Back to the 18th century

Jan Dwarhuis Senior Asset Manager bij Thirteen Asset Management

The invisible hand

Pfäffikon SZ, Switzerland – Adam Smith (1723 – 1790) was a Scottish moral philosopher and is widely known as the father of modern economics. He is also considered one of the founders of classical liberalism. He believes that the pursuit of one’s own individual interests would ultimately serve social interests. A free market is the most profitable for society as a whole. Smith called it ‘the invisible hand’ of the free market that creates harmony and balance.

Banks are better off

Banks today are financially better off than five years ago. Yet the banks and their bankers are still vilified, and that’s remarkable. In recent years there has been done a lot to make banks healthy again. Despite this process, we kindly ignore an investment in a bank. For example, you will not find us on the list of the by Gerrit Zalm so adored Initial Public Offering of ABN AMRO Bank. In addition, the competitive model of a bank in general is not functioning properly. I will come back to this point. A financial value that suits all our criteria is equivalent to finding a needle in a haystack. We have been able to locate only two of them worldwide, of which one is included in our Thirteen Diversified Fund. After all, in a diversified portfolio of only about thirteen stocks, exposure in a financial value is desired.

More interesting is perhaps why the appearance of the banker is so degraded. Notable in this context is the suicide of bankers worldwide. The issues Boumeester and Schmittmann are no stand-alone. Meanwhile, we are working hard to build a better banking landscape through a European banking union. Yet there is still something wrong.

Backing the wrong horse

Maybe we are backing on the wrong horse by implementing a European banking union and the almost irrevocable Eurobonds. I am not a fan of Eurobonds. The incentive of the countries that have violated the Treaty of Maastricht repeatedly disappears when we are sweeping debt together. They get rid of their obligations too easily. Countries such as the Netherlands and Germany pay a very high price in order to keep their expenses adequately. It is the world upside down. This dissatisfaction can turn into a remarkable result in the European elections [this article was written in April 2014, before the European elections 22-25 May, ed.].

The last few years Banks have been trying to achieve a change in their cultural settings themselves. The goal is to gain confidence again from consumers and businesses. Banks are generally determined to give this shift in culture a big twist. In addition, governments pull the reins further by increased supervision and having implemented associated regulations. Moreover, capital requirements are also increased step by step and liquidity in the financial system is maintained – through all kinds of strange detours.

Investors are guilty

The swelling bureaucracy should be less in my opinion. I conclude dryly that all measures have still not succeeded in fixing the crumbling image of the banker. Of course, such a process takes time. Many of the implemented measures are too much. The unnecessary extra protection of the investor is a good example. Who wants to invest, should do his homework well and know why and where to invest in. Today, the investor easily assumes that the regulator (AFM respectively) automatically detects and eliminates all the bears on the road. When something goes wrong, the supervisor gets the blame. Nonsense, of course, nine times out of ten you are guilty by yourself and you are faced with your own investment decisions.

The most important thing that has a negative impact till today is the wrong approach around the regulation of banks. In my opinion the regulation passed its goal. Banks should simply be part of the free market, where it is all about the customer and nothing else. In a competitive system it is in the first place not the culture or various government regulations, but to the customer who needs to get the full attention.

More competition

Competition ensures full responsibility of the own banking. Thus, the bank is forced to operate customizable, maintain sufficient capital and to create especially not peculiar side steps. The (capital) market thus forces Risk-based acting. When the bankers in question do not act this way, they will eventually go under. For me, they do not need to be saved. Letting the taxpayer pay for this kind of accounts, has been a bad plan.

Obviously there is an important role for the government and the regulator. They need to supply a stable framework for the match and provide an objective arbitrator. Only when the competing mechanisms do not work, the government must intervene. For example, an increase in capital ratios is a good development and does not get a healthy competition in the way.

Currently, however, everything seems reversed. The main focus is not the customer, but it is all about rules and regulators. Banks are under such heavy supervision that they can almost not make their own decisions. And the end is still far away. The government thinks that she is doing well, but is mistaken in the competitiveness of banks. At this time, competition can only do its job if the government is not intervening anymore. There is no market-based economy, which leads to all the consequences we have seen.

Some people already say that there should not be a market-based economy in the banking sector. That is a prejudice. In the last century, several banks have done an excellent job for decades. Many had their own niche and expertise. It remains ironic that there is practically nothing left from the fabulous international branch of ABN AMRO for example. The roots have been in the deep history, hundred of years ago. But the excellent local banking system of the Rabobank was also unable to withstand the test of time. The recently notable developments will be tough for the Rabobank.

Hank Paulson

On July 10 2006, Henry Merritt “Hank” Paulson Jr. began his job as the 74th “Secretary of the Treasury” of the United States of America. Important to note is that in this period the U.S. began to lose their power and influence as an absolute superpower. The trauma of 9/11 was still deep. China was the upcoming country and also Europe did well in that period. America seemed to lose the grip.

In 2006 there was apparently nothing to worry about, the bull market in global stock markets did excellent work. For insiders this was something else, as several market analysts have warned what was waiting us; the first cracks were already visible. Paulson had also known this as top manager of one of the most successful firms on Wall Street.

The bomb explodes

In March 2008 the bomb burst. The American Bear Stearns had an acute liquidity problem. Thirty years banks built on some ‘black boxes’ behind the scenes. Nobody knows what goes on there, but Paulson is very familiar with this information. But also Tim Geithner, the successor to Paulson, was already closely involved in the rescue of Bear Stearns. Geithner is known for his extensive knowledge in this area, which he built years before. Last but not least, of course, Ben Bernanke plays an important role in this process. Bernanke is known for his studies of the ‘Great Depression’ and thus, was perfect for the role. This trio knows what is going on. Remarkably, Bernanke has recently indicated that he would have explained the crisis wrong.

In any event; this trio decides to intervene at Bear Stearns. They write a check of $ 30 billion and give it to Jamie Dimon, CEO of JP Morgan Chase & Co. The mission is clear and JP Morgan buys Bear Stearns in a roundabout, financed with tax money.

Paulson then called, on September 12, 2008, the CEOs of the major U.S. financial institutions together. He explains them that Lehman Brothers would not be saved. Everyone was totally stunned. On September 15 2008, Paulson gave a speech in which he indicated that everyone now had to take care of themselves. The U.S. government would not help companies under any circumstances anymore. Paulson spoke the famous words of “Moral Hazard”. After the rescue of Bear Stearns, he would not be helping any U.S. financial institution anymore. It all turned out differently.

Good for the U.S.

On October 12, 2008, Paulson invited the representatives of the nine largest banks in the United States. Paulson is known to be straight ahead. It soon became clear that Paulson played the game very hard. Each bank received an injection of $ 25 billion under very flexible terms. Some bankers protested vehemently, including the rock-solid Wells-Fargo that did not need the money. But Paulson was adamant because it “would be good for the nation”. Finally, all nine bankers signed under heavy pressure from Hank Paulson. It was only the beginning of a rescue operation, which has not been so big in recent history. The U.S. in particular gained from it.

Interesting to note is that Paulson, as ex-CEO of Goldman Sachs back then, must have known quite well that AIG – the world’s largest insurer – would be the next problem. And that would make the problem of Lehman very small. Paulson also decided to rescue AIG. By rescuing AIG Paulson introduced the concept that systemically important banks and insurers cannot go bankrupt. Thus, he undermined the competitiveness of the economy, but he also gave a wrong signal to the financial sector. I wonder how Bernanke is going to explain this.

The invisible hand

There are two basic rules within the market-based economy. The first is that every person must adhere to the basic ethical rules and the law. Many bankers have lost in particular the ethical aspect, even though they are in principle capable and reliable people.

The second rule is as important as the first rule; the market-based economy even works if people are not behaving ethically. There is competition and the “invisible hand” of the market channels the self-interest of all persons concerned. The ethical aspect is then automatically evaluated.

Actually, we are back in the 18th century of Adam Smith. The banker must think and act as a butcher again. When the local butcher and baker do not serve its customers well, it is done with the merchant. Smith knew this already in 1780. A market-based economy is the most profitable for society as a whole. The invisible hand of the free market creates harmony and balance.

This article is translated from Dutch to English by the Editorial Board of Asset | Accounting & Finance.