I said in an earlier post that the banking sector needed to shrink. And I promised an explanation of this. Well here it is.
According to the BEA's figures, in 1987, the contribution of the banking and insurance industries to national GDP was 5.79%. In 1997 it was 7.17%. In 2007 it was 8%. The financial sector is becoming a larger and larger part of the US economy.
This shouldn't be the case. The wider economic value of the banking sector (yes there is one!) is in the efficiency it creates in the allocation of capital. A working financial system channels money to those parts of the economy where it provides the greatest return on capital. Banking does this by facilitating direct investment; insurance does it by turning small, catastrophic risks into more likely but less impacting ones, making returns more predictable and thereby encouraging investment.
But the point is that finance doesn't produce capital; It allows it to be employed more efficiently. So if the financial sector were improving - rather than simply growing - you would expect it to become a smaller part of the economy over time rather than a larger one as it became a more efficient mechanism for deploying capital. Even in good times you would expect, if not absolute contraction, then certainly to see finance becoming a smaller and smaller proportion of overall GDP.
How has Western finance escaped this reckoning?
The first ploy is simply by leveraging 'beta'. The economy has been growing. By borrowing and investing you can make money as long as things keep going up. Things go up, you go up faster. The flipside is of course that you go down faster too. The simplicity of this ploy has largely been disguised by developing increasingly complex and opaque derivatives.
As an aside, contrary to reports in the press, derivatives are not intrinsically ruinous. They are by definition a zero sum game. If one counterparty loses money, it is only because someone else has made it. But by and large, they are a not much more than a punt on the markets. As such, they don't (intrinsically) really help to realise the macroeconomic efficiencies in capital allocation I mentioned before. And the more exotic and complex they are, the more opaque and illiquid they become, and arguably the less efficiently they allocate capital. And banks have devoted a lot of resources to developing, trading and hedging these things. This represents an abandonment of the core purpose of finance and a failure to create a macroeconomic return in capital efficiency.
Derivatives can, I believe, create liquidity and enhance capital allocation, but to do so they must be simple, transparent and not generate long-term counterparty risk. Creating ever more complex, bespoke, over-the-counter products rather than moving derivative markets onto exchanges represented a move in the wrong direction for the financial sector.
To return to the main thread: The other, more significant, engine for the imploded growth of the financial sector was charging what were effectively brokerage fees for the supply of credit to the consumerist West. It hardly needs to be said, but consumption on credit is a really bad idea. It is fundamental misallocation of capital. It produces no return at all. The mechanism is opaque but by now well studied. I won't bore you with yet another essay on the bursting of the property bubble.
But a consideration of how banking went wrong wil be vital once the dust has settled. It is clear that the cost of their catastrophic failure is society's loss confidence in Big Finance to manage the economy. It was of course always suspect to imagine that a regime run for the self-interest of employees and shareholders would, in the long run, prove more competent than a political establishment accountable to population at large. But in future, the banks will be subject to a lot more government regulation - and rightly so. What is vital is that government regulation is well thought out and intended to realise the value of a well functioning financial sector as well as just curbing the excesses. That means it needs to be about realising efficiencies, promoting transparency and liquidity, formed around principle rather than bureaucracy. This will be a difficult thing to accomplish.
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3 comments:
Hi, I surfed over from the_lady_lilly's LJ. I would disagree that complex derivatives are inherently a problem - they play more of a risk management role than a profit role . A lot of complex products are tailored to fit the risk profile of the client. Others are designed simply to take a punt on the market, but to take a punt that suits the view on the market the buyer has. Where you run into trouble is if there is a feeding frenzy of investors who don't really understand why there products seem to be so profitable (well duh, they are high risk) and then you are in trouble.
I work in IT for an investment bank in the derivs section and am sick of the general public pointing the finger. he public liked my clients just fine when they were contributing quite strongly to the UK economy, after all..
Welcome!
I'm not at all convinced that "A lot of complex products are tailored to fit the risk profile of the client." This is because I've never been able to understand what a client would have to do to find themselves with a risk profile that would be more effectively hedged by a complex derivatives rather than the judicious use of more vanilla products.
On the other hand, a lot of complex products are engineered to look very attractive and conceal substantial risks. Most offer a good 'pick up' followed by very thin tail and a large negative sensitivity to volatility. In other words, you are charging your client a big fee for the privilege of writing you options.
There may be exceptions. It may be there are some complex structured derivatives that address a real need to manage a difficult risk profile. But I think they are rare and most of the volume comes from speculation. But arguably, the clients were sophisticated enough to know better and the banks certainly weren't forcing anyone to play their bunkum games.
But this is all rather tangential to my argument. My problem is not that I think banks are ripping people off. It is that they are investing a lot in a business that doesn't seem to produce anything of wider economic value. It's not that it's bad. It's that it's a waste of money.
The main attraction of a derivative over the purchase of the underlying is that you don't have to fund the purchase of all that underlying up-front. You pay a premium upfront only, OR even a deferred premium, paying a LIBOR-based stream of cash flows. So you get your exposure to the underlier without tying your cash up for months. You also avoid a lot of the transaction costs. For example, in Ireland, any share purchase is subject to 0.5% stamp duty. This can be a significant sum if you trade regularly. As long as you and your bank are not domiciled in Ireland, you can open a CFD that will do exactly the same with no stamp duty at all. (I know you know this, but I'm sure you have tons of readers who don't comment).
I mean, I'm in IT, and have had some products explained to me as I needed to know to write the software, and I had no trouble understanding exactly where the risks were. I find it hard to imagine that mutual funds, hedge funds, other banks etc had trouble understanding this.
I am being a bit defensive because I am being asked to justify my employers' activities by all my non-banking acquaintances lately, and get a tad fed up... I know you're not doing that.
The problem that an awful lot of the activity in finance does not appear to benefit anyone outside it is not new. I reckon that the City is allowed to get away with endlessly trading with itself, because that way someone is available to take the other side of a trade or transaction that someone from another industry looking for actual financing wants. But they seem to have made the whole building fall down this time, which is irksome.
Like a bunch of really annoying blokes who are a dab hand at fixing railway signalling systems, and so you let them be a pain in the arse and get overpaid because they are handy to have around, but who manage to cause a major accident...
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