The industry has undermined itself by failing to practice the gospel of free market capitalism that it preaches. My latest (and last column) for Financial News.
You don’t have to be a rampant anti-globalisation bank-bashing socialist to think that sometimes capitalism doesn’t work quite as well as it should. And one of the main reasons for that is that capitalists can get in the way.
Take this, for example, from two of the most free market economists you are ever likely to meet: “The greatest political enemies of capitalism are not the firebrand trade unionists spewing vitriol against the system, but the executives in pin-striped suits extolling the virtues of competitive markets with every breath – while attempting to extinguish them with every action”.
That quote comes from the book Saving Capitalism from the Capitalists, a paean to financial markets written a decade ago at the height of market triumphalism by two Chicago economists, Raghuram Rajan and Luigi Zingales (although Rajan may find it a little harder to put his views into practice in his new role as governor of the Reserve Bank of India).
If you replace “capitalism” with “financial markets”, and “trade unionists” with “regulators” or “members of the European Parliament”, you have a pretty good summary of the paradox in the capital markets and investment banking industry today.
In their book, Rajan and Zingales argued forcefully that capitalism – and in particular the free market-based variety – is the best mechanism that mankind has yet devised to allocate finite resources in the most productive and efficient way. But a decade before the revelations of Libor-rigging and price-fixing in the foreign exchange market, the authors warned that in any capitalist system, “incumbent industrialists” would eventually seek to protect their position by rigging market structures and even subverting free markets altogether.
Pulling up the ladder
The problem with this desire of incumbents to pull up the ladder behind them is that it detracts from the valuable role that capital markets play in fuelling the economy and undermines public and governmental trust in free market principles.
In the financial markets the “incumbent industrialists” are not American oil barons or Victorian factory-owners but investment banks, private equity firms, asset managers and other market participants who are less keen on open competition and market forces than you might expect. They are not necessarily actively seeking to rip off customers, but a lot of the danger signs that Rajan and Zingales flag up are on display.
For example, having benefited from technological change on the way up, large parts of the market have fought tooth and nail to stop new technology stealing their lunch (think of the resistance to centralised clearing and trading in the $600 trillion over-the-counter derivatives market, or open access clearing between European stock exchanges).
In the same vein, the industry resists efforts to make itself more transparent, often using cost or commercial sensitivity as a cover for keeping the sunlight out. If you work at a pension fund, try asking your fund managers to provide a full breakdown of the fees they charge. Just for a laugh, you might suggest the fund manager put the same question to his or her broker.
You could even be forgiven for thinking that the complex structures in the industry might have been designed to confuse clients (and regulators) and ward off competition. Why else would big banks have thousands of legal entities? Why would there be as many as two dozen market participants in the chain between Mrs Smith wanting to buy some shares and them actually finding their way into her pension scheme?
Poor corporate governance at some banks – such as odd decisions about bonus awards to chief executives who double up as chairmen – provides evidence not just of a technical breakdown in governance structures and processes, but of a more worrying reluctance to embrace competition and market forces.
And, of course, the industry has turned its economic power into enormous political clout, which it deploys to protect itself. Expensive lobbying helps to delay or dilute new regulations that could challenge the existing dominance of incumbent players (even if some rules such as Vickers or Volcker have got to the finish line despite fierce industry opposition). This political clout often blurs with regulatory capture: think of the revolving doors between regulators and Wall Street, or of how the Labour government of Tony Blair was captivated by the City of London.
But perhaps the most obvious indication of the “incumbent industrialists” in the financial markets is the persistence of bad economics throughout the industry. Loss-making investment banks that pay billions of dollars of bonuses to people who will jump ship at the drop of a hat. Or the curious consistency of new issue fees in the US.
Or the dog’s breakfast of the economic relationship between brokers and fund managers, in which neither side knows the cost, let alone the value, of the services they are producing and consuming. Or the strangely uniform fees at asset managers and wealth managers, despite vast disparity in performance. Or the failure of most fund managers, hedge funds and private equity firms to deliver net outperformance over any sustainable period.
This breakdown in economics is a sign of an industry that does not apply to itself the market discipline that it preaches and for which normal rules – for example price elasticity – no longer seem to apply. A simpler way of putting it, as one wise old chairman said last week, is that it is “an inertia that is guarded jealously by people who make a lot of money from it”.
The danger of this defensive behaviour by the “incumbent industrialists” in the financial markets is that it undermines faith in the market system itself. The inevitable economic concentration that comes from financial markets comes to be seen as oligopolistic. Healthy income distribution is instead seen as pernicious inequality when pay loses touch with basic economics – particularly when profits are privatised but losses socialised. While there will always be winners and losers in any free market capitalist system, the system relies for its legitimacy on the belief that market structures will be fair, even if market outcomes may not always seem so.
From this perspective, the blunt decision by the European Parliament to impose a cap on bonuses, French President François Hollande’s 75% tax on earnings over €1 million, or even the policy of the Labour Party in the UK to freeze energy bills for 18 months after the next election, are easier to understand (even if you don’t agree with them).
They are not attacks on the financial industry (or its new rival bogeyman, the energy industry) for extolling free-market principles. Instead they are being targeted precisely because they appear not to be applying those principles.
So what can be done? Most obviously, the industry needs to make a better argument for what it does and of the value that it provides. When was the last time you heard about how much investment banks had raised for companies and governments in the debt and equity markets? Or how many millions of people in Europe rely on fund managers for their future savings and pensions?
It also needs to invest some time in making the case for why it deserves to be paid such large sums of money in exchange. At the same time, the industry collectively could take a long hard look at itself to work out how and where it could be improved, reformed and simplified for the benefit of its clients. How could it deliver more with less? And how it might look if you were to invent it today.
How, in other words, can the investment banks, asset managers, hedge funds, the private equity firms, and everyone else in the industry, get together to help save the financial markets from themselves.
On a more personal note, this is my last weekly column at Financial News. After nearly 20 years of writing about the industry, I am signing off with some sadness. But I am also optimistic: I am setting up an organisation to promote the role and growth of capital markets – and encourage the reform and simplification of the industry at the same time.
I would very much welcome the thoughts and input of anyone involved in the capital markets as to how we can improve the industry for the benefit of all users and market participants. Please get in touch on firstname.lastname@example.org