If the Chicago School got the world into trouble, here is an attempt by the London School to set it right. The perception across the world of economics and finance is that it was the hard influence of the market-is-always-right doctrine of the Chicago School of Economics that set off the global financial crisis in 2008 when big finance grew in power over regulators and governments. Searching for a way to rewrite the rules that allow top management to get disproportionate returns for taking risks with other people’s money and lives, the British economist John Kay, visiting professor at the London School of Economics, was commissioned by the British business secretary Vince Cable to review the equity markets and devise a new set of road rules. Released in July 2012, the “Kay Review of UK Equity Markets and Long-Term Decision Making" asks a basic question: what are the key objectives of equity markets and do the markets in the UK meet these objectives? If the objective of the equity market is to earn returns on investment that meet long-term financial goals of the country, concludes the report, the equity markets are not effective anymore. The reason for this inefficiency is the breakdown of trust and confidence of savers and investors. Writes Kay: “Financial intermediation depends on trust and confidence: the trust and confidence that savers who invest funds have in those they choose to manage these funds, and the trust and confidence of investors in the businesses they support." The key problem identified is too many middlemen and their incentive structure that rewards short-term behaviour. His prescription to solve this problem is to move the market away from short-termism and over-trading and to make the sellers of financial products and managers of other people’s money more responsible through a fiduciary standard.

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Two, incentives are aligned across the product cycle to take care of the long-term financial health of all the players (manufacturers, sellers and consumers). If the market is all about following the money, why should this principle not be used to reward behaviour that sustains the entire market rather than work short-term for a few players? India saw an incentive structure in the pre-2010 Ulip that defrauded lakhs of investors by agents who were rewarded to hit and run. If the agent got 40% of the premium at sale and the company got to keep the rest if the investor was churned after three years, where was the incentive to not cheat? The 2007-08 sub-prime led market failure was the result of an incentive structure that rewarded sellers of unsuitable mortgages to people who could not afford to buy them. Says the Kay report: “Market incentives should enable and encourage companies, savers and intermediaries to adopt investment approaches which achieve long-term returns by supporting and challenging corporate decisions in pursuit of long-term value." What works? An absence of an upfront payment at the point of sale that is embedded in the product to stop churning and a mix of trail commissions, exit loads and fees to nudge longer-term behaviour by all in the chain.

Three, the fiduciary responsibility rests at the point of sale. This will ensure that the seller will look after the buyer and will put pressure on his supplier, the manufacturer of retail products, to design products that work for the final consumer. “The review believes that is it generally more effective, and in the long term less intrusive, to give incentives to do the right thing that to attempt to prevent people who are subject to inappropriate incentives from doing the wrong thing."

I hope some of you read the report and write in with views, comments and ideas.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, and Yale World Fellow 2011. She can be reached at expenseaccount@livemint.com

Also Read | Monika Halan’s earlier columns

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