Introduction
In "Other People's Money," John Kay takes a deep dive into the world of modern finance, exploring its evolution, current state, and the problems that have led to recurring financial crises. The book provides a fresh perspective on the financial sector, explaining complex concepts in simple terms and offering insights into why the system has become so disconnected from its original purpose of serving the real economy.
Kay argues that the financial industry has lost its way, becoming more focused on trading and speculation than on providing valuable services to businesses and individuals. He examines the history of finance, the causes of recent crises, and proposes ways to reform the system to better serve society's needs.
The Original Purpose of Finance
Improving Lives and Strengthening Economies
Finance, at its core, was designed to improve our quality of life and make conducting business easier. The financial system serves several essential functions:
- Facilitating transactions: It allows us to buy the things we need to live comfortably.
- Connecting lenders and borrowers: It brings together those who need money with those who can provide it.
- Providing insurance: It offers protection against major disasters or emergencies.
- Organizing personal assets: It helps us manage our wealth and pass it on to future generations.
One of the most significant innovations in finance was the mortgage, which made homeownership possible for many people. Mortgages benefit both borrowers, who can purchase property with a loan, and lenders, who earn interest as a reward for providing the funds.
Historical Benefits of a Strong Financial System
Looking back at history, we can see how a robust financial sector has contributed to economic growth and societal progress:
- Industrial Revolution: Strong financial systems in Britain and the Netherlands allowed these countries to become world powers during the early days of industrialization.
- Developing countries: Investments flowing into developing nations have helped improve living standards in many parts of the world.
- Contrast with communist systems: The failure of centrally controlled financial systems in communist countries demonstrates the importance of a dynamic, free-flowing financial sector for economic growth and job creation.
While capitalist freedom has led to prosperous industrialization and became a cornerstone of modern society, not all financial innovations have been beneficial. As we'll explore further, the financial industry has gradually lost sight of its original purpose and has begun to prioritize its own interests over those of society as a whole.
The Rise of Financialization
From Helping People to Trading Securities
In its early days, finance primarily focused on helping individuals and businesses obtain the capital they needed to realize their ideas. For example, a bank might provide a loan to a baker to open their own bakery. However, this focus has shifted dramatically in recent decades.
The term "financialization" refers to the rampant trading activity and massive growth in the finance sector that has occurred since the 1970s. While this growth has benefited banks and stock markets, it has had little positive impact on household income, small business growth, or the broader economy.
The Emergence of Derivatives
A major factor in the acceleration of financialization was the emergence of the derivative market. Derivatives are financial contracts whose value is based on the performance of underlying assets. They can be used for various purposes, including speculation and risk management.
One type of derivative that played a significant role in the 2008 financial crisis is the credit default swap (CDS). CDSs allow banks to protect themselves against borrowers defaulting on loans or mortgages. They function similarly to insurance: one institution promises to pay the bank in case of a default, while the bank promises to reimburse them with interest eventually.
The 2008 Financial Crisis
The proliferation of derivatives, combined with irresponsible lending practices, set the stage for the 2008 financial crisis:
- Banks issued loans to people who were unlikely to repay them.
- These risky loans were packaged into securities and traded.
- When borrowers began defaulting en masse, the system collapsed as institutions couldn't meet their obligations.
The crisis was further exacerbated by technology that made it easier than ever to trade securities and derivatives, leading to massive artificial inflation of the financial sector.
These practices amount to gambling with other people's money, which, as the recent crisis has shown, doesn't benefit society as a whole.
Changing Incentives in the Financial Sector
The Shift from Caution to Risk-Taking
Before the era of financialization, the economy was relatively stable due to a financial sector that promoted a culture of caution and long-term planning. However, today's finance sector operates as though it has little to lose, resulting in a far more volatile economy.
Misaligned Incentives for Banking Executives
In the past, banking executives were expected to invest their own money in their banks, which gave them a strong incentive to avoid excessive risks. When it came to providing mortgage loans, for example, it was in their best interest to grant them to reliable borrowers who were likely to make regular payments.
Being a bank manager was also typically a lifelong job, so executives would be around long enough to face the long-term consequences of their actions. However, the modern approach is often characterized by an "I'll be gone, you'll be gone" mentality, which involves making as much money as possible in the short term before moving on to the next opportunity.
This shift in mindset contributed significantly to the 2008 crisis, as countless mortgages were granted to people who were clearly unlikely to be able to repay them.
The Rise of Broker-Dealers
Another conflict of interest arose with the emergence of broker-dealers. Traditionally, brokers were agents who helped bring two like-minded traders together. During the era of financialization, however, brokers began making their own deals. They were no longer just earning commissions from their clients but also profiting from their own transactions.
This change meant that it was no longer in brokers' best interests to steer clients toward the best deals. A broker-dealer is now more likely to direct clients toward less lucrative trades while saving the best opportunities for themselves.
The 2008 Banking Collapse: A Predictable Outcome
The Myth of Unpredictability
Many people involved in the 2008 global financial crisis claim that it was impossible to foresee. However, this assertion is far from the truth. In reality, the crisis was the logical result of decades of dangerous and selfish decision-making within the financial sector.
The Role of Corporate Ownership
The transition of banks from largely private or family-owned businesses to corporate-owned entities played a significant role in creating the conditions for the crisis. Once banks became owned by shareholders and banking executives were in control of shareholders' money rather than their own, they were free to take much greater risks. With no personal attachment to the money, they were not held accountable for any losses that might occur.
This lack of personal stake allowed executives to be driven by greed and make deals that would either result in huge rewards or cause damage that would have no direct effect on them personally or professionally.
The Impact of Complex Financial Instruments
The introduction of credit default swaps (CDSs) and mortgage-backed securities (MBSs) further added to the lack of accountability and destabilized the financial sector. For an MBS to be profitable, the underlying mortgages and their associated payments must perform well.
The crisis began when greedy bank managers offered mortgages to people who were clearly unable to make the necessary payments. This caused the MBSs that Bank A was trading with Bank B to become very insecure. To offer added security, Bank A would also trade CDSs to Bank B, supposedly protecting themselves from possible defaults.
However, because Bank B was buying CDSs with nonexistent security from MBSs, both banks were destined to end up in deep trouble when the mortgages defaulted. In the end, both banks needed money but had none, which is why national governments then had to bail them out.
The Influence of Financial Institutions on Government Policy
Lobbying and Political Donations
The finance sector has an outsized influence on government policy, largely due to its extensive lobbying efforts and political donations. Some financial institutions even employ former government officials as consultants, guaranteeing them access to political networks and giving banks significant sway in legislatures and legal systems.
The finance sector spends more on political lobbying than any other industry. In the United States, between 2012 and 2014, the finance sector spent $800 million on lobbying, not including an additional $400 million donated to various candidates' electoral campaigns.
This level of financial involvement in politics comes with expectations, and elected officials are likely to feel a responsibility to somehow return a bank's generosity.
Government Bailouts and Moral Hazard
The massive government bailouts that followed the 2008 crisis were a clear sign of the financial sector's influence on the US government. These bailouts set a dangerous precedent by sending the message that it's acceptable for banks to be reckless since taxpayers will clean up their messes. Any lessons that could have been learned from the global disaster were quickly pushed aside.
The concept of being "too big to fail" further exacerbated the problem. Large corporate banks were aware that the government considered them too important to the economy to allow them to collapse, effectively providing them with a permanent safety net. This knowledge encouraged even riskier behavior, as the banks knew they would likely be bailed out if things went wrong.
The Complexity of Finance as a Shield
The finance sector has another important advantage working in its favor: the complexity of its deals and terminology makes it difficult for most people to understand what's really going on. Unless you work in finance, it's unlikely that you know what words like "subprime" or "derivative" really mean, and unscrupulous dealers can use this lack of understanding to their advantage when explaining away losses.
Before 2008, many people assumed that the well-paid professionals in the finance industry made rational decisions. However, the crisis revealed the truly irrational and risky behavior that had been going on for years. The sad part is, they didn't pay for these actions – the general public did.
The Double-Edged Sword of Financial Regulations
The Abundance of Regulations
Contrary to popular belief, there were numerous regulations in place when the 2008 financial crisis occurred. Some of these regulations dated back to the infamous crash of 1929 and the Great Depression that followed. However, the crisis revealed an important lesson: sometimes regulations can do more harm than good.
The Problem with Excessive Rules
When too many regulations are piled on top of one another, it becomes increasingly difficult to implement effective policy oversight. More often than not, these excessive rules simply encourage people to find new and creative ways of working around them, eventually making matters worse.
An example of this is Regulation Q, which set a maximum interest rate on bank deposits. This regulation worked until the mid-1980s when US banks began bypassing it by depositing their money into European banks that weren't subject to the regulation, and then transferring the money back to the United States. Rather than discouraging bad business practices, as the regulatory agency had hoped, it just created more work for the authorities.
The Challenge of International Regulations
One potential solution to the problem of regulatory arbitrage would be to create a set of international regulations. This is often a primary topic of discussion at G8 and G20 summit meetings. However, these meetings have yet to produce very effective results, highlighting the difficulty of achieving global consensus on financial regulations.
Complexity as a Barrier to Understanding
Another troubling reality of regulations is that they often make finance extremely complicated, which generally benefits the institutions more than their customers. Added regulations can make it harder for the average customer to understand even basic transactions. When we become dependent on supposed experts or specialists in a field, we become far more vulnerable to being taken advantage of.
The Securities and Exchange Commission (SEC) is responsible for enforcing financial regulations in the United States, and their aim is to make the system as transparent as possible. However, the average person will never know what's really going on with their money if the information available to them is so full of jargon that it might as well be in a different language.
As long as outsiders are kept in the dark, it will continue to be business as usual for the financial sector, with little real accountability or transparency.
The Need for Restructuring the Finance Sector
Restoring Trust
To prevent another major financial crisis, we need to restore trust in the financial system. This means restructuring the financial sector in a way that removes the temptation for professionals to act in their own self-interest over their clients'.
Separating Roles
One step in this direction would be to better separate the jobs in the financial system and eliminate positions like broker-dealer. This way, brokers would only be rewarded for negotiating successful deals between two parties and would be prohibited from acting as dealers and arranging self-serving financial transactions.
Protecting Savings Deposits
Another crucial step would be to protect people's savings deposits and keep them off-limits from banks and other financial trading institutions. This would serve several purposes:
- It would keep people's life savings safe in the event of another major collapse.
- It would prevent banks from using their clients' money as just another set of assets to include in their payments and trades.
- It would give a bank's traders far less of other people's money to play with, thereby reducing the likelihood they'd take on high-risk transactions.
Promoting Ethical Conduct from Within
Perhaps most important of all is to have proper ethical conduct promoted from within the financial system. Having the SEC threaten, and occasionally enforce, billion-dollar fines is clearly an ineffective way of promoting good behavior. Ethical business practices must be instilled from within the institutions themselves, by executives and leaders who set a good example and reward those who adhere to similarly ethical practices.
While this is easier said than done, every transformation has to start somewhere. By fostering a culture of ethical behavior and responsibility within financial institutions, we can begin to rebuild trust in the system and ensure that it serves its original purpose of benefiting society as a whole.
The Way Forward
Simplifying Regulations
Instead of adding more complex regulations, policymakers should focus on simplifying and streamlining existing rules. This would make it easier for both regulators and financial institutions to understand and comply with the regulations, reducing the likelihood of loopholes and workarounds.
Encouraging Long-Term Thinking
Incentive structures within financial institutions should be redesigned to encourage long-term thinking and responsible risk-taking. This could include:
- Tying executive compensation to long-term performance metrics
- Implementing clawback provisions for bonuses in cases of misconduct or poor performance
- Requiring executives to hold a significant portion of their wealth in company stock
Improving Financial Education
To empower consumers and reduce their vulnerability to predatory financial practices, there needs to be a greater emphasis on financial education. This could include:
- Incorporating financial literacy courses into school curricula
- Providing free or low-cost financial education programs for adults
- Requiring financial institutions to provide clear, jargon-free explanations of their products and services
Fostering Innovation in Financial Technology
Encouraging the development of financial technology (fintech) solutions that prioritize transparency, accessibility, and customer benefit could help create a more competitive and customer-focused financial sector. This could include support for:
- Peer-to-peer lending platforms
- Blockchain-based financial services
- Robo-advisors and other automated investment tools
Strengthening Consumer Protection
Regulatory bodies should focus on strengthening consumer protection measures, such as:
- Implementing stricter disclosure requirements for financial products
- Enhancing the powers of consumer protection agencies
- Establishing clear and accessible complaint mechanisms for consumers
Promoting Diversity in the Financial Sector
Encouraging greater diversity in the financial sector, both in terms of personnel and business models, could help reduce groupthink and promote more responsible decision-making. This could involve:
- Supporting the entry of more women and minorities into leadership positions in finance
- Encouraging the growth of community banks and credit unions
- Promoting alternative business models, such as mutual organizations and cooperatives
Conclusion
John Kay's "Other People's Money" provides a comprehensive and critical examination of the modern financial sector. By tracing the evolution of finance from its original purpose of serving the real economy to its current state of self-serving complexity, Kay highlights the urgent need for reform.
The book argues that the financial industry has lost its way, becoming more focused on trading and speculation than on providing valuable services to businesses and individuals. This shift has led to recurring financial crises, with the 2008 global financial meltdown serving as a stark reminder of the dangers of an unchecked financial sector.
Kay's analysis reveals several key issues plaguing the financial system:
- Misaligned incentives that encourage short-term thinking and excessive risk-taking
- The rise of complex financial instruments that obscure risk and create systemic vulnerabilities
- The outsized influence of financial institutions on government policy through lobbying and political donations
- The unintended consequences of well-meaning but overly complex regulations
- The lack of accountability for financial professionals who engage in reckless behavior
To address these issues, Kay proposes a series of reforms aimed at restructuring the financial sector and restoring trust in the system. These include separating different financial roles, protecting savings deposits, promoting ethical conduct from within institutions, and simplifying regulations.
The book also emphasizes the importance of financial education, consumer protection, and fostering innovation in financial technology as ways to create a more balanced and beneficial financial system.
Ultimately, "Other People's Money" serves as a wake-up call for policymakers, financial professionals, and the general public. It reminds us that finance, at its core, should serve the needs of the real economy and improve people's lives. By understanding the history and current state of the financial sector, we can work towards creating a system that once again prioritizes the interests of society as a whole over the short-term gains of a few.
The path to reform will not be easy, but it is necessary if we want to avoid future financial crises and ensure that the financial sector fulfills its original purpose of supporting economic growth and improving quality of life. As Kay argues, with considerable restructuring and a renewed focus on ethical practices, the financial sector could once again become a valuable and useful system that strengthens our economy and benefits society as a whole.