Searching for Loyalty and Prudence

In his provocative and knowledgeable new book, Other People’s Money: The Real Business of Finance, John Kay considers the complex ways that financial systems operate in between the real savers, on one hand, and the real investments, on the other.

He observes disapprovingly how very large contemporary financial systems have become, how much talent they absorb, how big are the bonuses they pay, how they often have lost sight of their basic fiduciary duty, and especially that “volumes in trading in financial markets have reached absurd levels.” Considering these unimaginably vast amounts of paper (electronic records) constantly being bought, sold and borrowed against among principal financial actors, he reasonably asks, “What is it all for?” He doubts that it really advances the fundamental purposes of financial systems.

Most of this activity involves somebody doing something with somebody else’s money.  To make this a “serious and responsible business,” in Kay’s intentionally old-school, and sound, view:

the guiding purpose of the legal and regulatory framework should be to impose and enforce the obligations of loyalty and prudence, personal and institutional, that go with the management of other people’s money.

This can be effective “only when the values appropriate to the handling of other people’s money are internalized by the market participants themselves.”  

Banks taking the deposits of the public, he adds, “are intended to be rather dull institutions.” They should be “limited in their choice of assets” to conservative ones. This recalls what Walter Bagehot observed in the greatest book on banking, Lombard Street, in 1873:

There is a cardinal difference between banking and other kinds of commerce; you can afford to run much less risk in banking. . . . A banker, dealing with the money of others, and money payable on demand, must be always, as it were, looking behind him, and seeing that he has reserve enough in store if payment should be asked for.

In Bagehot’s memorable summation: “Adventure is the life of commerce, but caution . . . is the life of banking.”

That sounds like the approach of the solid and careful Scottish bankers of Kay’s youth in the 1960s, whose virtues appeal to him far more than do the greater intelligence, quickness, and sparkle of the bankers of 50 years later.

About those former days, Kay reflects, “Banking was then a career for boys whose grades were not good enough to win admission to a good university.” If they joined the Bank of Scotland or the Royal Bank of Scotland, “they might, with appropriate diligence, after twenty years or so, become branch managers,” who were “paternalistic, notorious for their caution.” The branch manager of sober judgment “was a respected figure,” and “it never crossed his mind, or the minds of his customers, that the institution he had joined at the age of seventeen would not continue for ever.”

Instead of going on forever, these big Scottish banks both failed in 2008 and were taken over by the British government. By then, their leadership had degrees from elite universities. However, the “cleverer people managed things less well—much less well—than their intellectually less distinguished predecessors. Although clever, they were rarely as clever as they thought.”

This brings to mind a wonderful lesson taught me by an older banker years ago: “Remember Alex, that it is easier to be brilliant than right.” How right he was.

Kay likes old-fashioned banks. He most distinctly does not like traders or trading banks, especially those “people with an exaggerated idea of their relevance and of their own competence” whom he holds responsible for the 2007-2009 financial crisis.

When he was a director of a formerly old-fashioned institution, the Halifax Building Society, the board approved expanding trading activities. Kay asked where the Treasury profits would come from. He was told the institution would make money “because our traders were smarter,” he writes. “But the people I met did not seem particularly smart. And not everyone could be smarter than everybody else.”

However much an accomplished intellect like Kay may be irritated by the pretensions of the traders, was trading the fundamental cause of the financial crisis? Or was the real problem the more old-fashioned mistake of making a mass of bad loans, especially bad real estate loans? It seems clear to me that it was the latter: bad loans. Of course, trading activities did spread the bad loans around in the form of securities.

Kay poses a key question: Why did banking look so profitable before the crisis? He correctly answers that it is a business that combines “a high probability of a small profit with a low probability of a large loss.” When highly leveraged, the small profit looks big, and the large loss becomes catastrophic.

As an example of the problems this poses—in my words, not Kay’s—suppose we gamble in a statistically fair game with such a probability structure. For an equity investment of $10, it returns a $2 profit 90 percent of the time, but an $18 loss 10 percent of the time. I set the second probability at 10 percent because the average recurrence of financial crises is about once a decade. You might get a 20 percent return on equity for eight or nine years in a row, seeming to confirm how smart you are and triggering big bonuses, high dividends, and stock buybacks besides. Then comes the $18 loss, which wipes you out.

As Kay says, banking can only be meaningfully measured over a credit cycle, and in this game, the net profit for the 10 years as a whole is zero. But the bonuses from the nine 20-percent-return years are not paid back in the disastrous tenth year.

Whatever the problems were and are, Kay sees that the answer is not more reams of detailed financial regulations. “There has not been too little regulation, but far too much,” he writes. “We should put an end to the seemingly endless proliferation of complex rulebooks which are even now beyond the comprehension of the far too numerous regulatory professionals.”

Considering “the comprehensive failures of regulation before and during the global financial crisis,” and “why this approach was bound to fail,” he rightly cites the Austrian school’s critique of central planning.  He might have added, as Ludwig von Mises and F.A. Hayek would, that the ever-more-complex regulations serve the will to power of the regulatory bureaucrats and central bankers who write them. He might also have added that when the U.S. politicians and bureaucrats mandated making risky mortgage loans to promote home ownership, they obviously had no idea what they were really doing or how it would turn out—just as von Mises and Hayek would have said. (For an in-depth analysis of this, see Brian Domitrovic’s recent Law and Liberty post.)

Solutions are naturally more difficult than even the most insightful discussion of the problems.  Among his suggested reforms, Kay wants to make the lines between savers and investments clearer and more direct, to “re-establish short, simple linear chains of intermediation,” and to “restore specialist institutions with direct links to financial users.” These are interesting suggestions, but must make us skeptically think of the collapse of the specialist savings and loans and the specialist subprime lenders.

Kay also makes a proposal that would be excellent if it were politically possible: to “treat financial services as an industry like any other” and withdraw “public subsidies, state guarantees, and other mechanisms of government support.” If only we could. But we cannot even reform Fannie Mae and Freddie Mac, which continue to live entirely on government guarantees and support.

Finally, he stresses the central principle: that “anyone who handles other people’s money” should demonstrate “standards of loyalty and prudence in client dealings.”

This is worthy of constant effort, by precept and example.

Reader Discussion

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on April 13, 2016 at 14:42:34 pm

As a software engineer I find the high-volume computerized trading mentioned in the essay rather disturbing. The machines are constantly being optimized to gain the most return and that means someone loses. The losers in this case are the people without trading computers. That would be you and me. The computers are like the chess programs that beat us so well that we've given up playing against them. I've pretty much given up on most buy-and-hold tactics for any sector smaller than the main stock and bond indexes. The machines and their master (programmers like me, backed by genius IQ guys with advanced degrees in finance) will eventually, if they haven't already done so, figure out how to extract money from buy-and-hold investors.

Computers have changed the personal investing world, and will continue to do so for the foreseeable future. Because of the imbalance in investing power, computers could drive all of us out of marketplace investing and into government controlled "investing." Think Social Security on steroids.

As for the possibility of political change: Give the senators a secret ballot. Modernize their method of election into the senate. And set up a watchdog organization to run the senatorial balloting, watch for corruption, and address false claims of corruption. Those actions will create a conscientious Senate that will address most of the sources of imprudence discussed in the post. (And no, I'm not being brilliant here. I'm being right.)

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Scott Amorian
on April 13, 2016 at 16:01:50 pm

Interesting piece.
Am curious as to what Mr. Pollock thinks of the new Obama Admin regulations re: stockbrokers / managers being required to fulfill a "fiduciary" role with respect to their investors.
It would appear that the Editors at NRO do not like this - and not simply because, as is typical, it is a poorly crafted piece of regulation. This essay evidences both the need and value of the fiduciary role in banking and as Scott makes plain (above comment) the regular (and ill-equipped) investor is at a substantial disadvantage. Why not compel the money managers to act in their clients best interest rather than their own?
I have no problem with the idea of the new regulation even if the craftsmanship is rather wanting.

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on April 14, 2016 at 13:06:55 pm

I'm also a computer/systems/software engineer, and disagree that "The machines are constantly being optimized to gain the most return and that means someone loses." Neither side who voluntarily engages in a transaction thinks they are a loser; otherwise, they wouldn't make the transaction thus both sides always win, but often someone has erroneous thinking. And I'm also familiar with the Flash Boys and what they did.

Giving senators a secret ballot just hides what they do from us, their employers, and increases the ability to engage in corruption. A far better approach, is to remove commerce from the control of government and return it to free markets. After all, as Pollock points out, it was government meddling in the home ownership market that led to bad real estate loans, the 2008 crash (see "The Big Short" for a quick explanation) and the government (again meddling in markets) bailouts.

Kay's desire to "to make the lines between savers and investments clearer and more direct" is a good one. The big problem is fractional reserve banking, without which most banking wouldn't exist because banks couldn't create money without fractional reserves and demand deposits (the ability to withdraw ones funds at any time). But neither would bank runs result because of bank investment failures. Because then the saver would be directly tied to the investment and get rewarded/penalized based upon the results of the investment. With the "bank" putting the transaction together getting a piece of the action, and likely only if there was a profit. Government insured deposits, such as the FDIC, are simply subsidies to the banking industry.

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on April 14, 2016 at 13:24:46 pm

As a libertarian, IMHO, the Obama administration regulations requiring advisors to fulfill a fiduciary role is simply more government control of the investment market, rather than allowing free markets to work.

Free markets will weed out poor advisors, while good ones will last. E.G., advisors that disclose their fees will usually be chosen by customers, than advisors that don't. Free markets will ensure this, by independent firms that will arise to audit such advisors, and whose business will depend on their reputation for being honest. Unlike the government bureaucracies that don't have to worry about losing business. Such as the SEC regulators and their big 3 approved ratings agencies (S&P, Fitch and Moodys). The SEC was unable to say that these firms were overrating mortgage backed securities prior to the 2008 crash. Two institutions associated with the government (one part of the government, the others approved by the government to do ratings), rather than existing in the free market.

The Obama regulations, are simply more of this crony protectionism. Rather than applying to ratings agencies, it will apply to all investment advisors. And it will limit who can provide investment advice, even limiting your free speech to say what you think about certain investments, if you aren't part of the government approved cartel.

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Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.