Tuesday, 29 May 2012

"Heads I win, tails you lose."

I was at a private lunch in the City some 15 years ago discussing whether hedge fund investments should be considered a new and distinct asset class. A very prominent hedge fund trader was asked his opinion. Surprisingly, he said that hedge funds were less a new method for investment, than a new method for higher remuneration. The appeal of hedge funds was in the outsize fees rewarding the fund managers rather than any superior returns for investors.

I was reminded of that lunch again this morning by two pieces in my inbox. The first referenced a paper from the Bank of England estimating the public subsidy of the UK's largest banks at more than £220 billion during the past couple years. These banks secure a funding premium in wholesale and deposit markets from the implicit state guarantee of obligations attaching to their too big to fail status. The subsidy distorts competition and risk taking, storing up even more future draws on beleaguered taxpayers. The second was a blogpost summarising recent comments of a Bank of England executive to the effect that all the cost savings generated by technology advances and automation in the banking sector had been paid away in increased bonuses and remuneration. IT efficiency gains fund bonus payments. The financial sector's appetite for technology investment is not driven by a desire to provide more efficient services, but to secure ever larger remuneration packages. In fact, rapid financial innovation and technology transformation has led to less efficient intermediation if evaluated on a cost basis.

Regulation has had a pernicious effect in driving technology and complexity. As Chris Skinner observes,
Put another way, in the first iteration of the Basel Accord there were seven risk metrics requiring seven calculations; by the time we get around to implementing Basel III, over 200,000 risk categories will require over 200 million calculations.
At some point policy makers will need to turn their efforts from reinforcing and bailing out the bankers who use any and every opportunity to take public support as private bonuses and instead evaluate much simpler, lower cost models of financial intermediation likely to yield domestic investment in domestic businesses and assets.

I can almost hear the shouts of "socialist" from the usual defenders of banks and markets. I am not advocating state nationalistion of banks, but state withdrawal of explicit and implicit bank subsidies.

It is a conservative principle that the state should intervene when markets fail. If the banking system has failed (and it has) and requires a taxpayer subsidy to continue to operate (which it does), then conservative principles dictate that the state must intervene to secure a resolution in the public interest. More of the same is not a conservative policy, but social welfare for bankers.

We currently have a system of excess regulatory complexity, hidden market distortions and public subsidies. Moving away from the status quo requires state action to identify and reduce subsidy through promotion of business models that are simpler, more transparent and more directly aimed at securing public benefit.

10 comments:

Anonymous said...

LB I shouldn't give too much significance to an off-the-cuff remark at a City lunch (sorry "luncheon") 15 years ago. City lunches (sorry "luncheons") in the 1990s were notoriously alcoholic and the prominent (sorry "prominant") hedge fund trader may have been trying to impress. Of course he (or she) was interested in higher remuneration; why else would they set up a hedge fund? However without a reasonable prospect of superior returns why would sophisticated investors give him (or her) their money?

As for the Bank of England's estimate of the implicit subsidy of banks, you failed to note that the report acknowledges a wide range of other estimates for the scale of this subsidy. Oxera for instance estimated it to be around £6bn in 2011. That wouldn't pay many bonuses.

So "...all the cost savings generated by technology advances and automation in the banking sector had been paid away in increased bonuses and remuneration." Why shouldn't they be? If a firm makes capital investments which result in cost savings shouldn't the firm be able to distribute those savings as it wishes?

Finally, you note that "[We] have a system of excess regulatory complexity, hidden market distortions and public subsidies" and your solution is more state intervention, yet it is state intervention that results in regulatory complexity, and the known probability of state intervention drives the implicit subsidy. Surely a better solution would be less regulation, a better defined process for liquidating insolvent banks and a commitment to implement it.

As a further final thought I invite you to consider the Spanish cajas de ahorras as suitable examples of "...business models that are simpler, more transparent and more directly aimed at securing public benefit."

London Banker said...

@ Anon 08:58

I suppose what I am reaching for is regulation that simplifies intermediation and caps the rents that can be extracted. Some strict narrow banking models that have weathered the crisis well have transparent market financing with fixed fees for intermediaries.

We should be looking at what works in the real world - however inconsistent with regulatory fashion or economic theory - and doing more of it.

Anonymous said...

Perhaps the other anonymous should take a look at Terry Smith's blog on Hedge Fund fees. The data presented supports the allegation that they're structured to enrich the managers rather than the clients.

http://www.terrysmithblog.com/straight-talking/2010/09/fund-management-fees.html

RepubAnon said...

There have been studies showing that the more actively a fund is managed, the lower the returns to investors. In short, the money gained by improvements to the way the banks are run are being paid out to folks having nothing to do with those gains.

I'm putting my money in mutual funds with low management fees, and am getting better returns than my friends with funds under "expert" management.

Bottom line: The investment banking game is like poker: as more and more investors realize that the cards are marked in a way that only the big-money professionals can know, they'll stop playing. This would cause a lack of funds for investment, which would be bad for society.

Knute Rife said...

You, a socialist? That's a laugh. As for the rest, bingo. Increased bonuses have not been the only reason for the financial sector's love of technology. Even more fundamental is how technology can circumvent regulations. High-speed trading alone makes a sick joke out of the transparency model of regulation.

PeterJB said...

"If the banking system has failed (and it has) and requires a taxpayer subsidy to continue to operate (which it does), then conservative principles dictate that the state must intervene to secure a resolution in the public interest. More of the same is not a conservative policy, but social welfare for bankers. "

The above represents pure fascism which in turn represents what is called "crony capitalism: where all the cronies are the failed Bankers and their subordinate cronies namely politicians, bureaucrats and economists.

The latter three groups understandably just carry out the wishes of the Bankers which today, are directing the World's affaires, as always - "useful fools", but only to the Banks.

But, have you noticed that the World's socio-economic order is getting far worse since 2006 and the only winners are the Banks and their Recursive Scamming franchisees, those politicians, bureaucrats and economists?

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Northern Rock PPI Claims

Anonymous said...

Please London Banker,

Do you see and end to bank bailouts, to QEs and other 'extraordinary' policies?

Do you see a solution to the EZ problems?

Thank you.

scandia said...

Dear London Banker, While reading about another stress test for Spanish banks i wonder why they always say the banks are solvent when we are in this crisis. I would appreciate a posting by you on stress tests.Why are the results so off the mark( mark to market) ?

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