Reflections on my time in the City (pt. 2)

In part 1, I set out the key aims of the finance system, the central pillars of the Anglo-Saxon model which is the predominant school of thought on how this system should be governed and a brief discussion on whether this system was effective. In this post, I will explore whether, even if the system became more effective,  it is fair (and in particular whether it is regressive) and whether as a career it can be conducive to the good life.

Too many locusts, not enough bees

Let me start by saying that is very rare to meet someone in the city who is not clever, diligent and energetic (in some cases almost as good as teachers, doctors and engineers!) . That is not a criticism that can be fairly attributed to city workers. The real problem is that various mechanisms mean that they cream too much out of the saving-investment-return system I described above. Geoff Mulgan raises this in his book The Locust and the Bee: Predators and Creators in Capitalism’s Future. In the book Mulgan argues that there are two categories of cog in the capitalist system, namely the bee, who creates value, and the locust who tries to cream off value from things that already exist (rent-seekers) or off the back of the bee. The problem with finance is that there are too many locusts. Between you depositing your money into a savings scheme, and the money being invested and earning a return and then being returned to you, the fees earned by the finance system are staggering. In a typical cycle your savings will be charged a fee by an asset manager, a fund manager, a broker and the company’s management before being invested into something useful (and that’s an example of a short route). On the way back a proportion of any returns will be paid to the company’s management, to the fund manager, to the asset manager and only then returned to you.  Examples, which from my experience would not be uncommon, include:

• Mergers and Acquisitions (M&A) - an investment bank will often advise a company on how much it should pay to buy another company. In the chain I describe above, this is essentially another link in the chain where a company invests in another company rather than investing directly in something useful. Typically, advisors (including an investment bank) may earn 3-4% of the total price paid for the company. Whilst the work required from the investment bank may be arduous and detailed, there is no reason why M&A advisers should be earning these fees. Indeed the benefits for the individuals involved could be ridiculous. If you’re working on a deal for a company worth £1bn (not unusual) £30-40m could be paid out in fees. Say one bank is responsible for the majority of these fees (50%, the rest going to consultants, lawyers and accountants) and employs 10-15 people during the deal. In the worst case this would be £15m shared amongst 15 people. Assuming the bank gets its cut (50%), this would be c. £500k per employee over a 4-12 month time period. The senior managers would get a greater share – essentially setting themselves up as millionaires for simply doing their job (and remember they are not creating value, simply taking a cut of a stream of money)
• Private Equity - Without going into the same level of detail, I know of fee structures for private equity funds where similar groups of people will make similar returns on an annual basis for essentially sitting on a stream of money passing back to the original savers.
• CEOs - Another cog in this system who is more locust than bee are the executive management teams of big business (say worth >£500m). Again these are people who will be paid a six-figure salary and bonus of upto 100% of their current salary and a long term incentive plan often running into the millions if they hit various long term targets. Again I would say that these people are rare in terms of their leadership skills, understanding of a sector and experience. However, they are not the source of value for businesses. In the area I have worked in I’m not really sure how they could be. The infrastructure sector is about big bits of kit (water pipes, electricity networks, trains, oil storage facilities, schools and hospitals) which basically earn a return because they are there and are maintained to a reasonable standard. The CEOs of big water companies and energy companies simply cream off value that they do not themselves create – there is not other way I can put this. When I asked the firm I worked for, who own some of these companies and who sit on some of the remuneration committees that set levels of pay for management, why such high levels of pay were tolerated I more or less got a shrug of the shoulders. The reason they gave was that my company had its hands tied in terms of what it could do - we were simply at the mercy of the "market".

Brain Drain

One of the city’s most insidious impacts on society has been its ability to attract the brightest and best from Britain’s education establishments. I must admit at the age of 16 I weighed up whether to study engineering or economics / finance. A mixture of monetary incentive and prestige drew my young self to think of finance as the more worthwhile and rewarding. I do not know whether this dilemma has impacted other young, ambitious people – my concern is that it is quite a few. The cleverest (across the subject board) two people I knew at school / university ended up being a trader and a corporate tax lawyer respectively. In a recent visit to Cambridge I bumped into a young man, with a string of 1^st behind him who had just been to the Pitt club (Cambridge’s answer to the infamous Bullingdon Club). In a brief conversation he claimed he would soon be ‘a rainmaker in the city’ and ‘rolling in it’. Apart from the fact that over the next few years of his life he will finding himself filing legal documents at 3am on more than one occasion, and also that this was a decidedly toffish and arrogant thing to say, it is also a great shame that this bright individual saw this city lifestyle as the pinnacle of aspiration. By all means be a lawyer, but don't close off many types of law outside of corporate / finance law.

If indeed the city does deprive other parts of society and other industries bright, ambitious individuals, then beyond being a massive obstacle to having a healthy, balanced economy it can only lead to a more elitist, London-centric and culturally separated society.

Tax, Regulation and PPP

Some of the worst examples of greed I have seen in the city have been where the private sector takes advantage of the public sector – essentially taking social money (i.e. mine and yours) and transferring into rich, private hands. There are many examples a friend* of mine has witnessed, the following being stark examples

• The worst example of greed she saw was whilst working at an investment bank. The team she was working for had recently closed a deal whereby they had agreed to finance the building of a public hospital under a PPP contract. Essentially, the private sector (a builder and financier) agree to build a hospital and the government / nhs agree to pay a guaranteed rent once it is completed. The team at the time was congratulating itself for earning upfront fees and profit (legally) in the region of £20-30m (amongst let’s say 5-7 people) whilst the hospital is now struggling to stay open due to rental obligations. Now whilst part of the issue was bad procurement by the government, there is a sense of injustice here that I think is difficult to argue against.
• In another PPP project a company she worked for sold a set of schools for £19m that it had paid c. £7-8m to develop and build. What’s worse is that a few key individuals would have shared a bonus from this of between £500k to £1m (estimate). The government will still be paying a rent for these schools for another 20 years.
• This friend has now worked on three deals (of project worth £1-2bn) where fees made by lawyers, consultants, banks and accountants will have run to c. £30-50m per deal for c. 6 -18 months work. Again this will have been shared amongst a small pool of individuals with the potential to make 3-5 key people £250k+ in bonuses per deal and ensure that several individuals could survive on very healthy £50-100k pa salaries. Again the value creation in each of these cases will be spurious. All three deals will have involved the state or state-like bodies directly being worse off due to these fees.
• In his time in the city, she spent a good amount of time working on developing structures with the direct aim of reducing tax costs or avoiding new tax laws used to clamp down on previous loopholes that were targeted. What struck her was the sheer amount of time, effort and complexity that people were willing to engage with in order to achieve these outcomes. She was also astounded by how an investor would see a £ earnt from creating value (e.g. through investing in a new project) as worthy as a £ from an elaborate new tax structure. She, for instance, was staggered when she witnessed a scheme whereby a company was looking to make a further £3m profit by re-structuring its tax affairs on a c.£45m investment.
  
  

Is this the good life?

Within the city there are a variety of different types of job associated with making the saving-investment-return cycle work. At the top end of this spectrum in terms of pay will be corporate and finance lawyers, traders (sales, trading and research), m&a bankers, asset managers, fund managers, consultants, accountants, insurance brokers, actuaries and tax professionals. I cannot talk for many of these professions, but in relation to the two organisations I did work for (a bank's M&A team and private equity fund) I would say the following

1. The career path for a graduate is great in terms of early responsibility
2. The people you work with will be very smart, diligent and energetic (sometimes overly so). There will be a spattering of the arrogant and mean, but at the same time there will be some genuinely warm characters who simply want to do good for themselves and their dependants and take no pleasure from putting down others.
3. There are several factors which would detract from living a happy life, namely
• Anxiety due to the hire and fire nature of the world
• The areas I worked in demanded very long hours (think 9am to 2am for at least 3-4 months of the year, settling down to 9am-10pm for the rest). You may be able to convince yourself otherwise, but personally I thought this made it very difficult to live a happy life that is healthy, contains strong relationships, allows for some pleasures and allows you to develop your thoughts and understanding of the world around you.
• I think the career and the legal / commercial mindset you develop whilst in the industry encourages aggressive individualism and a lack of trust. You are taught to see every person as a self-interested, rational profit maximising agent who cannot be relied upon. Whilst I think such a mindset may be appropriate for business, I found it increasingly difficult to differentiate my work and social mindset.
4. The high wage at a young age has the potential to develop patterns of frivolous consumption – I have no real problem with this except (i) it is not necessary for the good life, it can only merely be a component of it and (ii) until we can say the industry is not regressive, such behaviour remains extremely perverse.

Conclusions

The piece above is very anecdotal and I'm sure some good arguments could be put forward as to how the various cogs involved in the savings-investment-return chain are merely participants in a competitive market place, and that the fees they earn are a simple function of supply and demand. I suspect, and part 3 will explore this further, that this sort of analysis is not quite right when you have a closed system (it is unlikely that one highly paid person will have a go at another highly paid person for fear of being labelled a hypocrite) and where the real monopoly power is with people (CEOs, city rainmakers, 'superstar' traders, city firm partners) rather than companies.

The other drawbacks: the city's brain drain, the (legal) predatory behaviour and the city life's conflict with the good life fit less squarely into a traditional economic framework. If we want to look to change these behaviours, a more creative approach will be required.

* All characters appearing in this work are fictitious. Any resemblance to real persons, living or dead, is purely coincidental

Reflections on my time in the City (pt. 1)

Seeing as the hamster will be leaving the City in a couple of months, I thought I would share some reflections on my short time in the City / in finance . Rather than a City Boy-esque critique of conspicuous consumption, the aim of these pieces is to compare my (totally fictitious for legal reasons) experience with some of the broader critical themes that have played out in the press of late. I will write in three parts. Part 1 will be more a technical critique of the system (for my own piece of mind), whilst part 2 will be more along the lines of good ol’ fashioned banker bashing. Part 3 will explore some potential solutions. Read as you desire.

To start with I will need to lay out the key pillars, governing our financial system, which I shall refer to as the “Anglo-Saxon” system. I want to then evaluate this, through the lense of my experience, against three criteria namely:

1)    Is the system effective in achieving its aims? (part 1)

2)    Is the system fair? (part 2)
3)    Is a career in the city conducive to living the good life? (part 2)

Whilst not a complete set of criteria, these are the questions that I believe are most pertinent.

The Anglo-Saxon model of finance

The principles and objectives of the finance system (the middle bit in the diagram above) are pretty straightforward. It starts with people having excess income and depositing this money in banks; saving in investment schemes and pensions; or paying national or private insurance premiums. These institutions (banks, pension funds, insurance companies) will try to preserve their clients’ cash whilst at the same time earning some sort of return. They will try to do this by giving the money to companies via the stock market; to you and me via mortgages, small business loans and credit cards; to the government; or to other funds (e.g. hedge funds, private equity funds) who come up with innovative way of ensuring some return. In the end, the idea is that this money goes to fund something productive and useful that otherwise could not have happened. This is a process I like to call writing big cheques – sums of money used to pay for things upfront (e.g. factories, agricultural equipment, hospitals, houses and home improvements, new businesses, roads) that we benefit from over a long period of time.

As the things bought with these big cheques are put to use they earn a return (of smaller cheques) that eventually work their way through the system back to a bank account, saving scheme or insurance claim.

The above system is not rocket science, however, there are many ways to govern it. The Anglo-Saxon model argues the system should be governed in three ways. Firstly, it argues that there is no need for strong oversight. The belief is that every little cog (saver, bank, fund, company) will want to act sensibly in their own self-interest. Depositors will leave their money at the institutions with the best track record, investors will only survive if they are competent and companies and individuals will only be lent to if they can show they are able to return on their big cheques. In this ‘only-the-fittest-survive’ model, this virtuous cycle of saving-investment-return evolves, with little intervention, into a robust system.

Another Anglo-Saxon belief is that no one cog in the whole cycle should either be the state, like the state or too big. The argument is that the state or big institutions are so entrenched and powerful that the ‘only-the-fittest-survive’ system of regulation breaks down and leads to either (i) the survival of the incompetent; (ii) the competent creaming off much more than they deserve or (iii) the whole system breaking down if one cog fails. As a result, the Anglo-Saxon model advocates a system made up of small, competitive cogs.

The third Anglo-Saxon belief is that everyone in the system should be allowed to innovate to make the system more efficient. Examples of such innovations include (a) the stock market, which allows money to flow quickly to where it needs to go, (b) various specially designed contracts (often known as derivatives)  which allow investors to make agreements with other investors to artificially pre-agree when and how their money is returned and (c) certain innovations which make it easier for you to forecast returns e.g. commodity futures markets that allow you to set the price of something well in advance.

The key interrelationship here is that Anglo Saxon pillars one (self-interest) and two (many small companies) mean that the outcomes of feature three (innovation) will ultimately be useful for the saving-investment-return system and not be money-making ends in themselves.

Compared to the past and the developing world, the system is doing alright..

On the whole, I think the system compares well to other systems. I say this mainly in relation to the context of history and our geography. I won’t go into history – the Ascent of Money by Niall Ferguson is a good summary of the development of finance in the last few hundred years. Set against this context, today's system, where big cheques are largely written based on commercial merit, is generally better than historic systems where investment was based on the fleeting whims of a clique of wealthy philanthropists, opaque family businesses, East India Companies and populist states. 

The other context, geography, is also important. Across the world there are markets that suffer from a patchy and inefficient finance system. Two examples that come to mind are the Indian economy where excess wealth often does not find itself in the financial system, but often invested into (socially useless) gold. The other is the example of smallholder farmers in Sub-Saharan Africa. NGO’s such as the One Acre Fund, have demonstrated that by providing finance, smallholder farmers are able to buy essential equipment and working capital (seeds, fertiliser) and increase their yields significantly. In his book, Roger Thurrow describes how without such finance, smallholder farmers may be limited to cultivating only a quarter of their available land, condemning themselves and their families to a hunger season every year. Compare this to a financial system in the UK which, for better or worse, will send you a credit card in the post that you can sign and use in the same day!

However, enough of the defence. My time in the industry raised several alarm bells that made me think, despite its successes, there are some features that tend to lead to perverse outcomes. I break these into the following categories:

The system is only as good as its savers, and their horizons

As set out above, the bedrock of the system is individual people’s savings (as opposed to say a trust fund of a nation’s wealth). People often want to deposit their excess wealth in savings accounts to preserve the value of the cash and earn a return. People also want to be able to access that cash should any short term need arises. This is in direct contrast to the investment horizons of big cheques, which will often only earn a return over a long period of time. This creates a tension in the system between the money supplied (short term, risk-averse) and the money demanded (often longer term and risky). Finance theory has two solutions to this problem, namely: 

1. You can use some short term money (deposits) for long term investments if you assume that people will not try to withdraw their cash en masse (this failure is very much at the centre of most financial crises and there is not enough space in this blog to explore it!)
2. A good system will have a variety of ‘savers’, who will place their money according to their own attitude to risk. As a result, you will have a wide pool of money with different time-horizons and risk requirements.

Fine in practice, but in my experience this leaves huge gaps. In particular, there tends to be a gaping whole in long-term, risky investment. What I mean by this is that the system is not very good at producing big cheques for projects or businesses that do no begin to reap rewards for 10 to 30 years and where there is an element of uncertainty attached. Again and again this means important investment in big long-term useful activity e.g. in upgrading trains, expanding social housing, backing heavy industry, developing green energy, funding research and development or investing in preventative healthcare is either not made or requires considerable help from the state or state-like institutions.

The result of this is in the past has been serious underinvestment. With the rolling back of the state beginning with Thatcher, Britain’s private finance back sectors have been slow to invest in several areas. This article, explores why, for instance, no-one has invested to upgrade trains in the UK for decades. In my experience, I have seen rolling stock companies backed with this "wrong" type of finance unable to invest in something society knows is important i.e. the replacement of knackered, inefficient, unreliable, 40+ year old trains (designed for retirement at age 30). In a damning reflection of the systems failure, I worked on a project to buy rolling stock which was originally called T'link 2000; the contracts were signed in 2013, in part due to dithering and ridiculously high levels of risk aversion amongst financing parties.

A particularly fashionable solution to short termism is for the state to de-risk investments by saying they will effectively guarantee any return or wear the costs should a project not complete. This is done to try and attract long-term, low risk money, which to some extent exists through pension funds etc. Whilst this solution, epitomised by Public Private Partnership (PPP), was effective at refreshing the UK’s stock of schools and hospitals, it also lead  to a big bonanza for the City during the New Labour era. I will I expand on this in part 2.

The ‘innovative’ solutions to the above problems are so complex that they either lead to instability or get captured by those in the know..

Although it was not the part of the city I was involved in, I believe certain innovations have become so complex, so critical to the system and understood by so few that any defence of their use has become spurious. Short selling, default swaps, options and packaged securities were all more-or-less created to solve the problem of matching up savers who have different preferences to the returns actually generated by their big cheques. But they have evolved into something else. The securitisation of  US subprime mortgages that effectively triggered the financial crisis is a striking example of an innovation that ultimately failed. What’s more, at the same time as destabilising the system and having little social use, these innovations were responsible for making a lot of people a lot of money. This is covered in part 2 of this posting.

High pay = odd incentives

Not only does the Anglo-Saxon system have shortcomings because there is not enough of the right type of money, there is also not enough of the right type of people! A big gripe of mine in my time in finance was the entrenched high level of pay and the knock on impact of this. Before looking at the merits of a project or the wider impact, I guarantee any finance institution will first ask how it can pay a partner or director a six figure salary, with annual bonus expectations of 2 to 3 times that amount. I’ve cringed several times when colleagues have joked that ‘"Mr. big shot director" will not get out of bed for any thing less than £50 million’ meaning that unless a project is big enough it will not even be worthy of attention. This leaves another gaping hole in our finance system and it is no wonder that banks struggle to lend to small and medium size enterprises.

The problem is that the city has developed to crowd around big cheques. A big cheque allows people to justify big pay. Say, for instance, you were a lender and you took a 1% upfront fee when making a loan. The natural pull will be either to (i) make big loans, rather than work through a myriad of smaller ones (if the time required to make small and big loans is similar) or (ii) make a series of small loans that require very little work. The result is that big money (lending to big corporations or projects) or dumb money (lending to say mortgage applicants based on online applications) are favoured. This leaves a whole swathe of the economy either:

1. ignored (a comparison of the history of my former institution and its current strategy to focus on big established companies is case in point);
2. subject to too much attention; or
3. subject to mechanistic, "computer-says-no" decision making processes (e.g. US sub-prime mortgages).

Model assumes that we know how to judge performance

Pillar one of the Anglo-Saxon model argues that little regulation is required in finance as Darwinian competition continually weeds out the weakest cogs in the system. One of the key metrics for understanding whether a cog (i.e. an investor) is successful is risk-adjusted return. Put simply, risky investments are expected to earn higher returns. Investors who make risky investments and low returns are deemed to be no good. Conversely, low risk investments that earn excessive returns are expected to be short-lived.

The problem with this is that finance is not like a goods market where people know if a product is any good or if people are charging too much. Finance is different in that it is very difficult to identify a bad product (i.e. an investment that delivers inappropriate risk-adjusted returns) . Even worse people can be deluded for very long periods of time and these bad products have the potential of destabilising a whole economy. The following are reasons why this is a feature of finance:

• Some people may just be lucky. Consider the analogy of an investor going to a roulette table with the strategy of choosing red everytime and re-investing all the money on every bet. Now say they were lucky in winning three bets in a row. In finance this person would regarded as having a good track record and someone who you should bank your money with. However, this does not take away from the fact that the next bet is still 50:50. In my time in the industry, there were several people who rode the wave of the good times (pre 2007) and now remain in the industry (and prosper), despite poor outcomes since, purely because of the ‘experience’ they were able to gather when they were (by luck) deemed to be good investors. These people do earn six figure salaries and large annual bonuses, but will have personally have been involved in investments that returned nothing or lost millions of pounds.
• Financial risk is not really that well understood as it pre-supposes you understand all future possible outcomes and are able to assign a probability to each. As we have seen, in this crisis certain unknown unknowns can completely destabilise the system. Further, even the stuff we do know may be highly influenced by factors we have little understanding of e.g. artificially low interest rates or the exuberance of traders.

That said, some parts of finance have learnt their lesson..

Earlier on my career I did used to get quite frustrated with the level of red tape in the business, often having to spend hours filling out various forms for compliance and regulatory purposes. In hindsight, such regulations are probably the product of reforms that have been fought hard for and for which the finance system (and in my particular experience private equity and commercial lending) should be proud. Without going into detail I think the system is very good at

• Corporate Governance – ensuring business are governed in a clear, transparent way
• Anti-Bribery policies
• Environmental, Health & Safety – I have seen investors very active in this place, pushing companies to go above and beyond what is expected of them and fighting entrenched lax cultures (e.g. in Finland or India). In western countries today I would be very surprised if investors allowed their companies to get away with environmentally damaging activities or neglecting safety standards for their workerss
• Applying due diligence and due process – despite some poorer investment decisions seen in the crisis, I have seen people go through very thorough processes (when writing big cheques). This means our system avoids, for instance, the c. 40% bad loan provision that the Chinese development banks had towards the end of the 1990’s.

So, is the system effective?

I still stand by the statement that relative to all historic systmens the anglo-saxon model is decent. However, it does have some sizeable shortfalls namely (i) it ignores vast parts of the economy and (ii) through its complexity and entrenched behaviour, it has the potential to de-stabilise a whole economy. In part 3 of this posting, I will look at possible remedies and see how alternative models e.g. Rhine capitalism and the Nordic model get around these issues.