The inefficient financial sector

By Felix Salmon
May 4, 2009

Jim Surowiecki thinks that the rise in the size of the financial sector — at least until this decade — makes perfect sense:

The desire to bring back the boring, small banking industry of the nineteen-fifties is understandable. Unfortunately, the only way to do that would be to bring back the economy of the fifties, too. Banking was boring then because the economy was boring. The financial sector’s most important job is channelling money from investors to businesses that need capital for worthwhile investment. But in the postwar era there wasn’t much need for this…

The corporate world was transformed by revolutionary developments in information technology and by the emergence of new industries like cable television, wireless, and biotechnology. This meant that the economy became, and has remained, far more competitive, while corporate performance became far more volatile. In the nineteen-eighties, companies moved in and out of the Fortune 500 twice as fast as they had in the fifties and sixties. Suddenly, there were lots of new companies with big appetites for outside capital, which they needed in order to keep growing. And it was Wall Street that helped them get it… Thomas Philippon, an economist at N.Y.U., has shown that most of the increase in the size of the financial sector in this period can be accounted for by companies’ need for new capital.

I’m sure it’s true that the economy’s capital-raising needs grew sharply between the 1950s and the 1990s. But why does that mean that the financial sector should have grown commensurately? After all, there was just as much “innovation” going on in finance as there was elsewhere; the technology revolution was in many ways driven by the needs of the financial sector. Wouldn’t you expect, in that case, that financial companies would have become more efficient at intermediating between companies and investors? Shouldn’t it have been much easier and much cheaper to issue a billion-dollar bond in 1998 than it was in 1968?

Famously there was something quite cartel-like during the dot-com boom, when the big investment banks all managed to continue to charge an eye-watering 7% underwriting fee for IPOs despite the fact that most of the companies pretty much sold themselves, and similarly-sized bond issues were coming to market at the same time for underwriting fees of about 0.1% or less. And when the likes of Bill Hambrecht tried to break the big banks’ iron grip on the market, they generally failed pretty miserably.

Even so, one would hope and expect that between sell-side productivity gains and a rise in the sophistication of the buy side, any increase in America’s financing needs would be met without any rise in the percentage of the economy taken up by the financial sector. That it wasn’t is an indication, on its face, that the financial sector in aggregate signally failed to improve at doing its job over the post-war decades — a failure which was then underlined by the excesses of the current decade and the subsequent global economic meltdown.

On this view, the seven-, eight-, and nine-figure salaries pulled down by Wall Street folks aren’t a sign of how efficient they are at doing their jobs, but are rather a sign of how inefficient their companies are. As Ryan Avent says:

When you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market.


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If you want cartel-like behavior, just take a look at the investment management business. Apart from the expense of establishing backoffice and distribution networks, even the big retail funds business isn’t a capital-intensive business. It’s a fee-based service business. Even more so for the folks who sell services privately to qualified investors. Yet they raise capital in public offerings. Barclay’s “crown jewel” is their advisory business, apparently worth “billions”. Etc. Competition ought to have narrowed those sorts of margins drastically, but of course no one wants to kill the golden-egg-laying goose, so they all pretend that they’ve got this fabulous net worth.

….we’ll, we’re still here, working hard to validate the point that you make. Clearly the cartel is a tough one to break, but we feel strongly that as an efficient and transparent capital raising mechanism, OpenIPO is indeed a better mousetrap. Better for the issuer, better for the purchaser, and the one approach to underwriting that can help the buyer and the seller to make better decisions. As to the cartel, one thing that WR Hambrecht + Co has clearly accomplished is to prove to the world of issuers that the notion of underwriting risk, as it was traditionally described and understood, is largely bunk, and that a bulge bracket investment firm is loathe to sacrifice their vested interest in their large commission paying clients for the benefit of an issuing company. We’d say that the argument for a 7% underwriting fee in every situation has been proven absurd. Perhaps the recent carnage on Wall Street, the removal of a number of bulge bracket firms, and the attendant loss of trust that has accompanied the meltdown will lead to a broad embrace of the openness and fairness that OpenIPO represents. Here’s hoping.

Add in two points:

1. Productivity in the financial industry was a mirage. Productivity was measured by number of transactions, which makes little sense compared to how we measure productivity in other fields, and that overstatement was used in a variety of ways, from claiming US productivity was growing (or that it has been higher than those socialist Europeans) to meaning that higher pay was warranted.

2. Much of the financial industry is a middleman, a distributor equivalent to the company that reps for the window maker to sell products for the window maker to the end consumers. Innovation in the middle should decrease costs, not increase them and yet much of the time the opposite has occurred. Much of this increased cost was passed off as innovation but much of that has been revealed as false – easy example, auction rate securities sold as “same as cash” by overpaid middlemen salespeople who read their canned speeches off notes provided by their companies. In blunt terms, how much innovation has actually enhanced the essential job for middlemen to connect the producer with the end consumer versus? Much of the innovation was unrelated – again, an easy example would be derivatives such as CDO squared that functioned as gambling instruments for the middlemen to sell but which had zero connection with the actual underlying product.

Posted by jonathan | Report as abusive

It is all well and good, and probably correct, to argue that the financial sector is inefficient.

It is simply not correct, however, to argue that, in an industry of thousands, “a lot of people in finance [took] home billions” as Ryan Avent claims.

The distribution of income on Wall Street is skewed, but not as skewed as Avent seems to suggest.

I believe that the growth of the financial sector is due to the growth in government backing for it. Take Citi, or whatever the hell it’s called now. How many bailouts or government subsidized mergers has it had?

The financial sector has grown as implicit and explicit guarantees by the government backing it have grown. And, please, no more about free markets or deregulation. What we had was increased leverage backed up by government guarantees.

I’m for Narrow/Limited Banking precisely because this happened right in front of everybody’s eyes, and yet few people, apparently, outside of the people investing based upon it, knew that this was our system. I remember the phrase “Too big to fail” being from the S & L Crisis. Since then, we’ve had a policy of “Too gigantic to fail”. Zero learning curve.

We can’t be trusted. Since I want a market economy, I feel that we need a secure and trusted base upon which to rest it. Otherwise, next time, it will be “How’d they get too big, connected, important, powerful, to fail again?”

The rise in finance had less to do with innovation than subsidization.

Thank you.

Very interesting topic, thanks for posting.