Politics & Law Series: Expert Comment

Can the law reform Big Finance?

By Dr Luke McDonagh

The global financial system came to the edge of ruin during the 2008 financial crash. 

Despite the enormity of the political and economic problems caused by the crash, fundamental reforms have not occurred, and many of the same dangers - cheap credit, unfettered capital, reckless behaviour - lurk again in 2016. So what needs to be done to reform 'Big Finance', and what role can the law play?

A recent public event, hosted by The City Law School, discussed this issue in detail.  The anthropologist and Guardian journalist Joris Luyendijk - recent author of 'Swimming with Sharks - My Journey into the World of Bankers' - recounted his experiences of interviewing more than 200 people working in the City of London, and outlined what he learned the causes of the 2008 crash. 

For Joris, blaming the 'bankers' for their 'greed' is a waste of time - after all, the current financial system provides bankers with perverse incentives, and any person would struggle to act ethically in this context. Moreover, financial products are highly complex, capitalism is inherently unstable and crashes will always happen. These are the inevitable problems that come once we accept that 'risk' is a necessary part of finance.

Perverse incentives and moral hazards

But the crucial problem of 'too big to fail' is not inevitable - it can be solved. To do this, it is necessary to do two relatively straightforward things: (i) break up the largest banks into entities than can be allowed to fail when a crash happens (i.e. bring back a measure of regulation similar to the US Glass-Steagall Act repealed during the Clinton Administration); and (ii) remove the perverse incentives and moral hazards that currently exist within Big Finance, so that if traders or financiers decide to take large risks, they know that if the risks pay off, they will be rewarded through a bonus - but that if they do not pay off, there is a measure of personal responsibility in the form of a financial penalty (loss of bonus, or a fine in some circumstances).

Dr Giuliano Castellano, of the University of Warwick Law School, discussed the legal reforms that have been considered and debated post-2008, as well as what the law's impact on finance is likely to be in the future. Dr Castellano noted that using the law to bring in criminal penalties can be counter-productive because in cases of financial fraud or misrepresentation proving 'intent' is always difficult. Moreover, law and lawyers are complicit in the current financial system, and smart lawyers will always try to find a way to get around the latest piece of regulation. Yet, regarding Joris' recommendations, Dr Castellano acknowledged that the law can play an important role in enacting both of these reforms - but what is required is political will. In the global economy, capital moves abroad very easily, whereas governments act on a national or regional basis.

The combined effect of the power of financial lobbyists and fear of capital flight restricts politicians' ability to act. Only a strong political movement across large regions of the world - the EU, North America, East Asia - would be able to counteract these forces, and at present such a force does not exist.

^{Image (right): photofriday / Shutterstock}

Anti-competitive nature of Big Finance

If political constraints mean the law cannot, at present, provide solutions, what are the alternatives to Big Finance for the consumer? The anthropologist and former broker, Brett Scott, outlined the role that innovative finance and peer-to-peer lending might have on the City of London, including the possible emergence of grass-roots alternatives to the big banks. Peer-to-peer lenders such as Zopa have gained a great deal of success and digital currencies such as bitcoin may point the way to the future.  Campaigns such as 'Move your Money' have encouraged more capital activism amongst ordinary people. However, these alternatives are not yet in a position to compete with Big Finance - for one thing, they are not 'too big to fail' which means that they may struggle to compete with the largest banks and lenders in the long term. The anti-competitive nature of Big Finance makes it difficult for ethical and sustainable alternatives to thrive.

What is perhaps most remarkable about the 2008 crash is that despite its substantial negative impact on all of our lives the essentials of Big Finance (too big to fail, moral hazards) remain intact.

Future systemic crash

The only real reform that has occurred has been the requirement for large institutions to maintain larger amounts of capital than they commonly did prior to 2008 – but there is no guarantee that the amounts held would be sufficient to prevent a systemic crash occurring in the future.

Fundamental reform is necessary and possible through law, but in order to get there several political hurdles must be passed, and with so much else on the political horizon (EU referendum, US presidential election) much of our energy is directed elsewhere. It may take another serious crash for politicians and electorates to face up to the serious task of reform.