Abstract
My principal objective in writing this book has been to correct a fallacy of composition, namely that the current regulatory route has made individual firms safe but in so doing has actually increased the whole financial system’s fragility. Casualties among ordinary consumers in a systemic crash are high. If we can make the system safer, this should give them greater protection. Often, proposals presented as making the system safer are really about better consumer protection. Examples of these include measures that encourage or ban certain instruments, the choice of discouraging bad behavior through either civil or criminal law, and the rearrangement of regulatory institutions. I address these questions over the next few chapters.
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Notes
- 1.
In the UK, there is a rich history of consumer advice bureaus. My mother never considers buying anything before consulting Which? consumer magazine. She would deliver an exasperated look if her children failed to follow this example.
- 2.
Lemon is a term used in the United States and elsewhere to refer to a faulty product.
- 3.
See Doug Galbraith, Chris Davis, and Phillips Fox, the HIH Royal Commission Report, (Canberra: Phillips Fox, 2003).
- 4.
This is explained further in one of the most powerful essays in economics: George Akerlof, “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 84, no. 3 (1970), pp. 488–500.
- 5.
For many more juicy stories of an abuse of conflicts of interest in finance, see Avinash D. Persaud and John Plender, “Fiduciaries,” in All You Need to Know About Ethics and Finance: Finding a Moral Compass in Business Today (London: Longtail, 2007).
- 6.
It was never presented thus and there were plenty of other legitimate reasons for the privatization of state assets and the deregulation of finance.
- 7.
See Persaud and Plender, “Mis-selling & Investor Protection,” in Persaud and Plender, Ethics & Finance, 2007; and Philip Augar, The Death of Gentlemanly Capitalism: The Decline and Fall of UK Investment Banking (London: Penguin, 2000).
- 8.
See Gary S. Shea, Understanding Financial Derivatives During the South Sea Bubble: The Case of the South Sea Subscription of Shares (Oxford Economic Papers 59, supplement 1, Fife, UK: University of St. Andrews, 2007), pp. i73–i104.
- 9.
While the principle of caveat emptor, Latin for “buyer beware”, gives responsibility to buyers, it does not mean that sellers are beyond reproach. This concept is neatly encapsulated in the following extract from the Bank of England’s Fair and Effective Markets Review (London: Bank of England, 2014, p. 17):
“[Caveat emptor] . . . has always been subject to the general law on fraud and misrepresentation, which has long been relatively strict, embodying the principle that (in the words of a Victorian judge, Lord Macnaghten in Gluckstein vs. Barnes [1900] AC 240) ‘sometimes half a truth is no better than a downright falsehood’. And over the years the practical application of the caveat emptor principle has been further qualified by judicial and statutory intervention (for example on implied terms), by disclosure and other provisions of consumer law, and, in the context of investment transactions, by statutory and regulatory rules. For example, caveat emptor does not trump the regulatory obligation on a firm to act ‘honestly, fairly and professionally.’ Market manipulation cannot therefore be said to be consistent with caveat emptor, even where it takes place between two counterparties of broadly equal bargaining power and sophistication.”
- 10.
Vendors are required not to discriminate against vulnerable consumers, which can sometimes rub against the need to give this group additional care.
- 11.
In October 2008, the limit of the Federal Deposit Insurance’s guarantee of bank deposits was raised from $100,000 to $250,000.
- 12.
Today, around 100 countries have some form of deposit insurance. Typically, not all depositors are insured. The insurance tends to only cover retail deposits—so not deposits of companies or counterparties. Even on retail deposits, there is a cap with the current EU cap set at €100,000. The argument for capping is that it limits the cost of the scheme, protecting those least able to protect themselves—the vulnerability distinction—while also eliminating the spectre of bank runs.
- 13.
This is because a key motivation of deposit insurance is to stop a bank run. Depositors recognize that the failure of one bank can trigger the failure of others. However, their precautionary attempt to pull out their deposit from a safe bank for fear of losing it during a collapse could itself cause a collapse. Runs on insurance firms are far less likely (except in the rare case of reinsurance, insurance firms do not lend to insurance firms) so there is no need to avoid them by insuring insurance payouts. There are schemes to help alleviate insurance losses. In the US, for instance, several individual states (but not the federal government) must place a proportion of insurance premiums into a fund that can be drawn on to compensate customers in case of an insurance firm’s failure.
- 14.
The headline-hitting pledges of Treasury support to banks came to over $7 trillion worldwide, with the UK government alone pledging £1.2 trillion. However, the final amount of direct support, and the ultimate cost once repayments are considered, was a small fraction of this, excluding the final costs of the support offered through the central bank, which has not yet been accounted for.
- 15.
In December 2013, EU member states agreed on reforms that would require governments to impose fees on banks equivalent to 1.0 percent of insured deposits, earmarked for disbursing the costs of resolving or rescuing banks.
- 16.
For an explanation of why this is generally a bad idea, see Chapter 8.
- 17.
Cocos (or contingent, convertible, notes) are bonds issued by banks that pay an attractive coupon in good times and in bad; contingent on the issuer’s capital falling below a stated threshold, they convert into equity that could be lost completely without any recourse. For the FCA press release on restriction of the sale of cocos, see www.fca.org.uk/news/fca-restricts-distribution-of-cocos-to-retail-investors .
- 18.
Further compounding the mixed messages, in the UK financial spread bets are also subject to the lowest level of betting tax—3.0 percent—but are banned outright in many other jurisdictions.
- 19.
Following the Glass-Steagall Act, the doyen of banking at the time, John Pierpont Morgan, chose to remain in commercial banking, but two of his partners, Harold Stanley and Henry Morgan, founded a new investment bank: Morgan Stanley.
- 20.
The official title is the Public Company Accounting and Investor Protection Act more commonly known as SOX. It was enacted on July 30, 2002 in the wake of a series of major corporate and accounting scandals, including WorldCom and Enron. Enron’s collapse brought down Arthur Andersen—at that time one of the “big 5” accounting practices. The company was found guilty of criminal charges relating to its auditing of Enron.
- 21.
This was a particular concern during the dotcom and later housing-finance bubbles when ordinary investors felt that banks were giving their more frequent trading clients, like hedge funds, priority access to information and opportunities regarding their investment banking clients.
- 22.
SOX-like regulations on auditor independence and stricter corporate governance were enacted in Canada, Germany, and South Africa in 2002; France in 2003; Australia in 2004; India in 2005; and Japan and Italy in 2006.
- 23.
In the UK, there was a raft of liberalization measures that were collectively referred to as the “Big Bang” of 1987. In the US, Glass-Steagall was watered down through the 1980s and effectively repealed by the Gramm-Leach-Bliley Act of 1999.
- 24.
See the ZeekRewards Receivership Web site: http://www.zeekrewardsreceivership.com/ .
- 25.
For an explanation of how banks’ risks have been exported off balance sheet only to return when the crisis struck, see Avinash Persaud, “Where Have All the Risks Gone: Credit Derivatives, Insurance Companies and Liquidity Black Holes,” Geneva Papers on Risk and Insurance 29, no. 2 (April 2004), pp. 300–12.
- 26.
For one of the best studies of modern Ponzi and pyramid schemes, see Ana Carvajal, Hunter Monroe, Catherine Patillo, and Brian Wynter, “Ponzi Schemes in the Caribbean” (WP/09/95, International Monetary Fund, April 2009).
- 27.
See U.S. Securities and Exchange Commission, “SEC Freezes Assets in Ponzi Scheme Targeting Investors in Japan” (SEC Press Release 2013-201, Washington, DC, 2003), www.sec.gov/News/PressRelease/Detail/PressRelease/1370539844572#.VNDq5GR4oz .
- 28.
See Chapter 5.
- 29.
Based on £1.58 million postings on Gumtree, the UK’s site for classified ads: www.gumtree.com .
- 30.
The idea of liquidity preference and its economic implications was developed by John Maynard Keynes in The General Theory of Employment, Interest and Money (New York: Harcourt Brace, 1936).
- 31.
See Rajendra Persaud, “Choose Long-Term Benefits over Constant Cravings, ” Times Educational Supplement, January 16, 2004.
- 32.
See Milton Friedman, and L. J. Savage, “The Utility Analysis of Choices Involving Risk,” Journal of Political Economy 56, no. 4 (August 1948), pp. 279–304.
- 33.
See Emily Haisley, “Loving a Bad Bet: Factors That Induce Low-Income Individuals to Purchase State Lottery Tickets” (Pittsburgh: Carnegie Mellon University, 2008).
- 34.
I recall UK regulators, prior to the GFC, wondering aloud whether it was right to deny the less well off the choice and benefits of investing in hedge fund-leveraged and unconstrained investment firms.
- 35.
See Daniel McFadden, “Free Markets and Fettered Consumers” (AEA Presidential Address, January 7, 2006). Professor McFadden shared the 2000 Nobel Prize in Economic Sciences with James Heckman for his work on the development of theory and methods for analyzing discrete choice.
- 36.
Some, like Renata Salecl and Barry Schwartz citing experimental psychology and consumer studies, describe too much choice as debilitating, a tyranny, and a source of despair. See Renata Salecl, The Tyranny of Choice (London: Profile Books, 2011).
- 37.
See Avinash Persaud, Liquidity Black Holes: Understanding, Quantifying and Managing Financial Liquidity Risk (London: Risk Books, 2003).
- 38.
I remember the Flash Crash well. I got up to give the after dinner talk at a conference in Geneva as the meteoric fall began. Only later did I understand why everyone was ignoring my carefully planned remarks and staring, nose down, open mouthed, at their BlackBerrys.
- 39.
After the GFC, many well-remunerated financial experts in asset management companies objected to being termed experts. They stated that they could not have possibly known what they were buying when they placed credit default swaps in their portfolio to spice up returns and boost performance bonuses. It is best not to assume anyone is an expert. Focus should be directed at their capacity for loss.
- 40.
See M. Friedman and L. Savage, “The Utility Analysis of Choices Involving Risk,” Journal of Political Economy, 1948, Vol 56.
- 41.
Which would be the preferred position of a risk and liquidity-neutral investor.
- 42.
See Experian Discretionary Spend Report.
- 43.
That number where 50 percent of observations are higher and 50 percent are lower.
- 44.
See Daniel Kahneman, Thinking Fast and Slow (New York: Farrar, Straus and Giroux, 2013). Daniel Kahneman won the 2002 Nobel Prize in Economics for his work on the psychology of judgment and decision-making and its implications for the study of economic behavior. Also see Richard Thaler and Cass Sunstein, Nudge: Improving Decisions About Health, Wealth and Happiness (New Haven, CT: Yale University Press, 2008).
- 45.
This refers to Section 31 of the US Securities Exchange Act of 1934. As of February 2014, it requires each exchange to pay the commission a rate of $18.40 per million transactions, which raises in excess of $1.5 billion to cover the costs of the SEC.
- 46.
Ferdinand Pecora, Wall Street Under Oath: The Story of Our Modern Money Changers (New York: Simon and Schuster, 1936).
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Persaud, A.D. (2015). Protecting Consumers. In: Reinventing Financial Regulation. Apress, Berkeley, CA. https://doi.org/10.1007/978-1-4302-4558-2_7
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