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LSE: Public lectures and events
The Future of Finance And The Theory That Underpins It - Session 15:00
00:32:26
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- [00:07]
A
Thank you, Paul. There are two broad reasons for structural reform of the financial services industry, and indeed the Secretary of State raised them in the course of what he just told us. The first group of reasons are to do with competition. They're the belief that in general, customers are best served by markets which promote competition between individually specialist but collectively diversified institutions. And the second group of reasons are to do with what earlier speakers today have characterised as systemic risk. Their structural reform as a means of breaking up the industry in a way that that would enable us to resolve the too big to fail problem, and the proposition that too big to fail is a state of affairs that neither a democratic society nor a market economy can contemplate for long, and a belief in the terms of systemic risk, that functional separation would create a financial services system that was at once more robust and more resilient. One group of arguments concerned then with the promotion of a more competitive environment, the other concerned with the promotion of a more robust and resilient environment that has less systemic risk. These are quite different arguments, but I believe that in the particular situation of the world of financial services services today, they point in essentially the same direction. That has not always historically been the case, or believed to be the case, as I shall describe, but I think it is where we are now. But in reviewing these arguments, I want to pick up a third argument which is different from either of these two, but is relevant to each of these two. And this is to say that it is quite hard to think of activities for which the appropriate corporate culture is more different than investment banking and trading on the one hand, and retail banking on the other. Investment banking requires people who are entrepreneurial, buccaneering, highly intelligent, typically very arrogant, typically very greedy as well. The management challenges of running such an institution are similar to the management challenges of running a university or a university department. And many people in the audience will know that they are virtually impossible. The corporate culture required for retail banking is essentially bureaucratic. Retail banking demands honest and unimaginative people who will process millions of transactions every day with a very high degree of accuracy. Even when I was a boy at school in Edinburgh, banking, which in Edinburgh in these days meant retail banking, banking was a career for people who didn't get good enough qualifications to go on to a good university. And I sometimes think of the career of which I was deprived by passing my hires, which would have taken me instead to a position today in which I would be facing redundancy or early retirement as a middle manager somewhere in the Royal bank of Scotland instead I'm here to. But I'm saying, I suspect some of the same things that that middle manager would have been saying. That cultural conflict then was always there. And it manifested itself first clearly in financial services in Britain after big bang in 1986, when, as you will recall, the major retail banks all took over a variety of wholesale actors within the City of London, with in almost all cases, disastrous results. That is, they could not manage the people they acquired with these businesses. And most of the businesses were wound up reorganized or otherwise restructured within a very short time thereafter. The next development was one which was taking place then again post Big Bang, in which American investment banks essentially invaded London, won market share rather quickly from established UK merchant banks, as we used to call them, with the result that both British and European banks built up, essentially investment banking franchises within their operations, modeled, more or less expensive, explicitly on the activities of these uns investment banks, as American retail banks themselves did. And that created what still remains true today, a cultural tension in all of these organizations between these different kind of activities, but as a cultural tension in which, by virtue of. Of the sheer ability and aggression of the investment bankers or traders, these people command an influence over the policies of the institution as a whole, which is disproportionate to the contribution they make, either in terms of number of employees or value added for the bank as a whole. We need to recognise that as a central background to the debate which we are having today. And it also takes us to what is one of the great paradoxes of what happened in 2007, 2008, which is that if one goes back to the ways in which financial markets evolved in the 1980s and 1990s, the development of markets in swaps and securitization meant that the maturity and maturity transformation and risk pooling, which had always been parts and the most difficult parts of the job of the retail bank, could very largely be disposed of in markets so that retail banks could be de risked. And, as was described this morning, largely were de risked. But paradoxically, other parts of the same institutions took on these risks in even larger quantities, in many cases, than the quantities in which the retail arms had disposed of them. That all, as I say, is the background to the discussion which we're having today. Now, when I talk about separation, the argument which I here must offer is, is the argument that says Northern Rock was a narrow bank and Northern Rock failed. Lehman not only was not a narrow bank, but it was not engaged in retail activities at all. And Lehman failed with the results that were disastrous for the rest of the financial system of the world economy. That argument, if I may say so, quite misses the point. The point of functional separation, the point of restructuring the financial services industry is not to prevent Northern Rock and Lehman going bust. It's particularly not to prevent Lehman going bust. We should all abstractedly be delighted that Lehman went bust. Lehman was a badly run organization of greedy people which took risks in property development that failed very badly. Lehman going bust. It was run by a domineering and vain chief executive. Lehman going bust is not an example of a failure of capitalism. Lehman going bust is an example of capitalism operating as capitalism is supposed to work. What we need is not an environment which will ensure that Lehman will not go bust. What we need is an environment in which an organization like Lehman can go bust without it damaging the rest of the economy. We could, with the expenditure of great amounts of public money, ensure that no financial institution went bust. Probably we might, though I rather doubt it, be be able to ensure that no financial institution went bust by detailed supervision of the affairs of every financial institution in the country. We might be able to do that, though I'm skeptical. But it is not desirable that we should do either of these things. For markets to operate as markets are supposed to work, people ought to be able to take risks. They ought to be able to bear the consequences of these risks. But one of the most important parts of capitalism working as it should, is that when people take these risks, it should either be with their own money or there should be a very direct connection between the money and the people who are taking the risks. And that is what is in large part been missing in the financial services system as it has recently evolved. In other words, the very diversity of the financial institutions that failed in 2007, 2008 is perhaps the best illustration that we could have of the inherent fragility of the financial system that we have today. And the fact that the knock on consequences of defaults on US subprime mortgages had a whole series of consequences that eventually brought the global financial system to its knees demonstrates that we need to build a system that is very much more resilient and robust than the one we have today. Now, we have a lot of experience with complex interconnected systems and with the design of these systems to secure that resilience and robustness. There's a certain irony in the fact that we're meeting today in the premises of the Institution of Electrical Engineers, because electrical engineers probably know more than anyone about the problems of designing complex interconnected systems which are vulnerable to severe disruption that takes place as a result of failures in relatively minor population, minor parts of the system. And the result of that is that a great deal of effort and expense is devoted by electrical engineers to structuring systems in such a way that these problems do not break down the system as a whole. Within the main very considerable success. Electrical engineers use words like modularity, redundancy. Electrical engineers talk about the see the need for diversity in the range of provisions of the system. All these are the things we need to be doing and the ways we need to be thinking in redesigning the global financial architecture, by which I mean not the kind of things that are discussed in G20 great regulatory organizations. The financial architecture in terms of the design and role of institutions and the linkages between them. Now, one of the metaphors that has been very successfully popularized over the last couple of years has been the metaphor I owe originally to Martin Wolf, the metaphor of the utility attached to the casino as a way of describing the financial system. We have the utility of the payments and deposit taking system attached to the casino of trading and investment banking. Actually, although that's been a potent metaphor, it's a metaphor which slightly oversimplifies the key issue. Because if we think of the role that government has and necessarily has in ensuring continued supply of commodities in the economy at large, we see there are not just two categories. There are actually three categories. The first is the network utilities, the telecoms network, the electricity grid, the gas transmission system, the water supply system, the rail network. Networks of a kind where we can't contemplate disruption of supply even for a few hours without there being great damage to the economy. And the result is that in these areas we have put in place both firewalls and resolution procedures that mean in the event of a corporate failure, there are provisions that come into place immediately that enable the system to go on being operated without disruption or difficulty for customers. So that when a rail track went bust, or when Metronet went bust, the trains kept operating, the tubes kept running, and the majority, when Enron went bust, Wessex Water continued to flow. And in all of these cases, many of their customers probably didn't know that the organization that had previously been supplying the services no longer existed or was no longer solvent. That's what we need to do in relation to the utility system element, which is basically the payment system and the deposit taking system. The second element is that of goods like food and fuel, which are best served in general by a competitive market. But where there are from time to time, force majeure disruptions, in which case government will intervene to take control of the system and service and direct it until such time as normal service through a competitive market can be resumed. Generally, these requirements to intervene are of short duration, infrequent, but intense when they arise. And I emphasize that group because that's the position which we are in and are still in in relation to the supply of credit for consumer loans and for small and medium sized enterprises in particular in Britain today. And the third group is the bulk of the commodities in the economy. In the case of the financial services system, the casino element, the elements in which government they will be provided if the market does provide them. They will not be provided if the market is not there to do it. The first group of arguments concerns the the need for structural reform to help handle the systemic risks in the financial system. The second group of arguments are those to do with competition in banking, especially retail banking. There was no important entry into the UK retail banking sector in the whole of the 20th century. There were five large retail banks Britain in 1900, there were four in England in 1900. There were four large retail banks in England in 2000, one of them having been formed as a result of the merger of two of the banks that were in place earlier in the century. Midland bank moved from being the largest of the banks earlier in the century to being the smallest of them at the end of the century. But that is the main change in the structure of the industry that took place. There is no other industry, no other British industry of which that kind of degree of stability is remotely true. Now, it might be that that's the case because this is an industry that served its customers uniquely well through the century. But I doubt personal if that is the explanation. A better explanation is to say there was a kind of deal in which we traded off a complacent oligopoly on the one hand for macroeconomic stability on the other. A deal which probably worked relatively well for most of the 20th century. But it's a deal that no longer works. The truth is what is behind this is that behavioral regulation, that is regulation that involves detailed supervision of the activities of particular firms, is a form of regulation that massively favors the positions of incumbent firms in the industry which is subject to that regulation. And that's the experience of almost all regulated industries. And it must be so, because if the object of regulation is to spread a particular concept of good practice across the industry, then that concept of good practice will necessarily be derived from the behavior of existing firms in the industry. And that's what takes us to the absurdity we see today, which is that Tesco, which is actually one of the best run companies in Britain today, is permitted to obtain a banking license after a lengthy battle, in effect by promising that it will behave in a way not very different from any established bank. Behavioral regulation and the kind of regulation which we have of financial services massively favors incumbent firms in the industry. A bias which we've ratcheted up by orders of magnitude by creating this doctrine of too big to fail. More generally, behavioral regulation, what we call supervision in financial services, has been seen in industry after industry to have the property of being simultaneously extensive and intrusive, and yet largely ineffective and subject to what is described elsewhere as regulatory capture. The regulators are not corrupt. They simply see the industry through the eyes of established firms in the industry. That's the general experience of behavioral regulation and why I believe the solution lies not in more detailed supervision of behavior, but in structural reform. More than 20 years ago, in 1988, John Vickers and I wrote a general article on experience of regulation, of which only two pages and a 60 page article as a matter of fact were about financial services. But the mantras which came out of that article were to say first of all, competition. The first mantra should be competition where possible and regulation only where necessary, where competition either needs to be promoted or. Or is difficult to introduce. Secondly, wherever a structural solution is available as an alternative to a behavioral one, we should look for the structural resolution. These principles have been applied since in industries as varied as gas and pubs, mostly I think with a degree of success and I believe these principles are right as general principles and write in their application for financial services. Other people have said in the course of today that if we don't solve the problems we have now effectively, we are in for a larger group of problems in a few years time. I want in what I have to say to reinforce that observation that we've seen a series of crises over the last two decades. I'd instance for example the Asian market and emerging market debt crisis of the 90s, the new economy bubble and burst at the turn of the century, the credit and securitization boom that led to our present crisis. Although the details of them are all wildly different, they all have the common feature of herd behaviour within the financial services industry leading to gross asset mispronounce, that gross asset mispricing has generated large and transitory profits of which a large share is taken by employees. And then when the illusory nature of the profits emerges, the losses impose substantial collateral damage on economies more widely. That's been true of the three crises I've been describing. And the collateral damage which has been inflicted in each case has only been mitigated by the injection of very large amounts of public money into the system in ways that has provided the fuel for the next round of the crisis. I think that is the problem which unless we are willing to adopt more radical measures to deal with, we are in danger of facing again. And I think, Paul, you were not overstating when you said at the end of what you had to say this morning that if we are not willing to handle these issues in a more effective way, then we risk further crises that are potentially the end not just of the financial system as we know it, but of the capitalist settlement that we have all enjoyed since 1989. Thank you. Thank you very much, John. Now, questions? Yes, gentlemen, here. Can you use your.
- [23:23]
B
Okay, I just by implication, your talk implies that you probably quite like to see an implementation Glass Steagall UK well, that's what it sounds like to me anyway. I'm wondering if you would comment on the value of perhaps reintroducing single capacity at the UK Stock exchange as well, because those are two examples where structural regulation has been replaced by behavioral regulation. The single capacity doesn't seem to be in quite such a disastrous failure as the the banking one, though.
- [23:51]
A
Yeah, I think. You're on the right lines in looking at these things. What I didn't do because I was talking for 20 minutes this afternoon is to spell out a model in particular detail for those of you who want a model. There is more detail spelled out in the paper which is in the book in front of you. And I've spelled out a variety of models in more detail in my CSFI paper, Narrow Banking. But I think one doesn't want to get hung up for the moment on the details of any specific proposal. I think the central move which needs to be made, and it would not, I think, be exactly on the lines of Glass Steagall, but the spirit of Glass Steagall takes one very much in the right direction, is to create a distinction between the kind of retail banking activities that I spent much of my talk talking about and the wholesale market activities that come under the general heading of investment banking. I think there is also much to be said for starting to think about thinking about functional separation within investment banking itself. If one thinks of the variety of activities that a modern investment bank bank typically undertakes, market making, securities issuance, corporate advisory services, proprietary trading, asset management, One simply has to list these services to see that there are substantial conflicts of interest and substantial issues of contagion between each of these groups of services. So I think in terms of structural reform of the financial services industry, the central issue is that wholesale to retail spread. But there are other groups of functional separations that should be considered as well in trying to move towards a structure that, as I described as smaller institutions with more emphasis on functional separation than on reducing size as such, and one which would be more robust and resilient to the kind of problems we've encountered in the last few years. Thank you. A question over here. Thank you.
- [26:22]
C
Diplock. I chair the New Zealand Securities Commission and I also chair the Executive committee of iosco, the International Organization of securities Commissions. Professor Kaye, I'd like to perhaps posit something quite controversial and quite contrary to the view you've just put, and that is that perhaps we're looking in the wrong direction in relation to a solution which is a structural solution. I'd like to suggest that what we should be looking for is a network solution. In other words, I think we're looking in a 20th century paradigm for what is a 21st century problem, and that is that the markets and institutions have now become so intertwined within the networks of the flow of capital and money throughout the entire system and throughout the entire world that we perhaps need to look at the way in which networks work, using, for example, the Internet perhaps as a model. And I might suggest people who are interested in this idea to look at the work that Andy Haldane has done, which has been very interesting, on networks of money flows, and whether we should be looking at epidemiology, geology, genetics and other sciences which are looking for network solutions to what is an interesting 21st century question. And in that framework, and while I don't necessarily believe it's the only way of looking at it, Iosco has recently approved two new principles of securities markets regulation, which looks at systemic risk in markets, including looking at the perimeter of regulation, which is actually trying to address the idea that systemic risk is not limited only to institutions. It has traditionally been fundamentally thought only in relation to institutions. So the prudential framework, the macroeconomic frameworks. But we look at what happened during the global financial crisis, I believe we may see that there are some other ways in which we should look at this. And perhaps the network is an interesting metaphor. And I think the work that Andy Haldane is doing is extremely interesting in this respect.
- [29:19]
A
I think the network metaphor is a very interesting one. And let Me pursue it a little for a moment. One can take the network metaphor in several ways. One can look at what the Internet would be a good example example of a regulated but basically open architecture network. That's a structure that works relatively well for the Internet, because the Internet has very little problem of, as it were, systemic disruption. That is, if a particular server or website fails, that doesn't create a problem for the network as a whole. Probably the more relevant analogy in network terms for the kind of system with which we're dealing here is the electricity network case, which I described earlier, which is peculiarly vulnerable to system disruption as a result of disruption in a particular place, in the way we've recently experienced in financial services. Now, there are actually two ways of operating that particular structure. One would be the old British solution or the existing French solution, which is to say you have a single agency which controls the whole network. That takes one, in effect, to nationalization of the overall global financial system. It seems to me that's not a terrible solution, but I can think of better ones than that. And the alternative is what one might describe as the British or the modern American. The modern British solution to electricity, which has been adopted in various other countries, which follows rather strictly the mantras which I described at the end of my talk of competition where possible, regulation where necessary, and whenever possible prefer behavioral solutions to structural solutions to behavioral ones. So I think the network perspective is actually one which has been very much in my mind in contemplating these proposals. Indeed, the more I think about the electricity analogy, the more relevant in many ways the electricity analogy seems to be. But one of the things that your contribution helps us with and Andy Haldane's work helps us with, and I think there need to be many more pieces of work done, is that we need to stop thinking about the problems of financial services as being entirely sui generis and understand that there are lessons to be learned from the structure of other industries and from regulatory successes and failures in other industries, which may not be directly applicable to financial services, but certainly should be in our minds as we think about financial services problems. Thank you very much, John. Please join me in thanking John for a very interesting presentation.