When the invisible hand dips into your pocket

News this morning that the FCA has abandoned its review into the culture of banking is surprising only in the fact that it has been announced. All of these reviews have had little real impact on the actual conduct of retail or wholesale banking, apart perhaps from the nuisance value of having to set up ring-fencing: but that too is being quietly watered down so that it will have modest impact on profits. The one review no government has threatened (and no opposition has called for) is a proper investigation into how banks actually make money: this would risk exposing the inherent vice of a system with, at the heart of its corporate side, almost total dependence on zero-sum-less-bonuses trading, and for retail, equal addiction to products which customers don’t understand.

And yet an increasing numbers of intelligent economists as well as journalists are recognising that in a mature, competitive market, banks are driven to cheat to survive. PPI tells the story, but there are countless other examples where banks and their customers form bargains in which the sources of profit are the asymmetries of information or other exploitations of customers’ cognitive errors.

You may say caveat emptor. But that isn’t what the politicians say. It has long been recognised that it is fundamental to the workings of society that banks be held to a higher standard that a fruit trader in a market stall. The position is some way short of the fiduciary role that a lawyer or professional advisor has, but (at least in theory) is considerably more burdensome than for the street trader. And it is imposed both by statute (for example, the Unfair Contract Terms legislation, which is supposed to stop big businesses hiding outrageous terms in small print they have drafted) and by regulation. Since everyone knows that banks are adept at getting round specific rules, regulation comes with the FCA Principles which are supposed to reassure consumers that they will be treated fairly.

Here are some of the most relevant ones:

Principle 6 (customers’ interests) A firm must pay due regard to the interests of its customers and treat them fairly.

Principle 7 (communications with clients) A firm must pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading.

Principle 8 (conflicts of interest) A firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client.

These are clearly modelled upon the English common law which imposes upon fiduciaries onerous rules such as never having a conflict of its own interests with those of a customer (“no conflict”), nor having a duty to one customer in conflict of that owed to another (“undivided loyalty”), and not profiting at the expense of the customer (except reasonable professional fees) (“no profit”).

But do the principles work? Or rather, are they applied?

In practice, no. The FCA and the Financial Ombudsman show an extraordinary reluctance to invoke them when banks are caught behaving unfairly (or cheating in everyday language). And when the regulators show signs of toughness, they are sacked.

First of all, what is fair? It’s not a term with a statutory definition, but I’ve written before about Lord Sumption’s judgment in the Plevin case. There it seems the regulators thought that as no specific rule was broken, the banks should be allowed to get on with it; however the judge had no difficulty in deciding that the consumer had been cheated because she hadn’t been told about the outrageous amount of her insurance premium which was being paid as commission without her knowledge. The only difficulty was how to bring this consideration into the decision; in that particular case a little known provision of the Consumer Credit Act was brought into play. But for most consumers the courts have no such power, and they are dependent on the Financial Ombudsman to enforce the general principles – i.e., not at all.

And from the FCA’s current consultation on how to respond to Plevin, they are determined to keep it that way. There is no suggestion that Plevin ideas should be allowed to sully any area of consumer finance where the specific CCA provision was not engaged: on the contrary, the consultation is about how to limit the fall out from such dangerous thinking.

But Lord Sumption’s principle, that the relationship cannot be regarded as fair if the customer is kept in ignorance of some term knowledge of which would lead a reasonable person to walk away from the deal, seems to me to be no more than the FCA principles imply. Such a term is clearly something the consumer needs to know, and not informing her offends each of the principles 6–8 cited above.

You can easily think of similar cases where this applies. When a bank pays interest on a deposit account, it is obliged to tell you or advertise if the interest rate drops by more than a certain amount relative to base rate: that’s a specific rule, breach of which should lead to a successful complain to the Ombudsman. (Of course it doesn’t, even then: in one case where a bank failed to advertise such a reduction, the Ombudsman rejected my complaint because I couldn’t prove that I would have seen the advertisement which hadn’t appeared; as usual I had to issue court proceedings to obtain redress). But what happens if a bank holds your rate where it is, the Bank of England continues to ignore upwards pressure on rates and to remain competitive the bank introduces a new account, identical except that it pays twice as much interest? They know that you would switch if you knew, so they don’t tell you.

Is that in accordance with your information needs and the other principles? Well, yes, according to the FOS: anything else would interfere with the banks’ legitimate right to cheat you. And if you point to the specific rule that says that banks go through certain procedures to monitor conflicts of interest (these are specific rules), they say it isn’t a conflict of interest. Indeed according to one ombudsman, putting the bank’s profit before the customer’s return can’t be a conflict of interest: “this particular principle [is] intended…to deal with issues arising from the potential abuse of business relationship [such as] where a mortgage intermediary passes large amounts of business to a lender because they have a relative working at that lender.” In other words he reduces FCA Principle 8 to the common law “undivided loyalty” rule, rather than recognising that it also embeds the simple “no conflict” rule. And it flies in the face of the actual wording of Principle 8 which includes the phrase “both between itself and its customers”.

Now many of you will think that I’m asking too much from banks by asking them to be held to Lord Sumption’s principle. But perhaps the real focus of my concern is not where the level of consumer protection is set, but the hypocrisy with which the FCA Principles are held up as shining examples of effective regulation where the practice is of ignoring their literal import at every opportunity. If the principles overreach where parliament wants to set the limit, they should be rewritten, not undermined. There is enough disrepute already in this industry.

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