In Defense of Finance

by Jacobian1 min read17th Dec 201831 comments


EconomicsFinancial Investing
Personal Blog

I'm sharing the link instead of a full cross-post because this essay has:

  • 5,300 words
  • 2 footnotes, with links that actually work
  • 1 GIF, 2 charts, 5 expanding brains
  • 30+ lively comments

This is a "much more than you wanted to know" type post on the financial industry:

  • Why everyone hates it, except for people in positions of power.
  • The value of finance in coordinating trade across space and time, told via the parable of Banksy and the corn cobs.
  • Are mortgage-backed securities a scam or a brilliant innovation?
  • The stupid arguments about bailouts, and the smarter arguments for/against bailouts.
  • Economists writing books about bank equity ratios without googling what those equity ratios actually are.
  • What is up with equity ratios? Is making banks hold 50% capital the solution to financial crises?
  • What banking regulations actually make banks do.
  • The inextricable romance between finance and government.
  • A final request for incrementalism and humility.
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This post has too many big problems for me to describe them all clearly in a reasonable amount of time, so I'll point to a few.

There are many rhetorical cheap shots; the tone in the beginning seems more interested in making fun of people who don't already agree than persuading them or figuring out what they are worried about. The "We are the 99%" line would be more apropos if the trader had profited off of obscure plausibly helpful manipulations for years, and now for some poorly-understood reason the system blew up and corn was slowly rotting in Banksy's siloes while the people growing the corn went hungry.

The post jumps from a fairytale description of the possible good done by trade and lending to the modern global financial system, without clearly explaining why and to what extent I should think the latter resembles the former.

The story about MBS explains why they might be good, but doesn't look much at what actually happened in the early oughts. The main driver of the cost of housing was that cities did not allow people to build new homes in the places people wanted to move to, not interest rates - and that declining underwriting standards allowed people to finance home purchases with loans they were less and less likely to be able to pay off. "Financial engineering" around MBS allowed financial intermediaries to make a little more money on something that - when it should have happened at all - would have mostly happened anyway. Then, in the financial crisis, several million homes were foreclosed on; in many of these cases (I'm not sure whether it was most, but neither are you because neither of us checked) the property was owner-occupied and a family was forcibly ejected from its home by the state. I think that when Russ Roberts says something like "I don't care about the costs" we should steelman him as meaning the costs are very unlikely to be as big as the costs of the status quo.

You refer to The Big Short but not to its description of obvious collusion by the financial industry to keep prices high until people like Burry had to abandon their bets against the market. I do not understand how that story is evidence against "malice." P-hacking also does not seem like a good example of something where incompetence is a better explanation than malice. I'm not sure there's even a difference. The Wansinck case stands out here. Malicious incompetence is a thing.

Are you aware of any critiques or defenses of the financial industry that are better than the level of this post?

Unfortunately, no. I think this post is just much too ambitious for a subject as poorly understood as finance, and the initial framing makes promises that just can't be delivered on.

I imagine that any of these would be take a lot of work to do adequately, and you'd need all three (and possibly more) before a summary post like the linked one seems reasonable to have:

  • An enumeration of specific functions the finance industry serves, how they fit into the whole, how they work with other parts, and how this compares with the idealized financier in the beginning of the linked post.
  • A marginalist explanation of what proposed limits to finance would do, concretely and not just in financial terms.
  • Some attempt to estimate how much financial crises cost (foregone production, hardships like mass foreclosures, and efficiency loss from wealth transfer to the rich), relative to the production we'd forgo through substantial systemic risk reduction.

More concretely: Many and perhaps most issues of The Economist give clear examples of how intermediation (of which finance is an example) helps people solve real problems. Some of Michael Lewis's books make detailed implicit critiques. I don't know of much that's really good at a more abstract level.

Genesis, Chapters 41 and 47 don't cover everything or even almost everything, but do form an interesting simplified mythical account of state-sponsored financial intermediation that (a) seriously assesses benefits and drawbacks and (b) looks like our own world much more than the Banksy example.

Are you aware of any critiques or defenses of the financial industry that are better than the level of this post?

This actually stopped me from writing a similar comment to Benquo's: I disagreed with the post, but was not really in its audience (I am, on net, probably pro-finance relative to the American public).

Like, I also thought the MBS were ridiculous because of skin in the game reasons, where there was widespread fraud in granting the mortgages, and a presumable contributor was that the granter was no longer on the hook for whether or not the mortgage was repaid. But more significant was that finance and government were conjoined twins, where the government could force everyone to make the same mistakes (I once went to a talk by a former bank CEO where he claimed that everyone is always in violation of some regulation, and so when the government wanted people to grant more mortgages, the regulators could just say "hey, the amount of slack we cut you will depend on how well you're meeting the president's minority lending targets"), and even more significant than that was a widespread belief that increased homeownership would cause more desirable behavior on the part of citizens, and upstream of that was widespread misunderstanding of causality (and statistics more generally; a study that showed that lenders were not biased against minorities (because their default rates were the same once you took credit score into account) was widely used to argue that lenders were biased against minorities).

Which is not the "hey, we should just increase reserve ratios" that Jacobian is responding to; he might disagree on the details ("how significant were minority borrowers to the crash, and how significant were attempts to increase minority borrowing to the erosion of lending standards?") but he's not going to disagree on the general thrust ("yes, governments should understand causality better").

That said, I think the 'free banking' academic subdiscipline is of quite good quality and highly relevant to other projects you might be interested in, but is quite hard to get to from where we are now.

When I worked for Fannie Mae, company size was a big reason why some lenders got slack and others didn't. A major "customer" (i.e. seller of loans) could easily get special exceptions to underwriting policies, but it often wasn't worth anyone's time to negotiate with small lenders, and each one has less negotiating leverage anyway.

Much like in the parable of the talents, unto every one that hath shall be given, and he shall have abundance: but from him that hath not shall be taken away even that which he hath.

This is a good reason to be worried about inequality, and more worried where the system seems opaque and mysterious.

Isn't this an argument for encouraging more profitable banking (e.g., by eliminating capital requirements) so that banks could afford to give personalized attention to small borrowers? If banking is restricted, there's only enough banking to go around for the big fish.

Sort of. With the kind of regulatory capture we have now, I don’t think we can assume that any plan like that will be done in a way that does what we want it to do, without a very close analysis of the specific institutions affected.

For example, it seems as though lower interest rates should have lowered the cost of living in a home. But instead they helped drive up prices where supply was inelastic until it was just as expensive. It also created a speculative bubble which led to the construction of many homes that eventually sat idle for a long time, not an obvious improvement in the use of capital. Wealth was transferred to incumbent homeowners, and intermediaries who make money on transaction volume. I worry that piecemeal deregulation like this would have analogous perverse consequences.

This might also just be trying to solve the wrong problem. If policymakers tried to make rules to keep the system stable, and then large actors used their bargaining power to extract profitable concessions that externalized costs onto the rest of the system, and then the system blew up in part because of those exceptions, it seems a bit strange to say that the problem is that small actors should have gotten a break too.

[+][comment deleted]2y 0

I think I understand better what my main problem is with this article now. The story in the beginning is about using a real good, food, more efficiently. This is clearly good. But finance is about using an unit of account more efficiently. This is good when saving money corresponds to wasting less of things that we care about for their own sake like people's time or trees or food or clean water or air.

But sometimes dollar savings do not represent doing anything else more efficiently. MBS don't use real things more efficiently to build houses. They are just a way for investors to pool financial risk. This makes it cheaper to borrow, if and only if you are doing the kind of thing that can be securitized: something that a lot of people are doing the same way, that Wall Street thinks it understands. It also makes the system more fragile by correlating risks.

If interest rates were not managed by central planners, this sort of program might lead to more real investment. But in our world, if financial innovation lowers borrowing costs in one area, an active central bank is likely to respond by raising interest rates. This would crowd out other kinds of investment.

This is why I think it is so important to distinguish between money and the real resources it stands in for. Financial engineering lowers the borrowing costs of large centrally planned investments, relative to small heterogeneous investments executed by small autonomous agents with local knowledge.

If in­ter­est rates were not man­aged by cen­tral plan­ners, this sort of pro­gram might lead to more real in­vest­ment. But in our world, if fi­nan­cial in­no­va­tion low­ers bor­row­ing costs in one area, an ac­tive cen­tral bank is likely to re­spond by rais­ing in­ter­est rates. This would crowd out other kinds of in­vest­ment.

This seems very far from obvious and needs more explanation even if it's true. Suppose that interest rates fell simply because people became more patient and intrinsically lowered their time discount. Would central banks raise interest rates and force the level of savings/investment back to previous levels? I think no, at least not in the long run, because central banks ultimately care about inflation, not interest rates, and if people lowered their time discounts and as a result shift resources from consumption to saving/investing, that shouldn't cause more inflation at least not as a first order effect. Maybe the central banks would raise interest rates a bit to counteract some second order effects but we should expect to end up with an equilibrium with lower interest rates and more saving/investing then before.

It seems to me that if financial innovation made it easier or more efficient to pool and redistribute risk for investing in some sector, so as to better match the preferences of investors, the results of that would be similar to the above. We should end up with an equilibrium where some resources have been shifted from consumption to investment in that sector, and overall more saving/investing then before.

I think you're right that my account is incomplete. Thanks for pointing that out. Possibly I was wrong to think central banking is even relevant here.

The direct consequences of MBS (or further financial engineering in that domain) is to simultaneously lower borrowing costs for home-buyers, and raise yields for debt similar to MBS. HIgher yields makes borrowing more costly for other ventures, before taking into account any action by a central bank.

We should also expect it to increase financial investment relative to consumption, but my understanding is that demand for financial savings is pretty inelastic on current margins, so I'd expect that to be outweighed by the inflationary effect of reduced borrowing costs for the debtors whose debts are being securitized.

In this new account though, shouldn't we expect MBS to be a good thing overall (modulo the initial growing pains)? I mean, if you reduce the cost of anything by making it more efficient to produce, you will often cause more of that product or service to be produced, and resources to be shifted towards that sector, and that's usually a good thing. If MBS makes it more efficient to coordinate between investors and home buyers, makes mortgages cost less, and shifts resources from other sectors (even if the shift is more from other investments than from consumption), why is that a bad thing?

I don't see why I should expect real costs to be lower here.

In cases where there are real savings, it's usually pretty easy to point to the kinds of resources being saved. Efficiency gains in real goods, such as just-in-time supply chains, allow for less warehousing of goods, which means we don't need to make as much stuff, in order to have stuff when we need it. I think the burden of proof here is on the claim that the financial savings in financial engineering correspond to real savings on net.

This kind of financial engineering allows banks to do something closer to just-in-time lending, reserving less against losses - the effect should be similar to lowering reserve requirements for banks. But with a managed fiat currency, it doesn't cost any real resources to warehouse money, so there are accounting savings due to MBS but no less actual stuff being moved around and consumed or people employed per house financed.

In a world that's exogenously liquidity-constrained, financial engineering on MBS creates liquidity, which can be very good. IIRC the original MBS were a US government backed program to achieve specific policy goals (government-guaranteed assets for banks to hold, more liquidity in the housing market) without massive overt subsidies. In a highly regulated banking industry with a fiat currency like the current US (and to a lesser extent global) system, it's not obvious that arbitraging slight inefficiencies there via financial engineering solved any real problem, while it very clearly created systemic risk.

Insofar as there are real rather than just nominal savings here, they're lower transaction costs for consumers and risk-pooling for investors, at the expense of reducing skin in the game, offloading to the US government the tasks of oversight and maintaining the underlying trust that lets the system work. These costs aren't accounted for financially, and offloading them to an entity that has little in the way of short-run competition and gets little short-run feedback on whether it's doing a good job seems likely to erode the relevant institutions in the long run.

I'm not saying we should never take advantage of economies of scale. I'm saying that if participation in large-scale activities is massively subsidized e.g. by the state, it's not clear that the financial savings from increasing dependence on that system are meaningful.

Ok, I think this story of why MBS might not be a good thing makes a lot more sense. The question then becomes, how good is the US government at picking policy goals that have more benefits than costs (including implementation costs and increased risks). If it's not very good, then the existence of a highly developed financial industry might make things worse by tempting the government into adopting more bad policy goals than it otherwise would have (i.e., by providing the government with a tool that it thinks it can use to do good). Does this seem right to you, and do you see any other major critiques of the financial industry that doesn't fall into this category?

I think this is the main problem. And for domains like finance that concentrate wealth a lot (enabling capture of the political decisionmaking system), the system has to be designed extremely well to avoid runaway alignment problems.

[+][comment deleted]2y 2

Any discussion of bailouts ought to note that some countries have much fewer banking crises than the US.

A constructive comment:

You point out that the US government orders banks to pretend that its debt is risk-free. This keeps treasury yields down. But there are more things like this going on. The equity premium and the small-cap premium mean that the farther down an organization is on the power food chain, the higher its borrowing costs. Going down lower, middle-class consumers borrow unsecured at even higher rates, often over 10%, and payday lending means that the cost of capital for the working poor is sky-high. This does not seem like a society in which there's a meaningful single capital market. It seems like there's something else interesting and unexplained going on here, which usually doesn't get accounted for in standard economic models.

At least in public equity markets the size premium is very weak. My team looked at it and decided not to use it as a factor to guide our investing. It's closely correlated to an illiquidity premia, which I do believe in.

Normally it is uselessly broad, but I wonder if the problem is information. Standard economic models habitually assume perfect, or at least similar, levels of information to simplify things. Some examples of how differences might appear:

My expectation is that as you go down the size scale, less specialized attention is available for managing debts: investment banks spend virtually all of their time and effort on problems of that kind; mid-size corporations that provide a consumer product or service dedicate a team to the problem; small businesses might keep one or two experts on tap; the middle class and working poor alike mostly either forgo expertise or temporarily engage it for the duration of an important transaction (like buying a house).

Is there any kind of reasoning process like "this institution has many other creditors so it is unlikely that I will get nothing in case of default?"

Is there any kind of reasoning process like "this institution has many other creditors so it is unlikely that I will get nothing in case of default?"

Yes, and this sort of behavior creates Too Big To Fail dynamics, which break the connection between long-run financial success and producing things people want more than the cost of production.

Given that the claim about the econ professors were wrong by a factor 4 when estimating equity ratios, I opened a Skeptics.SE question on it.

Perhaps shareholders will take a slightly lower return in exchange for a safer investment, but they wouldn’t take one-third.

Why not? It seems like you're assuming a bimodal distribution in investors' preferences for risk/reward: they either want 2% return at virtually no risk, or 11.5% at really high risk. I'm not suggesting this doesn't reflect reality, but why is there so little demand (or supply, depending on you want to think of it) in the middle? If this isn't a rational distribution of preferences (e.g., it's distorted by either human or institutional biases) then perhaps it doesn't make sense to create a big costly social structure to cater to it, or we should try to change the distribution instead of just taking it as given?

One good reason why risk preference would be bimodal: the Volker rule. Banks are generally prohibited and/or penalized for holding riskier asset classes. Both regulations and intrabank risk rules stipulate maximum leverage ratios for each asset class. Meanwhile, non-banks usually just can't get leverage ratios anywhere near what banks get, at all.

So, you get one class of investors (banks) who use high leverage to buy safe assets, pushing their return down very low. The returns on those assets are then too low for non-banks to hold them in large quantities, so non-banks hold the riskier stuff with bimodal returns.

I don't know how well this represents reality, but that's how I've thought about it for a while now.

One possible reason for it being bimodal is that it's very hard to measure and accurately predict risk, so human-level intuitions and heuristics take over. Humans are notoriously bad at nuance and routinely exclude the middle.

The question in my mind is: why isn't all of this arbitraged away already? This shouldn't happen, as the rational money should notice the mis-priced middle, and profit by it. My answer is "politics". There's human-level intervention in the form of regulation, bailouts, and tax treatments which remove the ability to profit by providing information. "moral hazard" is another way of describing this - the incentive to act as one believes is removed by such interventions.

I wasn't trying to sneak in an assumption of bimodality, I just wanted to go through the math for two relevant examples: 10% equity (where banks currently are) and 50% (where Cochrane wants them).

why is there so little demand in the middle?

I think there is - 11.2% is in the middle between 3% (the absolute minimum allowed) or the 6% pre-crisis and 50% (the highest non-joking suggestion). I don't know (I don't think anyone knows) whether 11.2% is the magic right number, but it seems to be in the right range especially compared to the extremes. But today all large banks are above the 6% average of 2007 and in the 8%-15% range (or 11%-17% if you're looking at Tier 1 Cap / RWA) and their balance sheets got more stable and boring.

This is how the system works: the pendulum swings back and forth from boom to crisis and eventually settles on a good equilibrium (for many things, not just capital ratios). This post is mostly an argument against kicking the pendulum viciously in one direction or another.

I wasn’t trying to sneak in an assumption of bimodality, I just wanted to go through the math for two relevant examples: 10% equity (where banks currently are) and 50% (where Cochrane wants them).

But aren't you doing that when you say "Perhaps shareholders will take a slightly lower return in exchange for a safer investment, but they wouldn’t take one-third."? If the capital requirement was 50%, then sure the return for shareholders would be much lower, but so would their risk since the overall risk would be distributed over a much larger pool of equity. Why wouldn't there be lots of shareholders willing to take that deal if preferences for risk/return wasn't bimodally distributed?

Well, as a matter of fact it doesn't seem like they do - they want 8%-15%. You could start a bank that promises to stay at e.g. 30% equity, but the market seems to indicate that you'll have a hard time finding investors. Banks work hard to differentiate themselves since they ultimately offer very similar products, and I don't know of any large bank that successfully differentiates by having high equity ratios.

Especially as in recent years investor preferences for lower risk, low beta, low vol, higher yield stocks (like utilities and staples) has been well documented as strong.

One related fact is that (at least some of the banks) feel like they haven't gotten credit for the risk reductions they have done. Given their lower leverage now, they feel like they should have higher multiples, whereas actually their relative multiples have compressed vs the market vs pre-crisis. Of course, this may be because their risk was under-estimated pre-crisis, so their relative multiple was too high.

Finance, the discipline of distributing risk.

With my improved insight into finance, check out my new fintech company! We do Risk-as-a-Service (RaaS) on a blockchain platform which we outsource! It is called RaaS-ma-TaaS.

Well, that joke sure didn't land! Downvotes accepted - I just had to get that risk-as-a-service gag off my chest. And the pun-name was extremely terrible, I grant.

If we started downvoting silly puns my entire blog would be at -1,000,000 points forever. You got my +2, hang in there, Ryan!