Interview Transcript: “The finance industry has created an environment so complex and beyond their cleverness to run”

Emmanuel Daniel (ED): I'm very pleased to be able to speak to John Kay, economics commentator, professor, and someone who’s worked very closely with the government in the United Kingdom and Scotland. His latest book, Other People's Money: Masters of the Universe or Servants of the People? focuses on where banks are today, how they’re being regulated, where they are headed, and how they influence the economy in that regard.

You are a pioneer in at least two think-tanks in the UK, where businesses were part of the process of influencing government policy as the UK was changing from a very Fabian type of economy to what it is today. Just give us a sense of how your thinking has evolved over time.

John Kay (JK): Banking has evolved during that time. And one of the things that has influenced the evolution of banking has been that change in the intellectual climate you're describing; essentially the much greater readiness to leave things to market forces than was true up until the 1960s. But I think actually, as far as the banking and financial sector is concerned, the main effect of that has been negative, not positive. You asked me where I come from in all of this. I go back to Edinburgh in the 1960s when I was a schoolboy, and then going in to the Bank of Scotland, or the Royal Bank of Scotland. That was a career for the boys in my class who weren’t going to get quite good enough grades to go on to good universities. These people would work in the bank for 20 years, become branch managers, and work for another 20 years before they retired with a pension. And they existed in that rather stable world, which everyone imagined would go on forever, and they were very much part of their local communities and through that, knew who it was appropriate to lend to and who wasn’t. And there’s this extraordinary paradox that by the time the Bank of Scotland and the Royal Bank of Scotland both went bust in 2008, they were run by very clever people with very good degrees from good universities; MBAs from the best known business schools. These people; well, we know what happened. They managed the businesses much worse. And the reason they managed the businesses much worse, actually, is that they and others had created a complex environment, an environment so complex that it was beyond even the cleverness of the people who were then running these institutions.

ED: Is it that we lost the plot, somewhat? We lost the narrative as it was being built? Take the time from the end of Bretton Woods when banking was essentially an asset, to what it is today, where banks make more money from their trading book than they do from the traditional business. You just mentioned that less than 3% of lending is to nonfinancial institutions in that regard. Did we lose the narrative? It was evolving; it was clear for everyone to see but we were imagining that it was something other than what it was. By the time we reached 1999, banks like the Royal Bank of Scotland had become a trading shop rather than a traditional bank. But they were making decisions as if they were traditional banks.

JK: I think that’s pretty much the case, or at least the trading activity was added on to the traditional bank. And the thesis of this book is that we need to get back to ask, not turn the clock back to the 1960s. We need to get back to asking what finance is for and how well finance meets the needs of the nonfinancial economy. In my view, banking and finance is about four things. It’s about operating a payment system. It’s about facilitating wealth management to enable us to manage our consumption over our lifetime through education at one end and retirement at the other. It’s there to do capital allocation, to take household savings and put them into worthwhile investments. And it’s there to help businesses and households mitigate risk. These are the things we want finance for.

ED: But is that wishful thinking? Is that the trajectory banking is on, is it raging on to its logical conclusion in that the whole economy as we see it today is what I would call the financialisation of the economy—banking looking for all kinds of assets to financialise. If you look at microfinance, for example, it started as lending to the poor community. And today, you have capital investments coming in from private equities that rip it up and make it very mercenary. Is that trajectory continuing?

JK: I hope it’s not helpless. But I think you’re making two key points, there, which are very much the themes of the book. The first is the way in which these core purposes of finance have been overwhelmed by volumes of secondary market trading. So what most people in the wholesale finance sector are doing today is actually trading existing assets with each other, rather than either creating new underlying assets in terms of new businesses, new infrastructure, new business investment and so on. They’re trading in things that already exist rather than creating these. That’s one of the important ways in which finance has gotten away from its purposes.

The second thing is, as you mentioned, that microfinance is a good example of financial innovation. Very often you have genuine innovations that serve a useful purpose for a limited group of functions and people. And yet, almost all of these innovations get pursued to enormous success. The way in which microfinance was transformed is a good example. One could have loads of other examples, ranging from what happened with credit default swaps, to what has happened with exchange-traded funds. All of these useful innovations that actually became damaging when pursued to excess.

ED: Nonetheless, they are still financial tools. Is there a nonfinancial model that we should be thinking about for hedging, for derivatives, that makes them maybe less tradable, closer to their purpose, and therefore less likely to be misused by the finance industry? The point here is that the finance industry cannot help by being itself.

JK: I think we have to change it so that it actually serves the needs of the real economy rather than go on living in this self-referential world where people are trading with themselves, talking to themselves, judging themselves by criteria they have themselves generated; criteria which are often irrelevant to the needs of the underlying users. For example, there’s this obsession with liquidity. People are talking about it every day, the limitations of liquidity, when actually, the amount of liquidity in the financial system that is needed by underlying users is very small. We have hundreds more liquidity than is actually needed to meet the requirements of people who are saving for retirement; companies that are raising capital for investment and so on. The liquidity is there to meet the needs of financial market participants, for markets in which they can readily trade.

Similarly, asset managers are judging themselves by benchmarks, which are effectively the average of performance of other asset managers. That’s not what people saving for their retirement care about, rather, it’s how much money they’re going to get in their pension.

ED: Right. And there is the question as well of what are you paying for in terms of skills. Are you paying to preserve your assets or to do what you would have done anyway, in that regard? Hence, the revenue being generated has to be fit for the purpose in that regard.

Let me ask you this. It is also my sense that commercial banking, in the run-up to 2008, did have a positive element in that it made credit cheaper. Given the experiment of the UK today, the challenge of high-street banks and challenger banks is going to be the costs of funds aspect. Not all of them are revealing too much of their cost-to-income ratio. In other words, to go back to what banking should be, which may well be a more expensive proposition than what we have actually created.

JK: I'm not sure challenger banks are central to the reform of the banking system. If I look at where we are in Britain, or indeed in most other countries, it seems to me the problem is not that we don’t have enough banks, it’s that all banks seem, to their customers, to be essentially the same. And that’s partly a matter of this self-referential world of the industry. It’s also a matter of regulation. That if you want to be a challenger bank, you’re told to get a license. You have to be pretty much like the other banks that already exist. And that’s not a recipe for effective competition. It’s one of the many ways in which I think regulation is actually failing to serve the underlying interest—the real interests—of the public in financial markets.

ED: What is your sense of regulation, how it’s playing out today? It’s becoming a terror, in a way, to the industry. And the industry is second guessing itself, dealing with regulation. What should the role of regulation be, and how can regulation guide the industry to the kind of sustainable model that you’re thinking about?

JK: I think we need to rethink the whole philosophy of financial market regulation. The idea that we can regulate any industry by reference to detailed prescriptive rule books is just a mistake, and hasn’t worked anywhere else. And it generates the phenomenon that everyone recognises in relation to financial regulation, which is it becomes ever more complex and less and less related to the underlying, real needs of users of markets. And that’s inevitable because the finance industry employs a lot of clever people.

Whatever regulatory structures are devised, if they don’t go with the grain of what people want to do anyway, they will find mechanisms of getting around them. And that just yields more complex rule books. We had Basel 1, Basel 2, now we have Basel 3. I'm sure we’ll have Basel 4 and 5 and 6. And I don't know how many we will get to before we realise that what is wrong is not that we haven’t quite gotten the rules right; it’s that we are trying to regulate banking along these kinds of rules, which was the wrong approach from the beginning.

ED: But Basel 1 was a very simple rule. And in fact, Bill Seguin, the US representative on Basel 1 said it took them one day to decide on Basel 1. By the time they got to Basel 3, it was a year longer than that. Basel 1 had a lot to do with the basic business of assets and liabilities and the need to have enough capital for assets and liabilities. Basel 2 had a lot to do with the execution, with markets.

Basel 3 went into markets in a very big way. By the time we reached Basel 3, we were already going into liquidity. When you look at the regulation regime that has been created, it is almost after the fact, or how to deal with a crisis that has happened earlier. And on top of that, one can argue that the fines that are imposed today are in a way making regulation a beneficiary of the kind of money that is made in banking.

JK: Right. So what you’re describing is really a litany of regulatory failure. The lesson of the Basel capital requirements, it seems to me, is that trying to regulate the system by this kind of prescription is not going to work. And we’ve just been through how it’s increased in complexity through Basel 1, 2, and 3, and it will go on increasing in complexity. And that at every stage, people will discover that it hasn’t quite had the results they wanted, and will add yet more bells and whistles. We can’t do it this way. I think what we have to do is to look at a banking world in which we separate the rather dull deposit-taking banking, which is inevitably going to be backstopped by the taxpayer, and we regulate that rather tightly. Most of the other activities we separate and have much less regulation of. And we let all institutions in these areas of finance to actually go bust.

ED: That seems to be at the heart of the issue—the ability to allow banks to be run as businesses and to go bust. And it’s not so much public opinion, but policy that determines that. Being as someone who’s been in policy all your life, or in the business of influencing policy, how do you think that’s going to change? At which point will regulators say that banks will be allowed to do whatever they want and at some point, the shareholders backstop them, and shareholders take responsibility for the decision that they make?

JK: This goes straight back to the issue with which we began, about the extent of secondary market trading that makes institutions interdependent. Most people now think it was a mistake to let Lehman fail. But I have heard nobody say that it was a mistake to let Lehman fail because we really miss the services that Lehman used to provide. The reason for Lehman failing wasn’t that Lehman was a very big financial institution. The reason for Lehman failing was that markets were so interdependent so that the consequences of Lehman’s failure spread throughout the financial system.

That’s why, in my view, we need to address it with a regulatory philosophy that is aimed at the structure of the industry, and the incentives of firms and individuals within it. It is not about trying to write detailed rules. And for me, that means a world of much less secondary market trading; of much less interdependence in which we have shorter, simpler chains of intermediation in relation to capital allocation. For example, the households are ultimately providing the savings, and the companies, homebuyers, and the like are being provided with the capital.

ED: What you are suggesting here is very interesting. In the US, there is a very clear distinction between Main Street banks and the trading shops out of New York.

JK: Or at least they used to be.

ED: Legally, yes. Goldman Sachs would still maintain the legal aspect more to protect itself but it’s still very much of a trading shop. In fact, one would argue that by being incorporated as a bank, it actually gets into even more trouble as a result. But at least that distinction is clearer in the US than it is in the UK or in Europe, where banks take on the whole spectrum of activity in that regard.

This thing about ring fencing, is that an artificial construct or is that a natural thing to do, to make a distinction between on one hand, the wholesale activities of banks where they have a lot to do with each other, rather than the industry or the man on the street; and on the other, commercial banking where they have to be honest with the man on the street every day?

JK: I think we do need to have that kind of ring fencing. I was suggesting earlier, when we do that, we can have tight and effective regulation of the rather dull retail banking sector, and largely deregulate the wholesale sector, in which people trade with each other. I think if we deregulate the latter, we’ll actually have much less activity in it because people will know that this activity isn’t backstopped by taxpayers. And what will, as it were, impose capital requirements on businesses will not be a regulator but actually the prudence of the management of the businesses concerned, and the willingness of their counterparts to do business with them. It’s very striking that, as it were, the capital ratios of hedge funds, which we know are going to be allowed to go bust, are so much larger than the capital ratios of the hedge funds that are within commercial banks, which are prescribed by regulators and where people perceive that there’s very little prospect of failure.

ED: In the prescriptions that you are suggesting in your book, how do you think they’re going to work? What do you think is the mechanism that needs to be in place for banking to be brought back to the sustainable regime?

JK: That’s very difficult because a large part of the problem we face at the moment is simply the political power of vested financial interests as they are at the moment. Wall Street is effectively the most powerful of industrial lobbies in the US, which is the country that matters most for these purposes, although for somewhat different reasons. In other major countries like the UK, France, or Germany, the established banking industry, the established finance industry, is all whole, and so has a very powerful influence on politics.

I think unless we break that nexus, we’re not actually going to get the kind of reform that I think is needed— a finance system that actually serves more effectively the needs of users of finance. I suspect it will take another major crisis to do that. Or—and this worries me more—I worry more and more about the way in which the rather unfocused public anger about what has happened in the last decade is translated into support for crazy guys at the extremes of the political spectrum.

ED: When you think about it, all of the liquidity that’s been created in the market today is created through leverage, and governments becoming leveraged,  governments issuing bonds and treasuries. That being the case, we are continuing on that trajectory where we left off in 2008. In fact, it’s larger today, given the balance sheets of central banks, which are now players very much like investment banks. We’ve just actually introduced yet another player into the equation.

JK: That’s the way in which central banks become de facto market makers in a variety of asset classes—as a result of the promises. Much of the liquidity that is apparently created by this activity in the system is a illusory, in the sense that when you want it, when you need it, it’s not actually going to be there. And that was one of the lessons of 2008.

ED: That’s the inefficiency of the system. We haven’t even started discussing that at all, of credit not going where it’s supposed to. And all of the new fintech players who are coming on stream, they're suggesting that they can get it to the required users efficiently. But I think that they, too, will be businesses and they’re not going to be providing credit cheaply. But that’s a completely different discussion. Nevertheless, the liquidity that has been created, as you say, is inefficient and it’s not serving the purpose it’s supposed to.

The underlying theme is this, that the entire capitalist model is based on the creation of credit and the distribution of credit, rather than the creation of wealth and the distribution of wealth. Some banks are suggesting that they are reformed today; they want to go into the wealth management business. But the system doesn’t give them anything to work with when wealth is created on the back of even more trading, and asset inflation comes from the rich being able to leverage what they have even more of, and the poor not having anything.

JK: There’s an underlying question, which is something that has puzzled me for a long time, and which I talk about in the book and try and sketch answers to. And this is, where does the profitability of trading actually come from? Because if you lock people in a room and they spend the day trading bits of paper with each other, they’re not going to add any value and they’re not going to make any gross profit. The amount of money they walk away with at the end of the day in total will be the same as the amount which they came with. If you ask where the money does come from, then I've come to the conclusion—and I describe this—that part of it is illusory.

Part of what happened in 2003 through 2008 was banks announced they’d made very large profits, much of it from trading. They paid a large proportion of these to their senior employees. And then they discovered in 2008 that it had all been a mistake; that much of the paper on their balance sheets was overvalued and they hadn’t made these profits after all. And that’s how shareholders and several major banks were effectively wiped out. So some profits are illusory, and some of them, like the returns that are generated from high-frequency trading, are basic. These are just attacks on long-term savers and investors, the households that actually want to put their money into the market.

ED: And while we are having this conversation, the financialisation of everything keeps raging on.

JK: Yes, I use the term financialisation in the book to talk about the way finance has become central to so much of our lives, whether it’s the rather desirable privatisation of a variety of traditional state functions, or the way in which business is paying attention to stock markets in a way that managers of 50 years ago would never have dreamt of doing. In the main, the effects of that are malignant rather than beneficial for the actual management of the business and the development of the nonfinancial sector in terms of long-term relationships with customers, suppliers, employees. Yet these are actually critical to what makes business—whether financial business or nonfinancial business—work.

ED: So in your book, you describe the malady but not the conclusion in that regard.

JK: I do talk about the remedies. And for me, the remedies lie fundamentally in two areas. They lie in reform of the structure of the industry. So what I want to see are many more specialist institutions, rather than the broad-ranging financial conglomerates that we have at the moment. Because as they’re functionally specialised, they will be smaller. And one of the really desirable objectives is that we can let markets work so that firms that do well grow, and firms that do badly fail.

So we need to reform the structure of the industry to go through the ring fencing that you’ve described of one, deposit-taking banking; and two, for the remainder of the financial system, deregulation, or letting finance operate like any other business in a market economy. What we also need to do is address individual and corporate incentives partly with sticks.

These, I think, are what we need to do, to have strict liability in financial organisations for what happens to them so that the people who are running these institutions don’t have the defense of saying we didn’t know what’s going on. This is precisely what has made driving home responsibility so difficult at the moment. And similarly, incentives that actually relate bankers’ rewards to meeting the underlying needs of users rather than trading in secondary assets.

ED: Final question: which regulatory regimes or which markets do you think are closer to becoming sustainable today, after 2008, because of real reforms that they’ve put in place?

JK: I think the regulation of finance has gone down a path that leads ultimately nowhere, it’s leading us through a maze that actually has no end, and we will just get buried deeper and deeper. People sometimes ask me do you have models of how regulations should work, and I often talk then about the airline industry. For 50 years from the beginning of airline regulation in the 1920s through to the 1970s, the industry went down the path we’re familiar with in finance, that of ever more complex prescription being written from the center. And there was then a 10-year interval in which we got rid of all that stuff and focused on the issues that really need regulation, which primarily have to do with passenger safety and public safety.

Today the airline industry has economic competition on one hand, and a cooperative culture in developing safety on the other. That’s what’s known as a just culture in the industry, which encourages people to report problems and mistakes when things go wrong. And that’s why our planes are safe and our financial system is not.