Thomas Philippon of NYU in this amazing paper points to another paradox of financial industry.
Paul Volcker had famously quipped that the most important fin innovation is ATMs! And BTW, ATMs is more of a technological innovation to deliver cash without going to a bank.
Just extending Volcker’s thoughts to general finance, one would imagine cost of fin intermediation might have declined with rise in technology. So financial innovations like CDS, CDOs etc may not be innovative per se, but atleast we should be seeing costs of intermediation declining over a period of time. Right?
Wrong. Philipon shows that cost of financial intermediation has been going up despite all these technologies:
Historically, the unit cost of intermediation has been somewhere between 1.3% and 2.3% of assets. However, this unit cost has been trending upward since 1970 and is now significantly higher than in the past. In other words, the finance industry of 1900 was just as able as the finance industry of 2010 to produce loans, bonds and stocks, and it was certainly doing it more cheaply. This is counter-intuitive, to say the least. How is it possible for today’s finance industry not to be significantly more efficient than the finance industry of John Pierpont Morgan?
The cost of intermediation grows from 2% to 6% from 1870 to 1930. It shrinks to less than 4% in 1950, grows slowly to 5% in 1980, and then increases rapidly to almost 9% in 2010.
What happened? Why did we get the bloated finance industry of today instead of the lean and efficient Wal-Mart? Finance has obviously benefited from the IT revolution and this has certainly lowered the cost of retail finance. Yet, even accounting for all the financial assets created in the US, the cost of intermediation appears to have increased. So why is the non-financial sector transferring so much income to the financial sector?
The comparison with Walmart and retail is interesting. What is the reason? Most technological developments have led to rise in trading. Moreover, rising trading has not led to any such gains like more information and more insurance:
One simple answer is that technological improvements in finance have mostly been used to increase secondary market activities, i.e., trading. Trading activities are many times larger than at any time in previous history. Trading costs have decreased, but I find no evidence that increased liquidity has led to better (i.e., more informative) prices or to more insurance.
Fab paper. A modern day evidence on Where are the customer’s yachts?
Philipon (along with Andrew Haldane) has made quite a reputation in this crisis showing how little value addition financial sector actually does. Based on his analysis in this paper, he thinks financial sector should shrink from its current share of 8% of GDP to 6% of GDP:
The finance industry of 1900 was just as able as the finance industry of 2000 to produce bonds and stocks, and it was certainly doing it more cheaply. But the recent levels of trading activities are at least three times larger than at any time in previous history. Trading costs have decreased (Hasbrouck (2009)), but the costs of active fund management are large. French (2008) estimates that investors spend 0.67% of asset value trying (in vain, by definition) to beat the market.
In the absence of evidence that increased trading led to either better prices or better risk sharing, we would have to conclude that the finance industry’s share of GDP is about 2 percentage points higher than it needs to be and this would represent an annual misallocation of resources of about $280 billions for the U.S. alone.
Such empirical papers act as useful references for finance bashing. Occupy Wall Street guys should be waving such papers in as evidence for their protests..
