Other People's Money: Masters of the Universe or Servants of the People?
By John Kay
The assets of British banks are around £7 trillion – four times the aggregate of the yearly income of everyone in the country. The liabilities of these banks are a similar amount.
Lending to firms and individuals engaged in the production of goods and services – which most people would imagine was the principal business of a bank – amounts to about 3 per cent of that total.
Modern banks – and most other financial institutions – trade in securities, and the growth of such trade is the main explanation of the growth of the finance sector.
Trade in securities has grown rapidly,but the explosion in the volume of financial activity is largely attributable to the development of markets in derivatives, so called because their value is derived from the value of other securities.
What is it all for? What is the purpose of this activity?
A country can be prosperous only if it has a well-functioning financial system, but that does not imply that the larger the financial system a country has, the more prosperous it is likely to be. It is possible to have too much of a good thing.
Many good ideas become bad ideas when pursued to excess. And so it is with finance.
I will describe the process by which the finance sector has gained such a dominant economic role over the last thirty to forty years as ‘financialisation’.
However, this is not another book about the global financial crisis: it is a book about the nature of finance and the origins of financialisation.
But finance is not special, and our willingness to accept uncritically the proposition that finance has a unique status has done much damage.
If buying and selling in the City not only absorbs a significant amount of our national wealth but also occupies the time of a high proportion of the ablest people in society,it can no longer be easily justified.
We need finance. But today we have far too much of a good thing.
The modern phase of globalisation of finance began with the development of the Eurodollar market in London in the 1960s.
The oil shock of 1973–4 gave oil-producing countries, particularly Saudi Arabia and other states in the Persian Gulf, windfalls beyond their capacity to spend. ‘Petrodollars’ were recycled as loans to Europe and the USA.
Japan, followed by other Asian countries * first imitated and then improved modern production methods, and began to export manufactured goods to Europe and North America.
Asian export success created trade surpluses, with corresponding trade deficits in the West.
The scene was set for the bizarre developments of the early years of the twenty-first century, in which the forced savings of Chinese peasants * would fund the excess spending of American consumers.
The mechanism by which this was achieved was the growing dependence of Western banks on wholesale funding derived from global capital markets.
The world of finance today is dominated by trading, and trading is a principal source of revenue and remuneration.
The rise of the trading culture has no single explanation but is the product of a series of developments, interrelated in origin and cumulative in impact. *
The list of factors contributing to the change is long, and has one striking feature: the change in the nature of finance had little to do with any change in the needs of the real economy.
The growth of securitisation, not just of mortgages but of all kinds of financial claim, changed the nature of banking for ever.
The collapse of the asset-backed securities market would be at the centre of the global financial crisis.
The rise of the trader and the development of a trading culture cannot be dissociated from the political climate of the times: the power of a market fundamentalist ideology, the election of Thatcher and Reagan, the collapse of the Soviet Union and the discrediting of central planning as an economic system. *
Politicians and public began to suspect that the recurrent crises of the finance sector were not simply the result of unexpected and unpredictable events, but symptomatic of deep-seated problems with the culture of the financial services industry. They were right.
Financial crises are not natural disasters like hurricanes or earthquakes, which we cannot avoid and must simply learn to manage. Financial crises have their origins in human behaviour. Economic policies can increase or reduce their frequency and size. And they have.
The proximate causes of these successive crises are very different * yet the basic mechanism of all these crises is the same. They originate in some genuine change in the economic environment:
Early spotters of these trends make profits. A herd mentality among traders attracts more and more people and money into the asset class concerned.
Yet reality cannot be deferred for ever. The mispricing is corrected, leaving investors and institutions with large losses.
Central banks and governments intervene, to protect the financial sector and to minimise the damage done to the non-financial economy. That cash and liquidity then provide the fuel for the next crisis in some different area of activity.
The booms are generally triggered by events external to the financial system. The busts may also appear to have extraneous causes:
It is not just that the modern financial system is prone to instability. Without the mechanics that produce recurrent crises the financial system would not exist in the form it does today.
In a broad sense, the development of a trading-oriented financial sector was closely associated with the free-market ideology that swept across public policy with the rise of Thatcher and Reagan.
The commitment of leaders of the financial community to the values of the free market was a pragmatic alliance of convenience, not the product of deep intellectual conviction.
The provision of an intellectual rationale for free-market ideology is one part of the contribution of economics to policy towards the financial sector.
The models that have been developed in financial economics are wide-ranging, and often technically ingenious. They include the Markowitz model of portfolio allocation and the Black–Scholes model.
The key components of academic financial theory, however, are the ‘efficient market hypothesis’ (EMH) and the Capital Asset Pricing Model (CAPM).
EMH asserts that all available information about securities is ‘in the price’.
Since everything that is already known is ‘in the price’, only things that are not already known can influence the price. The Black–Scholes model, and the whole subsequent development of quantitative models in derivative markets, relies on that assumption.
The capital asset pricing model takes the logic of EMH a stage further. The CAPM describes the equilibrium of an efficient market populated by rational agents each holding similar expectations.
The attraction of the CAPM is that it provides clear answers to the question ‘How are securities prices determined?’ – and the availability of an answer, which is perceived to give financial economics claim to scientific objectivity, overrides the observation that the answer is not correct.
More realistic alternatives to the CAPM need to accommodate disequilibrium, inefficiency that leaves profit opportunities on the table, and imperfect information which different people will interpret in different ways. They need to allow for control illusion and recognise that people chase their dreams.
We all chase the dream, but when taken to excess by individuals or in crowds, the chasing of dreams becomes madness. And chasing the dream with other people’s money is at best irresponsible and often fraudulent.
Uncontrolled gambling will increase society’s exposure to risk. And so it is with wagering in financial markets
These key insights were discarded as financialisation exalted the role of the trader and the overseers of the financial world assured each other that activities which in reality represented irresponsible gambling constituted a new era of sophisticated risk management.
The scale of financial market activity today would be impossible without the expectation – now proven to be reality – that both the liquidity and the solvency of banks are underpinned by government.
And so it has been with government responses to the global financial crisis. By supporting an industry structure not well adapted to the needs of users, policymakers preserved not just the financial system but also the institutions that had given rise to the instability.
Taken as a whole, although some particular hedge funds have been very successful, the hedge fund industry has been very profitable for hedge fund managers, but not for their investors.
The financial world can never have too much of a good thing. Above all, it can never have too much profit.
Cognitive dissonance enabled many bankers to persuade themselves – and some others – that the global financial crisis was not caused by their imprudent behaviour.
And even now politicians and the public are ready to believe that the bewilderingly complex transactions entered into by clever and very highly paid people are the product of profound understanding rather than ignorance and confusion. *
For all their superficial sophistication, the masters of the universe had no real understanding of what was going on before them.
If some people have skills that are worth paying for, but it is difficult to determine who they are, everyone will be able to charge more. This mechanism is part of the explanation of high profits – and high remuneration – in the finance sector.
In markets of today, what matters is not so much knowledge of the economy – knowledge of business, economic development, global politics – as knowledge of the activities of other market participants. That is the knowledge investment banks do have, and it is what gives them the Edge. *
All this activity was sustained by the illusion of profitability: the belief that financial innovation was adding great value and securing exceptional returns when the reality was that traders were borrowing from the future to fill their own pockets.
The possibility that financial institutions do not really make lots of money is difficult to grasp.
Can it really be the case that the industry is not, in fact, exceptionally profitable?
Shareholders in financial companies were victims, not beneficiaries, of the boom and bust of the first decade of the twenty-first century.
Large financial conglomerates were run for the primary benefit of the people who managed them – and, in the main, they still are.
Modern financial conglomerates are not so much engines generating large profits as institutions that survive as a result of public subsidy.
When government stands behind you, it is not necessary to be profitable to be politically and economically powerful – or well placed to provide handsome rewards to senior employees.
The more important point is that, if banks had to pay for the insurance provided by the doctrine of ‘too big to fail’, the trading activities in which they privately engage simply would not take place, or at least would not take place on the current scale.
‘If it seems too good to be true, it probably is.’ That maxim for investors applies equally to the profitability of the financial sector.
Financing the purchase of residential property is the largest element of the capital allocation mechanism of a modern economy. Until the era of financialisation, Wall Street, the City and other wholesale financial centres played only a minor role in funding housing. From the 1980s this changed, with disastrous results.
The growth of markets in residential mortgage-backed securities led not to an intensification of knowledge about housing markets but to its dissipation.
The paradox is that, while the resource diverted to financial intermediation in the housing market increased, housing expertise diminished.
By the time of the global financial crisis all but one of the major societies had either collapsed or been absorbed into a large financial conglomerate. Paradoxically, the exception – Nationwide – survived because in the 1990s it was too weak to attract the attention of a wider financial world.
Stock markets are not a way of putting money into companies, but a means of taking it out.
The use of capital markets by large companies today is mainly driven by tax and regulatory arbitrage, and undertaken by corporate treasurers with other people’s money.
Financialisation has created a world of people who talk to each other and trade with each other, operate in a reality of their own creation, reward themselves generously for genuine if largely useless skills, and yet have less to offer the real needs of the real economy than their less talented predecessors.
The payment system, which all of us use every day, is the principal financial service that business and households need.
And so for centuries there have been two principal means of making and receiving payment: the exchange of tokens and the transfer of credit.
The payments system is one of the utility networks – the electricity grid, the telecommunications network, the water supply system – that underpin social and commercial activity. We use these networks every day. If they are out of action for even a few hours, commercial activity grinds to a halt and social lives are disrupted.
Most utility networks are also natural monopolies. The twin characteristics of indispensability and monopoly explain why utilities are closely regulated. *
The physical networks of transport, telecoms and other utilities were planned by engineers.
Payment systems evolved in a more haphazard way and over a longer period of time.
In Britain, and in most European countries, the payment system is controlled by a consortium of banks.
In the UK residential mortgages account for about two-thirds of total lending, though the share is smaller in other countries. Business lending is a particularly small proportion of the total in the UK. Anyone who supposes that financing business is the primary function of banking is mistaken.
Between the company and the saver are registrars, custodians, nominees, asset managers, fund-of-fund managers, investment consultants, pension fund trustees, insurance companies, platforms, independent financial advisers. And when trade occurs, a high-frequency trader, an exchange and an investment bank all take a cut.
Their commercial objectives are not those of the ultimate users of markets – the savers whose funds are invested,and the companies whose shares are held.
This is the epitome of a financial system designed for the needs of financial market participants rather than the users of finance.
The modern investment bank has retreated from search, the creation and discovery of new investment opportunities, into trading with other people’s money for the benefit of its senior employees.
It is time to query whether the stock markets that consume so much resource and receive so much attention any longer serve an important economic function.
There has been little change in the structure or behaviour of the industry, with the result that successive crises are more or less inevitable. The huge sums of public money released into the financial system have done little to promote economic recovery since the funds provided were largely retained within the financial sector itself – or paid out in excess remuneration to senior employees.
Perhaps the long-drawn-out consequences of the global financial crisis were more damaging to the real economy than those which would have arisen from allowing the collapse in 2007–8 of major institutions, followed by a state-sponsored restructuring of the finance sector. *
The political power of financial markets and financial market participants is not just derived from the efforts of their lobbyists, the impact of their money and the degree of regulatory capture – although these are central facts of modern political life. The political influence of financial market participants extends far beyond policy towards financial markets. Why?
Britain, benefiting from its innovative financial sector, was a pioneer in the use of off-balance-sheet financing to flatter government accounts.
Since then concealment of public borrowing to meet state liabilities has become a routine feature of UK public accounts, and British financial institutions have promoted these techniques around the world.
The demand for safe long-term assets provides an opportunity to rebuild the crumbling infrastructure of Britain and the USA and to invest in long-term projects in energy and elsewhere on improbably favourable terms. This opportunity has been passed by in the interests of supporting the financial sector and satisfying the economic policy perceptions of traders in securities markets.
There are good reasons for scepticism about the economic value of much of the activity of the finance sector.
Private profit without public benefit is a policy problem everywhere in finance, but a particularly acute British dilemma.
Reported figures for the contribution of the finance sector to national income should be taken with a large pinch of salt.
The most disturbing downside of the global success of the City of London is the corrupting effect on society at large of a depreciation of ordinary morality and human values. The ethical standards associated with parts of the finance sector have been deplorable.
With crass hypocrisy, political leaders have set their public faces against future bank rescues while their operatives have reassured markets that they do not mean what they say.
The growth of financial activity has come from a massive expansion in the packaging, repackaging and trading of existing assets. The finance sector today does many things that do not need to be done, and fails to do many things that do need to be done.
The finance sector has experienced actual criminality on a wide scale, from liar loans to LIBOR rate-fixing. Leading firms in the industry have come to regard the payment of billions in fines and compensation as routine.
The complexity of modern finance has been designed, and has operated, principally to benefit financial intermediaries rather than the users of financial services.
Lehman was not, in any ordinary sense of the phrase, a business of economic importance. If it was a systemically important financial institution, it was not an important financial institution. The business provided no services to the real economy that were not available elsewhere, and few services to the real economy at all. The company was badly run and operated primarily for the benefit of its own staff, especially its most senior executives.
But Lehman was massively interconnected.
Lehman was not too big to fail, but it was too complex to fail. *
The failure of Lehman was not the cause of the global financial crisis – that was far more deep-seated. But Lehman made no contribution to the real economy commensurate with the damage done by its failure.
But very little that happens in the finance sector has genuine need. Only its most boring part – the payment system – is an essential utility on whose continuous functioning the modern economy depends.
Lehman – an ill-managed purveyor of unneeded products – represented exactly the kind of business that should fail in a well-functioning market economy.
The lesson is not that policy-makers should try to prevent such failures but that public processes should ensure that similar failures are more easily contained.
All the money that circulates around the financial system is other people’s money. Well, nearly all. In a modern institution such as Deutsche Bank around 3 per cent of the capital at risk is the bank’s own: the other 97 per cent belongs to lenders and depositors.
The Wall Street Journal has estimated that in 2012 and 2013 J.P. Morgan paid over $25 billion to settle charges against it – generally without admission of liability.
* Senior executives of J.P. Morgan are willing to hand over these astonishing sums to atone for past wrong-doing because they pay with other people’s money.
The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves exempt from any intellectual influence, are usually the slaves of some defunct economist (J.M. Keynes).
In the most extreme manifestation of a sector that has lost sight of its purposes, some of the finest mathematical and scientific minds on the planet are employed to devise algorithms for computerised trading in securities that exploit the weaknesses of other algorithms for computerised trading in securities.
We need some of the things that Citigroup and Goldman Sachs do, but we do not need Citigroup and Goldman Sachs to do them. And many of the things done by Citigroup and Goldman Sachs do not need to be done at all.
The belief that the profitability of an activity is a measure of its social legitimacy has not only taken root in the financial sector but has spread its poison throughout the business world.
Little progress can be made in reforming finance unless the influence of money on politics is reduced.
State funding of political parties, combined with strict limits on other sources of finance, seems a cheap price to pay for (more) honest politics.
It is possible to have a smaller, simpler, financial services system that is better adapted to the needs of the non-financial economy.
We will not wake up tomorrow, or next year, and find such a reality. Is it therefore pointless to articulate that vision? I do not think so.
The most effective counter to the misuse of power in a democratic society is the role of education in creating an informed public opinion.
It is time to get back to work: the serious and responsible business of managing other people’s money.