Thursday, November 12, 2009

Fitness for purpose

Problem: parts of the financial architecture have evolved without regard to their general economic function, spreading dysfunction, cost and instability.

Solution: extend the “fitness for purpose” concept from consumer to financial law. Link financial licenses to a statement of economic purpose (such as to provide payment systems, capital allocation, risk dispersal, liquidity, trade facilitation etc) and use this to develop industry structure, taxation and regulations concerning pay, risk, capital, governance and any other areas of regulatory oversight.

Newspapers love examples of financial institutions that serve their own interests ahead of shareholders, taxpayers and clients: excess fees, extended warranties, Goldmans’ Abacus CDOs, high frequency trading, partial equity research and many others. The market is supposed to correct these aberrant behaviours but it’s awfully slow about it.

One way to speed things up may be to borrow a concept from consumer law that requires goods sold to be fit for purpose. The case law raises quite a few discussions, from dull ones about whether stone cladding should be waterproof to the entertaining case of the Golden Fleece underpants, which looked at whether woollen garments dipped in irritating sulphites could really be fit for use as underwear.

Given recent bank failures and suspicion about the true origins of some City bonuses, is it time that finance should aspire to be fit for purpose too?

High finance is not short of legal duties but few are linked to the public good. To explain why they should be, look no further than Adam Smith. He argued that self-interest drives actors to socially beneficial behavior. Smith wrote in the Wealth of Nations that buying and selling creates optimal resource allocation, which is a public good and legitimises an individual’s profit.

With today’s complexities there is no time to ask if an activity contributes to the productivity of the economy or rides parasitically on its back. There is only time to count the profits and use these as a loose proxy for moral as well as economic value.

As the newspapers report, we do not live in Smith's world. There is no shortage of cases where self-interest works in the opposite direction, driving actors to anti-social behaviour. In financial services this is usually attributed to lack of competition, asymmetric information and agency distortions. Financial reforms proposed so far have focussed on preventing disaster through capital rules and living wills but could go so much further: surely finance shares the same duty to contribute to economic wellbeing as any other industry?

Requiring financial firms to state their economic purpose and then deliver services that fulfil them would strengthen the banking lobby more than any BBA press releases. As part of a licensing process it could even help regulators shape the industry along useful lines.

Articles of association already list corporate objectives, sometimes in great detail (see the articles of the LloydsTSB Group for example, to receive money on deposit and employ such money... to borrow money with or without security...etc), but they do not often state the firm’s role in the economy.

  • If retail bank directors were bound by statements of purpose, they might not convert their treasury departments into profit centres.
  • Stock exchanges committed to a healthy secondary market for long-term investors might not pursue innovations that undermine long-term returns and stability, such as high-frequency trading.
  • Firms that provide essential infrastructure, such as exchanges, might adopt non-profit ownership structures to benefit their members instead of always having to increase trading revenue.
  • Commodity desks could decide if they wish to make proprietary profits or earn commission on exchange for corporates, with different capital requirements in each case.
  • The pension and savings industry could be held accountable to savers for adopting remuneration policies on the same time scale as their long-term savers, and so on.
It's only one a raft of reforms needed, but a statement of purpose might have kept AIG from entering the CDS market, ratings agencies from overdosing on issuer-pays contracts and auditors from missing the Repo 105.

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