Changes in regulation played an important role in the expansion of asset management. In the US, pension funds had been obliged to avoid speculative and risky investment, precisely as a prudent man would have done. But in the 1970s, the relaxation of the ‘prudent man’ investment rule allowed pension funds to invest in less conventional ways, such as private equity (PE) and venture capital (VC), while the Employee Retirement Security Act of 1974 permitted pension funds and insurance companies to invest in a greater variety of funds, such as equities, high-yield debt, PE and VC. Fund managers pushed for this relaxation as a way to make higher-returning investments, but governments were keen to allow it because faster-growing private-sector funds would lessen demand for state-provided pensions. During this time, the rise in the number of very wealthy people – dubbed high-net-worth individuals (HNWIs) – also increased demand for professional asset management. An HNWI is now generally defined as someone with net financial assets (excluding property) of more than $1 million. Originally a rich-country phenomenon, it is now global as the ranks of millionaires and billionaires swell in emerging countries, notably in Asia and Latin America. According to the consultancy Capgemini, the number of HNWIs rose from 4.5 million in 1997 to 14.5 million in 2014. China now has more billionaires than the US.15 In 2015 the city with the most HNWIs was London (370,000), followed by New York (320,000).16
As fund management expanded, so the proportion of private investors shrank. Individual ownership of stocks fell in the US from 92 per cent of the total in 1950 to about 30 per cent today.17 The percentage held by private investors is even lower elsewhere – 18 per cent in Japan and just 11 per cent in the UK.18 In 1963, UK individual investors owned more than 50 per cent of the stock market; insurance groups, pension groups, unit trusts and overseas investors together accounted for about 10 per cent. Since then the trend has reversed: pension funds and, particularly, overseas investors have rapidly acquired a larger stake in the UK stock market, with the latter owning more than 50 per cent of quoted UK companies’ shares in 2014.19 In the US, some 60 per cent of publicly issued shares (equities) are held in mutual funds. Moreover, the fund management industry is now quite concentrated, especially in the US, where about twenty-five fund managers control 60 per cent of all the equities in the hands of investment institutions.20
In the last two decades the types of fund management have diversified, most noticeably into hedge funds, private equity and venture capital. The US has about 5,000 hedge funds, managing total assets of $2 trillion. Hedge funds have a glamorous image – in London many are clustered in the exclusive enclave of Mayfair – and some hedge fund managers have made a great deal of money: in 2016, forty-two were listed among the world’s billionaires.21 Some are even household names. George Soros shot into the headlines when on 16 September 1992 he reputedly ‘broke the Bank of England’, making $1 billion betting against British membership of the European Exchange Rate Mechanism (ERM), forcing the UK out of the ERM; the day became known as ‘Black Wednesday’.
Hedge funds, though, are a little tricky to define. One of their chief characteristics is shorting (betting on the price of investments falling) as well as going long (betting on the price of investments rising). Ironically, this was originally intended to take the risk out of their speculative investments, by enabling them to ‘hedge’ upwards against downward price movements. In practice, it lets them chase superior returns by placing expensive one-way bets, often using high borrowing (‘leverage’) to multiply their gains from tiny differences in price. Compared to other managed funds, hedge funds also have a high portfolio turnover and invest in a wide range of assets, from property to commodities. Many conventional investment funds are much more restricted in how and where they invest.
Private equity (PE) firms invest in companies, usually to take ownership and manage them, later – typically after three to seven years – selling them at a profit. They make their profit, if successful, from the increase in the equity value of the company after the debt has been paid off. They then realize the equity value by selling the company (sometimes to another PE firm) or through an IPO (initial public offering – in other words, a stock market launch).
These firms are called private equity because the companies they acquire are not quoted on the stock exchange, and because they themselves are also privately owned rather than through shares issued in the (public) stock market. In the US, PE firms control about $3.9 trillion of assets, 5 per cent of the asset management market,22 and own some well-known and large companies. For example, in the UK the American PE firm Kohlberg Kravis Roberts (KKR) paid almost $25 billion to acquire a stake in Alliance Boots, the UK high-street chemist chain. After KKR sold the final part of its stake in Alliance Boots in 2015 it was reported to have quadrupled its money.23 Other prominent PE firms include Bain Capital, BC Partners, Blackstone Capital and Carlyle Group.
Private equity firms claim to make companies more efficient and profitable, in part because they are the direct owners of these companies. In theory, separating owners (shareholders) and managers should resolve the vested interests that the latter have in increasing their own financial compensation rather than the price of the companies’ stocks. (This is the main reason why the overriding objective for the contemporary asset manager is to maximize shareholder value, as measured by the shares’ price.) Critics, however, say that private equity firms have a deleterious impact on companies: their aim is to cut costs in the short term, for example by firing workers and reducing investment, in order to make a quick profit selling the business, at the expense of long-term corporate health.
The owners of private equity firms are called general partners (GPs). The funds they use to buy companies come from investors such as pension funds, foundations, insurance companies and wealthy individuals. Public and private pension funds contribute about a third of the value of the total funds PE firms invest. All these types of investors are called limited partners (LPs). They commit their money for a fixed time, say ten years, during which time they usually cannot withdraw funds. However, a good deal of PE firms’ investment funds can be classified as debt, used to buy the equity stakes in the anticipation of repaying it with gains in equity value. PE firms are often criticized for placing that debt on the balance sheets of the companies they buy, while continuing to extract dividends from the companies rather than service the debt. KKR’s first high-profile acquisition, the leveraged buyout of cereal and tobacco group RJR Nabisco in 1988, captured in the book and film Barbarians at the Gate,24 loaded the Shredded Wheat manufacturer with debt from which it never fully recovered, but launched the PE firm on its continuing global expansion. PE firms have become particularly adept at borrowing to acquire a firm and then arranging a ‘special dividend’, often for a similar sum, which ensures a rapid profit from the deal even if the borrowings, transferred to the acquired firm, depress its resale price or even doom its existence. The PE firm TA Associates demonstrated how far this technique could be stretched when in 2014 it secured a $1.77 billion ‘syndication loan’ (a type made possible by banks immediately securitizing and reselling them) against drug-testing firm Millennium Laboratories – and immediately arranged a $1.29 billion special dividend. The transaction conformed to all rules imposed after 2008 to prevent ‘asset-stripping’ by private acquirers. When Millennium declared bankruptcy the following year, a court indemnified TA and other shareholders (the firm’s former managers) against any effort by creditors to claw back the dividend, even after it was revealed that the owners and their loan arrangers had not informed them that its biggest client, the US government, had successfully sued it for $256 million over fraudulent tests.25
HOW FINANCE EXTRACTS VALUE
How does finance extract value? There are broadly three related answers: by inserting a wedge, in the form of transaction costs, between providers and receivers of finance; through monopoly power, especially in the case of banks; and with high charges relative to risks run, notably in fund management.
I
n certain areas of the economy, such transaction costs are regarded as reducing efficiency and destroying value, not creating it. Governments are accused of inefficiency whenever they impose an income tax – which puts a wedge between what people receive for work and the value they place on leisure – or when they try to finance social security through a payroll tax, which disconnects wage costs from total labour costs. When they secure a pay rise for their members, trade unions are accused of increasing workers’ pay while their contribution to production remains the same.
As far as banks are concerned, their efficiency as useful intermediaries between borrowers and lenders might reasonably be judged by their ability to narrow the ‘wedge’, or cost gap, between the two. Maximum efficiency, friction-free capitalism, would in theory be reached when the interest differential disappears. Yet the ‘indirect’ measure of financial intermediation services adopted by national accounts (FISIM, explained in Chapter 4) assumes that a rise in added value will be reflected in a wider wedge (or, if the wedge narrows, by increased fees and charges through which intermediaries can obtain payment directly). The point, of course, is not to eliminate interest but – if interest is the price of financial intermediation – to make sure that it reflects increased efficiencies in the system, driven by appropriate investments in technological change, as some fintech (financial technology) developments have done.
Banks stand in sharp contrast to supermarkets. As we have seen, the cost of financial services probably rose in the twentieth century, despite the dramatic growth of the financial industry, suggesting that financial consumers did not benefit from economies of scale in the same way as they did with supermarkets, epitomized by Walmart in the US and Tesco in the UK. A large part of the explanation for the difference is the monopolistic – or more strictly, oligopolistic – nature of banking.
In 2010, five big US banks controlled over 96 per cent of the derivative contracts in place.26 In the UK, ten financial institutions accounted for 85 per cent of over-the-counter derivatives turnover in 2016, and 77 per cent of foreign exchange turnover.27 Only the biggest banks can take the risk of large-scale writing and trading in derivatives, since they need a comfortable cushion of equity between the value of their assets and liabilities to stay solvent if asset prices fall. Only a few banks worldwide have grown big enough to sustain the high risks of proprietary trading – trading on their own account rather than for a client – and to be worthy of state-supported rescue if the risks prove too great.
As a result, there are few banks with whom governments and large corporations can place new bond or share issues and expect subsequent market-making in those securities. The paucity of players, even in large financial centres such as London and New York, inevitably gives each bank considerable price-setting power, irrespective of whether or not they collude among themselves to do so. In retail markets, minimum core capital requirements for banks (raised after 2008, to 4.5 per cent of risk-weighted assets in 2013, 5.5 per cent in 2015 and 6 per cent from 2016)28 and the need for prudential regulation limits the number of banking licences that governments and central banks can issue, and confers significant market power on the few banks who hold such licences. This power enabled banks to secure 40 per cent of total US corporate profits in 2002 (up from 13 per cent in 1985). They still enjoyed 23 per cent in 2010 and almost 30 per cent in 2012 – just two years after rebounding after a brief plunge to 10 per cent in 2008, in a period when corporate profits were growing much faster than labour income or GDP.29
The high degree of monopoly in wholesale and retail banking is closely linked to its continuing ability to extract rents from the private and public sectors, even when these were shrinking in the aftermath of the 2008 crash. In the UK, since the financial crisis regulators have aimed to promote new banks and alternative forms of financial intermediation, such as peer-to-peer lending, in order to spur competition. The handful of new banks started in the UK since the crisis are somewhat optimistically called ‘challenger banks’ – a challenge that so far has not put much of a dent in the oligopoly of UK ‘high street’ banks. Nor are alternative forms of financial intermediation effective substitutes for the dominant banks. Only licensed banks can create money through loans,30 as distinct from merely shifting money between savers and borrowers. Once banks’ profitability has been swelled by the market power that allows them to extract rents from other sectors, their top employees can in turn exert internal labour-market power to channel a share of those rents to themselves, helping to give the financial sector its unique and entrenched bonus culture.
On top of monopoly rent, financial markets give investment banks and other professional ‘players’ another significant route to high financial returns, divorced from the high risk that is traditionally understood to justify those returns. Financial markets instantly adjust the price of company shares and bonds to the future profits those companies are expected to make. They can therefore instantly capture (and ‘capitalize’) the jump in expected future profit when, for example, a new drug wins approval for hospital use, a social media platform finds a way to monetize its millions of users, or a mining company learns that its once-exotic metal is to be used in the next generation of mobile phones. Owning an asset that suddenly jumps in value has always been a faster way to get rich than patiently saving and investing out of income;31 and the speed differential of asset ‘revaluation’ over asset accumulation has been amplified in the present era of historically low interest rates.
Revaluation gains in the ‘real’ economy are widely hailed as economically efficient and socially progressive. Entrepreneurs who cash in on a genuinely useful invention can claim to have reaped just rewards from genuinely productive risk-taking, especially when they are shown to have displaced hereditary landowners in the charts of ultra-high net worth. But when – as is usually the case by the time the revaluation occurs – shares have passed beyond the original inventors and become owned by private equity or quoted on financial markets, it is passive rather than active inventors who capture most of the revaluation gains. Financialization enables investment bankers and fund managers who picked the right stock – often by chance – to make profits that would previously have gone to those who built the right product, by painstaking design. And, having captured this value, they invariably race to extract it – channelling the gain into real estate or other financial investments designed to hold their ‘value’ – rather than reinvesting it in more innovative production, which rarely yields a comparable crock of gold a second time.
The relationship between finance’s share of employment and its share of income gives an idea of what has happened. Until 1980, finance’s share of employment and income in the US were almost identical (the ratio is 1). But, as Figure 17 reveals, by 2015 it had almost doubled to 1.8. This steep rise in average income per employee – scarcely interrupted by the crash of 2008 – was, according to its supporters, a sign of the financial sector’s rising productivity and a justification for channelling more resources into finance. But the productivity gain was, as seen in Chapter 4, highly dependent on a redefinition that boosts banks’ and other lenders’ ‘value added’. An alternative explanation for the rising income-to-employment ratio is that finance was reinforcing its power to extract value, and gain monopoly rents from other private-sector activities.
Figure 17. Finance employee compensation share of national employment share32
The concentration of banking and financial-market trading among a few large players, which is at its most extreme in the derivatives markets (Figure 18) underlines the extent to which financial ‘value added’ may be traceable to monopoly and oligopoly rents.33 It is in financial regulators’ interest to keep the number of players small, despite the risk of collusive behaviour: they want to maintain an overview of all market players’ exposure so as to guard against systemic risk, and the decision (after the 2008 crisis) to bring over-the-counter derivatives trades (derivatives that are not listed on a stock exchange and are often bespoke deal
s between professional investors such as banks) onto a more viewable transparent central platform works in their favour. Indeed, the rigging of a key interest rate (the London interbank offered rate, Libor, used to set many private-sector borrowing rates globally) in the aftermath of the crisis may have occurred with the connivance of some regulators, at least according to traders who successfully defended themselves against fraud charges.35 The rigging, and subsequent arguments over who gained and lost from it, highlight the extent to which banks and other financial market players today battle over, and perhaps collude in, the distribution of a surplus created by mainly non-financial businesses.
Figure 18. Concentration of US derivatives contracts ($ billions; fourth quarter, 2010)34
Banks are without doubt instrumental in moving funds from less to more productive parts of the economy. Instruments such as derivatives, futures and options can genuinely help to hedge against risks, particularly for the economy’s producers who are confronting uncertainty over future prices and exchange rates. Yet it must be said that some bank activities are clearly not productive, especially when they become too complex or too large relative to the real economy’s needs. Take the mortgage-backed security (MBS) market mentioned earlier. In 2009, mortgage-related debt in the US totalled around $9 trillion, having grown an astonishing 400 per cent in fifteen years to stand at more than a quarter of all outstanding US bond market debt. The revenue generated through interest payments on this debt has been estimated at $20 billion a year between 2001 and 2007.36 After the 2008 financial crisis, this line of business dried up completely. Around the world, holders of these US MBSs took huge losses, leading to a cascade of financial crises in other countries as borrowers who held them as collateral proved unable to repay their debt. Banks had extracted revenue for ‘managing’ and ‘laying off’ risk – but their own activities had actually increased risk in the process.
The Value of Everything (UK) Page 18