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www.johnkay.com 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