The Great Reversal

by Thomas Philippon

Figure 11.3 shows that this unit cost is around 200 basis points, just like in our example in Figure 11.1, and relatively stable over time. In other words, I estimate that it costs two cents per year to create and maintain one dollar of intermediated financial assets. Equivalently, the annual rate of return of savers is on average two percentage points below the funding cost of borrowers. The updated series are similar to the ones in the original paper. The raw measure of Figure 11.3 does not take into account changes in the characteristics of borrowers. In the Appendix I discuss the issue of quality adjustment in financial services, and elsewhere I show that the same patterns hold when finance is measured as a share of services, and when net financial exports are excluded (Philippon, 2015).

  FIGURE 11.4  Wages and regulation in finance. Data source: Philippon and Reshef (2012)

  Financial intermediation costs around 200 basis points today—about the same as a century ago. The more you think about it, the more puzzling it becomes. Despite all its fast computers and credit derivatives, the current financial system does not seem more efficient at transferring funds from savers to borrowers than the financial system of 1910.

  Prices in finance have not come down, but wages have certainly gone up. Philippon and Reshef (2012) compute the wages of employees in finance relative to employees in the rest of the private sector. We also construct a measure of financial deregulation. The industry was mostly deregulated until 1930. Regulations were put in place in the wake of the Great Depression. These were progressively lifted in the 1980s and 1990s. Over the same period, the historical data reveal a U-shaped pattern for education, wages, and the complexity of tasks performed in the finance industry relative to the nonfarm private sector (Figure 11.4).

  From 1909 to 1933 finance was a high-education, high-wage industry. The share of skilled workers was 17 percentage points higher than in the private sector. These workers were paid over 50 percent more than those in the rest of the private sector, on average. A dramatic shift occurred after the mid-1930s. By 1980, the relative wage in the financial sector was approximately equal to the wage in the nonfarm private sector. From 1980 onward, the financial sector became a high-skill and high-wage industry again, and relative wages and skill intensities returned almost exactly to their 1930s levels. There was some wage moderation following the 2007–2009 crisis, but it was relatively limited.

  Technological development of the past forty years should have disproportionately increased efficiency in the finance industry. How is it possible for today’s finance industry not to be significantly more efficient than the finance industry of John Pierpont Morgan?

  Information technologies (IT) must have lowered the transaction costs of buying and holding financial assets. An apt analogy is with retail and wholesale trade. After all, retail banking and retail trade both provide intermediation services. As we discussed in Chapter 2, the retail and wholesale industries invested in IT. They became more productive, and their prices went down. The contrast is striking with finance. Finance invested in IT, but prices did not decrease.

  What Is the Matter with Finance?

  The previous figures are puzzling. Finance is expensive, and computers have not made it cheaper. While most of the existing work has focused on the United States, Philippon and Reshef (2013) and Bazot (2013) provide similar evidence for other countries. Finance has obviously benefited from the IT revolution, and this has certainly lowered the cost of retail finance. Yet the cost per dollar of intermediation has remained constant, and the share of GDP spent on financial services has increased. So why is the nonfinancial sector transferring so much income to the financial sector?

  When an industry is deregulated, wages and prices usually fall. In finance, they seem to rise. In most industries, innovation is good for growth, but financial innovations do not seem to improve capital allocation very much.

  What, then, is the matter with finance? Why does it appear to behave differently from other industries? I am going to highlight three main issues: a high prevalence of zero-sum games, entrenched market power, and heavy and sometimes misguided regulations.

  Harvard economists Robin Greenwood and David Scharfstein (2013) study what goes on inside the black box and provide an illuminating picture of the growth of modern finance. They show that growth of finance since 1980 comes mostly from asset management (in the securities industry) and the provision of household credit (in the credit intermediation industry). The credit intermediation industry grew from 2.6 percent of GDP in 1980 to 3.4 percent of GDP in 2007. Traditional banking income has remained roughly constant, while fee-based transactional services, including loan origination and cash management, have grown. In other words, they document a shift from Figure 11.1a to 11.1b. Securitization and short-term funding also grew, giving rise to what is now commonly referred to as the shadow banking system.

  The securities industry grew from 0.4 percent of GDP in 1980 to 1.7 percent of GDP in 2007. Within this industry, the traditional sources of income (trading fees and profits, underwriting fees) have declined. At the same time, asset management fees and profits from derivative contracts have increased. Regarding asset management, they uncover an important stylized fact: individual fees have typically declined, but the allocation of assets has shifted toward high-fee managers in such a way that the average fee per dollar of assets under management has remained roughly constant.

  The wealth management industry also contributes to tax evasion, which is a negative sum game. The creativity of financial thieves is unbounded. For instance, the so-called CumEx network defrauded EU treasuries from billions of euros of revenues. Traders would lend each other shares in large companies to confuse tax authorities and make them think that each share had several owners. One side would falsely claim that taxes on dividends had been paid, and the other side would be able to claim a tax refund.

  The point is not that finance does not innovate. It does. The point is that these innovations do not seem to improve the overall efficiency of the system. For every useful innovation in online banking, there are several mostly useless or even harmful ones. The race for ever-faster access to market information is an obvious example. If you observe the information flow and you manage to trade on this information just a microsecond before everyone else, you can make a lot of money. Yet that activity does not contribute to the overall efficiency of the system. It does not matter whether information gets embedded in the price every microsecond or every second or even every minute. There is a large difference between foreknowledge and discovery as far as social welfare is concerned, even though the two activities can generate the same private returns, as economist Jack Hirshleifer explained in 1971. This tension between private and social returns exists in most industries, but economists tend to think that entry and competition limit the severity of the resulting inefficiencies.

  Lack of entry, however, has been an endemic problem in finance in recent decades. Allen Berger, Rebecca S. Demsetz, and Philip E. Strahan (1999) review the evidence on consolidation during the 1990s. The number of US banks and banking organizations fell by almost 30 percent between 1988 and 1997, and the share of total nationwide assets held by the largest eight banking organizations rose from 22.3 percent to 35.5 percent. Several hundred mergers and acquisitions occurred each year, including mega-mergers between institutions with assets over $1 billion. The main motivations for consolidation were market power and diversification. Berger and colleagues find little evidence of cost efficiency improvement, which is consistent with Figure 11.3. Robert De Young, Douglas Evanoff, and Philip Molyneux (2009) show that consolidation continued during the 2000s. They argue that there is growing evidence that consolidation is partly motivated by the desire to obtain too-big-to-fail status, and that mergers and acquisitions have a negative impact on certain types of borrowers, depositors, and other external stakeholders.

  Entry in finance is also limited by heavy—and sometimes biased—regulations. A good example of the benefits of entry, one that brings us back to Chapter 2, is
Walmart. Why did we get the bloated finance industry of today instead of the lean and efficient Walmart? As it turns out, Walmart applied for a banking license in 2005, but it was denied under—who would have guessed—heavy lobbying by bankers. That’s an important lesson: where retail store owners largely failed to prevent Walmart’s expansion, the bankers prevailed. Of course, this lobbying always takes place in the name of the separation of banking and commerce and for protecting community banks, as if debit cards and savings accounts were magical products that a retail firm could not possibly provide.

  What Technology Could Offer Finance

  Finance could and should be much cheaper. Finance has benefited more than other industries from improvements in information technologies. But unlike in retail trade, for instance, these improvements have not been passed on as lower costs to the end users of financial services. Asset management services are still expensive. Banks generate large spreads on deposits (Drechsler, Savov, and Schnabl, 2017).

  This might be changing, however, thanks to the entry of financial technology (fintech) players. Fintech includes digital innovations that can disrupt financial services. As usual, innovation is a double-edged sword. Innovations can provide new gateways for entrepreneurship and democratize access to financial services, but they also create significant privacy, regulatory, and law-enforcement challenges. Examples of innovations that are central to fintech today include mobile payment systems, crowdfunding, robo-advisors, blockchains, and various applications of artificial intelligence and machine learning. All the large financial firms have jumped on the tech wagon. JPMorgan Chase & Co. recently announced that it will require its asset management analysts to learn to use Python, a powerful and flexible coding language.

  This is not to say that all fintech ideas are great. There is a lot of hype and buzzword use. “Big” data is just data. “Machine learning” often simply means running a large number of nonlinear regressions on large data sets. Most of the transactions in Bitcoins involve drugs, pornography, and weapons.

  But there are also some genuinely useful ideas. A clear winner is the market for remittances. Remittances are the transfers of money by a foreign worker back to their home country. Poor households have been ripped off for decades by a highly concentrated banking industry. Thanks to entrants such as Transferwise, remittances have become cheaper. For instance, the cost of sending $200 in the World Bank sample of forty-eight sending countries has fallen from 9.8 percent to 7.1 percent over the past decade. Of course, 7.1 percent is still expensive. But at least the trend is in the right direction.

  For fintech to really succeed, however, regulations must be adapted. As in other industries, fintech startups propose disruptive innovations for the provision of specific services. The key advantages of incumbents are their customer base, their ability to forecast the evolution of the industry, and their knowledge of existing regulations. The key advantage of startups is that they are not held back by existing systems and are willing to make risky choices. In banking, for instance, successive mergers have left many large banks with layers of legacy technologies that are, at best, partly integrated (Kumar, 2016). Fintech startups, by contrast, have a chance to build the right systems from the get-go. Moreover, they share a culture of efficient operational design that many incumbents lack.

  How to Better Regulate Finance

  Competition is biased between entrants and incumbents in the finance industry. Ensuring a level playing field is a traditional goal of regulation. Serge Darolles (2016) discusses this idea in the context of fintech and argues, from a microeconomic perspective, that regulators should indeed ensure a level playing field. This line of argument, however, cannot be readily applied to many of the distortions that plague the finance industry. For instance, what does a level playing field mean when incumbents are too big to fail? Or when they rely excessively on short-term leverage? The level-playing-field principle applies when entrants are supposed to do the same things as incumbents, only better and cheaper. But if the goal is to change some structural features of the industry, then a strict application of this principle could be a hindrance.

  History proves that regulations are likely to be more effective if they are put in place early, when the industry is young. Let’s imagine a simple, counterfactual history of the money market mutual fund industry. Suppose that regulators had decided in the 1970s that, as a matter of principle, all mutual funds should use and report floating net asset values (floating NAVs) instead of fixed NAVs. A fixed NAV is like a deposit: you put $1 in and you can always withdraw $1; no questions asked and no matter what happens. But that’s a trick. The only ways to guarantee that your $1 is completely safe is either to invest it entirely in short-term government bills or insure it. That’s why bank deposits are insured, and that’s why banks pay insurance premia to the Federal Deposit Insurance Corporation (FDIC). The money market fund industry wanted to attract savings away from the banks—which is totally fair, that’s just competition—and they knew that people loved the idea of fixed, safe, dollar-for-dollar deposits. They then decided to report fixed NAVs, pricing their shares at $1 at all times, to make it look like they were offering deposits. But they were not investing in safe, short-term government bills. In September 2008, the Reserve Primary Money Market Fund (a large money market fund) “broke the buck” (that is, admitted that the value of its shares was less than $1) because it had invested in Lehman Brothers commercial paper. Lehman declared bankruptcy and the Reserve Fund posted a loss, triggering a run as investors pulled their money out to avoid further losses. The fund was forced to freeze redemptions and the US Treasury Department had to create a temporary guarantee program for the entire money market fund industry! So much for a safe investment … After the crisis, regulators proposed a set of reforms to force funds to float the NAV of their portfolios and avoid the illusion of safety. It did not go well. The industry fought back, and it took years to arrive at a mediocre compromise. My point here is that implementing these regulations would have been a relatively straightforward process when the industry was small, and they would have guided market evolution and encouraged innovations consistent with sound principles of finance. It is significantly more difficult to change the regulations when the industry has several trillion dollars under management.

  Thus the challenge for regulators is to look ahead when dealing with fintech. Effective regulation requires them to identify some basic features they would like fintech to have and mandate them as early as possible. I think that is a key lesson for the regulation of fintech. I recall a fascinating exchange at a recent conference about blockchains and privacy. There is a tension between the principles of blockchains (such as their permanence) and the right of individuals to request that their personal data be erased. To my surprise, however, the blockchain specialists said this would not be a big challenge, provided they knew what the regulator wanted. In other words, it is possible to implement a blockchain in which private data can be erased under some conditions. But it must be conceived as such from the beginning. It would be much more difficult to let it grow and then, ten years later, ask for new features to protect privacy.

  Fintech is also likely to create new issues of consumer protection. Think of the example of robo-advisors for portfolio management. Robo-advising will certainly create new legal and operational issues, and it is likely to be a headache for consumer protection agencies, as discussed in Baker and Dellaert (2018). Yet if the goal is to protect consumers, robo-advising does not need to be perfect: it only needs to be better than the current system. One must keep in mind just how bad the track record of human advisers has been. Investment advisers have a powerful and aggressive lobby. They have managed until recently to keep their fees high by hiding them from their clients. Most people simply do not know what they pay. Conflicts of interest are pervasive in the industry. For instance, Daniel Bergstresser, John M. R. Chalmers, and Peter Tufano (2009) find that broker-sold mutual funds deliver lower risk-adjusted returns, even before subtrac
ting distribution costs. John Chalmers and Jonathan Reuter (2012) show that brokers’ client portfolios earn significantly lower risk-adjusted returns than matched portfolios based on target-date funds. Broker clients allocate more dollars to higher-fee funds. In fact, investors tend to perform better when they do not have access to brokers. Sendhil Mullainathan, Markus Noeth, and Antoinette Schoar (2012) document that advisers fail to de-bias their clients and often reinforce their biases. Advisers encourage returns-chasing behavior and push for actively managed funds with higher fees, even if a client starts with a well-diversified, low-fee portfolio. Mark Egan, Gregor Matvos, and Amit Seru (2016) show that, in the US, financial adviser misconduct is concentrated in firms with retail customers and in counties with low education and elderly populations. They also document small labor market penalties for misconduct.

  Watch for the Lobbyists

  One can make the case that finance is (slowly) moving toward providing cheaper and more reliable financial services. But the road will be bumpy. Let me highlight three pitfalls.

  The first pitfall is that financial incumbents still earn large rents, and they are going to fight to protect them. To take but one example, private equity firms are heavily subsidized by taxpayers. They benefit from unjustifiable tax advantages for carried interests. Carried interest is the portion of an investment fund’s returns eligible for a capital gains tax rate of 23.8 percent instead of the ordinary income tax rate of up to 37 percent. President Trump promised to close the loophole during his presidential campaign, but Congress caved in to the lobbying of private equity firms and did not close the loophole. Instead of an outright repeal, Congress required that a fund’s general partners hold the relevant investments for three years instead of one. Moreover, private fund managers discovered a way to keep the carried interest advantage in the tax law’s exemption for corporations. They set up corporate structures for executives entitled to receive carried interest.