The Future of Finance

294 Pages·2010·3.82 MB·English

THE FuTurE
oF FinancE

The LSE Report
Adair Turner
Andrew Haldane
Paul Woolley
Sushil Wadhwani
Charles Goodhart
Andrew Smithers
Andrew Large
John Kay
Martin Wolf
Peter Boone
Simon Johnson
Richard Layard
futureoffinance.org.uk
Copyright © by the Authors. All Rights Reserved. 2010.
Adair Turner and others (2010), The Future of Finance: The LSE Report,
London School of Economics and Political Science.
Cover Design: LSE Design Unit
For further information, contact Harriet Ogborn
Email: [email protected]
Tel: [phone]
Contents

Diagnosis
Preface 1
Richard Layard
1. What do banks do? Why do credit booms and busts occur and what 5
can public policy do about it?
Adair Turner
2. What is the contribution of the financial sector: Miracle or mirage? 87
Andrew Haldane, Simon Brennan and Vasileios Madouros
3. Why are financial markets so inefficient and exploitative – and a 121
suggested remedy
Paul Woolley
4. What mix of monetary policy and regulation is best for stabilising 145
the economy?
Sushil Wadhwani

Ways Forward
5. How should we regulate the financial sector? 165
Charles Goodhart
6. Can we identify bubbles and stabilise the system? 187
Andrew Smithers
7. What framework is best for systemic (macroprudential) policy? 199
Andrew Large
8. Should we have “narrow banking”? 217
John Kay
9. Why and how should we regulate pay in the financial sector? 235
Martin Wolf
10. Will the politics of global moral hazard sink us again? 247
Peter Boone and Simon Johnson
The Authors 289

Preface

The financial crash of 2008-9 has been the most damaging economic event since the
Great Depression – affecting the lives of hundreds of millions of people. The most
immediate problem now is to prevent a repeat performance.

Much has been written about reforming the world financial system. But it is rarely
based on a searching in-depth analysis of the underlying weaknesses within the system.
Nor does it usually tackle the key question of what a financial system is for.

To correct this omission, we invited eighteen leading British thinkers on these
issues to form a Future of Finance Group.1 They included journalists, academics,
financiers and officials from the Financial Services Authority, the Bank of England and
the Treasury. We have met twelve times, for what many of those present described as the
best and most searching discussions they had ever participated in. The result is this book.

The issues at stake are extraordinarily difficult and profound. The central question
is what the financial system is for? Standard texts list five main functions – channelling
savings into real investment, transferring risk, maturity transformation (including
smoothing of life-cycle consumption), effecting payments and making markets. But if we
study how financial companies make their money, it is extraordinarily difficult to see how
closely this corresponds to the stated functions, and it is often difficult to explain why the
rewards are often so high. Any explanation must also explain why the system is so prone
to boom and bust.

Chapters 1, 2 and 3 in the book deal with these fundamental issues: the ideal
functions of the system; the way the system has actually operated; and the sources of
boom and bust. To answer these questions much of the abstract theory of finance has to
be abandoned in favour of a more realistic model of how the different agents actually
behave. Central to this is opacity and asymmetric information, combined with short-term
performance-related pay. For example, the asset price momentum which accompanies
booms occurs because the owners of giant funds expect fund managers to shift into the
fastest rising stocks. (They would do better to invest on a longer-term basis.)

The opacity of the system has increased enormously with the growth of derivatives.
Did this contribute to high long-term growth? The issue remains open. On one side,
people point to the high real growth in 1950-1973 (an era of financial repression) and the
real cost of the present downturn. On the other side, many studies, discussed in Chapter 4,
point to real benefits from financial deepening. But apart from this Chapter, all others in
the book invoke the need for a radically simplified and slimmer financial system

1 Other regular members of the group (apart from the authors) were Alastair Clark, Arnab Das,
Howard Davies, Will Hutton, Martin Jacomb, Jonathan Taylor, Dimitri Vayanos and David Webb.

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Preface – Richard Layard

There are four aims of such a reform. The first is to prevent the financial system
destabilising the real economy, as it has in the recent past. The second (closely related) is
to protect tax-payers against the possible cost of bailouts. The third is to reduce the share
of real national income which accrues as income to the financial sector and its employees
for reasons not related to the benefits it confers – thus absorbing into the sector talent that
could be more usefully used elsewhere. And all of this has to be done in a way that works.

There are two main lines of approach. The first is regulation – higher capitalisation
of all financial institutions, and levels of required capital that rise in a boom and fall in a
slump. These are discussed in Chapters 5, 6 and 7. Chapter 5 points to some of the
difficulties involved in any such regulation; Chapter 6 shows that asset price booms can
be identified, at least sometimes; and Chapter 7 discusses how such information could be
used, if there were an independent Committee specifically charged with ―macroprudential
regulation‖. (Chapter 4 argues by contrast that financial booms should be mainly
controlled via interest rates.)

The second main approach to a more stable system is institutional reform. Chapter
8 argues strongly for the introduction of narrow banking. In such a system, only deposit-
taking institutions could expect to be insured through the state, and they would not be
allowed to build up a balance sheet of risky assets. This is a version of the so-called
Volcker Rule.

Faced with these two possible lines of approach, Chapter 9 comes down in favour
of strong regulation, linked perhaps to some institutional reform, aimed especially at
greater competition. It argues that the state would in fact bail out any major financial
institution threatened with bankruptcy, whether deposit-taking or not; it must therefore
regulate all institutions.

Moreover managers must face totally different incentives and pay. In particular
Chapter 9 suggest the managers should be liable to repay a substantial proportion of their
pay if their institution requires state assistance or goes bankrupt within 10 years of their
getting that pay.

All these proposals would directly reduce the profitability of banks and the pay of
bankers. Do they have a chance? Chapter 10 documents the huge influence that banks
exert in the political sphere worldwide. And it argues strongly that only a worldwide
system of regulation embodied in a worldwide treaty organisation, like the WTO, could
have a chance. In this context it is encouraging that the Working Party of the G20
Financial Stability Board which will deliver proposals to the G20 Summit this November
is chaired by our first author, Adair Turner.

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Preface – Richard Layard

It has been an extraordinary privilege to chair the discussion of these chapters. The
book was discussed at a major conference at Savoy Place, London, on July 14th 2010.
Both the Conference and the work of the Group have been funded by The Paul Woolley
Centre for Capital Market Dysfunctionality at LSE. We are extremely grateful to Paul
Woolley for his financial support and for his foresight in establishing his Centre well
before the crash.

The Group and the Conference have been jointly planned by Paul Woolley in his
Centre and by myself in the Centre for Economic Performance. The Group has been
superbly organised by Harriet Ogborn, and the Conference likewise by Jo Cantlay.

Richard Layard
July 2010

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Chapter 1
What do banks do? Why do credit booms and busts
occur and what can public policy do about it?

Adair Turner

Over the last 30 to 40 years the role of finance within developed economies has
grown dramatically: debt to GDP ratios have increased, trading volumes exploded, and
financial products have become more complex. Until the recent crisis this growing scale
and complexity were believed to enhance both efficiency and stability. That assumption
was wrong. To understand why, we need to recognise specific features of financial
markets, credit contracts, and fractional reserve banks. The recent crisis was particularly
severe because of the interaction between the specific characteristics of maturity
transforming banks and securitised credit markets. The regulatory response needs to
distinguish the different economic functions of different categories of credit: only a
fraction of credit extension relates to capital formation processes. The response should
combine much higher bank capital requirements than pre-crisis, liquidity policies which
reduce aggregate maturity transformation, and counter-cyclical macro prudential tools
possibly deployed on a sectorally specific basis.

Introduction and Summary

In 2007 to 2008 the world faced a huge financial crisis, which has resulted in major
losses in wealth and employment and which has imposed great burdens on the public
finances of developed countries. The latest stage of the crisis – its mutation into sovereign
debt concerns – is still ongoing. We still need to manage out of the crisis; and we need to
learn the lessons of what went wrong, so that we can reduce the probability and severity
of future crisis. To do that effectively, we need to ask fundamental questions about the
optimal size and functions of the financial system and about its value added within the
economy, and about whether and under what conditions the financial system tends to
generate economic stability or instability. We need to debate what the ―future of finance‖
should be. That is the purpose of the essays combined in this book.

The recent past of finance, the last 20 to 30 years, has been striking, with three
important developments: (i) first, a very major growth in the scale of financial activities
relative to the real economy; (ii) second, an explosion of the complexity of financial
products and services, in particular linked to the development of securitised credit and of
credit and other derivatives; (iii) and third, a rise in intellectual confidence that this

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Chapter 1 – Adair Turner

growth in scale and complexity was adding economic value, making the global economy
both more efficient and less risky.

It is now clear that the third assumption was quite wrong: we need to understand
why.

Many aspects of what went wrong are obvious and have been set out in numerous
official and academic reports. Risk management practices were often poor, relying on
over-simplistic mathematical models; governance arrangements – the role of boards, risk
committees and risk managers – were often inadequate, as sometimes was supervision by
regulatory authorities. Rating agencies were beset by conflicts of interest. Complex
structured products were sometimes sold to investors who failed to understand the
embedded options; and in derivatives markets, huge counterparty exposures appeared,
creating severe risks of interconnected failure. The policy response now being designed at
European and global level needs to address, and is addressing, these clear deficiencies.

But even if these deficiencies are addressed, the future financial system could
remain dangerously unstable. Regulatory reform needs to address more fundamental
issues. To do that effectively it must recognise that financial markets and systems have
highly specific characteristics which distinguish them from other markets within a
capitalist economy. In particular: (i) financial markets are different because inherently
susceptible to de-stabilising divergences from equilibrium values; (ii) credit contracts
create highly specific risks which increase economic volatility, and different categories of
credit perform different functions and create different risks1; (iii) banks are highly
specific institutions which introduced their own specific risks into the economy.
Understanding these distinctive characteristics is central to understanding the potential
dynamics of modern market economies; too much of modern economics has ignored them
almost completely, treating the financial system as neutral in its macro-economic effect.

This chapter considers their implications. Its key conclusions are that:

(i) There is no clear evidence that the growth in the scale and complexity of the
financial system in the rich developed world over the last 20 to 30 years has driven
increased growth or stability, and it is possible for financial activity to extract rents
from the real economy rather than to deliver economy value. Financial innovation
and deepening may in some ways and under some circumstances foster economic

1 Three features of credit contracts carry important implications for cyclical tendencies within a
market economy: specificity of tenor; specificity of nominal value; and the rigidity and irreversibility of
default and bankruptcy. See Adair Turner Something Old and Something New: Novel and Familiar Drivers
of the Latest Crisis, lecture to the European Association of Banking and Financial History (May 2010) for a
discussion of these features.

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