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Business News/ Opinion / The future of finance
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The future of finance

Deposit-taking banks, John Kay believes, should be confined to buying very safe assetsconfined to 'narrow' or 'limited purpose' banking

Photo: Hemant Mishra/MintPremium
Photo: Hemant Mishra/Mint

There’s no shortage of books on the financial crisis and its aftermath. By now, the bar is pretty high for new entrants making a claim on one’s time. This time, I want to focus on the excellent newcomer, John Kay’s Other People’s Money.

This is not a detailed guide to the pre-crisis financial plumbing, much less a blow-by-blow narrative of what went wrong. (For the latter, Alan Blinder’s After the Music Stopped is hard to beat.) Instead, Kay goes back to first principles, asking what purposes the financial system is meant to serve, and measuring just how far the modern financial economy has moved from that ideal.

The point of finance, he argues, is to connect savers and borrowers—end-users, that is, not financial intermediaries. The test of a financial system is whether a household with surplus funds and a company or government needing to borrow for investment can be connected at low cost and in a way that makes both parties better off. Correctly understood, all the institutions that lie between such end-users exist to serve this underlying purpose.

In Kay’s view, modern economies have lost sight of this vital point. Finance has come to be seen as an end in itself, as though the global economy exists to serve Wall Street and the City of London rather than the other way round. If you applied that mindset to electricity generation, for instance, the absurdity would be obvious: You don’t generate electricity for its own sake.

Yet the modern economy has come to see finance and all its frantic complexities—intermediaries dealing with intermediaries dealing with intermediaries, with never a thought for the end-user—in just this way.

Does something of social value happen when investment bank A transacts profitably with asset manager B? Not necessarily. Only if the gain somehow makes its way through to end-users. If that doesn’t happen, the costs of the intermediation amount, in effect, to a tax on everybody else.

This insight raises many intriguing questions, which Kay carefully works his way through. In a modern economy, how big does the financial sector need to be? Not nearly this big, he argues. How did it come to be so big, if it’s failing to justify its expense of resources?

Essentially, by collecting various explicit and implicit subsidies—notably, the subsidy implied by the government’s promise to stand behind a failing institution.

What makes Kay’s analysis so probing is that he’s no knee-jerk anti-market type. He’s a distinguished scholar, a successful businessman and was chairman of a UK government review of equity markets after the crash. His overall perspective is actually pro-market. He opposes calls for stricter and ever more complex regulation; he’s against a “Tobin tax" on financial transactions because of its likely unintended consequences; and he thinks the obsession with “too big to fail" misses the point. (The problem isn’t size, he argues, but complexity.)

The right way forward, he argues, is to interrupt the flow of subsidy. Do that and market forces will start to nudge finance in the right direction. This sounds straightforward enough, but it has radical implications. It isn’t just a matter, for instance, of requiring banks to hold more capital—though that would be a good place to start. The problem is that, in Kay’s view, the amount of capital needed to make banks safe, and hence to deny them the implicit subsidy of government protection, is probably beyond the market’s capacity to provide.

Then, what is to be done? Deposit-taking banks, he believes, should be confined to buying very safe assets—confined, that is, to “narrow" or “limited purpose" banking. This is a proposal with a long lineage; the idea goes far beyond more standard prescriptions, such as reinstating the Glass-Steagall separation of commercial and investment banking. Narrow banking means that lending to firms and other risky borrowers should be undertaken by institutions that openly pass the risk on to the savers who invest with them. In general, Kay favours a financial system with many more such specialists, each of them more directly connected to one or other class of end-user.

In some ways, as Kay acknowledges, he’s asking for the clock to be turned back. Prudent lending to small businesses, for instance, requires deep local knowledge rather than smart algorithms and rocket-science math. That old-fashioned kind of specialist expertise, he believes, needs to be recovered. Modern finance should be more outward-looking and less obsessed with itself. If that’s turning back the clock, so be it.

There’s no question that something has gone badly wrong with modern finance, or that the current approach to regulation is compounding many of the industry’s defects.

Kay’s insistence on stepping back, on judging finance by the humdrum standards of any other industry, with its self-serving mystique and aura of inevitability stripped away, makes Other People’s Money one of the best two or three books I have read on the crash. Bloomberg

Clive Crook is a Bloomberg View columnist.

Comments are welcome at views@livemint.com

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Published: 24 Nov 2015, 10:34 PM IST
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