Though your towers were tall
and your powers were grand
you could not understand
how you fell from great heights
and you burrowed with speed
a kingdom you did lead
from heaven to hell
– A Fistful of Swoon, Vandaveer
Excuse me if I seem a bit sarcastic but I can’t help but smile. Slowly but surely the masters of the universe seem to finally be waking up to the inevitability of the eventual obsolescence of the archetypal business model of 20th century banking. I’ve been talking about this for a decade and the fact that it only took, let’s seeâ€¦a gigantic global financial crisis and several years of messy aftershocks for these great and good to even start thinking about switching horses? Well, you just have to laugh because the alternative is simply too depressing.
I happened to be traveling a fair bit this past week, which for me means I actually have a few minutes of downtime to read the Financial Times (thanks to British Airways and the rules forcing everyone to turn off all electronic devices upon take-off and landingâ€¦) and stumbled upon three articles that caught my attention. First up on Tuesday was Hugo Banzinger – Deutsche Bank’s Chief Risk Officer – highlighting the fact that “Banks must regain investors’ trust” on the op-ed pages. Really??You think?
Banks have also remained remarkably silent on how they plan to adjust their business models. Lenders will have to demonstrate that their future business models are beneficial to society, that they can be run safely and that they are able to restore profitability to make them attractive investments again.
Many investors shy from investing in bank equity. Business models and future profitability are too uncertain. Restoring bank profitability is of utmost importance, requiring drastic actions. The standardisation of products and automation of process has to replace the tailor-made approach of many trading desks. IT investment costing billions will be necessary. The number of people on trading floors will have to drop to levels seen at exchanges. Salaries will have to normalise to levels comparable to other services industries. Capital intensive inventory for securitisation will have to return to its originators. Market making will have to be networked and back offices will have to adopt lean production methods as seen in modern manufacturing.
These changes will eventually lead to a process revolution of the kind we experienced in retail banking in the early 1990s.
The industrial revolution in investment banking is all about creating a new paradigm for the execution of capital markets business. It is about reinventing the organisational mindset, replacing the traditional front, mid- dle and back office with a highly flexible and efficient product factory attached to a profes- sional cadre of relationship managers and solution providers who work with customers and clients to tailor products and solutions to be produced and executed by the factory. It is about viewing the services we provide as two distinct value propositions, one resting on the creativity and knowledge base of the bank and its bankers, and the other resting on the efficiency and accuracy of production and execution.
Much is promised by banks in terms of â€˜putting the customer firstâ€™ and â€˜delivering solutions not productsâ€™ however the reality is that, even if this is the good faith intent, the current structure of the banks is still aligned to the delivery of financial products as a holistic package with all the ancillary bits (settlement, research, payments, etc.) thrown in to a greater or lesser extent. An essentially analogue model for an emerging digital world. The â€˜digitalâ€™ model breaks down all aspects of the business into dis- crete component parts and allows for each to be optimised (either in-house or out- sourced) and then packaged and delivered to the client according to their needs.
Through this industrialization of the process, the skills and functions of the bankers must equally realign, with expert designers, engineers and manufacturers on the production side, and state of the art customer service representatives on the other.
I guess I just must have been saying’ it wrongâ€¦
Next, a bit later in the week, the infamous Sallie Krawcheck – yes the former Citigroup CFO & Head of Strategy, former CEO Citigroup Wealth Management, former President of the Bank of America Global Wealth & Investment Management division – was also given a slot by the Financial Times editors to explain to us that “JPMorgan shows fighting complexity is futile”. Gee, is this complexity stuff a recent development??
But despite coming a bit late to the game, she nails it:
It is complexity that in good part defines Wall Street and forms some of financeâ€™s highest barriers to entryâ€¦In the main, the response from regulators to the perceived causes of the downturn has been to fight complexity with complexity.
Iâ€™m not suggesting that no economies of scale make sense in banking or financial services more generally, only that they are subsumed by complexity within these â€˜integratedâ€™ financial behemoths. I even have some sympathy for the seductive logic underlying integrated business models, however in my view the theoretical benefits of an integrated model â€“ while possibly intellectually robust on paper â€“ are impossible to exploit in reality. It ignores what I describe as corporate entropy: ie in any corporate process there exists an inherent tendency towards the dissipation of useful energy.
Indeed â€“ sticking with the chemical analogy and without writing a book about it â€“ it would be fair to say that giant bank mergers are at best an (intrinsically unstable) intermediate product in the reaction coordinate and to make any sense need to be followed by a subsequent division into multiple new end products (which individually release the benefits of economies of scale and synergy without the instability engendered by excessive complexity.) So Citigroup (or UBS or HSBC or RBS/ABN Amro, etcâ€¦) should naturally â€œdecayâ€ to form multiple specialist firms that are more focused and efficient than the multiple firms that had been combined first to form these giants.
Of course more regulations hurt the large financial institutions, but they hurt new entrants more. And competition is a whole lot scarier than regulation to incumbents. If you want to get a sense of this, you could do worse than reading Aaron Greenspanâ€™s take on US payment regulations http://www.moneyscience.com/pg/bookmarks/Admin/read/77403/held-hostage-how-the-banking-sector-has-distorted-financial-regulation-and-destroyed-technological-progress-pdf. And similar examples exist across the spectrum of financial services and across the globe.
The irony is that most financial regulations are born through the desire to protect the little guy from losses, and to some extent they achieve this on one (direct) level but following the law of unintended consequences, the result to often is to create an environment where far larger risks (and losses) are incurred at a systemic level. And who pays for that? Well as we all know now, increasingly itâ€™s all of us (including of course, the little guy.) Via government subsidies, interventions, increasing costs to maintain ever larger and more complex regulatory regimes, all of which need to be paid for with higher taxes and more importantly slower economic growth. Here the bankers are right, all these new regulations make our current system less able to produce growth which of course hits the 99% hardest. But then the bankers stop before asking for a level regulatory playing field that would pour fuel on the smouldering fire of new, innovative, disruptive entrants. Please Lord deregulate me, but not just yet.
But of course if you are reading this, you already know we’re working hard and investing big to help change this. And despite my slight snarkiness above, I am actually excited to see views I’ve held dearly for many years starting to be adopted by (some of) the leaders and personalities of the financial services establishment. (Indeed, Sallie if you’re reading this, I’d love to have the opportunity to tell you about Anthemis and compare notes on the future of finance. And good to see you on twitter. Welcome to the (financial) reformation!)
The third article was about Senator Sherrod Brown trying to revive new legislation is the US which would mandate a break-up of the megabanks. He states:
â€œI am confident that we will see the government over time requiring some divesting of assets because if [big banks] keep getting an advantage in the marketplace, and they keep growing and having a higher percentage of assets, itâ€™s basically a government-endowed advantage. Thank you, US taxpayers.â€
I wonder if we might eventually see something along the lines of the break-up of AT&T, a process that was initiated in 1974 but took ten years and lots of litigation before taking effect in 1984. However ultimately, the problem with banking is not just about size. In this respect, I have some sympathy for the banking lobby: creating 5 or 10 mini-JPMorgans or BoAs is not really the solution (although it could be an intermediate step.) Sheila Bair has also been making the case for smaller, less complex banks:
Yet instead of waiting for the government or shareholders to act, the leadership of these megabanks should take the lead in downsizing. The best way for Dimon to provide a better return to his investors is to recognize that his bank is worth more in smaller, easier-to-manage pieces. Let’s face it, making a competitive return on equity is going to become even harder for megabanks as their capital requirements go up, their trading and derivatives activities are reined in, and their cost of borrowing rises as bond investors recognize that too-big-too-fail is over. If, by downsizing, Dimon can achieve valuations comparable to the regional banks’, he will potentially release tens of billions of value to his shareholders.
More importantly, I think we will inextricably move towards a fundamental reconfiguration of the industry: away from vertically-integrated monoliths and towards an ecosystem or “stack” of firms focused on different components of the industry. The stack metaphor I think is particularly apt, not only because it is a useful conceit to describe the financial system but also because finance is essentially an information technology business and much useful inspiration can be taken from observing the evolution of the ICT industry as it moved from the mainframe to the internet to the cloud era. And it’s not entirely coincidental that I first presented these ideas at a telecommunications conference in 2009.
In such a world, it would not be inconsistent to have several megabanks with enormous balance sheets, but these would likely be very simple constructs – highly regulated and limited utilities, providing a basic deposit taking and liquidity providing function to the system. As I suggested in my AmazonBay video in 2005, the ultimate destiny of (the core) of the global megabanks might to simply become “giant regulated pools of capital.” Such banks would have relatively few employees, extremely robust but relatively limited infrastructure, and would make consistent but modest returns on their capital. They would sit towards the bottom of the financial stack, the financial equivalent of the massive (but usually faceless) data centers that run the internetâ€¦
As you might suspect, we have a number of ideas of how this reconfiguration might play out, and this thesis deeply informs our investment process and some aspects of it are already reflected in our portfolio, other aspects not yet but soon we hope. I was thinking of writing an article that would map out how we see banking services being organized in say 2022 but rather than give too many of our secrets away here and now, I think I’ll keep some of these in reserve for the moment. Especially since the industry seems finally to be starting to pay attention and I don’t want to lose our 10 year head-start on designing the future of finance as it makes my job so much easier! As William Gibson said, “the future is already here, it’s just unevenly distributed”.
Financial institutions are already highly regulated and one could argue that at best, this has not achieved the desired outcomes and at worst has actually contributed to some of the most egregious behaviors as the clever folks in financial institutions lost sight of the end game (ie the products and services and customers that lie at the heart of their raison d’etre) and focused increasing amount of energy and talent to working the system.
And not unlike Br’er Rabbit fighting with the Tar Baby, getting stuck and then pleading with Mr. Fox not to be thrown into the Briar Patch, the large incumbent banks pleading with the regulators not to write more rules may just be a brilliant case of misdirection.
but do please, Brer Fox, don’t fling me in dat brier-patch
Of course more regulations hurt the large financial institutions, but they hurt new entrants more. And competition is a whole lot scarier than regulation to incumbents. If you want to get a sense of this, you could do worse than reading Aaron Greenspan’s take on US payment regulations. And similar examples exist across the spectrum of financial services and across the globe.
The irony is that most financial regulations are born through the desire to protect the little guy from losses, and to some extent they achieve this on one (direct) level but following the law of unintended consequences, the result to often is to create an environment where far larger risks (and losses) are incurred at a systemic level. And who pays for that? Well as we all know now, increasingly it’s all of us (including of course, the little guy.) Via government subsidies, interventions, increasing costs to maintain ever larger and more complex regulatory regimes, all of which need to be paid for with higher taxes and more importantly slower economic growth. Here the bankers are right, all these new regulations make our current system less able to produce growth which of course hits the 99% hardest. But then the bankers stop before asking for a level regulatory playing field that would pour fuel on the smouldering fire of new, innovative, disruptive entrants. Please Lord deregulate me, but not just yet.
Security theater is a term that describes security countermeasures intended to provide the feeling of improved security while doing little or nothing to actually improve security…Security theater gains importance both by satisfying and exploiting the gap between perceived risk and actual risk.
Regulators (and politicians) sensing the need to be seen to be doing something about the risk, fall into a trap of creating more and more regulations hoping to protect all of us from ourselves, only to create new (almost always) more dangerous and costly risks higher up in the system. Rinse and repeat. Until these risks reach the top of the pyramid and can no longer be shuffled and redistributed. At which time, they come tumbling down on all. This regulatory theater can be comforting in the short term but actually takes us further and further away from a sustainable solution to managing financial risks in our economies.
These risks exist and cannot be regulated away. Call it the 1st law of Financial Dynamics: the of conservation of risk. And I would postulate that pushed down to the base of our economic system, these risks would be easier and less costly to manage. With a more competitive and open system, with continuous renewal through many new entrants, the end users of financial services would get better (higher quality, lower cost) products and services with much lower risk of catastrophic systemic failures. Certainly – statistically – some of these new entrants would be managed incompently. Some would be frauds. People, customers would lose money. But the costs of dealing with these failures would pale in comparison to the multi-trillion dollar, economy-crushing losses that the existing system has allowed, nay encouraged to build up.
I’ll finish with an example, take UK retail banking. Concentrated, uncompetitive, legacy. No new entrants, no competition. Metro Bank, NBNK, Virgin/Northern Rock in my opinion are just shuffling deck chairs; better than nothing I would grant but essentially no real innovation, run in the same way with (mostly) the same assets, same people and same business models that previously existed. A token nod for the industry and the government to be able to say their is new competition (much as a dictator allows a hapless opponent to run in an election…) – window dressing. And even here, look at the hoops Metro Bank (who claim to be the “first new UK bank in 100 years”, QED…) had to go through to get a new banking license… If I were Cameron/Osbourne/Cable, the first thing I would do to start fixing the problem would be to create a new “entry” banking charter. Light touch. Basically just vet the founders and investors for fitness. Perhaps make them put up a certain minimum amount of the equity and/or guarantees as a percentage of their net worth. 90 days from application to charter. Nothing more. But restrict these new banks to say Â£50mn of assets until they have a 2 year track record (at which point they could apply for an increase in permissible assets and/or a full license.) Then oblige the large banks to open up their core banking infrastructure via APIs – analogous to obliging BT to make available their core telecom network to other operators.
I wouldn’t be surprised if within a year or two you had 30 or 40 new banks competing in various different ways, with many different (and differentiated) value propositions. And some would go bust. And some would be frauds. But even making the (ridiculous in my opinion) assumption that they all lost all of their customer’s money, and all of this money was insured by the government, we are talking about Â£2bn. Compare that to the direct losses of c. Â£23bn on RBS and Lloyd’s alone, not even considering the contingent losses and indirect costs born by the UK economy as a result of their predicament. Of course, I believe that many of these new banks would succeed and grow and any losses would be substantially smaller than Â£2bn. But none of these new banks would be too big to fail for a very long time (hopefully never) and although failure of even just one of them would attract headlines and aggrieved customers giving interviews on BBC1, especially if the cause of failure were to be fraud – it would behove us to put this into perspective. To not forget the difference between perceived and actual risk. To remember that huge failure even if diffuse and “no one individual could credibly be blamed” even if more psychologically comfortable, is actually much much more damaging than smaller point failures where cause and effect are more brutally obvious.
The world’s incumbent financial institutions are deeply mired in Christensen’s Innovator’s Dilemma, protected by regulatory barriers to entry that while not fundamentally altering the long-term calculus, have pushed back the day of reckoning only to make that day seem ever scarier. It might seem counter-intuitive, but I think we should be calling not for more regulation but for de-regulation of financial services (the real, robust, playing-field-leveling type and not the let-us-do-what-we-want-but-keep-out-any-competitors type). Competition is a far more robust route to salvation than regulation. Let a thousand flowers bloom.
I have long been concerned by the rise and rise of the global mega-bank, first due to my conviction of the impossibility of managing such complex behemoths (with the dangers as we all now know having repercussions far beyond any individual bank’s shareholders or creditors) and also due to the increasing rents such a de facto oligopoly could (and so logically does) extract from the rest of the global economy. I’ve started and then stopped writing this post at least half a dozen times in the past year; partly due to a sense of ‘what’s the point’, partly due to the problem being covered by many with much (much) more influence than I, and partly (I’m somewhat ashamed to admit) due to a small underlying element of self-censorship. As some of you know, we have ambitions to raise capital to allow us to catalyze the re-invention of financial services by investing in companies with disruptive new business models in this sector, and well the big banks are not only potential sources of capital in their own right, but also have significant influence with many of the people and institutions who are potential sources of capital for us. As regular readers know, I try always to tell it like I see it but if I’m objective, I probably have had a tendency to pull my punches a bit when discussing the banking industry. But as the debate on reforming global banking takes centre stage, and at the risk of annoying some of our potential future investors with a dissident opinion, I thought it would be worthwhile to lay out my key thoughts on the subject.
Weak competition is obvious to customers: financial companies demand high fees that are often calculated according to illogical tariffs. Fund managersâ€™ charges, for example, are usually large and are often not linked to the quality, or the real costs of their services.
The lack of competition shows up to economists in the sectorâ€™s staggering profitability. In the second quarter of 2009, 29 per cent of US domestic profits came from finance. The profit-generating power of financial companies across the developed world has stubbornly remained higher than that of other companies.
There is, in addition, good reason to suppose that competitive pressures will weaken further. The recent wave of bank failures and mergers, born of the crisis, have left the sector more concentrated. With fewer players on the field â€“ many enjoying implicit state guarantees â€“ competition will be further enfeebled.
But in more advanced economies, rent-seeking takes more sophisticated forms. Instead of 10 per cent on arms sales, we have 7 per cent on new issues. Rents are often extracted indirectly from consumers rather than directly from government: as in protection from competition from foreign goods and new entrants, and the clamour for the extension of intellectual property rights. Rents can also be secured through overpaid employment in overmanned government activities.
Rent-seeking is found whenever economic power is concentrated â€“ in the state, in large private business, in groups of co-operating and colluding firms. Private concentrations of economic power tend to be self-reinforcing. This problem was widely recognised in Americaâ€™s gilded age. The well-founded fear was that the new mega-rich â€“ the Rockefellers, Carnegies, Vanderbilts â€“ would use their wealth to enhance their political influence and grow their economic power, subverting both the market and democracy. Today it is Russia that exemplifies this problem.
But America has a new generation of rent-seekers. The modern equivalents of castles on the Rhine are first-class lounges and corporate jets. Their occupants are investment bankers and corporate executives.
So much of the conversation seems to revolve around this question of how do we deal with financial institutions which are “too big to fail”, with the turkeys running the world’s mega-banks almost unanimously (and somewhat breathlessly) insisting that breaking banks up would achieve nothing except to hurt customers.
Wouldnâ€™t it make much more sense to build a set of rules that explicitly addresses the vulnerabilities of a scale free network and as such focuses disproportion attention and resources on protecting the hubs from attack or failure. The beauty is that the digital global financial system of the 21st century and advances in the science of networks actually now allows us to do this: we can empirically and quantitatively observe, measure and manage the â€˜connectednessâ€™ of institutions. Forget the rating agencies, companies like Bonabeauâ€™s IcoSystems and others could help the regulators create, maintain and monitor network â€˜mapsâ€™ and score each market participant in terms of their connectivity. This should be the defining core metric of financial regulation and mirroring the power law distribution of the underlying network, financial regulation should focus its attention and resources in geometrically increasing fashion.
However it’s pretty frustrating to continue to read much of the ‘financial establishment’ – people who have the luxury and the privilege of being able to speak from the pages of the FT – continue to miss the point entirely and cling to a (slighty) new and improved version of the regulatory status quo. I have enormous respect for Jamie Dimon, and while I agree with him that the system must be re-engineered so as to allow any bank of any size to fail without jeopardizing the system, I disagree that breaking up the biggest banks would be damaging and serve no purpose. The rules need to be reset (to build-in automatic and steeply increasing impediments to growth in size and connectedness), but at the same time the biggest global and domestic mega-banks need to be pruned back to a size that is commensurate with this new paradigm.
The parallels between the rise and rise of Standard Oil in the late 19th and early 20th centuries, and its subsequent government mandated break-up and the rise and rise of giant global banks in the late 20th and early 21st centuries are real. John D. Rockefeller sounded every bit as sincere and paternalistic in calling for an ever bigger, ever more dominant Standard Oil – a company that would bring ‘order’ and ‘stability’ to the market making customers’ lives and choices ‘easier.’ Well of course we know that the market for oil products didn’t suffer as a result of the break-up of Standard Oil, nor did anarchy descend on the US telecommunications markets following the break-up of AT&T. I think you’ll actually find that there is a decent case to be made that things got better in both cases, with more robust and innovative markets and better value for customers. (I highly recommend that legislators everywhere take a moment to read Chernow’s great Titan: The Life of John D. Rockefeller, Sr. before reaching their conclusions as to the merits (or not) of breaking up the biggest banks.)
But the most important long-term reason to consider government intervention in the size and power of the world’s largest financial institutions is that failing to do so will inevitably starve one of the key sectors of the economy of innovation and progress with increasingly damaging results. Indeed, in the conclusion to his column Mr. Kay hits the nail on the head:
Because innovation is dependent on new entry it is essential to resist concentration of economic power. A stance which is pro-business must be distinguished from a stance which is pro-market. In the two decades since the fall of the Berlin Wall, that distinction has not been appreciated well enough.
It’s time for a change. It’s time to shake things up a bit. No?
I was cleaning up my office a bit this afternoon and came across my copy of Andy Haldane‘s brilliant paper “Rethinking the Financial Network (April 2009). People (including me) like to complain about the lack of leadership and insight at the commanding heights of the financial system, but based on this paper alone, I’m not sure the UK could ask for a better Head of Financial Stability at the Bank of England. (He was appointed to that position in late 2008, once the horse had not only left the stable but the country…)
If you are interested in the workings and health of the financial system, you simply must read this paper if you haven’t already. I won’t attempt to summarize it here, it is worth reading in its entirety but will excerpt his conclusion:
Through history, there are many examples of human flight on an enormous scale to
avoid the effects of pestilence and plague. From yellow fever and cholera in the 19th
century to polio and influenza in the 20th. In these cases, human flight fed contagion
and contagion fed human catastrophe. The 21st century offered a different model.
During the SARS epidemic, human flight was prohibited and contagion contained.
In the present financial crisis the flight is of capital, not humans. Yet the scale and
contagious consequences may be no less damaging. This financial epidemic may
endure in the memories long after SARS has been forgotten. But in halting the spread
of future financial epidemics, it is important that the lessons from SARS and from
other non-financial networks are not forgotten.
Last summer I wrote a post highlighting the fact that the global financial system is a scale-free network. This in itself is not particularly insightful – although I wonder how many of the most senior executives, regulators and politicians understand this explicitly and more importantly use it as an intellectual framework on which to base their ideas on systemic risk management and regulation. This is important because understanding the mathematical underpinnings and topology of such networks is crucial if we ever hope to construct a system of monitoring and regulation that is robust and well adapted. I was reminded of this late last night as I was re-reading an article written in 2003 by Albert-Laszlo Barabasi and Eric Bonabeau published in Scientific American on scale-free networks where they (presciently) note that:
Understanding how companies, industries and economies are interlinked could help
researchers monitor and avoid cascading financial failures.
For anyone wanting an introduction to scale-free networks this paper is an excellent place to start but basically as a reminder (via John Robb):
A scale-free network is one that obeys a power law distribution in the number of connections between nodes on the network. Some few nodes exhibit extremely high connectivity (essentially scale-free) while the vast majority are relatively poorly connected. The reason that scale-free networks emerge, as opposed to evenly distributed random networks, is due to these factors: Rapid growth confers preference to early entrants. The longer a node has been in place the greater the number of links to it.
This in a nutshell is why some financial institutions are ‘too big to fail’, or (as we heard much chatter about when first Bear Stearns, then Lehman Brothers went down) more accurately, ‘too connected to fail’. Scale-free networks are extremely resilient to random failure but highly vulnerable to specific failure of the most important hubs (Barabasi and Bonabeau):
In general, scale-free networks display an amazing robustness against accidental failures, a property that is rooted in their inhomogeneous topology. The random removal of nodes will take out mainly the small ones because they are much more plentiful than hubs. And the elimination of small nodes will not disrupt the network topology significantly, because they contain few links compared with the hubs, which connect to nearly everything. But a reliance on hubs has a serious drawback: vulnerability to attacks.
…The Achilles’ heel of scale-free networks raises a compelling question: how many hubs are essential? Recent research suggests that, generally speaking, the simultaneous elimination of as few as 5-10% of all hubs can crash a system.
Hopefully readers will recognize in this why the failure of ‘hubs’ like Bear Stearns or Lehman Brothers was potentially so damaging, setting off a cascading epidemic throughout the financial system. It is also why the Madoff failure in and of itself was not at all systemically threatening, whereas LTCM was – the key difference being ‘connectedness’ not size per se. A further consideration – based on the application of diffusion theories used to predict the propagation of a contagion throughout a population – is that the critical threshold (for propagation of an ‘infection’) is effectively zero for a scale-free network. That is all ‘viruses’ no matter how weakly contagious, will spread and persist in the system. In other words it is mathematically impossible to eradicate such sources of failure from a scale-free network. More bluntly, any attempt to eradicate or prevent financial viruses, say for instance poorly conceived sub-prime mortgages, is an act of futility.
Why is this important? Because most financial regulation, is conceived and implemented with this objective as a founding principle and worse ignores the topology and structure of the network it is trying to protect. Not only does this vastly increase the probability that the regulatory framework will ultimately fail to achieve it’s goal, but it imposes severe additional costs on the system for no greater gain in stability or robustness. Current financial regulation distinguishes far too little between the different nodes in the network, the vast majority of which are of no consequence to the overall robustness of the system. Fifty percent of financial firms could probably fail without any risk of catastrophic systemic failure as long as none of those firms were important hubs. I’m exaggerating of course (but not as much as you think.) That is why for instance the EU’s recent draft legislation on alternative investment funds – with rules uniquely predicated on size and leverage – is so wrong-headed: it misses the point. Not completely, but this is mainly due to the fact that correlation between size and connectedness is not zero (all other things being equal, bigger firms are likely to be more connected.)
However wouldn’t it make much more sense if the regulatory framework focused explicitly on the root cause of systemic vulnerability rather than accidentally or obliquely? Before any agitated readers get too excited, I realize that what I have outlined has been grasped (belatedly) to some extent by the regulators, bankers and politicians and has started to shape the discussion on the reformation of financial regulation, especially in the US where it seems increasingly likely that the new regulatory proposals will be much more concerned with the effective systemic impact of a market participant rather than their legal or organizational structure. The recognition that the fact that an organization is a bank or insurance company or hedge fund or whatever is less important than the exact types of activities it undertakes and its connectedness to the rest of the system is obviously a welcome development but it doesn’t go far enough.
Wouldn’t it make much more sense to build a set of rules that explicitly addresses the vulnerabilities of a scale free network and as such focuses disproportion attention and resources on protecting the hubs from attack or failure. The beauty is that the digital global financial system of the 21st century and advances in the science of networks actually now allows us to do this: we can empirically and quantitatively observe, measure and manage the ‘connectedness’ of institutions. Forget the rating agencies, companies like Bonabeau’s IcoSystems and others could help the regulators create, maintain and monitor network ‘maps’ and score each market participant in terms of their connectivity. This should be the defining core metric of financial regulation and mirroring the power law distribution of the underlying network, financial regulation should focus its attention and resources in geometrically increasing fashion.
This would have a number of (self-reinforcing) beneficial effects:
It would impose (geometrically) increasing costs on institutions as they grow in complexity and systemic connectedness creating a natural optimal equilibrium that balances the benefits (to the institution) of such growth against the external costs it imposes on the system. It effectively puts a price on the negative externalities and avoids the tragedy of the commons without needing to dictate to firms how big or complex they are allowed to become (which is doomed to failure due to the law of unintended consequences and the problems of quantum thresholds (ie clustering just below the threshold.) I doubt very much that a firm like Citigroup would have come into being under such a regime.
The size of a financial institution would not be a driver and so simple, relatively unconnected firms could operate with a very light regulatory touch. This would allow the system to naturally exploit economies of scale that don’t give rise to incremental systemic risk.
Innovation would be allowed to flourish without anyone – regulators, executives, politicians, super-intelligent alien forces – needing to decide which innovations were toxic and which were beneficial. As long as the key players in the system were vaccinated against these viruses and protected against mutations, you could let Darwinian evolution progress more or less unimpeded in the long tail of systemically unimportant firms. Indeed by allowing an increased rate of failure in the overall network, you would be able to more quickly and less painfully identify dangerous risks as they emerge in the network.
Resource allocation for regulators becomes much easier and more transparent. The amount of regulation and regulatory attention each firm would receive would become directly proportional to their systemic importance.
We can’t prevent dangerous risks from developing in the financial system but we can work with the grain of the underlying structure to mitigate the systemic danger instead of against it, or at best ignoring it. The robustness of scale-free networks to accidental failure has many advantages in that it allows our financial system to operate very efficiently and robustly most of the time. And by explicitly recognizing the mechanisms by which catastrophic failure can occur in our approach to regulation we will be much less likely to suffer such failures in the future and the costs of regulation will be appropriately borne within the system creating a virtuous circle that drives the system to self-organize into the optimal configuration of complexity and connectedness.
If you know Tim Geithner or Charlie McCreevy or Lord Turner, please send them this link. Hopefully it’s not too late! 😉
John Kay is one of the most lucid, accessible economic thinkers out there: pragmatic, insightful, skeptical and perhaps most importantly not prone to hyperbole. If you don’t already read his weekly FT columns (also archived and published here), I highly recommend them. (Perhaps one day I’ll get the opportunity to meet him, and be able to convince him to join our advisory board.) His column yesterday, “Why ‘too big too fail’ is too much for us to take” was particularly articulate and on target:
Commercial success and democratic election are the only sources of legitimate authority in a society that no longer relies on spiritual leadership nor respects hereditary titles. An organisation exempt from either of these disciplines represents an unaccountable concentration of power. As we have today at Citigroup, Barclays and Deutsche Bank.
If â€œtoo big to failâ€ is incompatible with democracy, it also destroys the dynamism that is the central achievement of the market economy. In principle, there is no reason why disruptive innovations and radically new business models should not come from large, established, dominant companies. In practice, the bureaucratic culture of these organisations is such that this rarely happens. Revolutions in business generally come from new entrants. That is why so many of todayâ€™s market leaders â€“ Microsoft and Google, Vodafone and Easyjet â€“ are companies that did not exist a generation ago. These companies could not have succeeded if governments had been committed to the continued leadership of IBM and AOL, AT&T and British Airways.
If there is one single learning we as democratic capitalist societies need to take away and apply in earnest from the Crash of ’08 it is to put in place mechanisms, policies, regulations, norms – whatever is needed, to ensure that no private or public commercial entity is ‘too big to fail.’ The externalities on society are too important (and the mis-pricing of these is probably the largest contributing factor to the excessive rents that accrue to such entities in times of stability.) The wonderful thing is that with the technology and economic infrastructure of the 21st century, it is entirely possible to implement a market-based pricing of intangible externalities if – and sadly this is far from a given – sensible, good faith laws and rules are put in place. The markets in pollution permits is an obvious example, although as has been seen in the carbon markets, all too often we see the entrenched power of incumbents forcing a distortion of the rules to dilute their effectiveness (think free allocation of CO2 permits vs. auctioning.)
(One of) the analogs in finance you could imagine would be a market in Central Bank liquidity rights: the right for a bank to borrow say 12mo funds from the Central Bank at a set rate or margin. Banks would have to hedge the committed lines of credit they extend with these liquidity rights. Designed correctly (tricky no doubt but doable), these could trade in a free market, with the Central Bank auctioning off and participating in secondary market operations to manage their supply and demand. With these you could actually price liquidity (perhaps not perfectly but still) and if they had existed, I suspect that banks would have been much more cautious before writing trillions of dollars worth of committed back-stop facilities to structured finance vehicles (SIVs, etc.) and corporates at derisory pricing.
For those of you that aren’t bankers – for years these kind of facilities were written even for weak credits with tiny commitment fees, most between 5-15 basis points (ie 0.05-0.15%.) They were never ‘expected’ to be drawn, and so were often treated as free money when in effect they were just out-of-the-money options sold without regard to the tail risk. Another ‘picking up nickels in front of a steamroller’ strategy that failed catastrophically. Of course everyone knew that these facilities were underpriced, and for most banks (but some of the dumb money smaller banks) they were notionally acknowledged as loss leaders to win other business. This in itself is not a problem per se. The problem arose because these ‘loss leaders’ actually made revenues and accounting profits (of course while storing up enormous contingent risks but these were invisible and seen as so unlikely as to be irrelevant, just like for super-senior CDO tranches) and so it was only too easy to keep selling more and more of them. A loss leader than makes you money: what’s not to like about that?
John Kay finishes his argument with a succinct recommendation:
â€œToo big to failâ€ â€“ whether the claimant is a bank or an auto company â€“ is not a status we can live with. It is both better politics and better economics to deal with the problem by facilitating failure than by subsidising it.
There has been much noise (on both sides of the Atlantic) on the appropriate role of government with respect to giving a financial boost to new ventures and entrepreneurs, especially given the vast sums that have been targeted towards failed giants. This is a debate for another time, but I suspect the single most effective thing governments could do to help entrepreneurship, innovation and economic renewal sustainably, over the long term and with the least risk of unintended consequences, would be to heed Mr. Kay’s call and ensure that henceforth no company in any sector is ever again too big to fail.
A few years ago Congressman Frank Wolf ranted in Congress that if UIGEA was not passed, people would be gambling in … (wait for it…) THEIR BATHROBES!!! Shocking I know. So many lives ruined. If they had only pulled on a t-shirt and a pair of jeans…
Anyhow, he voted for it:
In 2006, the Unlawful Internet Gambling Enforcement Act (UIGEA) was signed into law. This landmark legislation helps to cut off the flow of revenue to unlawful Internet gambling businesses. It outlaws receipt of checks, credit card charges, electronic funds transfers, and the like by such businesses. To do this, it enlists the assistance of banks, credit card issuers and other payment system participants to help stem the flow of gambling dollars.
This is about knowing all of the hard evidence about the byproducts of gambling â€“ crime, corruption, family breakdown, suicide, bankruptcy â€“ and not hearing our country’s leaders speaking out.
Where are the political leaders from both sides of the aisle? Religious leaders? Advocates for children, the poor and the elderly? Their silence is deafening.
It is time for Americans leaders to step forward and address the proliferation of gambling.
(Now replace gambling with banking and maybe we’re talking…UIBEA anyone? LOL)
I was also pleasantly surprised to learn from (an excellent and newly discovered blog) Zerobeta, that Delaware was thinking about legalizing sports gambling (picking up on an ESPN article):
The newly elected Markell, who has spent the past several weeks listening to proponents of gambling as well its opponents, is much more of a pragmatist than a betting revolutionary. He hasn’t been to Vegas in nearly 15 years and almost never hits the race track/casinos (called racinos) in his home state. But the way he sees it is this: Delaware already allows horse racing and slots. And with the state currently $700M in the hole, offering the Pats minus-six over the Jets when bettors come by to drop a nickel in the slots isn’t amoral. As he told me a couple months ago, “you can’t really be half-pregnant.”
How refreshing. Legalize. Regulate. Tax. The best way to address Mr. Wolf’s concerns, not prohibition. And for those of you who want to trade the probability of this outcome, head over here to InTrade(HT to Chuck for the pointer.)
(Disclaimer: As some of you may know, I am an investor in Betfair and so have an interest in a free and regulated US market (given the current legislation Betfair does not trade in the US in compliance with all federal and state regulations.) However I would hope that those who know me and even regular readers know that my views on the subject are not driven by this investment. Indeed I would say this investment was driven by my views.)
As some of you may know, I am very interested in how the advent of mobile computing (or as Gilder would say – teleputers) and in particular believe that the iPhone is the first device to really take us past the inflection point and has started to give us a good sense of what the future will look like.
Financial services and mobile computing are a match made in heaven, and the only thing that is surprising about the flurry of activity in this sector over the past 12-24 months is that it took so long. The fact that some of the earliest and most ambitious ventures in this area emerged in developing countries speaks volumes to the fundamental inertia and resistance to change and innovation in large corporations (in particular financial services firms and US/European telecom operators in this case.) People may laugh at the hysterical self-immolating attitude of the traditional media and entertainment industry, but well…you know – ‘glass houses’ and all that…
The innovative web app, which is featured on the Apple website, gives iPhone users an instant view of how financial markets are performing, and lets them place simple bets on whether prices will rise or fall. The app complements gnuTrade’s acclaimed web-based trading platform (www.gnuTrade.com), using its signature graphics to show live market price action, but via a handy touch-screen device.
Why are we excited about this? Well it brings together three big things: increased consumer interest and awareness of financial markets, mobile computing and mobile/p2p gaming. And all of this in a simple-to-understand, easy-to-use, oh-so-not-wall-street/city kind of way. GnuTrade is definitely not your father’s Oldsmobile so to speak. It’s social. It’s fun. It’s about not looking down your nose at people who are interested but are intimidated by traditional banks and brokers and spread ‘trading’ firms. It’s about prizes and play money or real money (only if you live where this is allowed of course.) GnuTrade is a digitally native markets company: they were early on Facebook(become a fan here), they are the UK’s most prolific twitterer (62,000 updates! follow them @gnutrade), and they have a pretty neat set of widgets if you are interested in adding some markets info to your blog or website – basically they ‘get it.’
Now the iPhone app is definitely not perfect. First of all it is a web app (runs in Safari) as Apple does not (yet?) allow ‘betting’ applications in the AppStore (to get the app for free on your iPhone, simply enter http://iphone.gnutrade.com on your iPhone’s Safari browser, and add the app to your homescreen.) Secondly, it’s beta so it has bugs (feedback and constructive criticism welcomed – send to @gnutrade for example) and thirdly – unless you have a blisteringly fast 3G connection – I would stick to wifi only for now.
They also have a very cool and fun beta application called NewsPools (similar to HubDub for example) that I for one would love to see on the iPhone (are you listening Lieven? 😉 ) And while you are at it, let’s see a market on when (what year say) the US will wake up and legalize, regulate and tax online gambling!
* tried but failed to find a video of a great comedy sketch (Monty Python?? not sure) where the Board of the Bank of England bets all the country’s reserves on the “1:15 at Cheltenham” and loses, very funny, if you’ve seen it and know where to find it please post in comments!
British MPs who oversee the Department for Culture, Media and Sport are a sensible bunch, with a keen eye for special pleading. But they’ve erred badly today. In a report on online ticket touting, the MPs have today given a strong recommendation for a levy on the resale of tickets for live events. (Report here.)
Resellers – and therefore punters – will be forced to pay this levy, and a levy collection agency would need to be established to distribute the tax. There’s no recommendation that the levy is returned to performers, as the MMF (Music Managers’ Forum) has proposed. As it stands, the levy will merely oil the machinery of the primary market: the promoters and their agents. This is a quite amazing stunt to pull off – and should serve as a wake-up call to everyone…
…there’s a very healthy after-market for tickets, sold through auction sites such as eBay and bulletin boards such as Gumtree and Craigslist. This is exactly what the internet is supposed to be good at: eliminating wrinkles caused by consumers having a lack of information. And it works very well.
Yet the major promoters have very nearly succeeded in banning this market outright. Instead they’ve won themselves a “right” not enjoyed by book authors, songwriters or composers – or even the RIAA! (Authors, publishers and record companies don’t get a cent from the second-hand sales of books and records.) …
The Committee said it wants the secondary market to continue, and declared itself reluctant to intervene. But it did so anyway, giving credence to a long laundry list of grievances raised by the mega-promoters, including Harvey Goldsmith. Goldsmith wants to extend his huge market power in the primary market by banning the secondary market, and does so by conflating issues such as fraud with touting. Of course, there’s already legislation in place to deal with fraud. But the ticketopolists want to fight fraud the cheap way: getting us to pay a tax, rather than using better technology or employing a few more people to check against abuse. And in this case, they’ve won an improbable victory.
I’ve only had the chance so far to read the summary or the report (but have printed out the whole c. 200 page pdf to read later) but I can’t for the life of me figure out how they managed to reach their final recommendations, which seem to contradict their own findings (!):
While the superficially obvious solutionâ€”of increasing ticket prices to whatever level the market will bearâ€”might keep all the potential profit within the industry and effectively eliminate the secondary market, it would run counter to the industries’ pricing policies which aim to make tickets affordable by their grass roots and genuine fans upon whose continuing interest and attendance the long term wellbeing of the industries depends. [Give me a break!!! There are so many holes in this argument I don’t know where to start…] We did not receive any evidence from the grass roots or fan bases complaining that they were unable to obtain or afford tickets for their chosen events…
…We also believe that the existing situation whereby large profits can be made on the secondary market with no benefit to the organisers or owners of the primary rights is unfair and must be addressed. [Why????? Change the primary market price if you think it is wrong!!!!] …
…We welcome the initiative of the Music Managers Forum to seek agreement for a voluntary scheme under which sellers of tickets in the secondary market would pay a proportion of the profit to the original organisers to be distributed in the same way as the original amount paid. In return, the organisers would recognise the legitimacy of the secondary seller and not seek to invalidate the ticket being sold. [So the secondary market participants pay the primary underwriters for their inability to correctly price and risk manage their inventory…wow. Wow! All I can say is I wish we had that kind of mechanism when I was underwriting bonds for a living!] Such a scheme would recognise the right of those in the entertainment and sports industries to a share in the profit made by others out of the events for which they are responsible in the same way that creators of artist works now benefit from sales of their works through resale royalties. We believe that a scheme of this kind offers the best chance of meeting the concerns of event organisers while still allowing the secondary market to operate unfettered and we strongly encourage all those involved to consider it seriously.
May I suggest an alternative model? A simple one. Liberalize and regulate the secondary market. Full stop. Fraud and manipulative and abusive trading is proscribed with both criminal and civil penalties depending on the situation (analogous to securities markets.) And the market decides. I guarantee you the world will not come to an end. Events will continue to be underwritten. Artists and performers will end up being fairly paid (sometimes a lot more, sometimes a bit less but closer to “fair market value” in all cases), consumers will be happier, and underwriters and distributors will make a decent living and innovation will thrive.
The crowning irony is that folks like Mr. Goldsmith would probably continue to be very successful – and the Sharpe Ratio of their business vastly improved – in such a new world. After all they still have their relationships which in an efficient electronic market paradigm generally become even more valuable insofar as they cannot be industrialized and yet can be monetized against a much more efficient infrastructure. But fear and habit are powerful ghosts…and change is well, scary. Like the recorded music industry before them, rather than clinging for dear life to the status quo, major promoters should be leveraging their position of market knowledge and leadership to participate and profit from change: partnering with and investing in innovative new participants and business models. And not leave it until it is too late.
I just wish I had know about the report. I would have liked to submit my Tickets & Markets Part 1 and Part 2 as evidence…