Other People's Money

The Real Business of Finance


By John Kay

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The finance sector of Western economies is too large and attracts too many of the smartest college graduates. Financialization over the past three decades has created a structure that lacks resilience and supports absurd volumes of trading. The finance sector devotes too little attention to the search for new investment opportunities and the stewardship of existing ones, and far too much to secondary-market dealing in existing assets. Regulation has contributed more to the problems than the solutions.

Why? What is finance for? John Kay, with wide practical and academic experience in the world of finance, understands the operation of the financial sector better than most. He believes in good banks and effective asset managers, but good banks and effective asset managers are not what he sees.

In a dazzling and revelatory tour of the financial world as it has emerged from the wreckage of the 2008 crisis, Kay does not flinch in his criticism: we do need some of the things that Citigroup and Goldman Sachs do, but we do not need Citigroup and Goldman to do them. And many of the things done by Citigroup and Goldman do not need to be done at all. The finance sector needs to be reminded of its primary purpose: to manage other people’s money for the benefit of businesses and households. It is an aberration when the some of the finest mathematical and scientific minds are tasked with devising algorithms for the sole purpose of exploiting the weakness of other algorithms for computerized trading in securities. To travel further down that road leads to ruin. A Financial Times Book of the Year, 2015
An Economist Best Book of the Year, 2015
A Bloomberg Best Book of the Year, 2015




From the 1970s until the global financial crisis of 2007–8, the financial sector grew in size, revenues and sophistication. The effects were felt by all businesses and households, and there were major consequences for economic policy and the political system. How did these changes come about (Chapter 1)? What claims were made for the benefits of this process (Chapters 2 and 3)? And what were the sources of the extraordinary levels of profit and remuneration that financialisation generated for financial businesses and their senior employees (Chapter 4)?



The Road to Pottersville

         A British bank is run with precision

         A British home requires nothing less

         Tradition, discipline and rules must be the tools.

         Without them: disorder, catastrophe, anarchy

         In short, you have a ghastly mess.

MARY POPPINS, Walt Disney, 1964

I was a schoolboy in Edinburgh in the 1960s. The capital of Scotland is Britain’s second financial centre and was the headquarters of two major banks, the Bank of Scotland and the Royal Bank of Scotland. Banking was then a career for boys whose grades were not good enough to win them admission to a good university.

The aspiration of many of my contemporaries was to join either ‘the Bank’ or ‘the Royal Bank’. With appropriate diligence, they might, after twenty years or so, become branch managers. The branch manager was a respected figure in the local community, and social interaction at the golf club or Rotary lunch was part of his job. He would know personally the local professionals—the accountant, the lawyer, the doctor, the minister and the more prosperous tradesmen. The bank manager would receive their savings and occasionally make loans. The regional office might review his figures, but would rely heavily on the manager’s assessment of character. He—there were no female managers—expected to spend his career with the bank, and to retire with a pension. It never crossed his mind, or the minds of his customers, that the institution he had joined at the age of seventeen would not continue for ever, in broadly its existing form.

A little later, I began my career teaching in an institution that still believes it will continue for ever in broadly its existing form: Oxford University. Few of my students then contemplated careers in the City of London, and those who did were generally less academic but socially well connected. If you had told me that within twenty years many of the best and brightest of Oxford students would spend more time preparing applications and seeking internships and interviews at City firms than they did in the library, I would have reacted with disbelief.

When my friends were joining ‘the Bank’ or ‘the Royal Bank,’ and I was beginning the study of economics, it was possible to believe that the historic problems of financial instability had largely been solved. There had been no major financial crisis since the Great Depression, and the failure of a major financial institution seemed inconceivable. My schoolmates were the last generation to aspire to fill the shoes of George Banks, the bank manager in Mary Poppins, who returned home at 6.01 each evening and expected his pipe and slippers at 6.02.

It is probably not a coincidence that the cinema celebrated the traditional bank manager—who was simultaneously a figure of fun and a pillar of the community—at precisely the moment such characters were being ushered from the stage. Mary Poppins was released in 1964. In the UK the television series Dad’s Army, a comedy about the wartime Home Guard, was a popular hit between 1967 and 1974; its lead character was the pompous, unimaginative, honest bank manager Captain Mainwaring. Frank Capra’s film It’s a Wonderful Life, though much admired when first released in 1946, was nevertheless a box office flop; but in the 1970s it became a Christmas favourite with US television audiences, and has remained so ever since. The hero was Jimmy Stewart as George Bailey, manager of the Bedford Falls savings and loan institution. Banks, Mainwaring and Bailey epitomised the role my classmates expected to assume.

That was about to change. In a scene at once comic and shocking, Bailey is shown by his guardian angel how the world might have been without him. Bedford Falls has been renamed Pottersville, after Mr Potter, the grasping member of the board who is single-minded in his pursuit of money. Pottersville is riven by self-interest and characterised by tawdry commercialism, and the housing project that was George Bailey’s great achievement is unbuilt.

Capra could never have imagined that Pottersville might actually come into being. But by the time my contemporaries accepted early retirement, the world they joined had altered beyond recognition. The causes of this transformation include globalisation, deregulation, technological and product innovation, new ideologies and narratives as well as a shift in social and cultural norms. These factors were not independent: each was bound up with the others.

Finance has always been global. The City of London became a pre-eminent financial centre as a result of Britain’s imperial role. The Fidelity Fiduciary Bank in which Mr Banks was manager financed ‘railways through Africa, dams across the Nile’. Wall Street rivalled London in scale and importance because of the size of the US domestic market and the voracious need for finance implied by the scale of its landmass. But the expansion of global trade and finance was set back by departure from the gold standard, protectionism in the years between the First and Second World Wars, and the decline of empire. The modern phase of globalisation of finance began with the development of the Eurodollar market in London in the 1960s.

In the USA, ‘Regulation Q’ meant that American banks were subject to restrictions on interest rates they could pay on deposits, and were required to hold funds with the Federal Reserve System, the US central bank, to demonstrate the security of these deposits. Restrictions could be avoided if the funds were placed with European institutions and then lent on to US banks; there were no controls on transactions between banks. Routing deposits through London therefore enabled dollar depositors to earn higher interest rates on their balances. This manoeuvre lowered funding costs for American banks while enabling European banks to earn a profit for renting out their services.

The structure of the global financial system was changing in other ways. In the immediate post-war era it was expected that America would remain the world’s dominant creditor nation. The post-war institutions of global finance, such as the International Monetary Fund (IMF) and World Bank, were designed around this assumption. But as Germany and Japan rapidly recovered from wartime destruction, and the American economy weakened in the 1960s, US economic hegemony declined, and in 1971 the dollar was devalued.

The oil shock of 1973–4 gave oil-producing countries, particularly Saudi Arabia and other states in the Persian Gulf, windfalls beyond their capacity to spend. ‘Petrodollars’ were recycled as loans to Europe and the US. Meanwhile, Japan, followed by other Asian countries such as South Korea, Taiwan and Hong Kong, first imitated and then improved modern production methods, and began to export manufactured goods to Europe and North America. After 1980 mainland China followed these countries into the world trading system. Asian export success created trade surpluses, with corresponding trade deficits in the West. As the oil producers had done a decade earlier, the surplus countries lent the funds back to those economies with trade deficits.

The scene was set for the bizarre developments of the early years of the twenty-first century, in which the forced savings of Chinese peasants (who had little choice about the economic decisions of their authoritarian government) would fund the excess spending of American consumers. The mechanism by which this was achieved was the growing dependence of Western banks on wholesale funding derived from global capital markets. These persistent global financial imbalances upset the traditional model of local depositors finding local lenders: the mainstay of traditional banking. The undermining of Regulation Q was a harbinger of the ways in which globalisation put pressure on existing—nationally based—regulatory structures.

The new financial markets were no longer a business for nice boys who had few academic pretensions but were agreeable golfing companions. By the time ‘the Bank’ and ‘the Royal Bank’ failed in 2008, most of their senior executives had good degrees from fine institutions of higher education. Andy Hornby, CEO of ‘the Bank’, had won an MBA from Harvard after graduating from Oxford; his counterpart at ‘the Royal Bank’, Fred Goodwin, had acquired qualifications in both law and accountancy after graduating from the University of Glasgow. The two dominant figures on Wall Street—Lloyd Blankfein of Goldman Sachs and Jamie Dimon of J.P. Morgan—were Harvard alumni, from its Law School and Business School respectively. The best students from Oxbridge and the Ivy League clamoured for jobs in the City and on Wall Street.

Larry Summers (of ketchup economics) described the transformation in this way: ‘In the last 30 years the field of investment banking had been transformed from a field that was dominated by people who were good at meeting clients at the 19th hole, to people who were good at solving very difficult mathematical problems that were involved in pricing derivative securities.’1 Summers (whose friends and enemies both know he is better at solving mathematical problems than schmoozing clients) reported this shift with evident approval.

Yet these cleverer people managed things less well—much less well—than their less intellectually distinguished predecessors. Although clever, they were rarely as clever as they thought, or sufficiently clever to handle the complexity of the environment they had created. Perhaps the ability to meet clients at the nineteenth hole is more relevant to making good investments than the ability to solve very difficult mathematical problems.

There may be less need today for the networker, the individual who knows whom rather than what; technology helps make connections, although personal relationships remain important. But there remains a need for individuals with the skills necessary to assess the quality of the underlying assets and the abilities of those who manage them. People with good understanding of the residential property market and experience in judging the capacity of prospective purchasers to meet their debts. People with knowledge of shops and offices and the finances of their tenants. People familiar with the financial operations of government, and with the management of large infrastructure projects. Above all, people with insight into the changing nature of business.

But the skills that were valued in the finance sector that had developed in the first decade of the twenty-first century were very different. The exercise of these skills by people with an exaggerated idea of their relevance and of their own competence in managing them plunged the global economy into the worst financial crisis since the Great Depression.

How did these changes come about? In the remainder of this chapter I will begin by explaining the two main components of financialisation: the substitution of trading and transactions for relationships, and the restructuring of finance businesses. I shall then move on to the broader economic effects of financialisation on economic stability, on the performance of business and on economic inequality.

The Rise of the Trader

         No sooner did you pass the fake fireplace than you heard an ungodly roar, like the roar of a mob . . . It was the sound of well-educated young white men baying for money on the bond market.

          TOM WOLFE, The Bonfire of the Vanities, 1987

         We are Wall Street. It’s our job to make money. Whether it’s a commodity, stock, bond, or some hypothetical piece of fake paper, it doesn’t matter. We would trade baseball cards if it were profitable. . . .

         We get up at 5am & work till 10pm or later. We’re used to not getting up to pee when we have a position. We don’t take an hour or more for a lunch break. We don’t demand a union. We don’t retire at 50 with a pension. We eat what we kill, and when the only thing left to eat is on your dinner plates, we’ll eat that. . . .

         We aren’t dinosaurs. We are smarter and more vicious than that, and we are going to survive.

          Reported by STACY-MARIE ISHMAEL, FT Alphaville, 30 April 20102

A shift from agency to trading, from relationships to transactions, is a central aspect of the financialisation of Western economies in the past four decades. The world of George Bailey was one of relationships with customers, borrowers and depositors. This was true of most areas of finance. Like the bank manager, the stockbroker would befriend his clients. He would be personally familiar with the companies he recommended to them. Investment banks maintained long-term relationships with large companies. They would have similar connections with institutions such as the insurance companies that channelled the capital of small savers.

The world of finance today is dominated by trading, and trading is a principal source of revenue and remuneration. Fifty years ago there was one large speculative financial market: the stock exchange. The volume of trading in it was, by modern standards, modest: the average holding period for a share was seven years.3 The stock exchange was also the place where government bonds were traded, but the bond market was sleepy in the extreme. Nick Carraway, the colourless narrator of F. Scott Fitzgerald’s 1925 novel The Great Gatsby, was a bond trader. The London Metal Exchange was the global centre for trade in copper, tin and other ‘hard’ commodities. ‘Soft’ commodities had their own exchanges. The Chicago Board of Trade (and its spin-off the Chicago Butter and Egg Board) was the centre of American trade in agricultural products. Shipping contracts were concluded on the Baltic Exchange. Twenty-five years ago the key location was shifting to the trading floor of investment banks. Today the screen is the source of information and the basis of trading: an increasing proportion of trade is conducted by computers silently trading with each other.

Anonymous markets have thus replaced personal relationships. A century ago the German sociologists Ferdinand Tonnies and Max Weber articulated this change by describing the difference between Gemeinschaft and Gesellschaft, words that lack precise equivalents in English but which broadly distinguish the personal and the informal from the formal and the regulated.4 The transition from Gemeinschaft to Gesellschaft is fundamental to understanding the processes of financialisation, and global differences in the methods of finance and the management of risk.

The rise of the trading culture has no single explanation but is the product of a series of developments, interrelated in origin and cumulative in impact. The globalisation of financial markets was part of the story, and so was the breakdown of the global financial architecture devised by the Allied Powers in 1944 in a conference at Bretton Woods (a beautiful location in remote New Hampshire intended to be difficult to access from New York or Washington). The creation of new markets in derivative securities, and the development of the mathematics of financial markets needed to analyse them, was another factor. Regulation and deregulation played a large, but partly accidental, role: few of the consequences of regulatory policy changes were intended. Institutional reorganisation played a part; traditional forms of business organisation, such as the partnership and the mutual, were folded into public limited companies. The support for free markets that followed the elections of Margaret Thatcher and Ronald Reagan influenced public and business policy in many ways.

The list of factors contributing to the change is long, and has one striking feature: the change in the nature of finance had little to do with any change in the needs of the real economy. Those needs remain much the same: we need financial institutions to process our payments, to extend credit, to provide capital for business. We want financial institutions to manage our savings and help with the risks we face in our economic lives. Some aspects of these services are better; many are not. Information technology has changed the ways in which financial services are delivered. But there has been no transformation in the services provided to customers comparable to the transformation in the nature and political and economic role of the industry that provides them. The process of financialisation had its own internal dynamic.

The USA’s abandonment of the gold standard in 1971 ushered in a new era of flexible exchange rates, which fluctuated far more than most economists had anticipated. There had always been speculative activity in foreign exchange markets, but as the post-war system of fixed rates established at Bretton Woods came under more and more pressure, the typical speculator was no longer an individual dealing on his own account but a trader employed by a large financial institution. The traditional business of converting foreign exchange for customers (and making an appropriate margin on the conversion) became linked with taking positions in currencies to benefit from anticipated changes in their value.

The Chicago Mercantile Exchange (CME) is the successor to the Chicago Butter and Egg Board. Futures contracts, which enabled a farmer to agree today a price for the produce he would bring to market in three months’ time, had been traded on the CME for many years. An innovative chairman of the CME, Leo Melamed, launched a financial futures contract in 1972. The idea was to apply the same type of contract to foreign exchange and subsequently to other financial instruments. Butter and eggs would soon be left behind.

This was the beginning of the development of markets in derivative securities. It is not a coincidence that the University of Chicago was then and is today a leading centre of the study of financial economics. In the following year two members of its faculty—Fisher Black and Myron Scholes—would publish a seminal paper on the valuation of derivatives.5 Much of the growth of the financial sector in the three decades that followed would be the direct and indirect consequence of the growth of derivative markets. Futures were not the only kind of derivative. An option gave you the right, but not the obligation, to buy or sell—you could use an option to insure yourself against a rise, or a fall, in price.

But you didn’t have to own a pig to sell pork belly futures: you might simply want to bet on the price of ham. And you didn’t have to plan to travel abroad, or buy foreign goods, to trade currency. As derivative markets grew, people used them to back their judgement on more or less anything—not just foreign exchange, or interest rates, but the possibility that a business might fail, a mortgage would default or a hurricane would strike the East Coast of the USA.

This revolution in the technology of finance was matched—indeed was only possible because of—the parallel revolution in information technology. When trading in financial futures began, the Chicago Mercantile Exchange still centred on ‘the pit’, in which aggressive traders shouted offers as they elbowed deals away from their colleagues. Today every trader has a screen. The Black–Scholes model, and the many techniques of quantitative finance that came out of Chicago and elsewhere, could not have been widely applied without the power of modern computers.

Regulation also promoted the growth of a trading culture. The growth of the Eurodollar market demonstrated that regulatory anomalies could be used by banks to attract business. And by countries. Governments that promoted the interests of these banks could make regulatory arbitrage easier. The Bank of England, which in the 1960s saw advocacy of City of London interests as one of its principal functions, actively encouraged the growth of the Eurodollar market. Regulatory measures intended to make the financial system safer may, as Regulation Q had done, have had the opposite of the intended effect: the consequence of the rule was to increase system complexity and to take transactions out of the regulatory net altogether. Inability, or unwillingness, to learn that broader lesson about regulation would have severe, and continuing, consequences.

Regulation Q was one of the many reforms introduced as a result of the Wall Street Crash. But the most important was the establishment of a Securities and Exchange Commission (SEC) with broad regulatory oversight of the activities of financial institutions and listed companies. The agency’s title is revealing. The focus of regulation was on securities and exchange. The new commission would be performing its task well if it facilitated the issue of securities and promoted exchange. As the agency increased the scope of its activity, if not necessarily its effectiveness or authority, that philosophy permeated the regulation of finance. And not just in the USA: the SEC would become a model for the regulation of financial markets around the world.

In the 1980s fixed-income trading was added to the list of active markets. Bond trading had previously been a backwater for the likes of Nick Carraway: in London it was an activity in which success depended largely on being born into the right family. Lew Ranieri had been born in Brooklyn, and not to the right family—he had begun his Wall Street career in the mailroom of Salomon Bros. But his invention of the mortgage-backed security would transform the bond market. The growth of securitisation, not just of mortgages but of all kinds of financial claim, changed the nature of banking for ever. Such securitisations eventually extended to the future royalties of pop stars (David Bowie raised $55 million in this way) and the revenues of film studios (Dream-Works) and entire football teams (Leeds United).

The mortgage-backed security consisted of a tradable package of mortgages. This idea could be applied not just to mortgages but also to other consumer loans—credit card balances, for example—and to small business loans. Credit and interest rate exposures, traditionally managed within banks, could be reduced or eliminated through markets. Swap markets enabled banks to manage interest rate risk: a loan whose rate was variable annually might be exchanged for a loan fixed for ten years.

These markets received a boost later in the 1980s, when the Basel rules on bank lending tended to treat asset-backed securities more favourably than the assets that went into them. Rating agencies—businesses such as Moody’s and Standard & Poor’s (S&P)—had diversified from their original business of commercial credit assessment into assessment of the credit quality of bonds. In the 1970s two changes occurred that gave rating agencies a central place in the financialisation process. The agencies began to charge issuers of securities for their services as well as—or, increasingly, instead of—investors, and they achieved regulatory recognition as ‘Nationally Recognised Statistical Rating Organisations’.6 Many financial institutions and regulatory bodies restricted investments to securities that met standards laid down by a rating agency. Ratings determined the regulatory risk-weighting of securities. The banks that created asset-backed securities paid the rating agencies—which appreciated that there was a competitive business in supplying such accreditation—and the banks ‘reverse-engineered’ their products to fit the agencies’ models. Many investors and traders did not care much what was in the package so long as it achieved the required credit rating. The collapse of the asset-backed securities market would be at the centre of the global financial crisis.

The elements of the new trading culture—based around fixed income, currency and commodities, and turbo-charged by derivatives—were now in place. Markets in shares were no longer the centre of speculative activity. Fixed interest, currency and, later, commodities (FICC) were central to the new trading culture. Sherman McCoy, the vainglorious anti-hero of Wolfe’s 1987 novel The Bonfire of the Vanities, was, like Nick Carraway, a bond trader.

But the environment in which McCoy worked was very different from that experienced by Nick Carraway. The changes that occurred in the structure of financial services firms are described in more detail below, but within these firms the dominant ethos changed radically. Wolfe’s fictional account satirises the new culture of financialisation, but the contemporaneous account of Michael Lewis’ time at Salomon Bros, where Lew Ranieri had made the firm a market leader in bond market innovation, demonstrates how little exaggeration was contained in Wolfe’s caricature.

The world Wolfe and Lewis described was aggressively male (there would in due course be a few women traders, but the links between testosterone and trading would become the subject of serious academic research).7 That world is full of obscenity, fuelled by drugs—notably cocaine—and given to sexual and alcoholic excess. Young men—some with high educational qualifications, some with none—suddenly found themselves in possession of amounts of money far in excess of those they were capable of handling.


On Sale
Sep 22, 2015
Page Count
352 pages

John Kay

About the Author

John Kay is a visiting professor of economics at the London School of Economics and a fellow of St John’s College, Oxford University. He is a director of several public companies and contributes a weekly column to the Financial Times. Kay is the author of nine previously published books and coauthor of The British Tax System with Mervyn King. John Kay lives in London. Follow him at @JohnKayFT and johnkay.com.

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