Kay, Financialization, Other People's Money

Financialization:

Financialization is an ugly word defined by John Kay in "Other People 's Money: The Real Business of Finance," as the process by which the financial sector has gained an increasingly dominant and often noxious economic and political role during the last few decades.
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Financialization activities absorb the efforts of many of the best graduates from the top universities and an increasing share of the nation's financial capital.

The financial industry has not only captured its traditional regulators, as is to be expected, it has also captured the national government and the central bank, which puts the wealth of the nation at risk to guarantee the credit of the largest, most systemically interconnected and important firms.

The useful - and indeed essential - roles of the financial sector have been largely reduced to a secondary status in favor of the modern derivatives and increasingly frantic trading activities. These high volume trading activities and modern derivatives are remote from real economic activities and are of dubious real economic value. However, they provide financial institutions with massive income flows that support extraordinary incomes for the high level management and top traders of financial firms.
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Kay points out that this activity thus absorbs the efforts of many of the best graduates from the top universities and an increasing share of the nation's financial capital. The income supports massive lobbying efforts that dominate the nation's politics.

"In the most extreme manifestation of a sector that has lost sight of its purposes, some of the finest mathematical scientific minds on the planet are employed to devise algorithms for computerized trading of securities that exploit the weaknesses of other algorithms for computerized trading of securities."

The financial industry has not only captured its traditional regulators, as is to be expected, it has also captured the national government and the central bank. The wealth of the nation is put at risk to guarantee the credit of the largest, most systemically interconnected and important firms.

The monetary policy of interest rate suppression provided negligible stimulus to the economy, but was and still is applauded by Wall Street because it pushed up financial asset and property asset prices. It is continued year after year because of fear of collapse of the resulting stock market and asset bubbles as well as the massive levels of indebtedness that it encourages all over the world.

The capital required to support current trading volumes and maintain stability cannot be provided without reliance on retail deposits and the taxpayer.

Any financial activity that cannot raise sufficient capital without putting retail deposits or taxpayer funds at risk "should not take place" or should be substantially reduced, Kay insists. The capital required to support current trading volumes and maintain stability cannot be provided without reliance on retail deposits and the taxpayer. Equity investors shy away from investment bank securities because of the risks and the amount of profits drained off by salaries and bonuses of senior management and traders.
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Multilevel risk contracts:

While derivative contracts based on real underlying assets provide price discovery and convenient risk hedging vehicles for the producers and consumers of real economic assets, derivatives based on derivatives are of little real economic use. Market traders have always usefully provided liquidity facilitating the markets that support real economic activities. However, modern extraordinary trading levels in upper level derivatives provide little additional or no actual economic advantage, Kay argues.
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Financialization thus threatens nation-wide and world-wide financial collapse at each economic contraction or whenever some vast trading scheme goes awry. There is no limit to the extent that financial engineering can develop secondary and third tier derivatives.

The notional value of derivatives has grown to several times the GDP of the home nations of the major financial institutions. Financialization thus threatens nation-wide and world-wide financial collapse during each economic contraction or whenever some vast trading scheme goes awry. There is no limit to the extent that financial engineering can develop secondary and third tier derivatives.
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The traditional activities of the financial sector include:

The management of other people's money for the benefit of businesses and households,
the facilitation of the payments system,
the allocation of savings into investments and consumption, and
the facilitation of transfers of wealth between generations.

The history of the development and increasing economic importance of the financial sector is set forth by Kay in some detail. Since about 1980, however, the traditional activities have been increasingly outweighed by modern financialization activities and now constitute perhaps only 10% of financial sector activity.
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Corporate investment bank officers now have much less interest in the long term success of clients - or even of the bank itself. They have much less "skin in the game."

Financial regulation is always behind the power curve of changes in financial practices.

Kay emphasizes the investment banking changes in recent decades, especially since the demise of the partnership structure for investment banks. Corporate investment bank officers now have much less interest in the long term success of clients - or even of the bank itself. They have much less "skin in the game."
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Financial regulation, of course, was left in the dust by these changes. The financial industry continuously adjusts its instruments and practices to avoid or take advantage of the existing regulatory scheme. Market participants are always alert to ways of arbitraging differences in the regulatory environment. Financial regulation is always behind the power curve of changes in financial practices.

"[Regulators] rarely remove otiose or ineffective regulations. The more usual response is to elaborate the regulation in an attempt to remove or reduce the arbitrage opportunity. Thus begins a game of cat and mouse, in which the financial services companies are generally one or more steps ahead of the regulator. The outcome is regulation that becomes progressively more complex but which is rarely fully effective in achieving its intended purpose."

Instead of spreading risks among those better equipped to handle them, these financial contracts dumped risks on those who understood less about the underlying activities.

Investors in financialization instruments are separated from the reality and lacking in the understanding of the underlying risks.

An increasing array of instruments originally created to avoid regulatory constraints have been developed. These include the Eurodollar market, the repo market and money market funds. Forward exchange rates, credit default swaps, and collateralized debt obligations "are heavily traded derivatives that do not impinge significantly on Main Street," Kay asserts. They cover risks "generated within the financial system itself." Instead of spreading risks among those better equipped to handle them, these financial contracts dumped risks on those who understood less about the underlying activities. "Risks were not more, but less effectively managed as a result of the transfer."
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Market professionals increasingly trade on the basis of momentary market behavior rather than on industry or corporate fundamentals. Knowledgeable intermediaries have been replaced by reliance on "the wisdom of crowds." Investors in financialization instruments are separated from the reality and lacking in the understanding of the underlying risks.

"US mortgage lending was probably the most extensive attempt to substitute mechanized assessment processes for face-to-face assessment."

"Transactions replaced trust, trading replaced agency."

The power of information technology must be a supplement to, rather than a substitute for, "the traditional and still indispensable interpersonal skills of the effective financial intermediary," Kay explains.

In the mortgage market, such interpersonal skills reside predominantly in small local commercial banks with intimate knowledge of the local real estate markets and their participants. Unfortunately, the compliance costs of Dodd-Frank regulations have had the impact of a major recession, forcing the closing of hundreds of these banks.

Purchase of these financial contracts is akin to buying insurance without an insurable interest - creating incentives for fraudulent conduct.

The trade in multi-level risk contracts can greatly exceed the risk covered. They become wagers on whether the risk will occur. The North Sea Piper Alpha oil rig fire in 1987, Kay points out, generated risk claims ten times as great as the very substantial losses from the fire.

"If you can earn profit by selling re-insurance contracts, you can also earn profit by selling contracts for the re-insurance of re-insurance. You could even create contracts for the re-insurance of re-insurance of re-insurance. And so on. The outcome was a nexus of contracts known as the LMX spiral, so elaborate and complex that it was simply impossible to ascertain the underlying risks to which the holder was exposed."

Financialization contracts can be inordinately profitable even with no relation to the value added from the financial activities. They can even become pure wagers having no impact on the underlying risks - like lottery tickets based on horse race outcomes that have no legal relation to the actual horse race. Purchase of these financial contracts is akin to buying insurance without an insurable interest - creating incentives for reckless or fraudulent conduct. It can be especially harmful when conducted with other people's money.

"Far from spreading risk and placing it in the hands of people well placed to manage it, the LMX spiral concentrated it in the hands of people who had no capacity to manage it at all."

Regulatory constraints and the tax laws always provide incentives for the development of financial techniques for tax and regulation avoidance. Regulatory constraints and taxes always create incentives to game accounting standards, resulting in vast increases in the complexity of regulations and tax codes and accounting standards. "Arbitrage and reaction to arbitrage are the principal reasons why regulatory rulebooks, tax legislation and accounting codes become progressively more complex."
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With globalization, firms can route transactions through countries with the most favorable tax and regulatory environment. Tax havens are generally also regulatory havens.
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Financialization contracts were viewed as neither insurance nor wagers. They were viewed as something new and different, thus evading the laws and regulations applicable to either of those categories. Financialization "exalted the role of the trader and the overseers of the financial world assured each other that activities which in reality represented irresponsible gambling constituted a new era of sophisticated risk management."
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Supporters of this view included Don Kohn, Alan Greenspan, Larry Summers, Robert Rubin, Ben Bernanke. (For some reason, the politicians who supported this view, like Barney Frank and Chris Dodd, are given a pass by Kay. See, Morgenson & Rosner, "Reckless Endangerment," They ardently defended the benefits of the new risk market vehicles and denigrated both the warnings and those issuing the warnings concerning the dangers these vehicles created. Yet all of these men retain their status as authoritative voices on financial matters and most have moved on to bigger and more lucrative positions in government or private financial entities. The Commodities Futures Trading Commission chairwoman, Brooksley Born, and others who issued the warnings and suffered the personal and professional assaults have faded into obscurity.

Kay attributes the Credit Crunch recession of 2007-2009 primarily to weaknesses in markets even though government policies undermined market disciplinary functions and made it impossible for the markets to function properly. Moral hazard credit insurance phenomena disarm credit market vigilantes; interest rate suppression disables market interest rate disciplines; lending standards were reduced for political reasons.
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Government subsidies designed to help the poor disable the pricing mechanism in markets for real estate, college tuition and health care. These markets respond predictably with price increases substantially above general levels of price inflation, rendering most of the middle class dependent on government subsidies for access to them. Government tax and credit subsidies push up real estate prices and accentuate the boom and bust character of real estate markets.
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In an incredible example of government managerial ineptness, the task of crafting reform legislation in response to the 2007-2009 Credit Crunch recession was given primarily to Frank and Dodd who predictably made sure all of their complicit policies were suitably protected.

Traditional conservative accounting practices have been displaced by "mark-to-market" practices that permit the current realization of future income that may be problematic.

The inherently nebulous nature of accounting is emphasized by Kay. Traditional conservative accounting practices have been displaced by "mark-to-market" practices that permit the current realization of future income that may be problematic.

"Traditionally, banks would squirrel profits away in anticipation of hard times: more recently, however, their senior management has had the opposite concern, seeking to justify their bonuses by declaring the largest profits possible."

There are trading techniques that can earn large profits until the trade breaks down, at which time they can impose sometimes spectacular losses on the employers of the traders. "Carry trades," for example, arbitraged interest rate return differences between Germany and Greece, enabling Greece to become over-indebted and threatening massive losses for German banks until bailed out at public expense. "Rogue traders" win until they lose big by constantly doubling down on losing trades until the trade turns profitable - or the trader runs out of bank money to trade. Nick Leeson, Jerome Kerviel, Bruno (the "Whale") Iksil, Howie Hubler, are mentioned by the author.
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Ponzi schemers like Bernie Madoff are numerous. Payment in kind schemes like the Keynesian repetitive rolling over of debts that never have to be repaid work wonderfully until they stop working. "Warren Buffett famously said of these schemes that 'It is impossible to default on a promise to pay nothing,'" but default they do by means of inflation of the currencies borrowed and by occasional actual default of government debt.
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High volume trading:

The financial market professionals create the liquidity that they themselves need, Kay asserts. Their trading facilitates their trading.
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The real requirement for end-users for market liquidity is far less than the need of those who trade in volume.

"Investing with other people's money" with pay and bonuses tied to profits provides incentives to favor volatile securities since agents profit from success but principals suffer all the losses.

However, they supply no capital to the markets. They thus do not increase the stability of the markets. Indeed, since they attempt to withdraw en mass in the face of crisis, they increase instability.
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Households and individuals, non-financial businesses and governments have only modest needs for liquidity in the markets they make use of. This can be satisfied by traditional low-volume trading. The real requirement for end-users for market liquidity is far less than the need of those who trade in volume.
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Kay explains risk evaluation, the characteristics of market risks and specific risks, diversification strategy, investment evaluation problems, risk leverage, and the "winner's curse" tendency for auction market prices to be overoptimistic. Leverage increases volatility and risk, but professional traders and agents trading with other people's money love leverage. "Investing with other people's money" with pay and bonuses tied to profits provides incentives to favor volatile securities since agents profit from success but principals suffer all the losses.
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The officials of major investment banking departments routinely claim seven figure salaries and often eight figure bonuses on claims of profitability that are little more than accounting gimmicks and the temporary peaks of volatility.

However, the profitability of the major investment banking operations of conglomerate banks are actually very small, Kay asserts. Indeed, what little profitability there is would disappear without the benefit of government credit subsidies for too-big-to-fail banks. Investment banking operations are also subsidized by the profits from their standard banking activities. Yet the officials of major investment banking departments routinely claim seven figure salaries and often eight figure bonuses on claims of profitability that are little more than accounting gimmicks and the temporary peaks of volatility.
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High volume trading is a zero sum game, the author asserts. It creates no value. Wins are at the expense of other market users, ordinary investors as well as traders.
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Kay explains trading strategies, their successes and failures, with emphasis on their misadventures during the last few decades and especially during the Credit Crunch recession of 2007-2009. He concludes:

"What did Bernanke, Greenspan, Geithner and others think was really going on, as risk built up in the banking system? Perhaps Upton Sinclair had provided the answer: it was more convenient, politically and ideologically, not to look or analyze too closely. Even now, politicians and the public are ready to believe that the bewilderingly complex transactions entered into by clever and very highly paid people are the product of profound understanding rather than ignorance and confusion. Surely the sophisticated mathematics is being put to good use?

The exact same thing can be said today of the vast expansion of leverage throughout the U.S. economy and worldwide, driven by the incentives of years of interest rate suppression policy and Keynesian deficit policies. What are the Keynesian economists and policymakers thinking as risk/reward ratios shift adversely under mountains of debt? It is as usual more convenient, politically and ideologically, not to look or analyze too closely. As so often in the past, "for all their superficial sophistication, the masters of the universe [at the central banks] have no real understanding of what is going on before them," or the slightest idea of how they can successfully unwind the resulting debt structures.

Market bubbles are based on self-deception, Kay explains. Broker-dealers avoid questioning the conventional wisdom on which the bubble is based. It is willful blindness rather than outright fraud. "Upton Sinclair's remark is again relevant: 'it is difficult to get a man to understand something, when his salary depends on his not understanding it.'"
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Business assets and financial claims:

Financialization diverts increasing resources into the process of capital allocation. Unless the process thus achieves superior material results, this diversion reduces productivity, Kay points out. Unfortunately, knowledge in the major financial firms is restricted to trading activities and strategies.

"The new generation of financiers know less, not more, than their predecessors about the needs of households for accommodation, the utilities that make everyday commercial and social life possible, the competitive strength and corporate strategies of new and established business."

"New sources of financing" are really just new ways of drawing on household wealth.

Financiers devised "clever structures" without knowledge - or regard for - housing and mortgage fundamentals. They displaced thrifts and building societies. Housing expertise was thus diminished by financialization. Concern shifted to trading in mortgage securities and disregard for housing needs. The cognizant regulators proved pathetic.

All financing of physical assets is drawn from the wealth of its households, Kay points out. "Where else could the resources come from?" "New sources of financing" are really just new ways of drawing on household wealth. (This is time tested wisdom. See, Adam Smith, The Wealth of Nations, at segment on "Accumulation of capital.")
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Kay goes in some detail into how financialization failed to improve - indeed destroyed - the efficiency of capital allocation in the mortgage and housing markets prior to the 2007-2009 Credit Crunch recession. "The housing system wasn't broken, but we fixed it, and then it broke."
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Financiers devised "clever structures" without knowledge - or regard for - housing and mortgage fundamentals. They displaced thrifts and building societies. Housing expertise was thus diminished by financialization. Concern shifted to trading in mortgage securities and disregard for housing needs. The cognizant regulators proved pathetic. He concludes:

"The problems originated in structural changes in the industry which followed from financial innovation - notably securitization - and the removal of restrictions on diversification by financial institutions -- measures which were well intentioned but in practice proved to be damaging. They were aggravated by related changes in individual and business incentives which rewarded trading volumes rather than productive long-term commercial relationships."

Modern capital markets no longer primarily allocate productive capital. Using "other people's money." they are used to arbitrage tax and regulatory costs and constraints. Thus, Apple, with over a hundred billion dollars kept in Europe to avoid U.S. taxes, borrowed $17 billion in the U.S. bond market to pay dividends.
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The general financial needs of large businesses, small and medium sized businesses, and startups - the basic building blocks of the real economy on which prosperity and economic development depend - are summarized by Kay. He reviews the unique characteristics of Silicon Valley, the German Mittelstand of small usually family owned niche specialty firms, the Tel Aviv tech specialists, and the financial systems that support them. Financialization provides little support for any of these productive economic sectors. Kay concludes:

"Throughout the capital allocation process, expertise in investment has been supplanted by expertise in the mechanics of financial intermediation, an activity that requires greater intellectual capabilities and the capacity to do complicated mathematics, rather than the convivial conversation of the nineteenth hole. In the housing sector, local knowledge of companies has been eroded and the greatest rewards are now earned by those who design and implement sophisticated trading algorithms. Banks have centralized small business lending, and venture capital investors have shifted their attention to the refinancing of established business. These are means by which financialization has created a world of people who talk to each other and trade with each other, operate in a reality of their own creation, reward themselves generously for genuine if largely useless skills and yet have less to offer the real needs of the real economy and their less talented predecessors."

Kay is not wrong, but he grossly overstates his case. Many of the modern financial innovations provide real benefits with respect to price discovery and risk insurance, but like all financial techniques, they are subject to abuse and must be adequately regulated and confined to their useful purposes. The financial system is in fact a part of the monetary system, so we are necessarily dependent on government for its proper regulation, a task the government all-to-often fails to properly perform.
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High taxes and increasingly burdensome regulations create the incentives for financialization. Regulatory arbitrage is absolutely essential to prevent proliferating regulatory burdens from strangling the economy. Tax arbitrage protects the productivity of the economy. Taxes and regulatory costs are, after all, a part of the real cost of goods sold and are routinely passed on to consumers. Businesses are not tax payers, they are tax collectors. It is you, as a consumer, that pays the business taxes and bears the costs of regulation.
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The "junk bond" market provides vital financing for small and medium sized businesses. Mergers and acquisitions provide the reward at the end of the rainbow that energizes Silicon Valley. This has become increasingly important since Sarbanes-Oxley regulations essentially closed off going public as a practical alternative for many startups. Credit default swaps reveal risks in the increasingly bloated credit markets and provide methods to insure against them. Even the much despised collateralized debt obligations now usefully provide financing for mortgages and other underlying debt instruments. Forward exchange rates hedge against the monetary volatility inherent in a Keynesian policy world. Money market funds will again prove their worth when current interest rate suppression policies break down.
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It is the abuse of these instruments, not the instruments themselves, that must be guarded against. In that, they are no different from traditional banks, stocks and bonds. Kay is on much sounder footing with respect to his criticism of the high volume trading in upper tier derivatives that have little or no connection to the real world.

Financial claims are at best of contingent value. They are subject to the optimistic bias of "the winner's curse," as well as outright fraud.

The inherent ambiguity of the accounting arts have been greatly increased by financialization, the author explains. Valuations today legitimately often have no relationship to physical assets. Apple has little physical plant.
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Financialization has taken this to an extreme, producing Enron and its trading contracts and the financial derivatives of the mortgage securities bubble. Financial claims are at best of contingent value. They are subject to the optimistic bias of "the winner's curse," as well as outright fraud.

"Financialization has created a vast edifice of financial claims built on top of a slim foundation of physical assets: that is how it came about that the value of outstanding derivative exposure far exceeds the value of all the assets in the world. Taken as a whole, these financial claims cancel out, but their existence leaves all the individual holders of these claims exposed to both market risk - changes in the market value of the claims - and credit risk - inability of the counterparty to pay. These exposures far exceed the net value of the positions. To be a millionaire is to enjoy a comfortable financial situation. To be in the position of owning $100 million of assets while owing $99 million of debt is another matter altogether. The more so if there is some uncertainty about the value of the $100 million and a tendency via the winner's curse and other mechanisms [involving malfeasance] for valuations to be biased upwards."

Financialization has multiplied the extent and complexity of international capital flows. "Both asset and liability totals are dominated by the amounts financial institutions owe to each other."

Government financial obligations - pensions, notes, bonds - are of even more dubious value, as is the corresponding burden for future taxpayers - some of whom have not yet even been born. Unfunded pensions, both state and employer, are of inherently uncertain value. Employees in France and Germany and other European nations are particularly dependent on unfunded public and private pensions.
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On the other hand, government assets such as economic infrastructure, parks and various service institutions, provide value that is hard to calculate. Globalization vastly complicates the calculation of wealth that is domestic. Financialization has multiplied the extent and complexity of international capital flows. "Both asset and liability totals are dominated by the amounts financial institutions owe to each other."
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Deposit intermediation:

Financialization has complicated deposit intermediation. The claims financial institutions have against each other now dominate the system. "Today the deposit channel is clogged - especially in Europe - by a doomed attempt to build up reserves of capital and liquidity sufficient to support the scale of these trading activities without the backstop of official support."
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Kay asks: "What is it all for?" Trading in fixed interest securities, currency and commodities mounts into the tens of trillions of dollars but is practically ignored by accounting systems because long and short positions cancel out and hedging contracts are available for estimated risks. Vast profits and high salaries and bonuses are justified by these trading activities. In 2008, the system broke down and only government could prevent financial collapse. Kay summarizes:

"The global financial crisis was primarily caused by placing on top of the deposit channel an elaborate and largely impenetrable superstructure of trading activities in FICC [fixed interest, currency and commodities] - impenetrable even by the executives of the institutions themselves. When the superstructure collapsed in 2008 in the face of abrupt recognition of the scale of counterparty risk, the collapse threatened to destroy the deposit channel - the mechanisms by which payments are facilitated and short term savings directed to home buyers and businesses.
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"Governments, of necessity, intervened in the only way possible to minimize damage - effectively guaranteeing all counterparty risk. But this is not an appropriate long-term response. The appropriate long-term response creates a firewall, or ring-fence - there is a wide choice of metaphors - between the deposit channel and the trading activity of banks. This is the underlying intent of the Volcker Rule."

Chasing transaction fees:

Fee-based financial activity has prostituted the financial system. It creates a bias to action. Kay provides an example.

"The position of the asset manager differs from that of other intermediaries in that asset managers are rewarded nor for transactions but in proportion to the value of the funds under their management. They have different incentives from others in the investment channel, but not necessarily one better aligned with the interests of their clients or free of bias to action. You might increase the value of your existing funds by stellar long term performance. But it may be easier and quicker to attract funds from other managers by stellar short-term performance."

Periods of success are quickly richly rewarded, periods of failure impose costs mainly on clients. Risky investment strategy is - necessarily - fruitless in aggregate - and "fruitless in the vast majority of cases." Fees and transaction costs closely account for the extent that actively managed funds under-perform their benchmarks.

It pays to take risks. Periods of success are quickly richly rewarded, periods of failure impose costs mainly on clients. Risky investment strategy is - necessarily - fruitless in aggregate - and "fruitless in the vast majority of cases," Kay points out. Fees and transaction costs closely account for the extent that actively managed funds under-perform their benchmarks.

"The chain of intermediation has become too long, and the length adds costs. Between the company and the saver are registrars, custodians, nominees, asset managers, fund-of-fund managers, investment consultants, pension fund trustees, insurance companies, platforms, independent financial advisers. And when trade occurs, a high-frequency trader, an exchange and an investment bank all take a cut. These intermediaries have their own costs, and their own business models. Their commercial objectives are not those of the ultimate users of markets - the savers whose funds are invested, and the companies whose shares are held. The strength and ethical integrity of a chain are [only] as strong as its weakest link."

In short, investment fund management reduces the savings available for productive investment. Costs of a single "basis point," one hundredth of one percent, costs about $5 billion for the $50 trillion in corporate shares. Passive fund costs range from 25-to-50 basis points, active management about ten times as much. In this period of interest rate suppression policy, low risk investment yields are generally negative, and even the anticipated risk premium on equities is risible after fees and other charges.

Kay advises people to do their homework and be their own investment adviser to avoid the fees and charges of the finance sector. It is precisely the availability of modern investment vehicles that make this sound advice.
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An investment plan based on a dollar averaging strategy, determinedly continued whenever the financial world seems to be imploding and securities are available cheap, using the major exchange traded funds that will provide instant diversification, will provide most investors with the best and safest returns. Long term, only optimism pays, and when that optimism is based on the long term growth of the American economy, it is the safest bet available.

Asset managers:

Kay reviews the good, the bad and the ugly of various fund categories and asset managers.

"The modern investment bank has retreated from search, the creation and discovery of new investment opportunities, into trading with other people's money for the benefit of its senior employees. Insurance companies and pension funds have withdrawn from the stewardship function of investment management and have become providers of administrative services. The positions once occupied by financial advisers are either filled by sales people or better done by computers. To describe these transitions thus is to caricature - but only a little."

The government response to these problems has been a massive increase in regulatory requirements and litigation risks of dubious benefit.

Several of the must successful asset managers are not listed companies. They are not encumbered with the regulatory burdens of listed companies. Their success depends on trust and reputation. "Managed intermediation requires trust," Kay emphasizes. He advises simplification.

Fund managers today generally have "little knowledge of business or businesses and none of underlying investment opportunities in the corporate sector." They have not the time or capacity to supervise the strategies of the businesses their clients invest in.
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The government response to these problems has been a massive increase in regulatory requirements and litigation risks of dubious benefit.

"[The] demand for transparency is, as I have emphasized, the product of a low trust environment. The most effective - in fact, the only effective - method of discriminating between the honest and the fraudulent is by reference to the reputation of the business and the people who run it: giving savers detailed knowledge of what these companies do, which they have neither the time nor the expertise to assimilate, is a very imperfect substitute."

As FUTURECASTS has repeatedly emphasized, you invest in managements much more than in industries or even particular companies.

Several of the most successful asset managers are not listed companies. They are not encumbered with the regulatory burdens of listed companies. Their success depends on trust and reputation. "Managed intermediation requires trust," Kay emphasizes. He advises simplification.

"[We] need simplification to provide short, simple chains of intermediation. In the deposit channel, that means separating the trading casino from the utility of taking deposits and lending them on. In the investment channel it requires the promotion of asset managers with skills in search and stewardship of the physical and intangible - rather than the financial - assets of the real economy. A finance sector dominated by deposit-taking narrow banks and asset managers offers the prospect of rebuilding trust in the financial sector, lowering costs and enhancing financial stability."

Capitalism is perforce the most ethical economic system known to man. At every level, it depends on trust and established business relationships. Instances of fraudulent conduct succeed because they are relatively rare and catch people by surprise. It is the business contractions of the market business cycle rather than regulatory processes that reveals most frauds. As Kay explains, the attempt to substitute increasingly complex and costly regulation for trust relationships is a costly, ultimately futile effort.

Government regulation:

Government regulation should thus concentrate on financial industry structure and market incentives rather than expensive distorting and ultimately futile intensification of supervision and control.
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The recent development of financialization and conglomeration "put a burden on regulators that they were not, in the event, able to shoulder."

The evolution of the financial sector from an agency format based on trust and informal rules of conduct and generally functional separation - banks, brokers and specialists - to the modern regime dominated by vast conglomerates interacting by trading mechanisms is summarized by Kay. The change began during the New Deal when the Great Depression highlighted the ethical weaknesses of the existing system, including rampant insider trading, market manipulation, occasions of serial fraud, and frequent exploitation of corporate and retail customers.
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New Deal reform objectives were designed to safeguard bank deposits, protect investors from fraudulent conduct and make sure that the failure of individual institutions did not lead to generalized market failure. However, the recent development of financialization and conglomeration "put a burden on regulators that they were not, in the event, able to shoulder."

Here again, this time with respect to the Great Depression, Kay gives a pass to the political policies and pressures that actively undermined the markets. See, Blatt, "Understanding the Great Depression and the Modern Business Cycle," and Great Depression, Summaries of controversies and facts, and the Great Depression series beginning with Great Depression, The Crash of '29. However, he does mention some involved in the 2007-2009 recession.

In Europe, a corporatist approach involving cooperation and collusion within economic sectors and with political entities restricts competition and serves to conceal difficulties to a significant extent.

"Europe today has many 'zombie banks' - institutions that are essentially insolvent but which rely on central bank support as they hope, over many years, to trade their way our of difficulties. Political rhetoric in France and Germany is particularly hostile to the financial sector, and indeed to market economics generally. But the corporatist flavor of policy in these countries means that reform of the financial sector, not vigorously pursued anywhere, has been imperceptible. And has created the paradox of Deutsche Bank, at once frighteningly fragile and reassuringly stable."

Disclosure requirements were undermined by voluminous and essentially opaque reports. Government credit guarantees in any event undermined market disciplines by removing counterparty fear of bank failure.

The advance of globalization, conglomeration and financialization was accompanied by pressure for deregulation - the massive abuses of which have led conversely to massive increases in regulation. Coordination of regulatory schemes among the different national regulators has proven to be a difficult and interminable process. Individual nations seeking to advance the interests of their individual financial institutions resulted in a weakening of banking supervision during the 2007-2009 crisis.
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Kay describes the "Basel II" accords that failed during the crisis. Disclosure requirements were undermined by voluminous and essentially opaque reports. Government credit guarantees in any event undermined market disciplines by removing counterparty fear of bank failure.

The only thing we have to fear, is the absence of fear in the markets!

Capital requirements were gamed by accounting gimmicks. "[A] bank would be very hesitant to lend to a new financial business whose equity represented only 8 percent of its assets." Yet investment banks were routinely geared 30-to-1 and some as high as 50-to-1, relying on informal government guarantees of their credit. Regulatory arbitrage undermined the regulatory process and the use of "off balance sheet vehicles" (SIVs) and instruments such as repos, mortgage-backed securities and credit default swaps.

"Misconceived regulation created the problem it was supposedly designed to tackle - and then promoted more regulation in order to deal with the new issues that had emerged."

Prevention of financial crisis is always hypothetical, the costs of preventive actions are always real.

The role played by interest rate suppression and monetary stimulus policies in the boom leading to the bust of 2000-2001 is recognized by Kay. However, he somewhat inconsistently denigrates the view (the view emphasized by FUTURECASTS) that affordable housing policy and interest rate suppression played a major role in the subsequent boom leading to the bust of 2007-2009. (See, Morgenson & Rosner, Reckless Endangerment;" Johnson & Kwak, "13 Bankers," Understanding the Credit Crunch: and Government Directed Business Cycle.
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Kay instead emphasizes the changes in structural regulations in creating the instability of the Credit Crunch recession of 2007-2009. He acknowledges the 1999 exclusion of the new derivatives from regulation and the structural changes permitted for the finance industry as it hurriedly transformed itself from partnership to limited liability corporations to replace market risk mechanisms with regulation of corporate risk management. He recognizes that banking and securities industries were still among the most heavily regulated industries.

Nobody doubts that the banks themselves were primary miscreants, but government policy had disabled market disciplinary mechanisms and enhanced the incentives for banking behavior that was risky to the point of recklessness, as well as for outright gaming of the regulatory system for individual profit at the risk of institutional collapse.

The strong political pressures that often inhibit aggressive regulation of the financial industry are recognized by the author. Prevention of financial crisis is always hypothetical, the costs of preventive actions are always real.

"'Light touch regulation' was the product not of idle regulators but of the demands of the industry transmitted through the political process."

Dodd and Frank were prominent transmitters of those political pressures.

Lending standards accordingly plummeted while the financialization of the economy accelerated. A flood of new money seeking employment opportunities was accommodated by a wide variety of new investment vehicles eagerly created and promoted by Wall Street.
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The push and pull of tax objectives and investment incentives lead to increasing tax code prescriptions riddled with investment incentive loopholes, inevitably responded to through financialization mechanisms designed for tax advantage purposes. Similarly, financial regulators promulgate increasingly complex rules that are bound to fail.

Financialization arbitrage mechanisms are all designed to gain advantage by "devising transactions with similar commercial effect but different regulatory, accounting or fiscal form." The price is paid by taxpayers and regulatory objectives.

"The idea - to which many regulators appear to cling - that arbitrage could be eliminated or well addressed by ever more complex rules is an illusion. In tax policy two centuries of income tax legislation designed to attack fiscal arbitrage have not abolished tax avoidance but have generated a tax code of extraordinary complexity."

"The center - the planner or the regulator - can never have sufficient local information to anticipate the needs or opportunities of the subordinate entity. In frustration, yet more rules and targets are added. The results are always more complex and rarely more effective. This was true of the Soviet Union. And of the Basel process."

Of course, Adam Smith had previously informed us of this wisdom, too. The lawyers and the accountants celebrate the refusal to accept this wisdom.

Median household wealth has stagnated during this period of financialization, Kay points out. It has increased less than 5% since 1973, while high income household wealth has soared. Middle class living standards increased during that time due to the great increase in mortgage and consumer debt, but that can't continue indefinitely.

Not just coincidentally, this period encompasses the entire duration of floating exchange rates and undisciplined Keynesian monetary expansion. A similar time line can be drawn from about 1966 or 1967, the entire period of the War on Poverty expansion in government efforts to improve lower and middle income living standards. Of course, those who denigrate the Reagan economic policies prefer to draw the line from 1980. The figures don't lie, but liars - and advocacy scholars - can lie.
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Of course, the "family" of today is considerably different from the "family" of 1973, and indexing efforts are obviously inadequate to sufficiently overcome 40 years of monetary inflation to render 1973 dollars comparable to 2013 dollars.

Regulatory requirements submerge the essential "price discovery" function in a deluge of often opaque and unusable data and boilerplate. Efforts to generate pertinent information by private discovery has been eradicated by insider trading rules. Corporate disclosure of useful information is deterred by litigation risks. The protection of market integrity is more important than consumer protection.

The "level playing field" is an impossible ideal. The current regulatory approach is designed to favor trading - for "liquidity" - and to facilitate trading - with "transparency." These requirements submerge the essential "price discovery" function in a deluge of often opaque and unusable data and boilerplate. Efforts to generate pertinent information by private discovery has been eradicated by insider trading rules. Corporate disclosure of useful information is deterred by litigation risks. The protection of market integrity is more important than consumer protection.
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Regulation should serve the needs of users by focusing on the integrity of finance providers rather than on the integrity of markets, Kay concludes.

"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 popularized by the American computer scientist Clifford Stoll, 'data is not information, information is not knowledge, knowledge is not understanding, understanding is not wisdom.'"

Regulation is dominated by personnel from the regulated industry who alone have the appropriate expertise.

It is unrealistic to expect some mid-level regulatory official to second-guess the risk management strategies of Goldman Sachs.

"In framing regulation, it is essential to be realistic about what regulation can achieve," Kay emphasizes. Regulation is dominated by personnel from the regulated industry who alone have the appropriate expertise.
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Kay reviews the problems of influence and capacity that undermine regulation. The regulators imposed endless petty restrictions on legitimate business, but were, "as the SEC was, unable to recognize, far less apprehend, the fraudulent Bernie Madoff despite detailed dossiers provided to it by Harry Markopolis."
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Nothing has really changed. It is unrealistic to expect some mid-level regulatory official to second-guess the risk management strategies of Goldman Sachs, Kay points out.
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The factors favoring regulatory capture by the regulated are numerous and powerful, the author points out. There was also "intellectual capture" of regulatory theory leading to "the shift of regulatory emphasis from a model that emphasizes the legal obligations of agency to one that promotes the abstract integrity of markets." The new theories blinded policymakers and regulators to the growing risks. (The same phenomena are obvious with respect to the growing risks of interest rate suppression policy.)

"At once extensive and intrusive, financial regulation is nevertheless beholden to the industry it supervises and ineffective in achieving its underlying objectives."

Robert Lucas and Ben Bernanke, among others, assured everyone during the 1990s that the business cycle had been "solved" or greatly "moderated." It was a new era of economic stability.
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More important is the right to fail - the winding down of failed firms and the ending of destabilizing practices. Unfortunately, Geithner and other regulators believe that the failure of major firms must be prevented "at almost any cost."

Kay speculates that permitting market elimination of major failed firms followed by support for normal market recuperative mechanisms might well have been the better alternative.

However, more important is the right to fail - the winding down of failed firms and the ending of destabilizing practices. Unfortunately, Geithner and other regulators believe that the failure of major firms must be prevented "at almost any cost."
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Kay speculates that permitting market elimination of major failed firms followed by support for normal market recuperative mechanisms might well have been the better alternative. (This has been FUTURECASTS position.) The counterfactual, however, cannot be known.

"There has been little change in the structure or behavior of the industry, with the result that successive crises are more or less inevitable. The huge sums of public money released into the financial system have done little to promote economic recovery since the funds provided were largely retained within the financial sector itself - or paid out in excess remuneration to senior employees."

Of the approximately $4 trillion provided by the Federal Reserve, approximately $2.6 trillion were brought right back into the Federal Reserve as reserves for the major banks. Heightened reserve requirements generally throughout the financial sector effectively sterilized the rest.

Government economic policy:

Kay summarizes modern monetary policies before turning to current interest rate suppression policy since the 2007-2009 recession. The traditional policy of restricting central bank lending to penalty rates and to solvent banks capable of providing good security has been abandoned. Moral hazard credit guarantees have been extended broadly by central banks as a subsidy for major economic as well as financial entities.

"Central banks have lent freely to commercial banks, at nominal interest rates, on weak security. The European Central Bank is owed €12 trillion, mostly secured against collateral of uncertain quality provided by Eurozone banks. The outstanding balances within the TARGET2 system, - - -, represent unsecured debts among Eurozone central banks. It is a fundamental principle of bad banking that it is convenient for everyone - borrower, lender, regulator - to pretend for as long as possible that doubtful loans will one day be repaid."

The risk of default on the debts of major nations like the U.S., the UK, Germany and France is denigrated by Kay in Keynesian fashion. The risk of default in the foreseeable future "for practical purposes is essentially zero," he asserts in criticizing the rating agency downgrades for UK, French and U.S. obligations. "Default is unimaginable."
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Kay advises using this period of interest rate suppression to increase public indebtedness to finance long term projects - infrastructure and investment projects. Instead, through quantitative easing, debt is being brought in to central banks "in the interest of supporting the financial sector and satisfying economic policy perceptions of traders in securities markets."

Kay ignores price inflation as a form of bankruptcy. Even at 2%, the current policy target, price inflation destroys most of the value of a 30 year bond before its maturity. With price inflation, governments cynically adopt a continuous bankruptcy process as intentional policy.

Kay denigrates the burdens of public debt with the Keynesian assertion that we just "owe it to ourselves."

However, the percentage of U.S. debt held abroad has ballooned in recent decades. Over 60% of U.S. Treasuries are now held abroad. We no longer just "owe it to ourselves." The Keynesian proposition was obviously false even when originally asserted. The figures cancel out only in the Alice in Wonderland world of mathematical models.

There are unique problems for consumer protection in the financial industry. The dangers faced by consumers on the one hand are balanced against the costs, impacts, difficulties and unintended consequences of regulation. Regulation can narrow competition (as demonstrated by the recent demise of hundreds of small local commercial banks overwhelmed by compliance costs). Regulatory capture is constant. Risk-averse regulators can cause considerable economic harm, and will inevitably fall behind the power curve of financial innovation.
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Nevertheless, Kay favors inclusion of consumer protection offices in regulatory agencies.
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Kay then gets to his principle question:
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What is the value of financialization? What are its costs?
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The profitability of a firm can detract from the profitability of an industry or an economy.

Inputs are useless factors for this purpose. Outputs, to the extent measurable, don't reflect quality with respect to meeting consumer and business needs. The standard services - facilitating payments, managing personal finance, allocating capital, controlling risk - are essential contributions of the financial sector, but the contributions of financialization services and products are questionable. The costs are immense in salaries and bonuses and diversion of the best young intellects, and in the application of financial engineering practices to thwart tax and regulatory policies. Kay also points out the corrosive impact of inequality, especially when based on activities of dubious economic or societal value.
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The "simple application of standard national accounts procedures give nonsensical answers when applied to the financial sector," Kay explains. He correctly disparages the assertion that profit demonstrates value. The profitability of a firm can detract from the profitability of an industry or an economy. (A monopoly provider may increase its own profitability but generally reduces both the services and profitability of the industry.) Financialization may be very profitable short term but is a growing burden on the economy and the financial system as a whole and a constant threat to the long term prospects of both.
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Profits are partly a return on risk, a particularly complex and slippery factor for accounting practices. Applicable accounting standards were shattered by the 2007-2009 financial crisis. Recent changes resulted in a 20% reduction in calculations of commercial bank contributions to U.S. GDP.
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The resources - the costs - of the financial sector have expanded massively, but that tells us nothing of the quality - the utility to society - of these activities. The modern industry deals mainly with itself rather than with real economic factors. The trading floor of an investment bank "is not the epitome of the market economy but an excrescence from it."

Financialization facilitates modern massive trading practices but, Kay asks, what practical benefit is that? The levels of trading activities prior to the 1980s development of financialization were perfectly adequate to provide the levels of market liquidity needed for securities market performance. The primary benefits of modern levels of trading is the facilitation of modern levels of trading, Kay concludes.
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The resources - the costs - of the financial sector have expanded massively, but that tells us nothing of the quality - the utility to society - of these activities. The modern industry deals mainly with itself rather than with real economic factors. The trading floor of an investment bank "is not the epitome of the market economy but an excrescence from it," Kay insists,

"The growth of financial activity has come from a massive expansion in the packaging repackaging and trading of existing assets. The finance sector today does many things that do not need to be done, and fails to do many things that do need to be done."

Regulatory objectives:

Financial industry complexity has been massively increased by financialization. It has been accompanied by a visible decline in ethical standards. This is being accompanied by a massive increase in the extent, complexity and costs of regulation. What for?

"The complexity of modern finance has been designed, and has operated, principally to benefit financial intermediaries rather than the users of financial services."

The modern trading culture has also contributed to financial instability and has "enhanced the bias to action that increases the costs of financial intermediation."
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Kay spends some ink on the intractable conflicts of interest involved in modern investment bank risk taking, and on the cultural conflicts when retail banking and investment banking are merged. "The ethos of trading - - - has contaminated the finance industry as a whole."
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Investment banks may engage in securities issuance, corporate advice and asset management, market-making in equities and trading in fixed income, commodities and currencies. Potential conflicts of interest exist between all of these activities. Except for asset management, there is a bias to action in these activities. Monetary returns depend on action.

"The culture of anonymous trading is divorced from economic context, devalues or eliminates personal relationships and fosters the self aggrandizing self. Quite apart from its broader social implications, that ethos is not conducive to the effective delivery of financial services. Functions have become conflated and confused, undermining the need for prudence and loyalty in dealing with other people's money. Without a clear acknowledgment of these duties, people who talk of restoring trust in the financial industry are whistling in the wind."

The legal and regulatory framework must be such as earns a high level of willing buy-in from the regulated - that encourages internalization of ethical standards by industry participants.

It is the ethics of the industry that must be addressed. Focus should thus be directed towards the structure of the industry to change its incentives and culture, Kay advises. The basis of reward should be success in meeting the needs of users from the real economy rather than from outwitting other financial intermediaries or gaming the weaknesses inherent in legal or regulatory systems.

"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 change in culture can only be imposed to a very limited extent by regulatory decree or management edict; change becomes effective only when the values appropriate to the handling of other people's money are internalized by market participants themselves."

The legal and regulatory framework must be such as earns a high level of willing buy-in from the regulated - that encourages internalization of ethical standards by industry participants.

"In an open, free, democratic society, law and regulation work - and can only work - if most of the people subject to such law and regulation already espouse the values law and regulation promote."

Kay is actually describing the unlimited liability partnership structure of the investment banking industry prior to the 1980s, working with capital that is not covered by government deposit guarantees. It was hardly perfect, but then nothing is. There is nothing like unlimited liability to focus minds on the maintenance of high ethical standards and prudence among investment banking personnel handling other people's money. As Adam Smith recognized, it is partnerships rather than limited liability corporations that of necessity are based on professional levels of ethical standards.

The removal of government and internal cross-subsidies would reduce the collateral available for trading and thus reduce trading volumes to more sensible levels.

Deposits should not be collateral for trading activities. With no remaining advantages for conglomerates from a retail banking arm, the costs of the latter would probably provide incentive to spin off retail banking arms.

Kay instead advises a prescriptive structural fix. He advises specialization that permits structural simplification, and the application of the legal principles of agency to all supervisory personnel working with other people's money.

"Restore focused, specialist institutions with direct links to financial users of financial services, deriving competitive advantage from their skills in identifying and meeting the needs of these users."

Structural reform can be encouraged by elimination of government subsidies and cross subsidies across activities. Structural reform should aim to reduce complexity, lower costs, enhance stability and facilitate information flows between savers and borrowers. "The objective should be to reduce trading volumes to the modest levels that serve the real needs of the non-financial economy." The removal of government and internal cross-subsidies would reduce the collateral available for trading and thus reduce trading volumes to more sensible levels.

"[Structural] reform is required to restore the clear distinction between agency and trading. The attempt to manage conflicts through regulation has failed because it has spawned complex rules without achieving its underlying objective. Those who handle other people's money, or advise on the management of other people's money, are agents of those whose money it is. Financial intermediaries can act as custodians of other people' money, or they can trade with other people's money, but they must not do both at the same time."

Structural requirements should encourage the establishment of "short, simple, linear chains of intermediation" with much fewer links between market participants and much stronger links with savers and the users of capital. A restoration of the right to fail can be achieved with the corresponding reduction of risks of financial contagion. Capital adequacy should be judged on the needs of customer support services, not on the needs of financial industry trading activities.
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A failure among financial conglomerates should not be able to threaten banks in the deposit channel. Deposits should not be collateral for trading activities. With no remaining advantages for conglomerates from a retail banking arm, the costs of the latter would probably provide incentive to spin off retail banking arms.

"The prioritization of transactions among intermediaries over transactions with end users is responsible for the excessive costs of financial intermediation, the instability of the financial system and the failure to generate the information required to achieve propriety in corporate governance and efficiency in capital allocation. These issues are obviously not addressed by providing more capital to support the trading activities of established financial institutions."

It is the hedge fund that is the appropriate vehicle as an institution dedicated to trading, Kay asserts. All parties to a hedge fund know what their money is being used for and the risks assumed. The collapse of a hedge fund unconnected to the banking system is unlikely to create broader problems.

"A deposit channel directed by retail banks and an asset management sector populated by asset managers who can be trusted to be managed intermediaries and have a long-term horizon for investment - that is how we recreate a finance sector aimed at meeting the needs of the real economy."

Penal regulation should be focused on particular issues - deposit protection, consumer abuse, fraud. Public subsidies and guarantees and other public support should be withdrawn.

Nothing would reinvigorate the market vigilantes like the withdrawal or strict limitation of deposit and other capital guarantees.

And, finally,

"Cease using the financial sector as an instrument of economic policy." (Good Luck with that!)

Lehman was not by itself an important factor in the performance of the economy. It was recklessly run and of primary benefit to its own personnel. Its complexity and interconnectedness, however, spread instability broadly across the financial sector. "Lehman was not too big to fail, but it was too complex to fail," Kay explains.
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"Failures in complex system are inevitable," and no one can anticipate the possible causes. Engineers meet the challenge with intentional systematic simplification, redundancy and modularity that enables the containment of failures.

"The basic principle should be that intermediaries in capital allocation should normally be familiar with the needs of either borrowers or lenders - or both."

Only the payments system requires continuous functioning, Kay points out.

"No terrible consequences 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 games that modern traders play have no wider relevance.

"The traditional bank manager's culture of long lunches and afternoons on the golf course may have yielded more useful information about business than the Bloomberg terminal.

Kay admits that campaign funding limits in Europe have in consequence permitted "surprisingly small amounts of money [to] have substantial influence." He advocates state funding of political parties with strict limits on other sources.

Kay deplores the political influence of Wall Street and the financial interests in other Western nations. Financial reform requires campaign finance reform to reduce this influence. He admits that campaign funding limits in Europe have in consequence permitted "surprisingly small amounts of money [to] have substantial influence." He advocates state funding of political parties with strict limits on other sources.

If course! What could possibly go wrong? Look how wonderfully the political campaign finance reforms of the 1970s worked out.
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Administered alternatives that seem so easy in contemplation often prove incredibly destructive in practice. Political reform efforts are never objective improvement efforts. They are always designed to favor particular political interests and agendas. Kay's intentions are no different.