Lloyd’s must adapt and innovate to remain relevant in the future

Last month, Lloyd’s of London entered the public debate about the future of the global financial industry by publishing a research paper by its bank risk division saying that some advances in technology, including machines, had made investment banking too riskier. Then, last week, the Journal of Finance newspaper published a book review that argued that this paper was wrong and lamented the fact that London had a tradition of printing money and trading insurance contracts.

The debate over what the financial industry will and will not survive is a lively one. For many, going into a financial services business seems to require little more than a high-school degree, a good grasp of foreign languages, and a willingness to shoulder risk.

Lloyd’s does not have the money or the support to face-off against the Stanford Business School, but it is a major, credible and profitable organization. Its arguments and positions deserve serious consideration.

So does a book review that focuses on the subject. As I say, the latter came from the Journal of Finance, a fairly obscure newspaper, and focused on an esoteric scholarly book, but it makes a decent case.

For those who don’t follow finance – and perhaps would like to, and for those who do – a rundown is really helpful. Over the course of the past half-century, London’s financial sector has developed very heavily into a gigantic institution. Its output of profits has reached astronomical levels; in 2010, the last year for which comprehensive data are available, Lloyd’s generated $54 billion of income from the sale of insurance in the Lloyd’s market, from issuing derivatives, and from the broking of credit default swaps. If you thought that speculation was not yet a major money-making industry, you would be wrong.

But history also shows that this model may not be viable in the long run. The financialization model that emerged during the boom of the 1970s has gradually gained acceptance, and now is enshrined as orthodoxy. With few exceptions, economists understand that this is a useful or even a desirable state of affairs. But it’s fraught with serious problems, and Lloyd’s goes to great lengths to emphasize just how serious they are.

London’s whole emphasis on financialization implies that investments have a risk profile that is increasingly similar to classic venture capital investing, in which one place bet on a new technology while another and a third somewhere else bet on that technology’s general adoption. As Eric Rosengren wrote in a Financial Times piece on the rise of the smart machine, the task for innovators is to navigate the regulatory and legal labyrinths needed to make their futures flow freely. Such capital-intense endeavors create huge pains, but they are essential to new business models, and they make London a net winner in a number of industries.

But the problem is that London has become so big that if riskier ways of investing lead to more very profitable companies, then London is likely to lose. Many of these businesses, which are large businesses anyway, will go to New York or Hong Kong, not to London. Also, global competition is fierce, and the marginal cost of raising new capital in a global economy is far lower than in the United States, which might be enough to see to that.

In addition, the conventional approach, wherein market makers serve as a stable counterweight to both individual investors and money-market funds, fails in the new world of “follow the leader.” Investors are used to entrusting their money to big institutions, and that faith is going to be threatened. The tendency is therefore to build cash buffer funds in the short run, and to assume that the fortunes of London will inevitably rise again.

This is something that the financial giant will have to adjust to, but even so, it’s a very heavy burden to place on one organization. It will be interesting to see how far it can go.

Paul Krugman wrote the book The Great Crash, but not about derivatives, and I’ve no doubt that the correct pronoun was “they” or “they and me.”

The editorial’s piece evokes my old favorite commercial, from the American bocce ball manufacturer, in which the chubby little woman in the oven suit says, “When life gives you A, B, C, D, E, F, and G, invest like you’ve never invested before!”

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