In the laissez-faire world of Adam Smith, when individuals pursue their own selfish interests they unwittingly contribute to the benefit of all. That may be so when people are acting for themselves, as principals in the exchange. But a problem arises when they use agents to transact on their behalf. Agents, of course, have their own interests at heart. As John Kay shows in his new book, “Other People’s Money: The Real Business of Finance”, in the financial world when conflicts of interest become widely abused, all hell breaks loose.
This is not a new problem. After the 1929 Crash, Wall Street’s copious abuse of conflicts of interest was revealed by stories of insider trading, market manipulation and the flogging of dodgy securities to an unwary public. New Deal legislation created the Securities and Exchange Commission to regulate financial markets and improve company accounts. “Sunlight,” as Supreme Court Justice Louis Brandeis had earlier opined, “is the best disinfectant.” The Glass-Steagall Act of 1933 separated commercial and investment banking operations on Wall Street to protect depositors from bank losses in the securities markets.
The history of Wall Street since has been one of the progressive emasculation of New Deal regulations, together with the revival of conflicts more extensive and pernicious than ever before. During the 1970s and 1980s, most Wall Street partnerships turned into public corporations. Bankers and brokers now acted as agents for outside shareholders. Two centuries earlier, Adam Smith had warned about the dangers of such arrangements: “The directors of such companies … being the managers of other people’s money (rather) than their own, it cannot be expected that they should watch over it with the same anxious vigilance … Negligence and profusion, therefore, must always prevail more or less, in the management of the affairs of such a company.” Smith might have been writing about Bear Stearns under Jimmy Cayne or Dick Fuld’s Lehman.
Once Wall Street’s partnerships had disbanded, bankers ceased being “long-term greedy”, as a Goldman Sachs managing partner had enjoined in the 1970s, becoming instead short-term rapacious. Long-standing relationships with clients were replaced with transactional relationships. A trading mentality came to dominate Wall Street.
Over the past couple of decades Wall Street’s conflicts of interest have become notorious. During the dot-com bubble, flaky companies were touted by the analysts whose investment bank employers were hungry for underwriting fees. In the course of the credit boom, such abuses became more extreme and far more dangerous to financial stability. Goldman and other Wall Street firms knowingly sold packages of toxic subprime securities to unwitting clients (like German banks) which had been put together with the collusion of other clients, such as the hedge fund manager John Paulson, looking to profit from the imminent credit crunch.
The banks were blind to the disastrous consequences of their behaviour, despite sitting on piles of financial and economic information. It’s easy to understand why. As the American journalist Upton Sinclair, cited by Kay, remarked: “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”
The dysfunctional character of finance has many ill consequences, besides the occasional financial crisis: Capital is misallocated; savings are wrecked; a bloated financial sector attracts the best and brightest whose skills might have been put to better use in the real world; mind-bogglingly large bonuses and the perception of rewards for failure (such as the $3.6 billion of bonuses paid by Merrill Lynch in 2009 after the broker had collapsed into the arms of Bank of America) contribute to inequality and foster a sense that the system is unjust.
Occupy Wall Street may have gone away for now, but the recent appointment of a 1970s-style socialist to head Britain’s Labour Party and the rise of Bernie Sanders as a Democratic presidential contender are signs that popular discontent with finance could still upset the established political order.
What is to be done? As Kay points out, most financial regulation – including the voluminous Dodd-Frank Act of 2010 – merely adds to the complexity of the financial world. Regulation even acts as a barrier to entry, entrenching the market dominance of the leading investment banks. It fuels Wall Street’s favourite game, “regulatory arbitrage”, which, as Hyman Minsky observed, involves clever financiers finding ways to get around the letter of the law in order to engage in risky and profitable activities. What’s needed, says Kay, is structural change, such as a separation of deposit banking from investment banking, along Glass-Steagall lines. Kay also abhors the U.S. government’s tendency in recent years to impose large fines on banks, which are paid by shareholders, rather than go after the banker-perpetrators.
“Other People’s Money” is a well-written and comprehensive account of the agency problems afflicting modern finance. Kay, who lately compiled a report for the UK government on the curse of short investment horizons among equity investors, is well suited to handle this subject. Rather too much of the book covers the familiar ground of the run-up to the global financial crisis. He could usefully have devoted more space to Wall Street’s long and infamous history of abusing conflicts of interest.
Kay wants to get financiers to extend their time horizons. Yet his reform proposals aren’t ambitious enough. Wall Street’s bonuses are paid annually out of current earnings. Yet the results of the bankers’ activities play out over a number of years. More needs to be done to link fees and bonuses to these long-term outcomes.
Here’s a simple suggestion which might achieve more than all the “macro-prudential” regulation of recent years. Investment bank bonuses should be held in a special account, invested in the bank’s shares, until the banker’s retirement. All fines would be paid out of this pool. HSBC has already made a move along these lines. If bankers were to start thinking again like partners, they might handle other people’s money with greater care.