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Socially useless?
The economic value and private profitability
of financial services
John Kay
München, 18th October 2010
“The government is very keen on amassing statistics.
They collect them, add them, raise them to the nth
power, take the cube root and prepare wonderful
diagrams. But you must never forget that everyone of
these figures comes in the first instance from the
village watchman, who just puts down what he damn
pleases!”
Josiah Stamp, President of the Royal Statistical Society 1930-32,
quoting an unidentified English judge
“Banking was conceived in inequity and born in sin.”
Josiah Stamp, Director of the Bank of England, 1928-41
A basic national accounting framework for financial services
Financial services industry
Exports
Imports
Financial services in large corporations INCOME
Non‐financial business
OUTPUT
Final customers
CONSUMPTION
Contribution of financial intermediation to GDP
(value added at current basic prices, £bn)
Financial
institutions
All industry
Financial
intermediation
as % of GDP
2001
2002
2003
2004
2005
2006
2007
2008
48.2
63.4
71.5
75.1
79.6
90.8
103.7
116.8
907.6
957.1
1015.0
1071.0
1116.6
1183.7
1251.7
1295.7
5.3%
6.6%
7.0%
7.0%
7.1%
7.7%
8.3%
9.0%
Source: ONS
Problems of national accounting for financial services
Banking revenues are principally derived from an interest
rate spread, but interest payments are neither a sale nor
a cost, in national accounting.
The distinction between transformation activity and asset
holding is particularly problematic in financial services.
There is frequent asymmetry between the treatment of
asset enhancement and asset impairment.
Some element of profit must be regarded as a reward for
risk.
What finance provides for non-financial businesses
and final customers
Payment services – medium of exchange
Managing savings – store of value
Managing savings includes maturity transformation
(now separable from managing savings)
Risk trading and spreading
(now separable from providing finance)
Capital allocation
What makes finance so profitable?
Asymmetric information
- the profitability of arbitrage
- agency problems
Oligopoly, cartels, natural
monopolies
- retail banking, new issues,
market making
Price insensitivity issues
- low percentages, large sums
- infrequent transactions in
noisy markets
Delusion
- the bezzle: borrowing from the
future (aggravated by marking
to market and further
aggravated by its optionality)
What makes trading profitable?
Government distortions
- government as non-maximising
players
- selective guarantees
Insiders versus outsiders
advantages
Cross subsidy
(asymmetric
competition)
Delusion
- smarter people (Demsetz dispersion)
- ‘unfair’ information
- from other rent generating
financial activities
information and limited
- the bezzle: borrowing from the
Sources of the bezzle
Ponzi schemes
- exchanging paper at ever
increasing prices unrelated to
fundamental value
Taleb schemes
- writing heavily out of the money
options
St Petersburg paradoxes
- structures that double up on losing
bets
Generalised winner’s curse
- complex products bought only
by those who overestimate their
value
Mark to market optionality
- profits can be recognised, losses
can be deferred