Ignacio de la Torre. Professor. IE Business School
7 June 2012
Independent advisers now have a golden opportunity to take over the distribution of financial products from banks following recent banking scandals.
Do you trust your financial adviser? In the UK over three quarters of the distribution of financial products are carried out through independent advisers. In Spain the vast majority are distributed through banking networks. Which of these models will prevail?
Take this scenario. The economic and banking crisis of 2007 and 2008 causes a massive drop in the price of assets, which in turn implies an enormous latent fall in value of banking assets. This fall in value, if acknowledged, reduces the amount of capital with which the banks operate, which could in turn mean that they find themselves insolvent. Recapitalization is then needed to regain a balance and ensure 1) that the bank has the minimum level of solvency required to avoid scares for accountholders, and 2) that credit can flow into the economy, given that zombie banks (those that lie about their assets in order to avoid having to recognize that they are insolvent) are not lending, as observed in Japan. Now let’s take a look at two different reactions to this scenario.
UK: Following in the wake of US action, the UK forced the immediate recognition of the drop in value of assets. This recognition resulted in a proportionate reduction in own funds, which placed many British banks in a position of insolvency. The state then forced a recapitalization using public funds which diluted the shareholders of the insolvent banks. Given that when this happened in 2009 government bond markets were working very well, the state had no problem issuing the bonds needed to fund the recapitalization process. Other European countries, including Spain, boasted about the “strength of their finance systems”, mocking the weakness of British banks, a weakness brought to light by recognizing such massive losses. The result of this rationalization over three years: credit flowing into the private sector has started to increase, laying the foundation for economic recovery.
Spain: in spite of being exposed to promotional and construction credit to the tune of 450 billion euros (45% of its GNP), plus an enormous risk in terms of mortgages and companies in difficulties, Spain opted for the “ostrich technique” and lied with impunity about the value of banks’ assets, lies that were firmly backed up by administrators, regulators, auditors and government. When the first savings bank (Caja Castilla La Mancha) had to be intervened it lied blatantly to the public, saying after the cabinet meeting that the intervention was “not due to problems of solvency but to problems of liquidity.” The Spanish finance system went “zombie” and after credit available to the private sector all but disappeared, the economy imploded. Three million jobs were destroyed as a result. Sooner or later the shameful goings on come to light (as Warren Buffett says, “only when the tide goes out do you discover who’s been swimming naked), and the grand dilemma of how to recapitalize the finance system arose.
The state no longer had credit in the bond markets, something that it would have had had in 2009. An increase in capital in the private sector would have totally diluted the old shareholder base, and it is doubtful if there would have been sufficient capital to inject into companies with such dodgy assets. Solution: saving deposits. The banking networks promptly set about “advising” savers to switch to “preferential” accounts, similar to their savings accounts but with a greater return on investment. A total of 30 billion euros have been issued since 2007 using mis-selling techniques. Seeing that preferential accounts stopped being counted as capital under the terms of Basle III, the following step was to convert these stakes into shares, causing in many cases enormous losses for savers. Given that even this measure was not enough to solve the problem, the banks started floating shares on the stock exchange in a highly questionable manner, which, when shares didn’t meet with much demand on an institutional level, led to their mass distribution among bank branches, again with very dodgy valuations of assets. These stock exchange flotations brought huge losses for subscribers. Lastly, there was an effort to shore up the financial system via massive injections of liquidity, and capital, and asset protection systems guaranteed largely by the deposit guarantee fund, that is to say, it was an indirect way of using the savers’ money to cover up the shameful results of such terrible administration and even worse supervision of the banking system, leaving said fund with practically no resources.
The banking distribution networks have a serious conflict of interests, given that the public go to them for advice, and yet they sell them what is in the interests of the bank, not the client, a hypocritical modus operandi, referred to by those in the trade as “placement”. The lack of financial culture among the greater part of the Spanish population has served as vehicle for such piracy, which explains the enormous profitability of the banking sector until recently. What has happened over the last few years has been as bloody a process as gutting the chicken that lays the golden eggs. The result is a before and after in terms of public confidence in the bank as a source of advice.
Hence, independent financial advisors, if they are in any way informed, are set to conquer Spain in the future. They will conquer Spain because the distribution policies of banking networks have broken the eighth commandment too many times, and the legal system will soon be passing judgment on whether or not they have also broken the seventh.