In the unlikely event that the G20 leaders can spare a few moments between photo opportunities and ritual denunciation of greedy bankers, they might give urgent attention to the question of how to extricate themselves from the underwriting of failed banks.
On Thursday at noon the Bank of England’s monetary policy committee will announce its decision on base rates. Suppose I think the rate will stay the same, and the market expects it will rise. At 11am I make a trade that reflects my judgment. I am right, the market is wrong, and I make a profit – perhaps a large one.
The social rationale of financial markets is that they discover information and create liquidity. But the benefit to society of more informed guesses of what the MPC will announce in an hour’s time is small. The benefit of creating liquidity at 11am, when the decision is uncertain, rather than at noon, when it is known, is also small.
Foreign exchange dealing is necessary to enable businesses to export and import and to handle the capital flows that are the converse of trade surpluses and deficits. Some speculative trading in these markets does indeed improve information, smooth prices and aid liquidity. But the volume of dealing that is needed to serve these purposes does not need to be several hundred times the underlying volume of merchandise trade. That level of activity creates instability, not stability, in foreign exchange markets.
These assessments are the basis of the claim by Lord Turner, the UK financial regulator, that trade in wholesale financial markets is far larger than can be justified by social benefits. He is right.
But more explanation is required. If my guess about the MPC decision is correct, someone on the other side of the trade gets it wrong. This activity may be very profitable for particular individuals and firms, but the gains and losses should net out for the financial sector as a whole. How can proprietary trading have been a very large source of earnings and profits for a large industry?
Explanations fall into three broad groups. First, the profits arise from government-created distortions, particularly state guarantees of the liabilities of financial institutions and opportunities for regulatory arbitrage. Second, profits are made at the expense of the customers of financial institutions. Corporate treasurers, pension fund managers and individuals mistakenly believe they can outwit dealers at investment banks. Trading firms that are also marketmakers use knowledge gained from one activity to profit in the other. Third, the profits are illusory; the reported gains are either borrowed from the future or from other segments of conglomerate financial institutions.
There is probably an element of truth in all of these explanations. At present, distortions created by subsidies and regulation are probably publicly the most important. When lending is tight, banks whose liabilities are implicitly or explicitly guaranteed by government enjoy substantial competitive advantages over other financial and non-financial institutions. In the unlikely event that the G20 leaders can spare a few moments between photo opportunities and ritual denunciation of greedy bankers, they might give urgent attention to the question of how to extricate themselves from the underwriting of failed banks.
There is also some truth in the observation that profits are made by smart banking insiders at the expense of unsmart, non-banking outsiders. But the last five years have shown that banks were less successful at selling toxic assets to other people than at selling them to each other. So we are drawn to the third element of explanation – that the profits that were reported, and on which bonuses were paid, never existed in the first place.
Carry trades, which yield constant small margins punctuated by occasional large losses and the repackaging of mispriced securities, offer transitory profits, and these are entirely offset by unrealised, but inevitable, future losses.
The best analogue is tailgating on motorways. Self-satisfied tailgaters congratulate themselves on skilful driving, and rebuff critics by saying their activities have been successful over many years. But every so often, the rest of us have to clear up their mess. The chief of police is right to warn drivers and the public that there is too much tailgating and its extent is hazardous to public safely.