Stephen Davis, Jon Lukomnik and David Pitt-Watson have a book that focuses on problems in finance. This includes the critical question, why does your pension fund charge such high fees? The authors have advice how we could recreate finance for the long-term. We need a financial system that has at its center a purpose that is to increase the benefits it provides to society and those that are investing the money, including pension funds. (Full disclosure David Pitt-Watson was my, frankly brilliant, boss at the Labour Party in the late 1990s).
How The Financial System Fails
This is a great review of what finance does and should do. The book is a few years old now. I was negligent in getting to read it, but I don’t think the central points will have changed much. For example, the concern that economics really hasn’t wholeheartedly embraced practical thinking. What is more, I think it remains reasonable to worry that working in finance doesn’t bring the best out of people.
The financial system, for all the money and talent that society pours into it, is a bit of a mess really. It implodes every now and then. Regulations get written that no one is especially confident will solve the problem.
The authors want more systematic regulation (big picture thinking) rather than the atomized regulation (a rule here, and a rule there), that is now commonplace. They argue that atomized thinking comes from the fallacy of composition. This fallacy is that if we make all the little bits as good as they can be everything will be great. But that does not work as things often don’t fit together.
What is more people in finance, for all their flaws, are clever. They can get round many of the individual rules. Gaps in between the rules are exploited. It would be preferable to have a more systematic review of what finance is for. Does your pension fund do lots of things that benefit them — generating fees — that don’t benefit you? (Or certainly aren’t properly explained to you even if they might benefit you).
What Is The Financial System For?
The authors suggest that the financial system is there to provide four vital services. (To be clear the authors have worked in the area. For all their concerns they clearly believe finance has a critical purpose).
- Safe Custody: you can deposit your money in a better location than your mattress.
- Payments System: being able to travel and pay easily is a bit of a modern miracle.
- Intermediation Between Lenders And Borrowers: moving money from those who have it to those who need to borrow it is a vital service.
- Reducing Risk: pooling risk allows beneficial risks to be taken that would be too scary for any individual to finance.
If the system isn’t doing this, if it instead is increasing risk, that doesn’t seem great for society.
Finance For The Long-Term
One problem is that the system is too short-term. Well intentioned ideas to pay executives in stock to align their incentives with investors have led to them chasing short-term success.
Current pay packages require CEOs and other executives to respond to market that value trading over stewardship.
Davis, Lukomnik and Pitt-Watson (2016), page 72
Shareholders, who you might assume want to positively influence managers, see it as easier just to sell poorly performing stock. The benefits of working on better management accrue to all, not just the shareholder working on it. It makes personal sense just not to bother if you are a shareholder, leaving poorly performing management teams to carry on doing whatever stupid thing they were doing. (Plus, the rules often insulate executives from shareholder pressures anyhow). All this means the authors want a system that makes it more sensible for shareholders to be more actively involved in creating more long-term value.
More Involvement From Shareholders
The authors think the system needs significant change.
Market institutions seem on a one-way path to divorcing our money from ownership, allowing tremendous misalignments of interest, not just in the finance industry but throughout the rest of the economy.
Davis, Lukomnik and Pitt-Watson (2016), page 62
This doesn’t just hurt shareholders. One problem with short-term thinking is that it can hurt other stakeholders. Abusing your employees can look profitable in the short-term but long-term is bad for both shareholders and employees.
The authors have some important suggestions. Definitely worth a read.
For more on long-term thinking in marketing see here.
Read: Stephen Davis, Jon Lukomnik and David Pitt-Watson (2016) What They Do With Your Money: How the Financial System Fails Us and How to Fix It, Yale University Press