The Financial System; Stick or Twist?
On preparing for a talk I gave recently in Istanbul, I was struck how lucky we were to have the problems that I describe in Finance, Society and Sustainability. Having an autocratic president deciding which of his supporters and friends make money in an opaque an arbitrary way just would not be allowed under UK or USA’s financial systems.
And yet, many Western countries are slipping, maybe not to authoritarianism, but to sometimes unpleasant and nasty versions of populism. And I see it the finance system having been a major contributing factor to this worrying turn.
There was the financial crisis of 2008. The bankers who crashed the economy largely escaped punishment, retaining highly paid jobs and bonuses, whereas everyone else was collectively punished via austerity. Even the large fines that have subsequently been imposed have fallen on the banks’ current shareholders (in RBS’s case the UK government), instead of on the executives who caused the crisis. No surprise that this has led to anger and widespread belief that the system is fixed in favour of a few.
The critique I outline in Finance, Society and Sustainability is structural and I argue is causing long run damage to society and the environment. The basic thesis of my book is that an ethical notion is embedded within the financial system, but this ethical notion is based on flawed beliefs. This ethics are that capital markets are free markets and free markets give an efficient allocation of resources so that everyone is as well off as they can be. Most critics, particularly of the left, fixate on whether or not free markets make people well off. But the book’s arguments is that the capital markets are not free markets at all, they are constructions of a complex interaction between regulators, governments and financial institutions. The rules under which they operate are arbitrary, which results in a great deal of opportunity for rent-seeking behaviour.
How has the led to the decline in the political landscape? Financial markets allocate society’s resources, so if the “market” decides that a sector or entity or person is worthy of credit and investment, they can expand because of the (often cheap) credit. The theory of free markets means that if this happens everyone will be better off.
Let me give a counter example: public traded pharmaceutical companies have access to cheap finance via the capital markets, and they are run to maximise shareholder returns. To ensure that this is so, company executives’ very high pay is linked to the company share price. Pharmaceutical companies get very good short term returns from lobbying activities – of which they have spent $2.5 bn in the US alone over the last decade. The returns are gained from regulators enforcing intellectual property rights, not allowing US public health services to negotiate prices, and worst cases things like ensuring regulators allow widespread use of opiates. This is not in the interest of society, the tax-payer, people who need medication, or people who have become addicted to opiates. The level of tax, poor quality and expensive health care, and the opiate crisis have been significant sources of anger in recent US politics. The theory that free markets does not consider that those with access to large amounts of finance can manipulate governments to maximise profits.
If we think wider than big pharma, financial intermediaries have managed over a long time to subvert the behaviour of capital markets to maximise their own revenue. This is not necessarily a conscious decision by individuals to game the system, but happens gradually over time through the operation of rules and incentives. The net result is that the financial services industry has grown ever larger and more important whilst not becoming any more efficient or offering better services to end users. This is all very well, but as capital is allocated in the interests of financial intermediaries, this ultimately does collateral damage on society and the environment.
There are blatant examples of financial iniquity, for example corporate takeovers where the purchaser loads the purchased company up with debt to fund the takeover. However, mainstream activities such as fund management is damaging in a slower and less obvious fashion. Investors are monitored and rewarded based on short term fund performance – typically quarterly returns - therefore the companies they own are encouraged to boost short-term share performance. Easy ways to do this are by avoiding tax, lobbying, reduce staff costs, reducing R&D expenditure and passing on externalities to society. It is not obvious that any of these boost the efficiency of the economy and it is likely that these result in longer term social and sustainability ills, and maybe even damage the long-term value of the investee company.
This is not because the investors themselves are bad people, but ultimately comes down to the way investors are incentivised, based on short term market prices, an approach enshrined in regulation. This is in turn because the regulation is based upon the presumption that the market knows best.
There has been recent signs of movement away from the market/shareholder value paradigm. For example, LGIM, the UK’s largest investor, has pleged to vote at AGMs against companies with poor climate and diversity records. The EU regulators have announced they would give climate friendly investments a lower risk weighting in solvency evaluations, and the UK government have announced that pension trustees should take account of climate risk. In a market-knows-best world, these would be irrational things to do, but these developments imply that there is a growing recognition that this is not so.
However, ultimately to get a financial system that contributes to sustainability and social well-being, a new paradigm is required. We need to decide what world we want to live in and then design financial regulation to achieve that world. This may seem idealistic and naïve, until we realise that current financial regulation embodies a set of values which are hopelessly idealistic and naïve – that we want to live in a world that is allocatively efficient, arbitrated by a free market. The capital market, constructed by government agencies, cannot be free and is therefore not going to be allocatively efficient.
Agreeing on what world we want to live in is a non-trivial task. But the Sustainable Development Goals (SDGs) are a pretty good start. What would financial regulation look like if its’ purpose were to achieve the SDGs? I have no idea, except that it wouldn’t look anything like current regulation. Also, there has been a great deal of activity for developing financial products and services which could contribute towards the SDGs, for example impact investment, ESG investment, triple bottom line accounting or social impact bonds.
In a world threatened by irrational illiberalism, the natural reaction is to defend the old liberal order, of which free capital markets are a core article of faith. However, as the rise of this illiberalism, has been caused by flaws in the way capital markets operate, it is even more important to re-imagine the financial system in a way that works for people and the planet.
Nick Silver is an actuary and economist whose expertise includes pensions and insurance, risk management and sustainable finance, in particular working in developing economies. He is managing director of Callund Consulting Limited which for 40 years has advised governments on pensions, social protection and developing capital markets.
NB: All opinions expressed here are the author’s own and do not represent the views of Palgrave Macmillan.