Professor Michael Mainelli, Executive Director, The Z/Yen Group
[An edited version of this article first appeared as "“The Religion Of Regulation: Too Big To Succeed”, Journal of Risk Finance, The Michael Mainelli Column Volume 9, Number 4 Emerald Group Publishing Limited (August 2008).
How does the Credit Crunch affect London? Bob Giffords and I call this the Credit Scrunch in the firm conviction that much more is at stake than just recovery from current economic confusion (Mainelli and Giffords, 2009). Scrunch means to crush, crumple or squeeze. We believe that reacting to current events with current mindsets could lead to the scrunching of the world economy, but likewise that we may need to crush, crumple and throw away traditional responses to financial markets. An important discontinuity requires a holistic rethink and response.
I am pleased to hear John Kay push real change with narrow banking (see ‘How to regulate banks effectively’ in this volume), because my points are largely to move some of these uncomfortable changes further along. Regulation cannot solve our problems, in fact it is a big part of the causes; we need more competition, not less. London has to decide whether it supports a quick return to dysfunctional normality, or whether it wants to line up to support radical changes to financial markets in a quest for improvement, to make finance sustainable, and to think about the long-term.
Treating all comers fairly
Z/Yen Group compiles the Global Financial Centres Index every six months on behalf of the City of London. The Index has shown over the past two years that London and New York City are neck-and-neck as the only two truly global centres. People focus on two frontrunners, but survey-by-survey Hong Kong, Dubai and Shanghai are making significant inroads. Whilst all financial centres are taking a hit, things are especially precarious for London.
The heritage of London and the UK is treating all comers fairly – the so-called Wimbledon effect - the local champion may have little chance, but the judging will be fair. London thrives when it is open to foreigners, from French Huguenots to Hong Kong Chinese. London suffers when it is unfair to foreigners - the expulsion of the Jews in 1290 or the closed shops of brokers and jobbers until 1986.
London has been built on others’ mistakes. Eurodollar markets grew swiftly in the 1960s when US tax rule changes meant multinationals found it attractive to leave dollars outside the control of US authorities. Sarbanes-Oxley requirements after 2000 increased the attractiveness of London as a ‘light touch’ regulatory environment. AIM listings increased listings at the expense of New York Stock Exchange. But when the UK makes mistakes, for example with the shipping industry last year, retribution is non-existent, but exodus is swift.
True, in the past 18 months or so pessimism has become the new black, but blackest for me are overseas clients claiming that the UK is a big political risk. Why? The answer is tax since 2007 – changes in six months to non-doms, capital gains tax, foreign dividends and trusts. First a proposed 45%, now a 50% tax rate. On access, they complain about visitors’ visas, work visas and ID cards for non-EU nationals. Then they mention terrorist legislation used against Iceland. Then they point out that it is difficult to get fair treatment in a country where the government controls the banks; whether it is a banana republic or the UK, the courts will not operate fairly. When I defend fairness in UK courts, overseas clients point to the 1992 case, Hammersmith and Fulham Council versus Hazell.
The Scrunch is about connectivity and feed-through [this “Extreme Connectivity” section is adapted from Mainelli and Giffords, 2009, pages 34-37]. In the late 1990s many business gurus made a fortune with breathless panegyrics to the internet. Marshall McLuhan had been right back in 1964: the medium is the message; we are living in a global village. The dot.com boom and bust did not really change anything. We would just arrive at the global village a little later. If liquidity provides the flow, connectivity provides the plumbing to pump it round the system. Extreme connectivity accelerated the systemic feed-through mechanisms on all levels, creating more leptokurtic exposures and increasing volatility. Walt Lukken, of the Commodity Futures Trading Commission (CFTC), concludes that derivatives may be one of the ‘flattest’ of global industries. His "aha" moment came when he realised that electronic traders in Gibraltar could now compete directly with the Chicago traders in the pits. "Clearly a flat world gives the advantage to the Rock over the Windy City," he concluded, given their off-shore tax and regulatory concessions.
Gertrude Tumpel-Gugerell, executive board member at the European Central Bank, noted the effect of extreme connectivity on equity volatility in 2003. Historical and implied volatilities on stock options had doubled from about 15% to 30% in a matter of six years on European and American stocks. She attributed this to, among other things, technology and questioned whether such pricing volatility might have an adverse impact on capital allocation decisions. More recently she pointed to the huge spike in implied volatilities on stock options on the DJ Eurostoxx index from 15% in 2006 to more than 75% in late 2008. In Chicago the CBOE VIX volatility index hit nearly 90 in October 2008 before falling back to 60 in December. It is hard to imagine such volatilities without the speed and connectivity of electronic trading and straight-through-processing. The Financial Times attributed the American volatility to the use of "aggressive algorithms" based on intraday pricing feeds. The linkage between equity and derivatives markets is also increasing, with some market participants suggesting that 20% or more of US equity trades probably involve a derivative play. In London anything up to 40% of equity trades are now said to be driven by contracts for differences (CFDs).
Together, these innovations translate into faster systemic feed-through and complex chains of systemic causality. People using similar models add to homogenisation and leptokurtosis. Much of this risk was concentrated in fewer than 20 global sell-side brokerages at the investment banks – in their roles as brokers for the buy-side, issuing dealers for derivatives and proprietary traders. Failure became almost inevitable.
The Credit Scrunch is a systemic failure with multiple causes and multiple effects. One key failure point is lack of competition. The wholesale financial system has systemically failed among an oligopolistic core of investment banks, auditing firms and credit rating agencies. It is important to stress that many zones of financial services thrive, such as foreign exchange, commodities, and clearing houses. But the core systems around the investment banks have failed. In the UK, Ireland and Iceland, an oligopolistic core of retail banks failed too. And the regulators of these systems failed. Note that Fannie Mae and Freddie Mac had their own regulator.
The strategic question facing everyone is whether the crisis is a short-term bump on an endlessly rising road to prosperity, or an apocalyptic warning that severe design faults imperil political and economic activity. If you believe the crisis is a blip, then you ‘hunker down’ and want to know when things will get back to normal. If you believe it foreshadows apocalyptic changes, then the question becomes: ‘how would you know when the financial system is working again?’
Religion of Regulation versus Open Competition
Market failure comes in three broad categories: lack of competition, information asymmetry/agency problems, and externalities. Wholesale finance certainly exhibits classic signs of lack of competition: self-evidently excessive salaries, a banking industry with 2006 profits per employee a magical 26 times higher than the average of all other industries worldwide (according to McKinsey), an industry that went from 5% of USA market capitalisation in 1990 to 23.5% in 2007, and a cast list of the top 10 that would be largely recognisable back in 1929, Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, Morgan Stanley, JP Morgan Chase, Citi … In summary, by 2007 there were less than twenty global investment banks, four auditing firms, three credit rating agencies. Perverse incentives of bonuses and regulatory dissonance expose the information asymmetry/agency problems. And, whether it is third world debt, savings & loan defaults, dot.com bubbles, or Credit Scrunch problems, the burden borne by taxpayers around the world shows too clearly the externalities.
But lack of competition is key. More regulation is a knee-jerk, and senseless response. ‘Never mind the quality, feel the width’. When we see market failure we should first try and fix it through trust-busting or anti-monopoly laws – the 1890s in Britain, the 1900s in the USA. Only Private Eye (2 October 2008: 3) had the guts to call a spade a spade: ‘Gordon Brown promised to increase regulation to deal with collapsing financial institutions, but his biggest move so far is a massive decrease in regulation’ suspending normal competition and takeover rules for Lloyds and Santander. Later we should add ‘supervision’, i.e. knowing what is going on. Later still we should add direct regulation, i.e. saying what should go on. We should start with the Competition Commission, not start with the Financial Services Authority.
People discuss the recent failure of free markets. Actually, the problem is that the financial markets that failed were hardly free; they were heavily regulated. Regulation failed to stop concentration in overly-large, dangerous banks. Regulation creates barriers to entry, thus promoting large banks over the small. Regulation homogenises and embalms, reducing diversity. But financial services regulation is a religion: ‘regulation failed because you really really didn’t believe in regulation. So pray harder.’ The religious faithful of regulation want to go much further the other way and now seek powers to follow mega-banks, rather than question whether size itself might be a sign of regulatory failure. We do not need special rules for system or large complex financial institutions if we don’t let them get too large. London failed to push for open markets among global investment banks, audit and credit rating, resulting in over concentration and loss of diversity, and a Scrunch.
If we were talking about the great internet crash of 2007 and looked at 2 billion internet users focused through less than twenty nodes, at least two of which crashed, several of which wobbled and all of which are dodgy, our analysis would simply conclude: do not concentrate on just twenty nodes. Break it up. Wholesale investment banking is no different. Even regulators need a nuclear option, the ability to look a bank in the eye and threaten to pull the license to operate. Without that ability, too big to fail is too big to regulate. The USA got through the savings & loans debacle by letting 1,700 of 3,400 banks go down over ten years from 1986 to 1995. It cost $125billion. We spend $1.25 trillion a month trying to keep two score too large organisations together when they should be broken up.
I would add that we need to look at three elements of open markets – competition (having participants keep each other in check); knowing what’s going on (supervision); and telling people what to do (regulation). These are three different, complementary and important roles, and they are not necessarily unitary or global. Competition among regulators itself promotes diversity and the information provided by supervision is a key part of keeping regulators on their toes. In fact, if current suggestions for regulatory homogenisation had been implemented earlier we could not look to Sweden, Spain and Denmark for lessons on other ways of regulating which seem to have worked. While supervisors should share data, who needs a global regulator if investment banks are not allowed to get too big? Regulation favours the big getting bigger, creating firms too big to fail, and thus too big to regulate.
The Credit Scrunch is not amenable to quick fixes but, in today’s world of ‘keep-it-simple-stupid’ bullet points, some high-level conclusions include:
- the Scrunch was not a failure of open markets but a failure of highly regulated markets that were closed;
- too big to fail is too big to regulate – financial services is a bit special (so are pharmaceuticals, defence, electricity, air travel, shipping, water, …), but the fundamental control tool in all markets is competition and we need to increase competition in financial services, not reduce it, or, in a nutshell, size matters;
- increases in regulation reduce diversity – a healthy financial services ecosystem should exhibit diversity, yet society appears to over-value presumed economies of scale in financial services when it should encourage heterogeneity and the broadest possible range of market participants.
Everyone has their favourite fixes, but the question we should be asking far more stridently is ‘how would we know when the financial system is working?’ More permanent solutions need permanent questions, such as ‘can a 20-year-old responsibly enter into a financial structure for his or her retirement?’ Such a question raises a host of related issues. The question draws in actuaries, accountants, life insurance, savings, investments, security, fraud, risk, returns and firm defaults. An average 20-year-old today should, under reasonable actuarial expectations, live to 95. Most 20-year-olds with whom I talk assume they’ll live to 120. So the question implies a financial structure that should last 75 to 100 years. Yet The Economist (‘Where Have All Your Savings Gone?’, 6 December 2008: 11) observes: ‘Any American who has diligently put $100 a month into a domestic equity mutual fund for the past ten years will find his pot worth less than he put into it; a European who did the same has lost a quarter of his money’. So 20-year-olds, and others, vote with their savings.
I do not know how 20-year-olds can responsibly enter into a financial structure for their retirement, but I do believe that the question matters. Another permanent question might be, ‘how do we fund a forest?’ These questions remind me of a question posed by the computer scientist Danny Hillis in 1995: ‘how could one build a clock to last 10,000 years?’ Dr Hillis’ question led to the 01996 (sic) Long Now Foundation, providing a counterpoint to today’s ‘faster/cheaper’ mindset by promoting ‘slower/better’ thinking. From the Long Now Foundation emerge projects such as a timeline tool (Long Viewer), a library for the deep future (Long Server), and tracking bets on long-term events (Long Bet). Another venture with long-term aims is Carlo Petrini’s Slow Food movement. Perhaps we need a Slow Finance movement or, my favourite, a Long Finance Foundation.
London seems a tragic hero – it lost its own principles of open markets in pursuit of a decade of quick bucks. Once you look at the problems involved in Long Finance, you realise that many of today’s sustainable finance issues arise because society’s core, global risk/reward transfer system, finance, does not have enough diversity to deal with the long-term. In conclusion, I do believe in the power of competitive markets to make the world a better place. I equally believe that markets are social tools requiring design and oversight to meet their objectives. I would argue that the focus must be on increasing competition - keeping London open as a market for all to be treated fairly, over the long term. London should lead the debate on Long Finance.
Michael Mainelli and Bob Giffords, The Road To Long Finance: A Systems View Of The Credit Scrunch" Centre for the Study of Financial Information, 62 pages, ISBN: 978-0-9561904-4-4, (July 2009).