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Friday, 13 May 2016

What they do with your money: Does the finance industry do its job well?

Ivaylo Iaydjiev (D.Phil. Candidate, St Antony’s College, Oxford)

Speaker: David Pitt-Watson, London Business School
Chair: David Vines, Balliol College, Oxford

What does the financial industry do with your money? That is the misleadingly simple question that motivates David Pitt-Watson’s new book (co-authored with Stephen Davis and Jon Lukomnik). Given the large amounts of fees we pay in transparent or often less so ways to financial professionals, this is a particularly pertinent question. More broadly, it invites us to step back from the complex and technical details that dominate everyday financial news and revisit how we think about the role of the financial system and its contribution to society. 

Mr. Pitt-Watson examines in his talk whether the financial industry does its job well, and his conclusions are not particularly optimistic. Intriguingly, he decides to tackle the question by first reconnecting financial activity with its initial purpose. As he aptly points out, there is a voluminous literature on what financial institutions exist, but it tends to proceed by assuming that the existence of such institutions must serve a purpose, and then deducing what that purpose might be. Instead, it is necessary to be clear on what the original purpose is and work out the institutions from there.

For Mr. Pitt-Watson finance serves four key purposes, largely in line with the academic literature. The first key function is the safekeeping of assets, especially money. In turn, this is central to the second function – transaction-processing, or reducing the costs of financial exchange. The third function is the sharing of risk through the provision of insurance, which however does not reduce the aggregate amount of risk. Finally, the financial system’s most important purpose is to intermediate funds from savings to investment. 

These four functions demonstrate that finance does indeed have a socially beneficial purpose. However, he is careful to point out that this purpose relies on technical knowledge as much as on trust in the institutions and financiers themselves. When knowledge and trust are combined with a sense of purpose, the results can be transformative. Therefore, finance is key to our economies, to opportunities for social mobility and development, and to addressing our current challenges.

How well does then finance currently fulfil its purpose? Here Mr. Pitt-Watson is more worried. As he rightly points out, the global financial crisis clearly demonstrated that from a stability point of view finance has performed poorly. Nevertheless, despite still suffering the consequences of the crash eight years later, we continue to use the same tools as in 2008 to think about finance, while regulations are getting both less effective at predicting problems and more watered down with time.
However, Mr. Pitt-Watson is even more worried by the inexplicable lack of improvement in the efficiency of financial intermediation. Here he quotes research by Thomas Philippon of New York University, showing that despite significant improvements in technology, the productivity of financial intermediation in the US has remained largely flat over the last 130 years. As he puts it, this means that the financial industry that supported the railroads is as efficient as the one financing the internet.

What explains this stunning finding? The key, according to Mr. Pitt-Watson, is that traditional accounts of finance have tended to focus on algebraic rigor at the expense of politics or philosophy. As a consequence, they present an incomplete picture of the financial ecosystem, which he proposes should be thought of in a broader fashion as a human system made up of institutions, cultures, and politics. These factors need to be built into the governance framework for finance, rather than assumed away.

Mr. Pitt-Watson also makes practical suggestions towards these ends to both academics and the general public. He in particular highlights the need to teach students more explicitly about the nature of finance in a way that can foster trust and ethics, rather than the uniquely self-interested behaviour that ultimately undermines the functioning of markets with asymmetric information. As for everybody else, he has a simple message: we should try to learn the real cost of all the commissions charged by the fund industry as seemingly moderate fees can compound into a large part of the total money pot.

In concluding, Mr. Pitt-Watson reiterates once again the need to start from the purpose of finance, to then measure how well it serves its goals, and only in turn then design institutions to deliver social values. However, as he points out, current incentives in the fund management industry are not aligned with more transparency. Achieving this would therefore require considerable public pressure to improve awareness of the full cost of financial services and, ultimately, corporate governance.

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