Let's Hurt the American Financial Services Industry

Pejman Yousefzadeh is upset:

The brain drain that the American financial service industry may face thanks to increasing regulation, the pursuit of class warfare rhetoric and policies by the Obama Administration and its allies, and the tendency to blame the current economic downturn on entities like hedge funds, which had nothing to do with the financial crisis, will only serve to hurt the American financial service industry down the road.

Well, yes. Think of it as a Pigovian policy response: you tax and regulate the stuff you want less of. And it’s pretty clear that the financial-services industry was far too big, before its crash. Recall Simon Johnson:

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent.

Financial services companies are meant to be intermediaries, middlemen. And any time that the middleman is taking 41% of the total profits in what’s meant to be a highly competitive industry, there’s something very wrong.

So yes, I do want to “hurt the American financial service industry down the road”, if by “hurt” you mean bringing its profits down to something less than 20% of all domestic corporate profits. That doesn’t seem unreasonable to me. And I especially want to hurt the American financial service industry down the road if by “the American financial service industry” you mean the too-big-to-fail banks which have caused such an enormous systemic risk to the global economy. Yes, I want to see them hobbled, much less powerful, and much less dangerous.

So no, I don’t have any particular interest in buying freshly-issued shares of Goldman Sachs at these levels. Buying shares is a bet on steady future growth. And Goldman is too big already. I want it to get smaller, not bigger. It was the imperative to grow which caused many of the problems at places like Merrill Lynch and Bear Stearns. Which makes this kind of equity offering part of the problem, not part of the solution.

Comments

[Alan Young:]

Bravo, well said. The less the middleman takes, the better off we are.
If only America's inventors, entrepreneurs, and artists were rewarded as well as our accountants, then America could once again become the master of the world.

Apr 13 10:20 AM

[morph366:]

Ironically the pace of financial innovation is often driven by the need to circumvent regulations. There could be even more stacking of layers of financial intermediation and complex products rather than less.
They will probably not be as profitable to any individual firm as they were during the last several years (until the bubble burst), and to that extent I agree with your comment on GS. But it may be even more expensive to clean up the mess when they go wrong again.

Apr 13 10:35 AM

[biomedlives:]

If there's a brain drain from the financial services industry, we may have fewer "innovations" like CDSs, subprime mortgages, and CD squared securities in the future. That situation would suit me.

Apr 13 10:55 AM

[Anandakos:]

Morph,

The complications you foresee will not occur if regulated and insured depository institutions are FORBIDDEN from any activity other than taking deposits and making loans up to their statutory capital ratio maximum. Not if they are FORBIDDEN from owning any subsidiary or being owned by a holding company that does unregulated activities. Not if any single institution is FORBIDDEN from holding more than 5% of the total deposits in the United States. Not if they are FORBIDDEN from loaning any amount to unregulated financial institutions. Not if they are FORBIDDEN from packaging their liabilities and selling them as opaque derivatives. Allow them to sell the liabilities one at a time as they used to before Freddie Mac invented the MBS, but prevent them (and Fannie and Freddie) from packaging and selling their liabilities in artificial securities.

In other words, make banking the utility it was until the 1970's and should be again, and let the sort of person who today runs a credit union because he or she is interested in public service run the a bank tomorrow.

At the same time, allow the descendants of investment banks and hedge funds to do what they want with invested money, not loans. And make it very clear that there is no Federal guarantee explicit or implied backing any of those investments. Caveat investor.

This would result in the shrunken financial sector Felix envisions operating at the service of the economy, not as its master.

And a fantastic "unintended consequence" -- well, in truth very much intended -- would be the humbling of a large group egregiously smug and reactionary opportunists. Rick Santelli, I'm lookin' at you and your millionaire trading buddies howling for the blood of poor people who listened to shysters in the mortgage origination business.

Apr 13 11:08 AM

[tedfoo:]

The finance "industry" always had enraged me, and I'm glad their grapes have turned sour. They produce nothing and skim away other people's hard earned money through these sham financial instruments (although 41% is hardly skimming).

This country could use more real workers and innovators - and less of these types. Pushing debt and monopoly money around all day is hardly productive work for any society. Guess we shouldn't have sent all those manufacturing jobs overseas, huh?

Apr 13 11:20 AM

[traden4alpha:]

Part of me is very attracted to the "utility model" for banks. But the utility model contains a basic flaw in that it assumes that consumers and corporations will deposit their money and take their loans from these institutions. Given the current high level of access to global markets, that seems unlikely.

Capital goes where it is appreciated. And unless consumers are FORBIDDEN from investing in non-depository institutions, their money will flow to non-depository financial vehicles (equities, corporate bonds, real estate, foreign investments, etc.).

I do agree that we need to regulate the financial industry to avoid "too big to fail" situations, but such regulation must consider the unintended consequences of where consumers and corporations move their financial activities.

On Apr 13 11:08 AM Anandakos wrote:
> Morph,
>
> The complications you foresee will not occur if regulated and insured
> depository institutions are FORBIDDEN from any activity other than
> taking deposits and making loans up to their statutory capital ratio
> maximum. Not if they are FORBIDDEN from owning any subsidiary or
> being owned by a holding company that does unregulated activities.
> Not if any single institution is FORBIDDEN from holding more than
> 5% of the total deposits in the United States. Not if they are FORBIDDEN
> from loaning any amount to unregulated financial institutions. Not
> if they are FORBIDDEN from packaging their liabilities and selling
> them as opaque derivatives. Allow them to sell the liabilities one
> at a time as they used to before Freddie Mac invented the MBS, but
> prevent them (and Fannie and Freddie) from packaging and selling
> their liabilities in artificial securities.
>
> In other words, make banking the utility it was until the 1970's
> and should be again, and let the sort of person who today runs a
> credit union because he or she is interested in public service run
> the a bank tomorrow.

Apr 13 11:36 AM

[Larrysyr:]

There's no need to forbid anything. The banks will do what they need to do - process transactions, take deposits, make loans. Utilitarian and necessary stuff, but there's no need to force excess capital into that industry. There will always be some demand for safe-havens, and isn't that what banks are supposed to be?

The risk-taking ventures, where capital receives a higher return, SHOULD be separate from banks.


On Apr 13 11:36 AM traden4alpha wrote:

> Part of me is very attracted to the "utility model" for banks. But
> the utility model contains a basic flaw in that it assumes that consumers
> and corporations will deposit their money and take their loans from
> these institutions. Given the current high level of access to global
> markets, that seems unlikely.
>
> Capital goes where it is appreciated. And unless consumers are FORBIDDEN
> from investing in non-depository institutions, their money will flow
> to non-depository financial vehicles (equities, corporate bonds,
> real estate, foreign investments, etc.).
>
> I do agree that we need to regulate the financial industry to avoid
> "too big to fail" situations, but such regulation must consider the
> unintended consequences of where consumers and corporations move
> their financial activities.

Apr 13 11:59 AM

[morph366:]

Anandakos
You suggest in response to my comment that we should "make banking the utility it was until the 1970's and should be again"
If only it was so simple... the financial landscape is totally different today to the 1970's.
I wrote somewhere else recently
The biggest step towards the world of modern finance was the abandonment of the Bretton Woods stability framework and fixed exchange rates that took place in the 1970’s and Nixon's final nail in the coffin for gold convertibility with the US Dollar.
It was not for the reason that most believe i.e. the creation of fiat currencies but because of the creation of a new era of financial complexity. Suddenly the world had a plethora of new financial variables - exchange rates, floating rate instruments denominated in euro-currencies and I do not mean the Euro of today but the euro market that originated for dollar based deals that were outside the US jurisdiction and based in London, financial futures and swaps etc. etc.

Not only was there an explosion in the number of variables but innovative financiers began to exploit relationships within this new web of financial variables eventually creating layers of derivatives etc. This opened up the era of financial arbitrage – and allowed the smart money to think they were getting a free lunch....

Thirty years later we know that the lunch was rather expensive

Apr 13 12:10 PM

[Anthony B:]

The amount of money investment bankers were making, made doctors and lawyers look poor. As a result much of America's top graduates went on to Wall Street instead of to med school, engineering firms, etc. This is finally reversing to norm.

Apr 13 12:13 PM

[old boat guy:]

Honestly, I've been in business all my life and there has been a shortage of educated, intelligent and qualified people. The problem for the financial sector and wall street is that those qualified people available don't have the "right" breeding, come from the "correct" families, or gone to "the" schools. Get a life.,

Apr 13 12:25 PM

[americafirst:]

I'm sure that all of those out of work financial "geniuses", will be able to find work in the auto sector,home builder or some other sector they have managed to help bankrupt. i guess India is doing well.....

Apr 13 01:47 PM

[Chris B:]

1) "you tax and regulate the stuff you want less of."

This is true and certainly effective (e.g. increasing tobacco or alcohol taxes have been shown to reduce purchases). It is also true that we've reduced taxes and regulations on the financial industry over the last 15-20 years, which means we got more of it. Taxes on capital gains, dividends, and interest were dropped to 15% to encourage more of this activity. Meanwhile, manufacturers WHO ACTUALLY PRODUCE THINGS AND EMPLOY PEOPLE still faced tax rates more than twice those amounts. Suppose you wanted to start a business. Would you start a factory and be taxed at 30% or a financial firm and be taxed at 15% (maybe)? It's no wonder that US manufacturing has been in decline for so long!

2) Much of the profit in the financial industry comes from credit cards. Watch the checkout counter at Wal Mart sometime - almost all card transactions. Visa and Mastercard get 2% of every sale. It's amazing. Their margins are often higher than the retailers'!

3) The traditional commercial lending banking model has only grown as fast as the economy in general. The "investment" banking model, credit cards, and the CDS market, however, have expanded much faster. Since Citigroup lobbyists persuaded Congress in 1999 to repeal the Glass-Steagal Act of 1933, it will be increasingly difficult to shave down the non-commercial side while preserving the commercial lending that keeps our economy growing. How do you hobble Bank of America or Citigroup without cutting off some productive business from one of its sources of financing, resulting in layoffs?

Apr 13 02:09 PM

[Tom Armistead:]

Looking at the 41%, only part of that was fees for useful financial services such as loans, M&A, etc. The rest of it was for speculation and manipulation, which operate by skimming off the flow of productive goods and services.

Regulators should make sure they reduce the CDS and other derivatives to a very small part of financial services, and the rest should be for tradtional banking services.

Apr 13 02:50 PM

[Linus Wilson:]

If Goldman raises $10 billion of new common stock to pay back the $10 billion of preferred stock and warrants that the U.S. Treasury bought, my paper "Debt Overhang and Bank Bailouts" at ssrn.com/abstract=1336288 indicates that that would be an improvement on the current situation.

If any of the big banks raises new common stock to retire preferred stock, that would make it less likely they will make bad decisions which are costly to taxpayers going forward. Common not preferred stock cures the problems of over leverage regardless of who owns the shares.

Apr 13 03:08 PM

[Lee Eugene ...:]

If you want to extract money from the system, man-up and trade. Take risk with your own money or capital that you raise from those that understand the risks and are looking for a pirate. This crap of Goldman saying they are an investment bank, but then running the firm as their own private hedge fund sickens me. There is nothing wrong with speculation, when you are upfront about it and not counting on the government or unsuspecting investors to pony up the capital. You eat what you kill. If this was the law, none of this would have happened.

Apr 13 09:41 PM

[Moon Kil Woong:]

I believe the rights issue will just lead to sucking up more capital into the financial industry with no growth in loan volume. Thus it dries up capital and credit while further bolstering banks that just want to pad their reserves with more reserves. This is exactly why we're are experiencing massive de-leveraging. It would be much more economically productive to take $5 billion and start a new bank.

This is something any real financial titan who wants to really help America should seriously consider. We need new, young, good banks not saddled with the relics of past bad loan practices and derivatives.

Apr 14 07:07 AM

[Pent up demand:]

Shrinking the financial sector is good. The problem is that the only growth sector that seems to be stepping into that gap is the public sector. That is not a recipe for prosperity either.

Apr 14 09:41 AM

[brad3378:]

We should outsource our white collar Wall Street Jobs overseas just like we did with our manufacturing sector. Just like Manufacturing, we can even call it "staying more competitive with the world" too.

Apr 14 10:24 AM

[normthefedup:]

Felix: why don't you vent your venom at the ratings agencies? S&P, Moody's, et al? These useless bastards sold us ALL down the river. Including the bloated banks that your contend caused this problem. I tend to think of myself as a "savvy investor" and I bought Fannie preferreds last March. All based on the "implied backing of the US government and that all-powerful AAA rating." These a**holes have in truth missed the carnage that THEY caused. AAA ratings BOUGHT with monies paid to the rating agencies who prostituted themselves to the entities that invented the garbage that has cost us all so dearly. You're beating the wrong VICTIM here. You have plenty of venom to spew, son. Spew SOME of it in the direction it should be spewed.

Apr 15 08:28 AM

[Mark Bern:]

There are plenty of parties to blame in this fiasco. Congress listened to lobbyists and repealed the Glass-Steagal Act of 1933 opening the doors for financial firms to cross lines they shouldn't and to operate in more and more speculative areas with our money. The financial institutions made loans to people who were not qualified. Then they packaged the bad with the good and sold the ratings agencies on the concept that the mix would reduce the risk. The ratings agencies did not do their due dilligence and handed out ratings that were not representative of the assets being rated. The regulatory agencies that have are supposed to regulate banking activities didn't regulate or dig deep enough to identify the irregularities that were occuring for years. Successive Administrations have deregulated areas that need government oversight and regulation. (Not that I like the government expansion model - I don't; but banks need to be kept honest because they are dealing with great sums of money from large numbers of individuals, the lifeblood of our economy.) Investment banks turned hedge funds were making most of their money in speculation instead of banking and investment services to customers. Individuals applying for loans that they cannot afford and the banks "peersuading" them that they can. The Federal Reserve kept interest rate artificially low too long adding to the bubble effect.

Yet, we are at the mercy, it seems, of those who created the problem. We stand by with our pockets turned out, watching helplessly as the problem is "fixed" by those who perpetrated the crimes. I don't believe that we headed for stability. Instead, I suspect that we are heading for another manipulated bubble.

GS, C, BofA, et. al. need to put up signs in front of their office and branch buildings that reads: "Your tax dollars hard at work!

Apr 15 05:34 PM