A New Start

FT: What drives the race to the top

It could be that potential entrants are put off by the working hours and high-pressure environment as well as the riskiness. It could also be a matter of timing. The really spectacular gains at the top are quite recent; and who knows how long they will last? Luck, too, enters into the picture. A young person starting out 20 years ago would not have been able to guess quite how large the pickings of the investment banker might be relative to that of a country solicitor or college head.

My hunch is that events will sort out many of these features. If electorates can accept the element of luck that goes into the earnings of superstars or the winnings from national lotteries, why cannot they accept this same element in the top professional and financial categories?

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What drives the race to the top

By Samuel Brittan

Published: July 4 2008 03:00 | Last updated: July 4 2008 03:00

"The rich are getting richer and the poor are getting poorer." Such beliefs fire the indignation of critics of capitalism and provide a guilty thrill for some of the better off. If only it were as simple.

Thank heavens, then, for the Institute for Fiscal Studies, which sheds so much light on the subject, for example in its recent Poverty and Inequality in the UK survey. My only quarrel with it is that it follows the academic herd in using the loaded term "inequality".

Its summary finding is that the so-called Gini coefficient of inequality (which I should prefer to call an index of skewness) rose "dramatically" in the Thatcher period of the 1980s, but remained more or less unchanged in the Major and Blair years, when it remained at historically high levels. In the Blair period, incomes after tax and benefit rose fairly evenly, taking one year with another, over all quintiles - that is, groups covering fifths of all households. Absolute poverty, defined as income below 60 per cent of the 1996-1997 middle-ranking citizen, has fallen from 25 per cent to 13 per cent of all households. But to achieve the target of halving (relative) child poverty by 2010-2011, additional public spending of nearly £3bn per annum would be required.

The most spectacular IFS finding, however, is that incomes of the top 1 per cent increased much faster and of the very top 0.1 per cent faster still. As the incomes of the very rich are highly correlated with the stock market and financial conditions, later estimates may show a partial reversal and hence more "equality" - cold comfort to those who lose their jobs.

An illuminating discussion of the reasons for what has happened is provided by Robert Gordon and Ian Dew-Becker in their survey , Controversies about the Rise in American Inequality (CEPR discussion paper 6817) - British trends are quite similar to those of US, if in less extreme form. The authors distinguish between three types of high-level gainer. First, there are the superstars, for example in sports and entertainment, where technological developments have magnified the reach of top individuals and reduced the demand for the not-quite-so-good. Second, there are the professionals, including lawyers, bankers and hedge-fund managers. Third come the chief executive officers, whose incomes can be enhanced by the back-scratching of their peers.

The sky-high earnings in at least some of these groups seem to fly in the face of one of the most basic teachings of Adam Smith: the tendency to equality of net advantages among non-competing groups. This suggests that the real advantages in different occupations will tend to be the same through the forces of competition, such as the entry of more workers into the highly remunerated fields and their exit, or non-replacement, in the badly remunerated ones. The classic example is that of the civil servant who would earn much less than his equivalent in a commercial concern but would compensate for it by job security, challenging problems and indexed pensions.

Why, then, are the spiralling rewards not competed away by would-be entrants? The superstars do form a non-competing group by virtue of inborn talent, aided of course by determination and ambition. It is the other categories that are more puzzling. When the top ranks of banks and investment institutions were confined to a narrow circle of people in striped pants who had been to a limited number of schools, tacit entry barriers would explain a lot. But a visit to any bar in a major financial centre would confirm that these barriers are largely down.

It could be that potential entrants are put off by the working hours and high-pressure environment as well as the riskiness. It could also be a matter of timing. The really spectacular gains at the top are quite recent; and who knows how long they will last? Luck, too, enters into the picture. A young person starting out 20 years ago would not have been able to guess quite how large the pickings of the investment banker might be relative to that of a country solicitor or college head.

My hunch is that events will sort out many of these features. If electorates can accept the element of luck that goes into the earnings of superstars or the winnings from national lotteries, why cannot they accept this same element in the top professional and financial categories?

The main argument for much higher taxation among top groups would be if it could provide a large sum for redistribution. The IFS estimates that the top 0.1 per cent of UK adults had average pre-tax incomes in 2004-2005 of £780,000 per annum and on average paid 35 per cent in income tax. If their tax contribution were doubled and divided among all 29.5m taxpayers, this would yield about £870 a year or £17 per week. This is not a negligible sum; but it would not take much in the way of disincentive effects, emigration or tax avoidance at the top to wipe it out altogether. A safer but less popular way of helping the least well off would be through modest increases in taxes throughout the income distribution - or selective cuts in public spending. Admittedly this route would not provide the same outlet for jealousy and envy.

Copyright The Financial Times Limited 2008

FT: Banks must learn to trust the word of humans too

Banks must learn to trust the word of humans too

By Gillian Tett

Published: July 4 2008 03:00 | Last updated: July 4 2008 03:00

A few years ago, Ron den Braber, an outspoken Dutch mathematics geek, was working in the risk department at Royal Bank of Scotland when he became alarmed about the models being used to price collateralised debt obligations.

Most notably, he concluded that the so-called Gaussian Copula approach then in use at RBS (and many other banks) significantly underplayed risks attached to the most senior pieces of debt - creating a danger of future, large losses.

So he duly tried to raise the alarm. But, as he tells the tale, he faced hostility. "I started saying things gently - in banks you don't use the word 'error', but the problem is that in banks . . . people just don't want to listen to bad news," Mr den Braber recalls.

Now, every corporate tale has many sides - and RBS, for its part, vehemently denies that it ever ignores challenges or stifles debate. It says it could not find any record of strong warnings about the Gaussian Copula model, is aware of its shortcomings, and, while it has recently suffered CDO losses, these relate to products acquired after Mr den Braber's time.

However, the story is worth noting since echoes of this saga now seem to be emanating from numerous banks. In particular, many other bankers have also recently told me that they knew that structured finance models were mis-pricing risk at an early date - and yet in many cases the attempts to raise the alarm were crushed.

Or as one senior risk manager writes (anonymously since he remains employed): "[My] institution has now taken multibillion writedowns - job losses result and significant share price erosion - and I wonder how this can have happened? Upfront we did express to senior management that we lacked the analytical skills . . . and highlighted deep concerns about the approach colleagues in the market risk area had taken . . . I feel responsible for not doing more, but I really did push my views, risking my immediate career."

So can anything be done to redress this? (Or prevent it playing out again now in the commodities world, say?)

Perhaps not.

Few bankers want to hear dissent about the models when they are enjoying a profit bonanza. Greed is what drives much of the modern financial world - combined with fear of getting sacked.

But, if nothing else, this saga shows the great blind spot that still haunts many banks. This decade, financiers have invented so many brilliantly clever mathematical tools to repackage risk that the industry has slipped, almost unthinkingly, into an assumption that "credit" is a collection of abstract equations, stripped from any human context.

Thus banks have become so dazzled with their powers that they have ignored how they interact with the rest of society - or how the tribal aspects of their own institutions can create dangerous traps.

Meanwhile, the cult of models has become so extreme that banks have believed them even when this collides with common sense. Yet, as any Latin scholar knows, the word "credit" hails from credere: "to trust". It is, in other words, also a social construct.

And bankers forget this human dimension to their cost - no matter how impressive the abstract numbers might seem. Or as the same risk officer says: "The billions involved were so hard to contemplate that we almost certainly lost sight of the possible consequences [of our credit business] until it was too late."

So, as the banks nurse their credit losses, they certainly do need to review why some of their clever mathematical models failed. That geeky Gaussian Copula stuff, in other words, matters hugely.

But, most important of all, they need to work out why the human processes around the models failed, too. Not just in the eyes of Mr den Braber, but also in the experience of numerous other junior employees who are now hugging their war stories, but are far too nervous to speak out.

* In the coming weeks I will be on sabbatical writing a book (about CDOs, modern banking tribes and much else.) I will return to the column after the summer.

gillian.tett@ft.com

FT: Bank leaders are a disgrace to capitalism

Bank leaders are a disgrace to capitalism

By Luke Johnson

Published: July 2 2008 03:00 | Last updated: July 2 2008 03:00

If you want to get a British entrepreneur worked up, one topic is bound to raise their temperature to boiling point: the behaviour of the clearing banks.

To ordinary business owners, it appears as if these organisations are the institutional equivalent of Jekyll and Hyde. In the space of a year they have gone from being rampaging expansionists to capital-starved risk-avoiders. Everyone in business is being battered by the blowback from the credit crunch. What on earth is going on in the financial services industry?

The UK high street banks are in effect an oligopoly that provides the loan capital to industry that in turn creates the wealth and jobs that keep the country going. They are vital to our capitalist infrastructure.

Their health matters - not just to their shareholders and staff, but to the business customers who rely on them to provide loans, overdrafts, credit card processing and myriad other money-related services that every company needs to function.

Cut off that flow of funding and you step on industry's windpipe and starve the brain of oxygen. And the sort of arbitrary and brutal credit decisions being dished out to customers mean parts of the banking system are breaking down.

Some of the Big Five UK banks appear to be behaving worse than others. In several incidents I know about they have been unnecessarily short-term and unpredictable, ignoring long-term relationships and using excuses to withdraw facilities summarily or charge usurious fees. In some cases this knee-jerk nastiness will help drive companies to bankruptcy, destroy jobs and damage the economy and society - while the banks will not even get much of their money back.

Part of the problem stems from the scale and complexity of banks' activities. In Barclays' 2007 annual report there are more than 100 notes to the accounts. How many of the board, or indeed the senior management, have studied that dense document and understand it all? Who really knows those risks? The auditors? The risk committees? The Financial Services Authority? I have my doubts. The balance sheet shows that at December 31 2007 it had £345bn of loans to customers - what one might consider the core business of a bank - but also £193bn of trading portfolio assets and £248bn of derivative financial instruments. What are they all? Are those items worth what the accounts say? And why does Barclays own them?

All banks have a core product - money - that is a fungible commodity, yet bankers are obsessed with suggesting their service is different from anyone else's. In reality they take deposits and lend money, but even in that simple game it seems they are forgetting first principles, such as trust, transparency and consistency. They expect these from their commercial borrowers. But do we get it from them? Not recently, I would argue. The banks have been in denial about their financial condition, and have misled shareholders, the markets and their customers.

Bank directors are not under-rewarded. The six executive directors at Royal Bank of Scotland, for example, took home £16m in cash last year - on top of their accumulated pension entitlements of £26m. These are not entrepreneurs who risk their own capital in life - they are just bank employees. That sort of cash should buy geniuses who never fail. It should pay for leaders who understand the larger role RBS plays in the system, and the vital contribution it makes in financing the private sector, since it claims it has the number one brand in corporate banking.

Yet in undertaking the "largest banking acquisition ever" by buying ABN Amro after the market had begun to turn, RBS has destroyed value and its management credibility on a breathtaking scale. How can they dare to withdraw facilities and berate borrowers when no one has been sacked for such gargantuan incompetence? How do the bosses retain the confidence of their staff, clients and stockholders? RBS was forced into a rescue £12bn rights issue in spite of saying it did not need one. The arrogance of certain of our top bankers is a disgrace to capitalism, while many of the board members of the Big Five appear to have been asleep at the wheel in the past couple of years.

lukej@riskcapitalpartners.co.uk The writer is chairman of Channel 4 and runs Risk Capital Partners, a private equity firm

Copyright The Financial Times Limited 2008

FT: Qatar's sharpest investor

Qatar's sharpest investor

Published: June 28 2008 03:00 | Last updated: June 28 2008 03:00

W hen Qatar's sovereign wealth fund pulled out of its bid for J. Sainsbury, the UK supermarket group, bankers dismissed the state investment authority's chances of making its mark on the City of London in the foreseeable future. Six months later, Sheikh Hamad bin Jassim Al Thani, the Qatar Investment Authority's chief executive, is back.

Qatar has invested more than £2bn ($4bn, €2.5bn) for a stake of up to 10 per cent in Barclays, the British bank, as part of a plan to put $15bn (€9.6bn, £7.6bn) into financial blue chips. The QIA, which is estimated to control $40bn-$60bn in assets, this week also lured NYSE Euronext to invest in Doha's stock exchange. Qatar is building up its financial centre in fierce competition with the established international hub of Dubai.

Sheikh Hamad will be feted at the top tables of international finance as hundreds of billions of dollars of surplus gas revenues flow into the investment vehicle that aims to keep this tiny Gulf state one of the wealthiest in the world long after its prodigious gas reserves run out.

His marriage of political power and commercial nous has made him one of the richest men in a region of very rich men. He has been foreign minister since 1992 and was also recently promoted to prime minister. The emir of Qatar is said to have quipped of his longstanding ally: "I may run this country, but he owns it."

Long before investments raised him to prominence, Sheikh Hamad's idiosyncratic foreign policy and backing of the free-speaking al-Jazeera satellite channel had already attracted attention. He talks openly of "his friends" in Israel, having forged relations with the Arabs' historical foe in the 1990s. At the same time, the Doha offices of Hamas, the militant Palestinian group, receive Qatari largesse. The deserts south of Doha host the largest US base in the region, yet Sheikh Hamad is more critical of Washington's foreign policy than his neighbours.

In some ways, these positions reflect the split personality of Qatar, which follows the conservative Wahhabi Islam of neighbouring Saudi Arabia but is also banking on tourism.

Last month Sheikh Hamad's pragmatism gave Qatar its greatest diplomatic coup to date when he halted Lebanon's descent into another civil war by brokering a truce. Pro-western Lebanese had perceived him as too favourable to Iran and Hizbollah, the Shia group, but in the end his contacts with Syria helped him to succeed. By the fourth day of the talks at Doha's Sheraton hotel his casual but determined style had won over Lebanese critics.

Born in 1959 in Qatar, Sheikh Hamad's studies took him to Lebanon but he perfected his English in the UK, starting his government career at the office of his uncle before becoming minister of municipal affairs and agriculture in 1989. Three years later he became foreign minister, making him one of the main power brokers in what was then a sleepy, underachieving emirate failing to invest its oil revenues for the future. As the current emir, Sheikh Hamad bin Khalifa, plotted against his father to speed Qatar's reforms, he found a willing ally in the foreign minister, who supported his cousin in a successful 1995 palace coup.

Sheikh Hamad's love of long Cuban cigars may fit the stereotype of the billionaire sheikh, but he is also a connoisseur of gourmet cheeses. Indeed, the former agriculture minister is fascinated by the technology behind food production. He is now leading Qatar's drive to invest in Pakistan and east Africa to clinch corporate farm investment deals in order to secure food supplies as global food inflation bites.

He divides his time between Doha and abroad, travelling often on foreign ministry or QIA business. His lack of protocol is also reflected in his management style. A quick decision-maker, he is also attentive to ideas from the small but growing team he is building at the QIA.

He has an extensive personal property portfolio, including, it is said, London's most expensive apartment at the Candy Brothers' One Hyde Park development, as well as other London area homes and hotels. In Qatar, his interests span the plush Four Seasons hotel in Doha and fast-growing Qatar Airways. His wealth has also generated envy. Sheikh Hamad is more likely than other leaders to stir quiet criticism from the loyal ranks of the Qatari populace. Qataris generally describe him as shrewd.

Sheikh Hamad had uncomfortable exposure in 2001 and 2002 when trust funds he controlled in Jersey were investigated by the island's authorities over payments made to them by a number of European arms makers, including BAE Systems. BAE has denied wrongdoing.

The case ended when the Jersey authorities closed it in 2002 on the grounds of public interest. At the same time, Sheikh Hamad paid the island's authorities £6m to compensate for any damage "perceived to have been caused" by the investigation and he continued to deny any wrongdoing.

The lines between the wealth of the Gulf states and their ruling families are blurred. Sheikh Hamad leads the QIA's investment strategy but often invests his own wealth in similar deals to the QIA's. This week's investment in Barclays included a tranche of his own money.

If his wealth is an issue for some Qataris, so are his reformist politics. Sheikh Hamad is a lightning rod for criticism from vested interests threatened by reforms the government is introducing as its increasing exposure turns the glare of international scrutiny on to its inner workings.

He often raises awkward questions about the need for Qatar's pampered citizens to play a more productive role in the economy. He has also likened the feudal system of sponsoring foreign workers, which forces most expatriates to seek permission if they want to leave the country, as approximating to slavery.

Once one of the main proponents of democratisation, he has cooled on prospects for expanding the electoral system beyond municipal councils, fearing the rise of Islamist sentiment and ruefully watching the political paralysis in the Gulf's most democratic state, Kuwait.

Outside foreign policy, Sheikh Hamad has enough on his plate as he builds the QIA's assets into an endowment that can one day cover the emirate's budgetary outlay, currently heading above $20bn a year. "I think if we invest it right, we can secure Qatar for a generation," he told the Financial Times last year.

Some in the region would wish him ill in his endeavours, but few would bet against him.

Copyright The Financial Times Limited 2008

FT:Qatar's ambition revealed in plans for exchange

Qatar's ambition revealed in plans for exchange

By Anuj Gangahar, Jeremy Grant and Simeon Kerr

Published: June 25 2008 03:00 | Last updated: June 25 2008 03:00

NYSE Euronext's deal to help Qatar revamp its stock exchange shows how seriously the tiny gas-rich state takes its efforts to develop its financial sector.

But it also illustrates how important the Gulf region has become in the global chess game of international exchanges.

This is NYSE Euronext's second foray into the Middle East, after in March signing a technology provision deal with the Abu Dhabi Securities Market. That came after the purchase in February of a 5 per cent stake in India's Multi Commodity Exchange, the sale of options trading technology to the Tokyo Stock Exchange in April.

The deal provides Qatar with a foreign partner with the technology and expertise to transform the Doha Securities Market, barely 11 years old, into a cash equities, derivatives and commodities platform.

If that seems ambitious enough - Dubai already has a head start with more developed exchanges - there are plans to roll the offering out into the broader region. NYSE Euronext is making its largest international investment yet to secure a slice of the fast-growing Gulf, where record oil prices are translating into a seemingly never-ending supply of liquidity. This is being ploughed into property, companies and stock exchanges.

Under the deal, NYSE Euronext will provide "management services and technology" - likely to be the equities trading platform used by Euronext in Europe, and the Liffe Connect futures system used by Liffe, the group's futures arm.

Duncan Niederauer, chief executive, says: "This is a much more strategic relationship [than with Abu Dhabi]."

It places NYSE Euronext at the heart of Doha's growth and reform strategy. As its huge gas exports kick in, Qatar is anticipated to become the fastest-growing Gulf state.

Doha, in the face of economists' doubts, claims it will be the second-largest economy in the region after Saudi Arabia by 2015 - leapfrogging the United Arab Emirates, which spans the oil powerhouse of Abu Dhabi and the business hub of Dubai.

The Qatar Financial Centre has attracted a modest number of international bankers and the country is set to finalise plans for the establishment of a single financial regulator.

Sheikh Hamad bin Jassim bin Jabor Al-Thani, Qatar's prime minister, said: "Our country's financial markets will be an integral part of a group which links together the world's major trading centres across the US, Europe and now the Middle East".

Yet Doha has thrown down the gauntlet to Dubai, which has staked out its claim to be the region's financial capital through the rapid growth of the Dubai International Financial Centre.

If the DIFC has an Achilles' heel, it is the Dubai International Financial Exchange (DIFX), where after almost three years listings are limited and trading rare.

Dubai is certainly waking up to Doha's challenge - founded on the country's vast current and future wealth.

But one official said Dubai still did not regard Doha as a serious threat.

Deutsche Börse is talking to the Kuwait Stock Exchange about a technical relationship, said one person familiar with the matter.

The KSE is a large, established bourse with sophisticated traders and offers some of the only derivatives products available across the Gulf. But it is a fairly inwardly-focuse market.

NYSE Euronext was preceded into the region by Nasdaq OMX, which last year joined the race for Gulf supremacy via a one-third stake in DIFX, part of the complicated deal that saw Dubai take a 20 per cent stake in the combined Nasdaq OMX group.

Yet NYSE Euronext is confident in the superiority of its offering, particularly built around its Liffe futures arm, especially with the emergence of exchanges trading oil futures.

Jean-François Théodore, deputy chief executive, says: "The vision we have there is that there is still quite some room for derivatives and commodities markets."

Up the road from Dubai, Abu Dhabi Securities Market (ADX) in March signed a technical co-operation agreement with NYSE Euronext to develop its cash equities market, but ADX also has plans to develop a Gulf derivatives market.

Additional reporting by Anuj Gangahar

Copyright The Financial Times Limited 2008

FT: Cautious of creating too much complexity

Cautious of creating too much complexity

By Bernard Simon in Toronto

Published: June 16 2008 03:00 | Last updated: June 16 2008 03:00

John Hull has a confession to make.

As a professor of finance at the University of Toronto's Rotman School of Management, he has won international acclaim for designing and valuing complex financial tools such as options and other derivatives.

But when it comes to managing his own money, Prof Hull has little use for such exotic instruments. His investment portfolio comprises mainly index funds. And while he keeps reminding his students about the importance of hedging risk, his own liabilities are heavily concentrated in Canadian dollars.

"In retrospect, I certainly haven't behaved optimally," the 62-year-old, UK-born professor says with a wry smile.

Seen from a different angle however, Prof Hull's financial strategy is entirely consistent with the message he hammers home as a teacher, author, consultant and expert witness in derivative-related lawsuits: that is, keep things as simple as possible.

"There's a danger, with all the people with PhDs in physics and maths who have moved into this area, that some of the models become too complicated", Prof Hull says. "There's a tendency for people with that sort of background to just want a really difficult problem to solve. And that's not necessarily what's needed."

His avoidance of this tendency helps explain the respect his work has garnered.

Izzy Nelken, president of Super Computer Consulting in Chicago, who has known Prof Hull for 16 years and co-authored several publications with him, notes that while "some folks like to couch it all in huge mystery, John doesn't do that. He always brings the latest developments in a simple, easy-to-understand manner."

Armed with a Cambridge maths degree, Prof Hull's first job was in operational research at a UK shoe manufacturer.

An interest in applying mathematics to finance led him to do a PhD at Cranfield University.

He had his first taste of Canada as a visiting lecturer at the University of British Columbia in Vancouver in 1979. He then moved to York University in Toronto two years later so he could work in a leading financial centre. He has been at Rotman since 1988.

Quantitative analysis and analysts have made deep in-roads in trading rooms and financial research departments since two University of Chicago economists, Fischer Black and Myron Scholes, devised a mathematical model for pricing options and corporate liabilities in the early 1970s.

However, the recent turmoil in financial markets has jolted faith in the so-called "quants".

Prof Hull agrees that "there's some ground for concern" that traders and analysts have relied too heavily on mathematical models in their decision-making.

"We need a much more common-sense approach to risk management and must not let quants and traders run free-rein for short-term profits," he says.

The problem, in Prof Hull's view, has been an overdependence on models that are based chiefly on recent market trends.

Over the past three years, for instance, "we were looking at a period when volatilities were very low", he says, "so values at risk were lower".

"To some extent, that model led to a false confidence on the part of the banks. Somebody should have been saying: 'Let's look at the big picture, what could go wrong? How well will we come out if it does go wrong?'

"In most institutions I don't think anybody was doing that. They were just relying on: 'We're making a lot of money, the value-at-risk model says we're okay'."

But heavy losses since the onset of the US subprime mortgage crisis have prompted a good deal of soul-searching among quants, and those who employ them. "I don't think there is a substitute for sound managerial judgment," Prof Hull says.

"In a few companies, however, rather than senior managers letting the traders run loose on this, they sat back and thought about the environment out there; about what could go wrong and how badly they would suffer if it did."

As for his own approach, he says that "my claim to fame is not being an out-and-out quant.

"It's more looking at a situation, coming up with the simplest model that captures the essence of it, and then writing it up in such a way that people will easily be able to understand it."

His seminal book Options, Futures and Other Derivatives , now in its seventh edition, is widely regarded as the bible of the subject. According to Mr Nelken, "he's had a substantial impact on a whole generation of financial mathematicians".

Prof Hull tries to bring equations to life by including actual figures in them. His books are dotted with "Business Snapshots" that show how quantitative theories and models are applied in real-life situations.

His books also demonstrate his appreciation of the shortcomings, as well as the advantages, of exotic financial instruments.

For example, the chapter on asset-backed securities in the latest edition observes that these financial products have been created from exotic assets such as royalties from the future sales of a piece of music.

"Dealers have been very creative - perhaps too creative - in their use of this type of structure," he concludes.

Copyright The Financial Times Limited 2008

FT: There is a better way to prevent bank failures

There is a better way to prevent bank failures

By John Kay

Published: June 18 2008 03:00 | Last updated: June 18 2008 03:00

Stuff happens. People make mistakes, parts go wrong, unexpected things crop up. When disaster ensues, politicians, journalists and savants blame the blunderers, the component manufacturers and the perversity of fate. But good systems, whether in engineering, in management or in regulation, are robust. When those that rely on infallibility break down, the fault lies with the structure - not the individuals, the parts or the gods.

Richard Bookstaber's fine book on modern financial innovation, A Demon of Our Own Design , distinguishes loosely and tightly coupled systems. The postal service is a complex network, but individual failures are contained and have no consequences for the integrity of the whole. Aircraft are safe because every critical element has a back-up. But the indicators of reactor core temperature at Three Mile Island were designed to give readings only within the planned operating range; neither the control room nor the instrumentation, Bookstaber explains, was designed with emergency operation in mind.

It seems absurd to design a monitoring or regulatory system on the premise of normality, but that is what we routinely do. Our systems are tested on data from periods of stability and our inspections confirm that everything functions as we intended. Northern Rock did not fail because the Financial Services Authority did not maintain adequate minutes, or because the tripartite authorities did not keep each other informed. It failed because the control room had not been designed with emergency operation in mind. The problems could, of course, have been defused at any time by the public authorities writing out a sufficiently large cheque - as they eventually did for Northern Rock, and as the Federal Reserve did much more promptly for Bear Stearns. Many social and economic problems can be ameliorated by the prompt disbursement of $30bn, although it is difficult to see why protecting the counterparty exposures of large financial institutions comes near the top of the list of priorities.

In a column last September, I made three proposals that would have led to the better handling of Northern Rock. Adequate deposit protection would have given an immediate assurance that no small saver would lose money, and ended the run. A special administration scheme would have given adequate power to deal with a failing bank. The government plans to implement both these measures. It should also act on a third proposal: that the Financial Services Compensation scheme becomes a preferred creditor in any liquidation.

Banks traditionally borrowed short from the public and lent long to business. The growth of innovative intermediation severed the link between borrower and lender. The outcome has been to make retail depositors less safe, not more, as their deposits have become collateral for proprietary trading. In an ideal world, retail deposits would be backed by genuinely first-class and liquid assets. Competition in the retail market would then be on the basis of relative effectiveness in the collection and processing of deposits. It is ironic that Northern Rock's efficient administration is being wound down owing to losses in different activities.

To impose that ideal through regulation would be intrusive - and also unnecessary. The preferential status of retail deposits would ensure that if deposits were not supported by government or similar quality obligations, wholesale lenders would be at risk for any shortfall. Such a structure is probably the only realistic regulatory intervention that would have prevented the Northern Rock fiasco. If both securitised mortgages and the retail deposit base had been ring-fenced, the residual balance sheet would have been insufficient to support the bank's risky expansion.

This proposal amounts to the privatisation of banking regulation. If public agencies are to supervise seriously the strategies of high street and investment banks, we might as well nationalise them; the proposal is entertained only because everyone knows it is not really serious. Such supervision will continue to be an exercise in box-ticking, analogous to confirming that today the reactor temperature was within the normal range, and equally helpless when, one day, it is not.

www.johnkay.com

Copyright The Financial Times Limited 2008

FT: How imbalances led to credit crunch and inflation

How imbalances led to credit crunch and inflation

By Martin Wolf

Published: June 17 2008 19:17 | Last updated: June 17 2008 19:17

Inflation is always and everywhere a monetary phenomenon. Milton Friedman.

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What explains the combination of a “credit crunch” in the US with soaring commodity prices and rising inflation across the globe? Are these unrelated events or part of a bigger picture? The answer is the latter. So far this is not a return to the 1970s. But action is needed to keep this true.

Inflation is a sustained rise in the price level: the result of too much money (or purchasing power) chasing too few goods and services. A one-off jump in commodity prices is not inflation. Nor need such a jump cause inflation. But a continuous rise in the relative price of commodities is a symptom of an inflationary process.

Whenever excess demand hits, the goods whose prices rise first are ones with flexible prices, of which commodities are the prime example. Commodity prices then are a pressure gauge. If we look at what has been happening in recent years, the gauge is showing red. The Goldman Sachs index of commodity prices has doubled since early 2007. Nominal prices of oil have increased by 150 per cent over the same period. The upward movement in commodity prices has persisted for 6½ years. It looks as though too much extra demand is pressing on too little ability to increase global supply.

The result is unexpectedly big increases in overall inflation: the consensus for world consumer price inflation in 2008 has jumped from the 2.4 per cent forecast in February 2007 to the 4.3 per cent forecast in June 2008. These jumps are modest, but not that modest. Nor is the forecast level. If people get used to the idea that inflation can jump like this, the notion may well become embedded in expectations, with dire consequences.

Yet how can we have an incipient global inflationary process when the US economy and those of other significant high-income countries are slowing down? The proximate reason is that they matter far less than they used to. The underlying explanation lies in the forces driving both global demand and supply.

On demand, two big things are happening: convergence and the imbalances. Under convergence comes the accelerated growth of emerging economies, above all of China and India. Under imbalances come the interventions in currency markets aimed at supporting competitiveness.

Charles Dumas of London-based Lombard Street Research notes that, at purchasing power parity, China now generates a little over a quarter of world economic growth in a normal year, while emerging and developing countries together generate 70 per cent. Even at market exchange rates, the growth of China’s gross domestic product is as big as that of the US in normal years for both countries.

The emerging countries are also in a good position to keep on growing, largely because they have such strong external positions. Many emerging economies have intervened in currency markets on a huge scale, principally in order to keep export competitiveness up and current account deficits down. Over the seven years to March 2008, global foreign currency reserves jumped by $4,900bn (€3,175bn, £2,505bn), with China’s reserves alone up by $1,500bn. Indeed, as much as 70 per cent of today’s reserves have been accumulated over this period. “Never again,” said the emerging countries hit by crises in the 1980s and 1990s; “not even once,” said China.

Interventionist policies aimed at sustaining export competitiveness expand economies. The results normally include rapid rises in net exports, low interest rates, aimed at curbing the capital inflow, and expansion in the monetary base, despite attempts at sterilisation. The Chinese economy is overheating as a direct result of this trio of effects.

Most of these reserves were accumulated by countries more or less explicitly targeting the US dollar and accumulating US liabilities. The resulting capital flow financed the US trade and current account deficits. But a trade deficit is contractionary: for any given level of domestic demand, it lowers domestic output. Thus, the US needed to expand domestic demand, in order to offset the contractionary effect of the external deficits. Some groups within the economy needed to spend more than their incomes. The most important such group turned out to be households. Thus the growth in US household indebtedness that led to today’s “credit crunch” is a direct result of the global imbalances.

Today, the hapless Federal Reserve is trying to re-expand demand in a post-bubble US economy. The principal impact of its monetary policy comes, however, via a weakening of the US dollar and an expansion of those overheating economies linked to it. To simplify, Ben Bernanke is running the monetary policy of the People’s Bank of China. But the policy appropriate to the US is wildly inappropriate for China and indeed almost all the other countries tied together in the informal dollar zone or, as some economists call it, “Bretton Woods II”.

Thus, not only have the imbalances proved hugely destabilising in the past, but they are going to prove even more destabilising now that the US bubble has burst. When most emerging economies need much tighter monetary policy, they are forced to loosen still further.

Meanwhile, on the supply side of the world economy, almost every piece of news has been bad. Whatever optimism one might feel about long-run possibilities for increased supply of energy, it is impossible to be optimistic about the short run.

What we see then is an incipient global inflation. Yet the central bank with the greatest influence on global monetary policy is the one confronting the post-bubble credit crunch. Its post-bubble predicament is made worse by the soaring energy prices that result from the strong growth of the world economy.

This then is a global challenge. The advanced countries are no longer the global driving force: they are importing inflation. If the world had a single central bank and a single currency, the former would surely tighten its monetary policy, in light of the evidence on the constraints on the rate of growth of potential global supply. In the absence of such a central bank, the right alternative has to be greater exchange rate flexibility and targeting of domestic inflation.

The world as a whole cannot import inflation: if every central bank assumes that the rise in commodity prices is the product of policies made elsewhere, general overheating must be the result. Worse, if that feeds into expectations the world will be depressingly similar to the 1970s. We are not there. Policymakers must ensure we never do get there.

martin.wolf@ft.com

Copyright The Financial Times Limited 2008

what people around the world think of money

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ST: Banks that provide good service can reap big gains

Home > Money > Story
June 9, 2008
COMMENTARY Banks that provide good service can reap big gains
They can boost their valuations by offering more personalised approach to clients
By Goh Eng Yeow, Markets Correspondent
LARGE companies such as banks and airlines spend millions of dollars to make sure consumers know about their cutting-edge services - and how they stand out from the crowd. Yet, it has become a grim fact of life for consumers - especially the less wealthy ones - that they are getting no service at all or poor service at best. In fact, even the affluent are complaining. Take the elite staff at banks hired to attend to 'priority and private banking customers'. Many of these well-heeled customers gripe that their relationship managers are poorly trained and behave no differently from commission-based financial advisers and insurance agents. 'Most of them have very poor product knowledge and some even give you wrong advice,' said Straits Times reader Sia Cheong Yew. The instinctive reaction of most consumers when confronted with such woeful service is to shrug their shoulders, suffer in silence, or move their money or business elsewhere. This is a big blow to the organisations that spent considerable amounts of time, effort and resources on trying to capture these potentially lucrative customers in the first place. Seasoned stock analysts say this failure at the all-important final step of marketing explains why some companies are valued highly by investors, while others are neglected, even if they operate in the same industry, serve the same mix of customers and deploy the same type of assets. A friend of mine said this point was driven home forcefully to him when he had to change his flight schedule while he was in Japan. A helpful Singapore Airlines (SIA) representative in Nagoya helped him to switch the departure city for his return flight from Tokyo to Nagoya, even though his travel agent had said the switch was impossible as he was on a budget ticket. My friend was delighted with the prompt attention that he received even though he was a 'cattle-class' passenger. He had enjoyed the now all- too-rare experience of talking to a real person at the other end of the line, rather than getting the usual automated voice message used by many companies to cut costs. Simple gestures such as these earn SIA enormous good will among passengers and investors, he said. In accounting terms, this good will translates into a dollar value that measures a company's intangible assets, such as a strong brand name and good customer relations. SIA's strong good will gives it a lofty valuation, with investors willing to hang on to the carrier's shares and finding it a 'great way to fly', even though soaring jet fuel prices have crippled many airlines. But as many who have tracked SIA's performance over the years would attest, good will takes years - sometimes decades - to build up. And it can be literally destroyed overnight by a company's blind greed as it pursues short-term profit and income. Nowhere is this more evident than in the financial sector. For instance, when was the last time you actually talked to a bank officer over the phone, instead of having to listen to some infuriating automated message giving you 10 different options to choose from? One writer in The Business Times recently lamented that, in recent years, banks and their front-line staff have become focused mainly on personal and corporate profits and targets. One bank even went so far as to blatantly advertise that it needed relationship managers to acquire new clients and quickly convert them into 'profitable, multi-product relationships' in order to enable it to lift its market share. 'I don't know about you...but I would run as fast as I can from institutions that roll out their red carpet with target-hungry, profit-maximising wealth managers,' he said. Just imagine how much good will, which these banks have carefully built up over the years, has been destroyed by their myopic obsession with profits, and the corrosive effect this has on their stocks' value. Sure, such practices will give the banks a boost in earnings in the short term. However, as the sub-prime crisis in the United States has shown, long after the commission-hungry managers have collected their bonuses and left the scene, investors may find themselves staring at considerable losses, as banks struggle to clean up their balance sheets. It is sad to note that despite such painful lessons, some banks may be sowing the seeds of trouble by failing to abandon such practices, alienating their customers in the process. Should wealth managers be encouraged in their obsession with selling products so that they can reach their targets faster? I should think not. As the SIA example shows, the intangible benefits from earning consumers' good will are inestimable, even if they do not raise the bottom line directly by a single cent. They have helped the carrier to scale fresh heights in a cut-throat business - in the face of soaring costs. Banks may even get a boost in their rock-bottom valuations from investors, if they offer a more personalised approach to their customers and give up the product-driven approach that many of them now practise. Getting a few pointers from SIA will certainly help. engyeow@sph.com.sg PRECIOUS YET UNDERRATED COMMODITY Good will takes years - sometimes decades - to build up. And it can be literally destroyed overnight by a company's blind greed as it pursues short-term profit and income. Nowhere is this more evident than in the financial sector.