How Much Does the Financial Sector Cost?

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

39 thoughts on “How Much Does the Financial Sector Cost?

  1. Benjamin Friedman writes in “Overmighty finance levies a tithe on growth” that the activity of so many of our young well educated luminaries working in finance “adds no economic value” In reference to this my first question is how does he really know it is because they are well educated and not because they work in a quasi-monopolistic environment? My second, if so are we not to blame professors for it? And third, should the world sue Harvard and other for their teachings?

    Of course Friedman has a point but what really levies a financial tithe on growth are the various tolls on financial risk. Regulators for instance order banks to have more equity for clients perceived as more risky, and credit cards financiers are more than happy to have the credit rating scores create the illusion they charge the “right” level of interests to their customers.

    Anyway I would argue that much more important than what the financial sector has earned in profits (before the losses of the crisis are netted out) is to think on what other growth opportunities could have been financed with those trillions of dollars wasted in the housing sector only because some managed to hustle up some credit ratings made overly important by the regulators.

    A question to the Professor Friedman or others here; when the regulators impose on the banks an 8 percent capital requirement when lending to unrated citizens and zero if lending to the government… are they not exceeding their mandate? Do they have a legal right to discriminate this way?

  2. I think this is the most fascinating bit of detail in the FT story:

    “From the 1950s to the 1980s, the finance sector accounted for 10 per cent of all profits earned by US corporations; in the first half of this decade it reached 34 per cent.”

    And we would not care one fig about that increased investment in finance at all if we saw wide growth across the nation as a result.

    But that’s not what we see today. Instead, we see:

    – The largest corporate welfare program in the history of the United States developed to bail out the failed financial sector – that same sector that saw such increased investment in recent years

    – The most bank failures since the early 1990s

    – The sharpest growth in unemployment since the Reagan recession

    – Record foreclosures

    – Bleak outlook for print media

    – Bleak landscape in the auto sector

    – Struggling airlines

    – And record bonuses for those slaving away at the investment banks – wait I mean those new bank holding companies that were going to be more risk averse and less bonus-focused….

    I end with Lloyd Blankfein’s thoughts on the need to reform executive compensation within the financial sector (given to the Council of Institutional Investors last spring):

    “Compensation should encourage real teamwork and discourage selfish behavior, including excessive risk taking, which hurts the longer-term interests of the firm and its shareholders.”

    Wondering if the CEO of Goldman will actually put such a compensation structure into play, seems unlikely.

    (For the text of the speech, click here:

  3. What I don’t see treated often is the linkages between the bloated financial sector and runaway healthcare price inflation, which I think are key to understanding what drove the financial “innovators” to invent such abstruse investment instruments.

    Public pension funds were caught in a big squeeze. On the one hand, they had huge unfunded future obligations to provide retiree healthcare, growing at 8-12% annually; while on the other hand they were generally limited by statute from investing in anything rated as “risky”. With the risk-free interest rate as low as it was from late 2000 onward, the funds really had no option other than some bizarre structured investment that looked “safe” but produced a higher return. But even without the outrageous rents excised by the finance industry these deals were sure to go south, particularly if the fund took a highly leveraged position (as the Wisconsin school boards did —

    Perhaps BaselineScenario can expand on this topic in a future posting.

  4. The next question, then, has to be: why aren’t there new entrants in the financial market driving the price of the services rendered (or not) by this industry to the floor?

    For instance, why do two companies in merger talks keep on paying billions to investment banks to get their blessing to go ahead with that merger?

  5. You failed to mention that Friedman in his piece threw up his hands and said simply that it was impossible to answer the questions he posed.

    “Does the increased efficiency our investment allocation system deliver meet that hurdle [of a net economic benefit]? We simply do not know.”

    You quote Felix Salmon as saying that increasing compensation and profits are a priori evidence of inefficiency but despite the use of the words “a priori evidence” in fact the statement is only an assertion.

    Friedman’s piece, I thought, was excellent particularly because it asked important questions and then addressed them with humility and an honest admission that the truth is still to be discerned.

    In fairness, I think that the depth of his thinking on this subject deserves more than the cursory use of a couple of excerpts in an attempt to drive home narrow points.

  6. Being an early receiver of a central banks largess is a hell of a drug. Being able to print unlimited money thanks to the effective elimination of reserve and leverage ratios is a hell of a drug. A government/taxpayer backstop to all your complete f**kups is a hell of a drug.

    Too bad. We could use more engineers.


  7. For all the small busines owners out there, if you want to have some fun, add a $9.95 fee to all of your invoices for the products and/or services you sell bankers (only).

    So, if a banker comes into your shop for an oil change, add a payment expediting and facilitation convenience fee of $9.95 to the invoice. Same for donuts, or anything else.

    Yes, I understand you would like to drive your car today, but it is our company policy to not release any vehicle until we have received payment for our services. And, we no longer accept payments at our local branch. Now, you can pay through our free no cost payment method by mailing a check to our payment processing center in Minot, ND which usually takes 5-7 business days to clear, and come back next week and get your car, or you can take advantage of our convenient pay by phone option which only costs $9.95 and drive your car home today, or eat your donuts before they go stale…..

  8. If profits and compensation went up in any other industry, would we regard it as something to “be proven” that they are also increasing value fast enough to cover that “tax”? Can you spell out why finance is different, without just saying: “look, it’s just causes a giga-recession” (which is a good answer, but not sufficient because we could have one without the other). Does finance perhaps involve elements of zero-sum games, where participants find it individually rational to spend more money playing that game, to no aggregate end?

  9. Roy — if profit and pay were up that much in any industry, you’d have to ask “are we getting our money’s worth”. (The huge amount of money going into health-care is making us ask that question now.)

    The financial sector “special” because it’s an apples-to-apples comparison. While it might to argue that the tech industry is over-priced or over-compensated (how do you convert 1 $ to 1 gigaflop) finance “creates” funding in the economy, and takes funding in compensation…when costs grow faster than product, we can say that efficiency is getting worse without arguing about “qualitative” differences in what is being output.

  10. Ben, interesting …. so if I follow you correctly, the productive purpose of the finance sector is to allocate capital with the objective of maximizing real output, so if the finance sector grows faster than real output, it cannot be doing it’s job by definition. I like that.

    What could confound this story? If the finance sector grows today because of the valuable service it is performing raising real output tomorrow, that could cause the sector to grow as a share of GDP today. But that’s not very plausible, plus if true we’d expect things to reverse when tomorrow arrives.

    What about the value of facilitating consumption smoothing and risk distribution (hah!) Is it plausible to say the sector increased its output of valuable consumption smoothing services? Not sure how/whether to separate out risk mitigation/distribution per se from the recent foobar, but if the finance sector allows risk averse firms/individuals to diversify away some risk, should that show up in real output, or is there a utility in itself that ought to be account for. Anything else?

  11. does the maths work? I mean, if the finance sector was able to, say, increase GDP growth by 1%, how much would we pay the finance sector for that service? If we did pay the finance sector this amount, would the finance sector increase as share of GDP?

    If finance sector starts at 1 with GDP as 100. Finance sector can turn GDP into 101 and gets paid 0.5 for this service. Finance sector share of GDP now 1.5/101.

  12. also, don’t we have to think about geography – perhaps the finance sector grow in the USA because it was providing valuable services that grew GDP in China?

  13. About”What is sorely missing is any real discussion of what function our financial system is supposed to perform “. Talk about an obvious question framed in a self serving way.

    What is sorely missing from this -dare I say- analysis are the obvious breaches of conditions for a competitive market, all which originate from this:

    Another cost that isn’t mentioned is the $442 million spent by the banks in political contributions, in 2008, vs for comparison, $17 million from the auto industry, and $0 from the silent majority.

  14. Roy – we’re not just having a giga-recession this time around. We’re seeing banks become recipients of one of the largest welfare programs ever developed in American history (if not the largest.)

    I don’t think anyone would care about all about the amount of money plowed into the financial sector had they not unwisely thrown the economy off the cliff last fall and required a massive trillion dollar bailout (plus all the other elements, including low cost loans, and the feds guarantees for all their debt.)

    And concurrent with the steepest rise in unemployment since the Reagan recession, we’re seeing the very same banks, the ones who’ve been the recipients of such generosity, setting aside massive amounts of money for their bonuses.

    So yes, since the US taxpayer has become an unwilling investor in the financial sector, we do need to be asking if we’re getting our money’s worth on this one.

    And, quite frankly, I’ve yet to see a case made for an affirmative answer to that question. We need a healthy financial sector, but one that requires privatized profit and socialized loss is an extremely sick system, one that will drag us under yet again in the not so distant future.

    The money we’ve invested in recent years (and particularly in the last year) has done nothing to bring health back into the US financial system. That’s of grave concern to me.

  15. Here’s what Benjamin Friedman of Havard university writes in May 2006 in this paper titled “Greenspan era”:

    “The record of economic performance that it [Greenspan] leaves behind is surely one to be admired. Perhaps some day we shall envy it.”

    Is the best qualified person (intellectually and morally) to teach us anything about the financial sector’s woes?

    Click to access The%20Greenspan%20Era.pdf

  16. I think additional fees should be levied for

    donut holes– $7.95 per hole
    donut filling– $5.50-$25
    donut deep frying– $6.50 per donut
    deep fry operator surcharge– $24.68
    sanitation fee– $1.65 per donut
    cashier’s fee– $1.56
    napkins — $.78 per napkin
    bags — $5.34 waxed paper, $1.56 brown paper
    taking time to order — $1-$10 per second*
    finance charge for time between order is filled and payment is received — 200000000000% interest APR
    cost of calculating additional charges-$56
    surcharge for supervising person who calculates additional charges– $156
    objections to this perverse system–$150 per word
    cost of reviewing objections–$10,000 per review
    time spent researching objections–$12,000 per hour

    *depending on how many customers are standing behind

  17. I would submit that this enormous cost is not the cost of financial services, but only a portion of the cost of Crony Capitalism. To be more precise the real cost of Crony Capitalism is at least equal to the losses of this recession/depression plus the extraordinary profits of the financial oligarchs taken over time minus the historical profits of the financial services industry over the same period. And that does not take into account the costs, and they are many, outside the direct costs paid to financial services industry.

  18. I’m not sure I would subtract the historical profits of the financial services industry. It seems pretty clear we didn’t get reasonable quality investment allocation and risk mitigation services from at least 2001-08.

  19. Anne: I agree. The FT article raises a critical question – what is banking ‘for’. The answer is, I assume, to allocate capital. So we can evaluate the industry on that basis. Do we think it did sufficiently well that we need to protect it? Did the economy boom as a result of all those innovative products?
    I think you know my answer.
    When banking veered off and became gambling our interest in protecting it [and bailing it out] should have fallen. That’s not practical I suppose, the result is that we still paid for something for which we have no return.
    So we should regulate the heck out it to prevent a repeat.

  20. I am not sure if this point was made, but I remeber hearing it somewhere. The rising profits of the financial sector also sucked up all the human capital. As people realized you make much more money trading bonds or finding tiny price deviations, the top graduates all migrated to finance, at the expense of other disciplines.

    I myself fell pray, and regret it. I took economics, and while I love drawing graphs, many of the problems I am interested in solving: climate change; urban sprawl, would have been better served had I studied engineering. To produce a new and innovative product or process, not shift numbers around. This is one of the main reasons China/India is beating the developed world in techonological change, and why the US is short has to import graduate students in the sciences. Why work long hours in a lab when an MBA is a lot easier (at least the math is) and you make 10 times the money.

  21. Far be it from me to defend the Financial sector, but let’s put everything into perspective here. The Financial sector has been the engine for GDP growth for the last 30 years, and they’ve been rewarded accordingly. Without getting into whether or not that was a good thing, what does the U.S. economy have to replace the Financial sector as GDP growth engine?

    Look, I think it is wonderful that some economists are starting to redisover their inner-Institutionalist and recognizing that, contrary to Milton Friedman’s twisted worldview, society exists after all, but current economic policy and the underlying econometrics don’t recognize and cannot measure societal value at this time. As a result, GDP measures consumption (not production, except inferrentially) and treats the consumption of services as equivalent to the consumption of goods. A dollar spent is a dollar spent.

    While I don’t agree with the way we measure GDP, it is what it is, and the “service” sectors of our economy have dominated GDP growth since Paul Volcker’s Fed destroyed America’s industrial base. The reason that financial “innovation” has been allowed to run rampant is that to show GDP growth, we have had to squeeze more consumption from fewer consumers (I’m speaking in relative terms; I know that there are nominally more Americans alive today than there were 30 years ago, but the income/wealth gap has been increasing, thus concentrating the wealth of the country into a smaller and smaller percentage of the population), which means finding new ways to stick those consumers with more fees, to create new fee-bearing transactions from thin air (e.g., CDOs), or to exapand the consumer base by loosening standards (e.g., sub-prime loans). These things, along with rising healthcare costs, drove GDP growth over the last eight years, so how could they be bad?

    Unless and until we start measuring GDP differently, the political will to meaningfully change the Financial sector simply will not come into existence. GDP growth is not an option, it is a requirement, and we as a people have accepted a definition of GDP that not only ignores societal value but destroys it by equating dollars that arise from phantom transactions with those that arise from the sale of real goods. Why shouldn’t we putting all of our talents to work to push bits from one account to another?

  22. @ Scot Griffin regarding “finding new ways to stick those consumers with more fees, to create new fee-bearing transactions from thin air (e.g., CDOs), or to exapand the consumer base by loosening standards (e.g., sub-prime loans).”

    If you have other smart thoughts like this, better for us that you keep your writing shorter so we can spot it quickly.

    Too bad the Harvard genius who wrote the article didn’t think of that instead of pompously (“sorely missing” etc) serving us insipid questions such as that of whether high compensations might betray inefficiency of the financial sector. Duh!

  23. “what other growth opportunities could have been financed with those trillions of dollars wasted in the housing sector”

    maybe there is no other growth sector promising immediate profits for the investors
    – isn’t there a story out there that there is a capacity to build 9 mio or was it bn cars a year but there are only buyers for only 6 mio or bn ?
    – maybe that’s a wide-spread thing, manufactured goods of all kinds having by all kinds of means (robots, outsourcing, just in time et al) become so cheap and so easily produced in huge masses that only by seducing people to discard beloved gadgets new ones can be pushed onto the consumer
    if money is poured into infrastructure that’s a common good but does it generate immediate satisfaction of profit-hunger?

  24. Most “transaction fees” are inflated because no one questions them. Whenever I challenge a fee, it tends to go down or vanish. The exception is the “origination fee” charged in mortgages — most banks feel entitled to it, though they charge separate fees for many of the tasks involved and make a huge profit on the loan. When times were good, “origination fees,” like real estate commissions, were industry standards and there was little competition. Those days are gone, and all fees should be both transparent and subject to challenge. No more of the “New in Town Tax” (like in the Robin Williams movie POPEYE). Time to confront the “costs” of financial services. If no service involved, then no fee. Let’s make ANTITRUST part of the equation.

  25. @ Frank T

    “Let’s make ANTITRUST part of the equation.” Exactly to the point . However, go tell that to Summers (and the $1bn trading loss that he left behind at Harvard).

  26. APR calculated on 360 day year, compounded hourly.

    You forget sight facilitation ambiant lighting surcharge $15

  27. @cityislander,

    If you consider how much I said in that little screed, you’d realize what I wrote WAS short. :-)

    Still, to be fair, I did not give myself the time to pare things back to make a single point. There are at least three to five distinct points in that comment.

    I do appreciate you overcoming your ADD long enough to find one of them, though. :-) I’ll try harder next time.

  28. @cityislander and Frank T,

    How much do you guys know about antitrust? I’ve studied the issue and litigated it a few times, and I’m trying to understand how antitrust law can be brought to bear on transaction fees. Still, I’m not an expert by any means. I look forward to your thoughts.

  29. Here is what I know about who wins in Antitrust:

    Big company breaking up cartel of smaller competitors: win
    Smaller companies breaking up cartel of bigger competitors: loss
    Domestic company breaking up cartel of foreign competitors: win
    Foreign companies breakig up cartel of domestic companies: loss
    Government breaking up a cartel: loss
    Government stopping mergers to form monopolies: capture

  30. @ Scot Griffin.

    If you’ve litigated it, wouldn’t be reasonable to assume you know more than us (at least me)?

    When an industry is able to cut for itself such immense privileges, including escaping fraud supervision (see link), there is a case for breaking these mammoths into smaller pieces or finding other ways to put a dam between them an congress ($450million in contributions in 2008 vs $17millions for the auto industry).

    The Tobin tax, regulating trader compensation etc. all seem like beating around the bush to me.

  31. You’re either self centered or over-estimates other readers availability by thinking it is a case of ADD that I take the time to outline an interesting point in your comments.

  32. Oh, well. I guess being lighthearted in writing is impossible, even with little smiley-faces dropped in as cues to indicate humor. Apologies.

  33. @cityislander,

    I have no idea what you know or don’t know. All I know is that, in my experience, I do not see how antitrust applies. But I’m no expert on the topic (I’ve dealt with only a couple of narrow issues in the area), so I was hoping that the people who were advocating bringing antitrust laws to bear would be able to explain how it might apply.

    FYI — I agree that the whole industry routinely rooks its customers with nonsense transaction fees, but I think that remedying that situation is a matter of consumer protection and not antitrust. I do not believe that financial institutions charge these fees because of how big they are (even the smallest players charge these fees) or because of any conspiracy among them. Rather, they charge these fees because they can, and consumers pay the fees because they feel they must. To me, this is an issue of unequal bargaining power best remedied through new regulations and/or better enforcement of the regulations we already have.

    From my limited exeprience, antitrust laws are most concerned with competition within the industry and not at all with protecting the consumer. That is, antitrust focuses on undue market power, not undue bargaining power.

  34. Your emphasis on transaction fees seems eerily out of touch with the multiple $trillion financial mess that is plaguing the people of this country for years to come.

    You would think that perhaps “too big too fail” has something to do with this mess, and that “too big” is another way of saying “excessively concentrated”.

    Now, if antitrust is not supposed to constrain a market’s concentration, then I don’t know why the word antitrust even exists.

  35. PS: This was already discussed on this blog. It couldn’t be phrased more clearly than this:

    The Department of Justice’s Antitrust Division should be called in to investigate the increasing market share of major banks, the anti-competitive practices of some market leaders , and the broader increase in economic and political power of the biggest financial services players over the past 20 years and the last 6 months – this is potentially damaging to all consumers and, obviously, to all taxpayers.

  36. Economics fails to answer satisfactorily the simplest question because it takes as a given that anything countable is an equivalent of anything else. Economics views increased profits as better regardless of how they are extracted and how they are distributed; growth is sold as the answer to every social dilemma. What the recent disaster has proved is the utter poverty of growth economics, that it is an academic scam and a political scam. Any instititutionalist could see the crisis coming. Veblen explained the essential problem more than one hundred years ago. Anyone interested should read the Theory of Business Enterprise. It is roughly 100 pages long (small print, I admit)

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