Other People's Money: The Real Business of Finance
Apple raised $17 billion in a bond offering in 2013. Not to invest in new products or business lines, but to pay a dividend to stockholders. The company is awash with cash, but much of that money is overseas, and there would be a tax charge if it were repatriated to the USA. For many other companies, the tax-favoured status of debt relative to equity encourages financial engineering. Most large multinational companies have corporate and financial structures of mind-blowing complexity. The mechanics of these arrangements, which are mainly directed at tax avoidance or regulatory arbitrage, are understood by only a handful of specialists. Much of the securities issuance undertaken by Goldman Sachs was not helping companies to grow but represented financial engineering of the kind undertaken at Apple. What
A regulator cannot easily challenge the fundamental strategy of a badly run financial services business, such as Lehman or Royal Bank of Scotland. No one within the businesses themselves was willing to challenge Dick Fuld or Fred Goodwinincluding the genuinely distinguished figures who sat on the RBS board (that of Lehman was decorated by friends of Fuld). Even the head of an agency may enjoy less access to the powerful than the senior executives of large corporationsif for no other reason than that the latter have considerably more largesse to dispense. Recall Gordon Browns fulsome tribute to Fuld and Lehman (see Chapter 1), and note that Goodwin and his (then) wife enjoyed weekend hospitality at Chequers, Prime Minister Browns official residence, even as the bank was sliding towards bankruptcy. It is not an accident that both Lehman and RBS were run by unpleasant, domineering individuals with good political connections: these characteristics are common pointers to the combination of personal success and corporate failure. Now
But simple consumer reluctance to switch providers is a major obstacle to competition in retail financial services. It is a well-known joke in the industry that customers change their spouses more often than their banks. They all seem the same: why transfer your loyalty from Tweedledee to Tweedledum? This inertia on the part of retail buyers is common across all financial products. Credit cards have consistently been one of the most profitable retail banking products. Bank of America, first mover in this industry, continues to hold a strong position, despite aggressive attempts by entrants to solicit new business. Many people just do not like buying financial services, and minimise the time and effort they devote to their purchase as a result. The days when retail customers of financial services were rewarded for their loyalty are long gone. The replacement of a relationship-based culture by a transaction-based one means that the best deal is almost always obtained by shopping around aggressively rather than by building trust. Customer perceptions have lagged behind this harsh reality. But
But the current investment banking modelwhether applied in a standalone institution such as Goldman or in a broad financial conglomerate such as Deutsche Bankis at the heart of the problems the finance sector poses for the real economy. Investment banks today engage in securities issuance, corporate advice and asset management; they make markets in equities and FICC, and trade in these markets on their own account. It is only necessary to list these functions to see that each of these activities conflicts with all the others. Each should be undertaken in distinct institutions. And with lower volumes of inter-bank trading, a diminished role for public equity markets and much more direct investment by asset managers the scale of most of these activities should be much reduced. Among all the actors in the finance sector today, only the asset manager, who typically earns a fee calculated as a percentage of funds under management, is rewarded for idleness. The profits of a segregated deposit-taking bank would similarly depend primarily on the scale of the deposit base, and secondarily on its success in making good loans. Dedicated channels of capital allocation have a more appropriate incentive structure than activities focused on trading and transactions. Whenever
Captain Renault: Im shocked, shocked to find that gambling is going on in here! [a croupier hands Renault a pile of money] Croupier: Your winnings, sir. Captain Renault [sotto voce]: Oh, thank you very much. Captain Renault [aloud]: Everybody out at once! CASABLANCA, Warner Bros, 1942 We were all appalled and shocked when we heard about these allegations yesterday. I have to tell you that I am sickened that these events are alleged to have happened. Not just because I was editor of the News of the World at the time. REBEKAH BROOKS, chief executive, News International, in a memo to staff, 8 July 2011 After
David Viniar, CFO of Goldman Sachs, claimed as the global financial crisis broke in August 2007 that his bank had experienced 25 standard deviation events several days in a row. But anyone with a knowledge of statistics (a group that must be presumed to include Viniar) knows that the occurrence of several 25 standard-deviation events within a short time is impossible. What he meant to say was that the companys risk models failed to describe what had happened. Extreme observations are generally the product of off-model events. If you toss a coin a hundred times and all the tosses are heads, you may have encountered a once in a lifetime statistical freak; but look first for a simpler explanation. For all their superficial sophistication, the masters of the universe had no real understanding of what was going on before them.
Figure 1: The incidence of banking crises Source: Own calculations, based on the reported numbers of major bank failures in OECD economies, from Reinhart and Rogoff (2010)
France and Germany are, among the countries with large financial sectors, the ones where anti-market rhetoric is strongest. But they are also the countries that have done the least to implement substantive financial reform since the global financial crisis. The principal reason is the instinctive corporatism of both countries, which equates the national interest in financial services with the interests of large national financial services firms. Thus the voice of Deutsche Bank is transmitted as the voice of Germany, not just in domestic German policies but also (and especially) in German positions in international financial negotiations. Germanys policy positions are also compromised by the local political links of its many regional and community banks (links that have positive as well as many negative aspects). In France the homogeneity of an elite that glides easily from boardroom to cabinet table and back reinforces the sense that its state and its national industrial champions are one. And since France and Germany are the two most influential members of the European Union, the corporate influence extends to the conference rooms of Brussels. Little
Guide the people by law, subdue them by punishment; they may shun crime, but will be void of shame. Guide them by example, subdue them by courtesy; they will learn shame, and come to be good. CONFUCIUS
He described the securitiescalled Abacusto a girlfriend: I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invent telling yourself Well, what if we created a thing, which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?).15
Investors look at economic fundamentals; traders look at each other; quants look at the data. Dealing on the basis of historic price series was once described as technical analysis, or chartism (and there are chartists still). These savants identify visual patterns in charts of price data, often favouring them with arresting names such as head and shoulders or double bottoms. This is pseudo-scientific bunk, the financial equivalent of astrology. But more sophisticated quantitative methods have since proved profitable for some since the 1970s creation of derivative markets and the related mathematics. Profitable
It is difficult to get a man to understand something, when his salary depends on his not understanding it.35
It is improbable that in fiftyperhaps twentyyears from now the deposit channel will have the central role in the financial system that it has occupied for centuries by virtue of its link to payments. The payment system is ripe for disruptive innovation, but to date entrantssuch as PayPal, Square and most recently Apple Payhave preferred to shelter under the umbrella of the high charging structure established by inefficient incumbent banks. This cautious sharing of oligopoly profits will not persist indefinitely, and in time the payment system will become an inexpensive utility distinct from the deposit channel. The
Lending to firms and individuals engaged in the production of goods and services which most people would imagine was the principal business of a bank amounts to about 3 per cent of that total (see Chapter 6
Many aspects of the modern financial system are designed to give an impression of overwhelming urgency: the endless news feeds, the constantly changing screens of traders, the office lights blazing late into the night, the young analysts who find themselves required to work thirty hours at a stretch. But very little that happens in the finance sector has genuine need for this constant appearance of excitement and activity. Only its most boring partthe payments systemis an essential utility on whose continuous functioning the modern economy depends. No terrible consequence would follow if the stock market closed for a week (as it did in the wake of 9/11)or longer, or if a merger were delayed or large investment project postponed for a few weeks, or if an initial public offering happened next month rather than this. The millisecond improvement in data transmission between New York and Chicago has no significance whatever outside the absurd world of computers trading with each other. The tight coupling is simply unnecessary: the perpetual flow of information part of a game that traders play which has no wider relevance, the excessive hours worked by many employees a tournament in which individuals compete to display their alpha qualities in return for large prizes. The traditional bank managers culture of long lunches and afternoons on the golf course may have yielded more useful information about business than the Bloomberg terminal. Lehman
organisers of weight-guessing competitions and advisers helping people to refine their guesses.
People who applaud traders for providing liquidity to markets are often saying little more than that trading facilitates trading
RoE is a seriously misleading measure of profitability. For businesses that are not very capital-intensive such as asset management, or other professional service firms such as accountants high returns on equity are achievable because the capital requirement is so small. Capital-intensive businesses in the modern economy they are principally banks, utilities and resource companies can achieve high returns on equity only through extreme leverage, as Deutsche Bank did.
Stock markets are not a way of putting money into companies, but a means of taking it out. The
The answer to information asymmetry is not always the provision of more information, especially when most of this information is simply noise, or boilerplate (standardised documentation bolted on to every report). Companies justifiably complain about the ever-increasing volume of data they are required to produce, while users of accounting find less and less of relevance in them. The notion that all investors have, or could have, identical access to corporate data is a fantasy, but the attempt to make it a reality generates a raft of regulation which inhibits engagement between companies and their investors and impedes the collection of substantive information that is helpful in assessing the fundamental value of securities. In the terms popularised by the American computer scientist Clifford Stoll, data is not information, information is not knowledge, knowledge is not understanding, understanding is not wisdom.9 In
The evangelists for bitcoin, the much-hyped digital currency that is a strange mixture of the visionary and the fraudulentare, in a sense, not imaginative enough. They are simply trying to reproduce in the electronic world a commoditycurrencythat has long existed in the material world. The larger question is whether currency as we have known it is any longer necessary at all. I once joked with beginning students that money existed because when a pipe burst it took too long to find a plumber in need of economics lecturesbut today it is possible to locate that plumber. It
The great muckraker Upton Sinclair had expressed a deep insight into the relationship between the world of ideas and the world of practical men: It is difficult to get a man to understand something, when his salary depends on his not understanding it.34
The payments system is the heart of the financial services industry, and most people who work in banking are engaged in servicing payments. But this activity commands both low priority and low prestige within the industry. Competition between firms generally promotes innovation and change, but a bank can gain very little competitive advantage by improving its payment systems, since the customer experience is the result more of the efficiency of the system as a whole than of the efficiency of any individual bank. Incentives to speed payments are weak. Incrementally developed over several decades, the internal systems of most banks creak: it is easier, and implies less chance of short-term disruption, to add bits to what already exists than to engage in basic redesign. The interests of the leaders of the industry have been elsewhere, and banks have tended to see new technology as a means of reducing costs rather than as an opportunity to serve consumer needs more effectively. Although the USA is a global centre for financial innovation in wholesale financial markets, it is a laggard in innovation in retail banking, and while Britain scores higher, it does not score much higher. Martin Taylor, former chief executive of Barclays (who resigned in 1998, when he could not stop the rise of the trading culture at the bank), described the state of payment systems in this way: the systems architecture at the typical big bank, especially if it has grown through merger and acquisition, has departed from the Palladian villa envisaged by its original designers and morphed into a gothic house of horrors, full of turrets, broken glass and uneven paving.6
The phrase too big to fail came into wide use in the global financial crisis to describe the dilemma that policymakers faced in resolving the affairs of systemically important financial institutions.3 The phrase provoked the justified rejoinder that too big to fail is too big. But too big to fail misses the key point. Financialisation has led to increases in the size of financial institutions, but the central problem is not size but complexity. Size in banking can enhance stability, at least up to a point. Britain avoided significant bank failures in the twentieth century precisely because its banks were big, in contrast to the collapse of the fragmented US banking industry in 1933. The failure of the UK banking sector in 2008 occurred, and was traumatic, not because the sector had become more concentrated, but because it had become more complex. Lehman
The use of capital markets by large companies today is mainly driven by tax and regulatory arbitrage, and undertaken by corporate treasurers with other peoples money. Financing
Too big to fail takes responsibility for the supervision of credit risks away from market participants and places it more or less exclusively in the hands of regulators: a duty that in this instance (and many others) they were not capable of discharging.
What is it all for? What is the purpose of this activity? And why is it so profitable? Common sense suggests that if a closed circle of people continuously exchange bits of paper with each other, the total value of these bits of paper will not change much, if at all. If some members of that closed circle make extraordinary profits, these profits can only be made at the expense of other members of the same circle. Common sense suggests that this activity leaves the value of the traded assets little changed, and cannot, taken as a whole, make money. What, exactly, is wrong with this common-sense perspective?
Why should I care about posterity? What has posterity ever done for me? attributed to GROUCHO MARX, but also credited to various eighteenth-century English figures
Yet it is intrinsic to oligarchy that oligarchs are a small minority, a point graphically made in the Occupy Wall Street slogan of We are the 99 per cent. But it is easier to identify what the 99 per cent are against than what they are for, an incoherence typical of the swell of unfocused public anger that followed the global financial crisis: anger with the finance industry and with the political failure to anticipate the crisis or respond effectively to it. Most countries ejected the governmentswhether left or rightthat had held office during the crisis. But that made no material difference to public policy towards the finance sector. In the absence of any intellectual framework for such policy beyond a call for more regulation, how could it? Perhaps
Yet perhaps the most surprising source of high fees for corporate advisory work is in the new issue market, since the percentages are not small and the money often comes from the pockets of founders and early shareholders. In the USA, 7 per cent is a standard fee for an IPO (initial public offering), and rarely discounted (European fees are typically lower and more variable).5 But no evidence of a cartel has been produced, and probably none existsthere is simply a strong perception of collective interest in maintaining the status quo. Regulation