Is Financial System Dysfunctional?

Adair Turner’s speech and Prospect’s top 25 list alerted me to the work of Paul Woolley. Paul Woolley has worked in financial firms, at IMF, has taught in Univs etc. So he has seen it all.

He has been working to show how efficient financial markets theory is not right and we need a new paradigm.

He has set up a Paul Woolley Centre for the Study of Capital Market Dysfunctionality at LSE where much of the work is being done. Prospects Magazine calls him the Britain’s new financial guru. Also read this detailed article on his work in the same magazine.

Anyways, what does he mean by dysfunctional financial system? One should read his must read speech he gave in 2007. The speech was given as the crisis was setting in. So he was also one of the econs who talked about the problems with the fin system.

He says:

Is society well-served by its financial institutions? I am referring here to private sector institutions such as the banks, investment banks, fund managers, and capital markets generally, rather than the public sector bodies such as central banks and supra-national agencies. Surprisingly, the question is hardly ever posed, let alone attempts made to answer it. There seems to be a tacit, and more or less universal assumption that competitive markets are efficient markets and, since competition does not appear in short supply among financial institutions and investors, everyone seems to be happy.

Indeed the notion of efficiency lies at the core of finance theory. The belief in the efficacy of competition propounded by the classical economists from before Adam Smith, was applied formally to finance in the shape of the “Efficient Market Hypothesis” in the 1960s. The ability of equity markets to deliver efficient pricing leading to the most productive allocation of resources was unquestioned through the 1980’s and even now holds centre stage as the principal building block of academic finance.

But reality is different

By most measures finance has become the dominant industry sector accounting, for example, for between 30% and 40% of the aggregate profits of the quoted corporate sector in the US, UK and globally, compared with only around 10% forty years ago. What model can explain its dominance? It seems strange that an industry whose role is that of intermediation rather than the production of consumption goods and industry whose role it is to allocate resources, retains the biggest share for itself?

This is the formal statement of the problem.

He then recounts his personal journey justifying his talk on financial markets. Career path is : stockbroking firm –  Univ to study economics – IMF – Fund Management – Paul Woolley Centre for Capital Market Dysfunctionality.

He discusses how the dotcom crisis changed his beliefs. He actually was a believer in EMH till then. He discusses momentum strategy and considers it as very effective.

Back to how finance is just growing:

Whether or not the scale and structure of the fund management industry is delivering efficient prices, the costs it imposes on end-investors is daunting. As a rough estimate, the costs of managing and trading the $40 trillion of global equity capitalisation is around $500 billion annually. 

There is no sign that competition is eroding the profits of the fund management industry. Rather, the scale of the industry is growing by leaps and bounds. What do I mean by scale?

The investment business is not like other industries where there is a finite production of, say, shoes or toothpaste. With the advent of derivatives in various forms, there can be as many tiers of active management as the ingenuity of managers can devise. You don’t need to hold underlying stock if you can transact in futures or contract for differences. Ten or fifteen years ago, most equity was also on the rise. Now, with hedge funds, overlay funds, proprietary trading by the investment banks, and higher turnover everywhere, the scale of activity has risen sharply. As a result, fees are now charged on a gross asset base that far exceeds the amount of stock in issue.

In recent years private equity has also entered the fray, bidding companies away from the stock market, repackaging, then reselling them back to investors. They extract their fees and winnings thereby lessening the potential return on the publicly quoted equity indices.

What has driven this growth?

there are the four asymmetries. I refer to the asymmetric pay-off pattern that arises from bonus payments to dealers, performance fees to fund managers, limited liability, and more topically, moral hazard – the willingness of central banks to step in to save a failing bank or system. Each of these emboldens financiers to take higher levels of risk or to embark on headlong expansion for their own ends.

Opacity is another device to extract supernormal profit and takes several forms. An increasing proportion of finance deals are over-the-counter or tailor-made, rather than executed transparently in the market, thereby removing the discipline of competitive pricing from the investment bank or broker. Hedge funds also fail to reveal their leverage, cost structure or source of profit, making the job of risk assessment impossible to the investor. Finally, the investor or customer has little negotiating power, fails to question questionable practice or is often supremely and foolishly optimistic.

Finally:

I believe that apart from war and peace, there are two great issues facing mankind, the first is climate change, the second is the dysfunctionality of the financial sector. The importance of the first is well-known, the significance of the second will dawn on governments and society in the years to come.

Well. It is 2010 now and dysfunctionality of the financial sector has already been seen by the governments and the society. Quite prophetic really. He also joins likes of Nouriel Roubini etc and others to predict how things would go wrong. Though he talks from a more systemic perspective. It is more on lines of Raghu Rajan who also said near similar things.

Useful stuff. I am trying to read up more on Woolley’s works.

2 Responses to “Is Financial System Dysfunctional?”

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    […] Is Financial System Dysfunctional? « Mostly Economics […]

  2. finance careers Says:

    Good article….
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