October 2015 newsletter – British Science Association Festival of Science Section F – Economics

The British Science Association held its annual Festival of Science at Bradford University 7-10 September 2015. This report comes from David Dickinson, the Recorder of the Economics section.

This year’s Economics Section President, Prof David Miles (Imperial College, London), organised a very stimulating session titled ‘Does the Financial Sector do more harm than good?’

He introduced the session by noting that the level of UK Bank assets had risen over a 20 year period from 100 per cent of GDP to 600 per cent immediately prior to the Crisis of 2008. He left the two main speakers, John Kay (Oxford) and Kevin Dowd (Durham), to explain why that rise had occurred, whether there was any social benefit from such an increase, how it created the conditions for the Financial Crisis, and what was necessary to stop something like it happening again.

John Kay introduced his remarks by arguing that most of the increase in assets that Miles identified had come from banks trading with other banks. He noted that banks were now engaged in activities that were far away from traditional banking business. He pointed out that those traditional activities (deposit-taking, lending, wealth management, trading of risks, trading of physical assets) were socially beneficial. He did not believe that the development of derivatives trading and the use of trading algorithms, which had fuelled the increase in banking assets, were of any value to society and clearly were socially costly when the assets were found to be worthless. To understand why there had been such an increase in banks trading with each other he referred to the work of John Kenneth Galbraith who had explained the 1929 crash as an example of the ‘Bezzle’. This term could be understood as the stealing of something without the owner realising that it had been stolen. Such a Bezzle could arise, as happened in the run-up to the 2008 Crisis, by banks trading assets with each other with each trade inducing a profit since the asset’s true value was overestimated by an increasing amount. The process was assisted by Ratings Agencies over-assessing an asset’s quality. Kay noted that we borrowed from the future and the future eventually arrived. No-one benefitted from this except those who worked in the industry and earned bonuses while the trades were happening. This led to Kay’s solution to the problem. He did not believe that more regulation was the answer since regulation just encouraged smart bankers to find ways around it (indeed some of the assets created in the run-up to the financial crisis were such regulatory-avoidance mechanisms). Firstly he wanted a shift of banks back to their core business. Secondly he wanted to ensure that senior banking staff accept responsibility for the actions their bank had taken. This implied, for example, that Bank Directors would have unlimited liability for the losses the bank incurred. It was no longer a satisfactory excuse that the CEO did not know what was happening. They needed to ensure that the bank was run in such a way that it could not happen. With these changes Kay felt that the Financial Sector would do more good than harm.

Kevin Dowd reinforced the analysis of Kay, agreeing with many of his points. He argued that traditionally bankers were trusted but this was no longer the case. Banks were now seen to be serving themselves rather than the community at large. He thought that an Investment Bank could create real value but that it would need to be a much different type of institution to those currently operating. There is too much risk-taking and too little capital. Hence the risk-taking was at the expense of the taxpayer and, as Kay had noted, the large salaries that bankers earned were essentially paid for by future taxes. The total cost of the Financial Crisis was of a similar level to the fighting of a war. Politicians needed to have the courage to stand up against the powerful vested interests that represented Banks. Dowd noted the example of Robert Walpole who had imprisoned Bankers and Cabinet Ministers who had been involved in the financial scandal known as the South Sea Bubble in the 18th century. Those who had profited had their fortunes appropriated by the Government in order to compensate the investors who had lost money. He agreed with Kay about holding those who had profited from the Financial Crisis to account and saw the need for a modern Walpole to show the necessary courage. Dow extended the idea of unlimited liability to bank shareholders although he agreed with Kay that introducing personal responsibility for senior bank staff was a key requirement. In the context of whether banks did more harm than good Dowd noted that our best brains have been going into banking but with little social benefit (By contrast, cash machines, internet banking and credit/debit cards were examples of innovations that improved welfare).

The session was then opened up for questions from the audience. A lively discussion ranged over a number of issues: the role of ratings agencies, politicians with vision to solve the problems, whether jail was appropriate for bankers, shareholding structures, crony capitalism, accountability but not scapegoating, bankers who pointed out the problems before the crash, computerised trading, Islamic banking. The extensive debate and broad questioning demonstrated very well how the three speakers had engaged the audience and that the issue of the role of the Financial Sector and how it benefitted society was a topic of great importance to the general public.