The Future of Finance 2013: Structure, Innovation & Ethics
- Future of Finance
- May 1, 2013
- 7 min read
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Welcome
Dr Christopher Sier FRSA
In 2012 we, the Financial Services Knowledge Transfer Network (FS KTN), realised that whilst there was plenty of discussion on structure and regulation of financial services, or ethics and morality within the sector, or indeed on innovation within the sector, these subjects are all linked and had not really been considered simultaneously. Furthermore, the various groups that might have some interesting comment on these issues could be much more collaborative. The upshot was the Future of Finance Conference 2013, which aimed to cover structure, regulation, ethics and innovation together and involve a wide array of stakeholders including traditional economists, ‘new’ economists, quant scientists and mathematicians, high-powered computer scientists, innovators, policy-makers, regulators, and, of course, the industry.
FS KTN is grant-funded by the Technology Strategy Board and the Economic and Social Research Council to foster knowledge transfer and collaboration within and across the financial services industry, and between financial services and other sectors and players such as government, academia and entrepreneurs. It is an independent body that acts as a platform for discussion to understand and perhaps solve some of the key challenges facing the sector. We actively seek industry based challenges and problems and act as a catalyst, often using academia and entrepreneurs as a source of new information and new solutions.
We took this model into the conference by bringing a wide and diverse group of people together to transfer some of the knowledge of work already done on key issues facing industry, and to encourage engagement between the sector, academia and entrepreneurs. Our experience tells us that sometimes this means articulating the needs of industry in such a way that academics and entrepreneurs can work on research topics that have impact. Sometimes this means expressing the data and support needs of academia that will allow them to produce good research. Sometimes this means taking developing research and innovative business models and technology to the industry for them to adapt, adopt or otherwise consider. In the following pages you will see this model for knowledge transfer and innovation in action, as indeed it was during the conference.
We would like to thank our collaborating partners and sponsors who made this conference possible. Details on all our partners can be found on page 92 at the end of this booklet. We would like to extend a special thanks to the University of Oxford institutions that collaborated so effectively with us from the outset: The Institute for New Economic Thinking (INET) and their Director, Eric Beinhocker, who gave the insightful and challenging opening keynote (page 5); the Saïd Business School for the use of their wonderful facilities; and the Oxford-Man Institute of Quantitative Finance (OMI) for their enthusiasm and support. In addition to academic collaboration, we also had support from the finance industry from BNY Mellon who sponsored The Great Debate (see page 51) and BNP Paribas.
Finally I would like to acknowledge the work and support of Dominic Hobson who contributed enormously to the agenda, edited the lengthy conference transcripts and then tied the whole document together. I hope you enjoy his efforts as much as we have enjoyed his insights, enthusiasm and drive.
Dr Christopher Sier FRSA
Co-Director
Financial Service Knowledge Transfer Network
Foreword
Dominic Hobson
Between 2007 and 2009 the financial markets and the institutions which inhabit them descended into practical, intellectual and moral bankruptcy. What did not occur, with a handful of notable exceptions, was real bankruptcy. The authorities decided that the banking and investment banking industries were not just too big to fail, but too dangerous to reform. All of the regulation which is being imposed on the financial markets today is a consequence of this want of courage. Choose your platitude. The regulators and the central bankers are the physicians treating the symptoms rather than the causes. They are the jerry-builders papering over the cracks. They are the second hand car salesman clocking the odometer.
Seven years on from the beginning of the great financial crisis, the only real change is that banks no longer fund their assets with commercial bank money, but with central bank money. The balance sheets of the Federal Reserve and the Bank of England have expanded more than four-fold since 2007, and that of the European Central Bank is twice as large as it was then. Interest rates are deliberately suppressed. The benchmark dollar interest rate has sat at one quarter of one per cent since 2009. The European equivalent has not risen above a single percentage point since the end of 2011, and the sterling benchmark rate has remained 0.5 per cent since the beginning of 2009.
These extraordinary monetary policies are now yielding pathologies of their own. Zombie banks propping up zombie companies haunt every economy. There is persistent asset price inflation in housing, and periodic but unsustainable bubbles in stock markets. Companies, awash with cash but convinced asset prices are inflated, are not investing. The infamous `hunt for yield’ has resumed. Market forces are not even in suspension. Their workings are actually being perverted. Cryogenic monetary and regulatory policies imposed from without are preventing capitalism from fulfilling its perennial Schumpeterian duty of revolutionising the structure of financial markets from within, by punishing businesses that are not fit to survive.
Yet these policies are the source of much self-congratulation in official circles, whose decisions and decision-making processes are followed by economists working in major financial institutions with all the detachment of cheerleaders. It is not by accident that most economists work in banks or government. Industry and commerce, which must deal in realities rather than abstractions, long ago concluded they had little use for mainstream economics. All of the theoretical paraphernalia of financial excess, rushed from the laboratory to the market not because it was viable but because it was profitable, has somehow survived being tested to destruction in the long bull market and its disastrous denouement. The irrelevance of capital structure, trade-offs between risk and return, capital asset pricing models, Black-Scholes-Merton options pricing theory and the efficient markets hypothesis are all still in day-to-day use.
Even risk – however much of it is collateralised, or intermediated through central counterparty clearing houses today - is still being managed by variants of the Value at Risk (VaR) methodology, as if the great financial crisis had never occurred. In other words, it is not just the unstable structure of the financial system which has survived the crisis, but its flawed intellectual superstructure as well. If reform of the banking and securities industries cannot come from without, or from within, it must be found elsewhere. The academy is the obvious place to search for a catalyst. Unfortunately, in even the finest universities – institutions whose principal purpose is to deepen and extend human understanding, beyond any limit of interest or ideology – the forces of conservatism have so far proved more powerful than those of reform.
There is a natural reluctance among academics to surrender the ideas which have informed their financial models throughout their professional lives, and which they have passed to the next generation as the essential mysteries of their professional caste, even in the face of a defeat as catastrophic for their practical application as that of 2007-09. After all, as hard a science as physics has yet to resolve the conundrum posed by the discovery of the quantum in 1900. So it is scarcely surprising that economics, whose aspirations to scientific status seem less realisable now than ever, is capacious enough to make it possible for Copernicans to survive in a quantum universe. But this does not absolve the rest of us from aspiring to the truth, even if we cannot yet possess it.
Which is why a large part of the purpose of the inaugural Future of Finance conference was to create a congenial home for that small but growing band of thinkers and practitioners (and sponsors) who believe that it is possible to understand better how financial markets behave, and then design and operate a financial system whose stability is not contingent on complex, detailed and distortionary regulation. To this Wartburg of the financial reformation, if you like, we welcomed those who believe that markets are complex adaptive systems more akin to organisms or ecologies than the equilibria of classical economics; that regulation is cause as well as consequence of financial instability; that parallel systems of finance are more soundly based than highly leveraged banks; and that liquidity is a cost as well as a benefit.
To the robotic, utility-maximising individual with stable preferences, buying and selling in markets which always return to balance, we opposed the richer, less rational and more rounded understanding of the character of homo sapiens derived from the study of biology. We asked whether regulation is the enemy of integrity, or a substitute for it, and questioned whether contractual relationships are morally inferior to personal affiliations. Against the abstract risk modelling of the Wall Street quants, we fielded risk managers drawn from the real worlds of medicine, air travel, defence and petrochemicals. We examined how technology could be used by banks not to add needless complexity, trap customers and deter competitors, but to cut costs, create new products, disintermediate expensive middlemen, and broaden the sources of financing and banking services for entrepreneurs, the young and the unbanked.
These ideas are not a blueprint for a better financial system. Their value lies in their humility. Unlike the orthodox schools, which hold that as large a sphere of human action and interaction as the financial markets can be reduced to mathematical models, and their imperfections remedied by regulation or taxation or both, their authors accept that understanding is always provisional, that knowledge does not rest on authority, and that stability evolves by discovery not diktat. They are aware also of the infinite potential of the explanations that we find. It became obvious in 2007-09 that existing explanations of the behaviour of financial markets were inadequate, but old patterns of thought have proved remarkably resilient. It is the earnest hope of those of us who were privileged to take part in the inaugural Future of Finance conference that this summary of its proceedings can play some small part in the liberation of bankers, economists and policymakers from failed ideas and the noxious remedies they spawn.
