Page last updated at 19:33 GMT, Tuesday, 26 January 2010

City Diaries: President Obama's new banking regulations

Man looking at a falling graph

This week our City Diarists discuss President Obama's new banking regulations and the US bank levy. It is reasonable that banks pay back what tax payers have lost? And could the same happen in the UK?

These diaries are written by people who work in finance and have had a front row seat as their industry goes through the biggest changes in decades.

They give us regular insiders' updates on the mood in the City of London and the dramatic changes in the world of finance.

STEPHEN

Stephen (not his real name) has worked in the City of London for over a decade.

Trader at computer
"Losing money teaches you a few home truths about yourself"

Humility - it's never been a word associated with "banker".

But you see an odd thing in the money business: a large number of the world's most successful traders work outside of the banking system and are sensible, unassuming types. Far from seeing it as something to brag about, plenty find their own success faintly ridiculous.

Contrast that with derivatives bankers I knew in the 90s who freely admitted that what they were doing would inevitably collapse, spectacularly. They did not care, saying "by the time it blows up, I'll be long gone." Presumably they're not the sort of people who care about their own vilification, but it's a pity they did not stop to consider what sort of world they would live in when the crash finally happened.

Some City workers were cheering President Obama's announcement

As a young trader I was told by my boss "the market will find your weaknesses and stomp up and down on them until you fix 'em or run away. Every time you start to think too much of yourself, it'll crush you."

He was right. There is nothing quite like losing a lot of money to teach you a few home truths about yourself. Successful, independent money managers learn to pull in their horns after a winning streak and take a break.

Despite the work traders do and the rewards that can be potentially gained, they are fundamentally no different from anyone else and it's important to remember that.

Our banks failed not only because of the short-termism of the reward structure, but also because they were taught not to fear their own financial mortality. Every time there was a small crisis, the central bankers stepped in to save them. They had no reason to be humble.

Obama's message

The US administration's proposed bank levy is the first step into a new financial reality, but this was immediately dwarfed by what came later in the week.

It may come as a shock to readers, but some City workers were cheering President Obama's announcement. Some of us appreciate things cannot go on as they are. Bankers have no entitlement to success, protection or special treatment, especially when their profits and bonuses are built on special privileges allowed only to banks. And their gilded lives should not be underwritten by future generations if they get it wrong.

It is absurd that taxpayers are losing their houses whilst culpable bankers are not

This blog has called for a separation between investment banking and utility banking. I'm delighted at Obama's square-on challenge to the banks and desire for a big fight.

But we have to be cautious because Obama's declaration was short on detail. It's devilishly difficult to define "proprietary trading". Specifically, hedging of client trades is an imperfect art.

Obama's announcement could be as popular with the people as it is earth-shattering for the bankers, but we need to wait and see whether he delivers before concluding it's not just a desperate act of populism.

Claw-back

Nevertheless, the absurdity is that taxpayers are losing their houses whilst culpable bankers are not. To solve this, the real solution is a simple "claw-back" regulation: bailed-out institutions would be forced to reclaim previous bonuses and to direct future profits (read "dividends") to repay bail-out funds. Also, executives would have to be prevented from leaving, to prevent poaching of top talent.

As extreme as this might be, it is absolutely necessary to connect the bonuses of bankers and income for investors with the costs of the crisis. A bail-out without consequences is not a penalty but a reward, which induces rather than discourages risky behaviour.

A claw-back would end the extreme individualism that causes bankers to care about only their own area and not keep an eye out for potential problems in others. Fear of losing previous bonuses would make banks stick to steady, sure-fire activities. Bankers would then not only cease to benefit from financial crashes, but actually underwrite them. And then, just maybe, they could develop a bit of the humility - and wisdom - that they are still so lacking.

ANTHONY

"Anthony" (not his real name) works for an investment bank in the City.

Traders work the floor of the New York Mercantile Exchange in New York City
"If you regulate the banks out of existence ultimately the economy suffers"

One hundred and seventeen billion dollars may sound like a lot of money but spread over 50 banks and over 10 years it does not amount to much. It averages at about a $250k per year which is barely one middle tier trader's bonus. I know the big banks will pay proportionately more but it is not going to cause the banks much concern.

As far as the UK is concerned, it seems I was wrong when I said in a previous blog that I thought the tax would not result in such a boom for the Treasury. First, the banks seem prepared to continue to pay bonuses, and also I had not appreciated that the tax is being levied as a payroll tax, and therefore will not be eligible to be offset against losses made by the banks in previous years.

Confusion still reigns about who will actually have to pay the tax. But in general the chancellor has got the result he wants, as he will get a much needed boost to his coffers in 2010.

Switzerland has been actively lobbying to lure City workers away from London

It could mean that the windfall gain in 2010 is more than offset by a fall in tax revenues, as London's financial services centre is severely reduced. I was right when I predicted that hedge funds would leave London to set up in Switzerland.

One of the Zurich cantons has been actively lobbying in London, they are hoping to lure people away with a promise of clean air, transport that runs on time and low taxes. Unless places like Switzerland play ball, the UK will suffer. The only thing in our favour is that London is a much more vibrant city in terms of culture and night life. I have worked in Switzerland and the experience is very peaceful but also boring.

Overreaction

The fact that UK banks are prepared to pay the bonus tax is an indication that they are much more concerned about retaining their top earners. What is more concerning is the muddled reaction to changes in regulation which will force the banks to hold a lot more capital. Having failed to regulate the banking sector, the reforms are an overreaction to an economic crisis which may not occur for another hundred years.

So what, I hear you say. The banks deserve it. The problem is that if you regulate the banks out of existence then ultimately the economy suffers.

That's fine if you think we don't need financial services and all the taxes they pay to keep this economy going, but what would we replace it with? I would love to see us do more manufacturing and less financial services, but is that really a viable proposition?

So, Mr Politician, think seriously before you hit the banks again with more taxes. Your exit strategy is to sell the banks that you bought at a profit and then reimburse the taxpayer. Do not introduce an Obama-style tax.

LAURA

Laura (not her real name) works for a commercial bank in London

Barack Obama
"The fiendish simplicity of Obama's proposal made me laugh"

In a similar way to payment protection insurance on your credit card debt, the Americans are levying a "premium" on bank profits for the next few years to recoup the amount invested by US taxpayers into the industry. Individual banks that were bailed out have to repay both the money they borrowed and, if they are above a certain asset size, the levy on top.

What made me laugh about this proposal was the fiendish simplicity of it all. No messing about with a certain rate of tax paid by the employee here and a different tax paid by the employer there. Once again the Americans take a bit of time to work out what they want and deliver it in a simple package which no amount of non-domiciliation can avoid.

The irony here is that the American government is likely to extract a larger tax chunk from the UK banks big enough to qualify (including RBS), than the Treasury will with their political point scoring bonus tax. In addition, as no staff are directly affected (although lower retained profits may mean a lower overall bonus pot), few people if any are going to bother looking into relocation from New York to Zurich.

You do wonder what other horrors this will bring out of the woodwork

There are occasions where showing your hand first can be an advantage - you can hail yourself as the leader on an issue, and shape world policy and debate. On other occasions you are just giving your competition the chance to out manoeuvre you, or to improve upon flaws exposed by public scrutiny. I believe that this is one of those occasions where in our desperation to be "decisive", and to take the lead on being tough against bankers we have shot ourselves in the foot. I expect another derogatory comment from a French official about British economic policy in the next few days.

Gamble

Amusing as the above diversion was for the financial press, far more concerning is the ambiguity over regulatory capital requirements in the medium term. Adopting Basel II requirements early is proving to be an uncompetitive move as pricing on lending is being forced up, and return for savers forced down. You do wonder what other horrors this will bring out of the woodwork in those banks which are still trying to work out how to sell half their business and avoid becoming a basket case, let alone changing systems, credit procedures and pricing models that are needed under Basel II.

The Basel Committee have already revised their previous suggestions for liquidity of banks so there is a gamble being played out in financial services. Do you start seriously complying with Basel II requirements now or do you wait until the music stops and there is a definitive policy established? If you move now you could end up overcompensating and duplicating work, if you do nothing you could see an even sharper change required in a shorter amount of time.

In economic terms, it is the classic "Prisoner's Dilemma".

Several central bankers have warned that requirements under discussion are edging too far into the realms of a straight jacket on the global economy. We shall have to wait and see, but the bank bashers out there may want to be careful what they wish for.




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