John Kay

The turmoil following the collapse of Lehman Brothers three years ago was an opportunity to
reform the world’s financial system. It was missed, and the new crisis promises little change.

After mistaken claims made ahead of the global crisis won much academic support, long-held assumptions were called into question – but the real world often remains overlooked or ignored.

Sovereign debt repayment is more about politics than economics.

In the dollar bill auction, one party eventually scores a pyrrhic victory and takes possession of the dollar bill. Both parties lose, but the smaller loser is the person who sticks out longest. That is not usually the rational player.

When New York crassly mismanaged its financial affairs, the president’s response was famously paraphrased as “Ford to City: drop dead!” When Greece was guilty of similar mismanagement the reaction of the ECB and the European Commission was “how can we help?”.

The credit crunch of 2007–8 was the direct and indirect result of losses incurred by major financial services companies in speculative trading in wholesale financial markets. The largest source of systemic risk was within individual financial institutions themselves. The capital requirements regime imposed by the Basel agreements both contributed to the problem and magnified the damage inflicted on the real economy after the problem emerged. This chapter argues that regulatory reform should emphasize systemic resilience and robustness, not more detailed behavioural prescriptions. It favours functional separation of financial services architecture, with particular emphasis on narrow banking—tight restriction of the scope and activities of deposit-taking institutions.

Why do we so often find that events reinforce what we already believe? John explains how confirmation bias characterises reactions to the financial crisis.

The suggestion that we might partially turn back the clock has been described as a call for “Hovis banking”, referring to an advertisement that plays on nostalgia. The commercial succeeds because we believe the bread our grandparents ate, before innovations in technology and marketing, was nicer and more wholesome. Perhaps that is true in banking as in baking.

We will succeed in managing financial risk better only when we come to recognise the limitations of formal modelling. Control of risk is almost entirely a matter of management competence, well-crafted incentives, robust structures and systems, and simplicity and transparency of design.

John explains (again) why structural reform is preferable to behavioural regulation in the banking sector, and applauds Sir John Vickers’ observations on the work of the Banking Commission.