Today there is an active discussion about the “purpose of business”. One important element is to make money. But the reason we can feel comfortable with businesses making money, is that in order to do so, they need to produce goods and services which customers value. As Adam Smith observed, the butcher, the brewer and the baker provide us with food for our dinner because we pay them to do so. The purpose is to give us our dinner; the mechanism is to appeal to self-interest.
But in the finance industry purpose is not so straightforward. We know the purpose of many industries: the drugs industry innovates to cure disease; the auto industry manufactures cars to bring us design choice, speed and comfort. We measure the success of these industries by how well they perform their functions.
Surely we know what function finance is there to fulfil? But try asking this simple question to your friends and my guess is you’ll often be met with a blank stare, or perhaps a jibe about bankers’ bonuses. If we are truly to master finance, first of all we need to articulate its purpose, in a way which allows us to measure how well it performs.
The function of finance
In the most basic terms, finance is there to:
1. Provide safekeeping
2. Allow us to transact with one another
3. Insure risk
4. Most critically “intermediate” between lender and borrower.
So, how well does a financial service perform this task of intermediation (how much it costs to borrow a dollar and lend it out again)?
That’s the question Thomas Philippon, Professor of Finance at the Stern School of Business, New York University set out to answer for the US finance industry. Every year, for 130 years, he looked at how much the finance industry had borrowed from, and then loaned, or invested in the “real” economy – excluding borrowing and lending between financial institutions themselves. He then worked out how much this process had cost each year, and plotted the trend.
With the help of information and communication technology, did he find huge increases in productivity? Were costs reduced? Did our collective improved understanding of how finance works help at all?
Here is the inconvenient truth. He found no improvement whatsoever. Instead, the “unit cost of intermediation” – remained, over time, close to two per cent. The evidence suggests that the finance industry which provided funds for railroads in the industrial era is as efficient as the one which funds today’s digital age. In other words the benefits of the productivity revolution of the last century or more, which has transformed most business sectors out of all recognition, has not been passed on to customers of the financial services industry.
Finance is critical to any economy. No wealthy nation is without a sophisticated finance industry and none of the world’s poorest countries have one. The benefits of an efficient industry are obvious; economic growth, social mobility, and better pensions and savings. The financial crisis of 2008 should be a lesson to all of us. If the finance industry fails to perform its purpose well, instability sets in.
So, what are the factors that help finance work well? What sort of institutions help keep costs low? How can participants get the industry to work on their behalf and to the benefit of their customers? In the last generation we have seen vast volumes of new regulation introduced; is it likely to create a better industry?
These are the questions that Masters in Finance students will address as part of their core curriculum. The new compulsory module is called simply: The Purpose of the Finance Industry.
The issues will rarely have a single definitive answer but are central to the effectiveness of our industry. How will we know if the course is a success? Well, perhaps in twenty years’ time, if Professor Philippon repeats his research he’ll find that, at last, the finance industry has become more efficient and a productive one.
Reference: David Pitt-Watson is Executive Fellow of Finance at London Business School.