Pulling no punches in the Library of Mistakes

Professor Russell Napier manages the Library of Mistakes to knock sense into a financial system that keeps making the same mistakes

Words: Professor Russell Napier
Engravings: ©Duncan P Walker


The heavyweight boxer Mike Tyson once said: “Everyone has a plan until they get a punch in the mouth.” The books we have here in the Library of Mistakes contain thousands of punches that have been dished out to investors over hundreds of years. We set up the Library so that people working in financial services can learn from the mistakes of the past. If you can work out some way of reacting to a punch, you’re going to be better prepared.

Everyone knows that a lot of mistakes were made in the run-up to the 2008/09 crisis but did we learn from those mistakes? There has been so much attention focused on the banking sector that some behaviours have changed there, but the same mistakes are still popping up frequently across the broader financial services market.

There’s only one thing that can change all this, and that’s to change the incentives that are given to people working in financial services. If I ruled the world, I would change those incentives. But I don’t rule the world, so I’m trying to change the way we educate ourselves.

Surprisingly, financial history is not actually taught at university. Instead, economics students are taught that human behaviour can be defined through equations. At the Library of Mistakes, we think that’s dangerous; we’re fighting back to say that finance is about equations but it’s also about sociology, psychology, politics, philosophy and more.

If the next generation of economics students moving into banking and financial services know nothing of financial history, and all the forces that determine economic outcomes, they will simply repeat the mistakes of the past, just like all the previous generations.

There was one famous development during the last banking crisis, when parents of economics students at the University of Manchester started asking their children why the crash was happening. The students didn’t know because the historical errors that were being made weren’t something that was included on their syllabus. So they — the students — demanded change, and some of them formed a Post-Crash Economics Society, which got some welcome publicity.

That was great but there is a fundamental problem in financial education and any change is piecemeal. All the universities are teaching X and we think they should teach Y. Well, where do you find the people who can teach Y? We’re critical about what they do but it’s actually very hard to change it. It’s harsh but, as Max Planck once said: “Science advances one funeral at a time.”

Yet current trends in society — such as Big Data — are pushing the mistaken idea that the equation is everything. Data is useful but it’s far from everything. A snail leaves data — it leaves a big trail everywhere it goes. But on its own, that data tells us on only part of the story.

We need a bigger crisis
So why did we create the Library of Mistakes? I’m an investment consultant and, for many years, I’ve been running a course called the Practical History of Financial Markets. I’ve also written my own book on financial history, and we have other ventures such as financial history walking tours. But the Library of Mistakes adds another dimension. It’s a physical space where people can come and read about financial history. We now also have an international branch at FLAME University in Pune, India, and are planning to create a network of branches across the world. By studying financial history, we hope to improve financial understanding one mistake at a time — and to spread that message.

Unfortunately, the crisis of 2008/09 was huge but it wasn’t big enough to change things substantially. It will take another bigger crisis to implement necessary changes such as those proposed by the 2012 Kay Review.

That bigger crisis could happen soon. The private sector debt to GDP ratio across the world is way above 2007 levels and it’s the same when you factor in government debt. You could come up with lots of reasons why the last banking crisis happened but top of the list would be too much debt — and here we are 10 years later with even more.

Furthermore, one of the great fallacies from 10 years ago is that it was all the fault of the banks — the theory that ‘if you fix the banks, you fix the problem’. But while the bankers may have been chastened, there are some really stupid things going on across the whole financial services sector, and not necessarily just in the UK but in places such as China, Turkey and Mexico. If you persist with the wrong incentives, you’ll get the wrong outcomes.

So what are the incentives that need to be changed? Private equity is a classic example. The buy-back of listed shares with debt is another. But the first thing I would do is to prevent interest expenses being deducted in the computation of corporation tax. Fundamentally, it’s not right that, if I want to finance something with equity, I don’t have to pay corporation tax on it. This tax perk for debt encourages too much leverage in the system.

The other thing I would bring in would be step dividends so that, as a shareholder, I would not necessarily qualify for the full dividend unless I’d held on to it for a period of time. Maybe after a year I’d get a third of it, then two-thirds after two years, etc. So as a shareholder, I’m probably not going to do very well by trading my shares quickly — it’s going to encourage me to hold on to them and, once we do that, the risk-taking activity of a corporation is likely to be much wiser and based on longer-term thinking. The agency problem is at the heart of most of the misaligned incentives in finance and we need to encourage behaviour compatible with ownership of capital, not merely rental.

Of course, these are all technocratic answers to social problems and politicians don’t get votes for those kinds of policies — so none of these ideas appeared in anyone’s manifestos for the last General Election. But at least there is some hope here and a little bit of momentum building.

For instance, take fractional reserve banking — the system we have had here since the 17th century. Fractional reserve banking means that, when a banking system expands its balance sheet, it doesn’t just create loans, it creates money at the same time. Most of the money in the world is not created by central banks but by commercial banks. This is the way we have been doing things, forever. However, Iceland is now talking about banning fractional reserve banking entirely and, in his recent book The End of Alchemy, the former Governor of the Bank of England, Lord King, discusses a similar approach. He draws on the so-called Chicago Plan of 1933 in which a group of eminent economists put forward proposals to American banks in the wake of the Great Depression. The plan, including the abolition of the fractional reserve system, caused much interest and discussion at the time, but attempts to legislate the recommendations were thwarted.

As I argued earlier, we can’t reform the system here until the next crisis forces us into action but, when that happens, I think some pretty radical things are on the agenda — and banning fractional reserve banking could be one of them.

“It’s difficult to be radical when you’re bound in regulation. A government doesn’t need to own a bank to control it; it just needs heavy regulation — and banks today are smothered by it.
They’re sitting targets for fintech and any other market disruptors. They’re like Lancaster bombers without bombs or guns, surrounded by fighter pilots picking off any bits they fancy”

Lancaster bombers without bombs
As things stand, there’s nothing radical happening with UK banks but it’s difficult to be radical when you’re bound in regulation. A government doesn’t need to own a bank to control it; it just needs heavy regulation — and banks today are smothered by it. They’re sitting targets for fintech and any other market disruptors. They’re like Lancaster bombers without bombs or guns, surrounded by fighter pilots picking off any bits they fancy.

Historically, large banks invariably become poodles of the state and, when that happens, what’s the point in planning for the future? You might as well just do what you’re told. I know banks will dispute this and say they spend a lot of time in rooms coming up with big plans for the years ahead but, ultimately, a lot of what happens is down to the regulators, and that’s very frustrating if you’re trying to turn a bank around.

And then there’s the whole customer service issue. Take Metro Bank — it’s a model that worked in the US and it seems to be working here. They are so focused on customer service that they seem to get away with paying relatively low interest.

You can take your dog into Metro Bank ‘stores’, and they’ll provide dog treats and water bowls. That shows they trust you — and trust you to look after your dog. But as Metro Bank’s founder, Vernon Hill, says: “All you need to know about British banks is that when you walk into a branch, the pen is on a chain.”

Of course, the big UK banks know they need to change their customer relations for the better and rebuild all the trust they lost, but those changes are hugely challenging given the IT, employment, pensions and property legacies they’re saddled with.

One possibility is to go back into history. If the banks want to re-establish trust, there is a lot of history they can make use of — for instance, Lloyds Banking Group has been clever with what they have done in Scotland with the Henry Duncan Awards.

And I think it’s important to also acknowledge that we all make mistakes — it’s just that if you’re working in finance, those mistakes are much more readily exposed. I know university academics who still believe in Marxism but nobody is going to fire them because they got that wrong. It’s not like that in banks.

And I make as many mistakes as anyone. I’ve been spending 22 years advising institutions on where they should invest their money. Anyone who does that for a living and gets 60% right would be considered a genius. I won’t even claim 60% but, by definition, 40% of everything I have done is a mistake.

In defence of finance, that’s why we’re often wrong — we live in the future. Mistakes are just part of what we do and, rather than hide them and try to forget them, we should learn to embrace them. That’s why the Library of Mistakes is important.

A trip to the Library?
It’s free to register as a Reader of the Library of Mistakes, enabling you to arrange a visit should you be visiting or working in Edinburgh. Quiet, secluded, with a wonderfully quirky charm, it’s a perfect place to while an afternoon away, dipping into the two rooms of books, and learning from the many mistakes of others. You can check the books available on the website. libraryofmistakes.com


Based on an interview with Fraser Allen, CEO at White Light Media

Professor Russell Napier, the Keeper of the Library of Mistakes, is founder of the Practical History of Financial Markets and author of The Anatomy of the Bear (2007), which predicted the global banking crisis of 2008/09. He is also a non-executive director of two listed companies, advisor to three fund management organisations and owner of the investment consultancy Orlock Advisors.