Why are financial industry paychecks so big?
The answer is simple, and it is the one Willie Sutton is supposed to have offered when asked why he robbed banks: “Because that’s where the money is.”
Those who want to do something about bringing that pay down ought to focus on why there has been so much money in the financial sector in recent years. It should be no surprise that people in that business wanted to be paid a lot; the surprise should be that there was so much money to go around.
For whatever reason, the money was there in recent years as never before.
The government estimates total financial industry profits each year, and it is easy to compare them to the size of the economy. In the six decades from 1929 through 1988, those profits averaged 1.2 percent of gross domestic product — and never went above 1.7 percent.
Then they shot up in the 1990s and went up further in the current decade, peaking at 3.3 percent in 2005. Even now, the figure is higher than it ever was before 1990.
Why were those profits so high? And did society get its money’s worth out of them? If those surging profits reflected the financial industry’s success in helping the real economy, we might be jealous but not contemptuous. You don’t hear a lot of carping about how Bill Gates and Steve Jobs became so wealthy.
There is no doubt that the allocation of credit — a primary function of the financial industry — is a crucial function, particularly in an economy undergoing change. If the finance business has done a great job of that, of directing money to where the new opportunities are, then there is no reason to begrudge them their wealth.
Unfortunately, there is little evidence that the financial industry’s success has done much for the rest of us. Capital was not well allocated during the recent bubbles, to say the least. The fact we had bubbles testifies to that.
Moreover, Robert Barbera, the chief economist of ITG, points out that in the middle of this decade there was a surge in borrowing by the rest of us — households and nonfinancial businesses — that was much larger than the simultaneous growth in the economy.
The last time that happened, he points out, was in the late 1980s, just before the previous banking crisis. Perhaps he has found an indicator that a systemic risk regulator could use in a coming cycle.
But saying the success of the financial sector has not been a godsend to society does nothing to explain why it occurred.
Let me suggest a few contributors to that success:
HIGHER CHARGES It is not just all those fees you have noticed on your credit cards and checking accounts. Much more important is the growth of the hedge fund industry.
The people who managed money for institutions a generation ago charged fees that seem tiny by today’s standards. Now hedge funds normally charge a management fee of 1 percent of total assets, plus 20 percent of profits. Those fees swell financial industry profits. To generate investment returns high enough to justify those fees, hedge funds use a lot of leverage. That borrowed money creates financial industry revenue.
CONCENTRATION “In 1990, the 10 largest financial institutions had 10 percent of financial assets in the United States,” says Henry Kaufman, an economist and author of a new book, “The Road to Financial Reformation.” “Last year, the figure went over 60 percent.” He points out that bid-asked spreads are rising in some markets, which will raise profits for the market makers, and that fees for underwriting securities are also rising.
DERIVATIVES AND COMPLEXITIES Richard Bookstaber, a former hedge fund manager and risk manager whose 2007 book “A Demon of Our Own Design” warned of the crisis that soon erupted, suggested in his blog last week that banks profited from “constructing informational asymmetries between themselves and their clients. This gets into those pages of small print that you see in various investment and loan contracts. What we might call gotcha clauses and what the banks call revenue enhancers. And it also gets into the use of complex derivatives and other innovative products that are hard for the clients to understand, much less price.”
EVADING TAXES AND RULES Many of the financial innovations of recent years were not designed to increase operating profits for customers. Instead, they sought to avoid taxes, or make accounting statements look prettier, or get around regulations seeking financial safety. At their worst, they boiled down to an offer to charge a customer a dime for letting him evade 20 cents in taxes. Such transfers do nothing for the larger society.
EXCESSIVE RISK-TAKING The banks took more and more risks in recent years. Some they pushed out to others via derivatives that often were badly priced. But others were kept. When things went well, the profits rolled in. When they went badly, we got to bail them out.
Floyd Norris comments on finance and economics in his blog at nytimes.com/norris.
Read Full Article »