Wednesday, July 25, 2012

Trying to understand the evolution of finance

Although I'm far from an expert in finance, I'm unavoidably a part of the financial system. I pay my taxes; I try to support my family; I live in a country where I must, for the most part, arrange my life to achieve the successful financing of my own retirement, my healthcare, my children's education, etc.

So I try to pay a certain amount of attention to the overal financial system of the country, and of the world.

Recently my attention was drawn by a number of related matters:

  • Writing on his excellent blog, Felix Salmon draws attention to the ongoing discussion about the role of government oversight and regulation in the prevention of financial fraud: Why finance can’t be fixed with better regulation.
    Jim Surowiecki and John Kay both have columns today looking at the way in which regulatory structure failed to stop abuses in the financial-services industry, and wondering how we might be able to do better in future.
    The Surowiecki column is here: Bankers Gone Wild, while the Kay column is here: Finance needs Stewards, not Toll Collectors.

    Surowiecki takes a full swing against those who claim the financial world is doing just fine with self-regulation:

    Even in the absence of market discipline, self-regulation could work if institutions had strong internal safeguards against corruption. But while every institution says that it has these norms—that’s why scandals like LIBOR are always blamed on a “few rogue traders”—the track record of the banking industry over the past two decades doesn’t inspire confidence in its devotion to the truth or to the public interest.

    Meanwhile, Kay swings hard, too, but in (more or less) the opposite direction, claiming that government has no hope, and regulators are doomed to be as corrupt as those they regulate:

    Regulators come to see the industry through the eyes of market participants rather than the end users they exist to serve, because market participants are the only source of the detailed information and expertise this type of regulation requires. This complexity has created a financial regulation industry – an army of compliance officers, regulators, consultants and advisers – with a vested interest in the regulation industry’s expansion.
    I think that Kay oversteps with his broad condemnation of the corruption of government civil servants. Certainly there are problems, but in my experience there is a vast civil service full of district attorneys, police detectives, FBI agents, IRS examiners, and so forth, who are honest, ethical, have high moral standards and are truly trying to do the right thing. James Kwak generally agrees, saying
    The only thing I would disagree with is the characterization of U.S. regulators as “crudely corrupt.” Yes, many Congressmen are “in thrall to Wall Street money,” but when it comes to the staff at the regulatory agencies I think the picture is more complex and closer to the “intellectual capture” that Kay describes in Europe.
    But as Salmon observes, overall these bitter conclusions leave us in a very tough spot:
    financial-industry scandals will continue to arrive on a semi-regular basis. When they do, they will always be accompanied by calls for stronger regulation: rules-based, or principles-based, or some combination of the two. But the real problem here isn’t regulatory, and as a result there isn’t a regulatory solution. The real problem is deeply baked into the architecture of too-big-to-fail banks.
  • For a detailed look at one such regulator, and how it is coping with this problems, you might find this recent article by Ben Protess and Jessica Silver-Greenberg interesting: New York Fed Faces Questions Over Policing Wall Street:
    But there are limits to its power. Despite its leading role in policing the banks, the New York Fed cannot levy fines. When examiners do detect questionable behavior, they often push the company to adopt changes. If the wrongdoing persists, officials can pass along the case to the Federal Reserve board in Washington.

    It is up to the central bank to take action. The Fed, which can impose fines and cease-and-desist orders, filed 171 enforcement actions last year. The cases are down 44 percent from the year before, but the actions have increased sharply from the precrisis era.

  • Much of the discussion about the future of financial institutions, including all the essays in the previous paragraphs, involves the topic of trust: how does the public come to trust their government, and their corporations, and their leaders?

    The Kay Report, published this week by the UK Department for Business Innovation and Skills, takes this question as its principal topic:

    Financial intermediation depends on trust and confidence: the trust and confidence that savers who invest funds have in those they choose to manage these funds, and the trust and confidence of investors in the businesses they support. Trust and confidence are the product of long-term commercial and personal relationships: trust and confidence are not generally created by trading between anonymous agents attempting to make short term gains at each other’s expense.

    Trust and confidence, or their absence, are the product of the prevailing culture. Incentives matter: not because, as some people crudely think, financial rewards are the only human motivation – although there are some people of whom that is true, and many of them are to be found in the financial sector. Most people have more complex goals, but they generally behave in line with the values and aspirations of the environment in which they find themselves. We must create cultures in which business and finance can work together to create high performing companies and earn returns for savers on a sustainable basis

    The report is long and detailed, with many specific recommendations, though I'm not sure when I might find time to read them all.
  • On this side of the pond, a recent column by Professor Luigi Zingales of the University of Chicago Business School has been receiving a lot of attention, at least partly for its attention-grabbing headline: Do Business Schools Incubate Criminals?.

    Although the headline may be outlandish, Zingales' article is clear and direct. He takes business schools strongly to task:

    Most business schools do offer ethics classes. Yet these classes are generally divided into two categories. Some simply illustrate ethical dilemmas without taking a position on how people are expected to act. It is as if students were presented with the pros and cons of racial segregation, leaving them to decide which side they wanted to take.

    Others hide behind the concept of corporate social responsibility, suggesting that social obligations rest on firms, not on individuals. I say “hide” because a firm is nothing but an organized group of individuals. So before we talk about corporate social responsibility, we need to talk about individual social responsibility. If we do not recognize the latter, we cannot talk about the former.

    and dismisses those schools which give only lip service to ethics as being worse than those who say nothing at all:
    The way to teach these ethics is not to set up a separate class in which a typically low-ranking professor preaches to students who would rather be somewhere else. This approach, common at business schools, serves only to perpetuate the idea that ethics are only for those students who aren’t smart enough to avoid getting caught.
    Zingales' conclusion is a call to action:
    The daily scandals that expose corruption and deception in business are not merely the doing of isolated crooks. They are the result of an amoral culture that we -- business-school professors -- helped foster. The solution should start in our classrooms.
  • Finally, and on a more theoretical bent, I've been wondering for a while when the academic side of the finance profession would start to weigh in on the theoretical questions surrounding the Great Recession of 2008, questions like:
    • How exactly did mortgage securitization affect the crisis?
    • How did credit default swaps fit into the picture?
    • How are the changing non-bank entities affecting financial markets?
    and so forth. So, I was quite pleased to learn, recently, that the Federal Reserve Bank of New York is in fact sponsoring exactly this sort of research. A recent press release explains some of their efforts in detail: New York Fed Launches Blog and Economic Policy Review Series Examining the Evolution of Banking.
    Today, the New York Fed’s Liberty Street Economics blog begins a seven-part series that explores the changing role of banks in the financial intermediation process. A series of Economic Policy Review articles will accompany the blogs. Both series discuss the complexity of the credit intermediation chain associated with securitization and note the growing participation of nonbank entities within it. These series also discuss implications for monitoring and rulemaking going forward.

    You can find some of the early articles on the bank's website, where you can find articles such as: The Evolution of Banks and Financial Intermediation: Framing the Analysis

    These papers are not easy for the non-practitioner to read; even the high-level summaries are full of pronouncements such as:

    The two hypotheses imply a specific relationship between the amount of enhancement afforded and the ex post performance of the security. Namely, buffering would lead one to expect higher enhancements among more poorly performing securities, while the signaling hypothesis would imply instead that high enhancements are associated with high performance. The authors’ econometric analysis suggests that buffering investors is in fact the main motivation behind the provision of enhancement in asset securitization, thus corroborating the underlying argument that banks have played a fundamental role in supporting the modern intermediation process.
    But it's great to see that the institutions are taking a serious, detailed, and thorough look at the financial industry and how it operates. Hopefully these studies will pay off.

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