Sunday, January 01, 2012

What We Need from the Financial Sector

This post by Brad DeLong, America's Financial Leviathan, provides a valuable taxonomy of the roles that a financial sector is supposed to play in a market-driven economy.  By my count, our current financial system is going 3 for 5 based on his classification:
  1. Insurance and diversification
  2. Finance of large, illiquid assets with small, liquid liabilities
  3. Enabling current borrowing against future, uncertain income streams
  4. Reducing transaction costs
  5. Promotion of better corporate governance
Brad notes, and I think it is pretty clear, that our financial sector is doing #1, #2, and #4 well and doing them better over time.  The financial sector is doing #3, but when done to less than fully rational customers, this is not an unambiguous win.  The biggest failures in the financial crisis were associated with the misuse of debt (and you could argue that some of them belong in #1 and have a point).  The financial sector may be doing #5, but the obvious places where it is not are just so glaring -- starting with publicly traded firms in the financial sector itself!

The larger context of Brad's post is to question whether the financial sector's increased share of GDP over the past six decades has contributed to economic growth.  Given how much of the financial sector is no more socially useful than a casino, I don't see how that could be the case.  Worse, the "house" and several of the "players" in this casino have used their growing resources to subvert our political institutions into believing that their institutions are "too big to fail."


Vivian Darkbloom said...

I'm not sure about #5, although it is not entirely clear to me what DeLong or Samwick mean by the "finance" (or "financial") sector improving corporate governance. What DeLong actually wrote was this:

"Finally, better finance should mean better corporate governance. Since shareholder democracy does not provide effective control over entrenched, runaway, self-indulgent management, finance has a potentially powerful role to play in ensuring that corporate managers work in the interest of shareholders. And a substantial change has indeed occurred over the past two generations: CEOs focus much more attention than they used to on pleasing the stock market, and this is likely to be a good thing."

First, the authors seem to assume there *is* shareholder democracy that is ineffective. Perhaps they meant to convey that there is a lack of shareholder democracy to begin with. In any event, It is not clear to me what is meant by "finance" (whatever that term means) "stepping in" (whatever that means) to further the interests of shareholders. Perhaps through the exercise of voting through proxies? But, they already do that and effectively control corporate boards, there is no change to the existing system in sight, and the results have not been very good, in my view. Perhaps Professor Samwick could exercise some influence here with the Delaware state legislature which has as much to say as any body on that problem. And, the last sentence (quite surprising coming from DeLong) is particularly suspect. Undue focus on the stock market, particularly the short-term market, and the financial rewards this brings both the "finance" sector and those which they are supposed to govern for our benefit, seem to be the root of quite a bit of our problems. It strikes me that short-term market gains and the potential renumeration that entails through overly generous stock options and other "incentive" compensation contributed to excessive risk-taking, including undue speculation in financial derivatives.

The frequent use of very general, ambiguous and unsupported throw-away statements like the one above DeLong made about corporate governance and the finance sector, and which then make the rounds, as here, is too often the norm in blogosphere. I sometimes wonder whether this method of discourse is really advancing anything worthwhile.

Vivian Darkbloom said...
This comment has been removed by a blog administrator.
Andrew Samwick said...

On questions of operations, "pleasing the stock market" will likely lead to better corporate governance without much downside.

On questions of accounting and leverage, the story of the past two stock market bubbles tells a different story. The potential to fool stock market participants has been too great a temptation.

When I talk with Dartmouth alumni from the 1950's and 1960's who spent their careers in the financial sector, they tell me that the sorts of abuses we have seen in recent years would simply not have occurred if the major investment banks had still been partnerships. Concentrated ownership of firms that issue large amounts of debt would have provided much better safeguards against excessive risk taking.

Anonymous said...

Great post.
In your comment, Does who bears the risk matter?

Have Financial institutions changed so that leadership is no longer accountable?

Has too big to fail destroyed much of the trust in BigFinance, but there is nothing we can do about it because they are holding our privatized pension money hostage in 401Ks and skimming too much of the returns that should be going to future retirees?

jonny bakho

Vivian Darkbloom said...

Thank you for your response. You wrote:

“On questions of operations, "pleasing the stock market" will likely lead to better corporate governance without much downside.

On questions of accounting and leverage, the story of the past two stock market bubbles tells a different story. The potential to fool stock market participants has been too great a temptation.”

Perhaps it would be useful if you would define what, exactly, you mean by “corporate governance”. If “corporate governance” means that the executives of a publicly traded corporation are responsible to, and act in the interests of their shareholders, then I think the distinction you draw here is very artificial.

You-stated that with respect to “operations” the market will lead to better “corporate governance without much downside”. What support or examples do you have for that?

As to the questions of accounting and leverage, are these not part of “corporate governance” at least as I have defined it? How is taking on too much leverage or other types of risks that may serve in the short term to boost the incentive compensation of corporate executives in the interest of their shareholders? Is this not merely an example of putting selfish interests above the interests of those to whom they owe a fiduciary duty? And, how is deceptive accounting, which is employed for much the same purpose, responsive to or in the interests of shareholders? Or, to use your own phrase, how could “fooling market participants” be responsible to, or in the interests of those very shareholders they have a duty to serve?

You cannot logically maintain, as you appear to have done, that being responsible with respect to “operations” (whatever that means, but I would welcome a definition and examples) is part of “corporate governance” but being responsible to shareholders and others with respect to accounting and risk management is not.

Vivian Darkbloom said...

As to your comment about the transformation of large investment banking firms from partnerships to publicly traded corporations, I can agree this has resulted in more risk-taking (and other bad developments). But, the reasons this is so demonstrate also why finance has *not* improved the "corporate governance" of non-financial publicly-traded entities, much less finance firms.

Not so long ago, firms like Goldman Sachs were operated as partnerships. What this meant is that the interests of the executives and the owners were aligned because they were more or less identical. Previously, if the partners of Goldman Sachs were to take on (excessive) risk, they would bear the primary brunt if things would go wrong because it was *their* equity at stake. Playing with other people's money removes some of the reluctance to take on that risk. Perhaps this is what you meant by "concentrated ownership of firms". But, this again, gets back to the very issue of "corporate governance" and that fact that, properly defined, it really means being responsive to and acting in the interests of non-managing equity (and stake) holders.

Another vestige of this partnership era, which is hardly questioned because our "corporate goverance" is so defective, is that the income of those finance partnerships was shared, roughly, 50 percent according to services (via partner salaries, bonuses, etc) and the remaining 50 percent to equity. The large finance firms such as Goldman Sachs operate their publicly traded entities as if those old partnership rule should apply. This explains why the publicly traded "finance" firms help themselves to a disproportionately higher share of profits than non-finance firms do. There is absoultely no reason why this publicly traded companies should continue to operate as if they were still partnerships.

I thnk you (and DeLong) need to re-think your hypothesis about "corporate goverance" and "finance" firms.

Vivian Darkbloom said...

Professor Samwick,

A few days ago, shortly after the last comment I posted, I posted a second. This was pertaining to the effects of financial firms converting from partnerships to publicly traded corporations.

Perhaps it was an oversight that the comment was not published. Or, perhaps it was not. If the latter, would you please be so kind as to set forth in a comment or some other fashion the particular rule that you think warranted blocking that comment. This would be of use to me so that I don't waste time in the future needlessly composing comments to your blog that end up in your electronic wastebasket.

Thank you.

Andrew Samwick said...

I am still working out the kinks in the comment moderation. I thought I had seen a duplicate and deleted it. I have restored all of your comments. Comments related to the topic are not blocked for any reason other than profanity or personal attacks. Let me know if it has appeared.

Ken Houghton said...

"[1] Insurance and diversification [2] Finance of large, illiquid assets with small, liquid liabilities [3] Enabling current borrowing against future, uncertain income streams [4]Reducing transaction costs [5] Promotion of better corporate governance Brad notes, and I think it is pretty clear, that our financial sector is doing #1, #2, and #4 well and doing them better over time."

I don't see him affirming #1 at all. "While it might be true that America's current finance-insurance system better distributes risk in some sense, it is hard to see how that could be the case given the experience of investors in equities and housing over the past two decades" seems rather clearly against the argument of "doing them better over time."

Jelle said...

I agree with the role of the financial sector. It has to be there. This is a good read, worth my time spent in reading it! Thanks for sharing!