Causes – long term trends that have undermined trust
It is commonplace to observe that the public reputation of banking in particular and financial services in general has fallen during the last decade. This is the first of a series of short articles, for boards and senior management, to help their strategic thinking in this area, starting with the causes of the decline. In future articles, we will go on to explore potential ways to regain this lost confidence.
Analysis to date has been mostly short term in perspective, and has focused on recent incidents of reckless behaviour and miss-selling. However, the roots of the trust problem lie much deeper, many of them in the way the financial services’ operating environment has altered radically over the last c.40 years, with neither firms’ operating models nor new regulations keeping pace. Outlined below are eight of the most influential causes for this loss of trust:
- Globalisation has opened up new markets, forcing organisations to change the way they operate. This has created new matrix reporting lines, and increased both the volume and velocity of decision making, encouraging risk taking in new areas while adding to the complexity of existing risks.
- Secular stagnation, combined with the increasing dependence of the UK economy on the housing market, has led to domestic growth becoming increasingly driven by consumer borrowing and debt, and has tended to increase financial inequality.
- The public policy emphasis on choice and competition, in a world of low yields and growing product complexity, has created perverse incentives for consumers to buy solely on price, and for firms to under-price risk.
- Our ageing population is much talked about but not yet well understood, not least because reliable empirical evidence of its impact is only just emerging. What we can say is that the resulting growth of long term financial products is likely to continue, with all the associated complexity and uncertainty.
- Ownership models have moved away from partnerships and long term investments towards investors who are shorter term in outlook and more aggressive in attitude. This has shifted financial services along the risk/return spectrum and altered the incentives of boards, management and staff.
- The operation of Moore’s law (which forecasts a continuing exponential increase in computing power)has transformed financial services from an industry largely dependent on human judgement to one predominantly driven by the systematic capture and analysis of data.
- The dismantling of barriers between financial markets – the 1990s repeal of Glass Steagall is often referenced as the prime example, but Big Bang in 1985 and the later growth of Bancassurance are also relevant – has made value chains more opaque and risk management more difficult.
- The transfer of responsibility/risk from the state and the employer to the individual and the financial services industry - pensions, mortgages and privatisation are the most obvious examples - has created new opportunities and risks.
These trends have meant firms’ relationships with their customers have become more distant and transactional as products and services have become more complex. Simultaneously, the impact of consumers’ weak financial capability has been accentuated as we become obliged to make more significant financial decisions. This has left us more dependent on the quality and suitability of the financial products we are buying.
In parallel, advanced mathematical techniques have fuelled the development of financial products (e.g. mortgage backed securities - MBS) and markets (e.g. securitisation), as well as the belief that the value at risk in any transaction could be measured and controlled. This changed environment encouraged greater hubris and excessive risk taking, while making risk management more complex and challenging.
The evolution of regulation through to the financial crisis
Since the Herstatt failure in 1974 (when a small German bank collapsed before it could settle its USD transactions), led to the first Basel Accord the following year, regulatory reform has routinely followed financial failures. Perhaps inevitably, these reforms have often been reactive rather than anticipatory, more focused on avoiding a repeat of the failure just experienced than preventing the next.
In the UK, the secondary banking crisis of 1973/74 and the failure of Johnson Matthey Bankers in 1985 both led to major reforms of banking supervision, while a subsequent string of failures, from Barlow Clowes to BCCI and Barings, triggered a complete regulatory overhaul. The resulting Financial Services & Markets Act (2000) created a single integrated authority, the FSA, from more than ten predecessor regulators.
During this same period, financial services’ regulation was becoming more international – at both global and EU level. Although driven partly by financial failures, the chief aim was to create a level regulatory playing field, both between firms and across jurisdictions. This has led to much greater granularity of regulation, designed to create certainty and consistency.
Consolidating regulation in the UK, while at the same time creating detailed standards at an EU and global level, created its own policy-making bubble. However well-intentioned, this risked losing touch with both reality in the industry and with the consumers and markets it was meant to protect.
To give two examples: there was a failure to spot the extent to which sub-prime mortgages were being packaged into AAA securities; and not enough connection was made between, or warning lights raised by, the growth in UK household debt and the expansion of credit, including through the housing market.
Good reasons for a loss of trust
When the financial crisis hit in 2007/08, public trust was severely damaged across the board - in financial services in general and banks in particular; in the FSA as the regulator, in credit ratings’ agencies that had under-rated the risk of MBS etc., and in the Government that had declared the end of boom and bust.
The position has since stabilised, but not at a level that encourages trust. Former banker and Australian Prime Minister, Malcolm Turnbull, spoke at last September’s G20 summit of the need to “civilise capitalism”. Average real incomes remain significantly below their 2007 levels, austerity is still the order of the day, and the wider economy continues to look more like the Long Depression of the 1870s-90s than the Great Depression of the 1930s or any subsequent downturn. In the context of this near perfect storm, it becomes easier to understand the loss of faith in “experts” that was a driver of the EU Referendum result. Meanwhile, although the industry has changed a good deal, consumers have not yet seen sufficient difference to believe financial services firms are on their side. And while regulation has been overhauled, the new twin peaks model of the PRA and FCA remains as untested as the FSA was pre-crisis.
The way ahead
Too much of the commentary around the loss of trust and integrity has focused on the short term, and so has both misunderstood and underestimated its causes. These are fundamental and long term, with good as well as bad results, and so restoring the industry’s reputation will require more profound change than the majority of industry activity and regulation assumes.
Likely components of this change include: aligning firms’ interests better with their customers’; reaching consensus on the role of consumer responsibility; reforming how firms manage their risks; and countering the tendency of automation to dehumanise the industry. We will explore each of these further in future Insights articles over the course of the year.
Restoring trust and integrity in Financial services
Part 1: Causes – long term trends that have undermined trust
Identified eight long-term causes of the loss of trust in financial services.
Part 2: Routes to improved customer loyalty and experience
Identified four key considerations to improve customer trust and loyalty
Part 3: Aligning firms’ interests with their customers
Aligning firms’ interests with their customers to gain trust and integrity within financial services
Part 4: The concept of ‘buyer beware’ is out of date in financial services
It is time for the regulator to step back and for firms to take on more responsibility for meeting their customers’ needs