Skroupa: How can we restructure this system for a better outcome?
Lukomnik: Yes, we actually focused on how to fix it; we didn’t want to just complain. The book has both micro and macro suggestions. In order to fix a system you need to understand the purpose of a system. People often make incremental changes, but they have no idea where they are heading. The penultimate chapter of the book addresses this discrepancy, it is entitled “Capitalism, A Brief Owners’ Manual” and suggests six critical steps. The finance sector must perform its core functions in an efficient way that also affects the real economy in a beneficial way. After guiding principles are instilled, spot-fixes emerge which fail to fix the root of the issue. Restoring accountability is another barrier to overcome, and that process begins with minimizing complexity where possible. Even Warren Buffett believes that complexity is the enemy. CalPERS just abandoned its Hedge Fund program, because the complexity wasn’t worth the cost. Finding technological ways to allow retail investors to vote on corporate matters more easily can evoke meaningful change. Encouragement of collective action by institutional investors for around topics such as stewardship would reduce the free-rider economic program. Changing tax laws and disclosure laws to favor long-term ownership would improve accountability.
Advisors have a fiduciary duty. Although fees are important, success should be measured against an investor’s long-term goals, such as a secure retirement or paying for children’s tuition, not against quarterly market returns. The way intermediaries collectively receive payment needs to be more transparent. Capitalism in its very nature is about ownership, and this should be promoted. Capitalism works best when owners care and are engaged. How many investors actually feel like owners?
Governance of institutional investing also needs to improve. This can be done through improved governance structures and self-evaluations. We need boards that have a sense of that fiduciary obligation. We suggest resetting regulation to be based on purpose, rather than form of incorporation. This does not entail more regulation. I want to make that clear; it may in fact be less regulation. Today, regulation has been degraded to what I call “spot regulation.” It is based on strengthening the weakest link in the chain. The problem with that is that while the chain won’t break there, it ceases to function properly as an entire chain; instead of functioning as a whole, spot regulation results in overwrought, elliptical pieces of metal that don’t bend or connect. Today, for example, the financial sector has 100,000 more compliance officers than we did pre-financial crisis. Does anyone think it’s functioning the way it should? To remedy this, a series of fiduciary standards and disclosures need to be combined within behavioral fixes, which combine smart, hard regulation with intelligent industry self-regulation. This accountability should revolve around guidelines which would, in my opinion, improve the effectiveness of what established spot regulation is needed.
Skroupa: How did the system became so complex? Anti-regulation people might argue that the cause of complexity is due to the fact that we keep layering new regulation upon established regulation, such as Sarbanes-Oxley, and Dodd-Frank. Do you think that is the cause of complexity? Or do you think that complexity is simply a way for the system to confuse the consumer?
Lukomnik: I call the book aggressively centrist in its critique, and so I’m going to endorse portions of both of those, but neither one exactly. There is a tendency for what in organizational theory is called “regulatory capture.” Ironically, as regulations become more complex, industries become really good at finding loopholes and utilizing that complexity. It is not just regulation, complexity is layered because we start with the original system, and we forget the first rule of fixing a system: identifying the purpose. People misconstrue the effect of their micro, marginal reform on the macro-view of the system. For example, there is dispute whether high frequency trading adds liquidity. My personal view is that it does add liquidity, but mostly for large capitalization stocks that might not need it. However high frequency trading it doesn’t affect the non-financial world to any great extent, but it does vastly increase the rules, regulations, technology, and compliance demands of the financial system.
Technology could change things. Until recently, the finance industry has not been disrupted—parts of it maybe—but generally it has either co-opted or bought any disruptive technology that could reap more efficiencies. But technology is both a lurking threat as well as an emerging opportunity. A friend of mine, Jan van Eck, who owns the Van Eck fund company, claims that San Francisco is attacking New York. Between robo-advisors, block-chain and payment systems, technology has been applied to finance and for finance. It is a little nuanced, I am hopeful that while the coding may become more complex, the actual end-to-end processes become less complex.