Opinion

Felix Salmon

Why investment bank profits persist

By Felix Salmon
October 1, 2009

One of the odder riddles of the financial markets is how they can be so highly competitive and so highly profitable at the same time. The financial innovation debate seems to be helping us find an answer, as clearly articulated by Karl Smith:

It’s not that firms refuse to compete by providing consumers the best products – its that they cannot compete in this way because consumers will naturally gravitate towards products which are bad for them.

That is, if you are offering a product that is just the same as the standard vanilla product but has some hidden tail risk then you can necessarily offer it a lower price.

Why don’t firms compete on offering products with hidden tail risk, and see prices driven down that way? Because there are extremely high barriers to entry when it comes to starting up a firm offering sophisticated financial products. Also, the unspoken rule among investment bankers that you try never to compete on price has somehow become an article of their faith among their clients, too, who tend not to trust investment bankers who try to compete on price. Hence the fact that Bill Hambrecht’s eminently sensible IPO method has signally failed to catch on, while the old fashioned give-the-bank-7% method remains standard.

More to the point, as Arnold Kling says, “a lot of the trick of investment banking is to figure out a way to transfer risks to taxpayers”. If you compete with other bankers, you drive down the profitability of your industry, and ultimately your own paycheck. Bankers tend to be hyper-aware of how much their competitors are paying, and they don’t like doing anything which is likely to bring that number down.

On the other hand, if the money you’re making is coming not from your competitors but rather from taxpayers — if they’re essentially insuring the excess downside on your bets for a premium of $0 — then the sky’s the limit in terms of how much money not only you can make, but all your other competitors potential employers can make as well. What’s not to love? The only people who are liable to object are regulators, and they often have half an eye on getting a lucrative financial-sector job as well.

Comments
8 comments so far | RSS Comments RSS

Any documentation for that “7%”? I had thought that IB’s persuaded IMO companies to dramatically underprice their offerings, offering immediate safe profits to the IB’s customer fortunate enough to get an allocation, such fortune being paid for by kickbacks to the IB (higher commissions for “research”, & etc). Basically I had thought that the overall take of the IB was way way higher than 7% even if 7% happens to be the only “transparent” part of the overall cost.

But I’d really appreciate seeing an authoritative citation where I can read more about his supposedly mere 7%.

Posted by axg | Report as abusive
 

Useless industry to send best and brightest too. The only utility of traders would be if a shortage in liquidity.
If someone were to measure investment banking pay caps internationally, and combine this with ranking regulations to avoid central banker capture discussed here: http://www.economist.com/blogs/freeexcha nge/2009/10/weder_di_mauro_roundtable_th e.cfm

…you’d have superior to Ratings Agency national credit risk profile and a good metric with which to assign Drawing Rights for enacting reserve currencies. Not perfect by far, banks only 40% of USA profits and maybe 20% of market caps… but no conflict of interest unlike Ratings Agencies. And international investors would presumably want to invest in nations that send their students to do something useful.

Posted by Phillip Huggan | Report as abusive
 

Felix,
Please UNFOOL the people: show them real asset price histories, e.g.,
http://homepage.mac.com/ttsmyf/RHandRD.h tml
which show price bubbles very well — and well-shown is well-deterred, surely!
Please clean the system!

Posted by Ed | Report as abusive
 

“Unspoken rule among investment bankers.” Oh the drama!

Posted by Dogma | Report as abusive
 

Are you still wondering why Zero Hedge has such broad appeal?

 

“Hidden tail risk” is implicit in any investment, up to and including a business investing in itself. Consider a machine shop preparing to buy a new die-cutter: expected useful life, ten years. Meanwhile, some clever toolmaker is, in secret, preparing the next-generation die-cutter, which will make that investment at besst obsolescent in two years. Is that not tail risk, as it is unforeseeable ?

Bottom line, there are no guarantees in investment. You ought not blame the IB community for the deficiencies of their clientele.

Posted by Fitz | Report as abusive
 

SO what you’re saying, then, is that it’s essentially the same phenomenon as rates at big-ticket law firms, where most observers agree that customers pay a lot simply because they have no other metric for measuring quality? (And because if you lose a case with a $1000-an-hour firm at your defense, you can rest assured that you lost fair and square, whereas if you lost the same case at $100 an hour everyone would know it was because you hired a lousy lawyer…)

 

Well, if the primary way to lower costs to the average customer is to fatten the tail risk, and the tail risk is by definition unobservable, it’s a relatively rational assumption that the cheaper banks have more nefarious schemes to suck out your money. This seems to be screaming for regulation that at the very least makes those risks more obvious.

 

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