Why the US financial sector is so large?

This is an interesting explanation of one of the curiosities of the modern economy: Why the US financial sector is so large?. In voxeo.org you can find more detail and some hard numbers about this phenomenon. Empirically, Greenwood and Scharfstein (2013) find that, in the US, financial services, which accounted for 2.8% of GDP in 1950, made up 8.3% of GDP in 2006. This huge amount could be the accumulated GDP of several countries.

In Biais et al. (2014), a formal analysis explains why finance markets have become so large. In a model developed, the growth of the financial sector is driven by innovation. The analysis is applicable to a wide range of innovations – such as collateralized debt obligations (CDOs) or credit default swaps (CDSs), to asset classes such as junk bonds or exchange-traded funds (ETFs) – and management styles.

The model considers two types of market participants: investors who own the assets, and managers who operate the innovation. The analysis is conducted under the assumption of symmetric information (investors evaluate the ability of managers), and asymmetric information, when investors are uncertain of managers’ competence or diligence.

Based on observed performance, market participants learn about the strength of the innovation. They rationally interpret good performance and the absence of shocks as a sign of robustness. Thus, when no shock occurs, confidence increases and the innovation grows, attracting funds and managers. As the innovation flourishes, managers’ earnings increase and exceed the norm of the other sectors, consistent with the empirical findings of Philippon and Resheff (2008).

In the symmetric information version of the model the innovation has remained at a size that is socially optimal. Investors know what they are getting and are paying a competitive price for it. Then the asymmetric assumption is introduced to the model, when opacity and complexity of the innovative sector prevent investors from perfectly monitoring the risk-control systems and efforts of managers. Negligent managers earn excess profits (‘informational rents’). The influx of relatively inefficient managers attracted by rich rewards for little effort spurs faster growth than under symmetric information. This takes the scale of the innovation beyond its social optimum and also increases the vulnerability of the sector. Consequently, the model suggests that information asymmetry implies more severe crises in a much larger system.

This conclusion should provoke discussions about the transparency and regulation of the financial sector in US, which market information imperfections and oversize will bring more severe crisis with global reach.

 

 

 

References:

Biais, B, J C Rochet, and P Woolley (2014), “The dynamics of innovation and risk”, Forthcoming in Review of Financial Studies.

Greenwood, R and D Scharfstein (2013), “The growth of finance”, Journal of Economic Perspectives, 2: 3–28.

Philippon, T and A Resheff (2008), “Wages and Human Capital in the U.S. Financial Industry: 1909–2006”, Working Paper, New York University.

The US Banks Oligarchy – James Kwak

The criticism that regulatory entities have lax oversight over main banks in US is growing. The artificial low lending risk associated to the financial intermediation business for big banks has created system aberrations. Following a great example from James Kwak’s most recent book…

“Middle class wages have been declining for ten years and stagnant for thirty years, and if you have a financial system that allows people making $15,000 a year to take out $400,000 mortgages, I don’t think that’s the fault of the guy making $15,000.  I think it’s the fault of the financial system.”

“But, let’s say I’m a guy who makes $15,000 a year.  I realize, wow, I can get a $400,000 mortgage and I can live in this house for a few years, and if housing prices go up, I can flip it and I can actually make a couple hundred thousand dollars.  And let’s say I’m really clever, and I say, if housing prices go down, I’ll just walk away and I will have gotten to live in a really nice house for three years at no cost to myself.  I mean, that’s the worst, most cynical spin you can put on it, right?  But this is exactly what people on Wall Street do.  The person who is criticizing the janitor for doing this is the same person who thinks that businesses should exploit every legal opportunity to make profits.  So even if you attribute the worst possible state of mind to the guy making $15,000, he’s still just doing what any businessman should do under the circumstances.  But our national ideology somehow doesn’t allow us to think about it in those terms.”

– James Kwak

“Too big to fail” – US financial system… really?

Have you ever thought about what actually caused the financial crisis in 2008?

The recent financial and housing crisis was fundamentally caused by the continuous misspricing of credit that fuelled a bubble in commercial and consumer lending, generating a massive wave of bad debt. The main players were the financial institutions looking for greater revenues.

In futurecasts.com review: “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown,” Simon Johnson and James Kwak set forth the extensive ties between Washington and the nation’s major banks.

The major banks have taken advantage of the recent financial turmoil to consolidate even further, vastly increasing in size and financial importance. Now numbering just six mega banks – Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley – they have created an ideology in Washington that considers the nation’s economic prosperity as dependent on the continued success of the mega banks. In other words: “What’s good for the mega banks is good for the U.S.A.!”

The authors compare the top managers of these banks to the robber baron industrialists of the J. P. Morgan era a century ago. They are “the new American oligarchy — a  group that gains political power because of its economic power, and then uses that political power for its own benefit.”

Unemployment falls to 6.5 % in Canada, 5.8% in United States. It’s not the full story though…

That the general unemployment indicators are going down is good news, indeed, but what I am not sure about is if that fact really reflects how the job market has evolved during the last few years. Most importantly, if the wealth associated to that market is being reflected and felt by real people.

We tend to relay on macroeconomic plain statistics, like the unemployment % in this case, without considering that the quality and the related income of many jobs have been deteriorated in many ways during recent years. Actually, there is a clear tendency to eliminate first level and operative jobs because of technology improvement and affordability. Many of these jobs have also been relocated overseas to low-income job markets, increasing the competition for higher intellectual and education jobs in pretty much all western countries.

As high-end job’s competition increases, education costs do so too, resulting in the social polarization and incremental socioeconomic frictions, dislocating the growing paths and opportunities of important population segments. This effect has been evident for years now in several countries where social pressure and security concerns have raised recently.

We must pay closer attention to the job market by aligning the education infrastructure with real production needs, but equally important, to make the education system affordable. This is the most important way to ensure social movement and efficient allocation of human resources in the economy.

Comments welcome…

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