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taking stock

Renowned British economist John Kay had strong views on the deep flaws of the financial services industry long before he was asked by his government to take a hard look at equity markets and whether they were meeting the needs of those who put their money into them.

But even he was taken aback by some of his findings in the course of a year-long review that produced a no-stones-unturned report last July. What he uncovered was a dysfunctional, distorted marketplace that's geared to meeting the short-term demands of participants – including the world's leading asset managers – rather than the longer-term financial needs of domestic companies and savers.

Although Prof. Kay based his conclusions solely on his research in Britain, he is convinced many of them apply equally to other major developed markets, including Canada, because similar forces are in play.

Most startling, perhaps, was his finding that British companies obtain almost none of their capital from the stock market. As a source of funds for British business, "equity markets don't even register on the radar screen," Prof. Kay told an audience of about 100 lawyers attending the business law lecture co-sponsored by Davies and York University's Hennick Centre for Business and Law at a breakfast meeting in Toronto Friday. "They're of no material significance at all."

Entrepreneurs have little interest in going public. And in cases where they do come to market, it's to provide liquidity for existing investors. "In a paradoxical way, the function of equity markets today is not to enable savers to put money into companies. It's to enable them to get it out."

Indeed, the total equity capital raised by British companies in the past two decades has been negative, if bank rescue rights issues since 2008 are excluded. "Considerably more money was taken out of equity markets from share buybacks and through acquisitions made for cash than was raised," said Prof. Kay, a visiting professor at the London School of Economics and a well known commentator and author.

"I thought I knew that equity markets weren't very important in capital raising. I was surprised by how far it had gone," the affable professor said later in an interview. An even bigger surprise has been the dramatic shift in power from domestic insurers and pension funds to large international asset managers.

Two decades ago, British pension funds and insurance companies controlled more than 40 per cent of the market. Today, their share has fallen below 20 per cent. By contrast, six to 10 of the largest global asset managers, some of them British-based, today account for close to half of all British holdings.

His study started from the position that "markets are for users [companies and investors], not for the people who work in them." What he found, though, was just the opposite. While business gets by without any appreciable financial help from the equity emporium, and investors have essentially made nothing for the past decade, a growing string of financial middlemen have cleaned up. He rhymes off a long list that includes registrars, custodians, nominees, asset managers, pension fund trustees, investment consultants, independent advisers and on and on – many with incentives that favour lots of trading.

Fund managers have told him they would like to do things differently, but can't. "There's no more powerful indicator of a dysfunctional system than that."

The big asset management firms are the most important link in the equities chain, but the others all line up at the trough, too. "The overall investment chain is now extremely long and extremely costly."

If equity markets aren't meeting the needs of savers or companies – apart from stakeholders seeking to cash out – doesn't that reinforce their image as little more than big casinos, where the small-time gambler is always at a disadvantage? And if so, should they be regulated differently?

"Banning gambling has never worked," says Prof. Kay, who opposes stricter regulation of the financial services sector in any case. "But once you identify it as being gambling, you have a different attitude towards it. And that's kind of where we need to go – and where we once were." As he observes drily, not so many decades ago, stockbrokers were typically regarded in the same vein as bookmakers and with about the same social standing.

That could do more to clear out the short-term, casino-like mentality than the tougher rules sought by every politician seeking public approval. "We don't want more financial services regulation, not because I love investment bankers and they should be allowed to do whatever they like," Prof. Kay says. "But because most of the regulation we have is at best useless."

John Kay on the markets:

Prof. Kay doesn't pull any punches when discussing the worst flaws of the market, the financial sector or the euro zone.

On the often-expressed industry view that people just need to better understand how the financial sector works:

"I do not know what is under the bonnet of my car and I do not want to know. ... Nor do I want to read large volumes of disclosures about what's under the bonnet of my car every time I sit behind the wheel. What I want is the confidence … that the combination of a modest amount of regulation together with a manufacturer's concern for his reputation means that ... I can expect that most of the time it will do more or less what I want it to do. That's very far from being the kind of comfort which people can today bring to their purchase of financial services."

On the rapid spread of high-speed trading:

"It is hard to see how trust can be sustained in an environment characterized by increasingly hyperactive trading, and it has not been."

On the glut of information available to investors:

"We need to dispose of the idea that more information is better and eliminate information that is at best noise that is irrelevant to the performance of the company and at worst information that actually distorts the performance."

On the euro zone:

"This is like watching someone walking along the edge of a cliff. You know they're going to fall off one day, but it's probably not today or tomorrow. And it might be Cyprus [that triggers the fall]. This is a stunning illustration of how you can screw up an infinitesimally small problem."