Other People's Money

1. Financialization has transformed the global economy, often to its detriment

The notion that finance was special was uncontroversial, and the inability of many intelligent people outside finance to understand quite what financiers did only reinforced that perception.

Financialization defined. Financialization refers to the process by which financial services, markets, and institutions have come to dominate the global economy over the past few decades. This transformation has been characterized by:

• The explosive growth of the financial sector relative to the rest of the economy
• The increasing complexity and interconnectedness of financial products and institutions
• The rising influence of financial motives, markets, and elites in economic and political decision-making

Consequences. While proponents argue that financialization has increased efficiency and risk management, critics point to several negative outcomes:

• Increased economic instability and frequency of financial crises
• Growing income inequality as financial sector profits and compensation have soared
• Misallocation of resources away from productive investment and towards speculative activities
• Short-termism in corporate governance and economic policy

2. The financial sector has grown excessively large and complex

If we command our wealth, we shall be rich and free; if our wealth commands us, we are poor indeed.

Scale of growth. The financial sector's expansion has been staggering:

• In many Western economies, the assets and liabilities of banks now exceed the total annual income of everyone in the country
• The value of daily foreign exchange transactions is almost a hundred times the value of daily international trade in goods and services
• The value of outstanding derivative contracts is estimated to be three times the value of all physical assets in the world

Increasing complexity. This growth has been accompanied by mounting complexity:

• Financial products have become increasingly sophisticated and opaque
• The chains of intermediation between savers and borrowers have lengthened
• Financial institutions have become more interconnected, creating systemic risks
• Even industry insiders struggle to fully understand the system they operate within

Consequences. The sector's size and complexity have led to:

• Increased fragility of the financial system
• Higher costs of financial intermediation
• Difficulty in effective regulation and oversight
• A disconnect between finance and the real economy it's meant to serve

3. Modern finance frequently fails to serve its core purpose of efficient capital allocation

The paradox is that the expertise that was valued in the finance sector that had developed in the first decade of the twenty-first century were skills that were related not to the needs of end-users but to the process of intermediation itself.

Core functions neglected. The financial sector's primary roles should be:

• Facilitating payments and transactions
• Intermediating between savers and borrowers
• Managing household finances across lifetimes
• Helping businesses and individuals manage risk

However, much of modern finance has drifted away from these core functions, focusing instead on:

• Trading for trading's sake
• Creating complex financial products
• Regulatory arbitrage
• Extracting value through fees and intermediation

Misallocation of talent. The sector has attracted a disproportionate share of top graduates, often diverting them from more productive pursuits:

• Many highly skilled individuals spend their careers on activities that add little real economic value
• The focus on financial engineering and trading has come at the expense of understanding underlying businesses and economic fundamentals
• This brain drain has potentially significant opportunity costs for society

4. Financial innovation has created more instability, not less

The objective of reforming the finance industry should be to restore priority and respect for financial services that meet the needs of the real economy.

False promises. Financial innovation was often touted as a means to:

• Improve risk management
• Increase market efficiency
• Enhance financial stability

Reality. In practice, many financial innovations have had the opposite effect:

• Credit default swaps, meant to insure against default risk, amplified the 2008 financial crisis
• High-frequency trading has increased market volatility
• Complex securitization made risk assessment more difficult, not easier

Unintended consequences. Financial innovation has often:

• Created new, poorly understood risks
• Increased system-wide fragility through greater interconnectedness
• Enabled regulatory arbitrage, undermining effective oversight
• Facilitated the creation of bubbles and speculative excess

5. Misaligned incentives plague the financial industry

The notion that securitisation is a useful approach to the financing needs of SMEs is another illustration of the misconception that the solution to most problems is found in complex financing tools.

Short-termism. The financial industry's incentive structures often encourage short-term thinking:

• Traders and executives are rewarded for annual or quarterly performance
• This leads to excessive risk-taking and a focus on immediate profits over long-term stability
• The "I'll be gone, you'll be gone" mentality undermines responsible decision-making

Agency problems. Misaligned incentives create conflicts of interest:

• Asset managers may prioritize their own fees over client returns
• Investment banks may push unsuitable products to generate commissions
• Rating agencies paid by issuers may have incentives to provide overly optimistic ratings

Moral hazard. The expectation of government bailouts for large financial institutions creates perverse incentives:

• It encourages excessive risk-taking, as profits are privatized while losses are socialized
• It gives large institutions an unfair competitive advantage
• It undermines market discipline and effective risk management

6. Regulation has been ineffective and often counterproductive

There has not been too little regulation, but far too much. What is needed is an entirely different regulatory philosophy.

Regulatory capture. Financial regulators often become too close to the industry they oversee:

• Many regulators come from or aspire to join the financial industry
• This can lead to a sympathetic approach to industry concerns
• The revolving door between regulators and industry creates conflicts of interest

Complexity begets complexity. As the financial system has grown more complex, so has regulation:

• The Basel banking regulations have grown from 30 pages to over 600
• This complexity creates opportunities for regulatory arbitrage
• It also makes effective oversight more difficult

Unintended consequences. Well-intentioned regulations often have negative side effects:

• Capital requirements can incentivize banks to move risks off their balance sheets
• Detailed rules can create a "tick-box" mentality, undermining ethical behavior
• Regulations often lag behind financial innovation, creating regulatory gaps

7. Reform should focus on simplifying and restructuring the financial system

The appropriate objective is to reduce trading volumes to the modest levels that serve the real needs of the non-financial economy.

Structural reform. Key principles for reforming the financial system:

• Separate utility banking (payments, deposits, basic lending) from speculative activities
• Shorten and simplify chains of intermediation
• Encourage the development of focused, specialist institutions
• Reduce the interconnectedness of financial institutions

Cultural change. Reform must address the industry's culture:

• Emphasize ethical behavior and fiduciary duty
• Align incentives with long-term outcomes and client interests
• Foster a sense of social responsibility in finance professionals

Regulatory approach. A new regulatory philosophy should:

• Focus on principles rather than detailed rules
• Emphasize personal responsibility and accountability
• Encourage simplicity and transparency in financial products and institutions
• Limit public subsidies and implicit guarantees for financial institutions

Refocus on core functions. The reformed financial system should prioritize:

• Efficient capital allocation to productive investments
• Long-term stewardship of assets
• Meeting the real financial needs of businesses and households
• Contributing to overall economic stability and growth

Last updated: October 11, 2024