Jamal Mecklai: The next cycle

An inescapable conclusion from the series of financial crises that have been roiling our lives over the past couple of years is that the financial sector has become much too big for our good. Finance used to be — and should be — a support function in life. It certainly is in most companies that add tangible value in terms of products and services. Instead, it has become one of the loudest aspects of contemporary life.


Indeed, financial companies comprise 19 of the Forbes top-50 global companies (down from 25 in 2008), and generate $1.7 trillion of sales (down from $2.5 trillion in 2008). Now “sales” of financial companies comprise gains on investments (trading) and fees charged to clients. Acknowledging that some parts of client fees are charged to other financial companies, and, at least according to Goldman Sachs, that trading is not too significant a part of the business, I would estimate that around $0.85 to 1 trillion of sales come from fees charged to “real economy” companies. With global GDP (back of the envelope) not too much more than $40 trillion, this works out to an average fee of more than 2 per cent, which is ridiculously high.

Another way of looking at the issue is to recognise that financial sector profits in the US rose to nearly 6 per cent of GDP in 2007 from a long-term average of around 1.5 per cent. Now, in a free market, if any business starts to increase profit share to that extent, it would attract sufficient competition to bring the profit share back down close to the long-term average. Even where there are technological advances that are responsible for the increase in profits, free competition would still work since new vendors would start to pass on the gains from technology to customers. If this isn’t happening, it only means that the market is rigged.

Which means that regulators have been captured and/or are asleep at the wheel. This is hardly unique to the financial sector — the oil spill in the Gulf of Mexico, the sale of mineral rights in India are only two more examples of failure of government to do its job of keeping the market reasonably free.

The good news is that the turmoil has galvanised the need for change, and, unsurprisingly, a shift back to common sense. Here are five common sense ideas, which are all under various levels of discussion:

1) Depositors’ money, which is insured by taxpayers, should not be used for speculation. Period. Banks should be banks in the most classical sense, where they intermediate between savers and borrowers.

2) No institution should be too-big-to-fail. The only way to ensure that no institution becomes too big to fail (or too interconnected to fail) is to define the largest acceptable size of an institution in terms of assets and simply tax any excess to death by having differential reserve requirements.

3) Non-banks that take money from investors, however sophisticated, must be registered in the same jurisdiction in which they take money and/or transact.

4) As many derivatives as possible should be shifted to exchanges; brokers on exchanges should be pure brokers. Trading entities, whether banks or non-banks, should be permitted as market-makers only on exchanges.

5) Regulators should stop using credit ratings for setting capital adequacy. They should build their own skills and/or use paid consultants to track banks’ internal credit systems. Investors too should do their own due diligence and/or pay reputable agencies to do it for them.

While getting this common sense implemented will be extremely difficult, given the nature of politicians and the high winds of financial sector lobbying, it is clear that the world is ready for a new regime. Indeed, the US government’s financial sector reform Bill and related efforts in Europe attest to the fact that politicians have no choice but to listen.

Of course, this fragmentation of the financial sector will certainly put some sand in the wheels of finance, which will result in slower growth, a higher cost of capital and a lower expected return on financial investments. While none of these sound appealing, they are necessary changes to ensure that both risk and capital are more appropriately priced.

On the positive side, it will create more “real” competition in the financial sector, leading to better pricing for end-users and improved financial efficiency of the real sector. Further, as the share of financial sector profits in GDP comes down, it will automatically put more meaningful controls on executive compensation, which, in turn, will drive young people into a broader range of career options.

May the next cycle begin.