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?

What value does the financial industry provide to the world?
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  • >It’s obvious that finance as a whole provides a lot of value.

    Is it really? Outside of the traditional services, I struggle to see a lot of added value.

    I’d quibble with your levels, but it’s not really an important point.

    I mean, the core (only) value of a financial sector is to mediate between (i) people who have money, and (ii) people who need money (can can use it for a positive ROI). That’s it, really; everything else is gravy (and mostly risk management).

    Traditionally, (i) banks collect money, and (ii) banks use those deposits to invest elsewhere in the economy. Additional entities exist to make that process easier, e.g. a VC fund aggregate money from multiple banks and other investors, and then makes the judgement call. Investment bankers are, in theory, the same.

    Secondary loan markets – moving loans off of the balance sheet of banks – isn’t something that has much net value to the system. But it has a lot of value to the individual bank/company, because it minimizes future risk. The downside is that if loan-making entities don’t hold the risk for the loans, there is no direct incentive for said entities to actually minimize the riskiness of the loans themselves. Thus, the dramatic drop in lending standards leading up to the financial crisis.

    I think you can make a pretty strong argument that over the lifetime of the practice, that has had sizable negative value to the system as a whole (even if/as individual firms have done well).

    I don’t see what the stock market has to do with company value, because multiple private parties exchanging public stock has precisely nothing to do with a company’s actual finances. The only reason people care about stock prices is (i) to minimize the chance of hostile takeovers, given what happened in the 1980s, and (ii) because stockholders hire to Board of Directors, who represent their interest by hiring C-level staff who care about short-time stock prices.

    If anything, high volatility (lots of trading) is bad for a company, because it means high turnover of shareholder interests.

    (I’m not sure why you put short selling in with options, as it’s really a part of stock trading. Just in reverse: you borrow stocks and sell them, hoping to buy them back when they drop – as opposed to buying stocks and holding them, hoping to sell them when they increase).

    Options are an interesting theoretical tool, but I really question the net value to the financial sector. Options very nearly caused the collapse of the financial system in 1998 when LTCM failed; they played a non-trivial role in the last financial crisis, when the expectation net shifted suddenly. Given the direct negative shocks they’ve had – and the related destruction of wealth – it’s unclear if the marginal (and hypothetical) increase is market efficiency outweighs the aggregate negative value.

    I’m also not sure why you classify “exotics” as a separate category, or what you mean to put in there. Securitized MBS? Structured Investment Vehicles? Those were clever – virtual banks with opaque balance sheets, exploiting an interest arbitrage opportunity if (and only if) the commercial paper market was functioning correctly.

    Some of them are clever, and some are useful. Some are really quite dangerous, but I think that the basics are more dangerous –

    Such, as I don’t know, corruption. The LIBOR scandal is bleeding insane; some of the casual corruption in the banking sector that Matt Taibbi writes about is eye-wateringly astonishing; Madoff and the numerous people who did the same thing. UBS and tax evasion; etc.

    And yeah, the brain drain from other fields to the financial sector has – likely – been a real problem for the competitiveness of the USA going forward. A handful of minor inventions would have had a greater aggregate value than the repeated financial meltdowns and bailouts we’ve had over the past 30 years.

    The financial sector accounts for nearly 30% of net profits in the USA. 30%! Thirty percent! Do you really think they account for 30% of the value? It was 44% in 2002!

    Additionally – and astonishingly – take studies like this:

    “in the United States, the growing influence of the
    financial sector has led to a reduction in the share of business investment as a percent of
    value added by as much as 2 percentage points in the last three decades.”

    Yes, that’s efficiency for you.

    http://www.ilo.org/public/english/bureau/inst/download/dp206_2010.pdf

    On page 2 the paper has a graph of profit share. Fun stuff.

  • Andrew

    I see I found a topic you’re passate about :)

    By exotics I was mostly talking about credit default swaps and (re)repackaged asset backed securities.

    Thanks for the comments!

  • I wouldn’t say I’m passionate, but I find it appalling. Of course, I could be wrong; that would be nice to learn.

    >By exotics I was mostly talking about credit default swaps and (re)repackaged asset backed securities.

    Makes sense.