I was having a discussion with my friend today on related topics and I couldn't figure out the answer to this question: where does the demand for talent in the finance industry come from? On a basic level, banks exist to facilitate loans. Someone with money gives it to the bank. The bank loans it out to someone who pays it back plus interest over a period of time. At the end, the bank and the original investor get some return on his/her money. The hardest part about this chain on events is picking people who wont default on their loans.
But clearly the demand for talent in banking is much higher than that. These people get paid extraordinary amounts of money. So where is that demand coming from? What service is being provided by banks that warrants the compensation?
Investment Banking has sky high salaries, not banking in general. That's mostly Mergers & Acquisitions, IPOs and Trading. The reason trading is so lucrative is obvious, if someone can make lots of money for you, they can do it for anybody so you haver tyo pay them lots to do it for you.
For M&A and IPOs it's also relatively simple; the differences in the amount of money you get can relatively easily be 20% or more depending on who's representing you. These are complicated transactions, you need a lot of expertise to do them, and you need a sales team in place to sell it, and an organisation capable of doing the research to drum up the deals. When you're dealing with huge amounts of money anyway and the top guys are vastly better than the mid market they'll be able to demand $BIGNUM because they're judges to be worth it.
If you can structure derivatives and other products in such a way that you can sell them to other people for more than they're worth, then you come out ahead. The cleverer you are at structuring them, and the better able you are to model their valuation, the more you can profit from other folks' stupidity. Basically, mugging people with your brains rather than your brawn.
As far as I understand it, beyond the basics of arbitrage, risk hedging and market making etc., investment banks are a zero-sum game - which after you add in the overheads and the profits, they destroy value.
So increased skill leads to markets that are less efficient because of complicated bundles of investments/loans? Why are complicated investments/loans even legal? What's the given justification for them?
My own train of thought lead in a similar direction as yours. What I'm really hoping for is the opinion of a hard core classical economist, because I feel like that's what I'm lacking. Are you familiar with such arguments? The free market determines salary, after all.
No, the markets are still efficient. It's just that intellectual capital is devoted to playing the market that could be devoted to other more productive things. If you want to borrow money, hedge risk or issue new stock you can do all that but there are fat profits to be had from being the smartest guy on the market or the one who figured out one particular arbitrage opportunity before anyone else.
Finance as waste: There's an arbitrage opportunity somewhere worth 100,000, and it will be picked up within a week of emerging. It is privately profitable to spend up to (100,000 - trading costs) to be the first to notice this, but the social benefits of it being discovered in 2 days rather than seven verge on zero.
It's the financial engineering area. In layman's terms it changes banking from being a dull industry where you loan money to people who you're pretty sure will pay it back to you to an exciting casino where you pit your really smart people against other banks really smart people to design really complex financial structures and collect fat commissions along the way.
The former is useful to the economy, the latter is a tremendous waste of valuable human capital.
Because what is now a dead boring normal finance was once a complex financial structure. Almost certainly we've gone too far, but you still get idiocy like people decrying shorting, which is a very old, well understood and totally economically justifiable practice. You need to have people who understand this stuff regulating it, but then you either get regulatory capture or incompetence because if you can understand this stuff well enough to regulate it you can make a lot more in the private market.
1) Officially a lot of the stuff is there for hedging/insurance.
2) It's quite hard to regulate this stuff out of existence, because the aforementioned really smart people will find holes in your regulation.
3) The financial industry is quite powerful and can hire a lot of lobbyists that talk about "improving efficiency" by reducing red tape surrounding their industry.
4) During the good times it looks like a lot of wealth is being created and no-one wants to commit political suicide by spoiling the party.
Comments
I was having a discussion with my friend today on related topics and I couldn't figure out the answer to this question: where does the demand for talent in the finance industry come from? On a basic level, banks exist to facilitate loans. Someone with money gives it to the bank. The bank loans it out to someone who pays it back plus interest over a period of time. At the end, the bank and the original investor get some return on his/her money. The hardest part about this chain on events is picking people who wont default on their loans.
But clearly the demand for talent in banking is much higher than that. These people get paid extraordinary amounts of money. So where is that demand coming from? What service is being provided by banks that warrants the compensation?
Investment Banking has sky high salaries, not banking in general. That's mostly Mergers & Acquisitions, IPOs and Trading. The reason trading is so lucrative is obvious, if someone can make lots of money for you, they can do it for anybody so you haver tyo pay them lots to do it for you.
For M&A and IPOs it's also relatively simple; the differences in the amount of money you get can relatively easily be 20% or more depending on who's representing you. These are complicated transactions, you need a lot of expertise to do them, and you need a sales team in place to sell it, and an organisation capable of doing the research to drum up the deals. When you're dealing with huge amounts of money anyway and the top guys are vastly better than the mid market they'll be able to demand $BIGNUM because they're judges to be worth it.
It's also because the stakes are so high. Suppose the #1 guy is only 2% better than the #2 guy.
2% of $100 million is a lot. If you need to pay the #1 guy an extra $100,000/year to keep him, it's well worth it.
If you can structure derivatives and other products in such a way that you can sell them to other people for more than they're worth, then you come out ahead. The cleverer you are at structuring them, and the better able you are to model their valuation, the more you can profit from other folks' stupidity. Basically, mugging people with your brains rather than your brawn.
As far as I understand it, beyond the basics of arbitrage, risk hedging and market making etc., investment banks are a zero-sum game - which after you add in the overheads and the profits, they destroy value.
So increased skill leads to markets that are less efficient because of complicated bundles of investments/loans? Why are complicated investments/loans even legal? What's the given justification for them?
My own train of thought lead in a similar direction as yours. What I'm really hoping for is the opinion of a hard core classical economist, because I feel like that's what I'm lacking. Are you familiar with such arguments? The free market determines salary, after all.
No, the markets are still efficient. It's just that intellectual capital is devoted to playing the market that could be devoted to other more productive things. If you want to borrow money, hedge risk or issue new stock you can do all that but there are fat profits to be had from being the smartest guy on the market or the one who figured out one particular arbitrage opportunity before anyone else.
Finance as waste: There's an arbitrage opportunity somewhere worth 100,000, and it will be picked up within a week of emerging. It is privately profitable to spend up to (100,000 - trading costs) to be the first to notice this, but the social benefits of it being discovered in 2 days rather than seven verge on zero.
It's the financial engineering area. In layman's terms it changes banking from being a dull industry where you loan money to people who you're pretty sure will pay it back to you to an exciting casino where you pit your really smart people against other banks really smart people to design really complex financial structures and collect fat commissions along the way.
The former is useful to the economy, the latter is a tremendous waste of valuable human capital.
So why are complex financial structures legal? There has to be some justification for them, even if they turn out to be gambling in practice.
Because what is now a dead boring normal finance was once a complex financial structure. Almost certainly we've gone too far, but you still get idiocy like people decrying shorting, which is a very old, well understood and totally economically justifiable practice. You need to have people who understand this stuff regulating it, but then you either get regulatory capture or incompetence because if you can understand this stuff well enough to regulate it you can make a lot more in the private market.
Four reasons off the top of my head:
1) Officially a lot of the stuff is there for hedging/insurance.
2) It's quite hard to regulate this stuff out of existence, because the aforementioned really smart people will find holes in your regulation.
3) The financial industry is quite powerful and can hire a lot of lobbyists that talk about "improving efficiency" by reducing red tape surrounding their industry.
4) During the good times it looks like a lot of wealth is being created and no-one wants to commit political suicide by spoiling the party.