A demon of our own design?
The title for this entry to KevBlog is taken from the excellent book of the same name by Richard Bookstaber. I was reminded of this whilst reading Brian Durrant's pertinent article in Issue No. 2295 of The Fleet Street Letter. Brian was remarking that the impact of regulation is "hard on the little guy, easy on the big guy". He commented that "We have the worst of all worlds. At the micro personal level, financial regulations are onerous, petty and often appear totally pointless. Yet, at the other end of the scale, banks can indulge in reckless lending practices with apparent impunity".
He is right, isn't he? As financial-planners we know that the observation is accurate. Brian Durrant is clearly thinking of the impact of regulation on the small investor, where the consequences must be bewildering and onerous, but exactly the same principles are true for individual firms of financial planners. The burden of the regulations on smaller firms becomes even more disproportionate when one considers the sheer scale of damage done to the financial sector by (apparently) very poorly regulated and managed processes in relation to the markets for financial instruments. The discontinuities between risk assessment and the burden and focus of regulation appear to be so extreme, that one is left wondering what regulation is actually about in practice.
Bookstaber's book is subtitled "Markets, Hedge Funds and the Perils of Financial Innovation". Originally published in April 2007, and focused primarily on the risk consequences of the proliferation of Hedge Funds ("unconstrained versions of traditional investment funds in that they do not have restrictions on shorting, levering or expanding to innovative asset classes"), the author makes the following pertinent comment: "With concentrated demand for convertible bonds and default swaps, convertible bond and credit derivative arbitrage funds are spring-loaded for crisis." Bookstaber's conclusions were preceded by Bill Bonner's 2006 blockbuster, Empire of Debt, which dealt with the mushrooming of US consumer debt, largely encouraged by the Fed. The conclusions are difficult to avoid: the present financial crisis was predicted well in advance, entirely forseeable, and documented extensively by those in the know. And yet, despite the vast, tottering edifices of regulation and bureaucracy, we have still sleep-walked our way into the current mess.
From this, I have drawn the following practical conclusions that I apply to my clients' financial planning:
- if the regulators cannot protect my clients, then it is up to me to do what I can when it comes to basic financial management and product-selection
- in the current market of interconnected, over-complex products, the safe bet is to use simpler, discrete financial products which have clearly defined and known risks
- most consumers are completely unaware of the level of associated or connected risk that they have assumed in relation to the acquisition of debt or other financial products - this is particularly the case where they have been 'direct sold' by the banks
- given that the banks clearly do not understand risk, and given that their 'over-the-counter' products appear to assume unquantified degrees of associated risk, there is apparently a huge market for IFAs who are prepared to operate as 'a safe pair of hands'
- a large proportion of consumers are in serious need of a 'financial detox'
- as is almost inevitably true in any context of life, the following principle should override my financial planning advice: just because we can do something, doesn't mean that we should.
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