I am becoming more and more certain that Wall Street, and the whole enterprise of financial capitalism, is destined to be massively disrupted.
But probably not until 2024 or so... E Five Steps That Banks Must Take To Achieve The Good Society http://www.forbes.com/sites/stevedenning/2013/02/14/five-steps-that-banks-must-take-to-achieve-the-good-society/ What are we to make of Wall Street? Can we avoid feeling some admiration for the swashbuckling titans and their brash handling of unimaginable amounts of money? Or horror at the greed and sleaze that their activities lead to? Should we deplore the feeble efforts at regulators to repair the damage that Wall Street caused to Main Street in the Great Recession of 2008, or to prevent another crisis? Or instead attack the dynamic within the banks that led to the financial meltdown in the first place? Fortunately help is at hand with Robert Shiller’s book, Finance and the Good Society (Princeton University Press, 2012). This is an important book, even with some serious shortcomings. The strengths of the book are that it presents us—for once—with a balanced historical perspective of what the financial sector has done for society over its five-hundred year history as well as a brilliant and convincing picture of what a responsible and morally sound financial sector should be contributing to the good society. The book’s main shortcoming is that it gives us an incomplete analysis of why the last thirty years have been such a particularly “bad patch” within the broader story of the centuries-long success of modern banking. As a result, the book misses five steps that are needed for banking and finance to help achieve the good society. Let’s start with the book’s strengths. “Finance” and “good society” are words that are today rarely used in the same sentence. Yet Shiller does us a service by reminding us that finance has in fact made important contributions over time to achieve a more an egalitarian society. Greed and the excesses of the recent crisis have made finance and banking today the least trusted sectors in the entire economy—a paradox, given that banking ultimately and necessarily rests on a foundation of trust. But Shiller points out that finance is not inherently elitist or an engine of economic injustice. In fact, finance has been central to the rise of prosperous market economies in the modern age— indeed their rise would be unimaginable without it. Finance is an essential social institution, necessary for managing the risks that enable society to transform creative impulses into vital products and services, from improved surgical protocols to advanced manufacturing technologies to sophisticated scientific research enterprises to entire public welfare systems. The connections between financial institutions and individual people are fundamental for society. It is central to activities like the development of a new laboratory, the funding of a medical research project, the building of a new university, or the construction of a new city subway system. Finance provides structure to these and other enterprises and institutions throughout society. If finance succeeds for all of us, it helps to build a good society. Shiller notes that the very financial system that facilitates some of our greatest achievements can also implode and create a disaster. But finance, despite its flaws and excesses, is a force that potentially can help us create a better, more prosperous and more equitable society. Banking’s original role was in serving primarily the wealthy and the financially sophisticated. Throughout history there has been a long trend toward the democratization of finance, the opening of financial opportunities to an ever wider circle of people and reduce the risks to which they are subject. 2. Historically, finance helps good society achieve its goals Shiller argues that at its broadest level, finance is the science of goal architecture—of the structuring of the economic arrangements necessary to achieve a set of goals and of the stewardship of the assets needed for that achievement. The goals may be those of households, small businesses, corporations, civic institutions, governments, and of society itself. Once an objective has been specified— such as payment for a college education, a couple’s comfortable retirement, the opening of a restaurant, the addition of a new wing on a hospital, the creation of a social security system, or a trip to the moon— the parties involved need the right financial tools, and often expert guidance, to help achieve the goal. In this sense, finance is analogous to engineering. Shiller accepts—at times—that finance is not just about “making money” per se. It is a “functional” science in that it exists to support other goals: those of the society. The better aligned a society’s financial institutions are with its goals and ideals, the stronger and more successful the society will be. If its mechanisms fail, finance has the power to subvert such goals, as it did in the subprime mortgage market of the past decade. But if it is functioning properly it has a unique potential to promote great levels of prosperity. Finance, suitably configured for the future, can be the strongest force for promoting the well-being and fulfillment of an expanding global population— for achieving the greater goals of the good society. The democratization of financial innovations has often proceeded at a snail’s pace, often over centuries. The challenge is to accelerate the pace of positive innovation, while averting the problems that have arisen. 3. The financial system is still going through a severe crisis While politicians wonder why there hasn’t been a more robust recovery from the crisis of 2008, Shiller points that the crisis hasn’t yet ended. The 2008 crisis began with subprime mortgages but it didn’t stop there. That was only the initial shock in a vast catastrophe. The consequence was a drop in real estate prices and the collapse of financial institutions, not only in the United States but also in Europe and elsewhere. By the spring of 2009 the crisis was so severe that it was described as the biggest financial calamity since the Great Depression of the 1930s—bigger than the Asian financial crisis of the 1990s and bigger than the oil-price-induced crises of 1974–75 and 1981–82. Beginning in 2010 it was complicated by a European sovereign debt and banking crisis, which by 2012 resulted in many downgrades of governments’ debt, and even of the Eurozone’s bailout fund, the European Financial Stability Facility. This crisis continues to have repercussions around the world. So the reason why the recovery is so weak is that the financial crisis of 2008 is not finished. Shiller writes: ”As I write in 2012, we certainly do not believe that it is over yet, and the worst may be yet to come. Efforts by governments to solve the underlying problems responsible for the crisis have still not gotten very far, and the ‘stress tests’ that governments have used to encourage optimism about our financial institutions were of questionable thoroughness.” Shller contends that “the financial crisis was ultimately due to fundamental structural shortcomings in our financial institutions. Yet such shortcomings as a failure to manage real estate risk or a failure to regulate leverage are still not really being addressed; the response to the crisis has not been to innovate confidently to address areas where our institutions failed.” 4. Continuing innovation in finance is needed Hostility among the general public generated by the crisis has, according to Shiller, had the unfortunate effect of inhibiting progress in banking and finance. There is a high level of public anger about the perceived unfairness of the amounts of money people in finance have been earning, and this anger inhibits innovation: anything new is viewed with suspicion. The political climate stifles innovation and prevents financial capitalism from progressing in ways that could benefit all citizens. Ironically, better financial instruments, not less activity in finance, is what we need to reduce the probability of financial crises in the future. Shiller is sympathetic to the goals of the Occupy Wall Street movement, if not its means: “While the arguments and rhetoric are not always coherent, the protests represent, in substantial measure, a welcome assertion of democratic values and citizen responsibility.” Financial capitalism is an invention, he says, and the process of inventing it is hardly over. The system has to be thoughtfully guided into the future. Most importantly, it has to be further expanded and democratized and humanized. Financial innovation is still percolating, at a slow and conservative level, but major new financial inventions cannot be launched now because of fear. The main focus of financial reform has not been on fixing structural issues. Initiatives have been shaped by what the public perceives as the problem, not the real problems. Those are the strengths of this important book which presents a brilliant picture of what the financial sector should be contributing to the good society. The book also has serious shortcomings in showing how we might get to the future that it depicts. Five steps should have figured more prominently. 1. Shed the romantic view of financial capitalism as a goal in itself Shiller has a romantic view of financial capitalism. “The past several decades,” he writes, ”have witnessed the rise of financial capitalism: a system in which finance, once the handmaiden of industry, has taken the lead as the engine driving capitalism. The triumph of financial capitalism or its analogues since the 1970s, even in formerly Marxian communist countries, is one of the most significant revolutions in history, and a radical departure from the past.” Here Shiller’s romance with finance causes him to lose sight of his recognition elsewhere that making money and finance are not goals in themselves: they are means to achieve the goals of society—a college education, a comfortable retirement, the opening of a restaurant, the addition of a new wing on a hospital, the creation of a social security system, or a trip to the moon or whatever. Finance is the means, not the end. 2. Recognize why the last 30 years have been booms and busts The book fails to recognize that the financial booms and busts of the last thirty years are directly related to the adoption of the theory that the purpose of a firm is to maximize shareholder value, i.e. to make money. This idea took hold in the early 1980s and became pervasive throughout the economy, ostensibly because firms, including banks, had been pursuing multiple goals: they had lost focus and so had allegedly poor performance. The idea was that a firm with a single goal would do better; the goal chosen was to make money for the shareholders. It has however led to some noxious consequences across the economy, particularly in the financial sector. In the ensuing single-minded search for profits for shareholders, banks slid into pursuing what Fred Reichheld has called “bad profits”. These practices were not illegal, but they were not in the best interests of customers or society. In their search for profits, banks got involved in price gouging, seeking unusual ways to levy hidden charges on customers, particularly customers who were vulnerable. Banks and others began practices that appeared to be gaming the system, such as betting against securities that they themselves had created. Banks and others began practices that seemed to resemble toll collecting, such as high speed trading, using their position to extract charges and profits, simply because of their position in the system. Banks and others began to spend a large part of their energies in zero-sum proprietary trading in derivatives, with dubious social benefit and great risk to society. Banks and others awarded themselves extraordinary increases in compensation, that were inversely related to the firms’ long-term financial performance or their contribution to society. At first, these “bad profits” were achieved through practices that were shady but not strictly illegal. But in due course, the temptations became too great and the “bad profits” turned into practices that were illegal. They include price fixing of LIBOR, abuses in foreclosure, money laundering of drug dealers and terrorists, assisting tax evasion and misleading clients with worthless securities, that led to settlements entailing tens of billions of dollars in settlements. Shiller cites the old saying that “while the problem with socialism is socialism, the problem with capitalism is capitalists.” The implication is that there might be a few rotten apples in the barrel, but basically the barrel is ok. This is not correct. The scale of the abuses was widespread at all levels and across all the large banks. What Shiller misses is that the problem with current capitalism is not a few bad capitalists, but shareholder capitalism itself. Shareholder value leads directly to “bad profits”, which in turn inevitably leads to “illegal profits”. It is the system that is to blame, as well as the individuals. 3. Recognize the alternative to financial capitalism Shiller asserts there is no alternative to the current version of financial capitalism. “Indeed there appears to be no viable alternative. We never hear talk of nonfinancial capitalism as a model… — although one could use such a term to refer to a market economy with poorly developed financial institutions, as we still see today in some poorer regions of the world. As much as we might like to criticize finance, no one seems to view these alternatives as suitable models for anyone’s future. Our task, both in the financial sector and in civil society, is to help people find meaning and a larger social purpose in the economic system.” There is however an alternative to financial capitalism. It’s called customer capitalism, as described by Roger Martin in his classic HBR article in January 2010: “The Age of Customer Capitalism”. An increasing number of firms like Apple [AAPL], Amazon [AMZN], Salesforce [CRM] and Whole Foods Markets [WFM]are now pursuing, with great financial success. By contrast, financial capitalism, aka shareholder capitalism, is struggling. It is based on a conceptual error. As Peter Drucker pointed out in 1973, “the only valid purpose of a firm is to create a customer.” Shareholder value, or making money, is the result of a firm’s activities not the goal. If shareholder value ever becomes the goal, it leads the firm into shady or illegal activities that eventually detract from shareholder value. Even the most famous exponent of shareholder value, Jack Welch the former CEO of GE, came to see in 2009 that maximizing shareholder value is “the dumbest idea in the world.” In banking, shareholder value has not only led the banks into activities of dubious social benefit, of great risk to society, loss of trust and eventually illegality. Pursuit of shareholder value has also had high opportunity cost for the banks. Pursuing profits has distracted banks from their true social purpose of reducing risk and increasing opportunities for an ever wider circle of citizens and enterprises. Innovation has been taking place in banking, but not in a way that provides sustained benefits for either the banks or society. 4. Support the paradigm shift in banking Shiller notes that many countries around the world are still struggling to deal with the aftermath of the financial crisis that began in 2007. He argues that we “must smooth the rough edges off our financial system— those aspects that can cause trouble when people make mistakes.” The leadership challenge for bankers requires more than “smoothing the rough edges”. What is needed is a paradigm shift in management towards customer capitalism. In banking, this means: a banking sector whose very goal is to continuously add value to its customers, not just making money or shareholder value. a banking sector that sees making money as the result, not the goal of its activities… a banking sector that deploys its very best talent in a continuous search to find new ways to secure the financial future of average citizens and make their lives better … a banking sector that cares profoundly about the well-being of its customers, seeing them as flesh-and-blood human beings, not as wallets to extract money from… a banking sector with products and services which are fewer in number, but which fit exactly the needs of its customers, even needs customers had never themselves imagined… a banking sector whose credit cards help customers pay down their balances and warn them of any late fees they may be about to incur… a banking sector whose managers and staff function as teams that are passionately committed to these goals … a banking sector that is totally transparent about all its activities, and proud to reveal how it conducts every aspect of its business… a banking sector that exists in a virtuous cycle of value creation, while also delivering superior financial results year after year, decade after decade… Banks must have one goal: adding value for customers. Shareholder value must be seen as a result, not the goal. Everyone in the bank must have a clear line of sight as to how their work is adding value to customers on a daily basis. Any jobs that are not adding value to customer should be eliminated. Wall Street is already signaling the case for change: the book value of most of the large banks is greater than their valuation in the stock market. It’s time that the banks themselves recognized the problem and pressed ahead with paradigm shift in management. 5. Resolve the #1 regulatory problem: lack of transparency Meanwhile with so many banks are on the wrong track, it’s not enough to expect them to reform themselves on their own. Regulation is needed. Shiller’s book recognizes that the current approach to regulation has failed. His book is aligned with the conclusion in the The Atlantic in December 2012: “Banks today are bigger and more opaque than ever, and they continue to trade in derivatives in many of the same ways they did before the crash, but on a larger scale and with precisely the same unknown risks.” The failure of regulation is not due to lack of effort. The effort has been massive: Draft Basel III regulations total 616 pages. Quarterly reporting to the US Federal Reserve requires a spreadsheet with 2,271 columns. The 2010 Dodd-Frank law is 848 pages The regulations may amount to 30,000 pages of legal minutiae This effort has increased costs for the banking industry without making the financial system safe. The brute fact is that this regulation doesn’t get to the root cause of the 2008 meltdown: lack of transparency. After Lehman’s collapse, no one could understand any particular bank’s risks from derivative trading and so no bank would deal with any other bank or shadow-bank. In retrospect, with the wisdom of hindsight, we can see that some “troubled assets” were not as toxic as people worried at the time. But at the time, the opaqueness created uncertainty and the uncertainty was enough to cause the meltdown. The numbers involved in the market in secret trading derivatives are now truly mind-boggling. The notional value of the entire derivatives market is some $700 trillion, or ten times the size of the entire world economy. We have little information on what this activity comprises. It’s not an exaggeration to say that the $700 trillion market in derivatives is a ticking financial time bomb that is large in scale and dangerous. If only a tiny sliver of this market were to explode, it could bring down the entire world economy. Thus the ongoing secret trading in derivatives is too large and too complex to manage. It’s too opaque to be safe. It is zero-sum in nature, i.e. it has little value to society. It doesn’t expand the real economy: it merely redistributes assets in the financial sector. It would have huge social costs in a financial meltdown. It would be too costly for today’s governments to bail out yet again. And it has massive opportunity costs. It distracts banks from their true purpose of expanding financial opportunities and reducing risk for an ever wider circle of citizens and enterprises. The conclusion is inescapable: trading in derivatives must be conducted in public so that the risks can be assessed and safety measures can be put in place. Shiller was among the few who were prescient in predicting the housing crisis in 2007. His book is once again concluding that the current approach to regulation hasn’t solved the structural problems of banking and predicts that “the worst may be yet to come”. The book however is less than clear about what should be to done to avert a global crisis that will be worse than 2007. For esteemed financial experts like Shiller, there is a special responsibility to press for the obvious top-priority change: transparency in derivatives trading. And read also: How bankers can recover our trust The dumbest idea in the world: maximizing shareholder value Big Banks & Derivatives: Why Another Financial Crisis Is Inevitable Does Wells Fargo practice radical management? Don’t diss the paradigm shift: it’s happening _________ Steve Denning’s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010). Follow Steve Denning on Twitter @stevedenning (via Instapaper) Sent from my iPhone -- -- Centroids: The Center of the Radical Centrist Community <[email protected]> Google Group: http://groups.google.com/group/RadicalCentrism Radical Centrism website and blog: http://RadicalCentrism.org --- You received this message because you are subscribed to the Google Groups "Centroids: The Center of the Radical Centrist Community" group. 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