Download AIF 25 Anniversary Symposium: The Better Future of Finance 27

The role of finance in a postindustrial society
Luigi Zingales
University of Chicago
Industrial Society
• Shortage 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)
Role of Finance
• Shortage of savings => channel savings to
investment
– Quantity is more important than quality
• Physical capital -> prevailing of debt financing
– Creditors’ protection crucial
• Big minimum scale of production -> need to
diversify the enterprise risk
– Equity offerings not a big source of capital
XX Century Finance
Main financial institutions
– Banks that finance corporate investments
– Equity markets that diversify that risk
• Hence the evidence
– D/GDP related to growth
– Stock /GDP no relation with growth
Industrial Transformation -1
• In 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
XXI Century Finance
• Excess savings
– More important how to preserve funds, than how to
channel them
• Intangibles
– Not financed with debt -> need for equity financing
• Extent of the market reduces the minimum scale
(Amazon cloud)
Declining in Capital Share
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
year
• No incentives to invest more
The role of finance in a post-industrial
society
• Excess of savings over investments
– Risk of bubbles
– Preservation of wealth more important than creation
• Lack of physical capital -> prevailing of equity financing
– Protection of equity investors crucial
• Equity offerings become an important source of
investment for small firms
• Bank lending becomes primarily household lending
Are the Changes Consistent?
Source: Greenwood and Scharfstein (2013)
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Are the Changes Consistent? -2
Commitments to U.S. Private Equity Partnerships
1980 - 2014 (in $ billions)
$300
$250
$150
$
Billions
$200
$100
$50
$0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Private Equity Analyst, Steven N. Kaplan
Is there any evidence that finance
accomplish well its role?
Business Formation
Source: Hathaway and Litan (2014)
Business Dynamism
Business Formation
Source: Hathaway and Litan (2014)
Competition for Small Business Loans
Helping Retirement
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?
1. Rules of the game favor rent seeking
2. Political economy prevents the change of these
rules
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 investors
• Problem could be easily solved with frequent batch
auctions
• Why is not? Concentrated benefit diffused costs of
current system
• Problem is not limited to high-frequency trading
• In fact, HFT is an example of how
1. 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).
2. 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 Example
• Pay 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).
• Pew Foundation analyzed the Colorado experiment
– Cap on rates + transformation in installment loans
– Borrowers 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
Other Examples
1.
2.
3.
4.
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 principals
• Principals 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
15%
10%
5%
0%
Source: Piskorski et al. (2013)
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Banality of fraud
• Royal Bank of Scotland employees’ emails
Senior 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 whistleblowers
• Remarkable 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 capture
– Deference 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
reputation
– see 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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