Kay’s Other People’s Money

John Kay’s Other People’s Money is generally an excellent book. Kay argues that the growth in the size of the financial system hasn’t been matched by improvements in the allocation of capital. He proposes that financial services are not as profitable as some headline numbers would suggest. And he suggests that the replacement of  those who are good at meeting clients on the 19th hole with those who were good at solving complex mathematical problems was not always a good thing - sometimes clever people are the problem, particularly in a complex environment.

I highlighted a lot of passages through the book. Here is a small selection.

First, the chapter on risk in excellent - particularly its treatment of rationality. The point in the following paragraph is in some senses obvious, but often ignored:

If you don’t behave ‘rationally’, you can be ‘Dutch-booked’ – an offensive phrase (to the Dutch – the origins of the expression seem lost in the mists of time) which means that others can devise strategies that will make money at your expense. Many economists use this argument to insist that people do behave ‘rationally’ – behaviour that does not conform to the model will be abandoned because those who engage in it lose money. I used this reasoning myself with students. But I now see it differently. People do buy lottery tickets, week after week, and they do so for reasons that seem entirely valid to them. People don’t behave – for both good and bad reasons – in line with the economic model of rationality. In consequence others do devise strategies that make money at their expense. That consequence is critical to an understanding of how financial markets operate today.

One of the most interesting threads in the books is that many of the regulatory mantras are about the financial intermediaries, not the end users. The drives for transparency and liquidity in particular come in for criticism by Kay. First, the demand for transparency is a sign of the problem:

Transparency is the mantra in the modern world of finance. But the demand for transparency in intermediation is a sign that intermediation is working badly, not a means of making it work  well. A happy motorist is one who need never look under the car bonnet. A good lawyer manages our problem; a bad lawyer responds to every issue by asking us what we want to do. When ill, we look for a recommended course of action, not a detailed description of our ailments and a list of references to relevant medical texts.

And is this demand for transparency even desirable?

The primary objective of the Securities and Exchange Commission … was to increase the quality and quantity of information available to the public. The corollary was that trading should take place on the basis of that information alone.

The idea has superficial attractions and fundamental flaws. The framework of thought is frequently described through the sporting metaphor of ‘fairness’: the ‘level playing field’ on which all players compete on equal terms. To achieve fairness, a standard template of information should be provided to everyone, whether director of a company, investment banker or day trader with a home computer. Market participants may deal, and may only deal, on the basis of that information. No trader can have better information than any other, and success depends only on skill in interpreting it - or anticipating the interpretations of others.

Of course, this ‘level playing field’ is not achievable or achieved, and would not be desirable if it were to be achieved. Yet, like the regulators of casinos, the regulators of security markets often describe ‘market integrity’ as their objective; their focus is on the efficient functioning of the market, in a narrow technical sense that is concerned with process rather than outcome. The emphasis on the preoccupations of market participants rather than the interests of market users is deeply embedded in current thinking.

…

The effectiveness of financial intermediation in promoting efficient capital allocation depends on the quality of the information available to market participants. Regulation whose primary purpose is to encourage trading by ensuring no trader has an informational advantage actually gets in the ways of efficient capital allocation, in principle and in practice. Effective information and monitoring are best achieved - perhaps only achieved  - in the context of a trust relationship.

And on liquidity:

The need for extreme liquidity, the capacity to trade in volume (or, at least, to trade) every millisecond, is not a need transmitted to markets from the demands of the end-users of these markets but a need, or a perceived need, created by financial market participants themselves. People who applaud traders for providing liquidity to markets are often saying little more than that trading facilitates trading – an observation which is true, but of very little general interest.

Kay also has a subtle shot at the ability of governments to use interest rates to achieve policy outcomes:

Is it desirable for government and its agencies - which have sensibly extricated themselves from the business of controlling most prices - to manipulate interest rates, with a view to managing not just the banking system but the economy as a whole? Electricity is an essential element of the national infrastructure, used by every household and business. It is possible to imagine a government trying to manage the economy by controlling the supply and price of electricity - restraining booms by limiting the availability of new power stations and new connections, or by raising the price of electricity, and tackling recessions with low electricity prices and plentiful power.

I suspect most people would share my instinctive reaction that this approach would be an extremely bad idea - that the outcome would be inefficiency in the supply and use of electricity, and instability in economic growth. Is the intuition that seems relevant to electricity not equally relevant to the financial sector?

I think it is.

And finally, on the inevitability of crises:

The organisational sociologist Charles Perrow has studied the robustness and resilience of engineering systems in different contexts, such as nuclear power stations and marine accidents. Robustness and resilience require that individual components of the system are designed to high standards. … More significantly, resilience of individual components is not always necessary, and never sufficient, to achieve system stability. Failures in complex systems are inevitable, and no one can ever be confident of anticipating the full variety of interactions that will be involved.

Engineers responsible for interactively complex systems have learned that stability and resilience requires conscious and systematic simplification, modularity, which enables failures to be contained, and redundancy, which allows failed elements to be by-passed. None of these features – simplification, modularity, redundancy – characterised the financial system as it had developed in 2008. On the contrary, financialisation had greatly increased complexity, interaction and interdependence. Redundancy – as, for example, in holding capital above the regulatory minimum – was everywhere regarded as an indicator of inefficiency, not of strength.