Vol. 35 No. 13 · 4 July 2013

Are we having fun yet?

John Lanchester on the banks’ barely believable behaviour

6574 words

As anyone who’s been there recently can testify, the blame in Spain falls mainly on the banks – as it does in Ireland, in Greece, in the US, and pretty much everywhere else too. Here in the UK, feelings were nicely summed up by the Parliamentary Commission on Banking Standards, which reported on 19 June that ‘the public have a sense that advantage has been taken of them, that bankers have received huge rewards, that some of those rewards have not been properly earned, and in some cases have been obtained through dishonesty, and that these huge rewards are excessive, bearing little or no relation to the work done.’ The report eye-catchingly called for senior bankers to face jail.1 In the midst of this cacophony of largely justified accusations, the banks have had a strange kind of good fortune: the noise is now so loud that it’s become hard to hear specific complaints of wrongdoing. That’s lucky for them, because there’s one particular scandal which really deserves to stand out. The scandal I have in mind is that of mis-sold payment protection insurance (PPI). The banks are additionally lucky in that there’s something inherently unsexy about the whole idea of PPI, from the numbing acronym to the fact that the whole idea of a scandal about insurance payments seems dreary and low-scale. But if there hadn’t been so much other lurid wrongdoing in the world of finance, and if mis-sold payment protection insurance had a sexier name, PPI would stand out as the biggest scandal in the history of British banking.

This is a big claim to make: an especially big claim to make at the moment, when bank scandals come around with a regularity which in almost any other context would be soothing. Here’s a short recap of some of the greatest hits of the noughties. Just to keep things simple, I’m going to leave out the biggest of them all, the grotesque toxic-asset and derivative spree which took the global financial system to the edge of the abyss. That was the precursor and proximate cause of the difficulties which are affecting the entire Western world at the moment, but the causal mechanisms connecting the initial crisis and our current predicament are a separate subject. The crisis and its consequences are too big to count as a scandal: they’re more like a climate. We can all agree that we’d prefer a different climate. We can all agree that we have no idea when this one will change.

Even once we’ve banished the elephant to his corner of the room there’s plenty of scandal and disaster to be getting on with. I’ll deal with two outliers first, because they are exceptions, for multiple reasons: they involve foreign banks, they are trading-floor disasters of a traditional kind, and they didn’t cost any money to anyone apart from the banks themselves and their shareholders. These losses were caused by Kweku Adoboli, the UBS wunderkind who lost £1.4 billion in 2011, and Bruno Iksil, the ‘London Whale’ at JPMorgan Chase, who in 2012 lost an amount described by his boss Jamie Dimon as ‘a tempest in a teacup’, until it turned out to be $6.2 billion. There were a number of classic features to these mishaps. The financial instruments involved were complex; they were things no one outside the City had heard of until they blew up (in Adoboli’s case, they were ‘forward-settling Exchange Traded Fund positions’, in Iksil’s they were credit default swaps on an index called the CDX IG 9); and although both banks are foreign-owned and based, these actions happened in London. Adoboli’s feats were deemed criminal and he has gone to jail; Iksil’s weren’t and he hasn’t. (Adoboli’s frauds were in cash terms the largest in British history.)

These two fiascos were different from the other scandals of the last few years because they were so familiar in their nature. Traders take financial instruments created to control risk and use them to make huge bets; sometimes they do it with their bosses’ approval, sometimes without. That’s just how they roll. Every now and then one of these bets goes wrong on a huge scale. The banks always claim they have procedures in place to control the relevant processes and manage the risks involved, until it turns out that they don’t. This is a story as old as gambling itself. The question we should ask ourselves about these incidents is why they happened in London, and why London has become the global capital of this kind of trading, and what the costs and consequences are for us as a society. That’s a large question and it’s strange that in all the fury and rhetoric and publicity swirling around the City, it has gone largely unasked: are we benefiting from the fact that London is a global financial centre, or do the costs outweigh the benefits?

As for the other scandals, the common denominator among them is that they concern behaviour which happened either just before or just after the crash, and which would never have come to light had it not been for the financial crisis and the resulting surge in attention – mainly legislative attention – to the murkier deeds of the banks. The simplest of these stories concerns HBOS. This is another familiar narrative in that it involves a British bank growing too fast and pursuing a catastrophic series of mergers. The company was formed in 2001 by the fusion of Halifax, the UK’s biggest mortgage lender, with the Bank of Scotland, thus, in the words of the parliamentary report which rolled over this particular rock in April this year, ‘turning the “big four” banking groups into the “big five”’. The bank grew by taking on unsustainable levels of risk and by lending money too recklessly. It is part of the strangeness of banking that when a bank lends money, it creates assets for itself: your mortgage appears on the bank’s accounts as one of its assets, and so does all the other money the bank lends. So a bank can grow with enormous speed – can create large quantities of assets for itself – simply by lending money much too freely. This HBOS did. The parliamentary report found that in the three years after the crash, £25 billion of UK corporate loans, mostly involving commercial property, had gone wrong; the figure amounted to 20 per cent of the loan book. Even without all the other things that went awry, of which there were plenty – another £15 billion of loans down the plughole abroad, failed joint ventures and equity investments etc – the corporate loans by themselves would have been adequate to destroy the bank.

The parliamentary report, crisply written and admirably direct, is called An Accident Waiting to Happen. That phrase has a particular sting because it came from a report to HBOS’s directors by their own group finance manager, quoting the views of the Financial Services Authority, as long ago as January 2004. The report adds: ‘Neither the FSA nor HBOS followed through on the implications of this characterisation. The accident happened.’ The bank’s governance ‘represents a model of self-delusion, of the triumph of process over purpose’ and its history amounts to ‘a manual for bad banking’. This was nothing to do with go-go derivatives and fancy mathematical engineering; it was nothing to do with overpaid investment bankers making bets they didn’t understand. HBOS was almost entirely a traditional retail bank. ‘Whatever may explain the problems of other banks, the downfall of HBOS was not the result of cultural contamination by investment banking. This was a traditional bank failure pure and simple. It was a case of a bank pursuing traditional banking activities and pursuing them badly.’ In other words, the single biggest factor in the collapse of HBOS was simple incompetence. And let’s not forget what happened next: when HBOS was clearly about to go broke, it was taken over by Lloyds, with the encouragement of the government. Unfortunately the extent of the losses was so great they ended up bringing Lloyds down too, and the new combined bank was bailed out by the taxpayer a month after the takeover. We, the taxpaying we, now own 40 per cent of the combined bank; 2008’s ‘big five’ are now only four, and two of them (Lloyds-HBOS and RBS) are partly owned by a reluctant us.

Next scandal up: Libor. This, the London Interbank Offered Rate, was explained with pellucid clarity in these pages by Donald MacKenzie in 2008.2 Libor is the single most important number in international financial markets, used as a reference point throughout the global financial system. It is a range of interbank lending rates, set after consultation between the British Bankers’ Association and two hundred and fifty-odd participating banks. During the daily process, each bank is asked the rate at which it could borrow money from other banks, ‘unsecured’ i.e. backed only by its own creditworthiness rather than by specific collateral. The question is, in effect: what would your credit be like today, if you had to ask? The crucial point, made by MacKenzie, is that the bank’s response is conditional: ‘A Libor input is what a bank could do, not what it has done.’

Even before the scandal, Libor was an example of the kind of technical process inside the world of finance which makes outsiders scratch their heads. During the credit crunch, the conditional aspect of Libor became overpoweringly apparent, since the salient fact about the interbank market was that banks were refusing to lend money among themselves. That, in essence, was what the credit crunch was: banks being too scared to lend to each other. In the very dry words of Mervyn King, the then governor of the Bank of England, Libor became ‘in many ways the rate at which banks do not lend to each other’. Euribor, the Eurozone version of Libor, is at the moment even worse, since in very many cases these banks would be more likely to turn themselves into lapdancing clubs than make unsecured loans to each other. The rates are largely fictional – and not realist fiction.

It seems bizarre that something so central to the global markets – $360 trillion of deals are pinned to Libor – should have such a strong element of invention or guesswork. The potential for abuse is immediately apparent. As MacKenzie prophetically said, ‘the obvious risk to the integrity of the calculation is that a bank on a Libor panel might make a manipulative input, trying to move Libor up or down so as to influence interest rates or the value of its swaps portfolio.’ Surprise! After the crisis, when investigators were taking an energetic interest in Libor, it turned out that that was exactly what had been happening, not just at one or two banks but across an entire swath of the industry. It’s not a difficult scene to picture. In a small office with no windows, a pointy-headed, glasses-wearing Libor ‘submitter’ – that’s the name of the people who tell the BBA what the notional lending rate is that day – sits in front of a keyboard. In a large open-plan office with windows on all sides, a roomful of shouting, swearing, meat-eating traders would be able to make enormous amounts of money by betting on Libor if only, if only, they had some way of finding out that day’s rate. If they had some way of actually influencing the rate, it would be even better. They could bet big on it going up, and then help it to go up. So a sweary, red-meat-eating trader picks up the phone, or fires up his email, or strolls down the hallway towards the submitter’s office and … but wait! The traders are not allowed to talk to the submitters! That would be wrong! And dividing them is an impenetrable barrier, that sacred and potent thing, profoundly respected inside banking, a ‘Chinese wall’. So nothing like this can ever happen! Except that here we would all do well to bear in mind something an experienced Wall Street investor told Michael Lewis: ‘When I hear “Chinese wall” I think “you’re a fucking liar.”’

If I sound cynical and unsurprised about the manipulation of Libor, that’s because I long since stopped believing assurances of ethical conduct on the part of the banks. To people who still trusted them, Libor was profoundly shocking, mainly because of the scale of the sums involved. (This is the world of money, remember. Quantity trumps quality.) ‘This dwarfs by orders of magnitude any financial scam in the history of the markets,’ a finance professor at MIT said. Mervyn King said that the bankers involved were guilty of criminal fraud. From this perspective, the important fact about Libor is that while the rate is controlled by the British Bankers’ Association, it is widely used, indeed is omnipresent, within the US financial system. So manipulation of Libor is a crime not just in the finance-friendly City of London, but in the eyes of US law enforcement. That profoundly changes the mood music, and the resources devoted to investigating wrongdoing. If Libor had only been of relevance within the UK, the same actions could have taken place in the same institutions and my suspicion is that we wouldn’t have heard a word about it.

The full scorecard from the Libor scandal isn’t yet in plain sight: we’re somewhere in the middle of the story and there will be more news, more revelations and more settlements in the future. So this is the half-time report. In June last year, Barclays paid £59.5 million in fines to the Financial Services Authority, $160 million to the US Department of Justice (DoJ), and $200 million to the US Commodity Futures Trading Commission (CFTC), making a nice round total of about £290 million. (It’s worth pausing for a moment to register the full magnitude of that: from one single bank, more than a quarter of a billion quid in fines.) Its chairman, Marcus Agius, and chief executive, Bob Diamond, both resigned. In December, the Swiss bank UBS agreed to pay $1.2 billion to the DoJ and the CFTC, £160 million to the FSA, and 59 million in Swiss francs to the regulators back in the old country. That’s a total £970 million, from a bank which had already lost £1.4 billion thanks to Kweku Adoboli and another $780 million in fines to the US authorities for helping rich Americans dodge their taxes. In February this year, RBS was up. They paid $325 million to the CFTC, $150 million to the DoJ, and £87.5 million to the FSA, for a total of about £390 million. Well, I say ‘they’, but since the bank is 82 per cent owned by the taxpayer, the people paying this bill turn out to be us. Are we having fun yet?

There’s plenty more to come: Deutsche Bank, Citigroup, Credit Suisse and JPMorgan Chase, four of the biggest banks in the world, are under investigation, along with many of their peers, and the bodies pursuing them include not just the DoJ, CFTC and FSA but also a variety of US state-level attorney generals. And there may be even worse news ahead for the banks, because these settlements represent only the criminal and statutory fines levelled against them. Libor reaches so deeply into the financial system that the fact of its manipulation opens not a can but an entire universe of legal worms. If anybody out there can prove that they lost money as a result of Libor manipulation, the scandal will get dramatically more expensive. The bad news, as the cases wend through the US legal system, could keep coming for years. To give just one instance where there are certain to be dozens and perhaps hundreds more, the city of Baltimore and a number of associated parties are suing a group of banks for a ‘global conspiracy to manipulate Libor’. The US municipalities’ losses on the relevant interest-rate swaps have been put at $6 billion, in addition to the $4 billion they’ve already had to pay to get out of them – that sounds like a lot, but they had bought $500 billion of swaps. Multiply this phenomenon globally and the full scale of the potential disaster for the banks becomes apparent.

The next set of scandals on the list is more fun, because it involves sexier forms of overt criminality such as money laundering and drug dealing. The first of the big British banks to be publicly busted was Standard Chartered, an international player which is less well known than it might be in the UK because although its HQ is here, its activities are located abroad, mainly in Africa, Asia and the Middle East. (The bank’s founder, James Wilson, also founded the Economist.) In August 2012, the New York State Department of Financial Services – a new regulator, formed in October 2011 to simplify and beef up supervision of finance in the state – accused the bank of running a scheme to deal, illegally under US law, with the Iranian government. The regulator said that the bank had been operating the scheme/scam for a decade and had used it to hide more than $250 billion in deals. The bank’s response was unequivocal: ‘Standard Chartered strongly rejects the position and portrayal of facts made by the New York State Department of Financial Services.’ It turned out that, once translated out of bank-speak, this meant ‘we did it.’ In September the bank paid $340 million to the DFS in settlement, then in December another $227 million to the DoJ and $100 million to the US Federal Reserve, and accepted a ‘deferred prosecution arrangement’ in which the authorities said they wouldn’t prosecute the bank if it abided by the conditions made in the settlement agreements.

Standard Chartered had odd body language through all this. Rather than looking guilty, they behaved as if they were severely pissed off. ‘The settlements,’ they said, ‘are the product of an extensive internal investigation that led the bank voluntarily to report its findings concerning past sanctions compliance to these US authorities, and nearly three years of intensive co-operation with regulators and prosecutors.’ They also said that the US Treasury had found that only $133 million in deals between 2001 and 2007 were in violation of sanctions. But if they only did $133 million in deals, how come they were willing to pay $667 million, two-thirds of a billion dollars, in fines? Was there a subtext here, a notion that these were American laws, expressing an American preoccupation with the Axis of Evil, and that for a British bank to have violated them was, how to put it, not quite so serious as all that? On 5 March this year, the chairman of the bank, Sir John Peace, said the following clunky thing: ‘We had no wilful act to avoid sanctions; you know, mistakes are made – clerical errors – and we talked about, last year, a number of transactions which clearly were clerical errors or mistakes that were made.’ This made the regulators furious, and in Sir John’s next statement on the subject, 16 days later, he said that he and the bank retracted ‘the comment I made as both legally and factually incorrect. To be clear, Standard Chartered unequivocally acknowledges and accepts responsibility, on behalf of the bank and its employees, for past knowing and wilful criminal conduct in violating US economic sanctions, laws and regulations.’ This was described in the FT as ‘the most abject apology that City pundits can remember hearing from a banker in recent times’, and their story reporting it contained a link to the Clash playing ‘I fought the law.’ The DoJ made it clear that without the retraction, the bank would have been prosecuted. Standard Chartered’s behaviour reminded me of the defining moment from the great sitcom Arrested Development, where the family patriarch, played by Jeffrey Tambor, explains to his son why he is facing prison: ‘There’s a good chance that I may have committed some [pause] light [pause] treason.’

You wait all this time for a deferred prosecution agreement between the DoJ and a major British bank, and then two come along at once. At almost the same time as the Standard Chartered disaster came a similar-but-different scandal with its neighbour HSBC. (I say ‘neighbour’ because both banks were historically based in Asia. In the old days in Hong Kong, their headquarters were next to each other.) L’affaire HSBC had more entertainment value in that it involved laundering money for drug dealers. The DoJ said that the bank had laundered at least $881 million in money for Mexican and Colombian cartels, and another $660 million in sanctions-avoiding transfers with Iran, Cuba, Sudan, Libya and Burma. Some of the details concerning the drug money were lurid. Drug dealers deposited hundreds of thousands of dollars in cash at HSBC in Mexico, and to facilitate matters, even designed special boxes to hold the cash that made an exact fit with the holes in the bank tellers’ windows. As part of the deferred prosecution deal, the bank agreed to have an independent monitor inside the bank, checking on its compliance, for the next five years – an unprecedented arrangement for a British bank. Also unprecedented was the size of the fine: $1.92 billion. That’s a stupendous amount of money for a fine, but it might not be enough to satisfy US critics of the deal, many of whom think that a criminal prosecution is preferable to the deferred prosecution arrangement; the judge in charge, John Gleeson, hasn’t yet signed off on the DPA. This story, already as bad as any crisis has ever been for HSBC, may yet turn even worse.

Before I get onto the story of the biggest and baddest scandal of them all, there is just time to fit in one more quickie, the RBS back-end payment system implosion of last summer. Almost all the other 21st-century bank cock-ups have something spectacular and/or criminal about them, but what happened to RBS is arguably, from the general public’s point of view, the most worrying of all of them. It was very simple: on 19 June, the bank introduced a software update into its payment system which – oops! – caused it to stop working. It was impossible to make either payments into or withdrawals from the bank’s accounts. Since RBS is a huge company, embracing all the customers of its various retail brands such as Coutts, Ulster Bank and NatWest, this failure left a very large number of people unable to use their bank accounts. The consequences went from the mild irritation experienced by people like me who couldn’t pay their credit card bill by the due date, to, at the other end of the scale, some of the examples mentioned ungrammatically but vividly on Wikipedia: ‘Completion of new home purchases were delayed, others were stranded abroad, another was threatened with the discontinuation of their life support machine in a Mexican hospital, and one man was held in prison.’ It took about a week for the bank’s systems to be working properly again.

The main public after-effect of the scandal was that Stephen Hester, the chief executive brought in to return the bank to profitability en route to a reprivatisation, immediately announced that he would waive his bonus for 2012. It was the second bonus he had waived in six months: only in January a public outcry had forced him to give up his £963,000 bonus for 2011, leaving a frugal £1.2 million in basic pay as his only compensation for the year’s work. That was the big story after the payment system mishap, and I know some bankers who think RBS got off very lightly. The bank’s ‘back end’, as it’s called, meaning all the computer systems which keep it running, has an industry reputation for being in poor shape. It was the chaotic condition of that back end which caused the proposed sale of 316 branches of RBS to the Spanish bank Santander to fall through. ‘It’s a mystery why people weren’t angrier,’ one banker told me. ‘I mean, how much worse can it get than people not being able to get hold of their own money? I don’t think people realised just how big a deal it was.’ That’s true, and especially so when you think for a moment about the mysterious virtual nature of modern money, which so often comes down to nothing more than numbers on a screen. When those numbers vanish or blur or wobble, it’s scary. Perhaps this was a case of customer fear-fatigue in the aftermath of 2008; in any case, RBS got off very lightly given what could have been its second near-death experience in four years.

It follows from all the above that when I say that the PPI scandal is the biggest ever to hit British banking, I’m making a very big claim for its scandalousness (scandalosity? scandality? scandalaciousness? scandaltude?). The bar is set so high it’s practically in orbit. So the simplest way of stating the magnitude of the PPI scandal is to point to the amounts the banks are going to have to pay out to settle it. The first mentions of PPI as a potential liability for the banks had the then astonishing, then unprecedented amount of £1 billion mentioned as a possible upper limit to the damage. When the crucial court case against the claims was lost by the banks in April 2011, the FSA knew it was going to be expensive: their estimate of the cost to the industry was £3 billion. But that turned out to be a huge underestimate. To get a sense of how far the benchmarks for PPI have shifted, in the last quarter of 2012 one bank alone, Lloyds, had to increase its provision for settling PPI claims by £1.5 billion. So instead of £1 billion as an all-time maximum penalty for the entire industry, we have now arrived at a point where one bank in one three-month period has to spend £1.5 billion, not to cover its total liability, but just to cover the extra liability it has acquired in those three months. In fact, Lloyds’ total provision for PPI has now hit £6.7 billion, getting on for the full cost of the London Olympics, just from that one bank. Across the industry, the latest estimates for the total cost of the PPI scandal have kept going up, and then up again, and then up a bit more, and are now at £1.5 billion for HSBC, £2.2 billion for RBS, and £2.6 billion for Barclays. The most recent guesstimate for the total cost is £16 billion. That, as near as dammit, is twice the bill for the London Olympics. Add the costs of a related scandal involving insurance swaps that were mis-sold to small businesses, and the headline figure keeps going up. The biggest number I’ve heard reliably quoted was from the BBC: £25 billion.

In one sense, that number tells the story: the PPI scandal is the worst because it is the biggest and most costly there has ever been. But the real reason the PPI affair is such a shocker isn’t just to do with the money: far more serious is the crisis in values and behaviour it implies. The other scandals and crises are bad, and involve behaviour that is variously unethical-to-criminal, but they also belong to a type that a very broadminded cynic would file in the already bulging category of boys-will-be-boys, subsection ’twas-ever-thus. Traders push the rules: that’s just who they are (Libor); drug dealers will find somebody, somewhere, who will launder their money (HSBC); Iran is a rich country with a lot of banking deals to transact, and frankly who cares if the Americans hate it (Standard Chartered). These were all serious breaches of ethics and the law, but they are explicable as specific things that went wrong in one part or another of big, complicated institutions facing a lot of big, simple temptations. The story of PPI is different because it involves a more basic breach of what banking is supposed to be about: looking after other people’s money. That’s the first thing that is qualitatively different about PPI; the second is that the misdeeds happened not inside rogue units of these huge global institutions but at the centre of their retail operations. This was an industry-wide, systematic cheating of the banks’ own customers.

The irony is that there was nothing inherently sinister about the product being sold. PPI stands for ‘payment protection insurance’, and that is what the products in question were supposed to do: provide insurance for customers who owed payments which for one reason or another they were no longer in a position to make. The two classic examples would be mortgage payments or credit card payments, and the two classic reasons for needing insurance would be falling ill or losing your job. If you took out PPI, you would, in the case of sickness or redundancy, have your mortgage and/or credit card debt taken care of by the insurance you had so prudently bought in advance. Simples.

The problem was that the majority of people who bought the policies would not, in the real-life instances for which they were buying the policies, be able to use them. Two categories of people who were not eligible to make claims against PPI were the self-employed and anyone with a pre-existing medical condition. They couldn’t use the insurance, but they were, in their (our) hundreds of thousands, sold it anyway. They weren’t told the basic facts about the insurance they were buying, facts which were not merely marginally relevant or potentially relevant, but which directly contradicted the raison d’être of the policies. The banks sold them to customers in the knowledge that they were not and would never be of any use to them. In many cases, customers bought products which had PPI tacked on, without being told they were being charged a premium for insurance which for many of them was useless. That’s what’s costing the banks all that money now: refunding the money paid, plus interest which was added on top, plus 8 per cent interest which could have been made if the money wasted on PPI had been put to some legitimate use. The average pay-out by the banks is in the region of £2750. It’s all those payments which add up to the £16,000,000,000 that the banks are going to have to pay; which gives you some sense of just how many people were mis-sold these crappy policies.

Insurance, it has to be said, is often like that. When it works, of course, it’s very welcome. I’ve noticed that children instantly get the point of insurance, and find the idea very reassuring – as indeed it is, as an idea. From the customer’s point of view, though, insurance often seems to be an industry which relies on not doing what we think it’s going to do when we take out a policy. Most of us will have had the experience of trying to make a claim for something we thought we had insured, only to find that the policy we bought in good faith has some weaselly small-print clause that allows the insurance company to deny the pay-out. My own formative experience in this respect involved a burst pipe which I thought was insured: it turned out that water damage was insured, but not the pipe itself. In other words, the insurance covered about 20 per cent of the final bill. Lesson learned, I hope. And once you learn the lesson, and start reading the small print, you often find yourself shaking your head in wonder at the things insurers get away with. Mobile phone insurance, for example. It is possible to insure a mobile phone against loss or theft. Except, when you look at the small print, they have clauses saying that the insurance does not cover situations in which the phone is ‘left unattended’ or ‘left in a public place’, and in relation to theft, the usual wording goes something like this: ‘Theft from the person is not covered unless force or threat of violence is used. Theft while in any form of public transport or public place is not covered unless force or threatened force is used.’ What this means in practice is that an enormous number of possible cases of loss or theft are simply not covered – and this by insurance policies which, if you have a smartphone insured by the phone company itself, will cost £10 a month. In other words, it’s a scam, designed to extract extra revenue from gullible punters.

The PPI scandal was a scam of that sort. After a number of drinks and off the record, bankers will explain the origins of PPI in three words: ‘free current accounts’. High street banking in Britain has for many years been a cartel dominated by the big banks, all of whom offer essentially identical products with an identically poor level of service. The public respond with inertia: we overwhelmingly tend to stay with the same bank all our lives.3 This means that the banks have eye-catching features designed to make us take that initial decision to sign up for their accounts. One of the features designed to entice new customers is free banking (that’s ‘free’ with a couple of provisos to do with staying in credit). But current accounts are not free to run. The banks could choose to fund this service by using profits they make in the other parts of their operations. If they did that by, say, transferring revenues made by their investment banking arm, that would be a benefit of ‘universal banking’, in which banks do everything from small-change retail banking to high-stakes financial gambling – the model which has brought us to the too-big-to-fail reality of our current banking sector. But there is no such transfer and no such benefit. Instead, the banks chose to make current accounts pay for themselves in two ways: by charging erratic customers unjustifiably large amounts for going overdrawn and mismanaging their accounts; and by selling PPI. At its peak, according to Which?, the revenue from PPI was £5 billion a year. So the revenue from wayward account holders and PPI chumps would keep our current accounts ‘free’.

The trouble with this thinking is that it missed out the fundamental fact about banking: that it is based on trust – on credit in more than just the economic sense. Trust is the banks’ most important intangible asset: if it were lacking, none of us would ever use them for anything, ever. In a sense, trust is what banks do. In a capitalist economy, companies make money by supplying needs or wants: we pay for things knowing that some of that money is profit for the businesses involved, and are in general content to do so, because we know that’s how the system works. Companies align themselves with our interests and make money in the process. To take just one example, I subscribe to Sky television in order to watch the sport. (I know that lots of people refuse to subscribe to Sky because of its connection to Rupert Murdoch, but News Corp owns only 39 per cent of BSkyB and the Murdoch family owns only 12 per cent of News Corp. That means that more than 95 per cent of Sky is owned by not-Murdoch, which as far as I’m concerned puts it in the clear. Murdoch’s 4.68 per cent of Sky is only a fraction more than Libya’s 3.27 per cent share of Pearson: I’ve never heard of anyone refusing to buy a Penguin book because of Colonel Gaddafi.) The sport is a luxury, as both Sky and I are well aware, so they add features to make their subscribers stay with them: in this case, free phone calls to landlines not just in the UK but anywhere in the world for a flat £5 a month. That’s unbeatably good value, which Sky offers not because they love me and want to have my babies, but to keep me coughing up the cash for the sport package. They’ve worked out a way to align themselves with my interests and to make money that way. The computer on which I’m typing these words is another example. It’s a MacBook Pro, made by Apple, a company which has two reputations. For consumers, it is famous for making cool stuff which is also shiny. For economists, it is famous for its astoundingly high profit margins: last year, its margin hit 47.4 per cent. That is so high it makes analysts do a double-take and rub their eyes. For comparison, Wal-Mart, the biggest company in the world by sales, currently has a margin of 3.3 per cent. So if you buy something from Wal-Mart, you’re giving them 3 per cent of the cash you hand over as profit, but if you buy from Apple, you’re handing over nearly half. How do Apple get away with that, you may well ask? The answer: by making products that people really, really want. This computer is four and a half years old and my only problem is that I’ve spent so much time staring at the bloody thing that I’m sick of the sight of it. It’s working as well as ever and the only way I’m ever going to be able to justify getting a new one is if something – cough – happens to it. As far as I’m concerned, as an Apple customer, margin schmargin. Apple, like Sky, aligns itself with my needs and interests and it’s fine by me that it makes money en route.

Banks are perfectly placed to make money by aligning themselves with their customers’ interests. That process is baked into what they do: they align themselves with us by taking our deposits and looking after them safely, and they align themselves with us by lending us money to buy things and houses and keep the economy running. Their business is our interests. Or should be. But the PPI scandal showed a fundamental breach in that alignment between them and us. The other scandals of recent years are variations on the theme of banks breaking rules and making mistakes. This, though, wasn’t a mistake or a rule-breach, or rather it was, but the main thing about it was an order of magnitude more important. PPI was about banks breaking trust by exploiting their customers, not accidentally, but as a matter of deliberate and sustained policy. They sold policies which they knew did not serve the ends they were supposed to serve and in doing so treated their customers purely as an extractive resource. That is why, uncharismatic as it sounds and dreary in many of its specifics as it is, PPI is the worst scandal in the history of British banking: the one that shows just how badly wrong the industry had gone, and just how fundamentally it violated what should have been its basic values. No wonder that there’s been what the Parliamentary Commission on Banking Standards, in the very first sentence of its 571-page report, calls ‘a profound loss of trust born of profound lapses in banking standards’. PPI is the final proof that our banks became rotten.

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Vol. 35 No. 15 · 8 August 2013

John Lanchester writes that ‘banks are perfectly placed to make money by aligning themselves with their customers’ interests’ (LRB, 4 July). But the problem is that banks and other global financial firms are perfectly placed to make even more money by continuing to treat their customers as what Lanchester calls ‘an extractive resource’. Banks have refined the money-making techniques of levying fees and charges on retail financial services and mis-selling expensive, unnecessary, add-on products, such as Payment Protection Insurance. A 2006 US report found that late-payment penalty fees levied on credit cards had almost tripled in ten years, rising from an average of $13 in 1995 to $34 in 2005, and a recent UK study reports that in 2011 British banks obtained revenues of £8.8 billion from retail current accounts, the equivalent of £139 for each active current account in the country. The standard free-if-in-credit account generated an average revenue of £141, prompting the Office of Fair Trading to observe that ‘it appears unlikely that mis-selling of other financial products would be prompted by low revenue.’ One might therefore respond sceptically to bankers’ off-the-record comments to Lanchester that the PPI scandal is a result of free banking.

The fraudulent selling of PPI-style products is a global phenomenon that consumer organisations and regulators across the world have struggled to stop. In 1998, the same year Which? magazine began its UK campaign against the mis-selling of PPI, the Consumers Union and Centre for Economic Justice in the US reported an estimated loss to consumers of $2 billion annually from the sale of consumer credit insurance. But the fraudulent selling of such products continued: the first public enforcement action by the Consumer Financial Protection Bureau, the new US regulator, in July 2012, levied a penalty of $25 million and ordered $140 million to be paid out to US consumers for the mis-selling of PPI and similar products. (Incidentally, the firm involved, Capital One, is one of the first of the larger firms that the FSA fined in 2007.) Australian consumer advocates attacked the mis-selling of consumer credit insurance in 1991, and after reviews of the market in 1991 and 1998, regulation was enacted, including a cap on sales commission. But a November 2011 report still found ample evidence of the mis-selling practices endemic in the PPI markets in the UK and the US.

PPI mis-selling became routine because financial firms structure their retail businesses to maximise the extraction of income from financial consumers. The most interesting aspect of the PPI scandal in the UK is not so much that banks and other financial firms systematically ripped off consumers, but rather that they have been forced to disgorge some of their illicit gains. This is a consequence of sustained efforts by consumer advocates, such as Citizens Advice and Which?, the work of the Financial Ombudsman Service in dealing with consumers’ complaints, and the activity of UK regulators, including the Competition Commission, the Office of Fair Trading and the much maligned and now superseded Financial Services Authority. A realignment of banks’ interests with those of their customers could protect against outrages such as the PPI scam, but such a realignment poses an enormous regulatory challenge.

Iain Ramsay & Toni Williams
University of Kent

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