Banks, Exchanges, and Regulators
Global Financial Markets from the 1970s
RANALD C. MICHIE
Great Clarendon Street, Oxford, OX2 6DP, United Kingdom
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I dedicate this book to my wife, Dinah Ann Michie, née Brooks. I owe my life to her and her prompt action on 28 December 2019. The NHS then did the rest.
Preface
My original intention for this book was to write a history of recent developments in the global stock market following on from the publication in 2006 of my book, The Global Securities Market: A History. When I was writing that book I became aware that I had collected a large amount of material relating to the period from the early 1980s onwards that I was unable to make full use of at that time. In particular the information I had already gleaned from the Financial Times (FT), and continued to do so on a daily basis, was adding a level of depth and breadth regarding more recent events that would completely unbalance a general account of the development of a global securities market from medieval times to the present. The decision I reached, reluctantly, was to put most of that material to one side, though not to ignore it completely, and pursue my original intention, which was to provide an account of the rise, fall, and recovery of the global securities market over the centuries but with an emphasis on the last 200 years. That is what I did. What then happened was the Global Financial Crisis, which had its beginnings in 2007, reached its crescendo in 2008 and continued into 2009 and beyond. That crisis forced a fundamental rethinking of the way I had been viewing the global securities market, especially from the 1970s onwards. In particular, I became much more conscious of the role played by regulators, the growth of the Over-The-Counter Market and the importance of a small number of banks with global operations. Though I had been collecting material on these subjects for some time I was not fully aware of their significance until the Global Financial Crisis. Clearly I could no longer write a book that would simply be a continuation of the history of the global securities market, as that would not suffice in the face of the revelations produced by the Global Financial Crisis.
However, as I began the process of researching and writing a book that would not only build on my history of the global securities market but also take account of all that the Global Financial Crisis had revealed, my academic work took a new direction. Under pressure from the university authorities to apply for and obtain external research funding I became involved in a bid to the Leverhulme Trust in response to their invitation to conduct research into Tipping Points. This bid was led by Professor Stuart Lane of Durham’s Geography Department and Director of its Institute of Hazard, Risk, and Resilience. As my contribution I put forward the suggestion that I would lead a strand that looked at the financial crisis of 2007–9 as a Tipping Point in British banking history. Until the failure of Northern Rock Bank in 2007, followed by the rescue of the Bank of Scotland/Lloyds and the Royal Bank of Scotland/NatWest in 2008 there had been no banking crisis of this dimension in Britain since the collapse of Overend and Gurney in 1866 and the bank failures associated with that. I thought it would be an interesting diversion to explore what had happened to the British banking system prior to the crisis of 2007/8 that had transformed it from one of the most resilient in the world throughout the twentieth century to one of the most vulnerable. That proved a fascinating voyage of discovery whose fruits were published in 2016 by Oxford University Press in a book entitled British Banking: Continuity and Change from 1694 to the Present. In 1989 David Lascelles had observed that, ‘It is a mystery
to most people in the banking industry why those outside find it dull’1 and I can only echo his views.
Nevertheless, my focus remained firmly on writing the more recent history of the global securities market in the light of the financial crisis of 2007–9. That plan was then disrupted by the shock of the Durham team winning the Leverhulme Trust mandate to undertake research into Tipping Points. This was a five-year collaborative research project lasting from 2010 to 2015, and it absorbed most of my research time. Neither the University of Durham nor the Department of History made any allowance for the work involved in the project through a reduction in my other duties, and so I continued with both a full teaching load and additional administrative duties, most notably acting as admissions tutor. I was also let down by the first Research Associate appointed. He used the post to concentrate on his personal agenda to the exclusion of the work required for the project. This placed the burden of the project on me until the appointment of a replacement Research Associate, Dr Matthew Hollow, who delivered far beyond what could be reasonably accepted, considering the circumstances under which he took the post.
Throughout the years of the project I continued to collect material relating to my planned book on the more recent history of the global securities market and to write the occasional piece on that subject. Eventually I finished my contribution to the Tipping Points Project with the publication of a book on the history of British banking in 2016. Once that had been done I begun the massive task of transforming my cuttings from the FT into a digital file that would provide me with the material I required in a form that could be used to write this current book. I had expected this to take me the whole of 2016, while seeing the banking book through the press. That would then leave me 2017 in which to write the book with publication in 2018. As I had been granted the academic year 2013–14 as delayed research leave, and then retired from the University of Durham on 30 September 2014, after a forty-year career, I envisaged that I would have plenty of time to finish the Tipping Points Project, assemble my FT notes, and then write the new book. This was a wholly unrealistic assumption. No sooner had I retired from Durham University but Newcastle University Business School asked me to contribute to a module, ‘Accounting Change and Development’, in which I could use my expertise in financial history. That module gave me an opportunity to apply my accumulated knowledge to a new audience and I eagerly accepted their offer. That teaching also put me in regular contact with Professor David McCollum-Oldroyd, whose module it was, and I have benefited enormously from discussing the progress of this book with him over the years. The result helped me to better formulate my understanding of recent financial history though the effort was far more absorbing of my time than I had expected. In addition I had totally underestimated how much material I had amassed from the FT and how long it would take to read it and extract what was both important and relevant. In total it took me twenty-two months to complete the examination of my cuttings and type the results into a digital file. By the end, as I kept adding new material from the FT, I had over 800,000 words. Converting that into a draft of the book of around 450,000 words took another twenty-two months with an additional four months required to produce a finished product of 300,000 words. Overall, this book took me four years to complete. My friend, Francis Pritchard, then helped with the copy-editing and compilation of the bibliography, for which I am extremely grateful.
1 David Lascelles, ‘Anything but dull’, 25th September 1989.
Over that initial twenty-two-month period, in which I worked through my FT material, the scope of the book broadened to include not only all financial markets but also banks and regulators. Over time the idea grew of writing a book on the theme of the role played by banks, exchanges, and regulators in global financial markets from the 1970s to the present. This would take a holistic approach to the study of financial markets by attempting to incorporate those elements that did not take an institutional form, as was the case of exchanges. Why did some markets, such as stock exchanges, become highly institutional while others did not, puzzled me as there was no obvious answer. There was no clear trajectory over time from informal direct trading or a reliance on specialist intermediaries to highly-organized exchanges as much of what took place from the 1970s witnessed the reversal of that. In turn that led to questions concerning the role played by banks, as they had the capacity to internalize the market mechanism within a single business. I was also increasingly aware of the consequences of state intervention in the regulatory process as a supplement to or replacement of self-regulation. Writing a book on the history of the global securities market, completed in 2006, followed by one on British banking, finished in 2016, provided me with two fundamentally divergent views on the development of financial markets, especially in the light of the Global Financial Crisis of 2007–9. Writing the history of British banking had provided me with insights into the working of diverse financial markets, especially those for money, currencies, and derivatives and an appreciation of the position occupied by banks and their over-riding concern regarding liquidity. At the same time the need to gain an understanding of what had led to the Crisis, and the role played by central banks and their supervision of the banking system, led me to give far greater prominence to the role of regulators.
It was the work conducted for the Tipping Points Project, and the interdisciplinary nature of the research involved, that has framed this book and made it radically different from the one that I had planned in 2006. Prior to that time I was focused on the competition that had emerged between exchanges and the challenge they faced collectively from both electronic platforms and the internal markets operated by global banks. What I had not comprehended was how all this fitted into the convergence between different financial instruments, whether they were stocks, bonds, or derivatives; their relationship to other financial markets such as those for money and currencies; and the interplay between formal exchanges and Over-The-Counter (OTC) trading. In my defence all I can say is that these issues appeared to be little understood by others at the time, which is probably why there was a global financial crisis in 2007–9 and why lessons need to be learnt from what happened at that time. But these lessons need to be informed by past practice because nothing that happened in 2007–9 was that different from what had taken place in the past. Gillian Tett emphasized in 2018 how important it was to learn from the past so as to avoid the disasters of the future: ‘Never before have those financial history books mattered quite so much.’2 Past crises had led to solutions being devised that contributed to a more stable and more resilient global financial system. It was not only the British banking system that was remarkably stable from 1866 to 2007, for the world financial system was also remarkably stable from 1873 to 1913, or a period of forty years, before being subjected to the shocks of two world wars and an intervening world depression against which there was no protection. It was also stable again between 1945 and 1971 but in many ways that was a false position because it was achieved through the suppression of the market and the
2 Gillian Tett, ‘When the world held its breath’, 1st September 2018.
compartmentalization of banking and financial systems rather than an acceptance of change within a changing world. The result was the crisis of the 1970s, followed by an ongoing series of mini-crises that finally erupted with the Global Financial Crisis of 2007–9.
This book is an attempt to merge my two experiences of approaching banking from the perspective of financial markets, as in the Global Securities Market book, and financial markets from the perspective of banking, as with the British Banking book, with the third dimension of regulation being added to the mix. The triangulation of analysis, the concentration upon the events of the last thirty years, and the need to explain the Global Financial Crisis are the driving forces behind this book. However, none of that would be possible without the information culled from the pages of the FT. The period covered by this book is the one during which the FT established itself as the authoritative voice of international finance rather than a London-based newspaper specializing in financial news mainly of interest to a British readership. It was this switch from a British business newspaper to a global financial newspaper that made this book possible. One example of that change was the printing of a European edition in Frankfurt in 1979 and the launch of a US edition in 1997.3 Today the FT claims to be the ‘World Business Newspaper’. Otherwise the collection of the relevant information would have been an impossible task. Important as data is in capturing global trends over time, especially for the recent past, it alone is insufficient to explain the decisions taken that were instrumental in determining the fate of different banks and exchanges and the policies followed by regulators. As the eminent statistician, Hans Rosling, reflected in 2018, ‘The world cannot be understood without numbers. And it cannot be understood with numbers alone.’4 Reading the FT has provided me with both the numbers and the information required to interpret them.
Nevertheless, this book is far more than a recycling of old stories or a summarizing of past analysis. It is an attempt to explain the revolution in global finance that has taken place over the last thirty-five years using the information that was being gathered daily by FT journalists, correspondents, and contributors from around the world, and then relayed to their readership through the regular columns of the newspaper and the supplements produced covering specific topics and countries. I have extracted what I deemed relevant from this mass of reporting. What exists in this book is my attempt to make sense of what I have discovered from this material in the light of my past work in financial history. In the process of collecting the information much has been ignored while also much was left out in selecting what to use in the book. While objectivity was the over-riding principle the final product was also the result of subjectivity that was both deliberate and inadvertent. It was deliberate that a choice had to be made about what to focus on. Hence the title of Banks, Exchanges, and Regulators, as well as the more recent past stretching back to the 1970s but biased towards the mid-1980s onwards, and especially the years of the Global Financial Crisis and its aftermath. It was also inadvertent in what appears here is not the views and analysis of the hundreds of FT journalists whose work I have used, and relied upon, but my interpretation of what they wrote at particular times, on particular subjects and under particular circumstances. Some of that turned out to be highly perceptive in the light of subsequent events while others have not stood the test of time being the product of a specific era or a personal mindset. The same verdict can be reached regarding this book, and almost certainly will, but it is my best effort.
3 Lionel Barber, ‘The world in focus’, 13th February 2013.
4 Hans Rosling, Factfulness: Ten reasons we’re wrong about the world—and why things are better than you think (London: Sceptre/Flatiron Books, 2018).
Without this daily reporting of developments around the world by the FT it would be impossible to write a history of global financial markets over the last thirty to forty years. It was in those years that a revolution took place that transformed these markets and, luckily, the FT was there to report on what was happening around the world. However, this does not mean that this book is no more than a précis of that reporting. There is a completely different approach between a journalist reporting events as they unfold and an historian trying to make sense of those same events in terms of why they took place, the sequence that they followed, and the consequences that they had. In addition, the task of the historian is to make judgements with the aid of hindsight when trying to understand why the outcome was as it turned out rather than another. There was nothing predetermined in the revolution that occurred. The combination of a reading of my cuttings from the FT for a thirty-five-year period and the analysis derived from writing about the global securities market and British banking, brought home to me the accuracy of the comment that correlation was not proof of causation, though contemporaries, including journalists, were always too ready to make that assumption. To address the question of causation requires an understanding of the sequence of events and the context within which they took place. That is what I have been able to glean from the FT.
I began keeping cuttings from the FT regularly in 1982. While this initially focused on stock exchanges I was fully aware that a narrow institutional approach to the subject omitted the environment within which they existed and the interaction between them and other components of the financial system. Quite quickly that stock-exchange-focused approach was transformed into one in which financial markets became the focus with stock exchanges becoming only one field of study, and not always the most important. The material I was extracting from the FT broadened to include banks and regulators because of the key role each played in both shaping the financial system and being shaped by it. Throughout my scope was to cover the entire world, and it was a daily reading of the FT that made this possible. As an editor of the FT, Lionel Barber, so succinctly put it in 2008, ‘Journalism, so the adage goes, is the first draft of history.’5 So here is the second draft!
5 Lionel Barber, ‘How gamblers broke the banks’, 16th December 2008.
1.
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8.
Introduction
Chronology and Causality
General
A study of banks, exchanges, and regulators at any particular moment in time reveals a mixture of the new and the old. What is omitted is the deceased. Such a perspective is suggestive of inevitability as it ignores strategies that were unfulfilled but were of momentary importance, products that were of brief significance but were subsequently abandoned, businesses that flourished and then died, institutions that only fleetingly existed, and rules that were introduced only to be quickly repealed. By omitting these, what is lost are the banks, exchanges, and regulations that were instrumental in determining the eventual outcome, but are no longer present so that their contribution is ignored in the final reckoning. In contrast a perspective that recognizes change over time generates a deeper understanding as it captures all that had come and gone in the years before but had contributed to making the world of finance what it had become. Furthermore, the use of hindsight makes it possible to distinguish between the contribution made by long-term trends compared to major events. Without the richness of detail that narrative provides, the chronology that is essential in identifying cause and effect is absent. What is then revealed is that the outcome that emerged at any particular time was just one among a number of possibilities had different decisions been taken. Only by eliminating all alternatives can a convincing story of path dependency can be constructed linking the past to the present in a series of logical steps for which there is no other outcome. The problem with such an approach is that it assumes that the outcome that came about was the only one possible, and so selects the evidence that supports that conclusion. What is ignored is that evidence which points to a contrary outcome, and so leaves unanswered the question of why that alternative course was not followed.
It is equally important to trace what was not done and why as it is to plot those trends, events, and decisions that were instrumental in reaching a particular outcome. Otherwise it is impossible to plan a different future because the route forward has already been chosen. When all the possibilities are explored the conclusion that emerges is that the world was not trapped in a process that connected the changes that took place in the 1970s to the Global Financial Crisis of 2008 and its aftermath. Throughout the intervening period decisions were made within banks and exchanges and by regulators that influenced the pace, nature, and direction of change, but their importance can only be assessed if their existence is recognized. Contributing to the failure to recognize the significance of these decisions is the heavy reliance placed on statistical series and mathematical models to establish cause and effect and measure significance. Though mathematical models are an important aid to analysis, the degree of certainty they provide is only obtained through a process of selection and simplification that ignores the human element in decision-making. Humans react to the past and anticipate the future and this makes it difficult, bordering on impossible, to
Exchanges, and Regulators: Global Financial Markets from the 1970s. Ranald Michie, Oxford University Press (2021).
Ranald Michie.
10.1093/oso/9780199553730.003.0001
model their behaviour accurately through the use of numbers alone. After a lifetime’s study the eminent statistician, Hans Rosling, reached the conclusion in 2018 that ‘The world cannot be understood without numbers. And it cannot be understood with numbers alone.’1 It is the combination of the two that produces true understanding. There is another problem attached to making judgements without a full understanding of what preceded a particular outcome. That lies in the basis of comparison used. In the years leading up to the crisis it was the post-war era of control and compartmentalization that was regarded as untypical of global financial markets. Reflecting on that era in 2007 Martin Wolf wrote that ‘We are witnessing the transformation of mid-twentieth century managerial capitalism into global financial capitalism. Above all, the financial sector, which was placed in chains after the Depression of the 1930s, is once again unbound.’2 What this judgement reflected was a common view of the twentieth century which regarded the middle years as something of an aberration. As Martin Wolf himself reflected in 1999, ‘The twentieth century began in 1914, with the First World War, and ended between 1989 and 1991, with the collapse of the Soviet Empire . . . By its end . . . the world had returned, in a modernised and modified form, to the economic liberalism with which it began. . . . What war and depression did for nineteenth-century laissez faire, inflation and then rising unemployment, notably in western Europe, did for the Keynesian consensus.’3 Conversely, writing in 2015, in the years that followed the Global Financial Crisis of 2008, Philipp Hildebrand, the former head of the Swiss National Bank, viewed ‘the 15 years running up to 2007’4 as an aberration because it had led to financial markets unfettered by the chains of regulation. To him, normality was the era when central banks were able to exercise a high degree of control. Forgotten in any approach that uses a supposed Golden Age as representing normality was that each period was itself the product of a unique set of circumstances. For global financial markets there was never a period of normality against which all others could be judged, and to which a return could be made by undoing subsequent developments. As Larry Tabb, an expert observer of financial markets, said in 2011, ‘Markets are living and breathing things that grow and change over time, reacting to external pressures slowly but surely.’5 That is why a narrative account can be so much more revealing than either a snapshot or a model.
What a narrative account also provides is the context within which decisions were made, as these were the product of incomplete information and without perfect foresight. Globalization, liberalization, and the revolution in trading technology and business organization were major disruptive forces from the 1970s onwards and that made predicting the future especially difficult. Though the changes to the financial system after the 1970s owed much to the force of these global trends, combined with the actions of governments in removing barriers and forcing change, once begun they developed a momentum of their own. As Janet Bush observed in 1988, ‘The financial world has a way of conducting its own post-mortems and prescribing its own cures before the regulators and public opinion get in on the act.’6 Those actions were driven by bias, self-interest, and misconceptions and reflected a flawed assessment of the current situation, preparation for a future that never
1 Hans Rosling, Factfulness: Ten reasons we’re wrong about the world—and why things are better than you think, (London: Sceptre/Flatiron Books, 2018).
2 Martin Wolf, ‘The new capitalism’, 19th June 2007.
3 Martin Wolf, ‘Painful lessons from a turbulent century’, 6th December 1999.
4 Patrick Jenkins and Martin Arnold, ‘Lenders struggle to weather storms on all sides’, 11th November 2015.
5 Larry Tabb, ‘Playing ostrich over high-speed trading is not an option’, 14th July 2011.
6 Janet Bush, ‘Portfolio insurance loses its appeal’, 10th March 1988.
came about, or a misplaced faith in the precision and certainty of mathematical models. In 2011 John Kay reflected in the aftermath of the Global Financial Crisis, that ‘The belief that models are not just useful tools but are capable of yielding comprehensive and universal descriptions of the world blinded proponents to realities that had been staring them in the face. That blindness made a big contribution to our present crisis, and conditions our confused responses to it.’7 Though fundamental forces were at work it was these decisions that were instrumental in determining which financial centres prospered, which banks emerged as the leading players, which exchanges discovered the formula that led to success, which regulations were introduced, and what markets and products thrived. Driving these decisions was not only a reaction to what had happened and what was current, but also attempts to anticipate what was to come, however misguided that turned out to be. Few prophesied, for example, that there would be a global financial crisis in 2008. As John Kenchington reflected in 2014, ‘One of the most remarkable things about the 2008 financial crisis was the fact that almost nobody saw it coming.’8 There was nothing predetermined in what took place in global financial markets from the 1970s onwards because they were the product of decisions taken for numerous reasons. To contemporaries, even the most informed, the future was hidden even if they believed otherwise, and they had to do their best with the knowledge they had available and the conclusions they drew from it. It is important to keep in mind the ancient Chinese proverb, ‘We think too small, like the frog at the bottom of the well. He thinks the sky is only as big as the top of the well. If he surfaced, he would have an entirely different view.’9 Contemporaries were no different from the frog at the bottom of the well and their actions need to be judged accordingly, especially at a time of considerable change.
What is uncontested is that world within which banks, exchanges, and regulators existed was transformed from the 1970s onwards, and contemporaries were increasingly aware of what was happening. Writing at the end of the twentieth century a number of commentators expressed their judgements on the degree of change that had taken place. One was Peter Martin who observed that:
It has become much easier to run a global company. Falling communications costs, the existence of third-party logistics suppliers, lower trade barriers and internationally accessible financial markets—all these make it easier for any company, even a start-up, to operate on a global scale Because there are advantages in operating at the largest possible scale, national companies appear to be rapidly losing out to those that operate around the world. More and more industries are moving towards a situation in which there is merely a handful of global competitors, surrounded by a cluster of thousands of national or local niche players. The room left for substantial, mass-market national competitors is diminishing all the time: the choice is to seek to be global, or settle for a niche.10
Another was George Graham who applied his analysis of current trends to banks: ‘One of the most striking effects of technological advance on banking has been to make it much easier for new entrants to break into a market, without going to the expense of building a new branch network. To confront these new entrants, and to keep pace with the efficiency
7 John Kay, ‘A realm dismal in its rituals of rigor’, 26th August 2011.
8 John Kenchington, ‘Investors are being urged to stress test fixed income funds’, 3rd November 2014.
9 Often attributed to Mao Zedong.
10 Peter Martin, ‘Multinationals come into their own’, 6th December 1999.
opportunities within the traditional banking industry, banks have embarked on a quest for scale.’11 Jeffrey Brown traced the implications of these trends for financial markets, noting that ‘Globalisation of equity markets looks unstoppable as trade and capital flows are increasingly liberalised and multinational companies continue to dominate the marketplace.’12 An inescapable conclusion was that a transformation was underway and this had implications for all aspects of finance, forcing fundamental changes on the way each component operated and their relationship to one another. The certainties that had built up since the Second World War had ended in the 1970s. A world characterized by the compartmentalization along national and sectoral lines was being replaced by one involving the free movement of funds around the world, the inability of institutions to enforce market discipline, the disappearance of divisions between different types of financial businesses, and the declining power of governments to exercise direct control over financial systems.
Nevertheless, this was not a return to the pre-1914 era because government-appointed regulatory agencies and state-owned central banks had the authority to impose rules that governed the behaviour of banks and the operation of markets. At the same time new possibilities in finance had emerged because of the much greater volatility of prices, exchange rates, and interest rates and the degree of international integration made possible by the ability to communicate at speeds that came close to destroying the separation of markets. The response came in the form of global banks, international rules, and financial derivatives. The ending of fixed exchange rates created active foreign exchange markets. The ending of commodity controls and fixed-price regimes created active commodity markets. The ending of stock exchanges as regulated monopolies created active securities markets. The ending of bank cartels created active money markets. However, it was not simply the removal of controls that led to a flourishing of active markets. Human ingenuity also played a major role as can be seen in the exponential growth of derivatives. As business became organized in the form of ever-larger companies able to internalize the market so derivatives were created to provide a way of minimizing the risks that these companies were running whether it involved currency fluctuations or interest-rate volatility. In turn a market developed in these products so creating a new life for the commodity exchanges, whose role had been supplanted by the managed supply chains existing with multinational corporations. Alternatively, new exchanges were created in which these derivative products could be traded. At the same time banks turned to these products to cover the risks they were exposed to if one of their customers failed. It was not only the banks that were becoming ‘too big to fail’ but also the businesses that banks served, forcing them to seek ways of spreading the risks that they took which, in the past, would have come through a numerous and diverse customer base. However, the very growth in scale of banks allowed them to either internalize this market in derivatives or develop an Over-The-Counter (OTC) market in which they traded risks between each other, especially in terms of currencies and interest rates. To those who commented daily on the changes taking place, such as John Plender and Martin Wolf, the transformation of global financial markets was symbolized by the emergence and expansion of the financial derivatives market. The outstanding value of interest-rate swaps, currency swaps, and interest-rate options rose from nothing in 1970 to $3.5tn in 1990 before reaching $286tn in 2006.13 It was the use made of these derivatives
11 George Graham, ‘Cottages consolidate’, 6th December 1999.
12 Jeffrey Brown, ‘From slow start to relentless build-up’, 1st January 2000.
13 John Plender, ‘The limits of ingenuity’, 17th May 2001; Martin Wolf, ‘The new capitalism’, 19th June 2007.
that was then held responsible for the Global Financial Crisis that followed. Writing in 2011 Patrick Jenkins, Brooke Masters, and Tom Braithwaite acknowledged that:
With hindsight, it is clear the structure of the sector was an accident waiting to happen. Institutions had grown distorted in the pursuit of bumper profits. They held little equity capital to protect themselves—and what they did have was in many cases amplified by as much as fifty times with debt instruments. Vast profits were made from borrowing cheaply, often short-term, and assuming that the risks inherent in products from domestic mortgages to complex derivatives were negligible.14
Banks
In this changing world of finance banks, exchanges and regulators had to make decisions of what strategy to follow. Banking, in particular, was in a state of flux. Before the 1970s a number of distinctive types of banks operated, each seeking to maximize the profits that they could generate and minimize the risks they ran. All banks were exposed to two main types of risk. One related to liquidity and the other to solvency. As a bank made loans using borrowed money it could face a liquidity crisis caused by those from whom it had borrowed money demanding its return more quickly than its receipts from those to whom it had lent. When a bank was unable to meet withdrawals it would have to close, having lost the trust of those who had lent it money. As John Authers observed in 2018, ‘Banks are fragile constructs. By design, they have more money lent out than they keep to cover deposits. A self-fulfilling loss of confidence can force a bank out of business, even if it is perfectly well run.’15 A bank could fail due to a liquidity crisis even if it was solvent. It also faced a solvency crisis when its liabilities were greater than its assets, which could occur if those to whom it had lent money were unable or unwilling to repay. To survive a bank had to cover both liquidity and solvency risks while conducting a business that met its costs and generated profits. This meant it had to take risks in accepting money, which it promised to repay on demand, while making loans for a longer period. The income generated from doing this business came from the differential between the two rates of interest charged. One way of containing risk and generating income was to operate through an extensive branch network as this spread the business over numerous and diverse customers, provided it with the scale required to support the training and monitoring of staff, and allowed it to retain reserves necessary to meet a sudden rise in withdrawals and increase in losses. These banks collected deposits from savers and lent short-term to borrowers, adopting a policy of constantly matching liquid assets with liquid liabilities. They operated the lend-and-hold model of banking as loans were retained until maturity and, when expertly managed, these types of banks proved both stable and profitable though restricted in the range of activities they engaged in as they avoided making long-term loans despite the higher returns generated because of the liquidity risks they posed.
An alternative to branch banking was to operate as a universal bank. A universal bank provided the full range of financial services ranging from collecting deposits and providing short-term loans to making long-term investments and issuing and trading securities. These long-term investments in individual businesses did expose a universal bank to a
14 Patrick Jenkins, Brooke Masters, and Tom Braithwaite, ‘Hunt for a common front’, 8th September 2011.
15 John Authers, ‘In nothing we trust’, 6th October 2018.
liquidity crisis caused by the sudden withdrawal of deposits that had been used to fund assets that could not be easily liquidated or quickly repaid, especially fixed assets like property. To reduce this risk universal banks restricted long-term investment to a few carefullymonitored high quality assets, held a portfolio of securities that could be easily sold, had a large capital base, and kept extensive reserves. A universal bank used a mixture of the lendand-hold model of banking and an originate-and-distribute one. With the originate-anddistribute model a bank made loans but then converted them into negotiable securities like bonds which were then sold to investors. In that way the bank could be repaid the money it had lent as well as freeing itself from the risk that the borrower would default. In addition to these types of banks there were numerous other variations, which specialized in particular types of the business. These ranged from banks which collected savings and invested in bonds, to the financing of property development using a mixture of retail deposits and wholesale borrowing. There were also the investment banks, which provided long-term finance to government and companies through the issue of securities. They specialized in the originate-and-distribute model of banking, using funds borrowed from other banks to finance loans, which were then repaid once the stocks and bonds had been sold to investors.16 These divisions between different types of banks had never been rigidly observed, unless enshrined in legislation, and began to break down from the 1970s onwards. The growing size of business enterprises forced banks to respond in terms of scale and scope if they were to provide the financial services now required. Those banks operating the lend-and-hold model were called upon to provide larger loans as a result. However, once a business reached a particular size it could move funds internally so as to provide themselves with the credit facilities that had been previously drawn from banks, which undermined the business of those following the lend-and-hold model. Conversely, large businesses often adopted the corporate form and that led them to issue stocks and bonds, which required the services of an investment bank, as that was where their expertise lay. This benefited those banks that had adopted the originate-and-distribute model. The emergence of an increasingly integrated global economy also encouraged banks to expand internationally so as to participate in the new opportunities that were emerging and meet the needs of their existing customers. As a result of these changes branch banks were forced to expand into long-term lending while universal banks responded by opening branches to engage more directly with customers as competition between them grew. Specialist banks were then caught in the middle, including savings, mortgage, and investment banks, as the territory each occupied was invaded by others. Within this increasingly competitive environment there was a switch to the originate-and-distribute model as this was increasingly favoured by regulators. The lend-and-hold model was ideal when a bank could rely on the stability of its depositor base and the limited risk attached to lending as this greatly reduced the chances of a liquidity or solvency crisis. These conditions had prevailed in the 1950s and 1960s but faded from the 1970s onwards with far greater volatility of interest and exchange rates, more uncertain business conditions, and increased competition for savings. Under these new circumstances the originate-and-distribute model was favoured as it provided a means of reducing both solvency and liquidity risks. Loans could be made, repackaged into bonds, and then either retained by the bank or sold to investors. If sold the bank was then freed from its exposure to a default while, if retained, the bonds could be sold so releasing funds to meet a liquidity crisis.
16 Richard S. Grossman, Unsettled Account: The Evolution of Banking in the Industrialized World since 1800 (Princeton: Princeton UP, 2010) pp. 3, 63, 72–6.
As the popularity of the originate-and-distribute model spread so the traditional but blurred divisions between different types of banks broke down. The result from the 1970s onwards was the growth of a small number of super-banks that covered the entire range of financial activity and had a presence in all major financial centres around the world. These super-banks, or global universal banks, then suffered a reversal with the Global Financial Crisis of 2008. A number had collapsed, most notably the US investment bank, Lehman Brothers, while others had to be rescued by governments before they experienced the same fate. Such was their size and connections they were considered to be too big to be allowed to fail because of the consequences that would have for the entire global financial system. In the aftermath of the crisis there were widespread calls for the break-up of the megabanks and the re-imposition of the divisions that had previously existed. As the impact of the Global Financial Crisis faded these calls became less strident, through demands to restrict the range of activities that the megabanks engaged in remained, along with requirements that they held more capital and reserves to cover liquidity and solvency risks. Despite the action taken to curb the megabanks it became increasingly apparent that the world required banks that were both global and universal, regardless of the risks they posed to the stability of financial systems. The Global Financial Crisis had left unaltered the direction of travel being taken by the global financial system. This was towards greater openness and integration, and these conditions that had favoured the emergence of super-banks. Nevertheless, that did not mean that all such banks benefited because only a few were in a position to take advantage of the conditions created by much greater regulatory intervention that followed the Global Financial Crisis.
Exchanges
With the global financial system in a state of flux from the 1970s it was not only the divisions between different types of banks that were disappearing. The distinction between banks and financial markets was also being blurred, especially as the lend-and-hold model gave way to the originate-and-distribute one. Whereas in the lend-and-hold model banks made loans which were then retained until maturity, under originate-and-distribute these were converted into bonds which were sold on to investors. For this a market was required. This was both a primary one, where initial sales were made, and a secondary one, through which existing investors could trade with each other. In the past public markets like stock exchanges would have played a role in providing the secondary market. However, superbanks that were simultaneously global and universal were able to internalize many financial transactions that had previously passed through the market. This included not only issuing stocks, bonds, and related securities but also providing a market where they either matched buyers and sellers from among their own customers or used their own resources to act as counterparties. Super-banks maintained huge holdings of negotiable securities from which they could meet demand as well as controlling vast funds that could be used to make purchases. This allowed them to bypass stock exchanges. The markets for money and currencies had long been inter-bank affairs and that for bonds had gone the same way. A similar process was happening to corporate stocks and that was the route followed by the financial products that were generated by the increasing use of the originate-and-distribute model. All manner of loans ranging from mortgages to credit payments were converted into negotiable instruments, or securitized, and then sold to investors by banks, which then took responsibility for providing the secondary market. This also meant that stock
exchanges were increasingly bypassed. Commodity exchanges were also experiencing a similar fate as businesses internalized supply chains through horizontal and vertical integration both within countries and internationally. This left exchanges with residual roles as places where reference prices were set rather than supply and demand matched. Even the regulatory function of exchanges was increasingly undertaken by government-appointed agencies.
Not all financial instruments required the existence of an exchange to give them value and provide liquidity. Exchanges were designed to provide a market for standardized financial products traded through intermediaries on behalf of numerous buyers and sellers. What exchanges also provided was a means of coping with counterparty risk through a set of rules and regulations that governed who was allowed to participate, the standards they had to meet and the penalties for non-compliance. An exchange involved expenses and so the volume of trading had to be sufficiently large to justify those as well as providing the intermediaries involved with an income. Many financial products were not of this kind being issued in limited quantities or little traded, and this included a large number of bonds, derivative contracts, and the stock of smaller companies. Conversely, there were other financial products that were of a standardized nature and traded in high volumes that were also unsuited to exchanges. Numbered among these was money in all its forms, ranging for currency to short-term bills, as this was traded either directly between banks or through specialist intermediaries without the expenses involved in using an exchange. Those involved also constituted a closed group who were each responsible for the deals that they made and so had no need for the regulations imposed by an exchange. For those reasons only a subset of financial markets were provided by exchanges as they neither catered for customized products such as swaps nor the high-velocity trading in foreign exchange that was largely an inter-bank affair. These OTC markets were the ones that flourished most from the 1970s onwards despite the revival of exchanges. Stock exchanges benefited from the growing investor interest in corporate stocks and the mass privatization of state assets while those commodity exchanges that embraced financial derivatives experienced a boom. Nevertheless, more and more trading was of the OTC variety.
The growth of megabanks facilitated both the internalization of market activity and direct trading between them. A large bank was able to match sales and purchases between its own customers as well as being of a size that made it a reliable counterparty. The growth of a new species of intermediary, the interdealer broker, epitomized this change, as they provided banks with a network of connections that was previously only obtainable through an exchange. This trend towards trading gravitating to OTC markets was greatly facilitated by the increasingly important role played by statutory agencies, as they supplanted the selfregulatory authority that was once the exclusive privilege of an exchange. The desire to bypass exchanges had also been intensified by the way exchanges had used their regulatory powers to restrict access to the market they provided and so increase the charges levied on users. The authority vested in exchanges by governments had allowed them to monopolize trading in certain products, to the advantage of their members and the disadvantage of users. What happened from the 1970s onwards was that self-regulation was increasingly deemed inadequate to protect users of financial services and so increased power was given to statutory agencies, with a remit to promote competition while also maintaining stability. Such a trend played into the hands of the biggest banks, as they possessed robust regulatory mechanisms of their own and were already subject to external supervision. The result was a growth of OTC markets in which trading was conducted by these large banks either directly with each other or through the intermediation of interdealer brokers, and not through the exchanges.
During and after the 1970s the ability to create alternative market structures was also transformed through a technological revolution. The combination of near-instantaneous communication networks and the processing power of ever-faster computers with almost infinite capacity eventually produced a serious rival to the trading floor that had been at the centre of every exchange. These trading floors not only provided members of exchanges with the means of conducting sales and purchases but also gave exchanges the power to enforce rules and regulations. Those who refused to comply with the rules of an exchange were denied entry while those who broke them were expelled. With the dematerialization of trading and the rise of megabanks the exchanges lost control over the financial markets they had once almost monopolized. As this took place against a background in which government-imposed barriers that compartmentalized markets both internally and internationally were removed, the result was the emergence of global OTC markets, successfully challenging exchanges for business. The products of securitization, for example, were all traded on OTC markets and not exchanges as were most of the new derivative contracts. The Global Financial Crisis did raise the prospect that exchanges would, once again, return to a central position in the provision of financial markets. During the crisis it was a number of OTC markets that had caused difficulties by ceasing to operate, making it impossible to buy and sell the financial products traded there, or even obtain a price for valuation and collateral purposes. This had severe implications for those dependent upon the liquidity of the assets they held, such as the banks. In contrast, exchange-traded financial products continued to possess a market, which encouraged many to press for all financial markets to be placed under the control of exchanges. Quite quickly this course of action was exposed as impractical as it was recognized that exchanges could not provide the markets now required, whether it was little-traded swaps or much-traded currencies. A number of the most important OTC markets had operated without problems during the crisis, and those who participated in them resisted any attempt to force trading through exchanges. In a world where financial markets remained dominated by the buying and selling activity of global banks, international fund managers, and multinational corporations, the role played by exchanges remained confined to niche activities, such as corporate stocks and the pricing of key benchmark contracts.
Under these circumstances prevailing from the 1970s onwards those running exchanges had difficult decisions to make if they were to survive. One course was to pursue a national strategy that involved horizontal mergers, combining stock and commodity exchanges into a single multi-product institution. This institution would be in a position to monopolize what business there was, while spreading the costs involved over a large organization, especially those that necessitated a massive investment in the new trading technology that was becoming available. Another strategy derived from the use of electronic technology was to adopt the vertical-silo model, which combined trading with processing. Trading was moving from a reliance on face-to-face contact through the use of the telephone linking buyers and sellers to electronic platforms that matched orders automatically. At the same time computer-based systems handled clearing, delivery, and payment creating the possibility that the entire transaction, from placing of an order to final completion, could be handled as a single integrated operation. A final strategy was transnational mergers between exchanges that produced a single institution capable of providing a global market in whatever products they specialized in. Which of these strategies was the one most likely to succeed always remained open to doubt. It was never a foregone conclusion, for example, that the use of open outcry and voice broking were doomed to be replaced by electronic platforms. The vertical model was disliked by both banks and regulators because of the power
it gave to exchanges to impose their charges on users. There was considerable opposition to horizontal mergers from those that wanted to remain independent. This made achieving any of these strategies hazardous because of the barriers to be overcome and the risks to be taken, though hindsight revealed the eventual winners and losers among exchanges that was not obvious at the time.
Regulators
Prior to the 1970s the way that regulation was conducted was to treat the financial system as a series of separate compartments. This worked when governments were able to exercise a significant degree of control through erecting barriers between national economies. With the removal of those barriers regulatory intervention on a national basis was at the mercy of being subverted externally through the movement of activity to a rival financial centre. The effect was to greatly reduce the power of national central banks and national regulatory agencies to dictate terms within their own financial systems. A similar process was taking place domestically as the divisions between banks and markets broke down. Conventional wisdom separated banks from financial markets or went even further in focusing on particular types of banks or on specific financial markets, ignoring the links that existed between them and the degree of overlap. However, as national barriers disappeared with the ending of exchange and capital controls, and governments themselves fostered competition in order to appease complaints from investors and savers over low returns and borrowers because of a shortage of finance, it was no longer possible to regulate through the principle of divide and rule. These changes taking place in the global financial system created difficult choices for regulators. In the era of compartmentalized financial activity and national barriers regulators had been able to rely on the policy of divide and rule as a means of exercising control. Increasingly that was not available from the 1970s onwards, forcing regulators to search for alternative means of exercising their influence. The need to do so remained as governments continued to expect that financial systems would continue to be monitored and supervised to a high degree, especially the protection of savers and investors from fraud and even loss. Tasked with implementing monetary policy on behalf of governments central banks also looked for ways of policing the behaviour of banks and financial markets. One option was to establish a single authority covering the entire financial system, and so capture the convergence of financial activity that was taking place. Another was to retain specialist agencies to meet the specific requirements of different types of markets, businesses and institutions because of the continuing diversity present in the system. In no case and at no time was it obvious which of these choices would produce the best result but decisions had to be taken on one or the other. The Global Financial Crisis of 2008 then altered the relationship between banks, exchanges, and regulators, forcing all to address a new set of choices. Underlying these choices, whether before or after the crisis, was the ever-present regulator’s dilemma. If regulatory intervention was too intrusive and too draconian then financial activity was either suppressed or driven into channels that were beyond their remit. Neither of these outcomes was desirable as they undermined the ability of the financial system to deliver the services required of it in a safe and secure way. Conversely, if regulatory intervention was either non-existent or lax then users were left vulnerable to exploitation and the entire system rendered unstable. That was an equally undesirable outcome. Whatever decisions were taken they developed a momentum of their own which then influenced future regulatory intervention.
What did develop from the 1970s onwards was by government-appointed regulatory agencies placing increasing reliance upon large banks to act as their agents in supervising the financial system. With exchanges under suspicion because of the restrictive practices and all manner of OTC markets appearing, regulators found it easiest to operate through the largest banks. These banks were already subject to close supervision, not least by central banks, because of the risks they posed to national financial systems. This supervision also took place internationally through the co-ordinating role played by the Bank for International Settlements, as this acted on behalf of the world’s central banks. Central banks acted as lenders of last resort to their national banks, ready to intervene if a liquidity crisis threatened. It was these banks that increasingly dominated financial markets, especially the inter-bank ones where money and foreign exchange were traded, while their control over those for bonds, stocks, and derivatives was also growing rapidly. These large banks already possessed internal controls because of their size and structure and the liquidity and solvency risks they were exposed to. For regulators the use made of banks posed a dilemma. The regulators wanted banks to take responsibility for market regulation but that was best achieved by large banks as they had the scale and resources to train and pay for the appropriate staff. These large banks were also considered too big to fail, and had reputations to preserve, and so were in the position of trusted counterparties, guaranteeing that every deal would be completed. Increasingly it was the large banks that became the trusted gatekeepers of the financial system under the overall supervision of statutory regulatory authorities. Neither central banks nor regulatory agencies had the means or expertise to monitor behaviour within the entire banking system or the transactions taking place in active financial markets. They had no alternative but to devolve responsibility to others and their chosen instruments from the 1970s onwards were the megabanks. As these banks extended their operations around the world and into different financial activities they became the ideal partners for central banks searching for ways of ensuring stability in an integrated global financial system and regulators tasked with supervising highly-complex and inter-connected national financial systems. The dilemma came because central banks and regulators also wanted the financial system to become more competitive as this would better meet the needs of users, whether they wanted to save and invest, borrow, or make and receive payments. This was tackled in terms of exchanges by removing the monopoly power they possessed which helped account for the proliferation of OTC trading and the fragmentation of the stock market, which exchanges had once dominated. The solution in banking was to stimulate rivalry between banks, including megabanks, and remove the barriers between different types of financial activity so as to encourage greater competition.
There had always been an uneasy relationship between regulated markets provided by exchanges and those that operated on an OTC basis, ranging from the internal matching of deals within banks and fund managers to the more public trading of bonds. What changed after the 1970s was the balance as off-exchange activity became the new normality even in those markets, such as those for stocks and derivatives, which had previously relied on exchanges and the rules and regulations under which trading took place. These rules governed such issues as counterparty risk and market mechanisms to ensure that sales, purchase, and payments were honoured, prices were free from manipulation, and liquidity was maintained. It was not until the Global Financial Crisis that the consequences of this shift were realized. Confident in the resilience of large banks, as exhibited during successive crises, governments and regulators forgot the central importance of leverage and liquidity as the twin keys to understanding how a bank operated. Increasingly banks were no longer regarded as special components of the financial system deserving of individual treatment.
