Tuesday, 31 January 2012

Submission on New Model for Retail Finance

Over on The Fine Print, I've set out both the initial summary and my full submission to the Red Tape Challenge and the BIS Taskforce on Non-bank Finance. I'm very grateful to the colleagues who contributed, as mentioned in the longer document.

Some might say that the alternative finance market is small beer at this point, and it's not worth accommodating them in the regulatory framework. But it's unrealistic to expect alternative business models to thrive amidst the dominance of the banks and while the entire financial system is hard-wired to suit them and other traditional investment vehicles (see the series of articles by Vince Heaney, David Potter and Adriana Nilsson in February's Financial World).

Others might also say that we should wait until the 'winning' business models emerge before figuring out what regulation may need to change. Yet picking winning business ideas is impossible, as Peter Urwin explains in "Self-employment, Small Firms and Enterprise". He has found that, while "entrepreneurship is crucial for economic growth... we have no idea where it will come from - not even in the most general terms."

As a result, the best that we - and government - can do is to ensure "a climate in which enterpreneurship can thrive".

Thursday, 26 January 2012

Big Media: Inside The Propaganda Machine

You know something's hokey when the Financial Times, a leading paywall operator, devotes a whole page to the war on content sharing 'online piracy battle' just days after the big set back for SOPA/PIPA. Here's the lead article, snuggled between two stories from the 'front line' ("Parameters shift in online piracy battle" and "Upload websites bar file sharing"):

It's then you realise you're inside the propaganda machine for the Big Media faithful:

"Keep sluggin' it out, people! 
Less content sharin' means more money for us!"

Think about that.

Because these are the same institutions who were leeching public money out of New Labour in 2009 for help with copyright enforcement, with tales of 'losing £1bn in music sales in the next 5 years'. Whereas only 3 years later, the FT reports they have this to say:
[Rob Wells, of Universal Music] "Some of those big global subscription players are only playing on a small playing field... As they mature, they are more likely to be bundled with internet service provider or operator subscriptions which is where we start to see real anti-trust investigations scale. The future is looking extremely bright."
"We are going from headwind to tailwind," said Edgar Berger, chief executive at Sony Music International. "There is no question the music industry is going to be in great shape shortly, it will become a growing business again. The internet is a blessing for the music industry."
Big Media is not in the business of solving consumer problems. It's a cabal of institutions out to solve their own problem of how to return to rampant profitability at the captive consumer's expense. And they won't give up trying to stop you sharing content 'til your MP3 player looks like this:

Wednesday, 25 January 2012

Avoiding The Dire Strait of Retail Banking

So, competition in banking has worsened, according to research cited by the FT this week, and Which? is back on the warpath against "complicated and exorbitant" unauthorised overdraft charges.

Accenture's research found that in 2011 only 11% of customers switched at least one product and only 6% switched their current account - and 90% of us "had no desire to change providers". 

Financial services consultancy Oliver Wyman chipped in with this gem:
"if [banks] made their charging structures completely transparent, no one would want to pay them."
Forrester, the research firm, found that less than 25% of UK customers thought "their bank put their interests above the desire to generate profits."

Yet more reasons for levelling the playing field between banks and alternative finance models.

Thursday, 19 January 2012

War On Your Internet Use Rages On

"Get back on the sofa!"
President Obama may have thrown his weight against the latest attempts by the traditional media to outlaw individual people sharing content - the "Stop Online Piracy Act" and "Protect IP Act" (beware moral panic). But history tells us the war ain't over yet. 

As Clay Shirky eloquently explains below, the latest so-called anti-'piracy' bills in the US are Big Media's attempt at a nuclear strike on content sharing after last year's bills misfired and a previous surgical strike missed the target (the Digital Millennium Copyright Act). In short, Big Media won't give up until our computers are as interactive as an analogue TV - "Get back on the sofa!"

We need to care about such US legislation, because it targets US internet services and features that make the internet useful for individual people all over the planet. But this is not just a US problem. In the UK, for instance, we are blessed with our very own Digital Economy Act [crowd cheers]. 

The war on content sharing comes down to two things: political donations and votes. Currently, it's billed as a struggle between internet companies and entertainment businesses. But that analysis ignores the giant individual in the room: a few carefully directed £/$'s and a vote from each of us should ensure that our politicians work hard to protect our right to share. 

 Image from

Wednesday, 18 January 2012

Flaws In Bank Capital Models, Revisited

We saw a little sunlight on shadow banking back in 2010. But it transpires things went a little dark again for a while and, hey presto! Our banks may be holding insufficient capital. 

The latest burst of sunlight - at least for us mere mortals - came yesterday in two posts by FT Alphaville - one on 'BISTRO-style' high-cost credit protection transfer deals done by banks during 2010, and the other on how the FSA has responded.

But this is not about sub-prime malarkey, and the risk of mis-pricing towers of CDOs. This is about banks trying to reduce the amount of capital they need to hold for regulatory purposes to guard against failure... and getting it wrong to the point that it "could become systemic". 

Apparently, the banks strike deals with unregulated shadow banks which attempt to "...structure the premiums and fees so as to receive favourable risk-based capital treatment in the short term and defer recognition of losses over an extended period, without meaningful risk mitigation or transfer of risk... The underlying assets that have been used in these securitised deals include leveraged loans, loans to small and medium-sized enterprises and even books of derivatives counterparty risk." 

In guidance issued last May that took effect in September, the FSA revealed its assessment of the models banks have used to calculate the benefit of these deals in terms of reducing the amount of regulatory capital they need to hold:
"The underlying formula contains an implicit assumption that there is no systematic risk in tranches of diversified portfolios that attach at a level of credit enhancement above the capital requirement on the underlying portfolio. However, the performance of senior tranches of many securitisations since 2007 has shown this assumption to be flawed. In addition, where a firm’s [internal rating] model proves [later] to have under-estimated capital requirements on the underlying portfolio, the [model] leverages any undercapitalisation."
As Alphaville notes, this "ultimately means that banks come out with an answer that says they can hold even less regulatory capital" than they should. And the FSA states: "Therefore, the potential scale of firms’ use of the [models] for capital relief purposes is significant and the impact of any undercapitalisation due to the deficiencies in the [models] could become systemic." My emphasis.

That could mean another giant bailout is in the works, since the shadow banking sector was back to its pre-crisis size of $60trn by the end of 2010.

Yet again, the FSA has found itself outpaced by events, albeit perhaps the latest gap narrowed compared to the lag in response to the sub-prime crisis. And I guess it will be 2013 before we find out what flaws there were in bank capital models used during 2011.

But we should be wary of expecting too much of the regulators, given the culture they're up against... We're on our own: pay less, diversify more and be contrarian.

Thursday, 12 January 2012

Red Tape in Retail Financial Services

I'm off to Number 10 today, to talk about red tape that's constraining disruptive business models in financial services. In the interests of transparency, I've summarised my thoughts for both the legal community here, as well as below. I'll be submitting a more detailed paper in the coming weeks, both to the Red Tape Challenge and the BIS Taskforce on alternative business finance. I'm interested in any comments you may have.

In its invitation to submit evidence of ‘red tape’ that is inhibiting the developmentof ‘disruptive business models’, the Cabinet Office notes the example of Zopa, “a company that provides a platform for members of the public to lend to each other, who found that financial regulations simply didn’t know how to deal with a business that didn’t conform to an outdated idea of what a lender is…” 

Financial regulation similarly fails to deal with a range of non-bank finance platforms that share some of the key characteristics of Zopa’s person-to-person lending platform. Accordingly, financial regulation is failing to enable the cost efficient flow of surplus funds from ordinary people savers and investors to creditworthy people and businesses who need finance. In particular, the current framework: 
  1. generates confusion amongst ordinary people as to the basis on which they may lawfully participate on alternative finance platforms (even though some are licensed by the Office of Fair Trading); 
  2. does not make alternative finance products eligible for the usual mechanisms through which ordinary people save and invest, exposing lenders to higher ‘effective tax rates’; 
  3. discourages ordinary savers and investors from adequately diversifying their investments; 
  4. incentivises ordinary savers and investors to concentrate their money in bank cash deposits, and regulated stocks and shares; 
  5. inhibits ordinary savers’ and investors’ from accessing fixed income returns that exceed long term savings rates; 
  6. inhibits the development of peer-to-peer funding of other fixed term finance (e.g.mortgages and project/asset finance, and even short term funding of invoices); and
  7. protects ‘traditional’ regulated financial services providers from competition. 
These regulatory failings could be resolved by creating a new regulated activity of operating a direct finance platform, for which the best-equipped regulatory authority would be the Financial Services Authority (as replaced by the Financial Conduct Authority). Regulation of the platform would be independent of any regulation that may apply to the type of product offered to participants on the platform (e.g. loans, trade invoices, debentures to finance renewable energy and lending for social projects). Proportionate regulation that obliges platform operators to address operational risks common to all products would also enable economies of scale and sharing of consistent best practice, and leave product providers and other competent regulators to focus solely on product-specific issues (e.g. consumer credit, charitable purposes). 

Similarly, there is no reason why products distributed via these platforms should not also be eligible for the usual mechanisms through which ordinary people save and invest, such as ISAs, pensions and enterprise investment schemes.

Saturday, 7 January 2012

Role of The State: Part 2

In Part One of this post, I covered Warwick Lightfoot's book on the state of the UK's finances, Sorry, We Have No Money, which provides a useful context for Richard Murphy's The Courageous State. Another useful lens through which to view this book is Tim Harford's The Undercover Economist. Yet another is Michael Lewis's Boomerang: The Meltdown Tour... I think you're getting the picture.

Richard Murphy's thesis is that we need 'a new way of economic thinking' because the 'neoliberal' belief in the power of free markets is misplaced and has caused successive governments to retreat in a 'cowardly' fashion from areas where the state should intervene unashamedly. Richard argues that the 'cowardly' state is doing a poor job of providing public services like education, care for the elderly and so on, whereas a 'courageous state' would not.

Richard's proposed alternative model rests on the primary economic objective that the state should  enable people to achieve their ‘potential’ in terms of four groups of needs: 'material', 'emotional', 'intellectual' and 'purpose'. To do that, Richard recommends universal social benefits, a higher minimum wage, a 35 hour week, protecting union rights, reintroducing “industry wage boards” that replicate national collective pay bargaining, extra tax relief for employing people, free higher education, more social housing, removing any market element from the NHS, care for the elderly, youth services and ‘comprehensive payment of earnings-related pay-as-you-go pensions for all in society because no other form of pension provision eventually makes sense financially or economically.” He would claw back universal benefits and pension payments from people on higher incomes via 'negative tax allowances'.

To try to pay for all this, Richard suggests raising more tax revenue from progressive taxes, especially on higher incomes, capital gains, inherited property, land values, advertising and removal of deductions for business interest payments over £50k. Richard would also raise the corporate tax rate, but grant deductions to “those who add value by creating employment in the community or by providing training in society” rather than “the speculator or the company that survives on technology alone when so much of that technology will almost certainly be directed at excess consumption.” He would provide further incentives to charity and recycling shops, over and above their existing tax-free status. The minimum wage should be lifted - with additional increments for more expensive locations, like London, rather than reductions in line with local costs and labour market conditions.

Clearly this book does not represent a short or medium term solution for today's economic problems. It's more of a plea for a different mindset in the longer term. As a solution for the short term, it lacks any acknowledgement of our basic fiscal constraints that Warwick Lightfoot explained, or how the recommendations would operate within them:
  • Countries should aim to limit public spending to around 30 - 35% of GDP to avoid slowing the economy and reducing the absolute amount of tax raised;
  • Tax receipts in the UK have averaged around 38 per cent of GDP over the last twenty years and have never exceeded 40%.
  • Only a deficit of up to 2.5% of GDP can be financed sustainably;
  • As government borrowing competes with private sector borrowing any new spending proposal to generate benefits at least 25% greater than the explicit financing costs involved.
However, even looking at the longer term, I'm uncomfortable with the premise that the straightforward achievement of personal potential should be our primary economic driver for a 'new way of thinking'. Limiting our primary needs to 'material', 'emotional', 'intellectual' and 'purpose' overlooks our physical potential, notwithstanding the importance we attach to health and wellbeing. Richard is also a little unfairly dismissive of a purist form of free market economics, since economists only deal in models, which are imperfect (unlike mathematical theories), as Emanuel Derman has explained. In fact, a great deal of economic debate focuses on how to deal with market failures, as Tim Harford discusses in The Undercover Economist. Those failures tend to arise from suppliers leveraging scarcity or ignoring externalities associated with their activities ("a harm suffered or benefit enjoyed by some third party that isn’t reflected in a market transaction", e.g. the true cost of smoking). Asymmetry of information is another challenge, as is the overriding requirement for fair outcomes, particularly in relation to the vulnerable. So I'd have thought that any advancement on free market thinking ought to encompass those sorts of concerns in its central premise. Simply starting with the idea of enabling everyone to achieve their 'potential' is a model that begs the same questions as traditional economic thinking about whether this achievement comes at the expense of another person or is 'unfair' and so on.

I'm also uncomfortable with the idea that we should pour more tax revenue into a state that is 'cowardly' and inefficient. Richard does not say how this would improve public sector productivity, and Warwick Lightfoot points out that 30 years of attempts to improve efficiency have failed. Surely we need to see improvements in the way the state currently spends our money before giving it extra - even if we could pay it more within the fiscal constraints mentioned above.

Unfortunately, the more I get into the detail of Richard's recommendations, the more anxious I become for the future they would yield.

I worry about the statement that "There is little or no evidence that business people are motivated by eventually realising substantial capital gains: entrepreneurial activity is a lifestyle choice that genuine entrepreneurs take irrespective of taxes." The first part might be true - perhaps the 4.3 million sole business proprietors in this country are self-employed merely for the income, rather than the chance of selling for the capital gain that would fund their retirement. Perhaps, too, they prefer the lifestyle of answering to customers rather than a boss. But I know from personal experience that we are not in business 'irrespective of taxes'. At some point it becomes impossible to work any more hours or increase prices, and if that does not pay the bills one can only reduce costs. A person in that position will not generate any additional tax revenue, and may ease off and contribute less.

Richard's rationale for a 35 hour week is somewhat instructive here. He says we are working too long because we are either trying to do 'the government's job' of lifting ourselves out of poverty or “to consume more goods that [we] really do not need.” But the vast majority of those who work harder to earn more aren't among the relatively few fat cats. We work harder because we don't believe the government can keep us out of poverty, or pay off our mortgages by the time we retire, or provide better healthcare or a better education for our kids. As Richard says, we are already providing our own private solution for the ways in which he says the state is 'cowardly'. So is it 'fair' to expect us to pour even more money into that leaky public sector bucket knowing it will bring no improvement?

Richard also complains that “the UK has one of the lowest ratios of staff employed in small companies in the developed world”. I guess he's pointing to the fact that about 4.3m of our 4.5m businesses are owner-operated. He seems to be saying that the failure of these individuals to band together is somehow "the major impediment" to "staff"' having the opportunity to “join in the ownership of their enterprise to take a share of the profit when appropriate, and to eventually reach positions of senior management.” Richard says these people should be obliged to operate limited liability partnerships rather than to be allowed to operate as sole director/shareholder of a limited company. Or is he saying these 4.3m people should close up shop and seek employment with the remaining 200,000 businesses in the hope of one day rising to the level of senior management? This holds the same irony as the Mexican fisherman story.

But is 'employment' really the right model for everyone?

Richard says the 'courageous state' is one that “recognises trade union rights” (he advises the Trade Union Congress on tax issues.)  Apparently unions are essential to “health and safety, paid holidays, equal pay, protection from dismissal… collective bargaining, protection in industrial disputes, and representation in the workplace.” That may be true of the 60% of public sector workers they represent, but only for a far smaller proportion of private sector workers. The result has also been that public sector workers are 14% better off in terms of pay and pensions than private sector workers. And research shows the premium is much larger in some areas. The unions are pushing for an even greater premium, as we've learned from recent strikes. And while I have no idea of Richard's politics (he's equally damning of recent Labour and Conservative/coalition governments) it's no coincidence that the unions finance and control the Labour Party. The more public sector workers there are, and the better paid they are, the more votes there will be for the Labour Party.

So it seems the employment relationship works just fine for the public sector and at least one of our major political parties. But the adverse impact on the regional competitiveness of the private sector is another story. Local businesses can't hope to lure many staff from the public sector. Richard would address this in part by restoring “industry wage boards” to replicate national collective bargaining in the private sector. In other words, he advocates union-style pressure being applied to force regional businesses to pay their employees more. This must result in higher prices, further reducing demand for regional output, and hastening the decline of regional economies. On the other hand, Warwick Lightfoot suggests local competitiveness could be restored if public sector pay and pensions were reducd by 2% of GDP nationally - about £30bn or 17% overall in line with local costs and labour market conditions. The latter option seems logical to me. Richard would also help the regions by giving local authorities more powers, taxation rights and encouraging the issue of municipal bonds (doubtless backed by a bank guarantee and ultimately the taxpayer). So local businesses would not only be competing with the local authority for staff, but would also be paying higher taxes and competing against the local authorities for finance. Municipal bonds wouldn't be a great investment on that basis. The local economy would never generate the taxes to pay the promised return on the bonds, leaving local investors out of pocket and calling on the bank guarantee - and ultimately the taxpayer.

Richard justifies his proposed tax on advertising (other than local media job ads "and such other announcements") because he says advertising is a "pernicious" and “continual process of artificially manufactured dissatisfaction”. He rightly assumes that such a tax would increase the cost of such advertising and inflate the cost of any items advertised. But Richard does not explain why this inflation is desirable, or why the reduction in demand for the higher priced goods would help businesses pay their employees more, and thereby increase income tax revenue. He does not acknowledge the possibility that the reverse would actually occur and overall tax revenue could fall due to lack of demand for goods and downsizing. Richard would tax the production of luxury goods, even if that were to destroy those industries (“so be it,” he says, “this is a price worth paying”). Richard would ban advertising to children, but does not explain the impact this is likely to have on children’s TV programming, for example. He believes the media generally does not behave well enough to 'deserve' advertising revenue, but there are deserving elements that could receive government funding in return for impartiality or public service: please buy more lipstick, if you can afford to, so we can send more BBC staff to cover the Greek riots.

All this conjures up images of a fairly desolate future - I certainly don't see the funding of romantic comedies anywhere in Richard's plans.

But, ultimately, I'm most repelled by the notion that we should automatically rely on the state for our wellbeing. This encourages an 'entitlement culture' in which we are preoccupied with our rights but ignorant of our duties, as I've pointed out before. In turn, this allows us to cast ourselves as passive victims of our institutions - on which we lay the blame for crisis after crisis. Yet each crisis reminds us that all our economic problems ultimately fall on each of us as an individual, whether as a taxpayer, employee or aspiring benefits recipient.

If I were asked to suggest 'a new way of economic thinking' the premise would be one that encourages each of us to behave as an active participant in a society of our own making and under our own control and to acknowedge that each of us bears ultimate responsibility for the wellbeing of others. Such a premise would be that each of us is obliged to secure everyone else’s long term welfare, not just our own.

On that basis, the role of the state would be to enable each of us to fulfil our own fundamental obligation to secure everyone's welfare, not to deliver it for us. 

Tuesday, 3 January 2012

The Role Of The State: Part 1

The Christmas break finally allowed me to read various books that I knew were going to require some clear days, a rich diet, plenty of sleep and a deep sense of panic about our economic plight.

Amidst the pile were Warwick Lightfoot's Sorry, We Have No Money and Richard Murphy's The Courageous State. I read them in that order, but I also think the first provides a better context for the second, so I'll get to Richard's book in my next post.

Warwick Lightfoot's book provides a very helpful overview of public sector finances, reflecting his previous economic advisory roles at the heart of government.  It also explains a key problem that is destroying regional competitive advantages. 

First, it's worth extracting some basic fiscal rules that have emerged through economic experience:
  • Public expenditure needs to be paid for through taxation, either directly in the short term or indirectly by repaying public borrowing over the longer term. Tax is a 'deadweight cost' or inefficiency in the economy, so countries should aim to limit public spending to around 30 - 35% of GDP (more on GDP shortly). Try to tax/spend more than that, and the economy slows down and reduces the absolute amount of tax actually raised;
  • Tax receipts in the UK have averaged around 38 per cent of GDP over the last twenty years and have never exceeded 40%.
  • A deficit of up to 2.5% of GDP can be financed sustainably;
  • Govt borrowing competes with private sector borrowing and can crowd it out or drive up borrowing costs. As a result, the US Office of Management and Budget, for example, requires any new spending proposal to generate benefits at least 25% greater than the explicit financing costs involved. 
"GDP", or gross domestic product, is worth a separate explanation. It's the market value of all final goods and services produced within a country in a given period. There are 3 methods of determining it, which should all reach the same result. But it's worth considering that the figure is gross, so it includes wasteful or otherwise harmful expenditure, as Tim Harford explains in The Undercover Economist - like shoddy building work that needs to be repaired. So, I guess a fall in GDP due to a decline in harmful output could be seen as a good thing, but the economy is still smaller. Therefore we should still reduce the absolute amount of public expenditure by keeping it below 35% of GDP.  

Warwick Lightfoot explains that, above 35% of GDP, the marginal benefit from extra public spending drops sharply. I wonder whether this helps to explain why the EU, and Eurozone in particular, appears to be struggling to derive benefit from increasing EU public expenditure? It would seem tough to mirror the success of, say, the US when the timing of US federation meant that it's taxpayers captured the upside of the surge public sector spending from quite low levels during much of the 20th century, whereas EU came in after member states had already exhausted the marginal economies.

At any rate, how do the UK's finances stack up?

In 2009 public expenditure reached 48% of GDP from a low of about 37% in 1997-99. The structural or permanent budget deficit was about 7% of GDP and public borrowing was about 11% of GDP in 2009-10. The current government had aimed to bring public spending down to just under 40% and public borrowing down to about 1% in 2015-16.  Public spending of just under 40% will still be too high, and continue to act as a drag on economic growth. Further work will be needed to remove structural inefficiencies in the years beyond. Unfortunately, public sector productivity fell between 1997-07, while private sector productivity increased. The public sector faces fewer penalties for failure and has few effective incentives to use capital efficiently. None of the many efficiency measures of the past 30 years has worked.

It's important to understand that public expenditure is also a critical factor in local and regional development, and helps explain why local production capacity has been lost to other regions and countries. New Labour's solution to regional decline was to decentralise government, increasing the share of public sector expenditure as a share of the local economy - well beyond the proportion of 48% of national GDP.  That differential is largely explained by the fact that staff have been employed on wages and salaries agreed on a national basis with public sector unions (which account for 60% of public sector workers). That union activity has ensured that public sector workers enjoy a 14% pay and pension premium nationally. But the difference is disproportionately larger in communities outside London and the South East. So regional private sector employers face overwhelming competition for employees from the public sector. To compete on pay, private businesses have to charge more for their products, which means they lose out to competitors who don't face the same pay costs. Higher regional public sector pay also has local inflationary effects that mean it's less attractive for private sector workers to live and work in the regions. Inevitably, the regional private sector businesses close and those who wish to work in the private sector head to London and the South East - or to overseas production centres. Warwick Lightfoot estimates that public sector pay and pensions should be reduced by 2% of GDP nationally - about £30bn or 17% overall. But clearly this needs to take place on a regional or local basis if regional competitiveness is to be restored.

Meanwhile, social security payments put benefits recipients on a par with low income earners. So-called 'working' tax credits are paid to people who work 16 hours a week, but is progressively withdrawn for additional hours worked, so people don't take the perceived risk of working longer hours. Centrally determined tax credits also work harder against regional or local employers. Potential savings in remedying this situation are estimated at £30bn from a social security budget of £195bn (however, spending on older people also needs to be given higher priority, as we have no additional tax-raising capacity to fund our 'pay-as-you-go' liabilities on an ageing population).

So to restore regional - and therefore national - competitiveness, Warwick Lightfoot suggests that public sector remuneration and social security must be reduced in line with local costs and labour market conditions. Shifts towards local rather than national taxation would also enable localised competition.

The last time we were in this mess, in the 70's, public borrowing peaked at 9% of GDP, but none of the factors like high inflation, North Sea oil or public asset sales are there to help us now. My conclusion from Warwick's book is that reducing public sector pay and pensions and social security to working people in line with local pay and cost of living is one of the few options left to us to deliver the cuts needed to boost inward private investment that will power us out of the current malaise and set up a sustainably high standard of living. 

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