‘If we are buying carpets, we are suspicious. When it comes to really big decisions, we ought to be equally suspicious’
Suppose you were considering investing a large sum of money in Oriental carpets, about which you had little expert knowledge. As you approach the bazaar, you consider the people who will help you. First, you will want an adviser to give you some idea of the “true”, underlying value of the carpets, perhaps to be paid by an advisory fee or commission.
Second, you may be anxious that the clever market participants will sense that you are a buyer and will alter their prices (upwards, of course). So you will appoint a broker to enter the market on your behalf, to ask for both the buying and selling prices, and to get you the best deal. The broker will also be paid a commission.
Finally, you may meet the people who own the carpets, possibly on credit, with a view to trading them at a profit. You may meet the dealers to compare the different carpets available and to choose those most to your taste. The lowest purchase prices ought to have been established by your broker. You will pay the dealer only the purchase price of the carpet, because you, he and the broker know that he paid less for it, and the difference is his profit.
If someone suggested to you that the investment could be radically simplified by going to a single company that is simultaneously an adviser, a broker and a dealer in the carpet business, you would – surely – tell him, “Don’t be so silly. The adviser, the broker and the dealer are helping me in different ways. If a single company carried out all those services for me, it would be subject to severe conflicts of interest. The adviser would recommend the dealer’s lowest-quality stock, the broker might tell me both the buying and selling prices, but would dishonestly adjust the range upwards, and so on. Of course, I wouldn’t trust a company that claimed to be able to do everything for me in the carpet market.”
If we are buying carpets or second-hand cars, we are suspicious. When it comes to really big decisions, such as investing our lifetime savings in pensions or where to hold our bank accounts, we ought to be equally suspicious. The old-fashioned, pre-Big Bang, pre-1986 British approach to financial services had imperfections, but it had one vital virtue: it minimised conflicts of interest in the sale of financial products.
On the stock market, jobbers (holders of securities, analogous to the carpet market dealers) were separate from the brokers (who found the best prices). In the financing of companies, the merchant banks (which underwrote new issues of securities) were separate from the clearing banks (which extended loans). In the sale of insurance, a broker would, at least in principle, try to get the best terms for clients and would place the risk with a totally separate risk-bearing company. Then, people could look each other in the eye and shake hands on a deal, and only rarely did they go to their lawyers. But that is not how matters stand today anywhere. The US may be in some sense the “best example” of free-market capitalism, but it is rotten at organising its financial sector. It has destroyed its banking system on at least three occasions and, when Congress turned down the first version of the $700 billion bail-out package, it came close to doing it again.
Much of the trouble in the US, both now and in the 1929 Crash and subsequent Depression, has arisen from so-called “bank holding companies”. These contain a commercial bank (receiving deposits and making loans), an investment bank (trading and underwriting securities) and a fund management company (investing clients’ wealth). In the bazaars of modern capitalism, they do everything: originating, selling, lending, buying, deposit-taking and underwriting. From the point of view of shareholders and even more of bonus-driven managers, they are excellent in the good times. Their omni-competence enables them to collect all imaginable kinds of financial income: arrangement fees, underwriting fees, advisory fees, guarantee fees, brokerage commissions, net interest income and so on, and to generate fabulous profits. Carpet dealers and second-hand car salesmen look on in envy.
Indeed, in the good times even the clients are happy enough because share prices are rising. However, in the bad times, clients’ wealth falls, questions are asked and the conflicts of interest come out into the open. The bank holding companies’ managements are shown to have betrayed clients and misled their shareholders. That was why the Glass-Steagall Act was passed by Congress in 1933. It was designed to keep investment and commercial banking apart, and to prevent the abuses that led to the Great Crash.
But American financial organisations found that after the Big Bang – and to some extent before it – they could behave in London as they could not in New York. Glass-Steagall was repealed in 1999, at least partly so that the US could recapture financial business said to have been lost to the UK. Over the past decade, throughout the industrial world, large so-called “banking” groups have offered practically every imaginable financial service, regardless of conflicts of interest. The wider consequences, which include the dot.com mania, have been catastrophic. An international agreement is needed to break up bank holding companies, so that in 21st-century capitalism the tasks of investment advice, securities trading and commercial banking are kept distinct. Investment markets must be better organised than Oriental bazaars.