Fundiflora: Sketch of a Post-Bank Financial System

The engines at the heart of the post-bank financial system will be a whole new ecology of daily quoted money market mutual funds. These would be the principle way you saved, and would be the principle source of money for those wanting to borrow.

What's so great about money market mutuals? Let's say first of all what they are. Money market mutual funds are open-ended investment funds which invest in debt securities and the price of which is quoted every day. So if you buy a unit of a money market mutual fund at 100p on day one, and the fund receives interest of 1p during that same day, it'll be quoted at 101p the next day. Since it's an open-ended fund, there's no room for 'speculators' to manipulate the price, since it is re-priced every day at the net asset value of the unit. When you want to get back some of your savings, you simply sell the unit.

What does the money market mutual fund do with your savings? It lends them out, of course, by buying bills and/or bonds.

Why would a system of money market mutual funds be so much better for saver and borrower than the current ecology of commercial banks?

The first benefit is that by being a mutual fund, any money they earn goes back to you, the saver, not the 'banker'. I pointed out in The Sheer Cost of Opacity that at the moment average deposit rates are 0.31% whilst the average interest rate on personal loans is 13.38% - that's one potato for the saver, 25 for the banker. In a money market mutual fund, you get all the potatoes, except the scraps you're prepared to throw to the menial drudge who manages the fund for you. How much you choose to throw to the manager is up to you - after all, he's just advising on the administration of your fund.

If one stipulates that the fund must always provide its owners with a detailed breakdown of its holdings, then a second benefit emerges: we get an extra layer of transparency which should help to improve credit decisions.

The third reason is that such clarity and transparency will encourage a wildly diversified 'fundiflora'. Some people (many probably) will want the absolute security of return which forms the bedrock of the bad deals depositors make with commercial banks. For these people, there will be money market mutuals which invest only in government bills and bonds. True, the interest they receive on these bonds won't be great - but it won't be nothing, because, after all, 10yr gilts are yielding about 4% a year. But the fund will only every go up, not down (provided the government doesn't default).

Then there'll be people who want a higher rate on their savings are are prepared to accept more risk in doing so - perhaps by investing in commercial paper and corporate bonds. There's be some people who go the whole hog, and want to risk a portion of their savings in high-risk paper. They'll have to accept that at some point, their usually rapidly-rising fund will take a fall.

And there'll also be funds for people who have strong views about where their savings should end up. Why not have a money market mutual fund for people wanting to fund micro-credit schemes in developing nations (or Hartlepool for that matter?). Money market mutuals for people who want to make sure their savings don't finance the arms trade, or ciggies/booze trade, for example. Money market mutual funds, in other words, for those who want to put their money where their mouths and consciences are. Our current financial system blithely incorporates the assumption that 'homo economicus' is a simple creature motivated solely by profit. We all know people have vastly more complicated motivations than that.

Those are just the benefits for you the saver. But there are benefits to the borrower too: removing the opacities of the deal between saver and borrower will close the 'banking spread.' Will some borrowers object to their borrowing becoming public information? Oh, perhaps - but they've learned to live with it in the bond markets, and they'll learn to live with it in 'banking' markets, provided their terms improve. If they really want secrecy, they'll have to pay extra for it.

And, of course, if the terms for both savers and borrowers improve, then capital allocation improves and so, in the medium-term, does the performance of the economy lucky enough to be serviced by such a financial system.

But it's not just a better deal for savers and borrowers, and the economy, it's a better deal for the financial system itself, since money market mutuals are incomparably more stable than commercial banks. Though it's not absolutely impossible for a money market mutual fund to go bust, their transparency makes them many magnitudes safer than commercial banks. Quite simply, they can't be brought down by either sub-prime defaults, or by the collapse of the CDS market - if only because the flow of cash into those markets would be cut off as the problems appeared.

Finally, though the death-throes of the commercial banks in such a system would be appropriately dinosauric (flailing, lots of noise, teeth and cannibalism), developing such a system now, and in London, would reinvent the City for the 21st century. I've previously described commercial banks as a pretty decent compromise for 17th century problems. The new fundiflora I envisage is above all a response to the key conditions of the 21st century - the collapse of the price of information distribution and the associated death of credentialism.

You can be quite sure that such a system will emerge somewhere in the world, and with it a new set of industries servicing it: administrators, IT guys, loans-sourcers and packagers, credit-assessors, ethical counsellors - the full gamut. Properly handled, it'll just outperform the commercial banking system out of existence.

So if not London, where? And if not now, when?

Gary Player's Law - A Bit of Luck

I was loitering in Starbucks this morning innocently mopping up a cappu, when who should stroll in but one of the few MPs who doesn't necessarily view politics as a public auction of our liberties. So, after finishing what I was doing (creating a presentation on Taylor Rules -no relation - policy interest rates) I went over to give him a bit of encouragement.

(Well quite, I know what you're thinking - but the brave chap didn't flinch or cower. Rather, he humoured me, and finding I am an economist . . . . )

. . . he told me he was on a Parliamentary Treasury committee with Pope Vince Cable et al which was thinking about possible structural reforms of the City.

So if you're reading this, Mr D, always remember this: regulation rightly begins only when transparency, and thus choice, fails. Deal with the opacity, and a surprising proportion of the problems and failures are fixed . . . . by us.

Oh yes, and keep reading, because we've done most of the spadework now, and it's time to start building the new post-bank financial system.

The Sheer Cost of Opacity

So I think I can build a new and better financial system, do I?

It's not just that the opacity of the current banking system is wrong: you give your money to a bank manager, who promises to pay you a fixed return whilst he feels free to do with it whatever he and his derivatives team can imagine, and take the profit on it. Nor is it just that the opacity of the credit decisions he makes is likely to lead systemically to bad decisions - though it does. These are reasons why the commercial banking system is bad in principle.

But in practice, commercial banks are even worse. By which I mean they offer a rotten deal to the saver, and a rotten deal to the borrower. And, of course, the rotten deal they offer is the practical consequence of the opacities behind which they hide.

Right now, Bank of England data tells me the average interest rate on banks and building societies' time deposits is 0.31%, whilst the average interest rate on a personal loan is 13.38%. In other words, you the depositor are getting 0.31%, whilst they, the bank, get 13.07%. In terms of dishing out the meal, that's one potato for you, and 25 for the bank.

Yes, we're at an extreme point just now, but over the last five years, the average banking spread between fixed deposits and personal loans is just under eight percentage points, whilst the average deposit rate has been just 3.5%. One potato for you, two and a bit for the bank.

So personal loans are a bad deal? Well, yes, but so too are five year fixed mortgage rates at 5.35%, when you consider they're getting your deposit for 0.31%. That's one potato for you, and nine potatoes for the bank.

And you wonder how they pay those bonuses.

My guess is that these extraordinary banking spreads are only going to get wider in the next few years, as the costs of regulating the dangerous opacities of the system grow, as the cost of recouping the losses of their previous bad credit judgements are maintained, and the baleful influence of the inefficiency of the nationalized banks is felt more widely.

But what this means is that these ridiculously excessive banking spreads means we have not just the motive to build a post-bank financial system, we have the means. Somewhere between nine and twenty-five potatoes worth.

Elite Delusions and the Wisdom of Crowds

There are two reasons not to let commercial banks handle your savings. First, you can’t be sure that the bank will manage your money for your advantage rather than the banks’ (ie, the bank might take your savings to Monte Carlo, or, worse, the CDS market). Second, even if the bank manager doesn’t take depositors' savings out on the lash, he’s systematically unlikely to allocate them as well as the depositors themselves would, given the chance.

Commercial banks were a decent compromise solution to a very 17th century set of economic problems. First problem: the costs of collecting and distributing information were very high. Second problem: the costs of (and dangers of) transporting gold up and down England’s highways were also very high. It made sense to spread these costs as widely and thinly as possible, hence savings were agglomerated into commercial banks. For that economic benefit, though, savers accepted two opacities, two risks. First, they trusted the bank manager to look after their money carefully, even though they could have no direct oversight of what he did with it. Second, they trusted that in completing this task the bank manager would actually have better information than them on which to make credit decisions.

I think we all understand how things can go wrong with that first risk, and I’m not going to elaborate here. But if we are now really quite leery about what kind of gambles banks might be taking with our savings, the weight of justification falls ever-more heavily on the second opacity – ie, the idea that perhaps these experts really will do a better job than we could.

Trouble is, that argument has never looked more anachronistic. Now the costs of collection and distribution of information have fallen to near-zero, it is absurd to believe or expect that a bank manager will have any significant informational edge on credit decisions over any given intelligent and interested observer. But more, when you open up that credit decision to a mass of intelligent/interested observers, the betting would be that the bank manager’s decisions would be worse than the group’s.

(This is why investment clubs tend to beat the market, whilst fund managers don’t).

Hayek's crucial insight is that whatever else economics may be, it is a subset of information theory. Free competition, he said, is justifiable only because it uncovers information which cannot be discovered in any other way. (That's my precis of his life's work).

That's a statement not just, or even primarily, about economics. Rather, it is the practical justification for liberty, and the rationale every barbarian needs to start beseiging the walls of entrenched belief, buttressed as they usually are, by a credentialed elite. If you doubt how vigorous this truth turns out to be, take a look at this detailed account of how the market for ideas self-organized to overwhelm the most ambitious credentialist gatekeepers of our day. I think the writer is correct to identify that what matters in this debate is less the truth about climate change (which no-one knows), than the way in which the credentialist gate-keepers essentially brought into being their own self-organizing nemesis. The writer thinks it's an important moment in the history of ideas, and I think he's right.

Quakers have default-setting about their trusteeship of the world that correctly makes them vibrate to worries about the future of the planet. Despite that, Quakers should embrace this development with every fibre of their beings. The origins of Quakerism were, precisely, a revolution against the credentialism of the established Church, and the practice of meetings recapitulates this revolution every time someone gets to their feet to speak.

Back to economics and finance. The claim being that the banks experts (bank managers, the wedding cake structure of credit committees) can make better judgements about credit than depositors can is not only untrue a priori (cf Hayek) but it is also spectacularly untrue in practice, as we have discovered to our own and our children's loss.

The crisis of Western financial institutions is not just about the personal irresponsibility/ loss of understanding of what trusteeship entails, built into the structure of our financial institutions, but also about the epic stupidity its credentialist claims embody.

There used to be no alternative, but now there is. A friend in New York started a fund investing in Chinese companies in association with the #1 Chinese search website Alibaba.com. The point was to use the information received via Alibaba's collection of websites to determine how the fund's resources should be allocated. Want to do a credit check? Ask the customers, ask the wider world. It's like including Ebay’s recommendation system as part of your credit checking system. What, you mean you don’t?

When designing a post-bank financial system, this is one source of transparency you'd want - a system whereby major credit decisions are transparent to the saver (or indeed anyone else), and so open to challenge by the widest possible group of people.

At what point would you have been worried enough about your savings going to buy sub-prime mortgage paper to register an online query (what are you doing?). At what point would you have even contemplated your savings being played in the CDS market? Or look at it more positively: at what point do you consider that your savings might be better (in whatever sense you want to give to it) deployed in developing economies than in subsidising consumption in the West?

I don't pretend to know the answers to these questions. Which is precisely the point. What's needed is a structure that doesn't pretend it knows best.

In A Bar Off St James' Street

"If you're earning enough to start worrying about the tax regime, you're earning enough." Advice given by fund management principal to prospective hedgie. . .

Credit's Not a Bad Thing

This work is provoking difficult reactions. I'm getting support from those within the financial industry who feel that the Goldman Restoration is insupportable. From various Quaker sources, the reaction is more complex. Wary, as one would expect (although some at the Quakernomics website seem politely curious about views which at first glance are so comprehensively not theirs). But also disengaged - as though the very idea of thinking carefully about finance might be in itself corrupting. I was rootling around in the library of my local meeting house this week, looking for an account I thought I remembered on borrowing and lending, and I was pursued by one of the Elders. "I'm just not interested in money, you know" she said, "You mustn't think the Quakers have the answers on this."

Let it drop.

But Quakers really don't want you to check your intelligence in at the Meeting House door. So how can I let these questions drop, even though people I love and respect feel so unsettled by them? Finance is a serious thing, and the lopsided international access to credit is the biggest and most stupid (most wasteful) source of global inequality there is. How can one talk of equality if this topic is off limits?

So to work, and damn the torpedoes. What I want to do today is talk about credit - lending. I want to pursuade you, or maybe just remind you, that by and of itself it's no bad thing.

I think the reflex objections to credit are based on the fear of growing rich at the expense of others, and the siren call of luxury. Well, those are pretty good reasons to be wary. But to balance that I'd argue there’s far more poverty, suffering, injustice and enslavement in the world attributable to the absence of credit than there is to its profusion. When we speak instinctively of the lack of fairness in international finance, isn’t this partly what we mean – that if your skin colour is the right shade, and you live in the right part of the world, you have ‘access’ to inordinately more resources than if you aren’t born so prettily. If you’ve spent your career working in financial markets in Asia, you’ll have seen what happens when credit becomes available for the first time. Oh dear, I fear it may be true: HSBC has probably liberated more Asians than Oxfam.

(The logical extension of this, by the way, is that there’s also/even a moral case to be made even for ‘bad loans’. After all, if the real injustice is that people who could usefully use loans (ie, could use them to better their lives, and repay them) can't get them, then part of the job is to find the ‘limit’ of where lending should be made. And the only way you find that limit is by crossing it, breaking it.)

Where excessive caution allows human potential to go to waste, I can see no simple virtue. "The poor without employment are like rough diamonds, their worth is unknown" said John Bellers. I think you can say the same for the poor without credit in vast swathes of the world economy.

More, lending is the flip side of saving. No-one needs convincing of the virtues of saving, but unless people bury their cash, or buy gold (the same thing), their saving properly implies lending and interest payments.

And here we get to the nub of it: banking matters because the banker offers to intermediate between the saver and the borrower. The fact is, this is trusteeship, and it places the banker right at the centre of that 'vast and complex movement of social service.'

The early banking Quakers understood this, I think. A Quaker banker would have at the forefront of his mind the fact that he had taken deposit money on trust, and therefore he had to ensure he didn’t lose it. “If I lend you this money, are you in a position to repay it?” But in taking this care, in accepting this responsibility, perhaps he also brought something unusual to the table – an acknowledgement that a credit contract involves responsibilities not just for the borrower, but for the lender too. The lender has a responsibility to the borrower because he also has a responsibility to the depositor who’s money it is that is being lent. That responsibility starts in, and is implied in, the very extension of credit in the first place. The lender and the borrower have both put themselves in a position whereby they owe each other support.

And this insight,as I understand it, is what also underpins the success (measured by low default rates) of microcredit schemes.

It is also the insight that commercial banks have lost - completely, I think. The problem with ‘credit’ is, in fact, a problem with the institutions which allocate that credit. It is the lack of acknowledgement that borrower and lender have a mutual responsibility to each other, on behalf of the depositor.

So it's to the institutions that we must turn next.

Quakers, Finance, and the FSA's Folly

One of the main things I'm doing here is trying to fashion a defence the financial industry, sometimes as it is, sometimes as it could be, from a Quaker and libertarian point of view. It feels an outlandish task, since an antipathy to finance seems common ground held comfortably. I want to win back this common ground, in as honest and sympathetic way as I can, for many reasons. But two will start. First, this antipathy is new: early Quakers were not merely involved in finance, they helped to build the very institutions we now query - including Barclays and Lloyds, and Gurney (of Overend,Gurney fame/notoriety). Indeed, the financial involvement, and success, of early Quakers got up the noses of other radicals (including William Cobbett and Tom Paine). Were these early Quakers simply being unquakerly?

The second reason is far more important: finance is an extraordinarily important part of the framework-setting within which much of humanity succeeds or fails - so it's got to be done properly. At the moment, it's not being done properly, and I think Quaker voices should be raised to help it be done properly. More, I'd like to see Quakers begin the reconstruction of a financial system themselves, building better, just like the Barclays, Lloyds and Gurneys did before them. It is not too late, and certainly not too early, to start refashioning a financial system that serves humanity rather than itself.

Over the coming weeks I'll share my effort to untangle the good from the necessary from the downright pernicious. I know it'll be an uphill struggle. After all, I've read 20.63: 'So much has the public conscience been warped from the living Truth that a man who has acquired wealth by operations on the Stock Exchange is spoken of as having 'made' his money regardless of whether any useful purpose has been served. . . . '

Actually, I think the 'public conscience' is in a much worse state than that. Today's Sunday Telegraph carries the quite extraordinary story that - and here I'm quoting, m'luds - 'The Financial Services Authority did nothing to prevent Icelandic bank Kaupthing from setting up British retail operations eight months before it failed because it thought taking personal deposits would help boost the bank's faltering liquidity.'

The crucial word in that sentence is 'because'. Frankly, one doesn't expect regulators to be the sharpest tools in the box, an assessment fully justified by the fact the FSA's regulators allowed Northern Rock, a deposit-taking institution, to run a loan-deposit ratio of 500%+. But even the frankly dim can be expected to know theoretically why they are there. Financial regulators are there to protect the depositors in opaque financial institutions such as banks, from the danger the greed and folly of those institutions exposes them to. In this case, however, it seems that the regulator sought to protect the financial institutions from the consequences of their own folly, by using the blind-sided depositor as a sort of ignorant financial shield of last resort. This goes beyond stupid, and indeed beyond dumb complicity, but puts the FSA into the realms of accessories before the fact. The depositors were mown down by friendly fire.

The head of the FSA at the time was Callum McCarthy. He was knighted in 2005 for 'services to finance'. Enough said.

I seriously want to master my anger at such dangerous and negligent insouciance. So let's just say that when the official mind has so grievously misunderstood the nature of finance, and is seemingly intent on compounding that misunderstanding at our expense, these may be fertile times to develop a new vision.