'Healthy' Capital Markets and Innovation
Innovation
By focusing on 'the big picture', Capital Flow Analysis encourages the development of ideas on improving the capital market.
Market improvement is not a matter of altruism, but of survival.
Capitalism, in an ethical society, can be more efficient than socialism.
People who make careers in capital markets have an obligation to keep the market healthy.
Centralized management of economic activity usually does not work as well as leaving micro decisions to a free market.
Except in special cases, government is inherently less productive than the private sector.
However, capitalism depends on government to protect property, enforce commercial commitments, and establish incentives and standards of behavior that accrue to the benefit of all.
People who make careers in the market have selfish reasons to innovate and keep the market healthy.
'Healthy' Capital Markets
The idea of a 'healthy capital market' supposes two purposes:
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There should be an adequate supply of sound, long-term investment vehicles, fairly and reasonably priced, that would allow people to prudently accumulate adequate reserves for old age, education, a start in life for the next generation, and emergency needs.
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The goals of issuers of securities should be consistent with those of investors, and the aims of both and the allocation of capital should be directed towards the survival and improvement of society over the long-term.
The allocation of capital should be consistent with the survival of society over the long term.
Since Capital Flow Analysis is the study of supply and demand in capital markets, focusing on the motivation of market players and the merits of the various instruments, the analyst should naturally come to notice areas in which the 'health' of the market might be improved by new products, institutional change, or better policy.
One of the great unanswered questions of economics is whether it really is possible to sustain a 'healthy' capital market as envisionaged.
It is not clear whether prudent saving is feasible for all of society.There obviously are limits on the intergenerational transfer of savings, based on demographics and limitations on investment returns available for transfer to segments of society not able to earn productive income.
Whereas a prudent individual may be successful in saving for retirement and future needs, it is not clear whether the same degree of success is possible for all of society, if everyone were equally prudent.
Inevitable Change
The capital market is not static but in constant evolution.
Change is ongoing and is coming, for better or worse.
Moreover, the market is not immune from the incursions of the Five Horsemen, and change is not always for the better.
Here are some to the many changes that have occurred in the U.S. capital market in the last fifty years:
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The invention of money market funds, leading to the deregulation of interest rates and the Savings and Loan debacle;
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The creation of Asset Backed Securities, reducing the amount of equity needed for working capital and reducing the cost of financing;
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The invention of no-load mutual funds, changing the way investments were marketed and expanding demand for equities;
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The abolition of fixed commissions, intensifying competition among brokers;
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The development of scripless trading and book entry settlement, reducing back office paperwork and transaction costs;
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Creation of exchanges for financial derivatives, with implications for economic stability that, as yet, are not fully understood;
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Permission of stock exchange members to incorporate and raise capital by public offerings, leading to a weakening of personal responsibility and business ethics built on the integrity of individuals;
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The abrogation of the Glass-Steagall Act, the elimination of restrictions on branch banking, and the blurring of boundaries between types of financial institutions, creating financial conglomerates that are 'too big to fail' and too complex to comprehend;
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A gradual shift of corporate control from individual investors to institutional intermediaries, without a corresponding reassessment in the rules of fiduciary responsibility, leaving markets with ethical dilemmas, unresolved by touchy-feely resolutions on corporate governance and notions of independent directors.
The invention of ABS reduced the demand for equity.
Scripless trading and book entry settlement reduced transaction costs.
The shift of control to institutional fiduciaries created ethical dilemmas.
Institutions Are Not Eternal
For the newly-minted MBA at his or her first day of work in the financial market, the institutions may seem sturdy and eternal, but the only thing that is eternal is change.
Anyone who worked on Wall Street in 1950 and who again walked these 'canyons of finance' in the year 2002, would note a dramatic difference.
55 Wall Street, Citibank's once proud world headquarters, is now a hotel.
- Although Wall Street still exists, many institutions have moved uptown or gone elsewhere.
- The once proud world headquarters of Citibank at 55 Wall Street is now a hotel.
- Everywhere there are the scars of bronze plaques that had names of famous firms, removed and not replaced.
- Financial real estate, once extremely valuable, is leased to sandwich shops.
- Elegant bankers who came to work in Brooks Brothers suits, homburgs, and chauffeured limousines, have given way to back office workers in dirty jackets and ear muffs, pushing carts.
- The destruction of the World Trade Center in 2001 further encouraged firms to move uptown or to New Jersey or Connecticut.
- The New York Stock Exchange itself, a glaring anachronism of manual trading systems patched together with a hodgepodge of electronic band aids, still rings the bell every morning and defends an out-dated specialist system, while trading moves into cyberspace, making the messy trading floor irrelevant and quaint.
Brook Brothers suits and limousines have been replaced by dirty jackets, ear muffs, and push carts.
However, change is opportunity and an understanding of current market flows makes it easier to see what needs to be done.
Opportunities From Change
In 1959, Wall Street was dominated by traditional 'white-shoe firms' that sold stocks and bonds directly to wealthy individuals, mainly through contacts at country clubs and family connections.
(The term 'white-shoe' refers to the white buck shoes that were fashionable in Ivy League society.)
In 1959, flow of funds accounts showed a radical shift in investments from individuals to institutions.
Flow of funds accounts for the five years ending 1959 show that net direct investment in equities by individuals had fallen by 60%, while net investment in mutual funds had increased 130%.
Mutual funds were being sold door-to-door and households were less likely to buy shares directly from brokers.
The flow of funds accounts indicate that investment decisions were beginning to move from individuals to fund managers.
In 1959, three young Ivy League MBAs scraped together $240,000 and bought a seat on the New York Stock Exchange, although leading brokers predicted they would fail.
These young men had noted that the 'white-shoe' firms, living off high fixed commissions, were doing a poor job of providing professional investors with research in exchange for commissions.
The 'white-shoe' firms focused on wealthy clients they had served for generations and did not realize that MBAs now made investment decisions for mutual and pension funds and demanded a more sophisticated level of research.
The three men were William H. Donaldson, Dan Luftkin, and Richard H. Jenrette and the firm they founded was to become a leading investment bank on Wall Street for many years.
Mr. Donaldson eventually become president of the New York Stock Exchange and later Chairman of the SEC.
There is no indication that the DLJ founders got their idea by reading flow of funds tables.
However, the partners of Lehman Brothers, Goldman Sachs, and other 'white shoe' firms, might have better understood the shift in supply and demand for equities if they had perused these accounts.
Once DLJ became successful and took away business, the old line firms reorganized to focus on institutional clients.
If the established firms had paid attention to flow of funds accounts, they might have been able to adapt to change with less loss of clientele.
Resistance to Change
Any proposed change in capital market operations and institutions is highly controversial.
If the better is the enemy of the good, when it comes to capital market innovation, the present is the enemy of the future.
The reason for this is that there are potent entrenched interests defending the status quo.
Securities Law: When the late Louis Loss, a renowned and esteemed professor of securities law at Harvard, proposed and drafted a logical and highly useful codification of U.S. securities law, he met fierce opposition from Wall Street lawyers who had entrenched interests in their hard-won understanding of current laws.
Cryptic laws and rules benefit the professions.
Once one has invested long hours in learning the subtleties of a 10k report or SEC Rule 10b-18, why should one not be opposed to change?
From the professional point of view, it is much better that matters of securities law be referred to by cryptic numbers and codes, linked to the securities laws of the 1930s, than by any more easily understood system that might be accessible to the public.
Even the SEC, supposedly the champion of disclosure, refers to its forms, not by comprehensible titles that indicate the contents, but by obscure form numbers understood only by those who have invested time to become part of the inner circle of understanding.
NYSE Specialists: Specialists on the floor of the New York Stock Exchange have long defended their highly lucrative privileges against changes that would result in a substitution of archaic floor operations for modern, electronic floorless trading.
Investment bankers have interests contrary to investors and issuers.
Preemptive Rights: Wall Street investment bankers oppose the introduction of mandatory preemptive subscription rights for equity holders, not because this would be unfair to investors, but because preemptive rights would lower underwriting costs for issuers and revenue for bankers.
Fund managers join investment bankers in this opposition because the see preemptive rights as limiting short-term price appreciation and therefore their management fees, although the intrinsic value of shares is preserved for long-term investors.
Buybacks and Options: Opposition to change in the buyback-option culture is particularly fierce, led by investment banks, accountants, fund managers, professional executives, and employees holding stock options.
Defenders of buybacks and options are particularly fierce.
Back Office Procedures: Any change in back office procedures, no matter how obscure, meets vigorous resistance from institutions who have huge sums invested in current systems and support from vendors of competing systems.
Scripless trading, book-entry settlement, delivery-against-payment, same-day settlement, and many other buzz words of the world of securities administrators have all been battle cries of this or that faction in the endless battles for change.
Defenders of the Status Quo
Since corporations are creatures of the state, they are subject to rules enacted by legislatures and hidden bureaucracies, guided by an unknowable library of tax regulations and securities market rules.
Entrenched interests must be conquered, including those of lawyers, accountants, professors, regulators, systems manufacturers, and politicians.
Since corporate securities fall under the power of government and Congress, all matters related to capital market reform, innovation, and improvement are subject to determined and well-financed political controversy.
The entrenched interests that must be conquered are not only those of Wall Street institutions, defending revenues, but also of lawyers and accountants whose knowledge of the current system is at risk, professors who have books defending current theories, tax regulators fighting reduction in government revenues, securities regulators defending their turf, systems manufacturers promoting or resisting changes that favor or endanger their products and services, and politicians of all stripes, catering to the prejudices of the masses and the cajoling of lobbyists.
Fear Of Unintended Consequences
Because of the complexity of the capital market and the high likelihood of unintended consequences from reform, resistance to change has a positive side.
Capital markets are complex structures of rules, laws, and customs that depend on the confidence of millions as to the stability, reliability, and permanence of institutions.
Resistance to change has a positive side.
Therefore change, while necessarily, is best when hard fought.
Some change can be effected by a small group of people, such as the marketing changes introduced by Donaldson, Luftkin, Jenrette in the 1960s, or the pioneering efforts of Charles Merrill in the 1920s.
Other changes depend upon building consensus and support from many parties.
Innovation may originate from any of the many different participants in the market, not only Wall Street institutions, but also regulators, legislators, propagandists, academics, and supporting professionals, like lawyers and accountants.
Before proceeding, check your progress:
Self-Test
New products introduced into the U.S. capital market in the last 50 years included:
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Donaldson, Luftkin, and Jenrette saw a business opportunity in what change in market behavior?
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A group that has strongly defended their special privileges on the New York Stock Exchange are:
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