1. I write,
Franco Modigliani and Merton Miller point out that the real assets in the economy (fruit trees, oil wells, office buildings, and so on) are all owned ultimately by households. That fact is not changed by the way that financial claims are rearranged into debt and equity. As Miller was fond of putting it, “No matter how many slices you cut, it’s still the same pizza.”
Read the whole thing. It seems as though I constantly come across folks making broad generalizations about what to do about banks that are not grounded in an understanding of what banks do. My essay is an attempt to address that problem. It was provoked by receiving a new book by Anat Admati and Martin Hellwig.
I can estimate that the average hour worked in the financial industry generates nearly 30 times the average per-man-hour profit in the rest of the economy. That’s up from six times the average in 1964.
This could very well be a question of global comparative advantage, but I find that hard to believe on the basis of the employment figures. It seems substantially more likely, rather, that the financial sector’s profitability comes from the implicit and explicit subsidies of a market with high barriers to entry.
Pointer from Phil Izzo.
Keep in mind that the interesting fact is the increase in the relatively profitability of the financial sector. I think this creates quite a puzzle.
Have barriers to entry increased? Not in any obvious way. Much of the infamous deregulation that took place since the 1960s was designed to increase competition, which should have reduced profitability (Gary Gorton even argues that we need to reverse that, to increase profitability in finance in order to give banks an incentive to hang on to their franchises). We got rid of restrictions on interstate banking. The erosion and repeal of Glass-Steagall were hailed at the time as allowing commercial banks and investment banks to compete on one another’s turf.
Has the subsidy increased? That is a more difficult question. But I do not immediately see how it has.
If one thinks in terms of natural forces, for an industry’s profits to increase, one needs some of the following:
1. An increase in demand.
2. An increase in efficiency.
3. Enough barriers to entry to maintain profit margins.
I suspect that (2) is very important. Off hand, would not finance benefit more than other industries from information technology?
I would tell a story in which the main barrier to entry in finance is the value of reputation. In other industries, innovation creates opportunities for upstarts. In finance, it is more likely to create opportunities for those few incumbent firms that adopt technology quickly and intelligently, because upstarts cannot establish reputations rapidly enough. Thus, one might expect to see a big expansion of profits in the industry as a whole, concentrated in a relatively few firms.
Incidentally, this model may fit higher education going forward. If the Internet creates opportunities for tremendous increases in efficiency, then the “profits” may accrue to universities with strong reputations who adopt technology quickly and intelligently. I would prefer to see competition from upstarts, but first someone must find a way to overcome the reputation advantage of the incumbents.
In the spirit of making the best argument, the main barrier to entry into finance isn’t a barrier per se, it’s an inelastic supply curve of good money managers. What we see in those profits is that allocating capital has become very hard. It’s not coal, steel, cars… It’s the next iPhone.
One reason Japan did poorly was a state directed technology policy. A big goof in the 90s cratered the industrial giants in a coordinated way.
You may point out that many on Wall Street earn big doing poorly. The problem is information–finding the next big money manager. Most of those fanciful dressed Wall Street people are out the door unemployed within years. They usually have excuses but most are squeezed out.
What about changes for other industries?
The movement in relative profits could have come from either changes in finances OR changes in the non-finance sector.
I’d expect that the real productivity of the financial sector is very high compared to other sectors.
The productivity of the financial sector could be thought of as the increase in productivity that other sectors enjoy due to having finances available. As an example, if financing improves productivity by double, then the productivity of the financial sector is equal to half the total productivity of all other sectors.
The article arguing that bank deposit-equity split is determined by household preferences ignores the subtle points of pricing risk. Society may all go geriatric and have 100% preference for deposits over equity, but that doesn’t reduce the uncertainty on the asset side of balance sheet, probably increases it. Applying a neat 5% volatility of normal distribution is one of the tools that was used to attach an aura of mathematical purity to the bank model. However in practice it relies on the society holding unspecified amounts of implicit equity in the banks revealed during periodic crises. Equity that receives no dividend, unlike explicit equity. This is one avenue of subsidy. Then there is explicit subsidy via the Fed (interest on reserves, implicit put options underlying asset prices).
This is probably the most intricately constructed framework of power in human history. Quite elegant to an outside observer.
“Incidentally, this model may fit higher education going forward. If the Internet creates opportunities for tremendous increases in efficiency, then the ‘profits’ may accrue to universities with strong reputations who adopt technology quickly and intelligently.”
Hah, don’t make me laugh, the technology rollout at universities is a joke. They experiment here and there, then do nothing of import. It’s just not as rabidly competitive a market as finance, so the universities will be destroyed much easier.
Kling argues in the article linked that investors don’t want more equity, largely due to agency problems. (It’s easy to imagine other reasons, including loss aversion. And most stock market capitalization is in large stocks, which don’t have the same agency problems). But according to Kling’s own logic, the pie is always the same size, so the larger the equity slice, the more safe it is. And more equity doesn’t simply have to mean more stock equity. For instance if the Fannie and Freddie balance sheets were sold to the public as mortgage reits, there would be far more public, unlevered ownership of the housing stock. Much of the Fannie debt is owned by financial institutions, but it could just as easily be owned by individuals.
*or ownership of mortgages, not of houses.
*loss aversion is definitional, but the point was that equity is not just lower in the capital structure, it also owns an option, which is more volatile.
What portion of the increased profitability of the financial sector is the result of globalization? 1) The expansion of industry into developing nations has required financing. 2) Wasn’t it back in the 1990s that Greenspan talked of a global savings glut? All that extra cash has to be managed, and that leads to additional profits. 3) I assume that all international investments have to be hedged against a variety of risks–currency risks, political risks, standard risks relating to a firm’s profitability, etc. Each separate hedge probably generates profits for the financial industry. 4) The amounts of money involved in all these transactions is enormous, even in comparison to the large compensation of the financial industry. Thus taking a small portion of an enormously large amount results in huge profits, in Soltas’s terms, “per man-hour-worked.”
See also Steve Waldman’s comment:
http://www.interfluidity.com/v2/4043.html
I think you can make a plausible case that changing tax policies, changing Fed policies, and informal bailout policies have combined to favor debt more over the last forty years.
“Has the subsidy increased? That is a more difficult question. But I do not immediately see how it has.”
I think the perceived subsidy may well have increased, even if the real subsidy did not. Remember that we’re talking about an implicit subsidy anyway — that is, the government’s willingness to bail out failing banks. In the 1970s, banks might have thought bailouts were possible, but with a relatively low probability. But then, as bailouts happened in reality (first Continental Illinois, then Mexico, then Long Term Capital Management), the probability estimate increased. If the implicit subsidy is pB, where p is the probability of a receiving bailout B, then the implicit subsidy rose because of rising p.
Overcome reputation problem by buying a somewhat respectable but having-trouble smaller university? Maybe there too many non-profit-related problems to solve in trying to take over any known school.
Re higher ed: Technology is enabling innovative players to scale their enterprise rapidly. But if everybody can take MIT and Harvard’s online courses (EduX), what happens to their reputational value?
The coming education system shake-out (higher and then lower ed) is going to be pretty dramatic and traumatic for marginal participants. Will the cost and quality benefits to students offset the potential destruction of the US research complex? What will arise to replace the latter?
I finally finished reading your linked piece. I agree that increasing bank equity is not the answer, though it does have the benefit that share-holders are more likely to pay attention to what the bank is doing than depositors do. To the extent that most savers are not qualified to judge what the bank is doing, as you claim, perhaps more equity isn’t the solution. However, I completely disagree with your implicit approval of households’ “ability to use the funds on deposit at any time” as “highly desirable” to them.
The fundamental problem with banking is the instability this demand deposit promise causes, particularly in bad times when the bank makes mistakes, ie Diamond-Dybvig and the resulting bank runs caused by deposits available “on demand.” I see no reason why demand deposits should be such a high proportion of bank liabilities, as opposed to time deposits like CDs, which make up less than 20% of all deposits, and have penalties for early redemption. In fact, it’s amazing how little debt, which you praise, makes up of a typical bank’s balance sheet, less than 15%, according to the Fed.
I think the solution is to have depositors hold actual time deposits and bonds, which have clear dates when they can be redeemed. This takes a lot of instability away from the bank while not changing much for the depositor, as the vast majority of demand deposits are rolled over most of the time anyway. In good times, they will still be able to sell their bonds into liquid markets or perhaps even redeem their time deposits with little to no penalty, which is up to the discretion of the bank. In bad times, they won’t be able to start a bank run, either because liquidating the time deposits would have onerous penalties or because the secondary market for their bonds would have dried up.
Also, rather than have all their money put into a black-box portfolio of loans that they have no idea about or control over, you could let them choose to only put their money into bonds for “green” companies or dividend-paying stocks, with the presumption that the latter are safer companies. You could give the saver a lot more choice and make the banking system much more stable.
Will the banks do any of this? No, of course not, they are too fucking stupid. Somebody new will have to come along and do all this, putting all the existing banks out of business.
Regarding the rise in bank profits, I think it’s a combination of all three factors you list, plus increased utility, combined with an increase in predatory behavior. I don’t know enough to rank them, but I don’t think “barriers to entry” played as big a role as the other four. Predatory behavior would consist of actions like Goldman Sachs purposely underpricing the eToys IPO back in the ’90s in order to maximize their take.
How much of the rise in profits does this bad behavior account for? I don’t know, but I wouldn’t be surprised if it was a majority.