Vanessa Drucker: Dealers gain from complexity, customers lose out

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Clear and present dangers to the financial system still abound. For a sane and sensible summary, look at After the Music Stopped: The Financial Crisis, the Response and the Work Ahead by Alan Blinder. The Princeton professor’s arguments seem incontrovertible with 20/20 hindsight. Some topics have almost become clichés. 

But they still bear repeating, especially coming from such a credible source. Blinder served as vice chairman at the Federal Reserve from 1994-1996; he can hardly be blamed for the laisser faire policies that led to excesses and distortions by 2008.

Last week, Blinder outlined his “Ten Commandments” at a presentation at the Museum of Finance: investors’ memories are short, self-regulation does not work, control leverage, honour thy shareholders more than thy top executives, elevate risk management, hold assets on-balance sheet. 

Above all, keep it simple. Complex derivatives got short shrift. Blinder observed that dealers gain from the complexity, while customers lose out. The more standardised a product, the cheaper it should become. 

Blinder highlighted ongoing effects of perverse compensation incentives, noting how unbalanced risk and reward structures encourage traders to go for broke. Blinder’s own students realise that, once employed, at worst they may lose a job and need to jump ship, while at best, they can reap millions.  He also reminded that rating agencies continue to be paid by issuers, which creates a conflict of interest. 

We explored that very problem in Fund Strategy in April 2010, and it is disappointing that so little progress has evolved since then. Listing a few solutions to the difficult conundrum, Blinder suggested that third parties, like the Securities and Exchange Commission, might instead monitor and pay the rating agencies.

Some interesting remarks surfaced in the Q&A.  One audience member posed the inevitable question about income inequality.  In recent years, at almost every speech I attend, the issue comes up, as the flavor of the month. Blinder embraced a broad view.  With the rise of China, India and Russia, he said, labour has become more plentiful and capital more scarce. That hard-nosed economic approach sidesteps some of the current fashionable political rhetoric around social injustices.

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