Professor Michael Mainelli, Executive Chairman, The Z/Yen Group
[An edited version of this article first appeared as "Rewiring Business", Financial World, IFS School of Finance (July/August 2009) page 38.]
The Credit Crunch is a systemic failure with multiple causes and multiple effects. An oligopolistic core of wholesale investment banks, auditing firms and credit rating agencies failed. There are failures everywhere in finance, all the time, but systemic failure surrounds wholesale finance, as well as an oligopolistic cabals of retail banks in the UK, Ireland and Iceland. The key point of this article is the importance of reintroducing competition.
Was the Credit Crunch a failure of the free-market or of the regulatory state? Actually, the financial markets that failed were hardly free, they were heavily regulated. None of the systemic failures has been in an offshore centre, none has been a hedge fund. The two biggest failures, Fannie Mae and Freddie Mac, had no competition and their own regulator. Financial services regulation is a religion - “regulation failed because you really really didn’t believe in regulation. So pray harder.” The religious faithful of regulation want to go much further the other way and now seek powers to follow large systemically important financial institutions, rather than question whether their large size itself might be a sign of regulatory failure.
By 2007 there were less than 20 global investment banks, 4 auditing firms, 3 credit rating agencies. If we were talking about the great internet crash of 2007 and looked at 2 billion internet users focused through less than twenty nodes, at least two of which crashed, several of which wobbled and all of which are dodgy, our analysis would simply conclude don’t concentrate on just twenty nodes. Break it up. Wholesale investment banking is no different. It is worth distinguishing competition (making sure one group does not make the rules) from supervision (knowing what is going on) from regulation (saying what should go on). In competitive markets, customers have choice and choosy customers put pressure on weak firms. People snitch on each other to the benefit of customers, supervisors and regulators. With more – and smaller – firms around, more eyes are on the ‘coal face’ of finance, watching risk and adding value to customers, while fewer are looking up the political ladders endemic to large organisations.
Bob Giffords and I term the current financial crisis, “Credit Scrunch”, in the firm conviction that much more is at stake than just recovery from current economic confusion. The strategic question facing everyone is whether the crisis is a short-term bump on an endlessly rising road to prosperity, or an apocalyptic warning that severe design faults imperil political and economic activity. Scrunch means to crush, crumple or squeeze. We believe that reacting to current events with current mindsets could lead to the scrunching of the world economy, but likewise that we may need to crush, crumple and throw away traditional responses to financial markets. We have analysed the Credit Scrunch’s two tragic flaws of regulatory dissonance and private excess, as well as the four fundamental failures of liquidity inflation, extreme connectivity, deluded demutualisation and perverse incentives. Agreed, many zones of financial services continue to thrive, such as foreign exchange, commodities trading, clearing houses or mainstream insurance, but interestingly these are highly competitive with a rich diversity of participants.
Market failure comes in three broad categories: lack of competition, information asymmetry/agency problems, and externalities. Wholesale finance certainly exhibits classic signs of lack of competition: self-evidently excessive salaries, a banking industry with 2006 profits per employee a magical 26 times higher than the average of all other industries worldwide (according to McKinsey), an industry that went from 5% of USA market capitalisation in 1990 to 23.5% in 2007, and a cast list of the top 10 that would be largely recognisable back in 1929, Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, Morgan Stanley, JP Morgan Chase, Citi,… Perverse bonuses and regulatory dissonance expose the information asymmetry/agency problems. And, whether it is third world debt, savings & loan defaults, dot.com bubbles, or Credit Scrunch problems, the burden borne by taxpayers around the world shows too clearly the externalities.
When we see market failure we should first try and fix it through trust-busting or anti-monopoly laws – the 1890s in Britain, the 1900s in the USA. Only Private Eye [2 October 2008, page 3] had the guts to call a spade a spade – “Gordon Brown promised to increase regulation to deal with collapsing financial institutions, but his biggest move so far is a massive decrease in regulation” suspending normal competition and takeover rules for Lloyds and Santander.
‘Too big to fail is too big to regulate’. Tellingly, one investment bank in the 1990s had as its strategic objective: ‘to become too big to be allowed to fail’. It succeeded. Regulation creates barriers to entry, promotes the large over the small, reduces competitive variation and opens up huge exposures to risks behind closed doors. We don’t need special rules for system or large complex financial institutions if we don’t let them get too large. Society can afford a continual, low-level string of failures rather than periodic catastrophes and expensive rescues of a few dominant players. A corollary is that ‘too big to fail is too big to manage’, as many former executives of failed firms admit.
Injecting more competition means a serious re-examination of global investment banking concentration, audit firm concentration, credit rating agency concentration and actuarial firm concentration. There are real mechanisms to discuss, re-privatising UK retail banks in many pieces, requiring audit firms to provide indemnities for audits, or removing any special status for credit rating agencies. Where are the anti-monopoly or anti-trust changes? How are we changing our measures of ‘competitive’ and ‘open’.
Competition means having companies that can fail. Competition, then supervision, then regulation, with an objective of promoting ‘open’ markets. The debate should be about ‘open’ markets rather than dogmas of ‘free’ or ‘regulated’ markets. The acolytes of regulation work best when they worship at the altar of competition.