Friday, May 8, 2015

Social Costs of the Financial Sector

Luigi Zingales may seem like an unlikely person to ask, "Does Finance Benefit Society?" When he critiques the social benefits of the financial sector, he does so as an insider. He is Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, and recently president of the American Finance Association--made up of the economists and related disciplines who study finance in-depth. That question was the title of his 2015 Presidential Address to the AFA, which was delivered in January 2015. The address will be published later this summer in the Journal of Finance. However, you can watch video of the lecture or read the talk at his website.

In the aftermath of the dot-com boom, the housing price bubble, and the financial bailouts, it's easy enough for "finance" to sound like a swear-word. I pointed out a few days ago in a post on "Breaking Down Corporate Profits" (May 6, 2015), the "finance and insurance" sector earns more profits than another other sector of the US economy, just beating out the manufacturing sector and well ahead of wholesale and retail trade.  I've offered some thoughts on the financial sector in "Why Did the U.S. Financial Sector Grow?" (May 15, 2013) and "When is the Financial Sector Too Big?" (July 19, 2012), or for an alternative view, "A Defense of the Financial Sector" (May 17, 2013).

So it's probably useful to begin, as Zingales does, by pointing out that certain aspects of finance are pretty useful. I like being able to keep my money in a bank, and to get a mortgage when I buy a house. I like being able to invest my retirement savings in a mutual fund. Farmers like being able to use futures markets to lock in a minimum price for what they will grow; airlines like being able to use those markets to lock in a maximum price for what fuel will cost six or twelve months in the future; multinational companies like using futures markets to protect themselves against shifts in exchange rates. There's lots of evidence that the financial sector of a country tends to expand with economic growth, as entrepreneurs and established businesses find ways to use the financial sector to raise funds for investment and to hold down on risks.

But after dutifully acknowledging these kinds of issues, Zingales challenges whether the growth of the financial sector hasn't gone beyond the useful zone. Here's a sample (citations omitted):

While there is no doubt that a developed economy needs a sophisticated financial sector, at the current state of knowledge there is no theoretical reason or empirical evidence to support the notion that all the growth of the financial sector in the last forty years has been beneficial to society. In fact, we have both theoretical reasons and empirical evidence to claim that a component has been pure rent seeking. ...
There is a large body of evidence documenting that on average a bigger banking sector (often measured as the ratio of private credit to GDP) is correlated with higher growth, both cross-sectionally and over time. ... [I]in this large body there is precious little evidence that shows the positive role of other forms of financial development, particularly important in the United States: equity market, junk bond market, option and future markets, interest rate swaps, etc. ...
If anything, the empirical evidence suggests that the credit expansion in the United States was excessive. The problem is even more severe for other parts of the financial system. There is remarkably little evidence that the existence or the size of an equity market matters for growth. ...  I am not aware of any evidence that the creation and growth of the junk bond market, the option and futures market, or the development of over-the-counter derivatives are positively correlated with economic growth. ...
For the period 1996-2004, ... the cost of (mostly financial) fraud among U.S. companies with more than $750m in revenues is $380bn a year. Table 1 reports the fines paid by financial institutions to U.S. enforcement agencies between January 2012 and December 2014. The total amount is $139 bn, $113bn of which related to mortgage fraud. This severely underestimates the magnitude of the problem. First, some of the main mortgage lenders (like New Century Financial) went bankrupt and therefore were never charged. Second, even if the fraudulent institution did not go bankrupt, it can effectively be sued only if it has enough capital. The table includes just one fine regarding Madoff, for only $2.9bn, when the overall amount of the Madoff fraud totaled $64.8 bn.  Finally, Dyck et al. (2014) estimate that only one fourth of the fraud are detected. 
Zingales argues that it in the face of this kind of evidence (and he cites much more than this), it won't do to defend the financial sector by pointing to the good it undoubtedly does for certain parties in certain situations. Instead, one needs to think about why the financial industry is so prone to excess and misbehavior. Zingales argues that there is clearly lots of money to be made in duping investors about risks and returns, and about acting behind the scenes in ways that favor those in the financial industry but do not favor their customers. Zingales cites survey evidence that many house-buyers don't understand what an adjustable-rate mortgage means. It's clear that many big-time investors didn't understand very clearly how the LIBOR was determined, which is why insiders were able to manipulate it.

As a clear-headed economist, Zingales also points out that government regulation is often part of the problem here. For example, one ingredient in the toxic stew of the housing price bubble was the behavior of Fannie Mae and Freddie Mac, government-backed agencies that helped sustain housing bubble--and Fannie and Freddie then needed a $180 billion bailout after the crisis hit. More broadly, fine print is not the answer. It's not the answer when government seeks to regulate the financial sector with blizzards of fine print. It's not the answer when government passes requirements that blizzards of fine print "disclosure statements" be handed to to customers in the name of "transparency." As Zingales argues, simple rules are usually better (again, citations and footnotes omitted):

First, when the possibility of arbitrage and manipulation is considered, the best (most robust) solutions tend to be the simplest ones. ... Second, simple rules also facilitate accountability. Complicated rules are difficult to enforce even under the best circumstances, and impossible when their enforcement is the domain of captured agencies. In the context of regulation, however, there is one added benefit of simplicity. Not only does simple regulation reduce lobbying costs and distortions; it also makes it easier for the public to monitor, reducing the amount of capture. Finally, when we factor in the enforcement and lobbying costs, simpler choices, which might have looked inefficient at first, often turn out to be optimal in a broader sense. Thus, we should make an effort to propose simple solutions, which are easier to explain to people and easier to enforce and monitor. For example, a simple way to deal with the problem of unsophisticated investors being duped is to put the liability on the sellers. Just like brokers have to prove that they sold options only to sophisticated buyers, the same should be true for other instruments like double short ETF [exchange-traded funds]. This shift in the liability rule (Caveat Venditor) risks shutting off ordinary people from access to financial services. For this reason, there should be an exemption for some very basic instruments – like fixed rate mortgages and a broad stock market index ETF. 
Readers interested in getting up to speed on these arguments that the financial sector is too big might begin with Zingales's accessible talk. Some other recent resources on this topic include:



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