Finance – too much of a good thing?

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. John Kay in Other People’s Money

I have just finished reading John Kay’s Other People’s Money. Kay is not your typical populist anti-system finance basher. That makes his critique all the more damning.  The book is divided into three parts. The first part, Financialisation, looks at how the financial sector grew in size, revenues and sophistication from the 1970s up to the 2008 GFC. In the next part, The Functions of Finance, he explores the necessary underlying functions of a modern financial system. The final part, Policy, suggests some solutions for our malfunctioning financial system.

Kay recognises the finance sector’s critical roles:

  1. acting as a payment system
  2. directing savings to productive investments
  3. offering a service for managing personal finances across the life cycle and generations
  4. providing a marketplace for transferring and managing risk

It is these core functions from which banks have abandoned. And they have strayed into dangerous territory. Deposit taking has become a source of funding for uncertain, long-term risk taking. There is a lot of exchanging bits of paper. If banks want to make profits they need to take on extra risk. He compares their strategies to tailgating on the motorway. This high-risk approach will work most of the time until it doesn’t. There will be occasional devastating crashes. These risky strategies are often encouraged by the   skewed incentives bankers face. By taking risks they get all the upsides – the possibility of huge bonuses. On the other hand, if their bets are wrong there are no downsides for them – the bill for their mistakes will be picked up by shareholders or, ultimately, taxpayers.

When things are going well, there’s no problem. But it’s a fool’s paradise. Kay introduces us to the concept of the “bezzle”. It comes from economist J.K. Galbraith’s Embezzlement, an account the Wall Street Crash of 1929. In the period, which may be weeks, months or even years, between the commission of a crime and its discovery both the embezzler and the mark feel they are winners. The latter feels no loss at this stage. Thus there is a net increase in psychic wealth. It is this increase that the Canadian economist called the bezzle. Only later does the victim realise that he has been royally screwed. A variation on the theme was provided by Warren Buffett’s business partner Charlie Munger. His insight was that there does not have to be any criminal act involved – mistakes or self-delusion will do the job just as well. Febezzle, functionally equivalent bezzle, was the term Munger coined to describe the wealth that exists in the interval between creation and destruction of the illusion.

What we can do about it? In the last third of the book Kay looks at reform, which is not the same as regulation. What we do not need is more complex regulation. We have enough of that already. As I pointed out in A sceptic’s guide to regulation the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act had no fewer than 2,319 pages. Regulation is not the solution. Some of finance’s worst excesses come from what is known as regulatory arbitrage. The website investopedia has a nice definition:

“A practice whereby firms capitalize on loopholes in regulatory systems in order to circumvent unfavourable regulation. Arbitrage opportunities may be accomplished by a variety of tactics, including restructuring transactions, financial engineering and geographic relocation.”

And then you have regulatory capture, the way the industry is able to take control of the regulatory institutions. Kay bemoans the fact that financial regulation suffers from a faster-spinning revolving door compared with other industries. Many of the regulators themselves either come from the sector or hope to work there in the future.

The fundamental problem is the structure of the industry itself. Kay puts it this way: “We need some of the things that Citigroup and Goldman Sachs do, but we do not need Citigroup and Goldman Sachs to do them.” Instead of the vast behemoths that we have now Kay would like to see smaller more focussed institutions. For example, banks that accept deposits should have strict restrictions on the kind of assets that they hold. The intermediaries who handle other people’s money should be held to high standards of customer care, and be liable to civil and criminal penalties. And it is vital that these penalties should affect individuals, not corporations. The principle of individual responsibility needs to be re-established. When a corporation is fined they just pass on the cost to shareholders.

Above all, the finance sector should not be judged as a special case. If an activity is not profitable without taxpayer money, it should not occur. Banks must be allowed to fail. I have to say I’m not particularly optimistic about the future. I see little evidence of things getting better.

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