When Finance Becomes Self-Referential

The Bank of International Settlements has just published a group of working papers based on its annual conference held in June 2015. John Kay delivered the keynote address on the subject: "Finance is just another industry," which appears as part of "Towards a “new normal”in financial markets?" which include the speech by John Kay and essays by Jaime Caruana and Paul Tucker, BIS Papers No 84, May 2016.

Kay's keynote address is lively to read and full of vivid examples and metaphors. For me, a main theme is that what most of us think about "finance" can be divided into two parts: the part that directly helps actual people and firms and governments operate in the real world, and the part where the financial sector becomes self-referential and starts to interact largely with itself. Of course, this distinction is more like a spectrum, where one category shades into the other, rather than a black-and-white binary distinction. But the distinction is useful nonetheless. Here are some thoughts from Kay:

On the contributions that finance makes to society.

Finance can contribute to society and the economy in four principal ways. First, the payments system is the means by which we receive wages and salaries, and buy the goods and services we need; the same payments system enables business to contribute to these purposes. Second, finance matches lenders with borrowers, helping to direct savings to their most effective uses. Third, finance enables us to manage our personal finances across our lifetimes and between generations. Fourth, finance helps both individuals and businesses to manage the risks inevitably associated with everyday life and economic activity. These four functions – the payments system, the matching of borrowers and lenders, the management of our household financial affairs, and the control of risk – are the services which finance does, or at least can, provide. The utility of financial innovation is measured by the degree to which it advances the goals of making payments, allocating capital, managing personal finances and handling risk. Most people who work in finance are concerned with the first two of these functions. They operate the payments system, they help households with their personal finances. They are not aspiring Masters of the Universe. Mostly, they earn modest salaries. Half of the employees of Barclays Bank earn less than £25,000 ($40,000) per year. But Barclays also employs 530 “code staff” – people with executive functions – who earn an average of £1.3m each, and there are 1443 who earn more than £500,000 ($800,000). It is likely that “the one per cent” in Barclays Bank earn a total approaching half of the total wage and salary bill of the bank. Most of these people are employed in wholesale rather than retail finance. Their activities relate mainly to the other objectives of the financial system – capital allocation and risk management.

Although one of the functions of the financial sector is that it "matches lender with borrowers," Kay points out that a substantial part of investment--whether it's a physical capital investment or an investment in research and development and firm-specific skills for employees--is financed internally by firms out of their profits, not as a result of financial sector interactions.

ExxonMobil is both the most profitable company in the United States and the biggest private investor. Massive expenditure on exploration and development and on infrastructure is necessary every year to exploit new energy resources and bring oil products to market. In 2013, ExxonMobil invested $20 billion. That figure was in itself a significant fraction of total investment by US corporations. Exxon got all of that money from its own internal resources. In 2013, ExxonMobil spent $16 billion buying back its own shares, in addition to the $11 billion the company paid in dividends to shareholders. The company’s short- and long-term debt levels were virtually unchanged. It raised no net new capital at all. Nor was 2013 an exceptional year. Over the five years up to and including 2013, the activities of the corporation generated almost $250 billion in cash, around twice the amount it invested. ExxonMobil did not raise any new capital in these five years either. Instead the company spent around $100 billion buying back securities it had previously issued. Oil exploration, production and distribution are capital-intensive. Many modern companies need very little capital. The stock market capitalisation of Apple – the total market value of the company’s shares – is over $500 billion. Although the corporation has large cash balances – currently around $150 billion – it has few other tangible assets. Manufacturing is subcontracted. Apple is building a new headquarters building in Cupertino at an estimated cost of $5 billion which will be its principal physical asset. The corporation currently occupies a variety of properties in that town, some of them owned, others leased. The flagship UK store on London’s Regent Street is jointly owned by the Queen and the Norwegian sovereign wealth fund. Operating assets therefore represent only around 3% of the estimated value of Apple’s business. 

At some point, Kay argues, financial markets can become self-referential. For example,

We need a finance sector to manage our payments, finance our housing stock, restore our infrastructure, fund our retirement and support new business. But very little of the expertise that exists in the finance industry today relates to the facilitation of payments, the provision of housing, the management of large construction projects, the needs of the elderly or the nurturing of small businesses. The process of financial intermediation has become an end in itself. The expertise that is valued is understanding of the activities of other financial intermediaries. That expertise is devoted not to the creation of new assets, but to the rearrangement of those that already exist. High salaries and bonuses are awarded not for fine appreciation of the needs of users of financial services, but for outwitting competing market participants. In the most extreme manifestation of a sector which has lost sight of its purposes, some of the finest mathematical and scientific minds on the planet are employed to devise algorithms for computerised trading in securities which exploit the weaknesses of other algorithms for computerised trading in securities. ...

Nothing illustrates the self-referential nature of the dialogue in modern financial markets more clearly than this constant repetition of the mantra of liquidity. End users of finance – households, non-financial businesses, governments – do have a requirement for liquidity, which is why they hold deposits and seek overdraft or credit card facilities and, as described above, why it is essential that the banking system is consistently able to meet their needs. But these end users – households, non-financial businesses, governments – have very modest requirements for liquidity from securities markets. Households do need to be able to realise their investments to deal with emergencies or to fund their retirement, businesses will sometimes need to make large, lumpy investments, governments must be able to refinance their maturing debt. But these needs could be met in almost all cases if markets opened once a week – perhaps once a year – for small volumes of trade. ... The need for extreme liquidity, the capacity to trade in volume (or at least trade) every millisecond, is not a need transmitted to markets from the demands of the final users of these markets, but a need, or a perceived need, created by financial market participants themselves. People who applaud traders for providing liquidity to markets are often saying little more than that trading facilitates trading – an observation which is true, but of very little general interest.

The questions becomes how to assure that the financial system is resilient and robust, so that when the masters of finance are chasing their own tails, the rest of the economy isn't upset. In any complex system, trying to assure that no component will ever fail is a foolish goal. Failures are going to happen; in the financial system, banks and other financial institutions are going to fail sometimes. The goal needs to be to create a system that is resilient when such failures occur. Here's Kay:

The organisational sociologist Charles Perrow has studied the robustness and resilience of engineering systems in different contexts, such as nuclear power stations and marine accidents.16 Robustness and resilience require that individual components of the system are designed to high standards. Demands for higher levels of capital and liquidity are intended to strengthen the component units of the financial system. But the levels of capital and liquidity envisaged are inadequate – laughably inadequate – relative to the scale of resources required to protect financial institutions against panics such as the global financial crisis. More significantly, resilience of individual components is not always necessary, and never sufficient, to achieve system stability. Failures in complex systems are inevitable, and no one can ever be confident of anticipating the full variety of interactions which will be involved. Engineers responsible for interactively complex systems have learnt that stability requires conscious and systematic simplification, modularity which enables failures to be contained, and redundancy which allows failed elements to be bypassed. None of these features – simplification, modularity, redundancy – were characteristic of the financial system as it had developed in 2008. On the contrary. Financialisation had greatly increased complexity, interaction and interdependence. Redundancy – as, for example, in holding capital above the regulatory minimum – was everywhere regarded as an indicator of inefficiency, not of resilience. 

BIS has also put the other papers delivered at its annual conference last summer up online. In particular, the paper by Andrew Lo, "Moore's Law vs. Murphy's Law in the financial system: who's winning?" dovetails nicely with some of the themes raised by Kay, and digs into some of the same issues. From the abstract of Lo's paper:

"Breakthroughs in computing hardware, software, telecommunications and data analytics have transformed the financial industry, enabling a host of new products and services such as automated trading algorithms, crypto-currencies, mobile banking, crowdfunding and robo-advisors . However, the unintended consequences of technology-leveraged finance include firesales, flash crashes, botched initial public offerings, cybersecurity breaches, catastrophic algorithmic trading errors and a technological arms race that has created new winners, losers and systemic risk in the financial ecosystem. These challenges are an unavoidable aspect of the growi"ng importance of finance in an increasingly digital society. Rather than fighting this trend or forswearing technology, the ultimate solution is to develop more robust technology capable of adapting to the foibles in human behaviour so users can employ these tools safely, effectively and effortlessly." 

Here are the rest of the links:

"Mobile collateral versus immobile collateral," BIS Working Papers No 561

by Gary Gorton and Tyler Muir
Comments by Randall S Kroszner and Andrei Kirilenko

"Expectations and investment," BIS Working Papers No 562
by Nicola Gennaioli, Yueran Ma and Andrei Shleifer
Comments by Philipp Hildebrand

"Who supplies liquidity, how and when?" BIS Working Papers No 563
by Bruno Biais, Fany Declerck and Sophie Moinas
Comments by Arminio Fraga and Francesco Papadia

"Moore's Law vs. Murphy's Law in the financial system: who's winning?" BIS Working Papers No 564
Andrew W Lo
Comments by Darrell Duffie and a written contribution by Benoît Coeuré