Rent-seeking in Financial Services
When I was an undergraduate, I used to argue with my engineer pals about the social usefulness of Finance. They compared it with the work of a factory and described financial services as ‘just moving money around’. They accused it of adding no value.
My defence is that moving money around creates value and is socially useful in just the same way as supermarkets move groceries around, creating value and being socially useful.
The ecosystem of large and small manufacturers, supermarkets, wholesalers, retailers and the associated support industries such as packaging, logistics and advertising, is no different to the ecosystem of high street banks, investment banks, hedge funds, high frequency traders, private equity, pension funds and asset managers and their support industry of analysts, lawyers, and financial advisors.
The grocery market moves fruit and veg and household goods around from people who produce them to people that need to them. The financial services industry moves money from people who provide it (savers) to people that need it (companies and governments). The activities it facilitates, such as pensions, and private and public investments, are of immense social usefulness.
It is certainly true that financial services attract the type of traders who are out to make a fast buck, buying and selling stocks (or whatever) to each other with no intention of ever using the underlying asset. Theirs is a zero-sum game. What social purpose do they serve? A vital one actually:
- Price discovery
- Risk quantification
- Asset allocation
All those traders trying to rip each other off are doing the rest of us a favour. They help establish a fair price and – through derivatives – manage risk and, ultimately, ensure money flows to those assets where it is valued most, and therefore likely to be used most efficiently.
Since I was arguing with my fellow under-graduates in the mid-eighties, the financial services industry, and banking in particular, grew and grew, eventually occupying quite a dominant role in society. This is not so surprising because leverage turbo charges investment returns. However, as the industry expanded, rent seeking behaviour became so overt in the form of extreme bonuses that the whole industry, after a crash that nearly brought us all down, stands accused of being morally corrupt.
Rent-seeking is where someone finds a way to make money without doing anything productive. The term ‘rent’ really just refers to income; it is not accusing landlords of being unproductive. It refers to the ability of the rent-seeker to exploit power or position to make excessive and unjustified profits. Profiteering I call it. Rent extraction is not confined to financial services. I’ve been on the other side of the table with a construction company that exploited its position to make out-sized profits at the expense of the public sector. Compliant Remuneration Committees paying Chief Executives huge bonuses is a similar example. Such behaviour shows the rent-seekers to have no honour or integrity but it is the job of public policy to prevent or discourage it.
Where the financial services industry can be criticised for rent-seeking is its liberal use of ad valorem pricing. It means simply working on a big deal means earning a big fee regardless of the work you put in. Ten years on from the financial crisis, the industry is still adapting. One of the drivers of Populism is that it is not changing fast enough.