Are the world’s governments going about financial regulation in the wrong way? John Kay thinks so.
In this sweeping critique of how finance has developed over the past few decades, the British economist argues that the culture of financial firms and the structure of their business have deteriorated. Financiers have drifted away from a culture defined by serving customers to one in which they focus on using other people’s money to trade for their own profit. Instead of being motivated by values such as seeking to earn and retain trust as loyal agents of their customers, they regard minimal compliance with the law and regulation as being the only constraint on their profit-seeking decisions.
None of this will seem outlandish to Irish observers. The days are surely over when to be a banker was to be held in awe. The financial crisis that broke more than eight years ago – not just in Ireland but all over the world – exposed the deficiencies of banks’ risk-management techniques, as well as the complacency of those in charge. The damage to lives and prosperity has been extensive and persistent. All of this is commonplace by now.
But is it naive to imagine that things could be otherwise? Kay is no populist. He will be known to Irish Times readers as an astute columnist and commentator on economic policy issues. He is also an influential economic policy adviser with impressive academic credentials, which he wears very lightly. He brings to this well-worn topic a breadth of vision about how the modern economy works and what it needs from the financial system.
Kay's message in Other People's Money is that, although the crisis has been contained, the running repairs go not nearly far enough in correcting the underlying causes of the world's malfunctioning financial system.
The problem is partly one of structure. The financial sector has grown to a scale far in excess of what is needed to perform the functions required by households and businesses. More fundamentally, it is a problem of culture. Thus, Kay observes, much of this overscaling reflects the extent to which financiers are focused on short-term profit opportunities from trading with each other rather than on providing valuable services directly to the “real economy”.
As a result the firms and funds that make up the sector are, like tailgating cars on a motorway, so tightly conjoined as to make failure of one a serious risk to all in the overleveraged economy. Although bonus-seeking traders seem to generate profits for their firms, they often leave a hidden pile of debris behind, to be discovered only after they have moved on to the next job.
By tolerating this level of risk and implicitly insuring firms that have grown too big or too complex to be allowed to fail, governments around the world have underpinned the extraordinarily high levels of profit and remuneration typical of the sector. It is in this sense that Kay characterises the managers of the world’s too-big-to-fail financial firms as “spending other people’s money”.
The economist has long been an enthusiast for leavening the monoculture of the shareholder limited liability company of conventional capitalism with profit-sharing and mutual ownership of firms. So Kay is surely right in identifying the source of the malaise in finance as the spread of the naive “belief that profitability of an activity is a measure of its social legitimacy”.
This is not a new perspective: as he notes, it is, for example, the message of Frank Capra's famous 1946 film, It's a Wonderful Life, favourably cited here.
From the late 1960s, traditional banking practices and rules were eroded by a combination of innovation in communications and information technology on the one hand, and ideological change on the other. Ireland is mentioned from time to time (for example, as the home of “the world’s worst banker”), but the focus is more on the big international investment banks that have led and defined the financialisation of the global economy.
For example, the sleepy Scottish banks of Kay’s Edinburgh youth were destroyed a half-century later by the clever profit-driven fellows who were now in charge but who proved unable to deal with the scale and complexity that they created.
The treatment is well informed and insightful. Although many of Kay’s positions echo more populist critiques, his analysis is a more penetrating and discriminating one. He certainly emphasises the damaging excesses of financialisation, while fully acknowledging the vital role of the market, of profit, and of a well-functioning financial system in ensuring prosperity in modern economies.
But John Kay does want to turn the clock back. And, although his nostalgic recollection of the bankers of the past is surely too rose-tinted, the damaging excesses of the past quarter-century are systematically documented.
What is to be done? For Kay it is not a question of too little regulation. Indeed he argues that, in the reaction to the crisis, there is now too much regulation; intrusive, yes, but of the wrong kind and ineffective in achieving public policy goals. He puts this down in part to regulators being captured by the industry but more to the internationally driven design of financial regulation being the result of misconceived public policies. In his view regulation based on detailed prescriptive rules has undermined rather than enhanced ethical standards.
What is called for, he argues, is not better regulators but a different regulatory philosophy. Here the recommendations are presented not as a practical action plan but in the form of high-level principles. (And, no, it’s not the “principles-based regulation” of the past.)
These principles relate to structures (there should be less complexity: financial firms should be dealing directly with customers, less with each other); to culture (those that handle other people’s money should, if they fail to demonstrate high standards of loyalty and prudence, be subject to personal sanctions); and to the overall attitude of government (which should treat finance like any other sector, and not one deserving of special subsidy or hearing).
I hope that, in Ireland, in addition to carefully complying with the international regulatory standards, we have already taken steps in the direction of each of these principles in recent years. But recurrent evidence of sharp practices belies any suggestion that we are now free of the problems that Kay identifies.
Unfortunately, although Kay insists that reformed rules should be so designed that compliance is easily verified, the abstract and conceptual level at which he pitches his recommendations suggests how intractable is the problem of simplifying finance and inducing financiers to behave responsibly.
Patrick Honohan is Governor of the Central Bank of Ireland
