Was. Point, I welcome all of you to the opening session of the Beckham's third year of operation.
Uh, as you know, uh, Beckham All the political economy in Financial Markets program was established two years ago by,
uh, under the leadership of Max Watson, uh, sitting over there.
And he has led this program to great heights and we've had two very productive years and were about to embark on the third year.
Max suffered a health setback over the summer. So he's taking a backseat at the moment, but a very active, vigorous backseat role.
And David Vines has taken over temporarily as acting director.
David was going to be here tonight to open this this year's season, as it were, but he had to be in London.
So I'm going to chair today's session. And for those of you who want to get more involved with this, Julie Adams just popped out.
Is does the administration. And if you go to Julie she'll give you get you on the mailing list and also
point out to the website that you can access full publications on the platform.
We have six seminars here at European Studies Centre this term and there are two others one a
burial and one Chatham House that connected with Bentham in early November of the six seminars.
This term I would characterise for them as on the uh the the arc,
the financial architecture in the reform of the financial architecture in the wake of the crisis.
But also there are two which I would characterise as falling under the rubric of ethics and economics,
of which this one I think falls into that category.
And call him Matt. We are talking in part drawing on his book Firm Commitment that looks at the role of the corporation in society.
And then next week, David Lines will be talking about trust in finance.
So narrowing the focus a bit onto ethics and finance.
And as you probably know, this topic has been very much subject matter focus in the debate lately from all different disciplines.
And you can expect them to remain very active in this debate in the coming year.
There will be a podcast for the presentation for this week and also for the later weeks.
And but after the podcast, which is simply in the public domain, the question and answers will be held under the Chatham House rules,
which means that they are you cannot cite individuals in what is said.
Now I turn now to Professor Mann. He is the Peter Moores professor of management at the Syeed Business School.
And you are a dean of the school from 2006 to 2011.
And you're a Professorial Fellow also at Walden College.
You're an expert in all areas of corporate governance, finance and taxation, as well as of the regulation of financial institutions.
And you're a fellow of the European Corporate Governance Institute.
I think it's right to describe you as essentially an Oxford man.
As you did your first degree at ORIEL.
But you've also been at Harvard, the Bank of England, and a large number of other distinguished universities in your career.
You're also a director and chairman of Observer.
How about that? If I pronounce it correctly?
Between 1986 and 2010, which is now one of the most important and largest economic consultancies in Europe.
So a lot of praise, perhaps. Maybe I should now hand over to you.
Well, Adam, thank you very much indeed for that and for the introduction.
As Woody Allen said, since light travels faster than sound, people appear bright until you hear them speak.
Well, I'm extremely grateful for the invitation to be here.
I'm particularly grateful to Max for having suggested it, and particularly delighted to see you here today.
So thank you very much indeed for taking the trouble to be here.
I'm also very grateful to David Vines for having invited me.
Having invited me, he then promptly announced that he was not going to be here.
He he's gone to London to give a rival talk. So it's, in any event, a great pleasure to do this.
The last few years have been a torrid time for the financial system.
We've had the accounting scandals, market manipulations, payment protection, mis selling, mortgage, mis selling,
the LIBOR scandals, forex scandals, the financial crisis, executive remuneration scandals, tax avoidance.
And all these problems are basically associated with a variety of different underlying causes.
I'm going to suggest that, in fact, they don't have a variety of different causes,
that there's a common underlying problem that requires a common solution.
And that common underlying problem is the corporation, and the solution to it is to fix it and not everything else around it.
Underlying the corporation is an economic concept of a production function that takes inputs of material,
labour, land and capital and converts them into goods and services.
Or it it's regarded as a legal nexus of contracts binding together the various parties to the firm,
or it's a social construct for reducing the costs of transacting in the market relative to that in the firm.
And above all, the corporation exists to serve the interest of its owners,
its shareholders and its directors owe its shareholders a fiduciary responsibility to uphold their interests and to maximise the value of the firm.
And when that maximisation varies from the our interests as societies and communities,
then we seek to regulate the firm or if necessary, we take it into public ownership.
And when the corporation fails more, we regulate it more and we nationalise it more.
And when regulation and the state fail more than we liberalise and privatise,
and that notion of shareholder oriented corporations, regulation and state ownership is a widely accepted consensus.
It's the basis of national and international policies around the world.
But I'm going to suggest it's fundamentally wrong.
And the reason it's wrong is that that conception of the firm as a production function or a nexus of contracts
or a social construct that reduces the costs of transacting in the firm knowledge of the market is wrong,
and above all that the corporation does not exist to maximise the shareholder value.
It exists to do things to make goods and services that benefit us as consumers and communities.
And the corporation is exceptionally well placed to do that because it can balance the degree of commitment that it gives to different parties,
to the control that it exerts over them. It can contract to be contracted employee, be employed, sue and be sued just like us.
But it can actually do much more than that. It can offer degrees of commitment that we as individuals can only aspire to.
It's a veritable Alice in Wonderland, but over time, it's become a Frankenstein in Transylvania.
And the reason for that is it's been hijacked by one particular interest group, its shareholders, and very short term shareholders at that.
70 years ago, the average holding period of shares on the stock market was eight years.
30 years ago, it was four years. Today, it's a matter of months.
Or in the case of high frequency trading, a matter of days, hours, seconds or nanoseconds.
Now that shortening the horizon of corporations has had devastating consequences,
consequences for our economic systems, our financial systems and our environmental systems.
Because in the pursuit of shareholder gains, corporations have been willing to sacrifice our interests as creditors, communities and customers.
Now that problem of a shortening of horizons,
of shareholder interests has been exacerbated by a misdiagnosis of the underlying problem and therefore a prescription of the wrong cure.
The problem to which they're changing ownership of corporations and financial
institutions is thought to give rise is what is termed an agency problem.
That is to say, a separation between the ownership of companies and their control because of
the very dispersed nature of ownership in many countries around the world,
not least in the UK and the US. There's very little incentive for any one particular shareholder to exert a great deal
of effort in terms of overseeing the running of firms and financial institutions.
And as a consequence, management runs right. It pays itself egregious salaries.
It engages in wasteful investment. It undertakes disastrous acquisitions.
And nearly all policy towards the corporation over the last 30 or so years has been directed towards
solving that one particular problem of aligning the interests of management better with with shareholders.
Sarbanes-Oxley in the United States, Dodd-Frank. After the financial crisis in the United States, the cap recurred.
In the U.K., the European. Unions.
Shareholder Activism Directive, which came out recently.
All of those have as their objectives, to align the interests of management better with shareholders.
But the problem that underlay the financial crisis was not an agency problem at all.
Indeed those financial institutions. That had the highest powered incentives that aligned the interests of management best with our
shareholders were the ones that took the greatest risk and those that had the best corporate governance,
according to conventional measures of corporate governance standards, were the ones that failed the most.
The problem with the financial crisis was not an agency problem at all.
It was something very different. It was essentially a problem of fraud.
I don't mean fraud in the simple sense, which we might associate it with.
For example, Bernie Madoff. I'm talking about something that is much more subtle,
something that we teach our students in economics departments and business schools to do all the time.
To make money. There are two ways of making money.
The first is to do good or to make goods. And the second is to engage in wealth transfer.
By wealth transfer. What I mean is making money at the expense of others.
That was the problem of the financial crisis,
because there's a fundamental divergence between the two main parties associated with financial institutions, between the shareholders,
on the one hand, who benefit when the financial institution,
the bank is doing extremely well and when it's doing so badly that it's in distress or bankruptcy.
Then it's the creditors or ultimately the taxpayer that bears the losses.
So from the point of view of shareholders, it's a heads I win, tails you lose scenario.
And therefore they like institutions to take risks.
They like them to flip the coin, and they incentivise management to do exactly that.
That was precisely the issue that arose in relation to the financial crisis.
And it's not just the problem of excessive risk taking.
It's also a problem of excessive leverage because they incentivise management also to raise debt,
to pay that money raised out in the form of dividends and share buybacks to their shareholders.
And it's not just a problem that afflicts financial institutions.
It's a problem that afflicts employees who devote specific capital to the companies for which they work,
and suppliers to companies that dedicate physical capital to companies that they supply.
All of them are dependent on the continuation of the firms with which they engage.
So the problem is not an agency problem.
It's something that is really very different from that.
And what I'm trying to emphasise is that while we think about the problem of the corporation as
being essentially an agency problem of aligning the interests of management with shareholders,
it's at least a three dimensional problem.
It's a problem as well of aligning the interests of the company with its other stakeholders, its customers and its communities.
And it's a problem of aligning the interests of both current generations of shareholders and stakeholders with the interests of future generations.
Now, to deal with these problems, we have essentially one instrument.
You might think that perhaps the reputation of financial institutions and companies
might be sufficient to encourage them to act in a broader social interest.
But if you think that you'd be mistaken, it was July the 27th, 2012.
Up on the ticker tapes of the New York and London stock exchanges flashed the announcement that Barclays Bank
had been found guilty of the libel scandal between 1:30 p.m. and 4:30 p.m. when the London stock market closed,
the share price of Barclays Bank rose.
The stock market was overjoyed to hear that Barclays Bank had been found guilty of the libel scandal.
Now you might think, well, that was just a temporary blip and that after the share price of Barclays declined well over the subsequent six months,
Barclays Bank had to set aside £2 billion of provisions to pay compensation, not just for the LIBOR scandal, but also for payment protection.
And over that six month period,
its share price rose by 65% during a period in which the stock market as a whole went up by 10%, a 55% abnormal return.
Lloyds Bank had to set aside £7 billion of compensation for investors and customers, and its share price also rose by 65% over the same period.
And it's a problem that not only affects financial institutions, but it's a problem that's been widely observed.
For example, in relation to environmental regulation, when companies violate environmental laws,
their share price is found to either go up or to remain unchanged.
And this is exactly what one would expect if it's the case that a company is perceived to have acted more in the interests of their shareholders.
Then the share price should respond positively in relation to that announcement and revelation.
So from the point of view of society. The impact of reputational facts that come from the stock market are entirely perverse.
Now, the one instrument that we've got available to us to deal with that problem is regulation.
And in response to the failure of the in the financial crisis in this country, we're introducing a ring fencing between retail and investment banks.
We are introducing rules regarding bankers pay.
The European Commission is limiting the extent of bonus payments that can be paid relative to base pay.
We are determining who can run banks, how much they can get paid, what they can do, and how much they can charge for the services they provide.
We are running rings around the banks and what is going to be the consequence of that?
The consequence is going to be that banks are going to do less of the things that are regulated, like lending money,
which we might want them to do, and more of the things like derivative trading, which is unregulated, which we might not want them to do.
They're going to do less of the things in this country and more things abroad.
They're going to do less things in the form of formal, regulated banks and more in the form of unregulated shadow banks.
And the reason that this is happening is that the only way in which we can encourage
more ethical conduct on the part of institutions and companies is to regulate them.
But far from encouraging more ethical compliance, it encourages instrument avoidance.
Anyone who's been associated with the regulatory departments of utilities know that those are supposed to be compliance departments.
But in fact, anyone who's been involved in them would appreciate that.
Actually, they are avoidance departments designed to minimise the impact of regulation on the conduct of those institutions and companies.
Now in terms of trying to address the issue of how to actually encourage more acceptable conduct on the part of institutions and companies,
then what we might start by doing is perhaps looking at a few cases of where conduct has been a bit more acceptable.
The most successful bank in Europe at present.
Is a bank that is expanding rapidly in this country, opening branches all over this country at a fast rate.
It's one of the most profitable and high return banks in terms of equity returns in Europe.
It's a bank that did not have to be bailed out at all during the financial crisis.
It did not have to be bailed out during the Swedish banking crisis either.
It's the Swedish bank Handelsbanken.
Now there are a number of interesting features about this bank, the first of which is it pays its staff no bonuses.
No bonuses at all, except for when, at the age of 60, they finally retire.
Which stage? They can have a claim on the pension fund of the bank.
This performance is related to the financial performance of the bank.
The second interesting feature of this bank is that it delegates all decision taking to the branches, to the branch managers.
There's virtually no centralisation of decision taking.
The risks are managed by the individual branch managers to the extent that the Oxford branch manager, for example,
there is an Oxford branch and Botley determines the products that they're going to sell,
the prices they're going to sell, the way in which they're going to advertise the products in the area.
So all of the decision taking is devolved. The third interesting feature, the bank, is its ownership.
It's owned by two large shareholders.
The first one of which is. It's own pension fund octogenarian.
The second is it's owned by a Swedish investment company called Industry Varden.
And if you pose the question, well, who's the main shareholder in industry?
Varden. You've guessed it. It's Handelsbanken.
It's a cross shareholding. So here is a bank that pays no bonuses, devolves all decision taking, not at the board,
but right down to the branch manager level and is across shouting by every account.
It has all of the worst features that one can possibly imagine of a bank.
And what would generally be regarded as completely impossible from the point of view of recruiting any staff.
Let me give you another example. The the most successful period of British banking was, of course,
at the end of the 18th century when Britain had a whole series of local banks situated all over the country.
Those local banks were basically the basis on which the Industrial Revolution was financed.
Those were the basis of Britain becoming the workshop of the world.
Now those local banks suffered from a problem, and that is that they were exposed to their local economies when those local economies failed.
And so too did the banks and the central bank.
The Bank of England reacted then, as it did during the last financial crisis,
by trying to protect the financial system, culminating in the collapse of the city of Glasgow Bank in 1878.
And what it did to to correct the problem was essentially to encourage banks to merge.
So banks merged with each other and when they merged with each other, they shifted their headquarters from localities around the country to London.
And as they did that, then they severed their relationships with the companies that they were financing.
And basically the financing of small and medium sized enterprises ended in Britain at
the end of the 19th century when they were consolidated in five large banks in London.
And ever since then we've been trying to revive bank lending for small and medium sized enterprises in Britain, but with virtually no success,
except for one example of success, which came out of the Macmillan Committee that produced a report on the equity gap in Britain in the 1930s.
And the recommendations of that committee were that a new institution needed to be established to fund
British enterprise and in particular to provide financing for relatively small and medium sized enterprises.
And the institution that eventually emerged out of this in the post Second World War period was the Industrial Commercial Finance Corporation, ICF C.
Now, the interesting feature of ICF C is, first of all, its ownership pattern.
It was owned as a consortium by the clearing banks and the Bank of England.
So it was basically protected from market forces by the fact that it had a long term, stable ownership pattern.
The second feature of it is that it devolved decision taking on lending to the individual branches of the bank,
and it employed people known as controllers who had a very rare feature for British bankers.
They knew something about industry. They had industrial expertise as well as financial expertise.
And the result of this was that I CFC became an extraordinarily successful lender to SMEs in Britain.
To give you one illustration of a company that basically survived.
As a consequence of it and would not have without it. Oxford Instruments borrowed from ICF C in the early phases of its development.
Not only was it basically the mechanism by which many small and medium sized enterprises were financed in the post-Cold War period,
it was also an extremely profitable bank.
It also had an arm known as finance for industry, which was a provider of equity as well as debt finance to SMEs.
And towards the end of the 1970s, HDFC merged with a sister organisation, Finance for Industry to form.
Investors in industry. And investors in industry later changed its name to three.
Now, during the 1980s, investors and industry was essentially a venture capital firm, and it was indeed the largest venture capital firm in Europe.
And for a brief period of time, Britain had one of the most successful venture capital industries in the world.
But in its infinite wisdom and as part of basically a Thatcher privatisation.
It was decided that the Bank of England would sell off its share in three and so to with the clearing banks.
So at the beginning of the 1990s, three, as it was then known,
floated on the London stock market and virtually overnight it stopped doing lending for SMEs,
it stopped doing venture capital financing, and it became a management buyout business.
And basically since then we've had no significant as lending and a much reduced venture capital market in this country.
Now. The common features of the successful elements of financing that I've just described is,
first of all, the nature of the ownership of the institutions, the fact that.
Each successful owner, each successful institution had a long term owner.
The cross shareholdings in the case of Handelsbanken, the families in the case of the local banks and the consortium in the case of C and then three.
The second feature is a combination of knowledge about business as well as finance on the part of lenders loan officers.
Third feature is the devolution of decision taking to those respective parties.
Now in terms of.
Thinking about how to generalise this going forward and what this points to as an important component of the development of financial system.
Then I think there are three elements that this brings out.
First of all, there has to be a clear notion as to what the purpose of the institution is, what is the function that it's supposed to perform?
It was very clear in the case of the local banks during the Industrial Revolution
that their role was there to support the growth of new enterprise in Britain.
It's very clear if you look at the way in which Handelsbanken sets out its mission statement, what it sees as its purpose as being,
and that is to promote the development of lending to individuals and to companies in particular.
And it was very clear precisely what a CFC and three were supposed to do.
Now, although it's the case that we sometimes believe.
That the only purpose that companies that are listed on stock markets can perform is to uphold the interest of their shareholders.
That is not in fact the case.
In a survey that was undertaken of middle management in five countries around the world, that middle management was asked the question,
do you believe that your company is being run purely in the interests of your
shareholders or in the interests of your stakeholders more broadly defined?
In the case of the UK and the US,
70% of the middle management said that they thought that their companies and
institutions were being run solely in the interests of their shareholders.
In 20% of the French and German companies. They gave that response and in just 3% of the Japanese companies.
And those differences really matter because the middle management will also ask
the question If your company gets into financial into financial difficulty,
do you believe that it would cut employment or cut dividends?
In 90% of the British and American companies.
The middle management said that they thought that the companies would cut employment in 40% of the French and German companies.
They gave that response and in just 3% of the Japanese companies.
Now, the the notion that institutions and companies could have a purpose beyond just their
shareholder interests depends critically on not only expounding what that purpose is,
but also in having owners who are committed to uphold that purpose.
Now, the problem that is that arises in the case of in particular the UK and the US is not an agency.
Problem of inadequate control by shareholders is exactly the opposite.
It's the absence of any committed shareholders who are dedicated to supporting the pursuit of long term policies.
It's essentially a problem of having dispersed shareholders who are anonymous.
You cannot have a relationship with the anonymous.
And what British management finds in major listed companies is a significant problem is establishing what the
shareholders of the company are seeking as the purpose of the corporation beyond just making shareholder returns.
Now the feature of long term committed ownership is something that is very much observed in most listed companies around the world.
Those committed shareholders are, in many cases, families, so that while companies are listed on stock markets in most countries around the world,
they also have large, dominant family owners who hold shares for long periods of time.
Even in the case of the United States,
there is a greater prevalence of committed long term ownership and more of a presence of what this slide brings out here as block owners,
that is to say, significant concentrations of ownership in companies.
So this slide shows along here the average size of blocks in companies in different countries around the world and in the vertical axis,
the proportion of firms that have block holders at all.
And you can see that the UK is marked out by having very few firms that have got significant block holdings at all.
And where they've got them, the size, the average size of those block holdings is very small.
The US, in contrast, has shown up.
There is a country which is not dissimilar to many other countries around the world in having relatively significant share blocks.
And the US allows management a much greater degree of independence in terms of the way in which they choose to structure the ownership and control.
It permits companies to have anti takeover provisions such as poison pills, which protect management from hostile acquisitions.
And it allows companies to have dual classes of shares that concentrate control in the hands of particular long term shareholders.
So, for example, Google when it came to the stock market.
Kept control in the hands of Sergey Brin, Larry Page and Eric Schmidt, the founders of Google,
through a dual class structure linked in when it came to the stock market cap controlling the hand of Reid Hoffman, who founded the company.
Mark Zuckerberg retain control of Facebook recently.
So all of these companies essentially ensure a greater degree of continuing control through the use of dual class shares.
Dual class shares are not permitted. The companies that come to the London stock market because the London Stock
Exchange is concerned about protecting the interests of other shareholders.
Now what this points to is the fact that the US has benefited from a much greater degree of diversity of ownership,
including the prevalence of a much greater number of local banks that provide a local function
that is not dissimilar to what we observed in Britain during the Industrial Revolution.
The final component that's critical in terms of.
The pursuit of longer term prosperity, of interest beyond that of just shareholders is the role of boards.
Some of the most successful companies in the world are Bertelsmann, the media company.
Carlsberg, the brewery. Robert Bosch, the automotive supply company.
IKEA, the furniture company. Tata, the Indian conglomerate.
Velux, the window manufacturer. All of those have one thing in common.
They are all owned by industrial foundations.
Those foundations devote a majority of their profits to charitable purposes.
But it's not that charitable purpose that I want to emphasise.
The boards of those foundations are responsible for upholding the purpose laid down by the founders of those foundations.
And if the companies below them, like Carlsberg and Robert Bosch, fail to uphold those values and purposes,
then it's the boards of the foundations that take responsibility.
They essentially act like trustees, trustees of the companies below them,
ensuring that the purposes and principles of the firms below them are indeed upheld.
Now, while this combination of long term ownership clearly articulated, purposes and boards that are responsible for upholding those policies are,
I believe, critical elements in terms of establishing companies and institutions that one could trust.
The important point to to emphasise is that there isn't a single right model for how companies should be structured.
Indeed, we should be promoting diversity rather than seeking to impose a particular form,
because what is suited to small start up companies is very different from established high tech companies.
What is suited to high tech firms is very different from more traditional firms.
And what is suited, for example, to banks is very different from asset management firms.
So we should really be pursuing diversity.
And the types of approaches for pursuing diversity are, I think,
illustrated by some of the ways in which it's done in the United States and elsewhere.
So, for example, one of the most interesting innovations that has occurred recently in terms of public law is the
emergence of what is known as the Public Benefit Corporation B corporations as they're sometimes term.
These are corporations that have a clearly defined public purpose,
and it's the role of the board to ensure that those companies abide by the public purpose.
And if the company or the financial institution fails to abide by that public purpose,
then the owners of that company can sue the board for a failure to uphold that public purpose.
Now I think that this is particularly relevant in the context of companies and institutions that have a public function associated with them.
So, for example, in the case of utilities, energy companies, systemically important banks and other financial institutions,
companies with significant market power, companies that may have abused public laws in the past.
In each of those cases, there's an argument to be said for those companies and institutions having a clearly defined public purpose,
potentially buy it through a charter for which there should then be a board,
essentially like the boards of trustees of the foundations which are responsible for upholding those public purposes.
Because in essence, what is required to ensure the delivery of those public purposes is that there is not as
present a divergence of interests between companies and those responsible for regulating them.
Now turning to regulation. The traditional view of regulation is that there is essentially a separation between
the regulation of banks on the one hand and securities markets on the other hand.
Dating back to the Wall Street crash and the New Deal in the United States,
Securities Regulation was introduced in the early 1930s in 1933 and 1934, and bank regulation,
which established deposit insurance and the FDIC in the United States was part of the bank regulation,
including the Glass-Steagall Act, that separated investment banking and commercial banking.
And that distinction between securities regulation on the one hand and bank regulation on the other
now is an established basis of regulation of most financial regulatory systems around the world.
The second feature of regulation is it's very legalistic in nature,
basically derives from the use of black letter law for determining how regulatory systems should be structured.
The third feature is it's very institutionally based.
It basically looks at the institution and it poses the question, what is the appropriate form of regulation of that institution?
The fourth feature is it's very domestic regulation has really been evolved within countries on a domestic basis.
And it's only recently that we've seen a significant degree of international coordination of regulation.
And finally, for the most part,
until recently it's focussed on the micro regulation of individual institutions rather than thinking of the more macro elements.
Now I'm in the process of writing a book with four or five lawyers, four of whom are in Oxford John Armer Paul Davis,
Jenny Payne and Dan Ory and Jeff Cohen, who's at Columbia, in which we argue that this approach to financial regulation is basically entirely wrong.
First of all, the separation between securities regulation and bank regulation might have been appropriate at one time,
but it's certainly not appropriate now and that one should have an integrated approach that looks at regulation in a holistic fashion.
Secondly, that the underlying notion that regulation should be based on legal principles is also incorrect.
That in essence, these are economic problems which need economic forms of analysis to derive what is the appropriate basis for regulation.
Thirdly, that while the focus of regulation has been on institutional one,
the notion that institutions are the appropriate basis for determining regulation is clearly undermined
by the fact that many different types of markets and institutions do essentially the same things.
So instead of thinking about what the nature of institutions one should think about the
functions that those institutions are performing and regulate on the basis of function,
not on institutional form. Fourthly, that clearly in a global financial market, the notion of regulation being based on national factors.
Really needs to give way to thinking about how to formulate regulation on an international basis.
And finally.
The elements of systemic risk should be regarded as being essentially of paramount importance in terms of thinking about the design of regulation,
not the failure of particular individual institutions, except insofar as they give rise to systemic failures.
Now, the causes for these fundamental changes in the way in which one should be structuring regulation are firstly the fact that the there
have been technological changes which have facilitated the provision of finance in forms that were inconceivable only a few years ago.
You only have to think about crowdsourcing crowdfunding as a mechanism, peer to peer lending.
The sorts of things that are beginning to emerge as being very significant elements to appreciate that what was really
regarded as being forms of funding in the past are no longer going to be the dominant forms of funding gains going forward.
Second element that's critically important is the fact that. Markets clearly have become global in nature.
And the third element that's critically important is the emergence of shadow banking,
which is essentially non-bank institutions performing similar functions to those of formal regulated banks.
Now in terms then of trying to address issues about financial regulation from an economic standpoint,
the first thing then to do is to identify what are the underlying market failures,
and they're essentially full in nature, which are frequently emphasised.
The first information problems asymmetries in information.
The second are problems arising from free rider issues.
The problem that individual customers, for example, cannot really engage in activities that,
even if they are informed, ensure that they get delivered the types of services that they expect to get delivered.
The third problem is a problem of the monopoly power that many financial institutions might have in ensuring effective competition in markets.
And the fourth are potential failures and externality between institutions the sorts
of externalities that give rise to systemic failures or the appropriate responses.
Then a first of all, to think about disclosure as being in large part the way to deal with information problems, to think about enforcement,
public enforcement as a way of supplementing private enforcement,
where it's the case that for free rider problems, it's difficult for individuals to enforce contracts.
Competition policy is clearly a critical element.
And perhaps most importantly of all,
we have to think about how to design systemic responses to internalise the externalities across individual institutions.
And in particular, this point about emphasising these systemic elements is especially important because the approach of thinking
about regulation to the micro-level has the problem that it gives rise to serious unintended consequences.
You only have to think about the advice that suggested that banks need to hold relatively low risk.
Assets to to avoid potential failures to appreciate that.
That advice encouraged banks to hold government securities where we might have regarded government securities at one stage as being entirely riskless.
But it's slightly questionable now whether or not that was indeed very valuable advice.
Furthermore, in the process of encouraging institutions to hold particular types of assets,
the ones essentially introducing a systemic risk because one is affecting the prices of those securities as a consequence.
And those price effects then have implications and effects on other institutions.
I mentioned at the outset that rules regarding corporate governance.
Proved to be wholly inappropriate. Why is the screen for the gun?
It's tearing itself off. It is that unintended consequence we have.
You just have to think about the observation that those banks with the best corporate governance standards were the ones that failed the most.
To appreciate that recommendations regarding corporate governance can have entirely the wrong types of effects.
And likewise, the observation that those banks that paid the highest powered incentives were the ones that took the
greatest risks is another indication of how particular recommendations can have quite perverse effects.
Now, one illustration of this and let me try and put this back up is this slide,
which shows the changing nature of the ownership of of British companies over the period from 1989 to 2000 and 2010.
And basically, as you can see, what has happened is that in 1989,
the holding of UK equity by institutions like pension funds and life insurance companies was around about it was around about 50%.
But what if you see it now over here by the time that you get them and by the time that you get to 2010,
the proportion of holdings by pension funds and life insurance companies has declined from 50% to 14% one 4%.
It's better. Right.
Thank you. Okay. So there's been a phenomenal decline in the holding of British equity by pension funds and life insurance companies.
And a primary reason why pension funds have got out is that during the middle of the 1990s,
we introduced something called the minimum funding requirement,
which basically required pension funds to value their liabilities at a government index linked discount rate and to minimise their exposure.
What they did was they then shifted from equities into gilts, into index linked government government gilts.
And that has had the effect of driving down interest rates on government securities essentially to zero.
Now, this is this was not an unintended consequence, and it's had a very serious impact on the structure of financing of companies,
meaning that pension funds are no longer, in many respects, a serious player.
An analogy of thinking about how one should structure regulation comes from essentially the contrast between public health and medicine.
When we think about medicine, we're thinking about how to cure individuals, when we're thinking about public health.
What we have in mind is how to provide protection to societies and communities.
Medicine is concerned about diagnosis and prescription.
Public health is concerned about how does one identify potential pandemics?
How should one isolate the effects?
How should one immunise against?
And how should one intervene when failures occur?
Now there is, in essence a very similar distinction that arises in relation to financial regulation,
that if we're thinking about taking a systemic approach to regulation,
what we should be doing is to basically focus on how to identify potential failures,
how to immunise against them, how to isolate the effects of failures, and how to intervene when failures occur.
And what that basically involves is, first of all, having systems,
of being able to measure the extent to which there is exposure to failure to use capital to
immunise against failure to allow for bail ins in the event of isolation being necessary,
and to have methods of resolving failing institutions.
In other words, we will need a new approach which has begun to emerge as being the basis of the regulation of financial institutions,
but which really places systemic issues at the top.
And what this suggests is that in terms of designing our institutions for regulating financial systems,
then really what we should be doing is to place the systemic macro elements of regulation at the top,
to put this in the context of an international perspective of how to regulate the financial system and to regard the micro
elements as being overseen by the macro elements to ensure that these unintended consequences of micro regulation do not occur.
So to sum up, what I'm suggesting is that basically there's a complementarity between the governance of
individual institutions and companies and the regulation that occurs of financial systems,
that we should regard institutions as taking responsibility themselves for their own conduct and not simply going on doing things until someone,
namely a regulator, tells them to stop that they should have clearly articulated purposes that they should have long term owners, for the most part,
that are committed to ensuring that those institutions and companies abide by those long term purposes, that they have independent boards that are up,
that are responsible for upholding those purposes, and that we encourage diversity, not uniformity,
in terms of the nature of the ownership and governance of institutions that from the point of view of regulation,
what we require is a greater degree of emphasis on disclosure, on enforcement of failures such as bribery, corruption,
market and market manipulation and market abuse through stricter enforcement of criminal penalties than has been the case to date,
and that the particular emphasis of regulation should be on systemic protection,
with a focus on getting the necessary international coordination that is required, as well as the domestic coordination.
And it's that complementarity between the structure of regulation and the governance of institutions and companies that is critical to achieving this.
Because if you have regulation where companies and institutions are solely focussed on maximising shareholder returns,
then that regulation is essentially putting regulators in conflict with the companies and institutions that they're regulating.
One has to have an alignment between a public purpose and the function that regulators are trying to perform.
But on the other hand,
one cannot simply rely on the governance and the the way in which the private market operates to ensure that social purposes are fulfilled,
in particular, when there are market failures of the sorts that I was describing earlier on market failures of information,
of free riding, of externalities,
those require a public response and a public form of regulation which should be focussed on these elements that look at an improvement
in disclosure enforcement and addressing problems at a systemic level and an international perspective rather than a domestic one.
Okay. Thank you very much.