When I hosted the GBR panel “A New Kind of Capitalism,” I was certainly looking at the conference and work sponsored by the LSE as one of my benchmarks. Therefore, it was with sincere interest that I read their final report.
The LSE report presents essays on the current crisis and possible solutions for the future by a variety of important thinkers in the U.K. and in the global financial architecture. There are writings from Adair Turner, chairman of the Financial Services Authority; Paul Wolley, senior fellow at the Paul Wolley Centre for the Study of Capital Market Dysfunctionality at the LSE; the ever-present and always brilliant Martin Wolf of the Financial Times; and many more. The depth of analysis and the often provocative solutions offered in this report make it a must for those who want to have clarification on the crisis and for those who need tools to influence the debate.
Ultimately, we cannot reach sensible conclusions on how to improve the future of finance if we don’t define what we want the financial sector to really do for our society. A deeper understanding of the role of finance in a modern and functional society is the starting point. The report helps the reader understand where the financial sector is at the moment and how it grew in material size and in socio-political influence over the last 20 years. It would seem clear that the structure of the global financial sector grew out of proportion with its possible mandates of promoting growth and serving society to build a better future.
The role of banks, their regulation, and proper functioning is naturally at the heart of the debate. While most analysts seem to implicate leverage and lack of global regulatory coordination as classic culprits, how we design the next framework will be a function of what banks are required to do by society. The recommendations by the LSE report vary from more simplistic ideas, such as increasing equity capital requirements to more radical projects like narrow-banking (John Kay) or limited-purpose banking (Larry Kotlikoff mentioned by Martin Wolf).
However, the debate on the future of finance runs deeper than just reorganizing banks. An interesting point on debt is raised by Peter Boone and Simon Johnson: if globally we seem to be very reluctant to allow debt defaults (a recurrent theme in this crisis was bailing out bondholders at any cost), perhaps we should devise rules to discourage debt accumulation and make it more attractive to promote equity financing. The myriads of possible deductions for interest on debt naturally push a semi-rational system to seek more and more leverage. When you add to the mix a recurrent mechanism of bail-outs and a sanctified policy of too-big-to-fail, you have an explosive cocktail in your hands.
Unfortunately, reorganizing the financial sector to serve efficiently our society is not just the result of common sense and an honest global debate; the financial sector was able to reach its present size thanks to a masterful command of the political process. One indication from the LSE report would be to drastically reduce the politicization of finance. This is mandatory in my view, but frankly incredibly difficult to achieve. Depoliticizing finance would probably help reduce the size of financial institutions, bringing back a more diversified and more talent-driven model. The present mega-banks model built on the publicized rationale of economies of scale has failed not only because of the crisis, but also in achieving such size-related out-performances. The LSE report lists a number of studies that found no significant efficiency gains beyond certain size thresholds.
It is imperative that we collectively come to a common sense agreement (globally defined) that stabilizes the financial sector, otherwise, as Boone and Johnson remark, all of our present actions will only serve the purpose of seeding the next global crisis at which point we will have reached the fiscal and monetary limits of our ability to bail out the system.
So is it going to be Game Over or Game On?