Can we avoid the next financial crisis? Or are we hardwired for a crash?
Henry Kaufman has long been the dean of US fixed income analysts. By no means a spring chicken, Kaufman is still nimble minded. I was directed to his book Tectonic Shifts in Financial Markets: People Politics, and Institutions (New York: Palgrave MacMillan, 2016) by a review in the Financial Times, and made it part of my summer reading. Kaufman has unique observations about the markets and five bear deep consideration.
Let’s start with his closing argument, there is no returning to any golden area in either financial markets or national and global economies. We can change the current course, but we will create a new normal. When Kaufman appropriated tectonic shifts for his title, he surely is evoking the idea that the earth’s land masses were a super continent which been repeatedly broken up by the shifts in the continental plates over millions of years. In the short span of 40 years, the US and UK have led the global markets in similarly dramatic and permanent change. Kaufman effectively warns that the reintroduction of the barriers between investment banking and banking will not return us to the imagined economic tranquility of the 1950s.
The major financial reforms of the 1980s and 1990s that led to the removal of barriers between investment banking and commercial banking in the US failed. Different reforms on a similar scale, like the “Big Bang” in the UK drove dynamic changes in the UK and Europe as well. These liberalizations led to a greater conglomeration of financial services in too-big-to-fail institutions, and they facilitated conflicts of interest in the management of the financial sector. The resultant concentration, which has increased since 2008, has increased volatility in Kaufman’s view. More critically, it has restricted the capacity of regulators to act during a crisis.
Perhaps, Kaufman’s most harsh observation is that he does not believe that regulators fully understand what they have enabled. Although he zeros in on the Fed, Kaufman is unsure that any regulators have truly embraced the consequences of market liberalization. In part, they failed to analyze the prospective risks prior to deregulation, and trusted the markets to self police after the reforms. They failed to address how liberalization would change their roles. Philipp Hildebrand, the former Swiss central bank governor, is quoted in the FT as saying that in the post 2008 Financial Crisis Era, central bank policy frameworks have been exhausted. This is what Kaufman fears may affect their independence.
Liquidity has shifted from cash and assets to credit, i.e., the ability to borrow. This is a challenging observation. In the period before market liberalization, we looked to our salary, the net cash after spending and our real assets to understand liquidity. We were conservative. When we had to monetize an asset, there was a market with a price. Now, Kaufman emphasizes that concentration of players and sizes of portfolios in the financial markets means that large players lack ease and flexibility to monetize their assets. In a crisis, this infects the entire economy. In a performing economy, large financial conglomerates can make incremental sales without moving markets. In a crisis, they may lack buyers at any price. Their own investments paralyzed, they restrict credit and the entire economy loses liquidity. The crisis is exacerbated.
Nobody understands financial history. Kaufman observes that it isn’t taught in modern business schools. Kaufman is convinced that, unless future business leaders learn about the history of markets, the financial services industry, and how regulations have changed, we are doomed to business leading us into one crisis after another.
What should we take away from these points?
Kaufman notes that a return to siloed financial services will not recreate any post World War II golden era. Breaking up financial conglomerates, however, will reduce liquidity risk by reducing excessive concentration, and it should accompany stricter barriers agains conflicts of interest. If we can’t go back, we need to decide where we want to go. Only a few regulators seem to have foresight on this matter i.e. Bank Negara Malaysia and the Securities Commission of Malaysia. In the Malaysian case, the regulators are adding a values and social responsibility aspect to their mandates beyond governing a sound financial system and an orderly market.
If concentration has introduced new problems, then break up the FAANGs (Facebook, Amazon, Apple, Netflix and Google — now Alphabet), break up the financial conglomerates. Don’t let the FAANGs become the new systemically important financial institutions. Already the FAANGs are dipping their toes into the financial markets. In the past, one worried about manufacturing industries being integrated with banking. The fear was that they would serve their interests ahead of society, and by extension, the markets. Now, the same worry should be transferred to technology companies.
If we have learned that financial markets don’t self regulate for the benefit of society, then we have to re-introduce regulation. Better to be boring than hamstrung by a new crisis.
Do we want credit to be the determinant of liquidity? If we try to walk back from credit as the primary source of liquidity, what do we have to think through?
Educators: business history needs to be mandatory and deeper than a soft ethics course. Understanding the past is a key to building a better future. Consider the parallels between 1929 and 2008:
There was excessive concentration in the financial sector. But, after the financial crash of 1929, financial conglomerates were broken up in the US. Since 2008, concentration has increased globally.
Conflicts of interest were pervasive in the financial sector and without. This has been better addressed in Europe and the UK than the United States since 2008.
The credit markets dried up. In 1929, the solution included breaking up financial conglomerates, enhancing market regulation, reducing conflicts of interest. In 2008, massive liquidity was pumped into the markets, but many other issues have been left unaddressed.
Have we set ourselves up for the next crisis and our powder is wet? Perhaps another reader will find different lessons from this slender tome. Senior financial executives, regulators, policy makers, and business leaders will all benefit from their exploration of Kaufman’s observations. One hopes that we will think of how to build a better future with such insights.