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By Martin Hutchinson
The crash of 2008 seemed to put an end to the inexorable advance of financial services' share of the economy over the preceding quarter century. Yet in 2009-11 the financial sector rebounded, aided by ultra-low interest rates and a steep yield curve, locking in jumbo profits for even the doziest megabank.
It seemed that a bloated financial sector was a permanent part of the landscape, with legislators having done little to cut it down. Yet this year the financial sector has been in retreat, in terms of salaries, revenues and shareholder returns, with only the regulators reaping bonanzas from lawsuit after lawsuit.
It is now beginning to appear that financial services' dominance may be over. We may however have to endure another grinding recession before anything replaces it.
The simplest evidence that finance is becoming less important is that, after decades of increase, financial sector wages are declining. The Financial Times recently reported that global investment banks are set to cut remuneration by 5% in 2013, the third successive year in which this has happened.
Since global economies have been generally recovering and markets have been more than buoyant, with the S&P 500 up 27% since the beginning of the year, this is a pretty good sign that the change is not merely temporary or cyclical, but reflects a true change in the long-term trend. In retrospect, the mammoth bonuses of 2009-10, spurred by massive profits during the rebound from 2008, were an artificial peak, based on artificial Fed-generated profits.
Investment bank returns, also, are distinctly anemic, with Goldman Sachs' nine months earnings of US$5.5 billion representing an annualized return of only 9.5% on its 2012 capital of $75.7 billion, and the third quarter return on capital being even less. Even with today's low interest rates, investors putting up all that capital, with all the leverage and associated risk, and hiring large numbers of the most intelligent, aggressive and highly qualified people on the planet, should expect a return of more than 9.5% in a bull market.
In addition to receiving low returns, investors in large bank equities have seen their risks skyrocket. The principal new risk, not yet reflected fully in reported profits, is that of legal aggression by regulators worldwide. Almost every day we hear of huge fines being levied on banks for trivial or incomprehensible offenses.
The manipulation of London interbank offered rates (Libor), for example, was a game played by traders taking advantage of the horse-and-buggy system for Libor determination, mostly at the expense of bank counterparties in derivatives transactions. It produced tiny changes in Libor fixings that resulted in large nominal losses because of the staggering volumes of derivatives traded - which were matched by almost equally large profits on the other side of the transactions.
Now the banks are being fined billions of dollars, staggering multiples of their net profits on Libor fixing. The system needed reform, but the blame for its failure should rest not on the people who set up the existing system back in the innocent days of the 1960s but on the designers of trading desks which goosed the trading volumes outstanding to a huge multiple of those justified by genuine economic needs.
This highlights a central problem of modern financial activity - much of it depends on skimming tiny, sometimes unjustified percentages off a gigantic volume of transactions. In fast trading, returns are made by having knowledge of the deal flow more quickly than competitors - a form of insider trading.
In derivatives, as we have seen, returns are made by manipulating benchmarks, whether simple ones like Libor or complex ones like the "index" credit default swaps that produced a $6 billion loss for JP Morgan Chase in the "whale" debacle and no doubt equivalent profits for many other houses. On trading desks in general, we have heard that traders are making profits by receiving economic and other data a few milliseconds earlier than the market in general - again, a form of insider trading.
Trading is becoming increasingly automated; it seems almost certain that the returns from it will asymptotically approach zero, as in other hyper-automated businesses. Yes Apple makes excellent money, but Taiwanese electronics manufacturing giant Foxconn doesn't, and trading desks are Foxconns not Apples, because they have no way of building a real brand name.
None of this income adds economic value. All of it eventually will be stamped out by the regulators, and the fines to be imposed - perhaps a decade after the profits are received (and bonuses thereon paid) - represent a huge risk for investors in large financial institutions. To the extent that it cannot be stamped out legislatively, these tiny skimmed profits can be addressed by a sort of Tobin tax on financial transactions.
While such a tax large enough to zap the financial sector generally is a bad idea, a small one, which would leave the financial sector generally unscathed while attacking the "stealing pennies from in front of a steamroller" section of it, would be entirely justified. Indeed, it makes such good sense that within a few years it is inevitable.
A second reason for supposing the financial sector to have peaked is that its innovation appears to have shut down. The pace of financial innovation probably reached a peak in the 1980s, with the deregulation of the London and New York markets, the invention of most derivatives sectors and the proliferation of corporate finance techniques.
However, innovation, much of it spurious, was still in full swing before the 2008 crash, with "CDO-squared" and the refinements of index credit default swaps being products of the last five years before that crash. Fast trading techniques, too, were primarily a product of the late 1990s and 2000s.
Many of the innovative techniques of the 1980s and succeeding decades were ultra-profitable because they were undertaken using risk management methods that were naive at best, semi-criminal at worst.
When David Viniar of Goldman Sachs claimed in 2007 that he was seeing "25-standard deviation days, one after another", he demonstrated the intellectual bankruptcy of Gaussian risk management techniques such as Value-at-Risk (VaR), which pretend that the risk "tails" are an infinitesimal fraction of their true size. JP Morgan Chase was still using VaR in 2012 when it lost $6 billion through the London Whale. Presumably even the doziest regulators will eventually catch up and prevent banks from arbitraging their risk management systems against taxpayer bailouts.
As an ex-practitioner, I keep a sharp eye out for new financial techniques, in the press and through the recruiting advertisements (which is where the big ones show up), but I have to say I have spotted nothing that is both significant and new since 2008. To the extent that the bull market is bringing an increase in financial sector aggressiveness, it is for example reviving techniques in structured collateralized default obligations that had apparently been discredited by the crash but are now returning to extract a few more billions of suckers' money.
Mortgage real-estate investment trusts, which finance portfolios of residential mortgages through repurchase agreements, have proliferated since 2008 (though they existed before) but they are strictly a product of the steep yield curve induced by Federal Reserve chairman Ben Bernanke, and will disappear into insolvency once the markets right themselves.
Maybe there is stuff going on under the radar that will shortly burst into view, possibly though a gigantic loss by a major house. However, if innovation has indeed run out of steam, that is a sign that financial sector returns are on a downward trend because new products are the most profitable until the suckers figure them out. Once the products get commoditized (if they are not made illegal), the returns are rubbish.
Third, the leverage bubble has gone about as far as it can. Leverage rates in the US and worldwide are at record levels, "stimulated" by all the cheap credit. Once interest rates start to return toward more normal levels so that it is no longer profitable to borrow money, the world will be forced into another painful round of deleveraging, with government budgets forced towards balance, consumers pulling in their horns and overleveraged businesses going bankrupt.
This will be very healthy if painful; it will also cause massive losses to the banking system, which will not be balanced by restructuring fees.
Regulators are already attempting to force financial institutions to reduce their leverage, and are being resisted by the banks themselves. The regulators' efforts have so far been fairly unsuccessful because of the Basel regulations that allow banks to treat certain assets for capital allocation purposes at a tiny fraction of their true value, or, as in the case of government bonds, at no value at all.
A major downturn, involving massive defaults and restructurings by member governments of the developed countries group, the Organization for Economic Cooperation and Development, will be needed for this process to be prohibited, but it's only a matter of time before such a downturn arrives. Once it has happened, capital ratios will be set based on a percentage of total assets at full value, and that percentage is unlikely to be much less than 20%.
Finally, the returns available on the "buy" side through hedge funds and private equity funds, both of which make massive use of cheap leverage, have already shrunk below returns available through a simple "buy and hold" strategy and will sink further once leverage is no longer cheap.
At that point, even the doziest pension fund or Ivy League endowment will realize that investing in these kinds of "alternative assets" is not the way to achieve superior returns but merely to pay gigantic fees to intermediaries out of their portfolios. Various private equity funds and hedge funds will collapse, lawsuits and arbitrary regulatory punishments will fly, and the money flowing into these structures will return to the tiny fraction of the investment pool that is economically justified.
A large part of the financial sector's growth in the last three decades has been mere rent-seeking, figuring out ways to charge much larger fees and returns for performing a service with only modest economic value added. High-end real estate, luxury supercars and vulgar bling businesses will all suffer as the financial sector returns to an economically sustainable size. However, the global economy as a whole will be greatly enriched thereby.
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010).
The crash of 2008 seemed to put an end to the inexorable advance of financial services' share of the economy over the preceding quarter century. Yet in 2009-11 the financial sector rebounded, aided by ultra-low interest rates and a steep yield curve, locking in jumbo profits for even the doziest megabank.
It seemed that a bloated financial sector was a permanent part of the landscape, with legislators having done little to cut it down. Yet this year the financial sector has been in retreat, in terms of salaries, revenues and shareholder returns, with only the regulators reaping bonanzas from lawsuit after lawsuit.
It is now beginning to appear that financial services' dominance may be over. We may however have to endure another grinding recession before anything replaces it.
The simplest evidence that finance is becoming less important is that, after decades of increase, financial sector wages are declining. The Financial Times recently reported that global investment banks are set to cut remuneration by 5% in 2013, the third successive year in which this has happened.
Since global economies have been generally recovering and markets have been more than buoyant, with the S&P 500 up 27% since the beginning of the year, this is a pretty good sign that the change is not merely temporary or cyclical, but reflects a true change in the long-term trend. In retrospect, the mammoth bonuses of 2009-10, spurred by massive profits during the rebound from 2008, were an artificial peak, based on artificial Fed-generated profits.
Investment bank returns, also, are distinctly anemic, with Goldman Sachs' nine months earnings of US$5.5 billion representing an annualized return of only 9.5% on its 2012 capital of $75.7 billion, and the third quarter return on capital being even less. Even with today's low interest rates, investors putting up all that capital, with all the leverage and associated risk, and hiring large numbers of the most intelligent, aggressive and highly qualified people on the planet, should expect a return of more than 9.5% in a bull market.
In addition to receiving low returns, investors in large bank equities have seen their risks skyrocket. The principal new risk, not yet reflected fully in reported profits, is that of legal aggression by regulators worldwide. Almost every day we hear of huge fines being levied on banks for trivial or incomprehensible offenses.
The manipulation of London interbank offered rates (Libor), for example, was a game played by traders taking advantage of the horse-and-buggy system for Libor determination, mostly at the expense of bank counterparties in derivatives transactions. It produced tiny changes in Libor fixings that resulted in large nominal losses because of the staggering volumes of derivatives traded - which were matched by almost equally large profits on the other side of the transactions.
Now the banks are being fined billions of dollars, staggering multiples of their net profits on Libor fixing. The system needed reform, but the blame for its failure should rest not on the people who set up the existing system back in the innocent days of the 1960s but on the designers of trading desks which goosed the trading volumes outstanding to a huge multiple of those justified by genuine economic needs.
This highlights a central problem of modern financial activity - much of it depends on skimming tiny, sometimes unjustified percentages off a gigantic volume of transactions. In fast trading, returns are made by having knowledge of the deal flow more quickly than competitors - a form of insider trading.
In derivatives, as we have seen, returns are made by manipulating benchmarks, whether simple ones like Libor or complex ones like the "index" credit default swaps that produced a $6 billion loss for JP Morgan Chase in the "whale" debacle and no doubt equivalent profits for many other houses. On trading desks in general, we have heard that traders are making profits by receiving economic and other data a few milliseconds earlier than the market in general - again, a form of insider trading.
Trading is becoming increasingly automated; it seems almost certain that the returns from it will asymptotically approach zero, as in other hyper-automated businesses. Yes Apple makes excellent money, but Taiwanese electronics manufacturing giant Foxconn doesn't, and trading desks are Foxconns not Apples, because they have no way of building a real brand name.
None of this income adds economic value. All of it eventually will be stamped out by the regulators, and the fines to be imposed - perhaps a decade after the profits are received (and bonuses thereon paid) - represent a huge risk for investors in large financial institutions. To the extent that it cannot be stamped out legislatively, these tiny skimmed profits can be addressed by a sort of Tobin tax on financial transactions.
While such a tax large enough to zap the financial sector generally is a bad idea, a small one, which would leave the financial sector generally unscathed while attacking the "stealing pennies from in front of a steamroller" section of it, would be entirely justified. Indeed, it makes such good sense that within a few years it is inevitable.
A second reason for supposing the financial sector to have peaked is that its innovation appears to have shut down. The pace of financial innovation probably reached a peak in the 1980s, with the deregulation of the London and New York markets, the invention of most derivatives sectors and the proliferation of corporate finance techniques.
However, innovation, much of it spurious, was still in full swing before the 2008 crash, with "CDO-squared" and the refinements of index credit default swaps being products of the last five years before that crash. Fast trading techniques, too, were primarily a product of the late 1990s and 2000s.
Many of the innovative techniques of the 1980s and succeeding decades were ultra-profitable because they were undertaken using risk management methods that were naive at best, semi-criminal at worst.
When David Viniar of Goldman Sachs claimed in 2007 that he was seeing "25-standard deviation days, one after another", he demonstrated the intellectual bankruptcy of Gaussian risk management techniques such as Value-at-Risk (VaR), which pretend that the risk "tails" are an infinitesimal fraction of their true size. JP Morgan Chase was still using VaR in 2012 when it lost $6 billion through the London Whale. Presumably even the doziest regulators will eventually catch up and prevent banks from arbitraging their risk management systems against taxpayer bailouts.
As an ex-practitioner, I keep a sharp eye out for new financial techniques, in the press and through the recruiting advertisements (which is where the big ones show up), but I have to say I have spotted nothing that is both significant and new since 2008. To the extent that the bull market is bringing an increase in financial sector aggressiveness, it is for example reviving techniques in structured collateralized default obligations that had apparently been discredited by the crash but are now returning to extract a few more billions of suckers' money.
Mortgage real-estate investment trusts, which finance portfolios of residential mortgages through repurchase agreements, have proliferated since 2008 (though they existed before) but they are strictly a product of the steep yield curve induced by Federal Reserve chairman Ben Bernanke, and will disappear into insolvency once the markets right themselves.
Maybe there is stuff going on under the radar that will shortly burst into view, possibly though a gigantic loss by a major house. However, if innovation has indeed run out of steam, that is a sign that financial sector returns are on a downward trend because new products are the most profitable until the suckers figure them out. Once the products get commoditized (if they are not made illegal), the returns are rubbish.
Third, the leverage bubble has gone about as far as it can. Leverage rates in the US and worldwide are at record levels, "stimulated" by all the cheap credit. Once interest rates start to return toward more normal levels so that it is no longer profitable to borrow money, the world will be forced into another painful round of deleveraging, with government budgets forced towards balance, consumers pulling in their horns and overleveraged businesses going bankrupt.
This will be very healthy if painful; it will also cause massive losses to the banking system, which will not be balanced by restructuring fees.
Regulators are already attempting to force financial institutions to reduce their leverage, and are being resisted by the banks themselves. The regulators' efforts have so far been fairly unsuccessful because of the Basel regulations that allow banks to treat certain assets for capital allocation purposes at a tiny fraction of their true value, or, as in the case of government bonds, at no value at all.
A major downturn, involving massive defaults and restructurings by member governments of the developed countries group, the Organization for Economic Cooperation and Development, will be needed for this process to be prohibited, but it's only a matter of time before such a downturn arrives. Once it has happened, capital ratios will be set based on a percentage of total assets at full value, and that percentage is unlikely to be much less than 20%.
Finally, the returns available on the "buy" side through hedge funds and private equity funds, both of which make massive use of cheap leverage, have already shrunk below returns available through a simple "buy and hold" strategy and will sink further once leverage is no longer cheap.
At that point, even the doziest pension fund or Ivy League endowment will realize that investing in these kinds of "alternative assets" is not the way to achieve superior returns but merely to pay gigantic fees to intermediaries out of their portfolios. Various private equity funds and hedge funds will collapse, lawsuits and arbitrary regulatory punishments will fly, and the money flowing into these structures will return to the tiny fraction of the investment pool that is economically justified.
A large part of the financial sector's growth in the last three decades has been mere rent-seeking, figuring out ways to charge much larger fees and returns for performing a service with only modest economic value added. High-end real estate, luxury supercars and vulgar bling businesses will all suffer as the financial sector returns to an economically sustainable size. However, the global economy as a whole will be greatly enriched thereby.
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010).
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