John Kay, Other People's Money: Masters of the Universe or Servants of the People? (Profile Books, £16.99)
Now read an extract from John Kay's book
First, a disclaimer—I think John Kay is a quite brilliant economist, thinker and writer. As these three attributes are not always complementary, he is the rarest of breeds. That means I am probably incapable of writing a genuinely critical review of a John Kay book.
Fortunately, in this case there is no need to do so. His new book, Other People’s Money, is about as good a demonstration of Kay’s skills (as economist, thinker and writer) as you are likely to find. Where others have jumped in feet-first, Kay provides a head-first diagnosis of what contribution finance makes to wider society.
The core of Kay’s argument is simply put. Finance plays a crucial role in supporting the economy and wider society, along at least four dimensions: in facilitating payments between people, in matching end-borrowers and end-investors, in managing risks to one’s health and wealth and in managing money across generations. And historically at least, these are precisely the roles the financial sector has played. That is why, through the ages, it has been accepted (if not always especially liked) as a trusted servant of society.
But the past few decades have seen a sea-change in the functioning, and hence perception, of the financial sector. Latterly, that sea-change has at times risked flooding the entire economic and social waterfront. In a nutshell, finance has moved away from serving the economy and towards serving itself—and indeed remunerating itself. The financial services industry, Kay argues, has moved from servant of society to Master of the Universe.
Thus the simple financial products of yesteryear, tailored to customers’ needs, have given way to complex chains of transactions understood by few and ripe for rent-extraction. The sober-suited retail bank manager straight out of secondary school has given way to the sharp-suited investment banker straight out of business school. The cult of liquidity has usurped the ethos of long-termism. Manufacturing of transactions has displaced cultivation of relationships.
Even if this is something of a caricature, it is not an entirely inaccurate one. And this evolution, Kay observes, has not been benign in its consequences. It helped sow the seeds of the global financial crisis and the subsequent sequence of market abuse and mis-selling cases. These problems were rooted in excessive risk-taking, compensation and complexity. They were aided and abetted by inadequate risk-management and a diminished sense of fiduciary responsibility to customers and investors.
This structure for finance has also generated, Kay argues, an excess supply of financial products which benefit those inside finance and an inadequate supply of financial products which benefit those outside finance. Examples of the former include market liquidity and complex structured and derivative instruments. Examples of the latter include quick and efficient payment systems and simple and transparent pension products.
Of course, all industries are prone to blow-ups and abuse to some degree. But Kay argues, convincingly to my mind, that finance may have become particularly prone. At its core, financial intermediation is an information business. It involves knowing who best to connect to whom, which investment projects are worth supporting and which rejecting, and which instruments best manage the risks of retirement or floods.
This is information those inside finance possess and those outside finance do not. That places those working in finance in a position of considerable responsibility and power. But it also opens the door to potential abuse of this power—if you like, preying on the informationally disadvantaged through risk-taking and rent-seeking. And it is why trust in those operating in financial services is crucial to its effective functioning. If you like, it is the trust of society which gives finance licence to operate.
If the financial sector has not yet had its social licence withdrawn, then it has been clocking up penalty points at a rate of knots over the past few years. Trust in finance, according to surveys of various kinds, put it right at the bottom of the industry league table. In an industry for which trust is everything, finance starts with a reputational endowment of next to nothing. That begs the obvious question of what might be done, reform-wise, to reinvent finance as a trustworthy servant.
It is perhaps here—the prescription rather than the diagnosis—that Kay is at his most radical. He is sceptical about the regulatory path taken since the crisis, with additional layers of regulation. That is in part because he believes it may make a bad situation (an over-complex financial system) worse. More fundamentally, however, it is because he believes it is unlikely to work in restoring the cultural values to which finance needs to return. In short, you cannot legislate for trust.
Fines for market abuse or mis-selling are a case in point. These have risen dramatically in scale and prominence over recent years. They have been used to sanction, shame and censure financial firms and individuals. The question is whether they have fundamentally altered behaviour of firms and individuals. Only time will tell. But there is at least some risk financial penalties come to be seen simply as a cost of doing financial services business. If so then, as Michael Sandel has argued, they are potentially counter-productive by effectively putting a price on, and hence legitimising, bad behaviour.
For some of the same reasons, Kay is also sceptical about the value of transparency, or the provision of greater information generally, in tackling the financial sector’s culture problems. The need to provide large amounts of information to customers is, for Kay, a diagnostic on trust having been lost, not a means of restoring it. It also risks giving the least benefit to those who are the most informationally—and, typically, financially—disadvantaged.
Kay’s own proposals are to act on the structure of the financial sector directly, thereby reshaping incentives at source. This would mean, for example, separating retail from investment banking activities: rather than cross-dressing, the sober and the sharp suits should be kept in separate wardrobes. This is a move that is now being effected in the UK and, to lesser extent, the US and Europe.
Kay is surely right in his diagnosis of the gradual dilution of standards and incentives within the financial sector, culminating in the financial catastrophe of the past few years. He is also right in pointing out that the trust problem in finance cannot be solved by regulation, legislation or exhortation alone. Behavioural change is needed. And to be self-sustaining, this behavioural change needs to come from within firms and within the sector.
That is why, in addition to regulatory reform, professional standards matter—hence the new Banking Standards Board and the new FICC Market Standards Board in the UK. That is why governance matters, as I have discussed recently in the context of supporting longer-term decision-making by both financial and non-financial firms. And it is why building the understanding and trust of the financial sector among the public matters, to maintain its social licence.
To those ends, later this year the Bank of England is hosting an Open Forum to assess the role financial markets play in supporting society. This will be an opportunity for open debate among those managing others people’s money, those whose money is being managed and those whose job it is to align the two. It is recognition not only that change in the finance sector is an economic and moral imperative, but that change needs to be shaped by the needs of those outside rather than inside finance.
Now read an extract from John Kay's book
First, a disclaimer—I think John Kay is a quite brilliant economist, thinker and writer. As these three attributes are not always complementary, he is the rarest of breeds. That means I am probably incapable of writing a genuinely critical review of a John Kay book.
Fortunately, in this case there is no need to do so. His new book, Other People’s Money, is about as good a demonstration of Kay’s skills (as economist, thinker and writer) as you are likely to find. Where others have jumped in feet-first, Kay provides a head-first diagnosis of what contribution finance makes to wider society.
The core of Kay’s argument is simply put. Finance plays a crucial role in supporting the economy and wider society, along at least four dimensions: in facilitating payments between people, in matching end-borrowers and end-investors, in managing risks to one’s health and wealth and in managing money across generations. And historically at least, these are precisely the roles the financial sector has played. That is why, through the ages, it has been accepted (if not always especially liked) as a trusted servant of society.
But the past few decades have seen a sea-change in the functioning, and hence perception, of the financial sector. Latterly, that sea-change has at times risked flooding the entire economic and social waterfront. In a nutshell, finance has moved away from serving the economy and towards serving itself—and indeed remunerating itself. The financial services industry, Kay argues, has moved from servant of society to Master of the Universe.
Thus the simple financial products of yesteryear, tailored to customers’ needs, have given way to complex chains of transactions understood by few and ripe for rent-extraction. The sober-suited retail bank manager straight out of secondary school has given way to the sharp-suited investment banker straight out of business school. The cult of liquidity has usurped the ethos of long-termism. Manufacturing of transactions has displaced cultivation of relationships.
Even if this is something of a caricature, it is not an entirely inaccurate one. And this evolution, Kay observes, has not been benign in its consequences. It helped sow the seeds of the global financial crisis and the subsequent sequence of market abuse and mis-selling cases. These problems were rooted in excessive risk-taking, compensation and complexity. They were aided and abetted by inadequate risk-management and a diminished sense of fiduciary responsibility to customers and investors.
This structure for finance has also generated, Kay argues, an excess supply of financial products which benefit those inside finance and an inadequate supply of financial products which benefit those outside finance. Examples of the former include market liquidity and complex structured and derivative instruments. Examples of the latter include quick and efficient payment systems and simple and transparent pension products.
Of course, all industries are prone to blow-ups and abuse to some degree. But Kay argues, convincingly to my mind, that finance may have become particularly prone. At its core, financial intermediation is an information business. It involves knowing who best to connect to whom, which investment projects are worth supporting and which rejecting, and which instruments best manage the risks of retirement or floods.
This is information those inside finance possess and those outside finance do not. That places those working in finance in a position of considerable responsibility and power. But it also opens the door to potential abuse of this power—if you like, preying on the informationally disadvantaged through risk-taking and rent-seeking. And it is why trust in those operating in financial services is crucial to its effective functioning. If you like, it is the trust of society which gives finance licence to operate.
If the financial sector has not yet had its social licence withdrawn, then it has been clocking up penalty points at a rate of knots over the past few years. Trust in finance, according to surveys of various kinds, put it right at the bottom of the industry league table. In an industry for which trust is everything, finance starts with a reputational endowment of next to nothing. That begs the obvious question of what might be done, reform-wise, to reinvent finance as a trustworthy servant.
It is perhaps here—the prescription rather than the diagnosis—that Kay is at his most radical. He is sceptical about the regulatory path taken since the crisis, with additional layers of regulation. That is in part because he believes it may make a bad situation (an over-complex financial system) worse. More fundamentally, however, it is because he believes it is unlikely to work in restoring the cultural values to which finance needs to return. In short, you cannot legislate for trust.
Fines for market abuse or mis-selling are a case in point. These have risen dramatically in scale and prominence over recent years. They have been used to sanction, shame and censure financial firms and individuals. The question is whether they have fundamentally altered behaviour of firms and individuals. Only time will tell. But there is at least some risk financial penalties come to be seen simply as a cost of doing financial services business. If so then, as Michael Sandel has argued, they are potentially counter-productive by effectively putting a price on, and hence legitimising, bad behaviour.
For some of the same reasons, Kay is also sceptical about the value of transparency, or the provision of greater information generally, in tackling the financial sector’s culture problems. The need to provide large amounts of information to customers is, for Kay, a diagnostic on trust having been lost, not a means of restoring it. It also risks giving the least benefit to those who are the most informationally—and, typically, financially—disadvantaged.
Kay’s own proposals are to act on the structure of the financial sector directly, thereby reshaping incentives at source. This would mean, for example, separating retail from investment banking activities: rather than cross-dressing, the sober and the sharp suits should be kept in separate wardrobes. This is a move that is now being effected in the UK and, to lesser extent, the US and Europe.
Kay is surely right in his diagnosis of the gradual dilution of standards and incentives within the financial sector, culminating in the financial catastrophe of the past few years. He is also right in pointing out that the trust problem in finance cannot be solved by regulation, legislation or exhortation alone. Behavioural change is needed. And to be self-sustaining, this behavioural change needs to come from within firms and within the sector.
That is why, in addition to regulatory reform, professional standards matter—hence the new Banking Standards Board and the new FICC Market Standards Board in the UK. That is why governance matters, as I have discussed recently in the context of supporting longer-term decision-making by both financial and non-financial firms. And it is why building the understanding and trust of the financial sector among the public matters, to maintain its social licence.
To those ends, later this year the Bank of England is hosting an Open Forum to assess the role financial markets play in supporting society. This will be an opportunity for open debate among those managing others people’s money, those whose money is being managed and those whose job it is to align the two. It is recognition not only that change in the finance sector is an economic and moral imperative, but that change needs to be shaped by the needs of those outside rather than inside finance.
