“We are trying to make capitalism better for the world.”
That seems like a tall order. Fixing finance is on many people’s minds these days, but how drastic a repair job is needed depends on who you ask. Those in the industry say minor tweaks are all that is needed, while the more populist crowd sweeping the globe is keen for pitchforks, tar and feathers.
It is in that environment that I cracked open What They Do with Your Money: How the Financial System Fails Us, and How to Fix It by Jon Lukomnik, David Pitt-Watson and Stephen L. Davis. The book focuses on the inefficiencies in the current financial system and the missteps that are now common in the realm of corporate governance.
Like some kind of Michael Lewis novel, What They Do with Your Money takes complex financial subject matter and makes it imminently readable for those who work in the industry and utterly understandable for those who don’t.
The book opens with an explanation of how three sisters who live in different countries and earn the same amount of money over the course of their careers will see huge discrepancies in the amount of money they have available upon retirement. What is the cause of the discrepancy? The varying chain of agents who touch each sister’s money as it works its way through each country’s financial system.
On corporate governance, the book highlights ways boards of directors have seen their powers diminished via short-termism in the C-suite and misguided protocols for determining executive compensation.
The book finishes with the unveiling of a ‘Magna Carta’ that outlines steps the industry and individual investors can take to optimize the financial system.
I recently chatted with one of the authors – Jon Lukomnik – about the book and what he really means when he says he is, “Trying to make capitalism better for the world.”
What was the goal for you and your co-authors in writing this book?
What we tried to write was an aggressively centrist critique on the premise that what the finance sector does is really important, but we can do it better. … We want to hold the finance sector to the same standard it holds other industries.
There are different kinds of crises. 2008 was a decapitation. The issues we discuss in the book are more of a slow bleed and no one is paying attention to it.
The false dichotomy that exists is frustrating. If you criticize the finance sector, somehow you are not a capitalist or you don’t believe in business. As opposed to saying, ‘what we do is really important; let’s do it better.’
The book outlines a ‘Magna Carta’ of reforms that should be undertaken to ‘stop the bleeding.’ If you had a magic wand and could immediately implement two of those changes, what would they be?
The first thing I would do is make every person who touches investors’ money a fiduciary. Right now, the system deploys this chain of agents where many of the individuals are compensated in different ways and operating under varying business models. Every fee they charge makes an impact on investors, but we can’t always be sure they are putting investors’ needs first.
Speaking of fees, the second thing I would do is insist on fee transparency. There are new fees popping up in the industry and most investors don’t even know what service they got for their money. Not only should the actual meaning of every fee be clearly explained, but the fee should also be listed in dollar terms.
The book spends a lot of time on the role the chain of agents plays in our current financial system. Rather than make them all fiduciaries, is it possible to just eliminate some of them?
Canadian pension funds do a lot of direct investing. They do a lot of stuff in-house and they get better returns; pure and simple. They might have to hire people and pay them well to do the job internally, but that reduces the number of intermediaries and all the friction that comes with them. That is the model a lot of really sophisticated global investors are moving toward.
What trends in corporate governance trouble you the most?
We hire really good directors, then fail to maximize their expertise because we lock them into some data-driven, 3-year plan. What if market conditions of conditions within the company change? Three-year formulas prevent directors from using new knowledge to re-shape things like executive compensation. We have curtailed directors’ ability to use their judgment.
We also minimize the importance of allowing directors to act as stewards. Business models of today’s asset management companies are based on short-term, relative return. The way they distinguish themselves is through trading. … We are on a spiral toward ever-shorter holding periods, less stewardship and more focus on trading.
What is your view on high-frequency trading and the role it plays in today’s markets?
What does being able to price and sell shares in General Electric 3,000 times in a minute do for the real economy? Not a whole lot.
I don’t understand how the SEC, in the same month, can approve a fee increase the New York Stock Exchange wants to charge for co-location and fine the New York Stock Exchange for differential distribution of price feeds.
There is a nuanced regulatory approach that can be adopted to re-define certain types of high-frequency trading as market making and allow other types to continue.
Does the US have too many regulators?
People have talked for a long time about merging the SEC and the CFTC. That is a no-brainer. But that still leaves insurance and bank regulators in each of the 50 states. No matter what, we will have more than 100 regulators. Other countries adopt a national model, so they don’t have to deal with that. However, the US has a healthy skepticism toward anything that gets too big and too powerful, including single regulators.
There is no magic fix to resolve all regulatory issues. In fact, I don’t think there is a magic fix to resolve most of the issues in the book. I think there is a cognizance that needs to be raised because of the situation we have. We need to improve the coordination mechanism between all those regulators so thing won’t fall through the cracks.
What do you think of the new Masters in Systemic Risk course that Yale is going to be offering? It is designed for central bank staff and regulators who might be on the front lines of the next financial crisis.
I am not a big believer in spot regulation. We regulate the weakest link in the chain. And then we need to regulate the next link because our ‘fix’ on the last link has warped it. I just wish we could create a self-correcting financial system, rather than relying on spot regulation. We have literally 100,000 more compliance people in the banking sector now than we did in 2007. … And I don’t anyone who thinks it works better.
We won’t have the same crisis we had in 2008, but we are sub-optimizing how the financial sector works. We’ve got to come up with a way to improve the efficiency of the financial sector while safeguarding us from massive blowups.
The Labor Department’s fiduciary rule was still in the pipeline when the book was published. What are your thoughts now that it is has been released?
There is a reason the financial system isn’t trusted – as evidenced by all the campaign rhetoric. We keep telling the customers we don’t care about them. If you tell a customer you won’t be their fiduciary, what does that tell them about your level of service? If your advice is going to flunk a fiduciary test, maybe you shouldn’t be giving that advice in the first place. … People say the Labor Department’s fiduciary rule is unworkable because they have to jump over all these hurdles to get a fiduciary exemption. My point is: Why do want an exemption from your fiduciary obligation?
The industry missed a huge opportunity. The industry could have cut a ‘grand bargain’ and accepted fiduciary responsibility for a whole range of functions in exchange for a reduction in the heavy burden of ‘spot regulation.’ If there is a functioning chain of fiduciary agents, there would be no need for spot regulation.
The industry had an opportunity to regain trust and threw it away. The idea that you can’t be a fiduciary is ludicrous. No large pension fund would contract with someone who said they weren’t a fiduciary for them as an adviser. But the small guys who need it the most, you can’t be a fiduciary for? It is insane. … I don’t understand my industry sometimes. There is a purpose to finance and it is not just to make money.