Why is the Financial Industry this Big?

A few months back I wrote about why I thought salaries on Wall Street (and the city of London etc.) were not the big issue. The big one is about the humongous size and growth of the financial industry.

Matt Yglesias and Maxine Udall write about how talent, like capital, has been preferentially allocated to the financial sector in the last two decades during which the financial industry has grown from about 20% to above 40% in its share of corporate profits. It dropped sharply as Wall Street bled money in 2008 but if recent earnings results are any indication, they are headed back up there quickly.

The financial sector’s average pay has steadily increased where it is now close to 200% of the national average. This of course doesn’t sound too big because it also includes consumer finance and banking, not just wholesale capital markets.

In any industry that is growing like the financial industry did, pay automatically goes up. The real question is – is the natural, unsupported share of the financial industry closer to 20% or to 40%?

Sure there has been a lot of innovation in the financial industry, and you could argue that innovation has driven the expansion of the financial industry, just like the technology industry.

But there are significant differences. The tech industry has a business model that supports super sized growth and profits. There are the entry barriers – copyrights, trademarks and patents. And the marginal costs can be pretty low. This is not to say that the tech industry isn’t hyper competitive. Not every company makes money. But it is a fact that the winners in any product-market make out like bandits.

The financial industry is not like that. Yes brand matters, and size matters but in wholesale banking and fee based services these things should matter less. Yes innovation matters but business practice innovation is not much of an entry barrier. A new derivative can be quickly copied.

Yes people matter. Other things being equal, you’d rather hire a smarter management consultant or work with a better investment banker. But price also matters.

So why did the financial industry become so big relative to the economy? Is it because that is its rightful place? That the efficient allocation of capital is so important that it rightfully occupies 40% of economic activity? Or can at least part of it be explained by the special nature of the industry?

I can think of at least two ways in which capital markets are different and which allow it to expand seemingly without any limits.

1. Preferential access to information. Trading profits come from preferential access to information. This includes the Galleon type illegal insider trading, which happens more than you think. But it also includes legal ways in which the professional trader gets information and acts upon it. In the stock market it has become increasingly difficult to make money this way but there are many other securities which are just not as regulated. Even in the stock market, most of the capital invested contributes fee-based income to the financial company. The money from principal trading is far more nimble and better-informed because this is trading income for the company.

I am not as familiar with other securities markets, but I would aver that the same principal trading vs managed money difference plays out there as well.

2. Taking a cut from capital flows is easier. Much of financial service revenues come out capital flows. They don’t appear as an expense on a company’s income statement. When a public company raises capital, the investment bank takes a 6% commission out of the public issue, that commission comes out of the hides of the shareholders. The company retains the bankers but is completely insulated from the costs of it. Competing on cost therefore becomes meaningless. [Update: the IPO bankers’ fees are paid by the company and charged to the income statement. But as a one-time non-operating expense the charge is largely going to be ignored by the market. (Krishna thanks for the correction).]

Even for a retail investor, the 1% or so you pay as management fees to a mutual fund, psychologically is not an expense. It is a reduction in your capital gain (or increase in capital loss). Most consumers don’t pay it as much attention as an equivalent increase in say the price of gasoline. Although the popularity of ETFs points to the fact that retail investors are wising up.

Regulations can and do squeeze out the advantages that financial firms enjoy because of these two reasons. Take the equity markets. The SEC and other agencies have been in a constant battle against Wall Street with insider trading enforcement, Reg FD and most recently Flash Trading. But the fact that the SEC often is sleeping at the wheel and the New York DA’s office has had to take the lead points to the fact that Wall Street enjoys the benefits of the complacence, if not connivance of the SEC.

Another example. If you were to make the commission on public equity offerings to be accounted for as an expense on the income statement of the company raising money, you can bet your pension, price competition will bring that commission down in a hurry. Online dutch auctions, which have never worked, will become the rule rather than the exception. Investment banking salaries will plummet as they cease to be the Masters of the Universe.

But don’t hold your breath for that to happen. The investment banks protect their fees ferociously. As does the industry its profits. As long as they can make supersize profits for their companies, nobody can touch the bankers’ compensation. Maybe for a year, like in the UK. But no more. The order of the universe will remain unchanged.


  1. Krishna says:

    Capital issue expenses do appear in income statements. Depending on the operational stage of the company, it is either charged off against profits in the year of incurrence or is amortized over the following few years as outlined in the Accounting Policy elaborated under Notes to Accounts. This is a mandatory disclosure ought to be made by every capital raiser, an approximation of which is also to be mentioned in the offer document.

    Issue expenses cannot be charged off to capital as it would mean "reduction" of capital that is allowed only in the event of liquidation or restructuring with regulatory approvals after taking shareholders / creditors into confidence (You are in fact asking them to take a haircut).


    1. Krishna – I don't believe that is the case, at least in the US. Bears checking out though.


      1. Krishna says:

        Share capital is a liability. How can an expense that is incurred to assume a liability be reduced from liability? No Accounting Standard will permit it.


      2. Krishna – you are right. The investors don't pay anything, not even a brokerage commission. The bankers' fees and expenses are charged to the company which must therefore hit the income statement. I have made the correction in the blog post as well.

        Thanks for keeping me on my toes.


  2. Krishna says:

    To your question "Why the financial industry is so big?" – One major factor is, unlike the other factors of production (like land and labor), finance industry conjured up an ever elastic Leverage, allowing projections to be interpreted as "future actuals" by gullible financiers that rest on the built -in safety net (in the event of default, get bailed out by taxpayers) acting as a cushion. The only precondition for that assured bailout being size and scale of operation so that it is big enough to cause a gargantuan global collapse. No other factor of production (Land, Labor) affords disproportionate levels of leverage like Capital does (or did, at least until the meltdown).


  3. Nilanjan says:

    Capital flows is the clear answer to your question, and add on to it two new ‘innovations’ – derivatives and artificially low cost of money. Derivatives create a multi-factor leverage on the actual amount of underlying capital. Artificial rates make it easy for the participants to move capital without friction. The more this capital circulates – either physically or through derivatives – the more a ‘banker’ would make by way of commissions, margins, spreads and what not. See the timeline in your chart – financial industry’s share jumped up as capital flows were freed up, as these ‘innovation’s kicked in and somewhere down the line it became an unending party for all.

    To be clear, capital flows is not only about companies raising money, or about capital markets turnover – a big chunk is from govt borrowings, and from trade flows (a technical extension).

    To me, the whole business of ‘quantitative easing’ is nothing but the concerted efforts of politicians and banks that the show must go on. I think no one knows the downside if the party stops.


  4. Ashok says:

    Very thoughtful and well analysed article however the TRUTH behind the TRUH would be :-

    1.It started with Generational choice in America – in 80s and 90s the financial sector seemed so sexy/blue collared/HS that more and more youngsters jumped in without worrying of fallback. In India a similar sector I would say is entertainement and like how the entire US ideology/thinking is dominated by what WALL STREET thinks similarly Indian ideology is dominated by what Bollywood thinks .In Pakistan/Afghanistan it is what the war lords think :-))

    2. When the hand becomes lazy and mind becomes sharp and clever

    3. Cotorie between government and Business made it easy . Business would hide the blunders which Govt made by pouring millions when required and Govt would give a free reign to business.


  5. Jishnu says:

    In India, the financial regulator for stock market recently made the entry load which was 2.25% to 0% for Mutual Fund investment. Though there was murmur of protest somehow it got adopted. Also there is no exit load after 1 year. I am not sure how this will change things in financial sector in India. But also i do not see financial sector in India making superlative profit. May be US has something to learn from Indian regulators.


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