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Now the full extent of the Barclays duplicity is revealed, tough measures must include heads rolling and the threat of an inquiry
John le Carré's Tinker, Tailor, Soldier, Spy is one of the great postwar British novels. Set in the 1970s, it is the story of George Smiley's hunt for a KGB mole working at the top of MI6. Smiley narrows down the list of suspects to four, all of whom meet a Russian diplomat at a London safe house.
When interrogated by Smiley, one of the four – Toby Esterhase – says the purpose of the meetings is so that scraps of low-grade intelligence can be exchanged for Moscow's most closely guarded secrets.
"The only problem arises when it transpires that you've been handing Polyakov the crown jewels and getting Russian chickenfeed in return," Smiley says. "If that should turn out to be the case, you're going to need pretty good friends."
An apt metaphor, you might think, for the current state of UK banking. Bob Diamond et al told us we were getting the crown jewels, and should be grateful to boot. Actually, we were getting chickenfeed. And now the full extent of the duplicity has been revealed, they too are going to need pretty good friends.
Just like the mole inside British intelligence in Tinker, Tailor, the banks have had a cover story to justify why they have been subjected to only the flimsiest regulation of their activities. The argument has been threefold: the City employs a lot of people, it is a vital part of the economy, and the innovative products it has developed are beneficial to its customers.
The UK financial sector is certainly important, but not as big in terms of employment or output as the City and its supporters would have us believe. Much of it is relatively humdrum and continues to be a source of foreign earnings, as it has been for centuries. Finance and insurance generates a trade surplus of around £40bn a year from a workforce of just over a million.
The problem has not been with those toiling away in high-street banks and insurance company call centres, but with what might be termed the rogue elements, who have abused the freedoms they have been granted to blow up the economy and fleece their customers.
Much of what passes for innovation in the City is no such thing. Innovation in the rest of the economy is where a company develops a superior product for its customers in the hope of making a profit; innovation in the City is all too often about identifying and exploiting regulatory loopholes to come up with products nobody really wants but which enable investment bankers to get rich at the expense of their customers. Quite how this is supposed to be "good" for the economy has never been satisfactorily explained, and it has taken the worst financial crisis in more than a century, the deepest slump since the Great Depression and flagrant acts of wrongdoing for Britain's policy elite to conclude that there is – in Sir Mervyn King's words – something "very wrong" with the banks. Better late than never.
The priority now is not to squander a second opportunity to put the banks in their place. After the scandals of the past fortnight, the City is in an even weaker position than it was after the bailouts in late 2008, after which it mounted a protracted – and largely successful – campaign to frustrate radical reform.
To effect the culture change sought by Lord Turner, chairman of the Financial Services Authority, will require five elements. The first is the structure of the industry, which the government intends to address by implementing the recommendation of the Vickers commission on banking, which proposes putting a firewall between the retail and investment arms of the big financial institutions. This falls short of what is needed, because it is as plain as day that attempts will be made to circumvent the firewall almost as soon as it is erected. As King noted last week, the cultures of retail and investment banking are utterly different. The logic of that argument is that there should be a complete separation of the two entities.
A second element is personnel. It used to be said that a governor of the Bank of England could make his displeasure known by raising his eyebrow at a City grandee called in for a "chat". King could barely have made his displeasure more evident last week: at the press conference to launch the Bank of England's Financial Stability Report, the amount of eyebrow raising (metaphorically speaking) would have put Roger Moore to shame in one of the Bond movies.
But neither King (nor Turner) called for heads to roll in bank boardrooms, despite being given ample opportunity to do so, even though without changes at the top it will be impossible to get the culture change now being demanded. The argument is straightforward. Bank chiefs have been pocketing massive pay and bonus packages courtesy of the profits being made by the traders working beneath them. When those same traders are found guilty of serious wrongdoing, it is not tenable for senior executives to say "nothing to do with me, guv". A failsafe way for King and Turner to get shot of two or three of the so-called masters of the universe would be to advise David Cameron to make a speech in parliament warning the shareholders of banks that the government will set up a Leveson-style inquiry into the City unless action is taken against those seen as not "fit and proper" to run the business.
The third element of reform should be greater competition. Profits and compensation levels in the City reflect the barriers to entry in a business dominated by producer interest. Efforts should be made to encourage new entrants into the market, including some of the new – and genuinely innovative – forms of non-bank finance such as peer-to-peer lending and crowdfunding.
A rethink of how the Bank of England conducts monetary policy is also in order. This week will almost certainly see an expansion of the quantitative easing programme under which banks can sell government gilts for cash. Lambasting the banks one day and then providing them with lots of newly-minted money for them to hoard the next is, to say the least, sending out mixed signals. There is a case for setting up a national investment bank to channel the money directly to the economy, and a fully state-owned Royal Bank of Scotland would be one way of achieving that.
Finally, there is a case for punishment to serve as a deterrent against future wrongdoing. Rather than resist calls for a Europe-wide financial transactions tax, the government could throw its weight behind the idea and introduce the levy at a marginally higher rate than in Germany or France. The message to the banks would be that the FTT would be reduced, but only when their behaviour had demonstrably improved. If, as the City is fond of telling us, incentives matter, then that should do the trick.