STUC Submission to the Economy, Energy and Tourism Committee’s Inquiry,

‘The way forward for Scotland’s banking, building society and financial services sector’

Introduction

The STUC welcomes the opportunity to contribute to this important inquiry. The 2008 global financial crisis, of which the problems in the Scottish banks and building societies were a part, represented, the STUC would argue, the inevitable implosion of the ‘financialised’ economy. Whilst we cannot claim to have predicted the timing, scale and pace of events over the past year, the STUC can point to a consistent track record in questioning the sustainability of the economic model promoted by governments of all hues over the past 30 years.

Both the scale of the crisis in UK banks and the extent of its impact on the wider economy and ordinary workers are already being deliberately downplayed by those who will benefit from a ‘return to normality’. The opportunity for a fundamental overhaul of a failed economic and social model is in danger of slipping away before the implementation of any meaningful reform.

Therefore, the STUC believes it is essential that, at the very least, the public consultations and inquiries currently underway result in transformative change in the way the sector is regulated and financial companies managed. The financial sector must return to performing its basic functions effectively: mobilising savings, allocating capital and managing risk, transferring risk to those more able to bear it.

In doing so, the STUC believes that the financial services sector in Scotland can continue to be a key provider of quality, sustainable employment. The STUC believes that any reputational damage inflicted on the Scottish financial services sector is repairable. The aspiration must now be to rebuild a banking sector which supports rather than undermines the wider economy.

Questions

To answer the specific questions set by the Committee:

1. What is your view on the cause, nature and impact of the recent difficulties in the financial sector in Scotland?

Cause

It is impossible to a) separate the problems in Scottish banking from the wider global financial crisis or b) identify a single cause. The STUC believes that a number of factors conflated to produce the credit and housing bubbles which culminated in the 2008 global financial crisis:

I. Global macro-imbalances - ultimately, the roots of the crisis can be traced to the global macro-imbalances that have grown rapidly over the last decade. These are commonly believed to have driven two main effects: rapid credit expansion in developed nations and a ‘search for yield’ among investors; these processes in turn provided fertile conditions for the growth of complex financial innovation and, in the end, resulted in crisis.

II. Financialisation - The US economist Thomas Palley identifies 3 principal impacts of financialisation: (a) the elevation of the significance of the financial sector relative to the real sector; (b) the transfer of income from the real sector to the financial sector; (c) greater income inequality and wage stagnation. To these can be added a fourth; the sector’s extraordinary lobbying power.

III. The emergence of banking conglomerates - facilitated by deregulation and globalisation, huge financial conglomerates emerged which combine the traditional banking activities of borrowing and lending with asset management and advisory services. As John Kay has noted, ‘these institutions were riddled with conflicts of culture and of interests. They proved largely unmanageable and were largely unmanaged’ .

IV. Innovation - The belief amongst bank executives, other participants in global financial markets, regulators and government that financial innovation - particularly securitisation - had fundamentally changed the system was deeply held. Widely dispersed risk, so the argument went, provided for greater stability and negated the need for large capital reserves. Of course, when US sub-prime losses hit, it was discovered that this complex financial innovation had 1) led to the creation of products on which no accurate value could be placed; and, 2) ensured that the consequences of irresponsible lending in specific markets would be rapidly globalised.

V. Failure of corporate governance - bank boards were either incapable of identifying, or unwilling to object to, the unsustainable business strategies being pursued by those whom they supposedly had a duty to oversee. It is difficult to escape the conclusion that the primary cause of the recent problems in the Scottish banking sector was this abject failure of corporate governance.

VI. The prodigious growth of, and influence exerted by, the unregulated shadow banking system - to get around capital ratios and maximise profitability, the banks set about creating a huge and complex network of structured investment vehicles. Together with a growing hedge fund sector, this massively reduced transparency; rendering effective regulation practically impossible.

VII. Remuneration practices - there can be little doubt that the bonus culture encouraged excessive risk taking in an already fragile system. The arguments hitherto invoked to justify the massive rewards have been revealed as superficial and self-serving. It should now be abundantly clear to all that incentive pay may work for those performing the most basic, routine tasks but, in situations of any complexity, especially where the quality of decisions made is only revealed in the longer-term, pay that truly reflects performance is not only unachievable: the attempt to make it so is catastrophically counter-productive.

VIII. Conflicts of interest - the relationship between banks, auditors and, especially, credit-rating agencies, is replete with conflicts of interest - a state of affairs scandalously overlooked by government and regulators. For instance, credit rating agencies singularly failed to discharge their duty in relation to credit derivatives. To do so, would have jeopardised easy profits. In the majority of cases, UK listed banks paid considerable fees to their auditor for non-audit work. Of course, the most obvious and damaging conflicts were inherent in the financial conglomerates themselves.

IX. Regulation – regulatory authorities manifestly failed in the effective discharge of their functions. As indicated above, regulators were far too ready to accept the claims being made for financial innovation. It is also worth remembering that, until the crisis hit, it was not considered good form to raise any concerns over the potentially destabilising impact of the bonus culture. To have done so would have invited scorn from the beneficiaries and their supporters in the press, politics and government.

In relation to the Scottish banks, it is difficult to disagree with the assessment set out in the Treasury’s Reforming Financial Markets consultation paper: the firms that failed in the UK typically allowed their business to become overextended through:

• Excessive leverage and risk taking - between 2001 and 2004 HBOS jumped from being the 33rd largest to the 5th largest arranger of leveraged loans (loans whose interest rate is substantially higher than the base rate due to perceived higher risk); • Over-reliance on wholesale funding - when the inter bank markets seized following the collapse of Lehman’s, the business strategy disintegrated; • Poor management in respect of acquisitions - such as RBS’s decision to purchase ABN-Amro at the top of the market; and, • Over dependence on particularly risky product streams, such as buy-to-let mortgages and derivatives - the bubble mentality undoubtedly infected the business strategies of supposedly sober and respectable institutions.

These failures confirm the woeful inadequacies of corporate governance.

Impact

The impact has been severe. The global economic recession of 2008/09 is directly attributable to the credit crunch which began in summer 2007 as the housing and credit bubbles in the US and UK burst spectacularly. The impact of the credit crunch rapidly intensified following the collapse of Lehmans.

In Scotland, in the year to June 2009, employment has fallen by 54,000 and ILO unemployment risen by 75,000. The unemployment rate for Scotland has risen by 74% over the year to June. The corresponding figure for Edinburgh and the Lothians is 92%. In Lanarkshire it is 108%.

The fall in GDP is now apparent in Financial Services which showed a decline of 4.4% in Quarter 1 2009. Interestingly, the sector was still growing in quarter 4 2008 (2.2%). The greater impact of the recession on manufacturing is apparent in the figures~: a decline of 4.6% in quarter 4 2008 was followed by a further decline of 6.3% in Quarter 1 2009. The quarter 1 2009 GDP statistics confirm that the recession is affecting nearly all Scotland’s key industrial sectors.

It is difficult to provide accurate figures for job losses/gains in Scotland’s financial services sector over the past year. The drip feed of job losses in RBS and Lloyds Group has been at least partially offset by new investments. Trade unions initially estimated that job losses in the banking sector following the crisis could be between 10 – 30% and it is difficult at this stage to provide a more accurate figure.

The impacts extend beyond what can be easily quantified in growth and employment statistics. Those who are lucky enough to retain employment face increasing levels of economic inequality and insecurity, and real wages for ordinary workers will continue to stagnate (laying the grounds for another credit bubble?). There is a widespread lack of faith in the current model of globalisation to produce fair outcomes in both developed and developing nations and societal pressures associated with the rise of a super-rich class continue to grow.

The upfront costs of rescuing the banks are proportionately higher in the UK than any other OECD country. The scale and pace of decline in the economy has resulted in a huge drop in government revenue. Contrary to popular perception, this year’s deficit is largely attributable to the costs of the bank rescue packages and falling revenues; not discretionary stimulus measures.

1. What evidence do you have on the issue of the availability and the cost of credit and what effect have the initiatives undertaken by the banks, government bodies, regulators and others had?

Plenty of evidence on the availability and cost of credit is already in the public domain. The Scottish Government’s recent report found that the supply of finance has reduced and the cost has risen; findings confirmed by a recent Bank of England (BoE) lending survey. The BoE also noted that ‘spreads and fees are reported to have risen in recent months’ .

These findings support the considerable anecdotal evidence the STUC has received over the past year from trade union officials and workplace representatives. There can be little doubt that job related investment has suffered in Scotland as a result of the banking crisis.

The STUC has generally been supportive of the initiatives undertaken to date. The rescue packages of October 2008 and January 2009 may have left an unpleasant taste in the mouth, but there can be little doubt they were necessary to introduce stability and protect the wider economy. Similarly, with monetary policy having reached the limits of its usefulness, the BoE was correct to embark on a programme of quantitative easing and to extend it in August 2009.

It is difficult to discern the impact of the initiatives undertaken to date. It is clear that business lending is not yet at a desirable level, but the position would undoubtedly be worse were it not for the action taken.

It must also be noted that problems with availability and cost of credit are also, at least in part, attributable to the retreat of foreign banks from the UK market.

1. What changes can be expected as part of the ongoing and future restructuring plans in the financial services sector within Scotland?

It is difficult to answer this question with any certainty at this moment in time. The nature of restructuring of the financial services sector in Scotland will be determined by a range of factors:

• Convergence and contraction resulting directly from the recent crisis. For example, rationalisation within the Lloyds Banking Group and potential restructuring of global companies with a presence in Scotland; • Timing and nature of disposal of the Government’s stake in Lloyds and RBS; • Nature and extent of public sector support: of limited impact at this stage; and, most importantly, • Potential changes in regulation of the sector: it is difficult within the confines of this submission to do justice to the sheer weight of consultative activity which has recently reported or is currently underway. The Treasury Select Committee has reported extensively and the Turner Review has proved influential in setting the terms of the Treasury’s Review of Financial Markets and Sir David Walker’s Review of Corporate Governance (both currently ongoing). The FSA continues to consider how best to implement its code on remuneration. Nelly Kroes, EU Competition Commissioner is likely to continue taking a robust line on the lack of competition in the UK retail-banking sector. To this must be added the activity being undertaken by the G20 at global level.

The STUC would be prepared to submit a separate paper on regulation if the Committee would find it helpful. Given that it is not possible in this submission to provide a detailed analysis of the above listed reports/consultations, the STUC will simply highlight the following principles that we believe should underpin a sustainable regulatory response to the crisis:

• Regulation by technocrats and industry insiders – such an approach invites industry capture. The STUC believes that the boards of regulatory institutions should, as a minimum, include trade union representatives if not a range of civic society interests; • Global action is essential to reduce risk of regulatory arbitrage – the G20’s progress has been slow and action taken wholly insufficient; • There must be some separation of retail and investment banking - it is no longer acceptable for retail deposits covered by state guarantees to be used to fund speculative activity; • Action to address the bonus culture and the irresponsibility it generates is essential - this must move far beyond the proposed FSA code, which is in no way sufficient to deal with the scale of the threat posed by the incentivisation of irresponsibility in financial markets; • Regulators must have clearly defined roles and responsibilities and mechanisms for effective collaboration must be established as a priority. Paying regulators at similar levels to the highest earners in the sector is neither necessary nor desirable. Regulatory bodies should be sufficiently resourced and offer quality employment and career progression; • Transparent arrangements for the trading of debt securities must be established; • Strong action is required to promote transparency in tax havens and secrecy jurisdictions; • Systemically important institutions in the shadow banking sector should be subject to regulatory oversight - indeed, there is strong case for the hedge fund sector to be brought into regulatory structures; and • Corporate governance and remuneration structures need to support sustainable long-term growth.

It is important to stress that the impact of even mild regulatory reforms is potentially huge given the potential for reduced profitability. Three points are crucial here:

Capital requirements: the Basel Accords are founded on the principle that banks must hold a minimum amount of capital (cash or liquid bonds) to match their risks. The Basel II treaty set a Tier 1 capital ratio of 4%. Banks found a way round this requirement by creating a ‘shadow banking system’ where risks were parked off balance sheet. This minimized capital requirements and boosted profitability.

Therefore, even if regulators now only enforce a strict 4% limit, banks will find their opportunities to make profits severely limited. But the signals are that much higher ratios will be set: the British Government imposed a 9% ratio in October 2008 and the French Government quickly followed.

Risk management: as this submission is being compiled in September 2009, the FT index is rising strongly. It appears cash provided to banks through capitalization and quantative easing is being speculated with; not invested. However, it is difficult to escape the conclusion that banks are bound to become more risk averse. Regulation requires that banks calculate the risk side of the balance sheet using computer models based on available data. Prior to the crisis, the digital data fed into these models related only to the boom years. From this moment on, accurate data relating to the current crisis will have to be introduced into the models.

Competition: the convergence in the sector, some of it forced by the need to maintain stability, has led to the creation of huge banks operating in a more concentrated market. It is inevitable in such circumstances that banks will face tighter controls on their profits.

Consequently, it is sensible to anticipate even mild regulatory reforms producing potentially transformative results. In terms of what this might mean for financial services in Scotland:

• A smaller sector - if not in real terms then relative to the economy as a whole - and one that is potentially much less profitable; • Greater role for the state - if we are to witness, for the reasons listed above, a shift towards low profit, utility style banking where banks are asked/forced to meet social objectives, people will legitimately question whether or not it would be more efficient for the state to own key parts of the sector. Also, the STUC has long argued the case for a Scottish Investment Bank to support productive, long-term investment. The STUC also supports the People’s Bank initiative; • Fairer, more sustainable remuneration practices; see response to question 5 • More stable utility banking; and • Changes in nature and quality of employment: see response to question 5

1. How might these changes affect the business and retail banking market in Scotland, access to project finance, a reduction in competition on the ‘high street’ for lending, the plans for the retention of functions and ‘headquartering’ etc and what can the public sector in Scotland do to ensure the best possible result for Scotland?

Again, it is difficult to answer these questions with any certainty. Suffice to say that strong growth in the financial sector during this decade suggests that Scotland must be providing an attractive business environment. It is important that the public sector continues to deliver the skills and infrastructure necessary to support the sector. It is essential that this support does not seek to placate the more extreme voices within the financial sector who do not appear to have been cowed by recent events. Threats of offshoring of business services or whole firms for tax purposes, by institutions with a substantial public stake or who have benefitted from public guarantees, should be treated with the contempt that they deserve.

1. What are the current employment levels and skills base in the financial sector in Scotland and how may these change? Additionally, what are the types of jobs that might be expected to be lost as part of any restructuring plans?

The skills base remains strong and current activity underway through FISAB should help deliver the higher end skills necessary to support the sector. Recent inward investments such as Tesco Personal Finance provide hard evidence that the investment community has faith in the skills base.

Due to the extravagant rewards paid to executives and traders, there is a widespread misconception that wages and conditions in the financial services sector are well above average . Employment in the Scottish banking sector for the majority of staff has in fact been characterized by aggressive performance management practices using inappropriate target regimes. Counter staff have been incentivised to deliver sales while capacity to deliver effective retail services has been diminished. Pension entitlements have been reduced whilst executives have lined their pockets.

It is difficult to assess how these practices might change as the sector moves forward. Reduced profitability may threaten jobs, wages and terms and conditions unless prevailing attitudes over internal dispersal of wages change.

The STUC is clear that while the Government retains major stakes in RBS and Lloyds Group, it should exert control to match its shareholding. Further attacks on jobs, pensions, wages, terms and conditions should not be tolerated. There is also a growing fear that Scottish banks may revisit previous decisions not to offshore back office operations and/or voice delivered services.

The STUC supports UNITE’s campaign for a social contract for financial services .

1. How are employment levels in the financial sector calculated at present, under what definitions and how do these relate to ONS figures? What changes are required to make employment figures more meaningful and comparable with other financial centres?

No comment

1. What are your views on the current efforts across the public sector in Scotland to respond to the recent difficulties in the financial sector in Scotland and what, if anything, needs to change in the future as the situation develops?

The public sector has already provided assistance on a monumental scale to the failing banks.

A range of activity overseen by FISAB and the Finance Sector Jobs Taskforce is currently ongoing. The priorities for these bodies should continue to be:

• Retain maximum levels of employment in the industry;

• Redundancy response – in the first instance this should involve negating the need for job losses in the first place but where this is not possible, effective redeployment with other firms. It is essential that employers are open and honest about emerging redundancy situations to allow the public sector to assist the staff affected;

• Skills – in its 2009 Annual Report, FISAB lists strengthening the world class workforce as one of its key aims. It is essential that the partnership approach continues to deliver added value; and,

• Inward investment – SDI has sensibly approached the global crisis as an opportunity rather than a threat; the evidence is in the investments already announced. It is essential that SDI continues to work with the industry to deliver new investment for Scotland.

1. Has Scotland’s reputation as a global financial services centre been detrimentally affected by the global crisis and has this been to any greater extent than the problems felt in other financial centres?

The STUC does not believe that this is a particularly fruitful avenue for exploration. No financial centre has escaped the recent turmoil - the argument can be made that Scotland’s reputation for financial probity has been damaged, but what of our neighbours in Iceland and Ireland? Or the City, Wall Street and Frankfurt?

For those considering hard-nosed investment decisions, any fuzzy concerns around Scotland’s reputation for financial probity will more than likely be outweighed by the UK’s well-established reputation for security and property rights: the UK is currently 5th out of 181 countries on the World Bank’s ease of doing business rankings . This ranking is assessed on performance on 10 sub-indicators: the UK is currently 9th out of 181 countries on ‘protecting investors’ and 24th out of 181 countries in ‘enforcing contracts’.

1. How should Scotland differentiate itself and promote itself as a financial services centre in the future and what steps are being taken by our competitors in this respect?

On the skills base and quality of service provided. Whilst it is sensible to emphasise Scotland’s advantage over London, it makes little sense to market Scotland simply on the basis of lower costs.

1. How can we ensure that the Scottish financial sector continues to retain a global perspective and does not retreat into a purely localised lending regime?

The STUC does not believe that there is any prospect of the sector retreating in this way.

1. Why are "new" banks choosing to establish themselves in Scotland, what is it that is particularly attractive and how can we build on this and attract additional investment into Scotland?

Again, these investment decisions suggest that Scotland remains an attractive location for investment: primarily due to the skills base and the cost advantage over London. The regulatory regime has of course been attractive to financial services companies. For reasons that should be self-evident, the STUC would caution against continuing to promote Scotland on the basis of light-touch regulation.

Ongoing consonance with the UK regulatory regime is desirable.

STUC September 2009