Dominic Hobson Opinion

Whether or not its inventions are socially useless, it is hard to disagree that the investment banking industry has an extraordinary facility for innovating its way to disaster. The publication last week of a consultation paper on ETFs by the European Securities and Markets Authority (ESMA) is a further reminder of mounting regulatory and central bank concern that ETFs are becoming a case in point. They were invented as an even-lower-cost, open-ended alternative to the indexed mutual fund, with the additional benefit of stock exchange levels of continuous liquidity, no subscription or redemption charges, and (especially in the United States) greater tax-efficiency. Now regulators and central bankers are worried that, in the hands of over-inventive financial engineers, ETFs are in danger of degenerating into a yet another leveraged synthetic-cum-derivative financial instrument with no utility beyond the ability to be devised, sold, valued and traded by investment bankers and their clients.

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A tax on financial transactions is no longer the pipedream of an unreconstructed Keynesian economist of the 1970s called James Tobin. Celebrities such as George Soros and Bill Gates have declared themselves in favour. The Archbishop of Canterbury wants a transactions tax. So does the Vatican, a recent paper advocating “taxation measures on financial transactions through fair but modulated rates with charges proportionate to the complexity of the operations, especially those made on the secondary market” to fund a new global reserve fund to replenish the depleted firepower of the IMF. Less predictably, a financial transactions tax (FTT) has even attracted the support of a hedge fund manager, in the shape of David Harding, CEO of Winton Capital, provided the proceeds were invested in a better system of international financial regulation.

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There was some excitement last week at press reports that the Her Majesty’s Treasury was considering the establishment of a United Kingdom sovereign wealth fund to support public sector pensions. Naturally, custodians shared the excitement. Though not yet as large as pension funds, insurers, mutual funds or even central bank reserves, sovereign wealth funds are nevertheless highly desirable custodial clients. Their collective means greatly exceed the much-vaunted hedge fund industry, and they are conspicuous participants in major transactions. Indeed, they were among the earliest targets of ailing banks seeking a capital uplift in the early stages of the banking crisis of 2007-09. A Congressional report estimated that foreign sovereign wealth funds and other large investors sunk $37.9 billion into US financial institutions in 2007.

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The crisis which began in the Spring of 2007 is still with us. Neither the printing of trillions of dollars, nor the maintenance of interest rates at record low levels, has managed to re-start the credit cycle. There is a dawning realization, among bankers as well as central bankers and finance ministers, that hosing the financial services industry with more money is not going to work. The industry has a large, innate and institutionalized structural problem which repeated infusions of money can conceal for a surprisingly long time, but not forever. Policy has now reached the stage at which, to borrow a phrase from Maynard Keynes, low rates of interest and quantitative easing are tantamount to pushing on a piece of string. It is time to face reality, and adopt a new approach that fixes the disease, rather than treats the symptoms. As Boston University economics professor Larry Kotlikoff has described in a series of articles and a book published last year, mutual funds point to a compelling potential solution.

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The mutual fund industry has remained remarkably immune to the moral as well as the material effects of the financial crisis. Despite shedding $5.7 trillion of assets in the second half of 2008, money market funds are the only section of the global mutual fund industry to exhibit any signs of permanent damage, or to have attracted any moral opprobrium. Indeed, the industry as a whole is managing more now ($25.6 trillion) than it did when Lehman Brothers collapsed in 2008 ($24.6 trillion). So a degree of complacency is more understandable in the mutual fund industry than it is in, say, investment banking. Yet it is obvious to any disinterested observer that the mutual fund industry cannot go on like this. There are still too many funds, and too few of them create any value at all for investors. Indeed, a great many funds guarantee the destruction of value through the transaction costs they incur. Despite apparently abundant competition, and high levels of investment in labour-saving digital and telecommunications technology, those transaction charges remain embarrassingly high.

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The European Union has developed a reputation for boring its opponents into submission. With today marking the fifth anniversary of the unexpected decision by the Governing Council of the European Central Bank (ECB) to build a single central securities depository for Europe, nothing scheduled to go live for another three years, and the payback period stretching out to 2022, the TARGET2-Securities (T2S) project is shaping up to become a classic of the genre.

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The securities services industry has an astonishing capacity to absorb punishment without complaint. Custodian banks and their fund management clients have now effectively agreed to spend a fortune to speed up the European settlement timetable by one day no later than the first half of 2013. That means, at a time when it is already wrestling with nearly two dozen other regulatory initiatives, the securities industry has only two years to prepare for a substantial acceleration of the speed at which cash and securities must be exchanged.

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Institutional investors will warm instinctively to the European Commission proposal to increase disclosure of short positions as another blow to greedy investment bankers and hedge funds. They should also consider the consequences for themselves.

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Central bankers have much in common with generals, those other models of public sector profligacy and incompetence. Both are immune to repeated evidence of their own failure. Like the butchers of the battlefield, central bankers are disinclined to question either their strategy or their tactics, and tend instead to call only for the application of the existing methodology with still greater force. This is how our highly sophisticated commercial civilization has ended up being asked to believe that increasing the equity ratio of banks from 2 per cent of risk-weighted (under Basel II) to 4½ per cent of risk-weighted assets (Under Basel II) by 2015 will prevent a financial crisis like that of 2007-08 ever occurring again.

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Nobody would describe the average global custodian CEO as a visionary. It is not easy for the seers and the mavericks and the explorers to rise to the top of any organization, and hardest of all at a bank, where an excess of conventionality is the necessary mask of an outrageously dangerous activity. In fact, the last CEO to visualise the future of the custody industry and then act upon it was probably Bill Edgerly, and he retired from the top job at State Street at the end of 1992. Yet an industry which has undergone as great a trauma as the securities services industry in the last three years needs leaders with a lot more strategic imagination and ambition than shareholders, clients and staff have seen so far.

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Like the rest of the banking industry, securities services has undergone a great shock in the last two years. But if the banking industry has experienced a shock in the last two years, the securities services industry has experienced something closer to anaphylactic shock. This was because it went into the crisis with a business model that was almost perfectly designed to maximize the impact of the shock. Over the last 20 years, the custodian banks evolved a highly risky business model.

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If you go to the TD Waterhouse web site, you can find out exactly what they will charge you to execute an equity trade. It is a flat rate commission of £12.50 if you trade on-line, which rises to between £20 and £100 if you trade by telephone, depending on the size of the trade. If you are a frequent trader – which means anyone who transacts more than ten times a month – the on-line flat rate price falls to £9.95 and even telephone traders pay a flat rate of £19.95.

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Here is an interesting question for the custodian banks and their institutional clients: Is the current downswing in earnings from securities lending permanent or cyclical? It is interesting because securities lending is at the heart of the modus operandi of the modern global custodian bank. It is one of the three principal ways – the others are net interest margin on client cash, and foreign exchange transactions executed on behalf of clients – by which the global custodians reward themselves for looking after the assets of investors at sub-economic prices.

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No relationship in the whole of the financial services industry is more marsupial than that between a pension fund and its investment consultant. Asked who their most important adviser is, pension fund officials invariably name one of Mercer, Towers Watson, Hymans Robertson, LCP or the merging Aon Consulting and Hewitt. The tightness of the bonds between the two, reinforced by cross-subsidies between the various services supplied, are a source of perpetual chagrin to commercial competitors.

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There are so many ways in which institutional investors in the United Kingdom get ripped off by investment banks, fund managers, broker-dealers, custodian banks and investment consultants that it is scarcely surprising – if somewhat counter-intuitive – to be reminded that they are also capable of ripping themselves off. Such is the reflection provoked by the news today that the Office of Fair Trading (OFT) is to re-visit a hoary old question: are the costs of underwriting new issues of equity by public companies excessive?

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