John Kay on the illusory nature of bank profits
April 16th, 2012
In this speech the economist and author John Kay examined how the financial sector continues to make — or claims to make — returns-on-equity which are way in excess of any reasonable estimate of cost of capital.
Kay, a visiting professor at London School of Economics, examined various possible reasons but then focused on the fact that the profitability reported by banks and duly signed off by their auditors is “in significant degree an illusion”.
Speaking after the Bank of England’s Andy Haldane at the recent INET conference in Berlin (and on the same topic which was “How can we create a financial system that is socially useful?”) Kay outlined the three clusters of trading strategies which he believes are most widely used by traders today. The three he described were:-
- The generalised winner’s curse / Ponzi Scheme / ‘bezzle’
- Martingale betting strategies / St Peter’s Paradox
- Writing heavily out-of-the-money options
Kay also recounted recounted an interesting anecdote from his time as a non-executive director of Halifax, the former building society that merged with Bank of Scotland in 2001.
Kay was a director of Halifax from 1996-2000 and said that, early in his tenure, the board was asked to rubber stamp a proposal (presumably from chief executive Mike Blackburn or co-director James Crosby) that the bank should start running its treasury operation as a separate profit centre. Kay was sceptical and asked his fellow Halifax directors including its then chairman, former 3i venture capitalist Jon Foulds, whether they believed that trading in complex securities could, in aggregate, be profitable.
He was eager to know where the profits came from — or whether what was being proposed was just a zero sum game. No convincing answers were forthcoming. But even to question whether a mortgage bank’s treasury department should engage in casino finance was considered heretical at the time and Kay was duly sent off “to be re-educated” by a bunch of traders. Happily they failed to convince him of the ‘error’ of his ways.
Kay stepped from the Halifax board 12 years ago, eight years before the bank, by then known as HBOS crashed and burned as a result of massive governance failures and endemic malpractices and … treating its treasury operation as a profit centre … in September 2008.
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