I’ve spent my entire career working in the advertising and technology fields, but the finance industry has always fascinated me. From the time I was in high school it was clear that finance was firmly the “it” profession for the brightest and most talented students. It also didn’t seem to matter what you liked to study. Finance routinely gobbled up students who majored in biology, physics, biomedical engineering, electrical engineering, mechanical engineering – you name it. If you were smart and you wanted to make money, you went into finance.
In light of finance absorbing so much talent, I’ve always struggled with this one question: what value does the financial industry provide to the world?
Of course, this is kind of a silly question. It’s obvious that finance as a whole provides a lot of value. But do all parts of finance provide equal value? And is the value that the financial industry provides proportionate to the share of overall talent it consumes? Those questions are a bit more convoluted.
In order to address these questions, we need to break down the financial industry into different base parts. The mental map that I’ve developed consists of five levels:
Level 1: Loans
At the most basic level, financial firms loan money to people. These loans allow individuals and companies to buy expensive things and pay for those things slowly over time. This is no doubt a great service and one of the essential building blocks of our economy.
Value provided to the world: Huge
Smartness of people who do this: Above average
Profitability of this profession: You can make a good living
Level 2: Buying and Selling Stocks (Equities)
In my mind, people that work in Level 2 Finance are primarily in the business of investing in companies and trying to preserve or grow wealth for investors. It’s really a win-win. Companies get a high level of liquidity for their equity (there’s lots of trading) and individuals get returns that are correlated with the performance of their investment portfolio.
Value: Big
Smartness: Very smart
Profitability: Six figure salaries
Level 3: The Secondary Bond Market
Remember the loans we talked about in Level 1? People who operate in Level 3 buy and sell repackaged loans from the banks that issued them in Level 1. Buying and selling those loans on the secondary market actually makes it less risky for Level 1 financiers to lend money. It allows banks to diversify their risk and for a broader number of stake holders to share the risk of any one loan going bad. This sharing of risk ultimately allows borrowers to get loans at a lower cost because the bank giving the loan doesn’t have to hold onto all the risk for the term of the loan.
Value: Pretty valuable
Smartness: Extremely smart
Profitability: Six figure salaries and six figure bonuses.
Level 4: Options and Short Selling
Back to the equities market, Level 4 Finance consists of making bets on equities. Options (like puts and calls) as well as short selling allow investors to bet if the value of a stock is going to rise or fall in the future. Essentially turning equities markets into a casino, Level 4 Finance is much more complicated than Levels 1-3. It does add liquidity and efficiency to the financial ecosystem, but it is also largely a zero sum game (every dollar made by one party is a dollar lost by another).
Value: Less valuable
Smartness: Top 1%
Profitability: Seven-digit annual compensation, in a good year
Level 5: Exotics
In my mind, this portion of finance is a total free-for-all. In Level 5, banks and hedge funds continually dream up increasingly complicated securities, made up of lots of other things all mushed together and recombined in an opaque soup of billion dollar liabilities. The only thing that keeps Level 5 Finance at some level of sanity is the ability for financial institutions to buy these incomprehensibly complicated buckets of things, then turn around and sell a portion of the same trade to someone else – who in turn will sell it to someone else.
Value: Questionable
Smartness: Genius
Profitability: The sky’s the limit
Don’t get me wrong. There is definitely some value provided by Level 5 Finance. It’s one additional layer of liquidity and efficiency that trickles all the way down to Level 1 and lowers the cost of borrowing for companies and individuals. But how much real value is there here? Is it enough value to suck up so many talented people? If Level 5 Finance did not have the allure of sky-high compensation, what do you think these people would have been doing? Maybe they would have worked in finance anyway, but maybe they would have become inventors, technology innovators, doctors or even disease researchers. Interesting to think about, no?