Steer clear of Britain's rotten banking sector

published 14 February 2011

The big banks are angry. Very, very angry. And we've been hearing all about it.

News that George Osborne is hitting them with a surprise levy of £800m has sent shockwaves through the City. The chief executives of the big four banks are "livid', according to the BBC. And they have called an emergency meeting to decide whether, in the words of one irate banker: "they should throw their toys out of the pram".

What a great show they are putting on! What a spectacle! As the big bankers jump up and down, George Osborne entertains everyone with a song and dance about getting tough with the City. The Chancellor wags his finger. And everyone gets to indulge in a decent show of bank bashing.

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But that's all it is - a show. There is nothing genuine about the anger reported in the press. And the deal that the government struck with the banks - dubbed Project Merlin - will do very little to rein in the bankers' pay and their bonuses.

In fact, if it does anything at all, it exposes a fundamental and disturbing problem with UK banking. Something that directly affects you as a shareholder.

It's the shareholders that get stiffed

Project Merlin was never going to be a rough ride for the big banks. If you looked past the front pages of bank-bashing last week, you'd have read that the City funds 50% of Tory coffers. The Tories have no interest in biting off the hands that feed them.

Ultimately, the people losing out here are the banks' shareholders. And as a stakeholder in our nationalised banks, that you includes you.

The critical point is that the 'bankers levy' isn't a tax on bonuses. It is a tax on banking corporations. It will be the shareholders who get stiffed here.

So it's ironic that the public is supposed to cheer on this new 'bankers' tax, even as their own interests get hit. The bankers have managed to deflect the heat from themselves and onto shareholders.

And this exposes a problem that goes right to the heart of the banking crisis.

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Why bankers couldn't care less

What we have here is a 'principal' and 'agent' problem. As shareholders we are the principals (P), and we delegate the role of running the businesses we own to agents (A).

As large corporations evolve, the interests of the original owners usually give way to the interests of professional CEOs. And this leads to a fundamental breakdown in the relationship between you and the company.

Nowhere is this problem worse than in banking. You don't need me to tell you that the bankers have paid themselves gargantuan sums over recent decades. Or that they've loaded up the principals with risk while they've taken rich pickings.

As my colleague James Ferguson recently pointed out, the big four UK banks (HSBC, RBS, Barclays and Lloyds) reported pre-tax and pre-impairment profits of £374bn between January 2003 and June 2010. Over the same period, their loan loss provisions have added up to £172.5bn. So on the face of it, the banks appear to have made a profit of £200bn in that time.

The trouble, says James, is that that's almost exactly the same amount that the Bank of England has made available to banks under its funding subsidies. So in fact, the big four UK banks have not made a profit in almost eight years - despite paying out almost £75bn in bonuses.

The returns for the bank shareholders in that time have been abysmal:

The black line shows the FTSE 100. It's nearly back to pre-crisis levels - but the banks (the blue line) have long-since given up the ghost.

The markets aren't keen on bank shares and that's with very good reason.

The last thing the banks need is a raid on cash right now

The new bankers levy is nothing more than a tax on shareholders' funds. And yet, right now the banks need every cent they can get to build up some buffers for any nasty surprises to come. And there are plenty of catalysts for a nasty surprise.

A sovereign debt bust up, bad loan books, a derivatives black hole or a hike in interest rates could all tip the banks into serious trouble again. Just about anything that can go wrong for the economy could hit the banks hard. They need all the reserves that they can get at the moment.

Even if the banks do manage to avoid any nasty surprises, they will probably face new levies from government. Why wouldn't they? The public are baying for bankers' blood. And the government can levy new taxes in the knowledge that it won't hurt the big bankers' interests enough to make them want to leave.

This looks like a lose-lose bet for shareholders. As is often the case, the agents are in control and it's the principals that suffer.

I am steering well clear of the banking sector.

How can you avoid getting stiffed?

Unfortunately, there is not a lot that you can do to get around the cosy relationship between the City and government. You can avoid buying bank stocks. But then you still have exposure to the nationalised banks.

But there are two things you can do to avoid the principal-agent problem. One, you can invest in companies that pay decent dividends. As I said last week, a dividend is recognition of partnership between you and the company. It is well worth seeking out companies with a long and steady history of lifting dividends. Companies like the one I tipped last Friday - Amlin.

The second thing you can do is to invest in companies where the interests of the principal and the agent are aligned.

On Wednesday we'll take a closer look at how you can find those companies. I'll point to three ways you can spot a company that has your best interests at heart.

This article was first published in the free investment email The Right side. Sign up to TheRightSide here.

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.