March of the regulators will destroy banking innovation

Greedy, flashy, obnoxious and, when it all goes wrong, dangerous. Nobody liked bankers very much even before the crash of 2008, and ever since they have been about as popular as Russell Brand crashing the Tunbridge Wells Conservative Party’s Christmas bash.

Politicians have been competing with one another for new ways to tax them, and regulators have been devising ever more ingenious rules for bringing them under ever tighter control. At this rate, zoo animals will have more freedom of movement than the average City banker.

There is a problem, however. In the same way that generals are famous for fighting the last war, regulators are very good at fixing the last crisis, while also setting up the next one. Right now, they are doing that with the financial system. They are clamping down on a rampant bonus culture they believe created a culture of reckless risk-taking. But what they will end up doing is destroying innovation and new ideas – at precisely the time when the banking industry needs both commodities more than ever.

From the beginning of next year, bankers are going to be subject to stricter rules on how they are paid. Under a system drawn up by the Bank of England, bonuses will be subject to a seven-year clawback provision. You might pull off a clever deal in one year, and make a lot of money for your firm. But if the whole thing blows up a few years later, and the firm then loses a packet, you’ll end up having to pay the money back. It will be one of the toughest regimes on bonuses anywhere in the world.

At the same time, the European Parliament has decided to limit the bonuses that can be paid to bankers to the equivalent of a year’s basic salary, or double that if there is shareholder agreement. The Bank of England and the Treasury have been fiercely critical of those rules, arguing that they place too many restrictions on the City’s ability to compete against rival centres.

But in fact, both sets of regulation are heading down the wrong path. The issue is not so much that the EU is attacking the City out of jealousy at its success, although there is an element of truth in that. Nor is it that the regulators are not being smart enough at finding ways of forcing financiers to think for the long term. It is that they are backward looking, fighting the symptoms of the last crisis, instead of attempting to create a financial system that does not suffer from regular crashes.

Speaking to a Lords committee on financial regulation last week, HSBC chairman Douglas Flint made an interesting point about the clawback rules. He argued that the real problem was that it set up a system for paying bankers that was completely unlike anything that operated in any other industry. “When you say to someone in the tech industry that you’d like them to join banks to help with cyber risk, and say your money will be paid in seven years’ time, it’s an easy conversation – they decline to consider it,” he said.

True enough. The deal for bankers will be that they work on something, often very hard, and then they might or might not get paid in seven years’ time. And if they do get paid, and then use the money to buy a house, or pay their children’s school fees, they might have to pay it back in three or four years’ time. No one else is on that kind of deal. IT staff don’t get paid several years after they have done some work, nor do engineers, retailers, footballers or anyone else. Arguably entrepreneurs accept that they will be paid several years in the future, but they also have a lot of control over what they are doing – and also when and on what terms they can sell out.

Not only is it a very odd deal, it is a bad one as well. After all, markets can change dramatically in seven years. Other people may come along and change a structure you set up – and do so in a way that loses money. You neither have any certainty about your earnings, nor any control over them.

Next, take those bonus rules pushed through by the EU. Again, in what other industries are bonuses capped in such an arbitrary way? It would seem very odd if the designer of a hit computer game couldn’t be paid more than a year’s salary in bonuses for his or her efforts, or an advertising executive faced restrictions on what they could make from a campaign that boosted a client’s sales dramatically. Bankers will face far tougher curbs than any other comparable industry.

Plenty of people will say that doesn’t matter. The bankers were out of control and have to be brought to heel somehow or other. But it means banking will become an entirely closed industry. Anyone from outside the industry will look at the restriction on pay and bonuses, shake their heads and say, no thanks, that’s not for me. The financial sector will become completely insular, unable to recruit staff outside of its own narrow circle.

In the past, that might not have mattered very much – but right now it does. Finance is going through a period of shattering technological change, and that is only going to accelerate from now on. With the rise of peer-to-peer lending and borrowing platforms, payment systems from Apple and other tech giants, web-based advice systems and so on, the traditional ways of doing business, in both retail and investment banking, are being overthrown. This week, Lloyds is expected to announce the closure of dozens of branches, and the loss of thousands of jobs, as it adjusts to the rise of online and mobile banking. Dozens of new competitors, including giants such as Apple and Google, are about to crowd into the market, blowing up cosy cartels.

To respond to that, the banks need to bring in new people and new ideas – and they will need to get them from other industries. If they don’t, they will go into rapid decline. And companies that see their sales and profits decline start to bend the rules and take bigger risks, and cut more corners. We have just seen that at Tesco – when its sales started to fall, it started twisting the numbers. And we have already started to see it in banking, as declining branch operations mis-sell policies – because they can’t make money from day-to-day banking anymore.

The most likely cause of the next financial crisis is not bonus-hungry deal-makers taking crazy risks, it is banks overwhelmed and threatened by technological change becoming more and more reckless as they try to keep failing business models alive.

What the regulators should be concentrating on is making sure the banks can hire the people to steer them through that process.

Instead, by forcing them to become completely insular, they have made another crash far more likely.