Vegas Gambling vs Wall Street Gambling

One of the things that has always struck me about folks that treat the financial sector like any other business venture is the lack of understanding of what the finance sector really does.  There are several basic functions if you read the literature.  The banking industry originally evolved from goldsmiths that would safekeep gold for people.  This eliminated the need for every one to keep a small army with them at all times to stop robbers from stealing all their gold.  Goldsmiths eventually learned that a fairly sizable chunk of that gold never left their premises and found out they could lend some of it out for a return and not be caught short.  That eventually lead them from being gold babysitters to lenders.  Then, we eventually got around to trying to find some financial contracts that would help us if the worst happened by buying insurance.  From these sets of agreements, we now have exotic derivatives, financial innovations, credit default swaps, and a host of other banking services.  The basics things that the banking sector does is help you save or store up future purchasing power, borrow or lend purchasing power, and help move money around from place to place via the payment systems.  That would be check clearing and ATMs and things like that.  The Federal Reserve Bank was set up to handle that latter function but most of that function has been privatized since regional banks now clear checks and there are private clearing houses for Automated Payments.  The Fed’s role is now fairly small.  It still pushes cash from the US Mint/Treasury into the banking system and its FedWire system still handles a huge number of wire transfers between banks.  If banks won’t lend to each other via the Fed Funds market, it is also available to lend money at the discount window.  That used to be only available to member banks but it’s now open to a lot more institutions.

Bankers usually make money by charging fees on their services, interest rates on their loans, and then they make arbitrage profits if they invest.  For years, that last function wasn’t a big deal for bankers because laws stopped them from investing in anything very creative.  Laws have changed a lot over the last 10-20 years and even if commercial banks can’t make risky investments, they are likely to be part of a bank holding company that owns some subsidiary that can.  Allowing banks–who basically still have the role of “safekeeping”–to gamble has been a huge mistake.  Besides the lax laws, they have had a lot of cheap cash available because of Greenspan’s relatively lose monetary policy during the last years of his tenure and they’ve been able to reduce their risk by having deposit insurance which covers their deposits in case of default.  There has also been an increase in “financial innovations” and techniques which serve as pseudo insurance but generally come in the form of very hard-to-price assets so they can be risky. Many banks don’t use them just for hedging which is this risk management approach to their use.  A lot of banks just plan gamble.  We’ve definitely seen banks misjudge risk and rely heavily on what I would consider gambling activities.

So, I’ve worked back of the house at a casino and I’ve worked in banking and of course, I’m a financial economist so I’ve got a little knowledge and experience on all fronts.  The one thing that I will say about gambling in a casino is that a good time is had by all, every one understands it’s gambling, and the gambling industry hires a lot of people in the process that do fairly straightforward jobs.  They only get tips if the customers say so.  Bonuses for random wins are de rigueur in the finance sector.  Silly thing is that most financiers think they’ve actually earned those bonuses for doing some miracle.  There’s a few good reads to let you know exactly how misguided they are on their opinions of their skills.  The first is anything by Nassim Nicholas Taleb who is a practitioner of financial mathematics and a former Wall Street trader. His book “Fooled by Randomness” is just full of examples of the fallacies that drive Wall Street Bankers into thinking too highly of themselves and paying themselves based on gambling and randomly hitting the jackpot.   You can also read anything by Nobel Prize winner Daniel Kahneman.   Actually, you can watch them both talk about these things in a video at Edge in a program called Reflections on  a Crisis.

Kahneman explains why there are bubbles in the financial markets, even though everyone knows that they eventually burst. The researchers used the comparison with the weather: If there is little rain for three years, people begin to believe that this is the normal situation. If over the years stocks only increase, people can’t imagine a break in this trend.

Taleb speaks out sharply against the bankers. The people in control of taxpayer’s money are spending billions of dollars. “I want those responsible for the crisis gone today, today and not tomorrow,” he says, leaning forward vigorously. The risk models of banks are a plague, he says, the bankers are charlatans.

It is nonsense to think that we can assess risks and thus protect against a crash. Taleb has become famous with his theory of the black swan described in his eponymous bestsellers described. Black swans, which are events that are not previously seen–not even with the best model. “People will never be able to control a coincidence,” he says.

Okay, so that’s actually the background to something I want to point you to  on VOXEU called “What is the contribution of the financial sector?” by Andrew Haldane.  I think it’s a good thing to look at because we need to establish some basic knowledge and laws that separate the speculative activities from the banking activities that actually may provide value. (Although I still could argue that privatizing the payments system may prove risky and foolish some day, there are some things that banks do that are useful.)  This way we can see the damage done when so many politicians essentially empower the gambling aspects.  Another offshoot is our tax policy which favorably treats capital gains without any reference to the source of the profit.  People that run businesses that enhance economic welfare of every one are taxed at the same favorable rate as those that basically gamble resources away.  That’s a very bad incentive system.  Haldane points out the difference between managing risk of financial contracts and risk-taking that is basically gambling and how much of the Western nation’s financial sector has morphed more into a gambling sector than a financial services provider.

But crisis experience has challenged this narrative. High pre-crisis returns in the financial sector proved temporary. The return on tangible equity in UK banking fell from levels of 25%+ in 2006 to – 29% in 2008. Many financial institutions around the world found themselves calling on the authorities, in enormous size, to help manage their solvency and liquidity risk. That fall from grace, and the resulting ballooning of risk, sits uneasily with a pre-crisis story of a shift in the technological frontier of banks’ risk management.

In fact, high pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector. This was not an outward shift in the portfolio possibility set of finance. Instead, it was a traverse up the high-wire of risk and return. This hire-wire act involved, on the asset side, rapid credit expansion, often through the development of poorly understood financial instruments. On the liability side, this ballooning balance sheet was financed using risky leverage, often at short maturities.

This is an important statement because not only did political institutions loosen laws or not put in place laws to stop this from happening, but when it happened, we all paid and they’ve ignored how costly this was to every one else.  Plus, they keep wanting us to sacrifice instead of the people that broke the economic growth machine. The basic narrative is that these folks gambled with others’ money and the government had to pay the house.  This is wrong in every sense of what is and isn’t moral.  Haldane argues that risk-taking is not a value-added activity for banks and backs it up with empirical evidence.

The financial system provides a number of services to the wider economy, including payment and transaction services to depositors and borrowers; intermediation services by transforming deposits into funding for households, companies or governments; and risk transfer and insurance services. In doing so, financial intermediaries take on risk. For example, when they finance long-term loans to companies using short-term deposits from households, banks assume liquidity risk. And when they extend mortgages to households, they take on credit risk.

But bearing risk is not, by itself, a productive activity. The act of investing capital in a risky asset is a fundamental feature of capital markets. For example, a retail investor that purchases bonds issued by a company is bearing risk, but not contributing so much as a cent to measured economic activity. Similarly, a household that decides to use all of its liquid deposits to purchase a house, instead of borrowing some money from the bank and keeping some of its deposits with the bank, is bearing liquidity risk.

Neither of these acts could be said to boost overall economic activity or productivity in the economy. They re-allocate risk in the system but do not fundamentally change its size or shape. For that reason, statisticians do not count these activities in capital markets as contributing to activity or welfare. Rightly so.

What is a demonstrably productive economic activity is the management of risk. Banks use labour and capital to screen borrowers, assess their creditworthiness and monitor them. And they spend resources to assess their vulnerability to liquidity shocks arising from the maturity mismatches on their balance sheets. Customers, in turn, remunerate banks for these productive services.

The current framework for measuring the contribution of financial intermediaries captures few of these subtleties. Crucially, it blurs the distinction between risk-bearing and risk management. Revenues that banks earn as compensation for risk-bearing – the spread between loan and deposit rates on their loan book – are accounted for as output by the banking sector. So bank balance-sheet expansion, as occurred ahead of the crisis, counts as increased value-added. But this confuses risk-bearing with risk management, especially when the risk itself may be mis-priced or mis-managed.

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