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PBLS Conference Speech

I’ve been asked to speak today about balance in the financial markets, and I have decided, to make my life more difficult, and in order to begin, to start with the moment of its greatest imbalance.

 

pbsl-speechOn the 26th of March 2008, in Martin Wolf’s regular Wednesday column in the FT, he encourages readers to remember this day: “It is the day the dream of global free- market capitalism died.” To my mind, it is a massive social seismic event to have a market commentator of the calibre of Martin Wolf invoking the death of capitalism.

 

It’s worth asking what he means by free-market capitalism. What is today known as Anglo-Saxon laissez-faire capitalism ultimately rests on Adam Smith’s principle that there is an invisible hand that will continuously guide us toward optimum equilibrium. Of course, Adam Smith’s idea really becomes crystallised in more modern theories such as the Efficient Markets Hypothesis, which presupposes not just the existence of the invisible hand, but purports to be able to define it mathematically.

 

There’s oddly enough a great quote attributed to Frank Borman, the commander of Apollo 8, who memorably remarked in the 1980s: “Capitalism without bankruptcy is like Christianity without hell”. But that is in fact what we have today. We have the laissez-faire of deregulated financial markets, but we don’t have the stomach to allow large firm bankruptcy any longer. Where we have allowed bankruptcy, we probably regret it.

Perhaps we should be asking whether financial markets are, by their very nature, intrinsically unstable. My answer is no. This is palpably untrue given the benign period of stable economic growth achieved between the Second World War and 1973. It is only after the introduction of commodity and foreign exchange uncertainty with the OPEC crisis, the failure of Bretton Woods, and with the industrialisation of derivatives with Black & Scholes, that long-run financial market volatility tripled.

 

In defence of financial markets, one also needs to recognise that, treated as a domestic animal, the creature has been recently abused. It is only in the last decade that we have invented unfathomably complex financial instruments, such as the synthetic CDO, and unfunded credit default swaps, which have been undoubtedly one of the strongest originating causes of the instability.

 

So, if we are unwilling to blame the markets themselves, so to speak, and we blame only our recent abusive relationship with the markets, the question becomes: What caused the imbalance of the last two to three decades and how should we fix it?

 

One of the strongest arguments for the instability in the financial markets is the fact that the Glass-Steagall Act was repealed by Bill Clinton in 1999, possibly to help steer the Citibank and Travellers merger through regulations. This Act, which was first introduced in 1933 during the Great Depression, effectively separated investment banking activities from retail deposits and lending. It was precisely the removal of this Act which allowed investment banks to package and sell triple-A rated mortgage backed securities to investors in Germany that were made up of subprime mortgages originated in Nevada, for example. Known in the US as the Volcker Rule, it is also precisely what the UK authorities, through the Treasury and George Osborne, are trying to resuscitate today, albeit without actually separating the banks themselves, just all of their IT systems, personnel, funding liquidity and capital.

 

It looks like banks have been reacting strongly against the move, which has been called ‘ring-fencing’, citing increased costs and difficulty in raising capital to support both types of business. One could argue that banking after 1933 was perfectly safe and did not enjoy the benefit of having retail deposits fund trading activities, so why should it be such a disadvantage now? This argument would however be naive perhaps, and would ignore the fact that the world has moved on, and that it would take enormous international co-ordination to ensure that all countries instituted the same policies, in order to ensure the removal of competitive arbitrage.

 

But perhaps there is more to solving this problem than raising the Glass-Steagall Act from the dead. For one thing, it is worth noting that the period between 1973 and 1999, the year the Act was repealed, was anything but benign. In other words: there is no direct correlation between the separation of investment banking and retail activities with stable financial markets. The Savings and Loan crisis of the early 1980s was severe and prolonged and was not a function of the abuse of retail deposits.

 

Perhaps more philosophically, it is worth asking the question as to why financial markets require the kind of highly authoritative, paternalistic regulations that we are seeing augured in today. What does it say about us as participants, and what does it imply for the notion of capitalism as we would like to believe in it?

 

Putting aside for a moment the Volcker Rule and its various guises, I believe it is worth turning our attention rather to our behaviour as individual participants, rather than just focusing on the regulatory and institutional view.

 

I wish to attack, so to speak, two lines of argument.

 

The first has to do with the manner in which we see ourselves as financial participants and the financial system itself. Going back to Martin Wolf, was his doomsday message an overreaction typical of the times? Or perhaps it was a rare glimpse into the rickety philosophical foundations underlying not only the markets but also our social fabric itself.

 

To make my point: had Martin Wolf written his article only a year prior, he would have been accused of being an heretic. Received wisdom, in the western world at least, made it heretical to question the foundations of laissez-faire capitalism. It was only the wrenching uncertainty of 2008 that set the stage for a Martin Luther type moment. In 2008 it became almost de rigueur for journalists to undermine the Capital Asset Pricing Model, Black-Scholes, Robert Merton, Modigliani / Miller, and the Efficient Market Hypothesis. Yet, these assumptions and theories and constructs form the canon of our belief system. We’re taught these constructs at bible school, whether your denomination happens to be an MBA, Econometrics, or a Financial Engineering degree. They’re used abundantly – in pricing, rating, and forecasting.

 

This religious metaphor is one that crops up everywhere, and perhaps provides insight into the imbalances within the financial markets. As a great example, and if anyone doubts this, consider the fact that Goldman Sachs executive Brian Griffiths defended Goldman’s 1st half 2009 bonus pool of $11 billion at St. Paul’s Cathedral in London. “The injunction of Jesus,” he said, “to love others as ourselves is a recognition of self-interest … We have to tolerate the inequality as a way to achieving greater prosperity and opportunity for all.” Goldman CEO Lloyd Blankfein even claimed to be “doing God’s work”.

 

It is instructive I think to observe that banking had very little of this theoretical depth prior to the 1970s, nor was it dressed up as anything more than a social and institutional necessity. Somehow, following an academic revolution, led by the Chicago School in the early 1970s, banking and the financial markets somehow became the guests of honour.

 

My point here is that the problem resides not only in how we regulate ourselves, but in the very way in which we see the financial system itself. Whereas previously it had been the plumbing serving the purpose of supporting the industrial process, it has now become the main event. To my mind, the edifice of finance has justified its own importance to some degree through the implementation of a deep theoretical framework. In some ways I think we need to decouple ourselves from this theoretical framework in order to arrive at a system where we are not treated so paternalistically and authoritatively. For a brief moment in 2008, the clouds parted and we questioned our theoretical framework, sold to us as a factual order much in the same way that we would have studied engineering or biochemistry for that matter.

 

The second argument I wish to raise has to do with the nature of how we make decisions as individuals, and the assumption that these decisions are made rationally. Systematic irrationality of behaviour common to all human beings results in a pervasive myopia on the part of key players which is at odds with the clarity of the Efficient Market Hypothesis. It is well documented by behavioural psychologists that individuals display a disproportionate fear of feeling regret, are prone to cognitive dissonance, often resort to heuristics to ease decision making processes, tend to be wildly overconfident, and in the financial markets can substantially leverage these predilections.

 

Psychologists working in the field of behavioural economics have demonstrated, for example, that people tend to be excessively influenced by outside suggestion and even irrelevant information, a psychological bias known as the anchoring effect. The idea that has had the greatest impact on the field of behavioural economics is ‘prospect theory’, developed by Daniel Kahnemann and Amos Tversky. They found that people are loss averse rather than risk averse, as a loss has more of an emotional impact than an equivalent gain, with the result, for example, that a person will gain far less utility from finding a ?100 note in the street than they would lose by, say, receiving a ?100 fine. Because of this asymmetric value function individuals do not measure risk consistently, a finding completely at odds with the Capital Asset Pricing Model, upon which we base countless decisions.

 

Lack of balance in the financial system is exaggerated by the sheer size of institutions, and exacerbated by the information processing asymmetries which are evident at such an individual level. We need to ask how we can expect to absorb the onslaught of information with which we are daily confronted and make rational decisions, particularly with cognisance to our inherent and well-proven biases.

 

In summary, my shortcut for achieving greater balance in the financial markets would basically boil down to three points:

 

First, I would begin with a serious revisit to our theoretical foundations. As an example, it is CAPM and Markowitz which tell us to diversify across asset classes and to mathematically optimise capital, a notion somewhat at odds with Glass-Steagall and the Volcker Rule. It was Merton’s formula that gave us portfolio credit models, which massively underestimated portfolio risk in triple-A rated tranches.

 

Second, I would suggest that ring-fencing is not such a bad idea. It does not make rational sense to have retail deposits funding the creation of unfunded derivatives. It may be somewhat painful but a positive step nevertheless.

 

Third, and finally, I would suggest we start to model the asymmetries that drive behaviour and decision-making, albeit qualitatively, and not focus so entirely on producing reports.

 

We thought the Chicago School had the answers. But the Chicago School’s interpretation of Adam Smith’s concept of the ‘invisible hand’, and the implications thereof for unfettered free markets, has proven quite problematic. Moreover, the Chicago School’s closely related edifice of mathematical finance, while elegant, is demonstrably inadequate to even approximate reality. The unquestioning acceptance of financial theory and mathematical finance, which Paul Krugman has characterised as ‘mistaking beauty for truth’ and ‘panglossian finance’, has if anything exacerbated markets’ tendency to irrational exuberance and overreaction.

 

David Buckham, CEO of Monocle