Speaker: John Kay, Author Other People’s Money and Visiting Professor London School of Economics
Moderated by: Saurabh Mukherjea, CFA, CEO, Institutional Equities, Ambit
Written by: Chetan Shah, CFA, Director IAIP and Senior Portfolio Manager, Religare Invesco AMC
Most of us would assume that the principle function of finance is to provide 1) a payments system say for paying salaries to individuals or managing expenses, 2) capital allocation – to mobilize savings which could be channelized for the physical economy, 3) wealth management – smoothening out of spending over an individual’s life and transfer of wealth to future generations and 4) risk mitigation – managing market risks. However, lending to non-financial firms and individuals producing real goods and services amounts to less than 3% of total assets of banks and financial institutions in Britain today according to John Kay! Majority of financial industry’s activities comprise of trading bits of paper with each other and sometimes cutting these bits of papers into different shapes in the name of innovation! They have become somewhat detached from the real or physical economy. Their actions hardly help the real economy. What about their profits? Where do they come from? John argues that finance industry’s profitability is not the creation of new wealth but the sector’s appropriation of wealth from other people’s money.
Till the global financial crisis of mammoth proportion blew out in 2007, the tailgating behavior continued to dominate. Tailgating is the practice of driving too close behind the vehicle in front and flashing headlights for overtaking. The driver gets small victories of reaching 1-2 minute early with a possibility of crashing his car one day – analogous to small profits for very high risks taken. Hence a critical opinion like that of Raghuram Rajan at the Jackson Hole Wyoming Meeting during August 25-27th 2005 was not well received by Alan Greenspan & team who were in a celebratory mood. They stopped talking about the risks which would affect the common man, the unemployment rate or the destruction hurricane Katrina had caused in Louisiana around that time.
The Insurance business in the UK started in the 17th century around Lloyd’s Coffee House, where people used to gamble on anything from fate of ship to tide & weather to even King’s health. At around the same time in a Swiss village when a cow died, all the “club” members came together to buy a cow for the unlucky farmer; thereby starting insurance through the route of mutualization. However, John thinks that the balance between these two seemed to have been lost over time.
Likewise John regrets that too much attention has been paid by government, policy makers & politicians to save “too big to fail” financial institutions at the cost of small community banks. These smaller institutions have been crushed by excessive regulations. Now the economic reality is that they are “too small to succeed”. In the past, these localized financial institutions have been the foundation of economic growth for SMEs (Small and Medium Enterprises) in the US.
So what’s the solution for resolving? John suggests a) re-establishing short, simpler structure of intermediation, b) restoring focused specialist institutions with direct links to users of financial services, c) high standards of loyalty and prudence in client dealings for anyone who handles other people’s money and avoidance of any kind of conflicts of interest d) enforcing criminal and civil penalties directed primarily toward individuals rather than to organizations. While managing other people’s money put clients’ interests first.
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