Less Than They Think

What justifies the bloated expenses of the finance industry, the exorbitant salaries, percentages taken off the top, the finder’s fees, the bonuses?  We have to wonder what do bankers do that justifies the added cost of their services?

The cynical view is that they “take money from one pot, skim some off the top, and put it into another pot.”  But that can be actually useful, argues Thomas Philippon, professor at N.Y.U.’s Stern School, as that money is often needed to finance start-ups or expand existing enterprises.  And since there is a real service performed and some risk in performing it, they should be compensated.

Moreover, there has been genuine innovation in designing ways to measure risk and leverage resources.  As a result, less money can stretch further and do more, and that is an increase in productivity that deserves to be rewarded.

On the other hand, of course, is the fact that all too frequently those innovations led to a reckless denial of risk.  It wasn’t so much that assets were leveraged to an alarming degree, which they were during the credit bubble.  The more serious problem was that the original assets were over-valued to begin with and repackaged to conceal the real risk they held.  Driven by frenzied competition for investors, banks failed to question their decisions and, in many cases, the risk-management procedures they put in place were circumvented or just ignored.

As Kim Stephenson has pointed out on Mindful Money, new rules are not likely to work.  “Apart from anything else, you simply start an ‘arms race’ to see who can subvert the rules most effectively.”  But just as legitimate innovation can and should be rewarded, failures and lapses can and should be punished. (See, “Tough on Pay, Tough on the Causes of Pay.”)  And the banks that are too big to fail can be broken up.

Investors who were hurt by the catastrophic collapse of financial markets and the continuing weakness of the economy are rightfully upset that the punishment never happened.  The banks, in fact, are bigger than before.  The public is upset as well.  Enormous amounts of tax money were used to bail out the industry.  That amounts to a subsidy of failure, or what has been called “moral hazard.”  There has been no lesson to learn.

So it is time to look at our underlying assumptions about the finance industry, and that is what Philoppon has done in research reported in The Wall Street Journal.  Last year, finance accounted for 8.4% of our GDP in the U.S. – compared to 2.8% in 1950.  That’s a huge increase, but Philippon argues that the value finance adds to our GDP today is 2% below its current share.  In other words, it should be a bit over 6%.  That would be a reduction of almost 300 trillion dollars for the U.S., 45 trillion for the UK, using World Bank estimates.  (See, “Number of the Week: Finance’s Share of Economy Continues to Grow.”)

Those are sobering figures.  And they provide a hint about how much of a correction would be warranted if we could think rationally about what we were getting from bankers for the money they are getting from us.