‘No evidence’ of financial service productivity gains

The productivity revolution of the last century or more, which has transformed most business sectors out of all recognition, has passed one of them by – financial services.

Despite computerisation, despite sophisticated mathematical modelling and despite mega banking mergers leading to colossal economies of scale, the finance industry is no more productive today than it was when John Pierpont Morgan bestrode Wall Street in the early years of the last century.

That is the startling conclusion of Thomas Philippon, Professor of Finance at the Stern School of Business, New York University, who explained his findings at London Business School's Leading Minds Lecture, on February 3.

Setting the scene, David Pitt-Watson, Executive Fellow, Finance, London Business School, said Philippon’s work is critical because intermediation “sits at the core of what the financial industry does…there is no economy without intermediation”. 

No-one could have been more surprised by his findings than Professor Philippon himself.

“When I started my research in 2006, I was sure I would find large productivity gains. There were two reasons for this.

“The first was Adam Smith and what he taught about specialisation and the division of labour. As financial intermediation has become more specialised, bank managers no longer need to handle every aspect of the transfer of money from savers to borrowers.”

The second reason, he added, was the arrival of computers. “We know that finance uses more computers than the average industry, and that industries with a high IT intensity tend to show productivity gains.”

Despite these two apparently-powerful factors, he said, the reality was very different. “There ought to have been efficiency gains,” said Professor Philippon. “But they are not evident.”

Instead, the “unit cost of intermediation” – the sum total of wages and profits taken by the financial services industry – remains, over time, close to two per cent. During the past 130 years, there has been no productivity increase in finance

He contrasts this with the vast productivity improvements seen at, for example, America’s retail giant, Wal-Mart [note to editors: this is the company name, but the on-line store is Walmart]. And he contrasted also the behaviour of customers when buying goods, clothes, holidays and other products with their behaviour in the market-place for saving and investment products.

“Consumers seem to be very smart at finding the lowest price for everything – except financial services,” said Professor Philippon. “They pay too many fees, that is a fact.”

He made a partial link with the recent financial crisis and subsequent loss of trust in financial services, which has, in turn, led to the employment of many more people in monitoring and compliance roles, a development that, in turn, lowers productivity. In a similar vein, the professor added that the Big Bang reforms of 1986, which merged the City of London’s partnership businesses into huge new investment banks, may have been mistaken. “The partnerships – there was more trust and maybe it was more efficient,” he suggested.

Professor Philippon said his figures for the cost of financial services remained flat over time even when adjusted for developments such as the extension of mortgage and other credit down the income scale during the past 50 years, which inevitably creates more administrative overheads as each piece of lending is smaller.

Concluding, he said the lack of productivity gains should be a cause of concern for financial regulators. Furthermore, he said: “It is not surprising that some borrowers and savers are not happy with the service they are receiving.”

They may be less happy still if, as Professor Philippon suggested, efficiency gains finally show up in the sector as a result of wide-scale closure of bank branches.

Edward Bonham Carter, vice-chairman of Jupiter Fund Management, responded to some of the points raised. He said: “I am a great believer in markets [but] they are not perfect and we can do better.”

He said the gross value-added of the financial services industry accounted for ten per cent of UK gross domestic product.