The flaws of finance

The sector is essential to the economy. But it is rewarded too highly and imposes wider social costs. The penultimate in a series of farewell blogs.

BUSINESS school graduates do not all want to work in investment banking these days. The industry does not have the same kind of cachet it did before Lehman Brothers went bust. Still, 31% of those who left Harvard Business School last year went into financial services. That made it easily the most popular sector, as it has been in each of the previous four years. It is hardly surprising. In London, for example, the average pay for a finance worker is around £72,000, twice the level earned by other workers in the British capital.

Is this high pay justified? The finance sector has four key functions. The first is to operate the payments system, without which the economy could not function. The second is to channel money from savers to those who need capital either through the banking system or through pooled savings vehicles like mutual funds. Third, it provides liquidity to the system by making markets, and thus establishing prices for financial assets. Fourth, it helps people manage physical and financial risk via insurance policies and derivatives.

These functions are all very useful. But other sectors play important roles too. The economy could not operate without power and heat, water and sewage services, public transport and public roads, fire and police and so on. These sectors do not get the same level of rewards.

Thirty years of covering finance as a journalist, in various ways, creates the risk of being “captured” by the industry. But for this blogger, at least, time has only increased my cynicism. In particular, there are few images more irritating than that of the financier as some kind of Ayn Rand hero, fighting a daily Darwinian fight in the markets in the face of interference from the nanny state.  For a start...

Financial markets aren’t free. Deposit-taking banks rely on a public subsidy in the form of deposit insurance that prevents customers from panicking in times of stress. The insurance scheme lowers the cost of funding and reduces the chance of bankruptcy. Regulation also creates high barriers to entry for banks, insurance companies and other providers. That reduces competition and thus enhances profits. Asset prices have also been heavily affected by central banks in recent decades. First, there was the “Greenspan put” when the Fed seemed to intervene only when the markets fell, not when they rose. Second, there was quantitative easing. The aim may have been to revive the economy but the effect, by boosting asset values, was to raise the “ad valorem” fees of mutual fund managers, hedge fund titans and the like. It wasn’t a deliberate public subsidy but it worked that way.

The customer tends to come second, not first. There have been too many scandals, over too many years, for this not to be true. Often these involved the sale of a complex product to a client which clearly did not understand the terms (take the Libor squared swap sold to Gibsons Greetings in the 1990s). The Libor scandal saw bankers rig a key interest rate for their own purposes, a cost passed on to the many clients whose returns, and funding costs, were linked to the rate. The problem with so many finance deals is that those inside the sector have an informational advantage; they may have designed the product they are selling, or they may be the main price setter. Blandly saying that clients should follow the principle of “caveat emptor” is not good enough. 

Skill and luck are hard to distinguish. In the boom part of the cycle, bankers earn bonuses by making loans, arranging takeovers and other corporate deals or by taking positions in markets as a principal. But those loans and deals can go wrong during the bust phase. By that stage, the bankers will have moved on. Until recently, bankers’ incentives were too skewed to the short term. Even now, one wonders if the long-term incentive deals are long enough. In fund management, looking after other people’s money has been a popular way of getting rich. But it is very hard to find persistence in fund manager performance. You get paid for being lucky.

The social costs are high. Fractional reserve banking has been around for centuries. It is the way that most money and credit is created. But it is also the greatest weakness of the banking system since its assets (the loans it makes) are long-term and its liabilities (deposits) are short-term. Modern banking piled a whole set of other activities on top of this basic model; market-making, asset management, derivatives creation and trading and so on. It can be very hard to spot where the risks are and whether there is hidden gearing somewhere on the balance sheet. The modern global bank is very complex; so complex indeed that it is hard to manage. A Parliamentary report into HBOS, the British bank, concluded that those in top management “were incapable of even understanding the risks that some elements of the business were running, let alone managing them”. That didn’t stop those managers from earning very large rewards. 

Regulators have tried, in the aftermath of the last crisis, to make banks safer by requiring them to hold more capital. But it is ten years since that crisis and the tide is turning again; the Trump administration is committed to reducing regulation. Admittedly the Dodd-Frank act was overlong and overcomplex. But the number of financial crises we have suffered over history suggests that the precautionary principle is needed; those high salaries in finance have a huge social cost in the bad times and that cost needs to be accounted for.

Wealth does not equal wisdom, but it does equal power. The roll-back of regulation demonstrates that the finance sector still has plenty of lobbying power. After all, it has lots of money; over the past 20 years, it has spent $8bn lobbying Congress. It may not be just the money talking. It is natural to assume that rich people are wise and smart and thus to defer to them; think of how many Treasury secretaries have worked for Goldman Sachs. But if those riches have been earned by luck, or an implicit taxpayer subsidy, then it does not make sense to put such people in charge.