Recovering from a love affair with debt

Problems of fraud, mis-selling and excessive leverage tell us that even under the best directors, some banks are too complex for boards to manage with confidence, says a leading academic who gave evidence to the Parliamentary Commission on Banking Standards.

Professor Franks says: “Shareholders of UK banks are highly fragmented even by the standards of dispersed ownership markets – it’s an extreme form of free riding or ‘ownerless companies’ as described by Lord Myners.”

Julian Franks, who is Professor of Finance at London Business School, made the remark speaking about evidence he gave to the Parliamentary Commission on Banking Standards, which published its fourth report – ‘An accident waiting to happen: The failure of HBOS’, earlier this month.

Professor Franks, who will speak at the School’s Global Leadership Summit on 20 May with Iceland’s President Ólafur Grímsson, whose administration successfully eliminated a 50 billion euro debt with his radical approach to economic reform, has proposed five potential solutions to excessive risk taking and poor lending.

The proposed solutions, which include: remuneration linked to return on assets; incentives to bondholders to better monitor banks; decisions favouring consumers over shareholders; and greater control rights for certain classes of debt holders, could save banks from more drastic measures.

Professor Franks explains: “Unless we can be confident that these solutions will work, we will have to go back to the sledgehammer option of raising equity requirements to very high levels. If you are too big to fail, we will impose such high equity capital requirements so as to reduce the risk of insolvency to virtually zero.”

Many of these new measures are still untested though and should complement, not substitute other remedies, warns Professor Franks. His warning comes after Barclays’ plans to use Contingent Capital Bonds – known as CoCos – came under fire from the Association of British Insurers who warned the approach could dilute shareholder interests.