“When the anti-finance sentiment becomes rage, it is difficult to maintain a prompt and unbiased enforcement of contracts, the necessary condition for competitive arm’s length financing. Without public support, financiers need political protection to operate, but only those financiers who enjoy rents can afford to pay for the heavy lobbying. Thus, in the face of public resentment only the noncompetitive and clubbish finance can survive.”
— Luigi Zingales, finance academic and president of the American Finance Association, January 2015
“Trust and confidence have significantly been eroded over the past few years due to poor conduct within the financial industry.”
— Greg Tanzer, Commissioner, Australian Securities and Investment Commission, 27 May 2015
Luigi Zingales, who has been described as a welcome reminder of what conservative economics used to look like, is plain in his concerns. “I fear that in the financial sector fraud has become a feature and not a bug,” he says in this year’s American Finance Association presidential address. Like ASIC’s Greg Tanzer and many others, he is responding partly to the remarkable evidence from inquiries into the debacles that unfolded from 2008. He cites a typical example, an email exchange between Royal Bank of Scotland currency traders that reveals illegal manipulation of the Libor, the benchmark rate that leading banks charge each other for loans:
Senior Yen Trader:
the whole HF [hedge fund] world will be kissing you instead of calling me if libor move lower
Yen Trader 1:
ok, i will move the curve down 1bp [1 basis point, or 1/100th of 1 per cent] maybe more if I can
Senior Yen Trader:
maybe after tomorrow fixing hehehe
Yen Trader 1:
fine will go with same as yesterday then
Senior Yen Trader:
Yen Trader 1:
maybe a touch higher tomorrow
Both Zingales and Tanzer make the point that banks have paid enormous fines in recent years for their bad behaviour. According to Tanzer, British banks alone have paid fines and client repayments amounting to 60 per cent of their profits since 2011. Zingales raises the obvious question about the imbalances that drive these crimes: disproportionate financial incentives for bank executives and poor product knowledge among clients. “When I talk about poor outcomes for customers, this is a genteel way of saying people got fleeced,” says Tanzer. “And, sadly, those who get fleeced are usually everyday Australians, not wealthy people who can make a major loss and not blink. That is, those affected by poor culture are usually those who can least afford it.”
Tanzer’s speech was an appeal for leadership. He asks that banks improve their culture and says ASIC will be monitoring things like incentive schemes, training and complaint handling. That might very well be an admission that bank regulation has not been especially effective, even during this unhappy period.
Zingales clearly doesn’t think moral suasion is likely to achieve much. He’s fairly certain that bank regulation generally is ineffective and believes regulators quickly become captives of their industry. His approach is plain: use simple, obvious rules. “For example,” he says,
a simple way to deal with the problem of unsophisticated investors being duped is to put the liability on the sellers. Just like brokers have to prove that they sold options only to sophisticated buyers, the same should be true for other instruments like double short ETF [exchange traded funds, a superannuation savings product]. This shift in the liability rule (caveat venditor) risks shutting off ordinary people from access to financial services. For this reason, there should be an exemption for some very basic instruments – like fixed rate mortgages and a broad stockmarket index ETF.
His other solutions are similarly straightforward, involving improved transparency in reporting and clearer burdens of risk for those who create them. He also makes a great suggestion for dealing with the pass-the-parcel kind of madness that underpinned the financial crisis: make the financier liable for deals that rely on cheating regulations.
Zingales’s views are timely and relevant for Australians because we have a finance sector that is unusual by international standards. Like many others, Australians were aggressive in using debt in the lead-up to the financial crisis. Household debt is still high, but consumer debt has been flat for six years or so and overall household behaviour is focused on saving. In fact, recent private debt growth has been fuelled so heavily by investor mortgage borrowings – the so-called housing bubble – that regulators have been trying to cap lending, apparently with mixed success.
What we don’t know – possibly can’t know – is how much risk there is in the sheer size of Australia’s finance sector. As in many rich countries, ours has grown dramatically in recent decades, bloated in part by compulsory superannuation savings that drive around 10 per cent of everyone’s paypacket into (mostly) the sharemarket. The expansion of credit, meanwhile, has been fuelled by ready access to global credit at historically low prices. Australia might be an attractive market for lenders chasing security and good returns, but this is “hot” money, as the Asian financial crisis demonstrated in 1997. If the settings change, if the relative security or the returns come under doubt, then the illusion of easy liquidity and cheap money will evaporate.
Alongside the imbalance created by our appetite for foreign debt is the finance sector’s illusion of prosperity. This an industry styled after J. Wellington Wimpy, best known for his appeal to Popeye: “I shall gladly pay you Tuesday for a hamburger today!” Shareholders and clients of banks deal in assets and liabilities that rely on value sustained over time. When housing bubbles burst, borrowers – like those recently in the United States and thirty years ago in Britain – may have incentives to simply walk away from mortgages, incurring serious damage for themselves and their banks. But the bankers’ bonuses are paid in the years when loans are made.
Despite clear doubts about the efficacy of the policy, compulsory superannuation has created an enormous industry. Leaving aside that concern and the patent inefficiency of the scheme (which we shall come back to), there is also the question of whether it’s promoting risk. Through superannuation, most householders are forced to invest in the sharemarket, where investment cycles reflect a worrying volatility, even though they would prefer to pay off their mortgage. And it’s not as if the flood of compulsory super has engendered a large number of great new businesses. The privatisations of Telstra, the Commonwealth Bank, CSL and Qantas might have added sound investment options for households, but we’ve seen an overall lessening of competition in sectors consolidated by takeover, some growth for growth’s sake by companies like BHP and Rio and a massive increase in the price of banks. The question is, what happens later?
We know that Australia’s population is ageing, and that means many of those who benefited from the tax policies and asset inflation of recent years will begin to convert their savings to income streams. Sensible people might be wise to shift from shares to cash at that time, taking away the worry that the sharemarket might fall. But that sort of trend could fundamentally change the dynamics of the savings industry.
Then there’s the efficiency question. It’s safe to assume that Greg Tanzer’s views are shaped by revelations that banks and other institutions have been reckless in their method of selling superannuation products. As Zingales observes, this is a common problem: complexity is the friendly tool of the rent-seeker. The core problem is the policy design. Most people do not understand the sharemarket and would be best placed with a plain indexed product that can be had for a tiny management fee. Good options start at roughly 0.20 per cent of the investment. So-called active managers (taking more risk for the goal of more reward) often charge at least 1.30 per cent, and probably another 10 per cent if they manage to exceed a target rate of gain, but give none back when it fails to hit the target.
There’s little doubt that over the life of their compulsory saving most people would be better off with the plain product, for the simple reason that active managers rarely beat passive ones over the long haul. And then there’s the obvious fact that a household that has paid off the house will generally have a better savings result than one forced to divert 10 per cent of its salary income to equities.
A fundamental point that Zingales makes is that big finance is a powerful rent seeker. We know that from the American and British experience of recent years. In Australia, we’ve become used to the idea that our finance sector is safe – despite the evidence that compulsory super is converting household capital into super-earnings for some players in the finance industry; despite the regulators’ failure to crack down on the dubious techniques used to sell complex investment products; and despite Canberra’s evident fear of any suggestion of policy that might inhibit the flow of rents to financiers.
It might be that there’s more risk here than meets the eye. In this case it’s a community risk, just like the many instances going back to the US savings and loan debacle, the collapse of Victoria’s Tricontinental Bank, the Pyramid scandal, and many more recent catastrophes. In this case, don’t ask for whom the bell tolls… •