Irresponsible Bankers Should Be Jailed

20/06/2013 08:39 BST | Updated 19/08/2013 10:12 BST

The report published on Wednesday by the Parliamentary Commission on Banking Standards is a serious and thoughtful piece of work. Crucially, its key recommendations have cross-party support and a real chance of becoming legislation as amendments to the Financial Services Bill currently before Parliament.

One recommendation that's attracted a great deal of interest is the idea that irresponsible bankers could be prosecuted under a new offence of 'reckless misconduct' and, if found guilty, jailed. This is an idea that Matt Hancock and I first floated in our book Masters of Nothing back in 2011. At the time many people were surprised that two Tory MPs could have come to this conclusion, but to us it was entirely consistent with support for free market capitalism. Bank bosses get paid megabucks on the understanding that their decisions on direction and strategy are responsible for the success of the whole firm. I'm happy to see success rewarded, but the flipside of this system must be that bad decisions have consequences too.

Professional negligence can be prosecuted in other walks of life. Drivers face criminal charges for driving without due care and attention, election Agents face imprisonment for serious breaches of electoral law and doctors can be prosecuted for medical malpractice. But while a negligent doctor can harm our health, negligent bankers poison the whole economy. In finance we need to return to the idea that bankers too have a duty of care because they are stewards of other people's money. Those who don't want to accept this responsibility are very welcome to go and work for the many thousands of small, highly competitive, entrepreneurial firms in the City of London that thrive without subsidy and fail without bailouts.

The objection often raised by defenders of the status quo is that criminal sanctions for guilty bankers may be emotionally satisfying but would be hard to implement in practice. So how exactly would you prove reckless misconduct in court? The first step would be to introduce the principle that senior banking executives are liable to be prosecuted if they behave 'without sufficient regard' for the dangers posed to the safety and soundness of their firm. The economist John Kay has suggested that liability could be established by introducing a legal duty for directors of retail banks to protect their customers' deposits, while HSBC Chairman Douglas Flint has proposed that bankers be made to take a financial version of the Hippocratic Oath. If the bank then failed and/or was forced to draw on public funds the managers would be criminally liable.

One test prosecutors might use to prove 'reckless misconduct' would be to show that managers had failed to take reasonable steps to ensure the assets on their books were accurately valued. After the crash regulators in both the UK and US were able to demonstrate that the mathematical models banks used to value their assets were often seriously compromised. When, in 2009, the US Treasury conducted stress tests at major banks using independent models, it revealed major capital shortfalls despite the fact that banks were meeting their minimum capital requirements.

Negligence over valuation could also apply to a major acquisition. When RBS acquired the Dutch bank ABN AMRO in November 2007 it was, in the words of Merrill Lynch which advised on the deal, 'the world's largest bank takeover and one of the most complex M&A transactions ever'. As it turned out, ABN had been a latecomer to the subprime madness and was heavily invested in some of the most poorly underwritten mortgage-backed bonds and the losses sustained on ABN assets were a major contributor to RBS's eventual failure. A subsequent investigation by the FSA revealed that RBS's due diligence on the deal amounted to 'two lever arch folders and a CD'.

Finally, prosecutors could look at breaches of internal risk limits, as well as attitudes of senior management to the views of their risk officers. Earlier this year the Banking Commission took evidence from Paul Moore, who was head of group regulatory risk at HBOS between 2002 and 2004. In the years before the crash Moore had serious concerns about the sustainability the bank's business model and stated in internal reports that HBOS was 'going too fast', 'had a cultural indisposition to challenge', 'was a serious risk to financial stability...and consumer protection'. When he took his concerns to the top he was fired.

CEOs like Fred Goodwin were accountable to boards who rarely told them 'no', which is why 'reckless negligence' should apply to non-executive directors, as well as the executive officers. If the heads of the non-execs were also on the line this would change the calculation of risk, creating a greater incentive for boards to challenge their CEO.

I would hope that the new law proposed by the Banking Commission would rarely, if ever, have to be used, but the possibility of jail would help concentrate the minds of those entrusted with institutions of national economic importance. If we want to build a culture of responsibility in our banking industry we need real accountability too.