The Ecology of Finance

The financial system needs to start working like a productive ecosystem. It should be characterised by diversity and an ability to sustain specialised and adapted life in the face of external shocks.

Instead of a monoculture of mega-banks deemed too big to fail and answerable only to the demands of private shareholders, an ecology of finance would involve a range of different financial institutions.

In July 2009, the UK Treasury released its White Paper, Reforming Financial Markets. It argues that ​‘failures of commercial judgement brought the world’s financial system to its knees in October 2008’. But was that really the only significant contributory factor in what has been described as the worst financial and economic crisis in living memory? In this alternative White Paper, the New Economics Foundation (NEF) sets out a vision for an alternative approach to regulating and shaping the financial system so that it produces economic, social and environmental value in a way that leads to greater stability and a more balanced economy.

The Treasury is unambiguous in naming the causes of the financial crisis. There was excessive leverage and risk-taking; i.e., banks and other organisations and institutions took on too much debt and gambled more than they could afford to lose. There was an over-reliance on wholesale funding.

Northern Rock is just one of many examples of financial institutions that turned their backs on decades of received wisdom in order to generate more profits. Instead of having close relationships with depositors and borrowers alike, banks became more like speculators churning through debt and investment, increasingly trading with each other rather than with customers.

The Treasury identifies an overdependence on particularly risky product streams. Buy-to-let mortgages are just one notorious example of an overexuberant sector that was willing to put more and more eggs into fewer baskets. The White Paper also points to poor management decisions in respect of acquisitions. Banks went through wave after wave of consolidation, and the deal-makers received hefty bonuses for mergers and acquisitions that would ultimately destroy shareholders’ investments.

The White Paper aims explicitly to restore stability to the financial sector and the wider economy. It challenges financial firms to understand that in the future how they manage risk will change, as will the quantity and quality of capital they hold. For regulators there is an equally stark message: the way firms are monitored must change.

The Treasury’s proposed reforms stem from its understanding of how the crisis developed and why. It charts how the crisis unfolded. First, investors misjudged the risk of borrowers defaulting on loans made in the US subprime market. This led to banks lacking liquidity as unexpected losses showed up, but it also meant that banks did not trust each other’s ability to honour commitments. Lending began to dry up, and this problem intensified as significant losses were revealed in major banks and other institutions. The Treasury identifies the failure of Lehman Brothers as the moment at which the fragility of the system became so acute that unprecedented levels of support and global regulatory coordination were needed to preserve it.

What is notable about the Treasury’s analysis is what is missing: a positive vision of what the financial system should be for, and how it must change to bring about such a vision. This ​‘alternative White Paper’ attempts to define what the overarching purpose of the financial system should be, and what the Treasury needs to do in its follow-up to its White Paper to ensure that we all move in that direction. A key feature of our approach is to draw on lessons from corners of the financial system that are outside the mainstream, such as community and social finance. Many institutions working in these areas have weathered the crisis quite well. This is not a coincidence: it is the result of a combination of the activities they engage in and the way in which they are structured.

The vision set out here is to develop what can be described as an ​‘ecology of finance’: an integrated infrastructure that links together the financial system from the grassroots to the towers of high finance. The system of relationships between living things and their environment is contained within an ecology which in turn is one part of a wider ecosystem. A more productive ecosystem, one that is more robust is characterised by diversity and an ability to sustain specialised and adapted life in the face of external shocks. This is what is now needed in the financial system.

Rather than permitting our financial system to weather the current storm in order to return to business more-or-less as usual, we need to acknowledge that our system itself needs to change. The question is, how?

Functions of finance

Building on the work of Nobel Prize winning economist, Robert Merton, we identify the six core functions of the financial sector in the economy.

Finance needs to provide:

1. A payments system for the exchange of goods and services.
2. A mechanism for the pooling of funds to undertake large-scale enterprise.
3. A way to transfer economic resources over time and across different regions and industries.
4. A tool to manage uncertainty and control risk.
5. A signpost providing price information, helping coordinate decision-making in various sectors of the economy.
6. A solution to the problems of asymmetric-information and contradictory incentives – when one party to a financial transaction has information that the other party does not.

In combination, these six functions add up to the primary function of the financial system. Adapting Merton’s formulation in this alternative White Paper, we describe this as follows:

To facilitate the allocation and deployment of economic resources,
both spatially and temporally, to environmentally sustainable
activities that maximise long-term financial and social returns under
conditions of uncertainty.

This means that resources are spread into activities in different places and sectors. The resources are invested so that they produce greater returns over time. Together, the variation and balance of resources is also a strategy to cope with the risks of losses. The financial system in the UK has not really been engaged in this task in a broad sense. When we look at the six functions, it can be argued that our financial system was not performing any of these particularly well for all its stakeholders prior to the current crisis. For some stakeholders, and some functions, it was not contributing anything of value.

We believe that part of the problem has been a dominant philosophy that has been widely shared across the financial sector, not least among regulators and policy-makers. That philosophy is one of laissez-faire permissiveness, characterised by a high level of trust in the capacity of high finance to thrive on its own free enterprise and competition while protecting the public benefit through self-regulation.

This permissiveness and trust has been underpinned by a series of assumptions from which we now need to draw lessons. These lessons demonstrate that the trust is misplaced, and that a gradual approach to reform of the sector is likely to be woefully inadequate.

The major assumption behind pre-crisis regulation is one of confidence in markets’ ability to get prices right. However, from the tulip mania that afflicted Amsterdam’s stock market in the seventeenth century to the dotcom and house price bubbles of the past decade, the idea that markets will unfailingly indicate the correct financial value of assets is highly questionable.

This misconception is fundamental, since it is through getting prices right – in the sense that they accurately reflect underlying economic value – that markets are supposedly able to allocate scarce economic resources to their most productive use. Getting the prices wrong, in contrast, leads to waves of finance moving in and out of various sectors, generating unsustainable asset-price bubbles in the process. The effects of this reality on the real economy are highly visible today.

Blaming the problems created by the crisis on poor management or an excessive appetite for risk obscures the importance of acknowledging what is wrong with markets themselves. It is not ​‘a few bad apples’ but the apple tree that is the problem. The job of regulation has to be to offset and – as far as possible – to correct these tendencies. In regulatory parlance, it needs to ​‘lean against the wind’, rather than simply adding to its force.

There were further flawed assumptions underlying the permissive philosophy of the sector. Regulators were exceedingly relaxed about competition, relying on the UK sector’s international standing as proof of its competitiveness. Bolstered by the notion that the City’s prominence in the global financial sector demonstrated its efficiency, policy permitted an ever more homogeneous and top-heavy sector to develop. Consolidation, takeovers and aggressive acquisitions left the UK economy with fewer banking institutions, which in turn left consumers with a less competitive financial landscape. The exception was in highly lucrative areas such as mortgage finance, where banks were falling over themselves to lend money – but often on unsustainable terms.

Ultimately, the importance attached to the success of the financial sector may have negatively affected other parts of the economy. Interest and exchange rates, for example, have been geared more towards the demands of finance than towards the needs of other sectors, such as manufacturing. Whereas manufacturers and exporters hope for a low rate of exchange for sterling, and low interest rates to encourage investment, the City benefits from the opposite.

The consolidation and growth of banks revealed another key assumption: that bigger is always better, and that complex institutions trading in many different markets should be seen as a sign of sophistication and strength. In reality, as the passing of the phrase ​‘too big to fail’ into common language shows, big can be problematic. Many institutions have not only become too big to fail, requiring huge taxpayer bailouts when they face bankruptcy, but they have also become overly complex – in effect they became ​‘too big to bail’.

As the Treasury’s own account of the crisis reminds us, few institutions knew or could determine the extent of the financial losses they faced when the bubble popped. Bigger is clearly not always better at delivering the key functions described earlier. We have seen that size does not even guarantee safety.

Alternatives

In the UK, a host of alternative and innovative social or ecologically focused financial forms and approaches exists. In fact, the UK has been a hub of financial innovation for centuries. It is only in the past few decades, in which the assumption that the market always knows best has dominated, that the UK financial sector has grown to be so uniform. This report considers how the approaches of little-known but highly effective alternatives can point the way to reform of the entire sector.

The alternatives that already exist demonstrate that a more diverse and socially focused set of financial institutions can survive even in the extreme conditions that existed prior to the financial crisis. With enabling regulation and policies, the alternatives that we highlight could represent the ecology approach to finance.

These alternatives exist in many forms, some very familiar. One that we turn the spotlight on is the building society sector, which the White Paper picks out as the source of future competitions and diversity in the financial sector. The era of ​‘big finance’ extracted a heavy toll from building societies. From 1986 onwards, building societies were encouraged to join the stampede of conversion to just one type of banking: big and complex. But none of the converted, or demutualised, societies exists any longer.

Northern Rock is the most visible example of their demise. Just a year before its fall, the Rock testified to an all-party parliamentary group that ​‘mutual status does not encourage efficiency… [our] success over eight years would not have been possible under the old mutual model’.1 But the report published by that very all-party group asserted that, bar the high salaries awarded to senior executives, the wave of demutualisation brought little benefit to the financial services sector and its customers.

This alternative White Paper distils lessons for the reform of the financial system from organisations that are designed to capture social and environmental value, not just profit. In doing so it showcases examples of enabling legislation and a wide range of alternative financial institutions that could help the UK to develop the kind of diversity and dynamism needed to create a healthy ecology of finance. These include:

• Credit unions, community development finance institutions and community land trusts.
• Green investment banks such as the Nordic Investment Bank.
• The Community Reinvestment Act in the United States.
• The Mondragon Cooperatives and Caja Laboral Bank in the Basque region of Spain.
• A Social Investment Wholesale Bank and innovations including social impact bonds.

Recommendations

Policy-makers must act now to prevent a repeat of the kind of crisis that has just occurred. We identify a series of interventions that we believe are essential to rebuild prosperity, to support the most disadvantaged and to ensure greater stability in the future.

Preventative measures must:

• Separate out retail banking from other forms of banking by preventing deposit-taking institutions engaging in a range of financial activities.
• Regulate financial institutions appropriately according to their functions. Regulate financial institutions according to the riskiness of their activities, modified by consideration of their funding structure, governance arrangements and scale (with capital requirements being an increasing function of size).
• Develop counter-cyclical macroprudential regulation to offset the pro-cyclicality of the financial sector and encourage stability rather than volatility.

To achieve the vision of a financial system that fulfils the core functions the economy requires, reform will need to go beyond a focus on preventing another crisis. The goals of the White Paper – including greater competition in financial services, greater diversity in the sector and a system that is capable of investing in the long term – will require interventions that fundamentally alter the financial landscape.

NEF recommends that reforms:

• Put in place a Social Investment Bank at macro level, linked into a local network of adequately funded community development finance institutions (CDFIs) and other local financing institutions.
• Establish a Green Investment Bank to channel finance towards developing the environmental infrastructure we need, in such a way that regional inequalities are taken into account.
• Establish a national Post Bank based on the existing post office network, to address financial exclusion and provide real, fairly priced competition in local communities.
• Encourage the expansion of existing mutual institutions and the establishment of new ones, including from the remains of bankrupt, nationalised banks.
• Introduce legislation to harness the benefits of disclosure and investment obligations, based on the Community Reinvestment Act, to link large, commercial banks into an ecology of finance with local, excluded economies.