Key Points�� The Government’s upcoming Banking Reform Bill is more a response to understandable

anger at bankers than a well-considered response to the crisis. �� By diluting bankers’ authority, but giving them more individual responsibility and

imposing criminal sanctions for collective failures, rational bankers will leave the industry.�� Moreover, in the boom-bust cycle of finance, what appears the morning after to have been

a reckless party, often seemed innovative and clever the night before. Criminal convictions would be hard to achieve unless the legal standards used to convict in the bust are different than those applied during the boom when the mistakes are being made.

Author Prof Avinash Persaud

Criminal law is not a tool for improving financial stabilityIn this Spotlight article, Professor Avinash Persaud considers the UK Government’s amendments to the Banking Reform Bill, which support the recommendations by the Parliamentary Commission on Banking Standards, to introduce a new criminal offence of reckless misconduct in the management of a bank. He argues the proposals are well-intentioned but incoherent, they risk perversions of natural justice and are based around the false notion that financial crashes are caused by individual malfeasance.

nThe period just after a major financial crisis, such as the great credit crunch

that has engulfed the industrialised economies since 2007, is ripe for root and branch financial reform. Cries of “this time is different” heard during the boom, are replaced with shouts of “never again” as the bust unfolds. Crises are the handmaiden of financial reform. The requirement that the audited accounts of banks should be published can be traced back to the collapse of Royal British Bank in 1856. The US Federal Reserve was created in 1913 in response to the “Financial Panic” of 1907. The 1933 Glass Steagall Act, that separated US commercial and investment banking for over fifty years, was born out of the 1929 stock market crash. The 1974 establishment of the Basle Committee of G10 Bank Supervisors was triggered by the collapse of the relatively obscure Bankhaus Herstatt in June of that year.

While the moment for good reform emerges in the wake of a crisis, if it is not grasped, it soon submerges; letting bad reforms surge in. Regulators, caught up in putting out the fires of a financial crash, often see the point of origin quickly. Despite contributing to the crisis by designing the previous, flawed, bank regulations, the Basle Committee of Bank Supervisors delivered a blueprint for meaningful reform (Basle III) as early as April 2009, just seven months after the collapse of Lehman Brothers. But

over time, as tax payers’ money is used to bail out wealthy, under-taxed, bankers, and the ensuing government deficits lead to the scrapping of investment for the less fortunate, justifiable moral indignation morphs into understandable anger. With this, the consensus of what went wrong and should be fixed is lost amid the salacious details of individual villainy.

Since April 2009, many of the critical changes to the Basle Accord, such as the requirement for more stable funding and higher capital requirements, have been diluted and delayed. On 29 September 2013, Stefan Ingves, head of the Basle Committee, told the Financial Times that the proposed tough capital rules on instruments could be further softened. Basle’s retreat coincides with the strengthening of new proposals seemingly focused on the punishment of and shackling of bankers.

Politicians are drawn to the “bad apple” doctrine of financial crises that crises are caused by bad people doing bad things, often out of bad, foreign jurisdictions. It absolves them from the responsibility of being poor regulators. They lash out at the bad apples, with both the political left and right queuing up to express their anger at the bankers at the centre of the storm. Even other bankers, not so tarred, join the baying mob to prove their own innocence. 

On 8 July 2013, the UK Government came out in strong support of the

Parliamentary Commission on Banking Standards report “Changing Banks for Good”. In particular, the Government announced amendments to the Banking Reform Bill, in accordance with the Commission’s recommendation, to introduce a new criminal offence of reckless misconduct in the management of a bank. At the time of writing the Reform Bill appears likely to replace the existing “Approved Person Regime” with a new “Senior Person Regime”. Although further clarity is required, the reforms aim to identify the people who actually run the bank – including board and executive committee members and perhaps also non-executive directors – and to subject them to criminal sanctions for reckless misconduct in managing the bank. The offence may carry a custodial sentence. Following conviction, any pay or bonuses received by that individual, during the period of reckless behaviour, may be recoverable through civil proceedings.

In fairness, the Parliamentary Commission recommended that this offence should only be pursued in cases involving “the most serious of failings, such as where a bank failed with substantial costs to the tax payer, lasting consequences for the financial system, or serious harm to customers”. Defining “recklessness” is always a challenge. It is likely to hinge on a subjective assessment as to whether the Senior Person was aware (or should have been aware) that the risk existed or could exist, and, in the circumstances known to him, it was unreasonable for him to have taken that risk.

The proposal is well intentioned. It rightly seeks to reduce the asymmetry of privatised gains and socialised losses. But it will not work to protect us from financial crises and could lead to perversions of natural justice.

607Butterworths Journal of International Banking and Financial Law November 2013

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The first problem with the proposal is that the requirements for a Senior Person are incoherent. A Senior Person will now have:�� less authority over decisions, by giving

greater autonomy to risk managers and compliance officers; �� less certain compensation; and �� will carry more open-ended liability for

the outcome of collective failures.

Responsibility without authority seldom works in life.

More fundamentally the idea that financial crises are caused by bad individuals condemn us to repeat the boom and bust cycles. Individual bank failures may be caused by individual actions. But the authorities are already well equipped to deal with individual bank failures such as Barings in 1995 and Continental Illinois in 1984. It is financial crashes that cause destruction on a grand scale that we are trying to avoid. But crashes are not caused by random acts of malfeasance. Busts always follow booms. The longer and wider the boom, the deeper and more all-encompassing is the crash. Long, widespread booms do not happen because a few people do risky things they should avoid; but by many people doing things they believe are safe – so safe that it justifies them taking on greater risks. They are reinforced in thinking that what they are doing is safe by the dominant thinking of the day, broadcast by newspapers, universities and even regulatory bodies. The most sanctimonious central bankers today are often those who presided over the publication of annual Financial Stability Reviews that were the biggest cheerleaders of the notion that this time was different and that financial innovation will keep us safe as houses. If all those who would be convicted after a financial crisis were not around, the crisis would still arrive.

Moreover, while the outrage that underlies the proposed criminal reforms is understandable, it is difficult to compare the financial failure of an institution to other types of criminal behaviour. In a murder trial, for example, the jury has a relatively clear idea of the necessary ingredients of the crime and this does not

change beyond recognition over time. With reckless misconduct in the management of a bank, juries would have to differentiate between a normal investment decision and a reckless one – in an uncertain commercial environment where all investment decisions involve risk. Decisions that may be characterised as reckless with the benefit of hindsight, at the time they were taken, may have appeared reasonable to a reasonable person. And what happens to those who make reckless investment decisions but are just lucky? There is a distinct danger that we are merely criminalising poor or unlucky investment decisions.

There is the suspicion that when the Parliamentary Commission was considering the introduction of this new offence, foremost in their mind was the case of Mr Fred Goodwin, who as CEO of RBS led a meteoric expansion and spectacular bust of the bank, receiving handsome personal rewards along the way. Mr Goodwin backed big leveraged buy-outs and audacious takeovers. These included the takeover of National Westminster Bank when by assets it was three times the size of RBS, the expensive take over of US-based, Charter One Financial and, fatally, the attempted takeover of ABN Amro. Over-zealous expansion contributed to the timing and magnitude of a failure that was so large it necessitated public involvement. This would seem to be a clear case of reckless misconduct.

Yet for the better part of a decade it was not obviously so to the supervisors of RBS. In fact, supervisors favoured bigger banks as they were considered safer: they had more capital and benefitted from economies of scale. From Fred Goodwin’s appointment as CEO in 2001 to 2007, the cost-to-income ratio at RBS improved markedly and profits, capital, and assets grew strongly. The bond markets were unperturbed. Equity markets rewarded him with higher share prices. And it was not just fevered markets that blessed his conduct. In 2004, Mr Goodwin was knighted for services to the banking industry. Even in October 2008 after presiding over the largest loss in UK corporate history, the Daily Telegraph

concluded that Sir Fred’s “grasp of finance is in the Alpha class”.

The tragi-comedy of financial crashes is that today’s criminals are yesterday’s heroes. What appears the morning after to have been a reckless party seemed innovative and clever the night before. In the fatal words of Chuck Prince, former CEO of Citibank, “when the music is playing you have to get up and dance”. This would make criminal convictions hard to achieve unless the legal standards used to convict in the bust are different than those applied during the boom when the mistakes are being made. But where a person’s liberty is at stake should we not require greater legal objectivity and certainty than that – even for bankers.

Bankers were allowed to place asymmetric bets in which they pocketed the gains while passing losses on to taxpayers. The full range of fiscal and regulatory measures coupled with civil remedies, must be used to alter these incentives. Directors of bailed-out institutions suffer few consequences and should be disallowed from working in the sector. But even if we can provide good justice, locking up individual bandits is not going to save us from financial crashes. Thinking it will lead to dangerous complacency.

Crashes are not caused by the criminal behaviour of a few individuals, but by the madness of crowds. We are not going to minimise the heavy financial, economic and social cost of crises if we do not deal with the collective delusions that underpin the booms, by for instance, automatically ratcheting up higher capital adequacy requirements as lending growth rises above average. There is also too much reliance on flawed measurements of capital adequacy. We must not forget that the failed banks appeared well capitalised a year before. It is time to refocus bank safety away from malleable measurements of value that underestimate risks in the boom and overestimate them in the bust.

Future rules must be geared towards minimising the structural mis-match between risk taking and risk capacity – and must do so across the financial sector and not just across banks.  n

Biog boxAvinash Persaud is chairman of Intelligence Capital Limited, a firm specialising in financial, economic and governance advice to institutions and governments. He was a Member of the UN Commission on financial reform; a Member of the Pew Task Force to the US Senate Banking Committee and Visiting Scholar at the IMF and ECB. He was a Member of the UK Treasury’s Audit Committee and was elected Trustee of the Global Association of Risk Professionals and the Royal Economics Society. He won the Jacques de Larosiere Award in Global Finance and was the 2010 President of the British Association for the Advancement of Science (Economics). Email: apersaud@me.com

608 November 2013 Butterworths Journal of International Banking and Financial Law

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