The Future of Finance: International Edition

Bankers and hedge fund managers are fond of saying, “if you place restrictions on our activities in New York, we’ll just move elsewhere – like London.”  This makes attitudes towards the financial sector in other countries – particularly the UK – highly relevant for American public policy debate on this issue. 

Is it the case that the new found skepticism about modern finance and its effects on the real economy is confined to the United States?  Or is there a broader shift in thinking around the world, including in other leading financial centers?

A new book out this week from the London School of Economics, “The Future of Finance and The Theory That Underpins It”, suggests that a profound shift in the consensus is well underway. 

(Disclosure: I have an essay in this book, but as it is downloadable for free, there is no royalty involved.)

The book represents the views of leading UK-based thinkers and policymakers, including Adair Turner (the outgoing chair of the Financial Services Authority), Martin Wolf (the Financial Times columnist, now a member of the new UK Commission charged with determining if banks’ size and scope should be limited going forward), and Andrew Haldane (a senior Bank of England official who has been a high profile critic of the financial sector as it is currently organized).

This is obviously a group people who are willing to talk with each other, so some convergence in views is not unexpected.  Still, it is striking that a fairly disparate set of officials, academics, and practitioners should find themselves largely now in agreement that we have a problem – the financial sector in the UK (and elsewhere, like the US) has become potentially dangerous. 

The benefits from banking, broadly defined, on current scale and with its existing incentive structure are – at best – very limited.  In contrast, the costs – both in the recent past and likely future – are large and actually quite frightening.  The fiscal position of the UK has been literally ruined by the measures the last government had to put in place to support the big banks, directly and indirectly.  Whatever your assessment of the fiscal austerity measures being pushed hard by the new government, there is no question that much of the underlying problem arises from the continuing failure of financial regulation.

This then leads to the bigger question: What exactly should be done?  On this point, participants reflect the broader split in opinion.  Some prefer “better regulation”, which includes higher capital requirements (if we proceed along traditional lines) and a “macroprudential committee” (if we are to move regulation onto a new basis – creating a structure parallel to the committees that set monetary policy in many leading central banks).

But strengthening regulation is never as easy as it sounds – because the regulated banks get to respond and because more activities will move into relatively unregulated areas.  Charles Goodhart, for example, represents responsible thinking along these lines and many of the ideas that he discusses (e.g., on living wills) may be implemented.  But how much difference can such arrangements make when the big banks have every incentive to game the system – and when the resources commanded by the regulators are relatively tiny?

The alternative is new institutional arrangements, i.e., a different legal framework for the core of our financial system.

John Kay, also a Financial Times columnist, has been getting traction with his proposals for “narrow banking” – very much along the lines recently proposed by Paul Volcker.  Allow banks to only provide a limited range of essential financial services (around deposit-taking), and regulate those activities tightly.  Any other “risk-taking” parts of finance should be completely separated off from the regulated “safe” parts.  If that separation could really be effective – and that is the big “if” (ask Mr. Volcker) – then anything in the “risky” category could safely be allowed to fail, without disrupting the fundamental credit mechanism.

Martin Wolf prefers to directly control the way in which bankers can be paid – forcing their pocket books to face the consequences tomorrow of poor decisions today.  This is appealing in many ways, but also hard to implement.  The essence of limited liability – a cornerstone of modern economic development — is that your downside losses are capped.  And any attempt to impose unlimited (or even very large) personal financial liability on banking executives could surely be offset through insurance policies, either explicitly (if allowed) or implicitly (through all kinds of hedging transactions – remember these people have access to the fastest traders and best lawyers on the planet).

All this heads in the right direction but does not yet reach a definite conclusion.  In the last chapter, Peter Boone and I argue that we need an international treaty organization – along the lines of the World Trade Organization, but for finance.  We have to decide, by mutual agreement, what is and is not allowed in the international exchange of financial services – with a view to making the system dramatically safer.

If that sounds too complicated or not appealing for any reason, consider the implicit liabilities that underpin our current arrangements – and the cases (in our chapter) of countries devastated fiscally by their financial misadventures.

If we continue to allow the free international flows of capital alongside national (and antiquated) regulatory systems, the world’s banking system will get out of control repeatedly.  Increasingly, influential people in London and other financial hubs outside the United States begin to see the issue in these terms.

An edited version of this post appeared this morning on the NYT’s Economix.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.