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How to bring back the invisible hand of the market
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How to bring back the invisible hand of the market

Joshua Roberts Weekly bulletin May 2018

‘Oligopoly’ is not the kind of word PR teams generally advise their chairman to use when describing the sector in which his company is one of the key players. So when Bill Michael, chairman of KPMG’s UK business says of the Big Four accountancy firms that “We are an oligopoly – that is undeniable”, it is probably advisable to take him seriously.

Michael’s remarks were made in the wake of a parliamentary report urging the competition regulator to consider breaking up KPMG, Deloitte, EY and PwC, itself triggered by the collapse of Carillion. The subsequent investigation concluded that, with all four firms having been involved in audit and consulting work with the government contractor over the past 19 years, they had operated as a “…cosy club incapable of providing the independent challenge needed” to make an effective assessment of Carillion’s health. There is also an increasing body of opinion holding that the inherent conflict of interest in providing both consulting and audit services is simply irreconcilable within any one firm.

The threat to the Big Four is topical this week, but it is also representative of a much broader trend. The three decades that followed the fall of the Berlin Wall and the ‘end of history’ have largely been a story of consolidation, with businesses, economies, and political territories forming ever larger unions. These political and economic unions were supposed to reduce conflict by aligning countries’ interests and stabilising those economies most prone to collapse. Business mergers would increase efficiency, leading to lower prices and better service for consumers, and higher profits for shareholders.

As we now know, the reality fell somewhat short of these lofty aims, and we are now seeing a reversal of the consolidation narrative – call it fragmentation. The splintering of political and economic ties has been evident for some time in everything from Brexit to America’s new attitude to international trade, with the UK trend strengthening in recent weeks due to a renewed push by the SNP for Scottish independence. In business, even as the sizes of pharmaceutical and technology mergers reach ever-dizzier heights, we may be starting to see the first serious re-evaluation of the ‘too big to fail’ firm since the financial crisis.

Naturally, the first cracks appeared in the financial services sector in direct response to the crisis; it simply took so long for the relevant legislation to be passed that the full effects have only been felt relatively recently. In April this year, Barclays became the first UK bank to ring-fence its retail arm, separating it entirely from the investment bank and suffering a downgrade of its long-term debt rating to just one level above ‘junk’ due to the resulting loss of funding diversification. By 2019, regulators will require the other two largest UK banks – HSBC and Lloyds – to undergo the same process, presumably with similar results.

More pernicious has been the loss of faith in large firms being able to avoid the conflicts of interest associated with supplying multiple services for the same transaction (both debt advice and lending, for instance, or advice to both sides of an M&A transaction). One consequence has been the rise of so-called ‘boutique’ firms – small companies providing only one type of service to their clients and thereby avoiding any hint of conflict. In recent months, such firms have been advising on even the largest deals: Blackstone’s recent acquisition of a $17 billion stake in Thomson Reuters was its biggest deal in over a decade and was advised by the three-month-old Canson Capital Partners.

If this pattern spreads through to the professional services sector, aided by the regulator-ordered break-up of the largest accountancy firms, we will be seeing a fundamental change in how economic risks are distributed. On the one hand, ‘local’ or ‘counterparty’ risk will increase: as we have already seen with Barclays, smaller companies with less diversified businesses and funding sources will not be as credit-worthy as larger ones. This will increase the due diligence requirements for those seeking service providers, but it will also simplify this due diligence by orders of magnitude by reducing the complexity of the firms being assessed.

Far more importantly though, the end of the ‘too big to fail’ firm would finally bring about a genuine reduction in systemic risk: not just a buffer in the form of increased capital requirements, but a situation where even the largest company could fail without imperilling the economy. Raising the spectre of failure would also promote competition among such companies. Two and a half centuries ago, Adam Smith famously used the concept of the ‘invisible hand of the market’ to argue that market forces, not government favours to a few over-powerful merchant elites, should determine how resources were allocated. Recent experience would suggest that there are still a few who would do well to feel its effects.

Upcoming economic releases
• Tuesday: UK Public Sector Net Borrowing for April, expected at £7.1 billion (up from -£0.3 billion last month)
• Wednesday: Preliminary Eurozone PMI figures (Manufacturing expected at 56.0 down from 56.2; Services at 54.7 same as last; Composite at 55.1 same as last)
• Wednesday: UK CPI inflation data (expected at 2.5%, same as last month)
• Thursday: UK Retail Sales (Ex-Auto expected at 0.4%, up from -0.5% last month)
• Friday: UK GDP growth for Q1 2018 (no change expected from the advance figure of 0.1%)

 

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