This snapshot taken on 07/04/2010, shows web content selected for preservation by The National Archives. External links, forms and search boxes may not work in archived websites.
Newsroom & speeches
08 March 2010
In August 2007 a shock to global credit markets sparked what would become the most severe financial crisis in a century.
It is a crisis that we are only now emerging from and one that has claimed more than just some of the world’s oldest and most-storied financial institutions.
It has been a crisis that has seen 200 million people around the world lose their jobs. A crisis that saw world trade contract for the first time since the Second World War and a simultaneous and very significant deterioration of government fiscal positions in all of the world’s major economies.
An unprecedented global response from governments has meant that many millions of jobs that would have otherwise been lost around the world have been protected; here in the UK the number of repossessions and insolvencies is much lower than we would have feared just 12 months ago; and the vast majority of our international financial infrastructure has been preserved with no depositor in a UK bank losing a penny of their retail deposits.
But this response has come at a heavy price and with significant controversy. With a difficult period of public spending consolidation ahead and initially relatively subdued economic and job growth, there has been anger as banks have rebounded from the crisis by paying huge bonuses and with several posting record profits. There has been a widely held view that the crisis had negative consequences for everyone except those that caused it in the first place.
It is both unsurprising and completely appropriate then that we have spent the last two years engaged in intensive debate on global financial sector reform. At the domestic, European, and international level financial regulatory news has become front page news, with demands for change made by everyone from callers on talkback radio stations to leaders sitting around the head table at the G20 and G7.
We have had everything from fury over bank pay, calls to break up banks, proposals to tax the sector down to size, plans to reshuffle regulatory responsibility, pleas for nationalisation, and persistent gripes from some isolated quarters that we just should have let the whole system fail.
I for one welcome the intensity of debate. The financial sector has in the past hardly ever enjoyed the scrutiny that should come hand-in-hand with its power over our lives. But lost in the noise and heat of this debate has been a vital reflection on exactly what we want from financial markets. Without that reflection, securing the full range of reforms that will be necessary for real change is very difficult.
How can a consensus be built around fixes without describing how we want things to work and why they failed to work in the first place?
This is a reflection I want to attempt today. In my comments, I will explain how reasonable support for the market economy became something more dangerous over the last thirty years – a blind faith in the efficiency of markets and what might be called a pervasive market fundamentalism. This fundamentalism had the perverse effect of eroding healthy market discipline. We became so confident in models and numbers that we allowed ourselves to relax in our duties as market actors.
I will elaborate on a number of current and recent examples where markets have not delivered. I will discuss what the Government is doing to repair the system. But I will argue strongly that it is not just government that must act – we can make the system safe, we can work to make it more fair, but we should not be expected to force every market actor to play their basic roles. It is time for greater recognition of the value and self-interest market actors should see in scrutiny, engagement, and the basic scepticism that are required for effective market discipline.
My views on these topics have been shaped by the crisis of the last two years although they have been evolving since the mid nineteen nineties when I first produced two reports for the old DTI (when Michael Heseltine was the Secretary of State) on the need to address market failures in governance and investor stewardship. And my views here are unabashedly pro-market – the failures we have seen have not been failures of the market economy. They have been failures of men and women who forgot that market discipline meant that they themselves had to be disciplined in order to get results out of the marketplace. Too many people got complacent and lazy – and the market responded as we should have predicted, by extracting great costs from a great number of people; some deserved it, but many did not.
The efficient market hypothesis was first articulated around forty years ago by Eugene Fama of the University of Chicago. Though it has several variants, at its core is the belief that prices reflected in markets are always correct, based on the full sum of all public information at all times. If a price is inefficient at any time, it is instantly corrected by another player who seeks to benefit from the error, make a profit, and correct the price in the process.
Roger Lowenstein illustrates the sentiment behind the hypothesis with a joke about two economists who spot a $10 bill on the ground. As the first economist moves to pick it up, he is stopped by the second, who points out that if it was really a $10 bill, it would not be there anymore.
I do not need to get into the detailed background of the hypothesis in this discussion. What matters about the theory is what it allowed market actors to believe.
If markets were efficient and prices were perfectly set, it implied that most people in the marketplace were rational. Those that were not rational in their price setting, were offset by those that were also irrational, but in the opposite direction – the over-pricers are cancelled out by the under-pricers. Prices may be random and potentially impossible to predict, but it all works out in the end. Markets produced safe valuations on which we could rely.
And it was this comfort – that markets and indices and option pricing were the manifestations of immutable laws of economics – that is the most damaging legacy of the hypothesis. It was a comfort that Robert Shiller described as “the most remarkable error in the history of economic theory”.
For what the comfort blanket of efficient markets went on to provide was a platform for a wave of a distorted market fundamentalism that has taken three decades to effectively challenge, and one that still needs to be rooted out. Beliefs in laws of economics and a view of the field as a quasi-natural science instead of a social discipline allowed for a remarkable proliferation in mathematical modelling and the emergence of a dangerous sense that risk could be predicted accurately – or even eliminated. This confidence in markets also blinded us to the limitations of markets and insensitive to the plight of those for whom markets alone could never deliver good solutions.
An excellent feature in the Economist earlier this year charted the incredible rise of ‘the Quant’ inside the financial services industry. The first traders to use models worked in Chicago’s famous option exchange, using formulae provided by the economist Fisher Black. Though the early model-reliant traders were taunted by their peers and told to “trade like [men],” models quickly came to rule the world’s trading houses. In the 25 years to 2005, the number of quantitative analysts grew by five fold in terms of their share of overall financial sector jobs, and over that same period these folk enjoyed huge increases in pay.
Let me be clear that there is nothing wrong with rigorous analysis of trends in the marketplace. Quants have a role to play and produce important work. But the models they produce and the advice they provide became regarded in too many firms as the utterances of oracles, rather than just a part of the information mix. Investors became accustomed to being told by quants that if they put up x they would get y – it’s that easy. The rise in high frequency trading – with terminals located closer to the trading floor to gain nano-second advantage – further demonstrates the power of models to ‘predict’ markets, generating high volumes of market trades.
But that is, of course, a fallacy. We can try very hard to understand the way markets will behave. We can look to the past to try to gain an understanding about the way shares and investments may behave in the future. But investing and speculative activities are never more than well-informed guesswork. The unexpected can and will happen – you cannot plan for every eventuality. Any investor (or regulator) that forgets that does so at his or her own peril.
But many, many did forget that. The view of the marketplace as a field of competition, hard work, and above all else a place of trial and error was gradually supplanted by the view of the market as a force that could be harnessed, tamed, predicted, and fully hedged.
We should note that the ascendancy of efficient market hypothesis and quantitative modelling did not create this shift on their own. They were greatly assisted by the widespread discrediting of the state in the 1970s. Against a backdrop of ham-fisted attempts to control prices that led to inflation, of major economies being bailed out by the IMF, of inflexible labour market policies with stubbornly high unemployment, and ill-advised interventions in currency markets, by the turn of the 1980s the case against the interventionist state seemed well and truly made. Regan and Thatcher were on hand to condemn and bury it.
Efficient markets and models stepped into the void and provided the international momentum for an unwinding of financial sector regulation and a resulting boom in the financial services industry. There were plenty of bumps on the road from the early eighties regulatory changes to the meltdown of 2008 – Black Monday in 1987, the S&L scandal, pensions mis-selling the collapse of BCCI and Barings, the dot com bubble, the Arthur Andersen-assisted deification and destruction of Enron, just to name a few.
But even as it took heavy blows, market fundamentalism continued to grow in force. And attempts to constrain it and challenge it were met with fierce resistance. It seemed very little could be done to tame investor appetite for the profits that models promised them and efficient markets would surely deliver. The prevailing wisdom was pro-market with positive encouragement of liquidity and trading activity to facilitate “price and value discovery” and “direct” economic outcomes. Markets and market activity became a good in themselves – in many respects increasingly detached from the purpose of bringing together suppliers and users of capital.
Martin Hutchinson pointed last year to the amazing scale of derivative trading as an example. By the end of 2008, total outstanding derivative contracts stood at a combined $514 trillion. Now on the face of it you might say that derivatives are the ultimate admission that markets are not predictable – derivatives exist to defend against the unexpected and unknown risks to investments. But Hutchinson pointed out that $514 trillion is ten times the size of global GDP – there simply are not $514 trillion of risks to hedge.
I for one am a firm believer in the value of derivative markets. The UK is a world leader in derivative trading and our domestic market needs to be supported and defended.
But I challenge anyone to say with a straight face that everyone with money tied up in these hundreds of trillions worth of derivative contracts knows absolutely everything about how their investments are generating profits – or more recently – significant losses.
Michael Lewis has recounted the tale of a bright young analyst at Grant’s Interest Rate Observer who was asked by his editor to figure out how Collateralised Debt Obligations worked in order to inform the newsletter’s readers. The editor knew that with hundreds of pages of contractual and explanatory documents sitting behind CDOs that it would be a complicated task, but assumed that an analyst with an MBA who also happened to be a trained chemical engineer would be as well placed as any to make sense of the instrument. But after several days the analyst abandoned the task, declaring CDOs too complicated to understand, and started asking questions about how on earth so many people had become tangled up in the instruments.
It is possible to point to the case of the CDO, which we all now know can be a very dangerous derivative, as the quintessential example of the perils of market fundamentalism. I am sure many thousands of traders and investors were presented with models about the likely performance and value of CDOs backed by subprime mortgages. I am sure the majority of these models were created by people who genuinely believed they were providing sound advice.
But we cannot explain away the fact that many, many people entered into CDOs without having the slightest idea what they were doing. They had faith in the models. They had faith in the markets. They suspended reasonable judgement. And they made some very costly bad decisions.
My central point here is that an unswerving confidence in the efficiency of markets became an excuse for many to simply rest on their laurels. Making money is about hard work. It is about taking risks and just as importantly owning up to the fact that you are truly taking risks. And that means being smart, being at least minimally sceptical, and thinking through things before you do them.
But for the market fundamentalists, making money was about following formulae, plugging in the numbers, sitting back, and waiting for exactly what you predicted to happen to happen.
The crisis of the last two years should be one unholy reality check for the fundamentalists. The market did not fail. People failed. Like an over-confident swimmer caught in a riptide, they disrespected the power of the market and were pulled out to sea.
So what is to be done? How do we make the system work better? How do we move on from an age of market fundamentalism to a new era of genuine market discipline?
These are important questions, but we cannot address them before acknowledging a very significant feature of the crisis.
One of the injustices of the crisis is that the story did not end with the swimmer being taken out to sea. That swimmer, the financial industry, did not get pulled out on its own. It dragged with it the savings of our families; the jobs of our workers; the viability of millions of small businesses. And faced then with unprecedented, sweeping, and irreparable damage to the real economy, governments around the world had no choice but to send out the most expensive flotilla of lifeboats ever assembled to save the system.
Let me leave you in no doubt – saving the world’s financial system was unquestionably the right thing to do.
But in the process of saving it, we protected those very market fundamentalists who caused the crisis from the consequences of their actions. The risk is now that their confidence has not been sufficiently dented; that they have not truly learned their lesson. And the danger with this moral hazard is that they could put us all at risk again.
This is why a central part of restoring true market discipline to the world financial system must be major reform globally to the way banks and financial firms are governed and regulated.
Our reforms of the system must have three goals.
First, we must make the system safer and stronger.
We will introduce much more stringent capital and liquidity requirements. Firms will have to hold more capital overall. The capital they hold will have to be of a higher quality. And where their activities are deemed to be particularly risky they will have to hold even more capital against them. UK banks are now among the best capitalised in the world, and are much safer than they were just a year ago. We will take our reforms of capital standards forward through a coordinated global process, both at Basel and the EU level. The FSA has already begun to implement important new liquidity standards that will also be adopted internationally. The FSA has played a valuable role in leading global debate on these issues – working to achieve a more reliant global financial system. We need to build global consensus on common standards. The UK cannot unilaterally adopt standards which are significantly more demanding than in competitor countries without consequent disadvantage to the UK economy in terms of the availability or cost of credit. Nor should anger at the behaviour of some banks blind us to the fact that banks need to be profitable if they are to generate capital to support customer needs.
Part of making the system safer and stronger will also be making sure incentives for bank staff are aligned to the long-term health of their institutions. That is why the G20 has agreed to major reforms in the way bankers are paid with the UK Government unapologetically leading the world in implementation of deferral, clawback, and disclosure requirements. David Walker’s proposals will be implemented to give shareholders much more power and information to shape remuneration policies at banks.
Our second goal must be to make the system fairer for its everyday consumers – those people with mortgages, with pensions, with savings and current accounts. On this count, we are far ahead of the game. 10 years ago the UK mortgage market was entirely unregulated. Consumer protection had not been seen as a major priority. Gordon Brown as Chancellor moved to reform this, by establishing the FSA and giving it a mandate to see that customers were treated fairly. We did not have anywhere near the level of extreme exploitation of lower income people that caused the subprime crisis in the US and the fuel for the credit crunch.
But there are still over 500 different types of mortgage products on offer in this country and many people still are still faced with impenetrable language when they try to understand mortgage and pension provisions. That is why we have already proposed much greater transparency of contract provisions, mandatory income verification by banks before issuing mortgages, and a full suite of reforms to make financial products work in the interest of their buyers. We will also shortly be making announcements about the next steps in providing free money guidance to the general public so they no longer have to rely on the sellers of products for advice on what to purchase.
But it is the third aspect of our reform process that is the most important element for this discussion today.
It is the goal of this Government to make sure financial markets can punish just as easily as they reward. A lot of people lost money in the financial sector over the last few years – bank shareholders in particular suffered massive losses. But many people have been protected. Creditors have been bailed out. Far too many bankers themselves have enjoyed massive awards during the crisis, even as their firms were rescued. Counterparties, most famously those with ties to AIG, have been bailed out handsomely.
If we do not address this issue, we will have no hope in restoring true market discipline – the fundamentalists will get right back to business.
We are determined to make sure that no bank is too complex to fail. At Pittsburgh in Sept last year, it was agreed that we need internationally consistent recovery and resolution plans (living wills) for large cross border institutions. Our legal requirement for living wills is the centrepiece of our reform effort, and one of the most radical proposals in global financial reform in a century. Banks will have to keep detailed information on their counterparties at all times. They will have to prove that their corporate structure is not a source of risk in the event of crisis. They will have to prove to the FSA that if they got into trouble, they were structured in a way that allowed us the option to protect retail depositors while letting the rest of the firm fail. Work on living wills will be implemented alongside our important work to make sure we can manage the failure of investment banks in a calm way that does not overly rattle wider financial markets, thus making the threat of failure that much more palpable.
We are serious about removing the safety net that has allowed those with blind faith in market efficiency to ignore the consequences of their lack of discipline. We are also working with G20 countries and the IMF to assess the feasibility of an international levy or fee on financial institutions. This will make sure than any residual insurance that banks are perceived to enjoy even after living wills are implemented will not come for free.
In the past the implicit support of the financial industry has probably represented the most expensive public subsidy provided to any industry in any part of the British economy – vastly exceeding that paid to agriculture or the defence industry. There is no reason why the public, taxpayers, should continue to provide a free at the source of delivery subsidy to the cost of capital of the banking system. We need to do everything we can to shrink the subsidy to zero.
Regulation can also open up markets in a fairer way to all market participants. The Financial Services Bill will give new powers for consumers to seek redress through the courts, establish a new independent consumer education and information body and take forward the national rollout of a free national Money Guidance service.
So we will pursue a global reform agenda that makes the system safer and fairer, and will also make sure that mistakes can be punished.
But if we are going to fully overcome the anaesthetising effect of efficient market theories, the women and men who have money in the market are going to have start behaving as if they have something to lose. Because let me assure you, I believe they are already losing very substantially due to behaviours that can only be attributed to a lack of personal market discipline.
Let’s consider just a handful of examples.
First, take the significant increase in equity underwriting fees charged by investment banks. Over the past year, the risk of these underwritings has halved as rights issues have been heavily discounted and pre-marketed. Yet the fees charged by investment banks have doubled.
Fears of volatile markets do not even come close to explaining this pricing failure. Underwriting services are increasingly offered to hedge funds or others who have no long-term stake in the company; long-term shareholders are being short-changed. Only the unquestioning approach of consumers of investment bank services can be blamed.
What about takeovers? Takeovers are one mechanism for addressing poor management, but we know that they frequently fail to deliver on promise and allow no voice for other stakeholders, including employees and key customer and suppliers.
Our national predilection towards takeovers reflects the pressure on our fund managers to lock in 'pops' in the share price of the target company to enhance quarterly performance. Questions are rarely asked about whether the short term and long term are aligned. J.M. Keynes said that the long-term is a series of short-terms, but it is far from clear to me that institutional shareholders have always best served long-term interests of their clients by accepting take-over offers which might lift the current quarters’ investment return but at the expense of selling high quality focussed businesses to the shareholders of another company or other investors.
Bankers at RBS may have thought that buying ABN Amro would have been good for their bonus potential, but there were plenty of warnings that it wasn’t going to be good for owners; and this isn’t an isolated example.
The Takeover Panel is looking at these issues, and Lord Mandelson has made it clear that the Government is open to reform.
As he said in his Mansion House speech last week, this is a time to take a fresh look at this issue, and the decision by the Takeover Panel to consult on the Takeover Code is welcome.
At the moment, the Takeover Code is, for good reason, focused on protecting the interests of shareholders in the target company requiring all shareholders to be treated equally, given necessary information and advice. The code says little about the interests of the bidder company, and yet academic and anecdotal evidence (ask the shareholders in GEC) suggests that where a takeover leads to very bad outcomes it is normally at the expense of the bidding company and its shareholders.
A thorough review of takeover practice in the UK would require a critical focus on this issue, supplementing the current protections offered by the code to shareholders in the target company.
Similarly, I would encourage the Takeover Panel in its forthcoming review to produce a paper comparing and contrasting the range of responses available to a target company and its board in the UK compared with practice in other jurisdictions. I would particularly encourage the giving of serious consideration to a requirement that shareholders in the target company (as opposed to the board of directors) should be entitled to receive independent advice on any proposed purchase of the company from a qualified party having no financial interest in the outcome.
But ultimately, the call for change will not come from the Government. The owners of firms that have lost so much from ill-advised takeovers must generate the momentum for reform.
Finally, I have observed elsewhere that over the last decade net returns to investors in a basic basket of bank shares have been around zero. Over these same ten years, bank staff have taken home hundreds of billions in bonuses. How on earth has this happened? Owners are allowing employees to take all the benefits of the upside with no real exposure to the downside. Investors are losing out. Now, no investor finding him or herself in the position of being the sole, controlling, shareholder would have accepted this. But when shareholders diversify risk, they diversify their attention and have accepted sub-optimatal outcomes. This should also surely be of concern to regulators, who need to have confidence that the capital providers will ensure that their businesses are well run.
This is something shareholders themselves must want to fix.
You can also look at the behaviour of many professional investors to see evidence of inadequate market discipline. Earlier in this lecture I spoke about consumers not always being able to make the right decisions in connection with their personal finances, but the same could be said about certain aspects of professional investor behaviour - why do they spend so much money on active stock selection and so little on governance; why do trustees agree to lend shares that they own to hedge funds and others who might use these shares to drive down the value of their investment? Why is trusteeship the last bastion of amateurism in investment?
I believe that some of the issues I have highlighted have been exacerbated by the ascendancy in recent years of focus on relative investment returns as opposed to absolute investment returns - that is to say comparing performance with other similar funds or managers (where a ‘good outcome’ could be losing less than others!) rather than getting the right incremental return for each incremental unit of risk. This approach is contrary to fundamental economic assumptions that every market participant is seeking to be at the frontier of optimal market outcomes. It is a nonsense which we saw at work during the dot.com boom when many investors and analysts ended up investing in the shares of companies where they did not have the foggiest idea about what the company did or the risks in it’s business model. Similar herd-like behaviour was evident during the banking crisis when bank directors and senior management took comfort from the fact that other banks were following the same strategies, buying the same assets, adopting the same funding approach.
This approach was evident in the statement in July 2007 by Chuck Prince, the then head of Citigroup who said ‘when the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing’. Chuck Prince saw the problems but he clearly concluded that the market would not allow him to leave the party while the music was still playing and everyone was having a good time.
This tendency to herding invariably exaggerates extremes of valuation - the momentum created by all market participants acting can lead to significant contagion and systemic risk. This is why we have to ensure that the reform agenda includes an important focus on macro prudential regulation and the creation of forces which lean against the wind in checking the pro-cyclical tendency of markets.
There are many more similar issues. The point I want to make is that those who espoused efficient market dogma believed that rational forces guided market behaviour, and that any irrational behaviour would be offset along a nicely distributed bell-curve of outcomes.
But what these examples show is that many people in the market are not behaving rationally. It is time for real discipline from investors, from owners, and from anyone who has something to lose in the marketplace. Captain Renault observed when he walked into the casino in Casablanca: ‘I’m shocked to find that gambling is go in on in here’ – we should never find our selves shocked again. We should do everything we can to make sure failures of market discipline get the scrutiny and condemnation they deserve.
