Ask anyone the purpose of agriculture, they will tell you that it produces the food which we eat. Indeed they will think it strange you needed to ask. The same goes for the auto industry, retail, or pharmaceuticals. Ask the same question about finance, however, and many will have trouble coming up with a coherent answer.
Given that it is a sector that handles the collected savings of hundreds of millions of citizens around the world, this should come as something of a surprise. After all, shouldn’t we know the mission of a system that controls a pool of cash that currently amounts to no less than $85 trillion of our money and allows the people who handle it to work in grandiose office buildings with opulent boardrooms? Shouldn’t we know what purpose they serve, be able to measure their performance?
But, while financial services activity makes up 7 percent of the British economy – more than five times the value added by agriculture – and accounts for 20 per cent of the value of the New York Stock Exchange, its arcane workings, and their purpose are a mystery to many non-specialists.
This widespread ignorance is worrying is because if we do not understand the purpose of the finance industry we are unable to assess whether it is doing a good job. And we are certainly in no position to judge how it might be improved.
This failure to focus on purpose is one reason the sector is currently beset by a host of problems and issues. They range from continuing crises, to the failure on the part of banks, pension funds and insurance companies to provide adequate oversight of the companies in which they invest; they include a corrosive short-termism when it comes to trading stocks; and a tendency in the UK and the US to use worker savings as a virtual cashpoint, as intermediary after intermediary takes their cut of each transaction.
So how did we get to such a pass?
Origins of the finance industry
When many of our financial institutions were established, they had entirely laudable objectives. Before that, it was difficult to save wealth or for existing wealth to be productively deployed. Ambitious people fought over land and other physical possessions because they were the only stores of wealth available. Acreage was passed from parent to child and those who did not inherit land found it difficult to begin an enterprise for their own betterment. People were vulnerable to old age, illness and catastrophic life events, with the family acting as the only safety net.
The finance industry addressed these and other issues by providing four vital services. It helped people to keep their money safe, enabled citizens to conduct transactions with others, and allowed us to share and diversify risk; indeed that is the principle purpose of the insurance industry. But above all, the finance industry provided “intermediation” between lenders and borrowers, a system that can “take money from point A, where it is, to point B, where it is needed”, as the third Lord Rothschild once put it.
Without such an infrastructure, economic development is well nigh impossible. Indeed, you will not find a single advanced economy that does not have an advanced financial system. Finance handles everything from keeping safe the savings of the poorest people, to the funding of giant companies; from helping us transfer money to saving for a pension.
An uncomfortable truth
But an industry which may have started as a way of creating wealth for others has morphed into one that has become positively awesome at creating wealth for itself. To be clear, there is nothing wrong with making a profit, provided that the profit was made by serving customers well. And that is where finance has failed.
For evidence of this we need look no further than a landmark study by Thomas Philippon, professor of finance at New York University, published in 2012. His investigation into the productivity of US finance tracked how much money had been lent to and borrowed from the finance industry since the 1880s and calculated how much this activity has cost.
His central finding is as remarkable as it is simple. In a world where modern science, technology and smart management have relentlessly driven down costs, there has been no reduction in the costs of the financial sector. Philippon estimates that on average, the finance industry charges about 2 per cent for each “intermediated” dollar, that is, each dollar “used to pool funds, share risks, transfer resources, produce information and provide incentives”.
This apparent freezing of productivity might come as a shock to anyone who has observed the vast expansion in financial activity over the past few decades. While it is true that the scale of lending, securities trading and so on has mushroomed, most of this is trading within the financial system itself. Philippon looked at the borrowing and lending that the financial services sector undertook with the outside world, because that is its ultimate customer, and where it ultimately adds value.
His work suggests there may have been increases in productivity at a micro level, (there is lots more trading going on), but the benefits of that gain have been distributed far more within the finance industry itself, than to the outside world. We can see evidence of this in the proportion of US income that has gone into the finance industry over the years. In 1950, the financial sector accounted for just 4 percent of GDP. By 2010, that figure had doubled to 8 percent.
A Philippon observes: “The finance industry that sustained the exansion of railroads, steel and chemical industries, and later the electricity and automotive revolutions, seems to have been more efficient than the current finance industry.”
Compare financial services’ dismal record with other industries and the results are salutary. During the same 130-year period examined by Philippon, US GDP per capita, an approximate measure of national productivity, increased about tenfold. Given the finance sector’s leading role in the economy, its century-long stagnation represents a huge drag on growth rates.
So what can be done about a status quo that sees bankers, investment managers and hedge fund executives so handsomely rewarded even when, in aggregate, they preside over the stagnation in productivity of a sector which could make so much more of a contribution to the common good?
A crying need for transparency
In What They Do With Your Money, we make a number of suggestions. Perhaps the simplest one is that we need greater transparency. If citizens are going to be offered investment products, should they not know how much they cost to run? We can think of no market which is likely to work well when customers have little idea of the cost of the goods they are buying. But in investment management, the charges we are told about are often but a fraction of those deducted from our accounts. One landmark study was undertaken by the UK Railway’s pension fund. It had been told by its fund managers that it cost £75 million a year to manage its investments of over £20 billion. But after exhaustive investigation it was discovered that the cost was actually £290 million. That means that around 30% of the annual return had been disappearing in fees without the fund or its beneficiaries being aware of it.
Part of the problem is that the chain of specialists involved has reached a “reductio ad absurdum point”. The people and institutions that we entrust to act on our behalf have become so numerous that much, if not most, of their compensation comes from other agents rather than from us directly. As a result their business models are geared towards serving one another. Provided that savers, the economic principals who have put their money at risk, or who are signing for a loan, will go along with it, then the system will continue. And the agents will profit.
The agency system has become so large that it dwarfs what we think of as conventional finance. John Kay, the economist who chaired a UK investigation into the financial sector, concluded that British banks engage in around $7 trillion of lending each year. But only around $2 trillion of that is to the nonfinancial service sector or, in Kay’s words, to “businesses that do things”. The remaining $5 trillion effectively represents the banks trading among themselves – creating income for the intermediaries.
Missing out the middle man
Just the simple act of allowing us to know what is charged to or accounts would help the finance industry provide better services. We might decide to choose a low cost, or a high cost option for our savings. But at least we would know what we were paying.
There are scores of simple reforms like that which would help improve finance, and make it better fit for purpose. As we note in the book, the answer lies not in a single “grand plan” but in a series of reforms. We need to think how the checks and balances within the finance industry can be used to help it deliver to purpose.
What we don’t need is ever more products and ever more regulation. Today we have literally tens of thousands of funds through which you can save for a pension. Yet not one of them will tell you the full cost of managing your money. Nor do we need the explosion of regulation we have seen in recent years. In 1990, there were 3,000 pages of regulations in the UK covering pensions. Today the number is north of 80,000.
Solutions lie not in ever more complex algorithms but in a return to the basic tenets upon which successful financial systems depend; a return to ownership rather than the trading of assets; a return to institutions that will act in the customer’s best interests even when there is no short-term profit to be made; a return to transparency and trust; and a return to common sense.
What They Do With Your Money: How the Financial System Fails Us and How to Fix It, by Stephen Davis, Jon Lukomnik, and David Pitt-Watson is published by Yale University Press.