Andrew Haldane, the chief economist of the Bank of England, once stated finance has the “ability to both invigorate and incapacitate large parts of the nonfinancial economy.”
In theory, finance represents a simple function. It facilitates the transfer of money between capital providers, such as savers or investors, and capital consumers, for instance, borrowers or corporations, who allocate those resources into (hopefully) positive net-present-value projects.
At its best, finance permits an economy to move capital from those with excess cash and little to do to those with lots of ideas but little money to implement them with. Theoretically, this creates more wealth for all than would have been possible without the capital reallocation. In economist-speak, it allows society to maximize its collective utility function. That’s productive.
In practice, however, things are far more complicated. Multiple layers of intermediaries create a tangled pathway between saver and spender, resulting in a complex web of fees, expenses, and conflicts that are often opaque to all but the most informed.
Sometimes these intermediaries enable the efficient transfer of capital between counterparties to the entity best able to take risk. All too often, unfortunately, the excess intermediation, and sometimes obfuscation, instead results in the transfer of risk to those least able to understand and price it. The latter case functions like game of hot potato — like the distribution of toxic structured-credit securities that led to the global financial crisis — where one party simply profits at the expense of the other.
Measuring the effectiveness of such a convoluted ecosystem can be difficult. But sometimes the best solution to a complex problem is to simplify.
How could we easily measure the efficiency of a given market? Well, for the sake of argument, let’s start with the listed equity options market. We could probably all agree that the options market today is far more efficient than it was 20 years ago. Volumes are much higher, and transaction costs, including market impact and trading fees, are much lower. For instance, bid-ask spreads of a mere 1 cent can be found in many options today, as opposed to 25 cents or more prior to decimalization.
So, a market that is increasingly efficient is one where transaction costs, both implicit and explicit, go down as a percentage of transaction value. With this metric in mind, how does finance as a profession fare? Turns out, not so well.
According to the Bureau of Economic Analysis, the financial sector, after removing real estate, accounted for roughly 7.5 percent of the U.S. economy in 2016. Put another way, out of every $100 of gross domestic product created, $7.50 went to finance. In 1980 that number was just $4.70.
Unlike the options market, finance as a whole is moving in the wrong direction. Worse, it’s growing faster. Over the past four decades, finance has grown at 1.2 times the overall economy. That growth is not sustainable.
Researchers at the Bank for International Settlements have even shown that rapid growth in the financial sector comes at the expense of productivity growth in other sectors. Using a sample of 20 developed countries, they demonstrated a negative correlation between finance as a percentage of GDP and per capita GDP growth. In other words, at higher levels, finance increasingly crowds out real economic growth.
That’s finance for finance’s sake. That’s parasitic. So what can we do about it?
First, those of us in the financial sector should prepare for a future where our industry shrinks relative to the size of the broader economy. Margins and incomes will come under pressure for a great many institutions and individuals in the industry, and fewer and fewer jobs will be created.
This undoing of excessive global financialization won’t occur overnight, but there are signs it may already be starting. For instance, the number of undergraduates earning business degrees last year is 17 percent higher than it was ten years ago, whereas students graduating with health care–related degrees has risen 168 percent.
The investment industry, and institutional investors in particular, need to lead the way by focusing on true value creation as opposed to value extraction. For institutional allocators that may mean distinguishing between distressed funds that strip-mine companies through asset fire sales versus those with a more constructive approach to providing financing to help a business remain a going concern, as one example.
It also means we need to seek ways to explicitly weed out misaligned organizations and disrupt exorbitantly profitable — often anticompetitive — incumbents. This could take the form of allocators bypassing certain asset managers by investing in some strategies directly or in collaboration with others. Or it could mean individual investors accessing innovative fintech products for cheaper and more efficient financial services, whether it be online banking and lending platforms or robo-advisers.
Hopefully, firms like private equity shop Public Pension Capital and start-up Responsible Capital Management can redirect the financial sector toward more customer-centric, aligned-to-purpose, and sustainable business models.
And by raising our ethical game, finance can be productive for all of us.
