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Other People’s Money



John Kay





WHAT is the finance sector for? This vital question is all too often forgotten in the debate about the debt crisis of 2008 and its aftermath; it certainly seemed to be forgotten by bankers in the build-up to the debacle. But if the world is to avoid future banking collapses, or at least limit their economic impact, people need to think clearly about the issue.

John Kay's new book, 'Other People's Money', does the job; it should be read by everyone concerned with preventing the next crisis. The early books after the crash, like Andrew Ross Sorkin's 'Too Big to Fail', analysed how the collapse unfolded in minute detail; Mr Kay, an academic and columnist for the Financial Times, takes the longer and broader view.

In doing so, he skewers the pretensions of the finance sector and questions whether its high rewards reflect its true economic contribution. Barely a page goes by without an acute observation or pithy aphorism. 'A country can be prosperous only if it has a well-functioning financial system, but that does not imply that the larger the financial system a country has, the more prosperous it is likely to be,' he writes. 'It is possible to have too much of a good thing.'

The purpose of the financial sector is to process payments, extend credit and capital to business, to manage savings and to deal with economic risks. But the sector has become dominated by trading, with assets changing hands faster than humans can blink. This frenetic activity has had little to do with the needs of the real economy. 'People who applaud traders for providing liquidity to markets are often saying little more than that trading facilitates trading,' he writes. 'An observation which is true, but of very little general interest.'

The constant exchange of all these pieces of paper should not logically result in net profit for the finance sector as a whole, let alone the economy. When profits do occur, they require the taking of risk. All too often this trading resembles tailgating on the motorway—a high-risk strategy that works most of the time but occasionally ends in a devastating crash. Skewed incentives mean traders are rewarded for pursuing short-term profits; the cost of their mistakes will be borne by shareholders or, ultimately, taxpayers.

A further problem is that the finance sector is, by its nature, an intermediary. Banks channel money from savers to borrowers; fund managers invest on behalf of their clients. This agent-principal relationship has to rely on trust if it is to work. But the subprime mortgage debacle of 2007 showed the problems that arise from a long chain of intermediaries who cared little about the credit quality of the loans they were passing on. 'People who traded mortgage-backed securities knew about securities, but very little about mortgages, and less about houses and homebuyers,' Mr Kay writes. Smarter people have been employed in finance in recent decades, using more sophisticated technology, but the quality of intermediation has got worse.

So what is to be done about this? The authorities responded to the crisis with minutely detailed regulation, such as the voluminous Dodd-Frank act in America. But Mr Kay says there are already far too many regulations, not too few. The problem is the structure of the industry itself. 'We need some of the things that Citigroup and Goldman Sachs do, but we do not need Citigroup and Goldman Sachs to do them,' he writes. Instead of vast conglomerates, what is needed are focused institutions; banks that take deposits, for example, should be limited in the assets that they hold. Intermediaries who handle other people’s money should be held to high standards of customer care, and subject to civil and criminal penalties. These penalties should fall on individuals, not corporations, which tend merely to pass on the cost to shareholders.

Above all, the finance sector should be judged on the same basis as other industries; if an activity is unprofitable without taxpayer support, it should not occur. 'Our willingness to accept uncritically the proposition that finance has a unique status has done much damage,' the author wisely says. Let us hope those in authority will listen.

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