The role of finance in a post-industrial society - PowerPoint Presentation

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The role of finance in a post-industrial society

Luigi Zingales

University of Chicago

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Industrial SocietyShortage of savings vis-à-vis investment opportunities Investments are mostly in physical capital

Big minimum scale of production (canals, railways, electric power plans, car manufacturing)

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Role of Finance

Shortage of savings => channel savings to investment Quantity is more important than qualityPhysical capital -> prevailing of debt financingCreditors’ protection crucial Big minimum scale of production -> need to diversify the enterprise risk

Equity offerings not a big source of capital

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XX Century Finance Main financial institutions

Banks that finance corporate investmentsEquity markets that diversify that risk Hence the evidence D/GDP related to growth Stock /GDP no relation with growth

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Industrial Transformation -1In the last two decades of the XX centuries the United States started to divest from smokestack industries

need to get money out of firms not only in firms => new role of finance: to destroy, not only to create

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XXI Century Finance Excess savings

More important how to preserve funds, than how to channel them IntangiblesNot financed with debt -> need for equity financing Extent of the market reduces the minimum scale (Amazon cloud)

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Declining in Capital Share

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High Profits and Low Investment Needs U.S. mobile operators very profitable

Average Tobin’s q = 4 Yet, extra value comes from higher prices they charge consumers Value transfer vis-à-vis German prices = $65bn a yearNo incentives to invest more

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The role of finance in a post-industrial society

Excess of savings over investments Risk of bubbles Preservation of wealth more important than creationLack of physical capital -> prevailing of equity financingProtection of equity investors crucial

Equity offerings become an important source of investment for small firms

Bank lending becomes primarily household lending

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Are the Changes Consistent?

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Source: Greenwood and Scharfstein (2013)

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Are the Changes Consistent? -2

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Is there any evidence that finance accomplish well its role?

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Source: Hathaway and

Litan

(2014)

Business Formation

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Business Formation

Source: Hathaway and

Litan

(2014)

Business Dynamism

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Competition for Small Business Loans

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Helping Retirement

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How Is This Possible?

Size of financial sector has exploded but I claim its real role has not Normally, size of a sector and its profitability are good indicators of the value added to society

Why this is not the case for finance?

Rules of the game favor rent seeking

Political economy prevents the change of these rules

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Budish, Cramton, Shim (2015)

Market Correlations Break Down at High Frequency: ES vs. SPY: 250 milliseconds

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In a continuous limit order book, symmetrically observed public information creates arbitrage rents.Mechanical arbs like ES-SPY are built in to the market design

In equilibrium, these arbitrage rents are ultimately paid by investorsProblem could be easily solved with frequent batch auctionsWhy is not? Concentrated benefit diffused costs of current system

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Problem is not limited to high-frequency trading In fact, HFT is an example of how without proper rules – competition can lead to waste (in 2010, Spread Networks invested $300mm to dig a high-speed optic cable from NYC to Chicago).

It is difficult to change those rules because benefits concentrated and costs diffused

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Fundamental Problem

High margins + free entry -> excessive entry, bloated sector.Hsieh and Moretti (2003) demonstrate it for real estate agents by using the variation in land (not house) prices across U.S. Areas with more expensive land have more real estate agents.

Very difficult problem to eliminate if the source of the high margins is not eliminated.

Very difficult to eliminate source of high margins, when benefits concentrated and costs diffused

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Another ExamplePay day loans: high interest loans to unsophisticated consumers

Introduced in the early 1990s.Today more outlets than Starbucks and McDonald combined. Research identified both : the positive: better than the alternative Zinman

(2010) and Morse (2011)

the negative: spiral of debt Carrell and

Zinman

(2010), Melzer (2011), Lee (2016).

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Pew Foundation analyzed the Colorado experiment Cap on rates + transformation in installment loansBorrowers paid 44% less in interest

But received more credit Why? Excessive entry before Half of the stores closed Difficult to overcome without some regulation

Regulation difficult to implement for political economy reasons

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Other Examples

Duping investors Aiding and abetting agency problems

Outright fraud

Self-serving government intervention

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1. Duping investors

Two types of duping:straight duping : Celerier and Vallee (2013): retail structured products

Ben-David et al. (2015):

mortgages sufficiently complicated not to be understood by borrowers

indirect duping (shrouding):

Gabaix

and

Laibson

(2006)

teaser-rate mortgages

credit cards

So widespread that even the government does it (

Swagel

, 2009)

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Swagel (2009)“ A key insight is that under pricing insurance coverage is economically similar to overpaying for assets—but it turns out to be far less transparent. This insight underpins both the TALF and the bank rescue programs announced by the Obama administration in March 2009.”

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2. Aiding and abetting

Many buyers of financial products are agents (including elected politicians)Financial products are often designed to please agents at the expense of the principalsPrincipals can try to limit it contractually, their success depends upon

speed of innovation

flexibility of the technology

how present and active the principal is

Finance stands out on all three dimensions

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3. Outright fraud

Dyck et al. (2014) estimate that cost of (mostly financial) fraud among the U.S. companies with more than $750m in revenues is $380bn a year.In 2012-14 financial institutions paid $139bn in fine, $113bn of which for mortgage fraud.A whistleblower inside JPMorgan: 40 percent of the mortgages of some RMBS were based on overstated incomes (

Querner

, 2014).

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Pervasiveness of fraud

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Source:

Piskorski

et al. (2013)

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Banality of fraud

Royal Bank of Scotland employees’ emailsSenior Yen Trader: the whole HF (hedge fund) world will be kissing you instead of calling me if libor move lower

Yen Trader 1: ok,

i

will move the curve down 1bp maybe more if I can

Senior Yen Trader: maybe after tomorrow fixing

hehehe

Yen Trader 1: fine will go with same as yesterday then

Senior Yen Trader: cool

Yen Trader 1: maybe a touch higher tomorrow

There is no attempt to hide it, no sense of guilt. It is ordinary business.

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4. Government interventions

Bailout options:Kelly et al. (2012): a collective guarantee for the financial sector valued at more than $100bn Fannie and Freddie: Ex ante $13.6 billion a year

Ex post $180 billion

These are not the results of populist pressures against the interest of the financial industry, but subsidies to the financial industry

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What can we do?

Traditional response: more government regulation Regulation is part of the problem, not necessarily part of the solution What can we do? 1. In our empirical research

2. In our theoretical research

3. In our teaching

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1. Empirical research:

Act as whistleblowersRemarkable examples:“collusive” quotes on NASDAQ (Christie and Schultz, 1994)

postdated stock options (Lie, 2005),

inflated prices in house sales (Ben-David, 2011)

disappearing analysts’ recommendations (Ljungqvist et al. , 2009).

Not enough, why?

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Why?

Proprietary data: economists have to maintain a reputation for treating their sources favorably. Problem is even more severe with regulators Consulting: the money is where the concentrated rents are Cultural captureDeference to the most successful players

Economists’ capture (Zingales, 2014).

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2. Theoretical Research

All researchers are affected by fads, ideology, and biased by interests (Kuhn, 1962) We economists are not different, but we have one advantage:rigorous framework of analysis We should apply this advantage in policy proposals

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3. In teaching

Moral standards in the financial world seem to be very low. Is it just selection? Wang et al. (2011): the teaching of economics makes students more selfish.Cohen et al. (2014): bank employees behave more dishonestly when their professional identity is rendered salient.

Not true for other professional identities or bank-identity for

other non bank employees.

Are we training people to be (more) dishonest?

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3. In teaching – cont

We teach just positive analysis: A crime is committed when expected benefit > expected cost

But we label

irrational

someone who does not commit a crime under this condition

Most people label such behavior as moral

Being agnostic are we subtly teaching students the most amoral behavior without taking any responsibility?

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3. In teaching – cont

We need to bring social norms into our regular MBA classes. At the very least in the form of business reputationsee UK reaction to news of Starbucks’ tax dodging news

Markets are based on social norms too.

If we do not teach them to our students, we risk undermining the very institution we all support

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Conclusions

I believe that a good financial system is essential to prosperity and freedom. Creating and sustaining such a system is not easy.

Broad public support is necessary

Unfortunately, in the U.S. we have lost much of this support and it will not be easy to regain.

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Conclusions - cont.

As finance academics we can make a difference At stake is not our reputation, but our future. If finance becomes a business of political relationships, there is no scope for our teaching services, there is no room for us.

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