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Crony Capitalism
Aug 23, 2010

Capitalism is the dominant economic system in the world today. Despite the events of the last three years, it has proven itself to be an effective system for economic and material prosperity. The richest countries in the world have capitalist systems, as do the fastest growing emerging economies (China is not officially a capitalist society but it is one in reality).

Capitalist systems need other elements to work properly. First, the system is very unequal in terms of its income distribution. So it is necessary for governments to tax and redistribute some of the wealth all countries have this to varying degrees. Second, capitalism needs an effective set of rules and regulations. This is especially the case in the financial markets area. Over the last three years, we have witnessed how a lack of effective regulation nearly brought down the global financial system.

What makes capitalism work? One of the most important elements is having the right incentive structure. Good behavior should be rewarded while bad behavior should be punished. A company that produces good quality products at reasonable prices will be rewarded with higher profits. Similarly a company that produces poor quality products is likely to fail in the long run. A company always strives to make better products more efficiently. If they don't, another company will, and take all their market share.

The bottom line is that companies must have the threat of going bust. When it comes to banks, things are a little different. Banks hold citizens' money, so we must ensure that they can always fulfill those liabilities if need be. As a result, the government will tightly regulate what banks can and can't do, to ensure they are solvent. In the event they go bust, governments will reimburse depositors (up to a certain amount).

The large international investment banks make significant sum of money from trading profits. It can be in the hundreds of millions of dollars per day. Their trading operations range from executing client orders (and taking a commission) to make their own bets on which may markets will go (known as prop trading).

Prop trading is a risky business. There is a risk of losing money, much like is the case for any retail investors who buys stocks. As individual investors, we know this risk and accept the loss if our stocks turn out to be bad. Banks can get it wrong too. And they did. Banks took large losses on trading bets that went wrong, particularly in the mortgage markets. What happened? I'd like to say that the banks went bust, were punished for the behavior, and the next bank didn't dare make the same mistake. But no, this is the exact opposite of what happened. Instead, governments around the world pumped money into the banks, bailing them out, and effectively absorbed their trading losses. Today they are back to record making profits, but I don't see the taxpayer getting any of that back.

I am fully supportive of individuals, businesses, and funds using the markets to make a profit. The more market participants we have, they more efficiently they function. What's important is that people who invest in the market have the risk of losing money. This ensures they always try and make sound investment decisions. Imagine if you bought a stock. If it goes up, then you make a profit. If it goes down, the government bails you out and you don't lose anything. What would you do? Probably buy a lot of stocks. After all, it is risk free for you. Well, this is exactly what happens with the banks. They take high risks so that they end up with a large profit or a get a bailout and lose nothing.

This is exactly the kind of behaviour that leads to unstable financial markets. If we want to prevent the next crisis, we have to ensure that banks are not such risky entities. The taxpayer should not back entities that want to make bets in financial markets. Otherwise, their incentive structure is flawed. Those institutions that wish to invest in the markets should be separate from the banks, and not given a bailout in case their trades go bad.

Capitalism can be an excellent system with the right incentive structure in place. What we have now is a crony capitalism whereby gains are privatized but losses are socialized. Let's hope governments and regulators around the world recognize this and act before the crisis comes. This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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