The Future of Finance: International Edition

By Simon Johnson

Bankers and hedge fund managers are fond of saying, “if you place restrictions on our activities in New York, we’ll just move elsewhere – like London.”  This makes attitudes towards the financial sector in other countries – particularly the UK – highly relevant for American public policy debate on this issue. 

Is it the case that the new found skepticism about modern finance and its effects on the real economy is confined to the United States?  Or is there a broader shift in thinking around the world, including in other leading financial centers?

A new book out this week from the London School of Economics, “The Future of Finance and The Theory That Underpins It”, suggests that a profound shift in the consensus is well underway. 

(Disclosure: I have an essay in this book, but as it is downloadable for free, there is no royalty involved.)

The book represents the views of leading UK-based thinkers and policymakers, including Adair Turner (the outgoing chair of the Financial Services Authority), Martin Wolf (the Financial Times columnist, now a member of the new UK Commission charged with determining if banks’ size and scope should be limited going forward), and Andrew Haldane (a senior Bank of England official who has been a high profile critic of the financial sector as it is currently organized).

This is obviously a group people who are willing to talk with each other, so some convergence in views is not unexpected.  Still, it is striking that a fairly disparate set of officials, academics, and practitioners should find themselves largely now in agreement that we have a problem – the financial sector in the UK (and elsewhere, like the US) has become potentially dangerous. 

The benefits from banking, broadly defined, on current scale and with its existing incentive structure are – at best – very limited.  In contrast, the costs – both in the recent past and likely future – are large and actually quite frightening.  The fiscal position of the UK has been literally ruined by the measures the last government had to put in place to support the big banks, directly and indirectly.  Whatever your assessment of the fiscal austerity measures being pushed hard by the new government, there is no question that much of the underlying problem arises from the continuing failure of financial regulation.

This then leads to the bigger question: What exactly should be done?  On this point, participants reflect the broader split in opinion.  Some prefer “better regulation”, which includes higher capital requirements (if we proceed along traditional lines) and a “macroprudential committee” (if we are to move regulation onto a new basis – creating a structure parallel to the committees that set monetary policy in many leading central banks).

But strengthening regulation is never as easy as it sounds – because the regulated banks get to respond and because more activities will move into relatively unregulated areas.  Charles Goodhart, for example, represents responsible thinking along these lines and many of the ideas that he discusses (e.g., on living wills) may be implemented.  But how much difference can such arrangements make when the big banks have every incentive to game the system – and when the resources commanded by the regulators are relatively tiny?

The alternative is new institutional arrangements, i.e., a different legal framework for the core of our financial system.

John Kay, also a Financial Times columnist, has been getting traction with his proposals for “narrow banking” – very much along the lines recently proposed by Paul Volcker.  Allow banks to only provide a limited range of essential financial services (around deposit-taking), and regulate those activities tightly.  Any other “risk-taking” parts of finance should be completely separated off from the regulated “safe” parts.  If that separation could really be effective – and that is the big “if” (ask Mr. Volcker) – then anything in the “risky” category could safely be allowed to fail, without disrupting the fundamental credit mechanism.

Martin Wolf prefers to directly control the way in which bankers can be paid – forcing their pocket books to face the consequences tomorrow of poor decisions today.  This is appealing in many ways, but also hard to implement.  The essence of limited liability – a cornerstone of modern economic development — is that your downside losses are capped.  And any attempt to impose unlimited (or even very large) personal financial liability on banking executives could surely be offset through insurance policies, either explicitly (if allowed) or implicitly (through all kinds of hedging transactions – remember these people have access to the fastest traders and best lawyers on the planet).

All this heads in the right direction but does not yet reach a definite conclusion.  In the last chapter, Peter Boone and I argue that we need an international treaty organization – along the lines of the World Trade Organization, but for finance.  We have to decide, by mutual agreement, what is and is not allowed in the international exchange of financial services – with a view to making the system dramatically safer.

If that sounds too complicated or not appealing for any reason, consider the implicit liabilities that underpin our current arrangements – and the cases (in our chapter) of countries devastated fiscally by their financial misadventures.

If we continue to allow the free international flows of capital alongside national (and antiquated) regulatory systems, the world’s banking system will get out of control repeatedly.  Increasingly, influential people in London and other financial hubs outside the United States begin to see the issue in these terms.

An edited version of this post appeared this morning on the NYT’s Economix and it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

33 thoughts on “The Future of Finance: International Edition

  1. “we’ll just move elsewhere – like London”

    Strange, London bankers threaten to move to Switzerland or Singapore.

  2. Mr. Johnson wrote:

    “If we continue to allow the free international flows of capital alongside national (and antiquated) regulatory systems, the world’s banking system will get out of control repeatedly.”

    That ship has sailed.

    Wall Street Is Laundering Drug Money And Getting Away With It

    July 14, 2010 – Huff Post – excerpt

    “Too-big-to-fail is a much bigger problem than you thought. We’ve all read damning accounts of the government saving banks from their risky subprime bets, but it turns out that the Wall Street privilege problem is far more deeply ingrained in the U.S. legal system than the simple bailouts witnessed in 2008. America’s largest banks can engage in flagrantly criminal activity on a massive scale and emerge almost completely unscathed. The latest sickening example comes from Wachovia Bank:

    Accused of laundering $380 billion in Mexican drug cartel money, the financial behemoth is expected to emerge with nothing more than a slap on the wrist thanks to an official government policy which protects megabanks from criminal charges.

    Bloomberg’s Michael Smith has penned a devastating expose detailing Wachovia’s drug-money operations and the government’s twisted response. The bank was moving money behind literally tons of cocaine from violent drug cartels. It wasn’t an accident.

    Internal whistleblowers at Wachovia warned that the bank was laundering drug money, higher-ups at the bank actively looked the other way in order to score bigger profits, and the U.S. government is about to let everyone involved get off scott free. The bank will not be indicted, because it is official government policy not to prosecute megabanks.

    Too-big-to-fail isn’t just a matter of systemic risk and mathematical models gone haywire, It’s about the basic functioning of our democracy. You cannot have a functional democracy in which an entire privileged class of bankers can get away with anything–and if you can get away with laundering hundreds of billions of dollars in drug money, there’s not much you can’t get away with.”

  3. Banks Financing Mexico Gangs Admitted in Wells Fargo Deal

    Jun 29, 2010 – Bloomberg – Michael Smith – excerpts

    Just before sunset on April 10, 2006, a DC-9 jet landed at the international airport in the port city of Ciudad del Carmen, 500 miles east of Mexico City. As soldiers on the ground approached the plane…They found 128 black suitcases, packed with 5.7 tons of cocaine, valued at $100 million.

    The smugglers had bought the DC-9 with laundered funds they transferred through two of the biggest banks in the U.S.: Wachovia Corp. and Bank of America Corp., Bloomberg Markets magazine reports in its August 2010 issue. This was no isolated incident. Wachovia, it turns out, had made a habit of helping move money for Mexican drug smugglers. Wells Fargo & Co., which bought Wachovia in 2008, has admitted in court that its unit failed to monitor and report suspected money laundering by narcotics traffickers — including the cash used to buy four planes that shipped a total of 22 tons of cocaine….

    “Indicting a big bank could trigger a mad dash by investors to dump shares and cause panic in financial markets, says Jack Blum, a U.S. Senate investigator for 14 years and a consultant to international banks and brokerage firms on money laundering.

    The theory is like a get-out-of-jail-free card for big banks, Blum says.

    “There’s no capacity to regulate or punish them because they’re too big to be threatened with failure,” Blum says. “They seem to be willing to do anything that improves their bottom line, until they’re caught.”

  4. I don’t have much to add here. Just wanted to say I think it’s great when professors and people in the educational field offer books like this LSE one for free for public consumption. Of course professors also have a right to write commercial books and some “premium” content like things from time to time. They deserve a right to make a few extra dollars and live a good quality lifestyle. But it should never outweigh their duty to educate the general public and keep the society well informed and in the loop so we can make better choices as consumers/savers/investors/voters.

    So I applaud Simon Johnson and the others for this type thing. I was hoping that Kwak and Johnson would do a little tour of small university campuses promoting their book as a duo, but I guess they have other duties with work and family.

  5. It’s the biggest load of crap you’ll ever hear in your life. Where would Jamie Dimon and Lloyd Blankfein go, to Scotland to share a pitcher of beer with Hugh Hendry!?!?!?!? If Hugh Hendry had the sense I think he does, he’d bash Dimon and Blankfein’s heads together, throw them in the ditch and tell them they don’t like to share beer with corporate welfare recipients in their country.

  6. Mr. Johnson said:

    Bankers and hedge fund managers are fond of saying, “if you place restrictions on our activities in New York, we’ll just move elsewhere – like London.”

    I say, “Good Riddance”.

  7. Criminal charges against corporations are just stupid. A corporation is a contract. Only human beings can act. The Nurnberg defense (only following orders) failed sixty years ago. The criminal charges against corporations we have today are just as stupid as if prosecuting the “Third Reich” instead of its leaders. Only when we start holding human beings responsible for their acts instead of indicting contracts will we see any change in behaviour.

  8. Thank you for persisting in trying to draw attention to what needs to be done in spite of the fact that this administration, Congress and the mass media continue to base all of their actions on their own personal profit motives and to hell with the common good – just like the financial leaders who created the mess that needs to be cleaned up.

    Please continue to light those candles instead of cursing the darkness. We need more leaders like you.

  9. “Allow banks to only provide a limited range of essential financial services (around deposit-taking), and regulate those activities tightly. Any other “risk-taking” parts of finance should be completely separated off from the regulated “safe” parts. If that separation could really be effective – and that is the big “if” (ask Mr. Volcker) – then anything in the “risky” category could safely be allowed to fail, without disrupting the fundamental credit mechanism.”

    Ultimately, I believe this to be the correct course of action.

    For it to work, however, we need to consider any financial firm engaged in maturity transformation (e.g., money market funds taking deposits and buying commercial paper, broker-dealers using repos to fund longer term assets, credit hedge funds, etc.) to be banks and regulated as such.

  10. July 14, 2010

    “The Office of Congressional Ethics has sent corporate donors and fund-raising hosts more than three dozen requests for documents involving eight members who solicited and took large contributions from financial institutions even as they were debating the landmark regulatory bill, according to lawyers involved in the inquiry.

    The requests are focusing on a series of fund-raisers last December, in the days immediately before the House’s initial adoption of the sweeping overhaul, which could win final approval this week. Some of the fund-raising events took place the same days as crucial votes.”

  11. My first thought was London? Why not cut to the chase and go to Singapore. Welcome to the outsoursed club.

  12. Jamie and lloyd will go to singapore. keep your TARP to yourself and your cash in your mattress. jpm and goldman did not need it anyway.

  13. Simon and Johnson are getting too dangerous!! time to stop them. They mix facts with innuendo and present them as new ideas.

  14. “Allow banks to only provide a limited range of essential financial services…anything in the ‘risky’ category could safely be allowed to fail…”

    Sounds good, but–a big but–they will not be allowed to fail. Fear of “disrupting the fundamental credit mechanism” will triumph, just as it did in 2008 and before that in the LTCM crisis. That is the real issue. The Greenspan/Bernanke put with all its moral hazard implications is the underlying disruptive force.

  15. Goldman Sachs to Pay Record $550 Million to Settle SEC Charges Related to Subprime Mortgage CDO

    2010-123 – SEC – Press Release – excerpt

    Washington, D.C., July 15, 2010 — “The Securities and Exchange Commission today announced that Goldman, Sachs & Co. will pay $550 million and reform its business practices to settle SEC charges that Goldman misled investors in a subprime mortgage product just as the U.S. housing market was starting to collapse.

    In agreeing to the SEC’s largest-ever penalty paid by a Wall Street firm, Goldman also acknowledged that its marketing materials for the subprime product contained incomplete information.

    Today’s settlement, if approved by Judge Jones, resolves the SEC’s enforcement action against Goldman related to the ABACUS 2007-AC1 CDO. It does not settle any other past, current or future SEC investigations against the firm.

    Meanwhile, the SEC’s litigation continues against Fabrice Tourre, a vice president at Goldman.”

  16. Tim Geithner Opposes Nominating Elizabeth Warren To Lead New Consumer Agency

    07-15-10 06:34 PM – Huff Post – excerpt

    Treasury Secretary Timothy Geithner has expressed opposition to the possible nomination of Elizabeth Warren to head the Consumer Financial Protection Bureau, according to a source with knowledge of Geithner’s views.

    The financial reform bill passed by the Senate on Thursday mandates the creation of a new federal entity charged with protecting consumers from predatory lenders.

    But if Geithner has his way, the most prominent advocate for creating the agency may not be picked to lead it.”

  17. “Distinguished law scholar Elizabeth Warren teaches contract law, bankruptcy, and commercial law at Harvard Law School. She is an outspoken critic of America’s credit economy, which she has linked to the continuing rise in bankruptcy among the middle-class. Series: “UC Berkeley Graduate Council Lectures” [6/2007]

  18. Thinking of the Cold War and the quip that Generals
    prepare to fight the last war I note that we were once deathly afraid our military machines would get away from us and lead to our destruction. Movies like “Fail Safe” or Dr. Stranglove made the public aware of the danger of ‘accidental’ nuclear war.

    While Financial Armageddon may not wipe our species off the face of the earth, we do seem to have constructed financial ‘machines’ in the TBTF banks that have grown beyond our control. The US military
    would conduct extensive psychological and background
    checks on anyone whose finger went near a nuclear button yet we allow anyone to command a TBTF financial institution without having to pass any sort of screening whatsoever.

    While the militaries of the US and USSR managed to not place a Kubrickesque General Ripper in charge of a nuclear bomber wing, the financial world has been replete with Fuld’s, Cassano’s, Madoff’s and even low ranking rogue traders taking huge gambles with other people’s money. Maybe its not the ‘rules’
    we make so much as the kind of people we allow to inhabit the top of financial system.

  19. You might want to test your logic with the current Supreme Court. They’ve decided that these “contracts” can spend like drunken sailors when it comes to buying political favors.

  20. You might want to check out the link anchored to my name. I wrote about some of the ideas and circulated the paper for publication but that’s not an easy thing to do given the blizzard of words – online and offline – these days. I never got a reply.

    Finally, I sent it off to one of the blogs and it was posted. Like the old question of whether a fish knows about the water it’s swimming in, we seem oblivious to the technology that now baths most of our waking moments. Yet there’s never been anything like it.

    I’m quite honestly dumbfounded that we don’t seem to associate the faster cycles of ever-greater destruction with that technology. Networked computing power has given us the ability to create and market thousands of arcane CDOs in a flash. There’s never been anything remotely like it. It changed the entire scope and scale of the financial/investment world in just a few years during the 1990s. Yet we act as if nothing has changed.

  21. Agreed. The Fed’s role is now irrelevant. Can the TBTFs global role rule national defense?

  22. But we have a Supreme Court that claims that corporations have first amendment rights to free political speech (after having established that money is speech).

    Of course we need to hold human beings responsible. We also have to take back our right, as a people, to rescind corporate charters and abolish corporate “personhood” once and for all. See

  23. I should have said “to rescind corporate charters when appropriate and necessary”

  24. Do coporations that control our economy have to “Swear to protect and defend the Constitution of the United States”?

  25. Most oligarchies exist within the framework of individual nations, with littla or no linkage beyond national borders. Perhaps the scariest thing about finance is that there is almost seamless linkage between the financial sectors of all developed economies around the world, even including the WB and IMF. This is actually far more terrifying than Al Quaeda or any of its allies. These terrorists can kill a few thousand people every few years. The international banking community could literally throw the entire planet into chaos, and, as its power continues to rise, potentially in orders of magnitude, it threatens the lives of all in both foreseeeable and uncalculable ways.

    I dredged up an old Arthur C. Clarke quote recently, and, since he was British (albeit spending most of his adult life in Sri Lanka), it seemed particularly appropriate to offer it here:

    “This is the first age that’s paid much attention to the future,which is a little ironic since we may not have one.”

    And, if he were still alive, and commenting on this column, he may well have thought or said that in response.

  26. Got a chance to read your paper today and yeah, its very thought provoking. I don’t have your faith in ‘regulation’ being THE answer though it is an essential requirement.

    The problem, to again allude to the nuclear weapons dilemma, is that you have to know what you are trying to prevent. In the case of atomic weapons that was pretty straightforward. Unauthorized use or access.

    The dynamic and complex world of finance poses a much more difficult issue. Knowing what you are trying to prevent may not be knowable and thus make
    even the best designed regulations fail as they cannot predict every situation or outcome.

  27. Power corrupts and, as the saying goes, absolute power corrupts absolutely. Financial power is no different. International finance has no conscience and has serviced warfare and destruction as well as construction with equal zeal. The difference is that it is easier to destroy than to build, and when the finacial interests grow desparate it sees society itself as merely a marginalized externality. We have terms like “real politik” for raw political power, but the white wash of fiancial force is merely reiterated as free and unregulated markets. Until more work like the London School of Economics, “The Future of Finance and The Theory That Underpins It” becomes common best practice, we will have more of the same destructive potentials left to a handful of people of whom we truly know nothing about…runing our futures and fate.

  28. Thanks for the gracious reply. Assuming due diligence for regulators – or any one else for that matter – is always questionable, I agree. But it has to be part of the solution as you say. At the very least, having transparent access to the contents of these arcane instruments would be a huge step forward. What it implies, however, is even greater automation in the vetting of those instruments.

    That brings up another one of my concerns, however. The more autonomy we build into the regulatory system (either governmental or self-imposed by the traders), the more feedback such as system will have. That feedback would be built in to shut down trades, damp wild excursions during extreme short selling, that sort of thing.

    Well the more feedback in a system, the more likely it is that it will transition (or bifurcate as the nerds like to say) to unwanted states. Examples of such systems are literally everywhere around us though we barely make note of them.

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