You are an expert on “intellectual capital” in the markets. What does that mean exactly?
All modern businesses are now knowledge intensive. Some of the knowledge is written down and becomes part of the procedures. That’s one form of intellectual capital, but the most important part is the know-how of individuals and their capability to do things. Financial capital plus intellectual capital means stock market value in banking. People will say technology is important in banking and of course it is. But the point is: who designed the software? People. And that is knowledge. So banks’ knowledge intensity has increased rapidly in the past 50 years, and this has happened in tandem with a radical change in financial markets.
The markets are increasingly providing funding for companies and, as a result, they don’t have to use bank loans. This, in turn, means the banks need to fight back and find better and more complex new products to compete with the financial markets. As markets grow and become more complex, banks also grow and become more complex. Bank products eventually become commodity-like. But we have a problem here: these financial institutions become too complex for the general public.
Shouldn’t that “intellectual capital” make the financial sector learn from its past mistakes? Seven years after the crisis hit, there are still signs of bad practices …
There is another level of intellectual capital you need here, and that is can you manage knowledge and its creation? Can you manage learning in a bank? As your customers are changing you can imagine their needs and you can therefore learn in advance. Some banks are trying to do that, not with great success, but they are trying. Now the history of banking is a failure. And you can quote me on that. We know what makes banks work because we’ve learnt about the banks that failed. The universal banks and investment banks that failed and brought down the world economy were too complex. No manager nor regulator understood them. Some people had a vested interest in not understanding them because their pay was getting bigger and bigger. But they were not stable business models. So no, people did not learn from mistakes. Maybe 10 years from now we will learn. But we need a way of learning before these mistakes happen.
Is Basel III the best we can do to regulate banks?
No. We can simplify the banks a bit more and one of the proposals is to split up the investment banks from the retail and wholesale banks. This was done in the mid 1930s by the Americans with the Glass Steagal Act. We should consider doing it again. We want banks to help finance industry and to look after people’s savings. When it is required,we want them to help companies to issue securities for sound economic activities and encourage people to buy these securities to enhance their savings’ portfolios. Those are useful functions. But if banks persist in continuously changing their products and business models, making them so complicated that nobody understands them, then that creates exposure to future risks which can destroy the system. In that case, they are not doing anything useful for society.
It is in our interest that the core functions of the banking and financial systems are clearly understood and are not a risk to the economy as a whole. So we must insist that regulators regulate banks they understand, while banks and top management create business models they can justify, while fully explaining the risks and how they can be controlled. They cannot be allowed to pursue a policy of so-called innovation which has produced a lot of bonuses but not any major economic advantage.
In the long run, it is in the banks’ interest to start thinking about their social purpose. There is a crisis of confidence in financial capitalism and banking that needs to be addressed. If we believe that financial capitalism is useful, and I do, then we need to find a way to make it safer.
And yet the main risk is not in the banking system now. Asset managers hold about $76 trillion, the equivalent of the world’s GDP. The IMF just called for stress tests for them. Would that be a good idea?
Of course! Stress testing is exactly what I am talking about. They must be able to explain how they manage risk, it’s their core business! If they cannot do it, saying their model is changing because of competition, that is unacceptable.
And who should pay for those tests?
Obviously the institution taking the stress tests. They created the complexity.
Another elephant in the room: conflict of interests. Why should we still trust auditing firms? Who should audit them?
We should regulate to stop this. The Americans were aware of the deep conflict of interest in the universal banks in the mid 1930s. They broke up the concentration (in the auditing sector) and I think they should do it again. They saw the situation withArthur Andersen and the Enron case. And what happened? The US authorities closed down Arthur Andersen. That’s the kind of action we need. That doesn’t destroy financial capitalism, it strengthens it.
Today there is no way to avoid hiring the Big Four (PwC, Deloitte, Ernst & Young and KPMG)…
That’s why we need to break up this concentration of the Big Four. You should simplify their models so you have a pure auditor and a pure financial reporting consultant, working in separate companies.
Should there be an official public body? Paid by whom?
I would say I’d be very happy if there were an official European auditing body monitoring those matters across the European Union, overseeing the breaking up of the auditors and with the public being prepared to pay for some of the costs. There would be substantial benefits for the public. And free competition amongst consultants on financial reporting would be very useful for us all. Companies would be forced to accept the advice of an independent financial consultant and not one that’s part of an auditor which it could control.
What do you think of the former Swiss model, where the banks paid for the assessments but it was the national central bank who appointed the auditing firm in each case?
That makes sense. I think you should put the money into a central pool and the central regulator should allocate it. That takes away control from the company. All those things are about encouraging confidence in financial capitalism.