Benjamin Friedman, in the Financial Times (hat tip Yves Smith), questions the high cost (read: compensation) of our financial sector. But he does not simply say that huge bonuses for bankers are unfair. Instead, he says that the costs of financial services need to be balanced against their benefits.
The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes and what taxpayers have had to put up to supply first aid. The estimated $4,000bn of losses in US mortgage-related securities are just the surface of the story. Beneath those losses are real economic costs due to wasted resources: mortgage mis-pricing led the US to build far too many houses. Similar pricing errors in the telecoms bubble a decade ago led to millions of miles of unused fibre-optic cable being laid.
The misused resources and the output foregone due to the recession are still part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system.
In particular, Friedman wonders at the relationship between the value provided by financial services and the opportunity cost involved: “Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three. These talented and energetic young citizens could surely be doing something more useful.”
This reminds me of something Felix Salmon wrote about a while back: If profits and compensation in the financial sector go up and keep going up, that’s a priori evidence of inefficiency, not efficiency. Those higher profits mean that customers are paying more for their financial services over time, not less, which means that financial services are imposing a larger and larger tax on the economy. Now, it is possible that they are also increasing in value fast enough to cover the tax, but that is something to be proven.
By James Kwak
The Cost of (Equity) Capital
By James Kwak
For years, the world’s largest banks have been up in arms over threats by regulators to increase their (equity) capital requirements. Making banks hold more capital, they argue, will force them to reduce lending and will increase their cost of funding, making credit more expensive throughout the economy. One of the chief defenders of the megabanks has been Josef Ackermann, CEO of Deutsche Bank until last year and also chair of the Institute of International Finance, which claimed that higher capital requirements would reduce economic output by a whopping 3.2 percent.
Anat Admati and Martin Hellwig have been tirelessly debunking the myth that higher capital levels will force banks to curtail lending and torpedo the global economy, most recently in their excellent new book, The Banker’s New Clothes. Some of the arguments against higher capital requirements are simply incoherent, like the idea that banks would be forced to set aside capital instead of lending it. (Capital is the difference between assets and liabilities, not cash that you put somewhere for safekeeping; were it not for reserve requirements, which are something else, a bank could lend out 100 percent of the money it can raise.)
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Tagged bank capital, Deutsche Bank, finance