Financial institutions were created to serve the real sector by satisfying a need for financial intermediation. They were intended to act as agents. In the years leading up to the global financial crisis of 2008, however, these institutions acted more as principals — in effect, they became masters rather than servants of the real economy. As finance became an end unto itself and tipped the real economy into crisis, conflicts of interest were laid bare and the public lost trust.
Andrew Sheng, President of Fung Global Institute, told delegates at the 66th CFA Institute Annual Conference in Singapore that the central challenge for financial reform is reining in the financial sector, which has grown to be some five times as large as the real economy, as measured by the ratio of total financial liabilities to gross domestic product. Why should a financial engineer get paid five times or more the amount earned by a “real” engineer who builds roads, bridges, houses, office complexes, and the like?
As Sheng put it, quoting his line from the Academy Award-winning documentary Inside Job: “Financial engineers build dreams. And when the dreams become nightmares, other people pay for it.”
Indeed, the financial ecosystem, which has evolved into a complex, interconnected network, has changed from an “engine of growth” to an “engine of bubbles,” as he put it. This in large part can be attributed to financial engineering, Sheng argued, which creates Ponzi schemes. As he noted:
- Financial engineering enables leverage to be sizably increased.
- Significant expansion of shadow banking credit lowers interest rates, resulting in asset bubbles.
- Risks in the finance ecosystem are higher, but with fair value accounting, profits and bonuses are taken up front.
- The crash came and a bailout was arranged via the “Greenspan put,” in which central banks become lenders of first resort, and via zero interest rate policies.
- When things appear to go back to normal, financial engineers resume creating leverage for the shadow banks.
So given the massive distortions in the global financial ecosystem, what should Asia’s policymakers do? The good news for the region is that the global center of gravity is moving to the East, where the financial sector remains much smaller than in the developed markets of the US, EU, Japan, and the UK. Still, it is imperative that Asia shift the mindset and incentives in the financial sector by going back to basic activities that serve the real economy, such as commercial lending, trade finance, mergers and acquisitions, capital raising, and similar activities.
Sheng said that in setting the reform agenda, Asian policymakers should use the “four ABCD lenses” to guide their work. He defines these as the Architecture of Markets, Business Models, Context (resources, people, technology), and Direction (policy frameworks, incentives).
More specifically, Sheng thinks that the newly launched Statement of Investor Rights and Principles for Investment Reporting, unveiled as part of the CFA Institute Future of Finance project which he welcomes, are steps in the right direction. However, policy-makers must go further. Sheng believes that the success of reform will come from enforcing ethics and principles. However, regulators in Asia tend to over-regulate and under-enforce; the answer, he said, is to beef up the latter.