Friday, October 17, 2008

The Naked City

Roll the closing credits

Say goodbye to the City as the engine of UK growth. The head of the FSA has just formally announced the start of hard-line regulation, large swathes of our banking industry are now under Whitehall direction, and politicos of all parties are falling over themselves to announce further plans and controls.

There will be big consequences as bankers leave for more accommodating homes elsewhere (and see this blog).

Hedge funds are already rushing for the exit. Because of the UK's archaic bankruptcy laws, $65bn of their assets held by the London end of busted Lehman have been frozen by the administrators, with no date for their release. Hedge funds and their clients are very angry: they're switching billions in so-called prime brokerage accounts - a highly profitable business - from London to New York (HTP JW).

Now in all the circs, you're probably saying good riddance. The bill we taxpayers are now facing to clear up the high-rolling City's mess is outrageous. And the economic chasm that's opened beneath our feet has surely been caused by the City's greed and wild risk-taking.

Ah, risk.

Risk is a fascinating subject. Risk is something few of us ever want to take, but which is absolutely vital to our prosperity. Unless we're prepared to take risk, our cash lies stuffed under the mattress and economic growth becomes a thing of the past. Because growth depends on investment, and investment depends on risk-taking.

Let's take a look at how we as individuals choose to hold our wealth.

According to the Office for National Statistics, as at end-2005 our personal wealth totalled £7.6 trillion (about six times annual GDP). But over half of that was held directly in the form of property and other physical assets - assets we can see and touch every day, and which we use for our own benefit. That's wealth all right, but it's generally not productive investment in the sense of money we've risked on business ventures which will grow the economy.

Looking at the other half of our wealth - the bit we hold in financial assets - we find something just as interesting:

As we can see, a quarter of our financial assets were held in cash and bank deposits - ie they were stuffed under the mattress. These are savings that we assume to be absolutely safe. They are savings on which we accept low returns because we don't want to take any risk at all. Which is why we get so upset when banks start wobbling, and why no sane government can allow its banks to default on retail deposits.

Over half our financial assets are held in pensions and life assurance policies, which are especially interesting.

Because as any insurance salesmen will tell you, these products are sold, not bought. In other words, we mostly hold them not because we decided to do so, but because we somehow got talked into them. Sometimes that's because of a high pressure pitch from one of those salesmen, but more usually we just stumble into them via our employment (pensions), or via some other transaction like house purchase (eg those famous endowment mortgages).

Why's that important? Because it means most of us have absolutely no idea how risky such assets can be - right up to the moment they explode in our faces. That's the first time we find out that all the reassuring sounding pension promises and finely tooled endowment policies are actually no more than a "best endeavours" indication. We've been holding risky assets all right, but we never knew they were risky.

And when it comes to obviously risky stocks and shares, overall we hold less than 20% of our financial assets in that form - and most of us don't hold any.

So we make it absolutely clear in our savings behaviour that we don't like risk.

Which is a problem. Because as we've said, without someone taking risk, we don't invest. And if we don't invest, we don't grow.

We are now living with the Naked City.

The City is stripped bare. Any mystique it once had about sophisticated risk control, about delivering rocket fuelled returns without hideous risks, has been blown to smithereens. Investors have taken fright, hedge funds are in the process of imploding, and everyone realises there really are no free lunches.

Heavy regulation is on the way. There will be stacks more monitoring and control. Confidence tricks are out, and transparency is the new order.

Right now, there is no real choice. But just remember what happened when the authorities brought such regulation and control to other areas of finance:

  • Heavy pension fund regulation brought in after the Maxwell scandal is largely responsible for destroying our defined benefit pension system (excluding of course, in the tax-funded public sector)
  • Heavy life assurance regulation brought into control abuses by those oldtime salesmen is largely responsible for destroying the with-profits savings market

In truth, both defined benefit pensions and with-profits life assurance depended on a confidence trick. Savers believed they were pretty well riskless, when in fact they depended on the uncertain performance of financial markets. But because they were very long-term contracts, in almost all circumstances they turned out fine. They were a way of allowing us wimpy risky averse punters to invest for the long-term without worrying about the risks. And their loss is a loss to all of us.

In finance, revealing all for public inspection has a nasty habit of costing us dear.


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