Why can’t banking be more like baking?

5th November, 2013

The last time a bread maker laid waste to the City was 1666, writes Tim Harford

“It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.” Adam Smith, The Wealth of Nations

A tender medallion of steak, a foaming pint of bitter and a crusty roll still hot from the oven – no wonder that Adam Smith chose an alliterative trio of artisanal food providers to make his point about the benefits of capitalism. If he had chosen a junk bond salesman, a fund manager, and a quantitative analyst, wielding a Gaussian copula in an effort to price a synthetic credit derivative, his defence of the market mechanism might not have resonated down the centuries in quite the same way.

Smith’s point was a good one. We are unlikely to give our custom to butchers who poison us, brewers who serve foul beer or bakers who overcharge; food sellers find it profitable to serve decent food at reasonable prices. The system needs some oversight – hygiene inspectors, trading standards officers, the Competition Commission – but the main engine of quality is the market mechanism. People prefer cheap and delicious food to food that is pricey and tastes horrid – and that fact alone delivers more than regulators ever could.

For some reason, that does not seem to be true of financial services. No food regulator has ever described bakers as engaged in “socially useless” activity, a term Lord Turner levelled at the industry in 2009, when he was chairman of the UK’s Financial Services Authority. Mark Carney, the governor of the Bank of England, recently looked forward to the UK banking sector becoming even larger and more “vibrant”. He added that some would “recoil in horror” at the prospect, which some already have.

Surely nobody has ever recoiled in horror when a French technocrat expressed the hope that France would produce and sell lots of wine. Or when a Japanese minister wished the Japanese car industry well. There is something different – something sinister – about the financial services industry these days. So what is the difference between the baker and the banker?

The first difference is competition. This is partly about pluralism: there are lots of places to buy bread, but not so many to get a mortgage, or for that matter to underwrite an initial public offering. It is a devil of a job to set up a bank – and even harder to attract stuck-in-the-mud customers.

More fundamentally, many consumers of financial services cannot tell a good product from a bad one. The spectrum runs from payday loan customers unable to grasp quite what the loan is going to cost them, to people saving for a pension amid a fog of confusing charges, to clients of Goldman Sachs who bought into a subprime mortgage deal called Abacus 2007-AC1. (They did not realise that Abacus had been constructed with input from the Paulson & Co hedge fund, which was betting that the entire thing would implode.) It seems nobody is safe.

In a speech about the UK’s asset management industry this week, Clive Adamson of the Financial Conduct Authority quoted economist and Nobel laureate George Akerlof: “In a market plagued by asymmetries of information, the quality of goods will decrease and the market will come to be dominated by crooked sellers and gullible or desperate buyers.” Mr Adamson added that he did not mean to apply this description to UK asset managers; however it is hard to see why else he said it.

At the same event, Mr Adamson’s boss, Martin Wheatley, fired a shot across the UK asset management industry’s bows – although even trying to understand quite what Mr Wheatley is worried about will have the ordinary punter’s brain bleeding out of his ears. In a nutshell, some of the people who buy, sell and analyse shares are paying some of the people who run companies to meet up with some of the people who pick the stocks that go into the investment funds that your pension fund is buying. Mr Wheatley thinks that is OK, but the price tag for all this needs to be more transparent. (No, I don’t understand either.)

It is a safe bet that when the regulator cannot even clearly explain the commercial activities that are worrying him, the market has become too complex and opaque to deliver happy results.

If all that was wrong with finance was that customers at every level were repeatedly being ripped off, that would be one thing. But it gets worse. Income from banking is highly concentrated. When an economy – such as the UK’s – becomes highly dependent on financial services the effect can be a little like the phenomenon of “Dutch disease”, which afflicts oil-producing countries.

If a nation exports a lot of hydrocarbons, their exchange rates may appreciate, which means that it is difficult for those petro-states to compete doing anything except selling oil. As a result their manufacturing and industries decline. Similarly, it is difficult for bank-led economies to compete doing anything except selling financial services. And this matters if the employment in these sectors is slim. It would be going too far to suggest that either the City of London or Britain’s North Sea oilfields are a curse – but they are not an unadulterated economic blessing, either.

Then there is the fact that banking has a tendency to blow up, causing tremendous collateral damage. The last time a baker laid waste to the City was 1666, when one accidentally triggered the Great Fire of London; bankers seem to be able to perform the trick more frequently.

Mr Carney, and other financial regulators across the world, are forced to deal with a sector that combines the most unattractive features of the oil industry (well-paid jobs inflate the currency), the nuclear industry (occasional blow-ups and meltdowns) and the second-hand car industry (enough said).

What can be done? A wise course of action is to look for structural reforms that will make banking function a little more like baking. But there seems to be something irreducibly problematic about finance. I wonder if even Mr Carney will be able to make the market for pensions work like the market for croissants.

Also published at ft.com.

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