The line between enough and too much (of other people's money)

As I worked my way through Other People's Money I came to see it less as a policy document than as an exercise in nostalgia. Key clearly misses the City of London before financial services were provided by thinly capitalised, conflict-free, single-capacity private firms – partnerships in spirit if not at law, with no share price to be spooked by, managed by men from similar backgrounds who knew and obeyed the rules even when the rules weren't written down.

As the book's title suggests, he puts great emphasis on personal responsibility. He'd like to see standards of fiduciary conduct “enforced by criminal and civil penalties, directed primarily to individuals rather than organisations."

Kay did not discover financialisation, although Other People's Money may popularise the concept. I'm told sociologists have been particularly fascinated by the phenomenon.

Greta Krippner, who professes that discipline at the University of Michigan, published Capitalising on Crisis: The Political Origins of the Rise of Finance in 2011, in which she points out prior to 1970 the portfolio profits of non-financial corporations in the United States never exceeded 10 per cent of cash flow, but by 2000 the ratio was 40 per cent.

A TOUCH TOO MUCH

Kay does not answer the question of what defines the boundary between "enough" and "too much" finance and my academic friends tell me there is no consensus on the matter. I doubt Kay thinks that's important.

He sees the volume of trading relative to the real assets represented as self-evidently 'absurd'. What interests him is how we got so far over the line and what to do about the resulting distortions.

The book is less a history than a series of connected essays and anecdotes. It is enormously readable. I particularly liked learning about the divergent origins of insurance.

English gentlemen sitting at Lloyd's coffee shop amused themselves by betting on whether particular ships would make it back to London. Meanwhile Swiss villagers mutualised risk by agreeing if anyone's cow died they would all chip in the buy a replacement. Those two strands are still present in the schizophrenic culture of the insurance industry.

In Kay's view, finance has four legitimate functions:

1. Providing a payments service;
2. Connecting savers and investors;
3. Helping individuals manage the long process of accumulating savings while working, living on the savings when retired and passing wealth to the next generation; and
4. Managing the day-to-day risks of fire, theft and accident.

These services should be provided as straightforwardly as possible. We should “eschew unnecessary complexity" and “pay close attention to the management of unavoidable complexity." Kay gives two reasons for this: complexity increases risk and complexity hides conflicts of interest.

Toward the end of the book, Kay turns to the question of reform. He sees structural change as far more effective than new regulations. I counted 16 suggestions. Or perhaps they are better described as aspirations. “Anyone who handles other people's money or who advises them… should demonstrate behavior that meets standards of loyalty and prudence," he says.

Some of his proposals leave a lot of details to be worked out. For example, he would ring-fence deposits and only invest in residential mortgage loans and government securities. Other forms of consumer credit, business loans and property financing would be the responsibility of specialist asset managers.

I guess what that means is these assets would be originated and held by mutual funds. Liquidity management would be a challenge.

ELIGIBLE COUNTERPARTIES

One thread running through Kay's polemic is the role of modern financial theory in depersonalising finance and defining the way people view markets. Transactions have replaced relationships. Clients have become “eligible counterparties."

Another of the historical details that make Other People's Money so enjoyable concerns William Sharpe, who ultimately won the Nobel Prize for inventing the capital asset pricing model. Kay tells us Sharpe's first article on the topic was initially rejected on the grounds its assumptions were unduly fanciful. Yet within a short time the “CAPM" was treated as a description of real markets.

My historian friends tell me scholars have realised the most successful models are those that cause markets to resemble them. There's an invented name for this: “performativity."

Another sociologist, Donald MacKenzie at the University of Edinburgh, describes in An Engine Not a Camera: How Financial Models Shape Markets the process by which the Black-Scholes option pricing model effectively created the market in equity options.

In the words of Oscar Wilde, life imitates art. Key's book is a model, even if there aren't any Greek letters. He's painted a picture of the world he would like to inhabit. One can only hope performativity will move the world in his direction.

Harrison Young is a novelist, Commonwealth Bank director, the former chairman of NBNCO, a former banker and regulator. His third novel, Nantucket (Ventura Press), set in the luxury enclave of investment bankers, has just been published.