We're a long way from getting bank regulation right

The movie version of The Big Short is so good you probably don't need to read the best-selling book by my far-and-away favourite finance writer, Michael Lewis.

If you want to go deeper than the events culminating in the global financial crisis of 2008 to a more systemic analysis of why we've had so much trouble with the financial system and will continue to unless we change the rules more radically than we have, I recommend you read Other People's Money, by a leading British economist, Professor John Kay.

It's required reading for the nation's economists but, although it's very thorough, it's eminently readable by ordinary mortals. Similarly, although it doesn't deal specifically with Australia's financial system, its analysis is more readily applied to Oz than a book more focused on Wall Street.

Kay was in Australia this week, and when I spoke to him he left me in little doubt that he wasn't wildly impressed by our financial system inquiry, conducted by a panel dominated by people from the industry and led by former Commonwealth Bank boss, David Murray.

Not much there to ruffle the industry's feathers.

The Murray report does little to contradict the conventional wisdom that the huge expansion of the "financial services" industry over the past 30 years has been a great boon to the wider economy.

We've benefited from much financial innovation, deeper financial markets and a revolution in the management of financial risks.

But have we? We've certainly enjoyed much greater access to credit and much more convenient banking thanks to automatic tellers, direct debits and credits, and bill-paying on the internet.

But much of this is owed to advances in information processing and telecommunications rather than banking expertise.

Much of the "innovation" in the development of new financial products has been motivated by a desire to get around government taxes and regulations.

We're often told that all the trading of financial claims the banks and other market participants do between each other has made financial markets deeper and more liquid, thus making it possible for bank customers – individuals or businesses – to buy or sell a large block of shares or currencies without their transaction having a big, adverse effect on the market price.

Kay counters that all the trading of claims between financial institutions has, in fact, made financial markets far deeper than is required by users from the "real economy". Their need to buy and sell securities without moving the price could be met by opening the markets for a quarter of an hour a week.

But surely all that trading – in conventional securities, but also in ever-more exotic "derivatives" that get ever-more removed from the physical assets they are supposedly derived from – is aimed at helping customers manage the financial risks they face.

Well, that's what bank bosses and economists told us for years. Kay recalled the now-infamous incident in 2005, where a young Indian upstart from the International Monetary Fund attending the US Federal Reserve's annual conference at Jackson Hole, Wyoming, queried the value of recent innovation in financial markets and warned of troubles ahead.

The young fool was quickly put back in his box. One heavy defended the innovations, claiming that "by allowing institutions to diversify risk, to choose their risk profiles more precisely, and to improve the management of the risks they take on, they have made institutions more robust".

"These developments have also made the financial system more resilient and flexible – better able to absorb shocks without increasing the effects of such shocks on the real economy," he went on.

Later, another heavy agreed: "Financial institutions are able to measure and manage risk much more effectively. Risks are spread more widely, across a more diverse group of financial intermediaries, within and across countries."

You've guessed how this story ends. Within two or three years, the global financial crisis revealed all that as the opposite of the truth – to the great cost of taxpayers who had to bail out banks in the US and Europe and all the people in the real economy who lost their jobs or businesses.

It turns out the financial markets weren't managing risk by spreading it thinly across many people – as happens with an insurance policy, for instance – but were multiplying it (by gearing up and by creating derivatives of derivatives) and concentrating it in the hands of a relatively small number of big banks. Nobody knew how much risk particular banks had taken on.

The other way to "manage" risk is to find someone whose particular circumstances give them the opposite "risk profile" to yours. Do a deal and the problem is solved at each end.

In practice, however, such perfect matches are very hard to find. The best you can do is find a partner who's "risk seeking" – they want to take on the risk because there's a chance they'll clean up if you've jumped the wrong way.

In other words, they're willing to speculate. Turns out that's the main thing our bigger financial system is doing: not managing risk in any genuine sense, just making bets with each other.

These days, no central banker makes speeches extolling our bigger financial sector and much better ability to handle risk.

Trouble is, Kay says, all the tightening of regulation – including the requirement for banks to hold higher levels of capital, which the Murray report so strongly supported – hasn't done enough to ensure we don't have another crisis.

We have loads of regulation, all of it acceptable to the banks, whatever their grumbles. We could have less regulation if we regulated the right things the right way.

We could leave speculative trading between financial institutions largely unregulated provided it was separated from the normal banking activity than must always be effectively government-guaranteed. But the banks mightn't like that.

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Good reason to be angry about the banks

Are you angry about the banks? A lot of Australians are. And a lot of people in the United States and Europe are a lot angrier than we are, with good cause.

In Oz, we're annoyed mainly by the banks' very big profits and the way they never seem to miss a trick in keeping those profits high.

In other countries, people are angry about the way the banks and other financial institutions, having stuffed up their affairs to the point where they almost brought the global economy to its knees, were promptly bailed out at taxpayers' expense, so that few went bust, with almost no executives going to jail and many not even being fired.

By now, however, you're probably used to bankers and economists saying you don't understand and are quite unreasonable in your criticisms.

That's why you need to know about the book, Other People's Money, by John Kay. Kay, who's visiting Australia and this week spoke to a meeting organised by the Grattan Institute, says he wrote the book to help ordinary people understand "what it is they're angry about".

You want the dirt on the banks? No one's better qualified to spill the beans than Kay, an economics professor from Oxford and columnist for the Financial Times, who was commissioned to write a report on the sharemarket for the British government.

He starts by noting that over the past 30 or 40 years, each of the developed economies has experienced "financialisation" – huge growth in the size of what these days is called their "financial services sector" to the point where it's among their biggest industries.

For years, we've been told this is a wonderful thing, a sign of our economy's growing sophistication and ability to manage risk. Kay doesn't believe it.

We've always had a financial sector composed of banks, insurance companies and other institutions, and we've always needed one.

We've needed it to help us make payments to each other, to bring people wanting to save together with homeowners and businesses wanting to borrow, to help us save for retirement and to help individuals and businesses manage the risks associated with daily life and economic activity (insurance policies being the obvious example).

We need a financial sector to service the needs of the "real economy" of households and businesses producing and consuming goods and services. But none of this justifies the huge growth in the financial sector we've seen.

Most of that growth has come in the form of massively increased trading between the banks themselves in "financial claims", such as shares and bonds and foreign currencies and "derivatives" (claims on claims, and even – if you've seen The Big Short – claims on claims on claims).

If you add together all the financial assets ("claims") owned by all the banks and other financial outfits, they exceed by many times the value of the physical assets – such as houses and business buildings and equipment – which are the ultimate basis for all those claims.

The value of foreign currencies changing hands each day vastly exceeds the value of currencies needed by businesses and tourists paying for exports and imports. Similarly, the value of shares changing hands each day vastly exceeds companies' needs to raise new share capital and end-investors' needs to buy into the market or sell out.

Kay says that, in Britain, bank lending to firms and individuals in the real economy amounts to only about 3 per cent of their total lending.

All the rest is lending to other banks and institutions busy buying and selling bits of paper to each other – making bets with each other that the prices of those bits of paper will rise or fall in coming days.

Kay makes what, for an economist, is the very strong condemnation that almost all this speculative activity is "socially unproductive". It might or might not benefit the people doing the trading, but it's of no benefit to the rest of the economy.

He observes something I've noticed, too: economists have put little effort into explaining why all this trading in claims is so hugely profitable, allowing people near the top of the banks (but not their many foot soldiers) to be paid such amazing salaries.

If all they're doing is making bets with each other, why aren't the gains of the winners exactly cancelled out by the losses of the losers?

His answer is that the claims-trading parts of banks have found ways to exaggerate the profits they make by counting expected future profits they haven't actually captured – "paper profits" – but delaying recognition of expected "paper losses" until they're realised.

This game can continue for as long as everything's on the up and the bubble's getting bigger. Once it bursts, of course, former supposed profits become present, unavoidable losses. Many banks teeter on bankruptcy, but the government bails them out and they live to gamble another day.

Kay says the answer is to rigidly separate the old-fashioned parts of banking – the facilitation of payments, and lending to households and businesses; the bits that must be kept going through recessions – from all the speculative trading in claims.

It's a free country and "investment" banks should remain free to bet against each other, but there should be no taxpayer bailouts or other government protection for those that do their dough.

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