VERY PRELIMINARY - PERI



VERY PRELIMINARYDraft 1.0Comments WelcomeHow Big is Too Big?What Should Finance Do and How Much Should It Be Cut Down To Size?Gerald Epstein and James CrottyWith the Assistance of Iren Levina and Nina EichackerDepartment of EconomicsUniversity of MassachusettsAmherst, MAUSASeptember 28, 2011AbstractThe financial sector has grown significantly over the last several decades and some have suggested that the sector is now too big. Yet we have no obvious theoretical framework nor clear metric to measure the social usefulness of financial activities to help us determine the desirable size of the financial sector. In this paper we explore some ways to conceptualize the appropriate size and quality of the financial sector and present some initial data on gambling versus productive finance and the productivity of financial innovation.I. IntroductionBy almost any measure, the size of the financial sector in the United States, and in many parts of the world, exploded over the past several decades, prior to the financial crash of 2008. (See some summary data in section II below; see MacEwan and Miller, 2011, on the role of finance in the crisis). In the aftermath of the crisis, many analysts, some in surprisingly high positions of authority in the world of financial governance, have argued that the financial sector has grown too big, that many of its activities have little, or even negative social value, and that the productivity and efficiency of the world economy could be improved in the financial sector were to shrink. Lord Adair Turner, Chairman of the UK’s FSA remarked in an interview with Prospect Magazine and then in a speech in September, 2009: “…” …not all financial innovation is valuable, not all trading plays a useful role, and that a bigger financial system is not necessarily a better one.” (Turner, Mansion House Speech, 2009). Defending his Prospect magazine remarks, he remarked: “…I do not apologise for being correctly quoted as saying that while the financial services industry performs many economically vital functions, and will continue to play a large and important role in London’s economy, some financial activities which proliferated over the last ten years were ‘socially useless’, and some parts of the system were swollen beyond their optimal size.” (ibid.)Paul Volcker was more blunt. He reportedly told a room full of bankers:Top of FormBottom of Form “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence,” said Mr Volcker.”Despite this general and, one might add, increasingly wide-spread view of the bloated state of the financial sector, there has been relatively little research which has tried to analytically frame and carefully estimate the extent of “unproductive” finance and to estimate the dimensions of financial bloat and its impacts. (see, however, Arcand, Berkes and Panizza, 2011, and Panizza, 2011, for a recent attempt; the work by Turner, Haldane and colleagues, 2010, is also of significant interest here).This paper takes some small steps in the direction of trying to make some sense out of these perceptions and concerns. A complete study of these issues would address the following questions:1) What metrics should be used to determine the appropriate size of the financial system? How can we tell if it is bloated? 2) How can we determine which activities of the financial sector are socially useful and which are not?3) How can we determine which financial innovations are socially useful and which not?4) What do the answers to these questions imply about the appropriate level and nature of financial remuneration in the financial industry?5) What do the answers to these questions imply about the appropriate type of financial regulation, including the nature and level of financial taxes?The answers to these questions have important implications for policy. For example, a number of economists and regulators, including Pollin and Baker, the European Commission, Lord Turner, and some IMF economists have endorsed the idea that financial taxes should be increased. An industry response is that this would reduce the size of the financial sector below the optimal level and hinder useful financial innovation. Most financial reform legislation, including the Dodd-Frank legislation recently passed in the United States call for increased capital and liquidity requirements which may shrink the size of the sector relative to what it would be otherwise. Bankers and others have expressed concern that these need to be levied in such a way as to preserve “international competitiveness” of the financial sector, and to prevent activities from going “offshore”. But if, at the margin, the financial sector is not socially efficient, then a “lack of competitiveness” which causes the sector to shrink is not socially harmful. Others have called for significant restrictions on the level or form of banker pay in order to generate more fairness and to reduce excessive risk incentives. (Crotty and Epstein, 2009; Crotty, 2009). Critics have responded that these actions might lead to “banker brain drain”, leading to the movement of the most highly paid bankers abroad. Here again, this is of particular social concern only if the activities of these highly paid bankers are making a significant social contribution. The answers to the questions posed above are obviously relevant to these key policy issues.Given the breadth and complexity of these issues, in this paper, we will focus mostly on two aspects of this very broad set of questions: 1) the issue of financial gambling engaged in by U.S. investment banks in the lead up to the financial crisis and 2) the issue of the social productivity of financial innovation. These discussions are highly preliminary and can at most make some initial progress toward assessing the question: how big is too big.In what follows we will first offer some initial definitions with regard to the social productivity of the financial sector. In section III we will present a broad overview of the growth of the financial sector in the last several decades and briefly review some literature that has raised questions about the social value of its role. In section IV we will present some rough estimates of the share of income generated by U.S. investment banks from gambling as opposed to other aspects of their activities. In section V we will discuss the social productivity of financial innovation and in the final section we will summarize and present some suggestions for future research.II. A Socially Productive Financial Sector? Initial DefinitionsIn this difficult area, we begin with James Tobin’s important essay, “On the Efficiency of the Financial Sector” first published in Lloyd’s Bank Review in 1984 and reprinted in Essays in A Keynesian Mode (Jackson, 1987). Tobin defined four different types of efficiency of the financial system. The first three are: 1) information arbitrage efficiency 2) fundamental valuation efficiency 3) full insurance efficiency. While these three concepts only really make sense in an Arrow-Debru type world, and need major reconceptualization in a world characterized by “Keynesian Uncertainty” (Crotty, 2008) it is the fourth concept of efficiency which is most immediately relevant to this paper:“The fourth concept relates more concretely to the economic functions of the financial industries... These include: the pooling of risks and their allocation to those most able and willing to bear them... the facilitation of transactions by providing mechanisms and networks of payments; the mobilization of saving for investments in physical and human capital... and the allocation of saving to their more socially productive uses. I call efficiency in these respects functional efficiency…I confess to an uneasy Physiocratic suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. “(Tobin, 1987).Here, we begin with Tobin’s concept of functional efficiency and use it to frame our discussion of the roles the financial sector has been playing in recent decades. To measure these roles, new measures will have to be developed. Standard measurements of the contribution of the financial sector to the economy, such as value added of the financial sector, rate of return on equity, and wages are highly problematic because they have reflected mispricing of risk, excessive leverage and monopoly power, (Haldane, 2010). According to some analysts, notably William Black, they have also reflected fraudulent activities. Thus, other measures of functional efficiency and inefficiency will need to be developed. Though it might be a useful starting point, Tobin’s taxonomy of different types of financial efficiency is itself highly problematic, for at least two reasons. First, they mostly assume that financial fundamentals exist that can be readily known and that it makes sense to judge efficiency with respect to the proximity of values to the fundamentals. From a Keynesian perspective based on fundamental uncertainty this does not make much sense. Second, Tobin suggests that the financial sector at worst can be unproductive; but a broader perspective – based in different ways on the works of Marx and Minsky – would suggest that the finance sector can engage in exploitation and destroy value. We return to these points later in the paper.First we present some basic data that show how dramatically the finance sector has grown in recent decades to place the issue of “financial bloat” in an empirical context.III. Brief Overview of Recent Trends in The Size of the Financial SectorNo matter how the size of the financial sector with respect to the rest of the economy is measured, the trend of massive growth is obvious. Financial sector total financial assets grew from about a third of total US economy financial assets in the post- World War II decades to 45 percent of total financial assets. Their value was approximately equal to the US GDP in the early 1950s, whereas now it amounts to 4.5 times of the US GDP. Financial sector profit has grown from about 10 percent in the 1950-60s to 40 percent of total domestic profits in the early 2000s. This rise in the financial sector as a whole is accompanied by a drastic rise in some of its segments. Investment banking has drawn special attention during the 2007 - present crisis, because these financial institutions were at the heart of creating new financial products and because bankruptcy of some of them and forced acquisitions of others triggered the beginning of the crisis. Financial assets of the securities industry amounted to a constant 1 percent of total financial sector financial assets from 1945 till the early 1980s. After that, they rose five-fold and reached the level of 5 percent of the total financial sector financial assets. Their rise as a share of GDP has been even more pronounced – from 1.5 percent in the post- World War II decades to 22 percent in 2007. Other measure of the size of the securities industry in the US gives an even larger figure, with the securities industry total assets reaching 45 percent of GDP in 2007. The rise in the size of the financial sector and its individual firms is important as it suggests major changes in the way economies operate. Nevertheless, a rise in the size it does not necessarily follow that this rise is a “social waste”. Hence, what matters is not the size of the financial sector per se, but its size with respect to its economic function – the services it provides. The Rise of FinanceAt least since the outbreak of the recent financial crisis, the debate on the size and the role of the financial sector in the economy, has related both to the size of the finance sector over-all and to the size of particular financial institutions (the “too big to fail” TBTF issue. So, the first question is the size of the sector as a whole. No matter how the size of the financial sector with respect to the rest of the economy is measured, the trend is obvious. Financial sector total financial assets grew from about a third of total US economy financial assets in the post- World War II decades to 45 percent of total financial assets. Their value was approximately equal to the US GDP in the early 1950s, whereas now it amounts to 4.5 times of the US GDP. Financial sector profit has grown from about 10 percent in the 1950-60s to 40 percent of total domestic profits in the early 2000s. (Figure 1)Figure 1This rise in the financial sector as a whole is accompanied by a drastic rise in some of its segments. Investment banking has drawn special attention during the 2007-09 crisis, because these financial institutions were at the heart of creating new financial products and because bankruptcy of some of them and forced acquisitions of others triggered the beginning of the crisis. Financial assets of the securities industry amounted to a constant 1 percent of total financial sector financial assets from 1945 till the early 1980s. After that, they rose five-fold and reached the level of 5 percent of the total financial sector financial assets. Their rise as a share of GDP has been even more pronounced – from 1.5 percent in the post- World War II decades to 22 percent in 2007. Other measure of the size of the securities industry in the US gives an even larger figure, with the securities industry total assets reaching 45 percent of GDP in 2007. (Figures 2, 3)Figure 2Figure 3The discussion about the rise in size of the financial sector is usually related to that about its economic contribution – a debate triggered by Turner Review in which Turner posed a question of the extent to which the rise in the financial sector corresponds to its real economic function. (Turner, 2009)The other theme discussed is the rise of individual financial institutions with respect to the financial system as a whole. This shifts the focus of the debate from financial sector being “too big” compared to the economy to individual financial firms being “too big” with respect to the sector. These claims are usually supported by data on rising concentration ratios. And indeed, both commercial banking and investment banking industries have been getting increasingly concentrated. Top five commercial banks received 20 percent of the total sector revenues in the early 1990s and 40 percent in the late 2000s. The investment banking concentration ratio also rose from 35 to 65 percent during the same time period. An important observation here is that not only have the concentration ratios been rising, but also that that the top five investment banks receive almost twice the share of the industry total revenue as the top five commercial banks. (Figure 4)Figure 4This sector-wide concentration is reinforced by concentration of individual activities. A prime example is derivatives trading. Top five commercial banks and trust companies hold about 95 percent of notional amounts of total derivative contracts held for trade in the 2000s. This allowed these five banks to receive 76 percent of the entire sector trading revenues from cash instruments and derivatives in 1998-2006, on average. Nevertheless, this exposure to derivatives also made the top five banks account for 100-105 percent of the total industry losses from cash and derivatives trading in 2007-2008. These losses did not last long though, and already in 2009 the top five banks got 44 percent of total trading revenues, followed by the historical record of 87 percent in the first quarter of 2010. (Figure 5)Figure 5These two issues – that of the rise in the financial system and its segments and that of the rise in individual institutions and concentration – are usually discussed separately. Nevertheless it is important to understand that the two are closely interconnected. On the one hand, a rise in the financial system fosters rising industry concentration. Over the past several decades the rise in finance has been mostly driven by wholesale finance, and it is not surprising that demand for liquidity on a large scale cannot be met by small institutions. On the other hand, the large financial institutions are responsible for a substantial part of the total growth in finance because it is these institutions that are the main site of financial innovation and creation of new instruments. In that sense a rise of individual institutions feeds into a rise in the financial system. Thus, there seems to be a structural problem, with the current financial system requiring big financial firms to function, and the big firms reproducing the growing financial system.This in turn poses challenges for financial regulation. What exactly needs to be reduced in size? Are these individual firms that are too big with respect to the size of the financial system? Or the financial sector as a whole?III. Investment BankingOverviewThe rise in the size of the financial sector and its individual firms is important as it suggests major changes in the way economies operate. Nevertheless, form a rise in the size it does not necessarily follow that this rise is a “social waste”. This rise might be partly explained by a rising importance of the services the financial sector provides, and only partly by some other factors. In principle, it is possible to envisage a situation when the financial sector would grow relative to the economy as a whole, but it will be due to an increased need for its services. Furthermore, there is no theoretical foundation for an “optimal size” of the financial sector and its sub-segments in relationship to GDP or any other indicator of productive dimension of an economy.Hence, what matters is not the size of the financial sector per se, but its size with respect to its economic function – the services it provides. At a theoretical level it is in line with the functional perspective on banking. One way to look at the rise in the financial sector size is through the lens of financial institutions activities. Given that investment banks were at the heart of the recent crisis, we will focus on them for the purposes of our study. How can one infer a relationship between the rise in investment banking and services it provides?Investment banks and their services are different from traditional banks transforming liquid liabilities into illiquid assets – both assets and liabilities of investment banks are highly liquid. For this reason balance sheets are a poor indicator of what investment banks do and of the content of their activities. That is why we will focus on structure of investment banks revenue which is a better reflection of what they do.Incidentally, even if one wanted to use investment banking industry aggregate balance sheets to study what these banks do, one would have faced serious limitations due to data opacity. Since the late 1970s, miscellaneous financial claims have been rising as a share of securities brokers and dealers financial assets, and since the early 1990s these miscellaneous assets have amounted to a half of total assets held by investment banks. On the liability side the data are more transparent. One can infer that since the early 1990s securities brokers and dealers have been funding themselves through three main channels – equity investment in subsidiaries, security credit, and repo – with each of the three categories amounting to roughly a third of total liabilities.Figure 6Figure 7We will focus on the top five investment banks and the structure of their revenues.Not only have the top five investment banks grown as measured by their assets, but also they have been receiving a rising share of revenues. Net revenues of these banks amounted to only 0.3 percent of GDP in the early 1990s, but increased more than two-fold since then. In 2006, top five banks’ net revenues amounted to 1 percent of GDP. Where do these revenues come from? What are the activities that generated these revenues? The study will address these questions.Figure 8Figure 9Leverage plays a key role both in terms of the profits of investment banks, and the vulnerability they face that proved their undoing during the financial crisis.The investment banking segment is highly leveraged – more than financial sector as a whole and more than commercial banks. Notice, before the crisis, IB leverage was rising, whilst that of the FS as a whole – falling (Figure 11) It makes investment banks more sensitive to liquidity risk – a fact that was proven by the 2007 crisis. Hence, leverage can be used as one key measure of financial institution risk exposure.Figure 11Note: Securities industry consists of all broker-dealers doing a public business in the US.Figure 12Figure 13Global dataSource: Turner Review, p. 19As we will see in our discussion of financial innovations in the next section, investment banks played a key role in the creation of toxic structured products.Figure 14Gambling vs. Functional Efficiency in Investment Banks We start with investment banks. This is of particular interest given that investment banks were at the heart of the recent crisis. Investment banks and their services are different from traditional banks transforming liquid liabilities into illiquid assets – both assets and liabilities of investment banks are highly liquid. For this reason balance sheets are a poor indicator of what investment banks do and of the content of their activities. That is why we will focus on structure of investment banks revenue which is a better reflection of what they do.Even if one wanted to use investment banking industry aggregate balance sheets to study what these banks do, one would have faced serious limitations due to data opacity. Since the late 1970s, miscellaneous financial claims have been increasing as a share of securities brokers and dealers financial assets, and since the early 1990s these miscellaneous assets have amounted to a half of total assets held by investment banks. On the liability side the data are more transparent. One can infer that since the early 1990s securities brokers and dealers have been funding themselves through three main channels – equity investment in subsidiaries, security credit, and repo – with each of the three categories amounting to roughly a third of total liabilities.Thus, precisely because of the nature of investment banking activities as distinct from traditional banking reflected on banks’ balance sheets, investment banks can be best understood through the lens on their income statements, not balance sheets. An analysis of investment banks income statements and ways in which they make money is at the core of the present study. Specifically, we will look into composition of revenues coming from different activities and changes in this composition. This will provide a link between what investment banks do and the extent to which their growth can be validated by their economic function. Put differently, composition of investment banking revenues can be used as a proxy for composition of activities investment banks perform, hence, changes in the former would reflect changes in the latter. Growing components of revenue would reflect types of activities accounting for the overall growth in investment banking business.This study cannot be done at the aggregate level due to data limitations. According to the data from SIFMA – the only data source on the aggregate securities industry income statements – “other revenue related to the securities business” and “other revenue” combined amount to a rising share of total revenue. This share grew from 40 percent in 2001-2004 to almost 70 percent in 2008. This data source can obviously not be used to decompose the structure of revenues. For this reason, given that investment banking is a highly concentrated industry with the top five investment banks receiving up to 65 percent of total revenues, we will focus on the top five investment banks and the structure of their revenues. Not only have the top five investment banks grown as measured by their assets, but also they have been receiving a rising share of revenues. Net revenues of these banks amounted to only 0.3 percent of GDP in the early 1990s, but increased more than two-fold since then. In 2006, top five banks’ net revenues amounted to 1 percent of GDP. Where do these revenues come from? What are the activities that generated these revenues? The study will address these questions.Functional Efficiency of Investment Banking: Gambling vs. Social ProductivityMethodological Issues:We attempt to distinguish between “gambling” (of functionally inefficient) and “socially useful”( or functionally efficient) activities of investment banks.To make this distinction we will first analyze the implications of major financial theories and their implications for how to evaluate the distinction between trading-related and gambling.Efficient markets theory: Standard efficient markets theory would suggest that all trading is efficient and contributes to value-added. Hence, for this approach, the distinction between trading and gambling would not be relevant since gambling would be seen as serving a social purpose (enhancing utility in an efficient way.)New Keynesian and Assymetric Information and noise-trading Approaches: These approaches suggest that with informational imperfections, there may be “noise-trading” which does not disappear because of the absence of perfect arbitrage. Hence there can be temporary movements of financial assets away from their fundamental values and that trading activity which moves asset prices in this way is not socially useful. (See, for example, Stiglitz, 2010 and the body of work that he and co-authors have contributed to in this area). Utilizing this approach then, one would attempt to estimate “fundamental or equilibrium” values of assets and then the trading activity that is associated with significant movements away from these activities. This form of trading would not be functionally efficient.Rent Extraction and Value Destroying Approaches: Crotty (2010) develops an analysis of rain-maker incomes from trading activities that rely on imperfect labor markets, oligopoly structures of financial markets, the creation and profiting from financial bubbles, and the value extraction from other stake-holders of the firm (also see the work of Summers, Vishney and Schleifer and others in this area). From this perspective, then, trading can be a mechanism by which to redistribute rents among stakeholders, and even destroying wealth in the process.In what follows, we will not be able to fully apply these methodological distinctions. In what follows, we will simply be able to make a very first pass at estimating trading and gambling.First Approximation estimates of trading/gambling:As a first approximation, we define “gambling” is as trading and other “trading-related” activities of investment banks. “Socially useful” (or “functionally efficient”) activities constitute the rest of banks’ operations. Due to differences in categorizing sources of revenues by different banks, an application of this conceptual criterion requires a firm-specific analysis. In what follows we have space to only present the summary data based on the firm specific analysis. We construct a data set for the seven largest investment banks for 2006-2008. To show the evolution of the structure of investment bank activities, we need to compare the findings to the earliest possible time period. Investment banks went public in different years, and some of them went bankrupt or were acquired in 2008, for this reason the time period for which SEC filings are available differ across the firms. More specifically, the 10-k reports are available for Goldman Sachs that are filed in 2000-2009, Merrill Lynch – 1994-2009, Lehman Brothers – 1994-2008, Morgan Stanley – 1997-2009, Citigroup – 1994-2009, Bear Sterns – 1995-2008, JP Morgan – 1994-2009. In our data set, we use the first 3 and the last 3 years available in the SEC filings. When there is a change in a firm’s reporting standards, we try to construct the data set consistent with the current methodology used in the latest reports.The tables below present the results of our calculations of gambling as a share of net revenues for the 5 largest US investment banks. These data suggest that revenue from “gambling” as a share of total revenue was highly significant for these investment banks. If one looks at the height of the bubble just before the crash, say in 2006 or 2007, “gambling” revenue is often as much as 50% or more of total revenue. These data bear on the issue of proprietary trading that is so important to the Volcker rule. First, consider Morgan Stanley. The data shows that in 2008, Morgan Stanley’s trading and investment revenues were about 2% of total revenue as was widely reported in the press. Though we do not claim that this is precisely “proprietary trading” as defined narrowly, the fact that this figure for Morgan Stanley for 2008,was so widely cited by bank analysts does suggest that our data is in line with quoted estimates. Now, note that this 2% figure is from 2008, the year the system crashed. But in 2006, at the height of the bubble, trading income as a share of total revenue was more than 19%. A similar story holds for Goldman Sachs. In 2008, trading income as a share of gross revenue was re-ported in the media to be around 10% and according to our figures, about 15%. But if one goes back to the boom years of 2006, it was more than a third of the gross revenue, almost 35%. As a percentage of net revenue, trading income was much higher, 36% in 2008; in 2006 and 2007, it was a whopping 64% or more of net revenue. For Citigroup, our numbers are even rougher than for Morgan Stanley and Goldman, but they tell an interesting tale. Trading and investment revenue as a share of gross revenue in 2006, at the height of the bubble, was only about 5% of gross revenue, the number cited by many in the press. If one uses the more appropriate net revenue figure then this share jumps to over 9%. Interestingly, if one looks at the contributions to Citi’s revenue losses during the crash, according to these admittedly crude estimates trading and principle investments played a significant role. In 2008, for example, trading and principle investment losses amounted to 20% of gross revenue and over 40% of net revenue. If one counts these trading losses as a percentage of the declines of total and net reve-nue, these numbers become much higher. For example, between 2007 and 2008, Citigroup’s total revenues fell by almost $50 billion and net revenues fell by almost $26 billion. In 2008, Citigroup lost $22 billion which amounts to 44% of total revenue losses and more than 80% of net revenue losses. Contrary to the bankers and pundits that claim that “proprietary trading” did not cause the crisis, these losses led to a tax payer bailout and constitute, in fact, one of the main components of what most of us mean by “the financial crisis.” Table 1Gambling vs. Functionally Efficient ActivitiesFive Large Investment BanksGS (Goldman Sachs)199819992000…200620072008millions $Commissions1,3681,5222,307Trading and principal investments2,3795,7736,62725,56231,2269,063Securities services7307729402,1802,7163,422Net revenue8,52013,34516,59037,66545,98722,222"Gambling" as a share of net revenue, %52.560.459.573.773.856.2Note. Gambling = commissions + trading and principal investment + securities services, for 1998-2000, and gambling = trading and principal investment + securities services, for 2006-2008, due to a change in methodology.MS (Morgan Stanley)199419951996…….200620072008millions $Commissions874.31,022.51,163.13,7704,6824,463Principal transactions421.9478.9449.313,6126,4681,260Other101.993.5107.85451,1616,062Net revenue5,554.16,419.67,462.429,79927,97924,739"Gambling" as a share of net revenue, %25.224.823.160.244.047.6Note. Gambling = commissions + principal transactions + other.BSC (Bear Stearns)199319941995……200520062007millions $Commissions4214835471,2001,1631,269Principal transactions1,1571,1348603,8364,9951,323Net revenue2,1432,4172,0757,4119,2275,945"Gambling" as a share of net revenue, %73.666.967.868.066.743.6Note. Gambling = commissions + principal transactions.LEHM (Lehman)19891990199119921993……200520062007millions $Commissions1,8581,5081,6491,6771,3161,7282,0502,471[Market making and] principal transactions1,2691,1991,6961,6971,9677,8119,8029,197Net revenue4,8924,0164,9055,4265,21814,63017,58319,257"Gambling" as a share of net revenue, %63.967.468.262.262.965.267.460.6Note. Gambling = commissions + [market making and] principal transactions.MER (Merrill Lynch)199119921993……..20062007*2008*millions $Commissions2,1662,4222,8945,9857,2846,895Principal transactions1,9062,1662,9207,248-12,067-27,225Other3402812852,883-2,190-10,065Net revenue7,2468,57710,55833,78111,250-12,593"Gambling" as a share of net revenue, %60.956.857.847.7-62.0241.4Note. Gambling = commissions + principal transactions + other. * Losses (negative numbers) require cautious interpretation of these percentages.As we will see in the next section, these revenues were achieved partly by selling toxic products that were at the core of the financial meltdown. Hence, one can reasonably argue that not only were these activities unlikely to be socially productive, they are actually quite destructive.V. What is the Functional Efficiency of Financial Innovations? Initial EstimatesBankers often fight against financial regulation by arguing that regulations will stifle regulations. What is the functional efficiency of financial innovations? What is the impact of these financial innovations on the real economy? Are they associated with higher profits for the innovating firms? More importantly from a social point of view, are they associated with more investment, more rapid economic growth, or higher productivity growth? Do they reduce instability, or risk? Unfortunately, there have been very few rigorous empirical analyses of this topic. As a theoretical matter, there is no presumption that more financial innovation contributes to higher social welfare. Complex mathematical analyses have shown that financial innovations, in principle, can either increase or decrease social welfare (Elul, 1995; Frame and White, 2004). Theory vs. Practice: Financial Innovation, and CDOs, CDSs, and Synthetic CDOsWhile mainstream authors discussed above have touted the social benefits of financial innovation, heterodox economists have taken a more critical stance toward them. Crotty shows in great detail the destructive nature of many of these “innovations”, and how their existence deliberately made price discovery harder, and transparency more difficult: in that way they could generate higher revenues for their issuers. This flies in the face of justifications for innovation based on effiecient markets theory (see Crotty’s 2008 article “Structural Causes of the Global Financial Crisis: A Critical Assessment of the New Financial Architecture,” and the “Rainmaker Financial Firm”)In the 1989 article “Financial Innovation and Financial Fragility,” Michael Carter applies Minsky’s theory of financial fragility to the financial innovation and instruments of the 1980s, and concludes that those new instruments – junk bonds, mortgage backed securities, interest rate swaps and others – contributed to increased financial fragility. Other papers that have examined the consequences of the Global Financial Crisis have shown evidence that several – if not all – of the outcomes that Minsky predicts have held true for different sectors of the population that have been affected by the sub-prime mortgage crisis and its aftermath.Empirically, there has been very little evidence provided on these key questions. Lerner (2006) does find that financial innovation raises the profits of the innovating financial firm, at least in the short run. But what about social impacts? Frame and White (2004) published a comprehensive survey of the determinants and effects of financial innovation. As their paper shows, there has been relatively little study of financial innovation. As a result, there is virtually no evidence that financial innovations contribute to lower cost of capital, more investment, or higher rates of economic growth. Indeed, in light of the enormous costs associated with the current crisis, we have a great deal of emerging evidence on the high costs associated with some financial innovations. Micro Level DataIn the most comprehensive studies to date, John D. Finnerty and his colleague created a list of securities innovations organized by type of instrument and function/motivation of the issuers: debt, preferred stock, convertible securities, and common equities) (Finnerty 1988, 1992, 2002). Finnerty's initial study (Finnerty, 1988) dealt with both consumer and corporate financial innovations and listed eleven motivations/functions: (1) Tax advantages, (2) reduced transaction costs, (3) reduced agency costs (4) risk re-allocations, (5) increased liquidity, (6) regulating or legislative factors, (7) level and volatility of interest rates, (8) level and volatility of prices, (9) academic work, (10) accounting benefits and (11) technological developments. In his later work, Finnerty reduced the functions to six: In his later work, Finnerty reduced the functions to six:(1) reallocating risk, (2) increasing liquidity, (3) reducing agency costs, (4) reducing transactions costs, (5) reducing taxes or (6) circumventing regulatory constraints. One should add two other motives: first, firms have a motive to create a proprietary innovation that is complex and murky enough to give it proprietary advantages for at least an initial period of time (Tufano, 2002; Das, 2006). We will call this (7) the "proprietary" or "redistributive" motive. An eighth motive, implicitly proposed by James Tobin, is to open new ways to gamble on trends or to limit losses when such gambling occurs. We will call this the (8) "gambling motive." Clearly, many of these have nothing to do with reducing transactions costs or increasing social efficiency.Table 2, taken from Crotty and Epstein (2009) uses the three Finnerty studies to calculate that number and percentage of innovations that are at least partly motivated by tax, accounting and/or regulatory "arbitrage" or "evasion." Our estimates reveal that roughly one-third of these "innovations" are motivated by these factors, rather than simply efficiency improvements. This estimate, in fact, is almost certainly a gross under-estimate of innovations motivated by tax and regulatory arbitrage, since Finnerty (and Emery) presented a selected set of innovations which they suggested would have "staying power" due to their "addition to value." Their list is not anywhere near a complete list of new types of securities.Table 2 Financial "Innovations" Motivated by Tax or Regulatory EvasionStudyTotal Number of Security Innovations(1)Number motivated at least partly be tax or regulatory reasons(2)Percentage of total innovations motivated by tax or regulatory reasons(2)/(1) x 100(%)Finnerty, 19881034544Finnerty, 1992652134Finnerty and Emery, 2002802531Sources: Finnerty, 1988; Finnerty, 1992; Finnerty and Emery, 2002 and authors' calculations. (Crotty and Epstein, 2009)I believe these believe these are likely to be a significant underestimate of the innovations due to tax evasion, regulatory arbitrage, and even fraudulent activities. Our proposed research is likely to come up with a significantly larger number. Part of the reason is reflected in the quote from the recent study by Tufano. Indeed, Tufano (2002) reports a much larger number of innovations than suggested by the Finnerty, et. al., lists:"In preparing this chapter, I asked my research assistant to compile a complete listof security innovations so that I could update an estimate from the mid-80s that showed that 20% of all new security issues used an “innovative” structure. One place to begin this exercise was Thompson Financial Securities Data (former SDC), a data vendor that tracks new public offerings of securities. He provided me with a list of 1,836 unique“security codes” used from the early 1980s through early 2001, each purporting to be adifferent type of security. Some of the securities listed were nearly-identical products offered by banks trying to differentiate their wares from those of their competitors. Others represented evolutionary improvements on earlier products. Perhaps a few were truly novel. " (Tufano, 2002, p. 7). In short, it is likely that a much larger percentage of new products are implemented for tax, accounting, regulatory, casino and redistributive motives than are indicated in this table.Hence, much of what passes for financial innovation does not contribute to the increase of the social product, but is used to bypass regulations, avoid taxes, and shift income from some people or institutions to others.In addition, financial innovations can actually be destructive: indeed, several of them were at the center of the recent financial crisis. In what we follows we give a very brief history of two of them: CDOs and CDSs.Financial Innovation, CDOs, CDSs and the Financial CrisisIntroductionThough argued –that the development of the collateralized debt obligation (CDO), credit default swap (CDS), and synthetic CDO in the lead-up to the global financial crisis represented the best of financial innovation (efficient placement of risk, increased efficiency in the mortgage market, creation of credit, generation of large returns for investors), these securities echoed the opaque (and often doomed) securities from the nineties that Frank Partnoy describes in Infectious Greed. Yet, as Partnoy and Michael Lewis show, bankers designed and market these financial products primarily to help them avoid regulation, earn massive service fees, and increase profits for themselves in the shortest term, with little concern for the long-term effects of these more complex and less transparent securities on either their own shareholders or their investors. CDOs, CDSs, and synthetic CDOs present clear instances of the divergence between the theory and practice of financial innovation.The synthetic CDO was the quintessential financial innovation of the financial crisis. As Partnoy describes: “the Synthetic CDO was the ultimate in financial alchemy. A Synthetic CDO was like a standard cash-flow CDO, except that a bank substituted credit default swaps for loans or bonds. In other words, the ‘assets’ of the [special purpose entity] were credit default swaps. As a result, the companies whose debts formed the basis of a Synthetic CDO had no relationship at all to the deal; most likely, the companies would not even know about it. Neither the investors in the SPE, nor the banks, ever had to touch the companies loans or bonds.” (Partnoy, 2009, 383)The synthetic nature of this asset – representing a further step away from concrete finance that is easy to visualize and comprehend – was emblematic of larger trends in finance. Barnett-Hartt and Partnoy both describe the historical evolution towards these assets made from other assets as a systematic process. Barnett-Hartt notes that there was a significant decrease “in collateral backed by fixed-rate assets and the increased use of synthetic assets,” (Barnett-Hart, 2009, 14) from 1999 until 2007. She concludes that “CDOs began to invest in more risky assets over time, especially in subprime floating rate assets. Essentially, CDOs became a dumping ground for bonds that could not be sold on their own – bonds now referred to as ‘toxic waste.’” (Barnett-Hart, 2009, 14) And according to Partnoy, as of 2002, synthetic CDOs:“were a mainstay of corporate finance. In 2001, banks created almost $80 billion of Synthetic CDOs. During 2002, even after the bankruptcies of Enron, Global Crossing, and WorldCom – companies whose debts were referenced in the credit default swaps of numerous Synthetic CDOs – financial institutions were continuing to do these deals.” (Partnoy, 2009, 383 – 384)Regardless of the increasingly toxic nature of these synthetic CDOs, their popularity increased. Tett writes:“Derivatives versions of CDOs enabled investors to place bets on whether mortgage bonds would default or not.... They would lead to a frenzy of speculation, all based on the fundamental premise that the default risk of bundles of mortgages had been virtually erased by the process of bundling and then slicing them into tranches. If banks chose to hold more and more of the risk in these tranches on their books, selling only the more popular tranches of notes, such as mezzanine, that was no worry because the risk had been so effectively dispersed that the chance the banks would ever take a hit from it seemed so remote as to be unfathomable.” (Tett, 2009, 97)Actors within the financial sector – investment bankers, credit rating agencies, and hedge funds – manipulated instruments, data, and people, ignored ample evidence of the groundlessness of the CDO and mortgage-backed security sector in general, and all the while argued that institutions incapable of understanding the securities that they, the intermediaries, peddled must not regulate them. Investment banks had several key roles in the lead-up to the global financial crisis. First, many of them started mortgage brokering divisions in order to provide raw RMBS material for cash-backed CDOs. Banks underwrote and sold CDOs and synthetic CDOs (and tranches of CDOs and synthetic CDOs). They created hedge funds and structured investment vehicles (and special purpose entities) to purchase their proprietary RMBS, and fill their portfolios primarily with CDOs. They also bought and sold CDSs, depending on how astutely they evaluated the fate of the housing market, and the prospects of massive and sustained default by sub-prime mortgage owners. Through all of this, they paid rating agencies to give their assets high ratings despite the increasingly rotten value of the underlying securities, and put a tremendous effort into marketing CDOs and synthetic CDOs, regardless of whether they believed those securities were sound (in the case of the ignorant investment banks), or rotten (in the case of the mercenary ones).Some investment banks successfully profited from the situation by double-dealing. Deutsche Bank assigned one bond trader, Greg Lippmann, to market CDSs to hedge funds (since unregulated hedge funds could buy such a security while other institutional investors could not). Lippmann lobbied hard for hedge fund managers to take advantage of the oncoming collapse of the CDO market – which would occur after devastation in the housing market – rather than somehow attempting to warn other Deutsche Bank clients that were long on the securities of the inherent risk in their investments.Goldman Sachs took things further than Deutsche Bank. Goldman aggressively marketing synthetic CDOs filled with destined to fail securities – RMBS, CDOs backed by RMBS, and commercial mortgage backed securities – to hedge funds and other institutional investors, including public pension funds. (Morgenstern, 2010) It took care to insulate its bond sales staff from the knowledge of the full risk of the RMBS backed CDOs by shifting the duty of selling RMBS CDOs and other permutations of the CDO instrument to those unfamiliar with the origins of product, while continuing to pressure these new sales staff to sell as many as possible. Behind the scenes, Goldman’s bond traders’ emails described RMBS backed CDOs as crap and worse, while management repeatedly warned the bond sales staff not to give clients any indication in writing that these bonds may be risky, even as clients grew increasingly testy about the securities once they began to decline in value. (FCIC, 2011)As with investment banks, the themes of greed, ignorance, and perverse incentives to destroy value in the interest of short-term personal gain are present in the story of how hedge funds behaved in the lead-up and aftermath of the sub-prime mortgage bubble and global financial crisis. Hedge funds were the largest share of customers for the equity – riskiest – tranche of CDOs and synthetic CDOs – in the 2007 OECD article “Structured Products: Implications for Financial Markets,” Adrian Blundell concludes, after reviewing private industry data, that “Hedge funds have around 46% of [total exposure to CDO tranches], followed by banks at 25%, asset managers at 19%, and insurance at 10%.” (Blundell, 2007, 45) Further, hedge funds as of 2007 held the largest percentage of those riskiest tranches – 19.1% compared to banks at 4.9%, asset managers at 1.7%, and insurance companies at 9.8%. (Blundell, 2007) The official justification for the lack of regulation of hedge funds is their presumed sophistication. Jennifer Taub clarifies that the term ‘sophisticated’ as it applies to hedge funds refers to nothing sartorial or intellectual – merely that hedge funds have a lot of capital to invest on behalf of their clients. However, this assumed sophistication has not, on average, kept hedge funds from acting either recklessly or individualistically with respect to RMBS and CDOs. Much like investment banks, many hedge funds put their clients at risk by investing in those risky assets, and by using risky short-term financing to pay for those risky assets. Failures or changes in either market had the potential to create financial calamity for the hedge funds, and by extension, their investors.In another similarity to investment banks, a few savvy hedge funds foresaw the inevitable downturn in housing prices and the resulting rise in defaults. Like Goldman Sachs and Deutsche Bank, these hedge funds used CDSs to short CDOs and synthetic CDOs. Magnetar and John Paulson’s Paulson and Co. were chief examples of hedge funds that worked with banks to underwrite CDOs and synthetic CDOs based overwhelmingly on risky and doomed securities – CDOs, RMBS, and CDO2s based on tranches of CDOs that banks had been unable to sell. While Paulson worked chiefly with Goldman Sachs and Deutsche Banks, Magnetar worked with multiple banks, including Merrill Lynch, J.P. Morgan, UBS, smaller pension funds, and other intermediaries with CDO holdings to put together riskier than usual bundles of debt. (Eisinger and Bernstein, 2010) In both sets of dealings, the hedge fund made sure to insure itself against future losses by holding the affiliated CDS, and merely waited for the housing market to collapse and to be paid billions of dollars by those long on the bet.V. Conclusion In this paper, we have tried to sketch out several pieces of evidence that bear on the issue of how productive is finance: we tried to share of the revenues of investment banks coming from gambling activities; we looked at the share of financial innovations that seem to be motivated by tax or regulatory arbitrage; and we studied the history of several financial innovations that were crucially connected to the financial meltdown. Obviously, none of these methods is definitive and much more work needs to be done before we can truly determine the “functional efficiency of the financial system”. 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