Never Mind Keynes, Wealth Managers Should Read Kipling

This article appears courtesy of WealthBriefing, where it was first published.

Whenever there is a crisis in financial markets such as that we have lived through, of one thing you can be sure: there will be lots of books written on the subject, frequently with weird or racy titles such as “The Big Short”, “How I Caused The Credit Crunch,” or “Fool’s Gold”, just to name three. But as I explain later, it makes more sense to read Rudyard Kipling instead.

Some of these books are quite insightful; some are just rattling good yarns and a chance for bruised investors to indulge in schadenfreude. The quality is highly variable: clichés about “greedy bankers”, for example, get wearying after a while. (Earth to media and politicians: greed was not invented by Milton Friedman or credit derivatives).

As far as wealth management is concerned, the value of any study of the recent disasters must be in ideas on how banks and other institutions can be better managed in future to avoid heavy losses and above all, to restore client trust and confidence. That is the ultimate point of spending a few hours ploughing through such tomes.

There are a few works out there that are worth your time, and I recently came across what I consider to be one of the very finest: “Alchemists of Loss: How Modern Finance and Government Crashed the Financial System,” written by Kevin Dowd and Martin Hutchinson. Dowd is, among his other positions, emeritus professor at Nottingham University Business School and since 2002, he has also been director of research at Black Swan Risk Advisors in Berkeley, California. Hutchinson is a veteran of the financial markets with 25 years’ experience under his belt. Both men are able, through their business and academic learning, to get their minds around the eye-wateringly complex fields of what they call Modern Financial Theory – a term embracing all the various innovations in risk management, asset allocation, options pricing, derivatives, accounting standards and credit analysis. They argue that while there are some aspects of MFT worth retaining, much of it, they say, is “rubbish”. They don’t mince their words!

The book makes a number of broad points about how we got into our current predicament and usefully, what sort of institutional and policy changes are needed to improve the situation. Here are the main points:

A return to honest money

Central banks, as issuers of fiat money and led astray by the hubris of trying to manage an economy by manipulating interest rates, have created a huge credit/asset bubble by maintaining dangerously low interest rates in recent years. A reprise of economic history, such as that of the US and UK housing bubbles, is used by the authors to ram this point home. The writers are supporters of market liberalism, arguing for a return to “hard money” – such as some kind of commodity-based currency. They oppose bank bailouts, saying that dud banks should be folded up under controlled bankruptcy processes like any other business. The authors are harsh about many aspects of what they call “crony capitalism” in Wall Street and London, and often say rude things about so-called tax havens, not to mention well-connected bankers at Goldman Sachs and other firms. However, make no mistake – the authors warn of a regulatory backlash that can be just as damaging as the original crisis. For example, they argue that many regulations, such as the Sarbanes-Oxley accounting laws in the US, are damaging.

Ownership liability

Another crucial reform area, the authors say, relates to limited liability laws and other regulatory changes. This is all about how firms are owned and the alignment of incentives. They say that limited liability, and its twin, bankruptcy protection rules, have fostered a climate of short-termism and risk-taking in banks and finance. This is one of the most controversial parts of the book. Dowd and Hutchinson want a return to unlimited liability partnership structures of the sort still used by many Swiss private banks such as Pictet or Lombard Odier. Short of such a move, shareholders in banks should have extended liability, such as by the practice of making bank shareholders liable for twice their shareholder investments. Another idea is to create, in the Articles of Incorporation, various protections against owners selling out, or at least encouraging them to look after long-term interests. One way is that Articles could require a relatively high dividend payout.

A more prudent approach to risk

The authors argue that a more partnership-friendly form of banking, harking back to the more cautious model seen in London before the post-1986 “Big Bang” reforms, would clear out many of the allegedly reckless trading practices that are associated with the crisis. For instance, owners of such banks would no longer tolerate heavy use of leverage. Credit derivatives would be used far less; securitisation of debt would decline and off-balance sheet techniques would be frowned upon. Clarity is supreme. Banks would be less likely to risk their own and client capital in highly leveraged hedge funds, private equity and other vehicles. And with banking less prone to encourage leverage, so the authors argue, the “con-trick” of hedge fund mangers being paid to deliver market Beta-plus-leverage would disappear as the price of money was based on supply and demand of real savings, not funny money. To earn a genuine crust, active management would be a more sober affair.

Many investment models don’t work

The authors point out, in convincing detail, that MFT has grossly underestimated risk at the “tail” of any bell-curve distribution of likely outcomes.This leaves investors dangerously exposed. A lot of value-at-risk models, for instance, seem to assume that a 2008-type event happens only once a century, the authors say. Well, consider the crises of recent times: the UK stock market bubble and crash of the early to mid-1970s; the 1979 oil shock; the 1987 stock market crash; the Japanese stock market crash of the early 1990s; the 1997-98 Asian crisis and Russian debt default saga; the 2000-01 implosion of the dotcom boom; September 11, 2001; the housing bubble and of course, the bankruptcies and mass failures of 2008. That is a pretty high level of frequency. And a lot of assets, such as those that were supposedly lowly correlated in normal times, have proven to be very highly correlated at precisely the point when investors need these theories to work.

Conclusion

I found much of the argument that the authors present to be compelling, although I think the limited liability issue perhaps has not been developed sufficiently (a follow-up study would be good to see). One criticism I do have is that they sometimes try a bit too hard, I think, to go for the populist vote by bashing the likes of “non-doms”, “tax havens” and the like. (In fairness, they want flat, lower taxes across the board, which would put some international financial centres out of business). But in general, there is a verve, and sense of drama, in this book that makes for compelling reading. One of the most demanding parts of the book for me was its chapter on modern risk management ideas. But they managed to make their discussion of the risks in VaR models, or Gaussian distributions, remarkably vivid. They showed how so much of the modern banking industry has, by a mixture of hubris, bad thinking and cheap money, been led into such dangerous territory. And the experience of 2008, which has seen so much turmoil, gives their argument a lot of credibility.

I am not so sure whether Modern Financial Theory will die out soon. A lot of time, money and intellectual capital has been invested in such ideas over the years and it will take a lot of reform, maybe through a new generation of young financiers, for better ideas to gain ground. There will also need to be change in the institutional ownership structure of banks and less leverage in the economy overall. And it is folly, I think, for anyone to imagine that speculative activity will go away, nor should it. Even in a world of “hard money”, some of these ideas will linger on. After all, in the kind of free market Dowd and Hutchinson want to see, there will, I assume, still be a need for large, liquid financial markets in derivatives to enable firms to hedge price risk. To do that, you need speculators willing to make prices in markets and shoulder the risks that others are not willing to bear. The much-maligned speculator has been around since the dawn of human market exchange – even the ancient Greeks speculated on olive oil.

It is fascinating, by the way, to compare this book with a work produced back in 2003 by Raghuram G. Rajan and Luigi Zingales, “Saving Capitalism from the Capitalists”. These authors, unlike Dowd and Hutchinson, are far more positive about certain government rules and structures such as limited liability. They see limited liability, which in the UK and US developed in modern form in the mid-19th Century, as a great engine of capitalism, not a moral hazard, and they argue that much supposedly toxic trading activity creates choice and liquidity. For instance, they argue that the more conservative banking model that Dowd and Hutchinson applaud often was a very clubby, unimaginative one that did no favours for entrepreneurs. For example, whereas Dowd/Hutchinson defend old US state restrictions on bank mergers, the other authors say that bans on cross-state border banking hurt business growth. I guess that the authors of Alchemists might argue that yes, a lot of old regulations were harmful, but the modern financial models are often slow at providing start-ups with capital and anyway, with much speculative froth removed, bankers could and would focus more on channelling savings to business, not dangerous finangling.

Alchemists of Loss is a book that urges us to heed the message of Rudyard Kipling’s magnificent poem, “The Gods of the Copybook Headings”. Here it is:

Then the Gods of the Market Tumbled, and their smooth-tongued wizards withdrew

And the hearts of the meanest were humbled and began to believe it was true

That All is not Gold that Glitters and Two and Two make Four

And the Gods of the Copybook Headings limped to explain it once more.

Or to put it another way – we need a return to honest money. While not everyone will be convinced of all the authors’ points, this is a book that deserves to be taken seriously by the wealth management sector


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