What would the financial services industry look like if it was structured to service the non-financial services sector, rather than itself? Economist John Kay, author of the Kay Review into short termism in UK equity markets, aims to find out.
In an ideal world there would be one, maybe two, intermediaries between the saver and the actual investment, says economist John Kay.
Not only are there too many players in the financial service chain, having the effect of diminishing the return to the saver whose money is invested, but almost all players in the investment universe get paid by the level of activity, he says.
“The vested interest in not doing this is too high,” Kay says. “It is a long haul to get to a sensible place, but we need to set out what that is and why it doesn’t need to be how it is today.”
For Kay, that “sensible place” is a back to basics view of the purpose of the industry.
“So much of what the financial services industry does today is trade with each other, and they are making a lot of money. They go out to Canary Wharf and trade paper with each other and then go home,” he says. “We need a better mechanism for lending to business, and a simpler system of mortgage lending. We need more specialist institutions, with less distinction between debt and equity financing, that will service the needs of start-up business.”
Kay is writing a book on financial services and how to construct a financial services industry based on the needs of the non-financial economy, or what he calls “businesses that do things”.
And to do that, he says, requires imagining a world that is vastly different to the one we live in now.
According to Kay, in the UK, banks engage in about $7 trillion of financial services lending. Only about $2 trillion of that is to the non-financial services sector: and further, about one third of that amount is for non-residential property, consumer credit and non-property related business loans.
“What that reveals is how small bank lending to business really is,” he says.
Kay says he doesn’t want to blame anyone for the current structure of the industry, where financial services companies effectively create work for, and service, themselves and their competitors, but if he did it would most probably be the investment banks.
Still, contrary to other commentators, he contends that the answer is not to have asset owners engaged more with companies.
“I don’t think asset owners have the skills to participate in that role,” he says. “It is more important to get the role of asset managers right than to demand activity from asset owners.”
Last month, the UK Law Commission issued its consultation paper on the fiduciary duties of intermediaries. The project was commissioned by the Department for Business, Innovation and Skills and the Department for Work and Pensions, to investigate how the law of fiduciary duties applies to investment intermediaries and whether the law works in the interests of end investors.
The review, takes up some of the points raised by Kay in his review, and specifically investigates how fiduciary duties currently apply to investment intermediaries and those who provide advice and services to them. It aims to clarify how far those who invest on behalf of others may take account of factors such as social and environmental impact and ethical standards; and to evaluate whether fiduciary duties are conducive to investment strategies in the best interest of the ultimate beneficiaries.
The paper attempts to unpick the various strands of law applicable to financial intermediaries to bring greater clarity to the debate.
For Kay this is an important development in the potential consolidation of financial services players.
“If the legal position can be clarified and then regulatory standards can be stepped up to limit distinction between wholesale and retail clients in terms of counterparty obligation, it will be a potential large lever for disintermediation and functional reform,” he says. “We need less players or more specialised players, more horizontal and less vertical service companies.”
A final report by the Law Commission will be produced by June 2014.