A vibrant and professional financial services industry is essential to a prosperous economy. Only market economies can provide citizens with the standards of living that the people of western Europe and north America have come to expect. A market economy requires a financial sector to direct investment to the most productive uses and to monitor the performance of large businesses. This finances the operations of governments and, by borrowing short and lending long, enables borrowers and lenders to operate on different timescales. A well-functioning financial sector serves the individual financial needs of its citizens, allowing them to save and to borrow to meet their changing needs during their lives. It protects citizens, or enables them to protect themselves, against the risks they encounter in daily life.
The liberal capital markets of Britain and the US achieve all these things—not particularly well, but better than any other system, and certainly much better than the state-controlled economic systems of the old Soviet bloc. But the scale of activities needed to allocate capital efficiently is a fraction of the resources that the financial services sector employs today. We have created a monster (see Jonathan Ford in Prospect, November 2008 "A greedy giant out of control"). The scale of resources the sector demands, its financial rewards and its political influence are all excessive. It sucks in talent that would be better employed elsewhere, and distorts the values of whole societies. Moreover, twice in the last decade—the technology bubble of 1998-2000 and the credit bubble of 2003-07—financial follies have threatened the stability of the world economy.
What has gone wrong? Financial markets have always been unstable. But the origins and scale of the present crisis are to be found in the development of financial conglomerates. Deregulation and globalisation encouraged the financial institutions of Britain and the US to acquire and diversify. The banker's traditional activities of borrowing and lending were combined with asset management and advisory services—the business of selling and underwriting securities for large corporations. These conglomerates traded in a wide range of markets on their own behalf as well as for their customers. The once conservative universal banks of continental Europe took the opportunity to use the cheap funds provided by their retail depositors to speculate in global capital markets. The complex institutions that were created were riddled with conflicts of culture and of interests. They proved largely unmanageable—and were largely unmanaged. As the credit crunch developed in 2007-8, it became increasingly clear that the senior executives of these businesses did not really understand what had been going on within them.
The conflicts of interest inherent in the financial conglomerate were starkly revealed in the recriminations that followed the bursting of the technology bubble in 2000. Banks had sought banking and issuing business from the companies on which their securities analysts did research. Investment research that was critical of corporate customers had the potential to jeopardise these transactions. The banks resolved this problem by concluding that corporations mattered more to their revenues than investors. Analysts were co-opted to become part of the sales force of the investment banking business. Yet those analysts were seen by investors not as compromised figures but as seers and talent scouts. Mary Meeker of Morgan Stanley, whose 1995 report helped to start the tech boom, was called "the internet goddess," her sponsorship "a laying on of hands."
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But the underlying problem was more evident than ever. A telecoms analyst employed by Weill's new Citigroup conglomerate, Jack Grubman, maintained that what had once been a conflict of interest was now a synergy—investors were able to benefit from the exceptional insights derived from Grubman's close contact with corporate clients. This privileged knowledge enabled Grubman to maintain his enthusiastic recommendation of Worldcom and his admiration for its then chairman, former basketball coach and future convict, Bernie Ebbers, until the day the company went spectacularly bust.
The technology bubble burst in the spring of 2000. But it would take less than five years for the next market folly to begin. The mind of the market, jaundiced by stocks, turned to bonds. While the puffery of the tech bubble had been aimed largely at retail investors, the puffery of the credit expansion was aimed at more sophisticated professionals. Financial institutions plied junk to each other. For a time, the boost to profits was just as satisfactory. Their employees earned bonuses by selling securities, and it did not matter to whom they sold them. But the consequences of the credit bubble would be more profound. Its bursting would bring down many of these financial institutions themselves.
The traditional activity of a bank was to borrow short and lend long—to collect deposits from individuals and businesses and lend them on for house purchases and productive investment. Banks were vulnerable to runs—depositors could demand their money back sooner than the loans could be recovered from borrowers. But while occasional crises occurred, the scale of banks' operations and the ultimate support of central banks protected the depositors and shareholders of essentially sound institutions.
British banks were once required to maintain 8 per cent of their deposits in cash and 28 per cent in other readily realisable assets. Provided this cash and liquidity was not used as collateral for the bank's other activities, these ratios were more than sufficient to ensure complete security for depositors—and achieved that result. But as banks sought to diversify their activities in a global capital market, deposits became a diminishing part of their liabilities and loans to customers a diminishing part of their assets. Consequently, these rules became both less effective as a guarantee of security and constraining of competition and growth. They were swept away in the 1970s, and "big bang" in 1986 removed the last regulatory obstacles to diversification.
Intermediation is the name for the process by which banks borrowed and lent, not just to and from customers, but to and from each other. As banks—along with large corporations—expanded their trading activities, intermediation grew to levels at which intra-market dealing in financial markets came to account for a very large multiple of the trades conducted on behalf of final users.
In effect, conglomerate banks contain gigantic hedge funds—assemblies of speculative trading positions. But if a hedge fund makes losses of 5 per cent of its assets, it has a bad year: if too many unhappy investors seek to liquidate their positions quickly, it can suspend redemptions for a time. Many hedge funds have recently had one or both experiences. Banks are much more fragile because they carry only a small cushion of equity to absorb losses. Most banks have gross assets of up to 50-100 times their equity capital. Consequently a bank that lost 5 per cent of its assets would see its equity wiped out and would, without government support, face closure. Were it to suspend payments, it would also be dead meat as the confidence of depositors would be irretrievably lost.
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Why did banks engage in so much speculative trading, despite knowing the risks? Bank executives took comfort in the apparently sophisticated risk management models which the industry had refined since the 1990s. These models use historic data on volatility and correlations that is necessarily drawn from long periods of stability and may not be robust under stress.Thus the models fail in precisely the situations in which they are most needed. Such weaknesses were foreshadowed in the 1998 collapse of Long Term Capital Management and proved to be endemic after the credit bubble burst in 2007.
Bond trading, once a backwater, became one of the busiest and most exciting activities. Banks began to take packages of loans and parcel them into bonds of shorter or longer maturity. Bankers talked of the "originate and distribute" model, in which the bank's role was to originate loans and then distribute them as securities in wholesale markets to money market funds, hedge funds, insurance companies and so on.
The fundamental value of these securities depended on the quality of the loans that underpinned them. As more layers were piled on, it became harder to determine what they were worth. Meanwhile the originators of loans became less bothered about the quality of the business they were doing because they no longer held loans to maturity. The most notorious result was the development of "sub-prime mortgages" for indigent borrowers. But the funding of property and private equity deals with unaffordable levels of debt was even larger in scale.
As the fundamental value of these securities could not be established, the "mind of the market" (see box p55) determined their price. The bond rating agencies played the cheerleading role that analysts had fulfilled in the technology bubble. On 9th August 2007, the bubble burst. Doubts about the value of asset-backed securities had been rumbling ever since defaults had started to grow on subprime mortgages. Traders had assumed, as in 2000, that the value of an asset was the price that someone was willing to pay for it. But if there were no buyers, you had to rely on its fundamental value—and no one knew what that was.
So the market dried up. In the first instance, banks were left with loans they had originated but could not now distribute—that caused the rapid collapse of Northern Rock. But over time, the consequences spread. Banks held large portfolios of asset-backed securities—many of them in structured investment vehicles (SIVs), off-balance sheet entities which held the securities and issued short-term debt to finance them. The banks had convinced their auditors that these debts were off their books, and had therefore not been obliged to reserve capital against them. But when it became impossible to roll over the short- term debts that the SIVs had taken on, rather than see the securities they held be liquidated, most banks brought them back onto their own books.
The inability to determine the value of asset-backed securities made it impossible to determine the value of banks themselves. Bank shares fell and the ratings of their own debt deteriorated. Investment banks, with little capital relative to the overall scale of their assets and liabilities, ceased to be creditworthy. Of the five major investment banks, two folded, one was rescued by Bank of America, and the two strongest—Morgan Stanley and Goldman Sachs—only clung on by taking in new investors and transforming themselves into bank holding companies which, like retail banks, are entitled to the support of the US government.
Even the retail banks, well funded with deposits provided by small savers, weren't immune. These events demonstrated another problem that resulted from the repeal of Glass-Steagall. Retail banks around the world had, in effect, used their deposit base—on which there was an implicit government guarantee—as collateral for their speculative trading. Politicians were fearful—with justification—of a replay of the events of 1932–33, when the US banking system almost collapsed. To avert the threat of systemic failure, governments everywhere bailed out the banks.
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In the complex and uncertain world of modern finance, such behaviour takes us far away from market efficiency and fundamental value. In all market bubbles—from the tulip mania to the credit bubble—distortions are supported by commercial interests that benefit from their promotion. There was always a kernel of truth in the bubble consensus. Speculators in the South Sea bubble were on the verge of an industrial revolution and an explosion of world trade. Modern IT does indeed transform many activities. Financial innovation did create opportunities for better risk management. The people who lost money in these bubbles were not mistaken in their basic thesis but overestimated both the pace of change and the extent to which individual companies would benefit.
In the distorting mirror provided by ostensibly sophisticated risk models, bankers saw irresistible profit opportunities. The "originate and distribute" model was a new paradigm, and the winners would be the ones to pursue their fantastic vision most vigorously. Even if they secretly doubted the paradigm, they would not act on their doubt because to do so was to risk losing one's job. Of course, the price of going along with the mind of the market would also be to lose one's job, but at a later date.
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The modern financial services industry is a casino attached to a utility. The utility is the payments system, which enables individuals and companies to manage their daily affairs. It allows them to borrow and lend for their routine activities, and allocates finance in line with the fundamental value of business activities. In the casino, traders make profits from arbitrage—differences in the prices of related assets—and from short-term price movements. The users of the utility look to fundamental values. The players in the casino are preoccupied with the mind of the market.
Modest levels of speculative activity may improve the operation of the utility. By exploiting arbitrage opportunities, traders can bring the mind of the market back in line with fundamentals. But as trading levels increase, the mind of the market, determined by the power of conventional thinking, becomes itself the main influence on prices.
The primary objective of the regulation of financial services in the future should be that the casino should never again jeopardise the utility. Many people seem to think that the best method of achieving this is close supervision of the casino. This is misconceived. Instability is endemic to financial markets, driven by greed and the force of conventional thinking. There is a little government can do to raise standards of public morality, but not much to address banality of thought. So such instability cannot be removed, or even much, reduced by government action. Regulators cannot be expected to decide which financial innovations are necessary and which not. Nor can they act to restrict unsound business strategies.
The junior officials of a public agency do not have the capability, or the authority, to advise bankers paid multimillion pound salaries and bonuses against what, with the benefit of hindsight, appear to be errors in the direction of their business. It is unrealistic to imagine that they could have this capability or authority—even the boards of these banks did not. Nor is it realistic to think that, if regulators did have such capacity, they could exercise it in a world in which the financial services industry is the most powerful national political lobby and the threat of judicial review hangs over every regulatory action.
The better response is to separate the utility from the casino. The purpose would be to restore the "narrow banking" that once existed—the business of facilitating the payment system, taking small deposits, and lending to meet the day to day needs of consumers and small and medium sized businesses. Narrow banking requires little flair and imagination, rather the conscientious completion of millions of transactions a day with minimal error. While technology and innovation have changed the processes by which narrow banking is provided, the customer needs that are served have changed very little.
Financial conglomerates are, as Senators Glass and Steagall recognised, a bad idea. They are a bad idea for their shareholders, victims of recurrent tension between investment and retail bankers; bad for customers, because they are riddled with conflicts of interest; and bad for taxpayers, who have to pick up the bills when traders driven by avarice have gambled away too many of the retail customers' savings.
For the moment the credit crunch has actually strengthened the role of conglomerates, because size has come to be seen as a strength. A new Glass-Steagall Act would probably not work, as the old Glass-Steagall ultimately did not work. Although financial conglomerates do not serve the interests of those who work for them, own their shares or use their services, they do serve the interests of the greedy and ambitious men who run them, whose aspirations will find ways round any such restrictions in the future as they have in the past.
Instead, structural rules should firewall the utility from the casino, by giving absolute priority to retail depositors (or the institutions which protect retail depositors) in the event of the failure of a deposit-taking institution. The creditors of the investment banking subsidiaries of that deposit taker would be pushed to the back of the creditors' queue. This might incentivise them to police their own activities more rigorously. The primary object of regulation should not be to ensure good practice in financial services businesses, but to protect the non-financial customers of financial institutions. There is a public interest in keeping crooks out of wholesale financial markets; but that is as far as public involvement need, or should, go.
The metaphor of the casino invites both the citizen and the saver to treat financial services with less deference and respect. Bookmakers are prosperous, but most people regard them as slightly ridiculous. Their prosperity is the product of human frailty, deep cynicism indispensable to their success. Not many decades ago, stockbrokers, though drawn from a different social stratum were regarded in much the same way. This is probably how it should be.
The City of London is an important export industry and deserves substantial credit for that. But an effective process of change should lead to a volume of wholesale market activity much smaller than we have become used to. Moreover, reform will begin by taking the City less seriously than politicians have hitherto taken it, and less seriously than it takes itself.
