any material discrepancies. Within 24 hours staff in risk would be alerted to exposure levels, informing them whether risk limits were breached or that something else was wrong. From that point three scenarios could have come into play. The risk managers could have been too intimidated by the bank’s “star traders” to report their findings upwards; they could have been satisfied with the explanations given by the trading desk for the irregularities and made a judgement to close the matter; or they could have reported it upwards only to be overruled by senior management.

One reason that senior managers may have overruled them was because they believed the risk exposure levels to be acceptable. Their decision may have been influenced by the impact those trading positions were likely to have on their year-end bonuses. At the heart of this decision point lies the skewed relationship between the trading function and the risk management function at many investment banks. Until the 2008 financial crisis, risk managers at bulge bracket banks often had very little credibility at board level when confronted by a “star trader”, so many of these power struggles were won by the trading desk. This is partly due to the way banks are organised. In recent times the senior echelons of bank executives have been dominated by front office staff – the rainmakers. As a result, risk management has been grossly under-represented at board level.

Despite the fact that no UBS member of staff has come out in Adoboli’s defence, it is highly unlikely that Britain’s largest ever banking fraud was the work of one man acting alone. So it is worrying that prosecutors chose to go after a relatively junior rogue trader rather than prosecuting someone higher up the chain of command.

For many years, banks have been playing a complex game of chess with the authorities. Time after time, they have outmanoeuvred law makers, central bankers and regulators. It is a shame that the authorities have, once again, decided to respond to a fraud of this magnitude by killing a pawn instead of taking out a few knights.

How to fix the banking sector

First published on Huffington Post on 31 July 2012

As London’s banking sector lurches from one crisis to another, ordinary Londoners can only despair at how long it is taking regulators to clean up the city. Following a series of government-commissioned reviews of the city’s practices — from the Vickers report on banking to the Kay review on equity markets – one could be forgiven for assuming that the authorities are close to regaining control.

The causes of the original 2007 credit crisis can be summed up by three phrases: the bonus culture, moral hazard and conflicts of interest. Yet, despite the burning of midnight oil by Treasury officials, Bank of England supervisors and academic experts all producing pages upon pages of post-event analysis, the government still appears to be clueless about what the core problem in the banking sector is or how to go about fixing it.

Moreover, with a series of fresh scandals breaking out in recent weeks, many experts are now calling into question the scope and conclusions of some of these earlier assessments of the state of the banking sector. Just a few months ago, when the bonus season kicked off, many of the larger investment banks insisted on paying out bumper bonuses to their staff. Yet this time it wasn’t left-wing protestors that questioned their rationale; it was their own investors who argued that bank employees were taking out far too much in relation to bank owners, shareholders. Then there were the series of mis-selling scandals involving mis-sold insurance and other financial products, costing bank shareholders £8 billion in fines alone. Then JP Morgan, the golden boy of risk management, informed us of its own failure to manage risk, resulting in losses of $6 billion and rising. Then the LIBOR scandal erupted where traders at a multitude of banks were involved in attempting to rig key interest rates used by governments, corporations and homebuyers around the world. Finally, RBS allowed its IT controls to deteriorate to such an extent that its entire banking system crashed in the aftermath of a botched software upgrade, causing millions of customers to lose access to their funds for days.

The core problem for London’s investment banking sector is a problem of culture. Sort out this cultural problem and the three main causes of the banking crisis — the bonus system, moral hazard and conflicts of interest — can eventually be overcome.

The bonus culture
In the boom years, bankers justified record bonuses by pointing to record profits. In the barren years, they justified record bonuses by pointing to how fast they could turn record losses into record profits again.

And herein lies the problem. You see, the problem with banking is that you never know what profit you’ve actually made until years — sometimes decades — later. It’s always a guess. After all, many bank executives reported record profits to their shareholders in 2005 and 2006 only to hit them with the biggest banking losses in banking history just a year later in 2008.

Banking profits are much harder to calculate than profits in other industries. Take motor cars. At Ford, things are pretty simple. They bought this much steel, this much plastic, put it together with a bit of electronics and wheeled out this many cars. Make a few adjustments and hey presto, this is your profit — or loss in their case. The key thing is, in the majority of industries, most of that profit is actually generated by selling your product and banking the cash. Profits will, of course, be manipulated by accounting adjustments and be affected by year end stock levels. But the maximum stock a car company, say, might hold could be a month’s worth of cars, maybe two months.

At a bank the maximum stock — by way of loans — could be 20 years. So we cannot be sure how much profit the bank will make on some of these loans until twenty years from now! But whilst a bank’s profitability can only be sensibly estimated over the long term, bonuses are paid out in the short term. If things turn sour from one year to the next and you’ve paid out too much in bonuses — tough.

Banks can manipulate profits like my baby daughter can manipulate her daddy. Banks calculate a big element of their profits not by what they’ve sold, but by pricing what they haven’t sold. In the jargon, it’s called “mark to market.” These profits are sent up or down at the click of a computer mouse. They’re not based on real sales — like they are at Ford, or Apple or McDonalds. They’re based on guessing the value of their assets. But that guess is rigged. Because the higher the valuation of those assets, the higher the bonus pool for the banks’ key executives. By the time we figure out what the real value of a bank’s assets are — the bonuses have already bolted out the door. And all your left holding in your hand is the same stuff that I’ve got every morning right after my daughter’s nappy change. And it stinks.

The banking industry’s line on bonuses is, of course, predictable: Talent has to be rewarded. Risk takers have to be rewarded. Last year the global banks set aside over £100 billion for their bonus pools. Yet what risk have banking employees taken at a time when their entire business has been underwritten by taxpayers? George Soros, the legendary investor, summed this up in an interview he gave to the Financial Times in the midst of the banking crisis, “Those earnings [referring to bankers bonuses] are not the achievement of risk-takers. These are gifts, hidden gifts, from the government.”
But banks don’t sell hamburgers, or cars or iPads. Banks sell trust. You go to a bank, hand over your money and trust that they will look after it. When you’re in the trust business, you have to act honorably. And honor simply doesn’t sit comfortably with million dollar bonuses.

So to those people who say that we need to reward talent with multi-million-dollar bonuses, I say you’re hiring exactly the wrong kind of talent.

Moral hazard
Some would say that if you live by the sword die, you should die by the sword. The sword of bankers is capitalism. The first rule of capitalism is that you should protect capital; yet all banks failed to do that. The second rule of capitalism is that it is survival of the fittest; yet bankers expect taxpayers to bail them out when they lead their businesses to the brink of bankruptcy. The third rule of capitalism is that the providers of capital should reap the biggest rewards. Yet the biggest provider of capital to UK banks over the last five years has been the UK government — on behalf of the UK taxpayer. We have provided direct capital injections into banks like RBS and HBOS and indirect capital support to banks like HSBC and Barclays, who would have lower profits had taxpayer’s money not come to their assistance. Yet, as the largest provider of capital, the UK government seems to have little control over how its own capital is allocated. No doubt that is partly because the capital was handed over to the banks at a time of crisis, when the Treasury was more concerned about averting financial meltdown than negotiating a good deal for the taxpayer. Yet now, after averting the banks from bankruptcy, the banks seem to be in a state of ’employee capture.’ Bank employees are grabbing capital provided by their shareholders to enrich themselves rather than using it to recapitalize their banks. That’s not supposed to be how capitalism works.

And that’s because capitalism in the banking sector has been distorted by moral hazard — the concept that bankers will continue to take excessive risks with other people’s money as long as they know that the government will be there to bail them out.

The concept of moral hazard is against the instinct of all free market economists. In capitalism, if you take big risks and fail, you go bankrupt. That’s the end of it. In the banking sector however, several banks took large risks, secure in the knowledge that they were too big to fail.

Now I’m not going to argue why we need to save big banks — that’s obvious — the economy would collapse if the banking system collapsed.

What I want to focus on is why have banks taken on such big risks. And that leads me to the conflicts of interest that continue to plague the banking sector.

Conflicts of interest
Now there are many types of conflicts of interest within a large investment bank. My book, City of Thieves, for example, covers one type of conflict – the conflicts an analyst faces every day. He’s under pressure to change a rating because somebody somewhere in the bank stands to make a lot of money by manipulating stock ratings. That type of conflict is well documented. It was headline news in 2002, when Eliot Spitzer, the New York attorney general humiliated the top 10 U.S. investment banks by pointing out that analysts like Merrill Lynch’s Henry Blodget were telling clients to buy internet stocks whilst internally saying they were crap.

Spitzer fined the banks $1.4 billion for allowing these conflicts to go unchecked. A year later he was very publicly discredited when he found himself embroiled in a prostitution racket. That was pretty convenient for the banks. Since then very few regulators have had the guts to take on the banks with quite the same vigor and success as Spitzer. So the banks just returned to business as usual. Back to precisely the same bad old tricks, for which they had been fined $1.4 billion back in 2003 by Wall Street’s highest ranking law enforcement officer.

As a result of the conflicts exposed by Spitzer, pension funds and other big investors still — to this day — do not trust the stock research flowing out from the big banks. There’s always an angle, always a hidden agenda behind it. An analyst at a big bank is supposed to provide independent analysis. But he has a lot of big hitters to please back at head office — the commercial lending guys, the M&A guys, the equity capital markets team, the derivatives team and the fixed income guys. And it shows in their research.

Going one step higher than conflicts faced by stock analysts, the mother of all conflicts of interest is how banks handle your money. Remember bank’s sell trust. You give them you’re money and trust you can get it back any time. You might even pay them a fee to hold it. You expect them to take care of it, to put it in safe investments. But of course safe investments don’t generate big returns. Risky investments generate big returns… and big bonuses.

So the biggest conflict of all in a bank is that bankers are tempted to put money — your money — that should be destined for safe investments into risky investments, without telling you about it.
It’s a major conflict because it goes to the very heart of what banks are — custodians of our money.

Conclusion
All throughout my career I saw the good guys in the city fall like flies. Those who refused to follow questionable practices were laughed at and thrown out onto the street. They weren’t part of the club. They were the losers. Greed was good. Well, nobody’s laughing at the good guys now. There aren’t enough of them.

As a society, our livelihoods and even our happiness are to a large extent determined by the morals and values that we are taught to hold dear. They are ingrained in us from an early age and they form the fiber of our being. We never really think about them until they are undermined.

Until the culture within the banking sector is systematically overhauled by regulators whose policies reflect the moral code of our society as a whole, we will never put our banking sector in order.

Regulating banks is not so easy

First published on Huffington Post on 18 July 2012

Many of us blame the FSA and the Bank of England for the banking crisis that has brought such turmoil into our working lives. They should have spotted the reckless behavior of bankers before it got out of hand and nipped it in the bud years ago.

Really?

It’s easy to bash regulators. But it’s not so easy to be one.

Banking regulation is a difficult balancing act because your number one priority is to ensure banks don’t go under. Yet banks by the nature of what they do are always technically bankrupt.

To be bankrupt means you are unable to pay short term debts as they fall due.

Banks borrow short term and lend long term. At any point in time they are always technically bankrupt, because they are unable to pay all their depositors at once, because of the maturity profile of their assets. The only thing that actually stops banks from going bankrupt every day is confidence in the banking system. And the job of the regulator is to maintain confidence in the system. So the Bank of England, when it was in charge, had sensible rules that had been developed over hundreds of years to safeguard depositors’ assets — to make sure that our money was rarely put at risk

Some of these rules were just plain common sense: don’t lend over three times a borrower’s income; keep sufficient general reserves to allow you to cope with bad times; pay bonuses only out of profits not out of revenues; and the golden rule — don’t invest in anything you don’t understand.

In 2007, when the credit crunch began to unfold, not one of these basic common sense rules was being followed at any major bank.

Why?

Partly greed, partly the global nature of banking flows and partly bad regulation.

The greed refers not just to bankers’ unrelenting search for profits, but also to our own individual craving for more credit, more material goods and more instant gratification.

The global nature of banking flows means that many bankers have been able to profit from regulatory arbitrage: shifting business activity to jurisdictions where regulation was more lax. For some financial products, it was London itself that had the most lax regulatory environment.

Bad regulation stemmed in part from Gordon Brown’s weakening of the Bank of England in 1997 and his creation of a tripartite structure involving the Treasury, the Bank of England and the Financial Services Authority. Regulation by committee gave banks a license to run wild, slipping through the gaps between these three bureaucratic institutions. Then, of course, there is the small matter of competence. Regulators simply do not understand all the new banking products that have been emerging with alarming speed. It’s not because the products were particularly complicated or that regulators are particularly stupid — although both are undoubtedly true. It’s because banking itself had become too complex for any one human brain to comprehend.

But by far the biggest problem the typical regulator faces is exerting authority over the bankers themselves. Let’s put it this way, how do you give orders to someone who is taking home 100 times what you make? It kind of saps your confidence in the system, don’t you think?

Honour amongst bankers

First published on Huffington Post on 11 July 2012

Appointing a trader to run Barclays, one of Britain’s finest retail banking names, was a big mistake. Almost as big a mistake as appointing Andy Hornby, an ex-supermarket boss, to run HBOS. Neither had the right skills for the role of chief custodian for our deposits: one was too willing to gamble it away; the other was a salesman who did not understand risk. Thankfully, both are now gone and the British banking system is that much safer for it.

The LIBOR rate-rigging scandal that forced Bob Diamond’s hand is symptomatic of an industry that has lost its way and betrayed customers’ trust. Let us hope that the next generation of bankers follow a more acceptable moral code. Like many senior executives in the banking sector, Mr Diamond and his board forgot what banking was about.

Banking is about honour
The most important issue in banking today is the ethical issue. Are banks behaving responsibly? In order to answer that question, it’s worth reminding ourselves what banks actually do.

Banks don’t sell cars or iPods or hamburgers. Banks sell trust: you go to a bank; you hand over your money; and you trust that the bank will look after it. The problem is, when an industry is based on trust – solely on trust – there is an i lot of scope for abuse.

Over the last 10 to 20 years, bankers have blatantly abused that trust. Simply by not putting aside enough money – enough ‘capital’ – to guarantee that they could pay back the money they owed in good times and in bad.

Now trust takes a long time to acquire. London became a leading banking centre because it had built up trust over the centuries. Then somewhere along the way, the honour dropped out of the banker’s dictionary. Traditional, safe banks became hijacked by pirates, by treasure hunters, by risk takers. People who rarely risked their own money, but were happy to risk yours. And to add insult to injury, they’d get you to pick up the losses whilst they kept the bulk of the profits.

How did this come about? And have so many commentators branded this an Anglo Saxon banking crisis? The origins of this crisis lie in two regulatory changes on either side of the Atlantic: the first was “Big Bang” which began in the UK in 1986; and the second was the Repeal of the Glass Steagall Act in the USA in 1999.

Big bang was the sudden deregulation of the UK’s financial markets under Margaret Thatcher. It was done to make London an attractive place for foreign banks to set up shop. And it worked. It became easier to get a banking licence and you could do more with it. Everyone, especially the American banks, came to London to do what they weren’t allowed to do by law in their own back yard: take excessive risks and invent highly complex products that no one could understand.

London became one big free-for-all and banking became ridiculously complicated overnight. No one could understand how everything fitted together any more, or how some of these fancy derivatives worked, least of all the boards of the banks that took big risks with our money.

The Glass Steagall Act was America’s response to the credit crisis that created the Great Depression in the 1930s. Its sole purpose was to prevent bankers from putting savers’ deposits into risky investments. It separated retail banking from investment banking. The risky bit of banking would stay in investment banks and the safe bit in retail banks.

There was a good reason for this split. Depositors regard banks as an institution whose core role is to safeguard their money. Attaching a casino to a bank is not the best way to do that. President Clinton repealed the Act in 1999. That allowed the investment banks to take your money and gamble it away, laying the foundations for this crash.

So within two decades you had a banking regulatory environment that was just asking for trouble on both sides of the Atlantic. In the UK, you had regulation that was so light it was virtually invisible. In the USA, you had the government openly signalling to their banks that it was OK for them to invest depositors’ money in risky assets like sub-prime debt.

As if that weren’t enough, you also had cheap money, thanks to Alan Greenspan, the Chairman of the Federal Reserve. That meant banks could borrow money at very low interest rates. Cheap money can be a good thing if it is used to lend to solid, growing businesses to generate wealth and jobs. But when cheap money is simply used to make the bankers themselves rich, that’s what Lord Turner was referring to when he described them as socially useless. And that’s what they did. The banks used cheap money to gear up their own positions to absurd levels. For example, Lehman Brothers balance sheet, just before it went bust, had a gearing ratio of 40x. That meant that for every £1 of its own money it invested, it borrowed £39 from someone else. In the old days, that ratio was closer to 2 or 3.

Can anybody spot the problem? If you did, you’ve passed the test to become CEO of an investment bank. Congratulations. We know from our own experience that too much borrowing can bring us down. Yet, the banking regulators ignored this danger. They simply left the banks to manage their own risk, to police themselves. Then, they feigned shock horror when the bankers turned London into a City of Thieves…

“City of Thieves”
Back in 2003, after 14 years of working in the financial services industry, I no longer liked what I saw. So I took a sabbatical year and wrote a book about what was wrong with banking. When I approached publishers they said it was too far-fetched. Just not credible. Bankers simply wouldn’t be so unethical, they told me. So the book sat on my bookshelf gathering dust. Five years later the credit crunch came along and I had more literary offers than I knew what to do with.

“City of Thieves” is a murder thriller set in London’s banking sector. It tells the story of one man’s fight to protect his honour in a world where honour holds no value. Written from the viewpoint of a young analyst who stumbles almost by accident into a high-powered banking job, the novel delves deep into the characters that make the City what it is. My aim in writing this story was to show how badly things can go wrong when a bunch of alpha males are given other people’s money and set free on the markets. My hope is that the next generation of bankers put honour back into banking.

City of Thieves is published by Sphere and is available on Amazon and all good book shops around the world.