Six Reasons We Don’t Trust Wall Street
In 2013, finance is the least trusted industry globally.
It hasn’t always been this way. Within the industry, it’s tempting to think that trust can be regained by reputation management. Reputation is seen largely as a function of communications or PR departments in 50% of companies in one survey.
But it goes deeper than that – deeper even than enlightened views of reputation management. There are serious structural issues that have driven down trust in the sector, and it’s hard to see how trust can be restored without directly addressing some of them.
But let’s let you be the judge of that. Here are Six Reasons we’ve lost trust in Wall Street.
1. “Wall Street” Ain’t What It Used to Be. In 1950, a discussion of “Wall Street” unambiguously meant the NYSE, the Big Board, and brokerage firms like E.F. Hutton. Today, Wikipedia says:
The term has become a metonym for the financial markets of the United States as a whole, the American financial sector (even if financial firms are not physically located there), or signifying New York-based financial interests.
That means “Wall Street” came to include commercial banking (think Chase and Bank of America), mutual funds, hedge funds, investment and trading operations like Goldman Sachs, private equity, and insurance companies like AIG. I think it’s fair to say the “new” financial businesses have had more than their share of the negative press that financial services has gotten over the years.
Many years ago, the president of GM could say – in good conscience – “What’s good for General Motors is good for America.” Can you picture Lloyd Blankfein saying, “What’s good for Goldman Sachs is good for America” with a straight face?
2. Finance Has Shifted to Zero-sum Uses. In traditional banking, borrowers create increased value with the money they borrow from lenders and put to good economic use. By contrast, in pure trading, no value is created. It is a zero-sum proposition. And the proportion of the financial sector represented by essentially pure trading has increased dramatically.
At the same time, Paul Volcker says the financial services’ share of “value-add “in the US economy grew from 2% to 6.5%. That’s not “value added” in the economic sense – it’s just an increase in price over cost. And, Volcker added, it was due not to innovation, but to increased compensation. As he famously put it, “The biggest innovation in the industry over the past 20 years was the ATM machine.”
Wall Street has increasingly focused on the “point spread,” not the fundamentals. In the NFL, they don’t let players bet on point spreads. But on Wall Street, that’s the name of the game.
The industry’s counter to such data is that they have increased liquidity, thereby lowering risk and volatility. Yet volatility in the stock market has steadily increased for decades, while the industry has gotten less efficient. And “black swans” have become part of our lexicon – we have massively underestimated risk. The value of the added liquidity is far outweighed by the risks it has entailed.
3. Finance Is a Larger Part of the Economy. In 1950, the US financial sector accounted for 2.8% of GDP. By 2011, that number had grown to 8.4%. In 2011, the financial industry generated 29% of all US profits. That proportion had never exceeded 20% in all of the 20th Century. From 1980 to 2010, the profit per employee in the financial sector of the US economy grew by over a thousand percent – far more than all the rest.
And as finance became less efficient, more profitable, and more zero-sum oriented, it also came to dominate business more. In 1937, 1 percent of the graduates of Harvard Business School went into finance. In 2008, that number hit 45%.
4. The Shift to the Short Term.
As of 2011, 60% of the daily turnover in US stock markets was accounted for by high-frequency trading something that didn’t exist a decade before. In 1960, the average holding period for stocks on the NYSE was 8 years. By 2010, it was down to 3-4 months.
In 1950, the marginal tax rate was 85%, putting a brake on short-term trading, since capital gains taxation of 25% kicked in only after 6 months.
A short-term mentality has always plagued the US in comparison to Europe and especially Asia. The shorter the timeframe, the more focused we become on transactions, and the less value we place on relationships. And that kills trust.
5. The Transactionalization of Finance. J.P. Morgan once said, “A man I do not trust could not get money from me on all the bonds in Christendom.” For several years now, we’ve had the IBGYBG problem on Wall Street: “I’ll be gone, you’ll be gone – do the deal, who cares.”
Can you say “moral hazard?”
In the Christmas movie It’s a Wonderful Life, local employees of a local bank lend mortgage funds to local borrowers, with the bank then holding the mortgage itself. By 2007, the lending was done by non-local employees of non-local mortgage companies who then resold the mortgage to non-local banks, who then securitized and sold to global investors. A relationship business had become thoroughly transactionalized. This drives down trust.
6. The Attack on Regulation. The LIBOR rate-rigging scandal shocked everyone last year. But rate-rigging turned out to be not a bug, but a feature. The chairman of the CFTC said LIBOR rates “are basically more akin to fiction than fact.” The truth is more like the Wizard of Oz saying, “Pay no attention to that man behind the curtain.”
It’s a market that turned out to be mythical – can you say “Bernie Madoff?”
The Glass-Steagall Act was repealed in the late 90s, arguably giving free reign to bankers to misbehave. The industry has fought consumer legislation governing things like credit card costs, not to mention the mix of Dodd-Frank rules.
It’s hard to trust an industry which visibly and without much embarrassment argues for more and more, after the rather remarkable feast of the last two decades.
The solutions to trust issues that I hear about most coming from the financial services industry tend to be reputation management and personal trustworthiness. I do believe that both these tools – especially personal trustworthiness – could be applied to great effect in certain financial sectors – notably financial planning, wealth management, traditional investment banking, and commercial lending.
But that’s not where the money is, nor where the biggest problems lie. And it’s going to take a whole lot more than the usual approach to reputation management to deal with them.
Until the sector can address those six areas of structural disconnect, the issues of trustworthiness will continue to dog the industry.
Charlie
As usual I largely agree with you, but think there are some additional complexities.
1 – I can imagine Lloyd Blankenfein saying this, even though Goldman Sachs has done things you and I don’t approve of. Goldman Sachs has business because its customers believe they get value from working with it. And you know that financing business and helping them grow remains a major Wall Street activity.
2 – There always was a zero sum component to finance. It is just more prominent now, as finance has grown in relative size to the rest of the economy, and as it gets more journalistic attention.
High frequency trading exists because of regulatory changes pushed upon the old Wall Street against its will. That was the shift from meaningful to negligible buy ask spreads. If this hadn’t happened high speed trading would have no profit potential. A new tax of 1 cent for every share sold would end it.
Volker is wrong about compensation in finance. It is an effect, not a cause. It has grown as profits have grown. And whether it is excessive or not, the compensation in turn feeds the real economy, through consumption, taxes paid and investments made.
3. The fact that Finance has a much larger share of American profits is less sinister than it seems. Think about the share of finance revenue and profits in the economy of New York. It is a huge percentage of the New York City economy. This is simply because finance is disproportionally based in New York. Most of the profit comes from other places. In fact Wall Street serves the world. If China and India had more competitive financial sectors, the revenues and profits of American financial institutions would be considerably lower, as would the tax revenues of the city and state of New York.
I don’t know why you think finance is less efficient than it used to be. The huge compensation in the industry is an counter indicator.
4 – The shift to the short term is a very important one that deserves a book, but high speed trading is not really relevant. There are many economically valuable activities that are short term. Fresh vegetables rot pretty quickly. They need to be shipped sold and eaten within weeks.
I think that one change that contributed to this was the conversion of the investment banks from partnerships to traded corporations. That completely changed their risk profile. The bankers were now gambling with stockholders money rather than their own. Was there a regulatory change that encouraged this? If so it certainly took place long before 1999.
5 – Its A Wonderful life is a very good movie, but it is a little simple. The fact is that Fannie Mae was established during the depression, and the Building and Loan would have been selling mortgages to it throughout the Second World War.
6. The key change in financial regulation in 1999 was to allow commercial banks to engage in investment banking, and insurance. As I read the history of the last 15 years, that had little impact on creating the crisis, but a significant one on mitigating it. If JP Morgan Chase and Bank of America had not been able to buy Bear Stearns and Merrill Lynch, the crisis might very well have been worse. Certainly the government officials who pushed these sales onto unwilling buyers certainly thought so. And those two banks’ reputations would certainly be better if they weren’t being blamed by the government for the sins of the acquired companies.
There were other, earlier regulatory changes that were much more important and dangerous. We have already discussed the reduction in share spreads on Wall Street. The most important and dangerous change in regulation was a change in the mortgage rules. In the 50s and 60s the rule of thumb was that you needed a 20% down payment on a house whose value could not exceed 2.8 times your income. This kept housing prices tied to the real economy and kept leverage and societal risk down. I have no idea when and why this was changed, but when I bought my apartment in 1982, I was offered a 100% mortgage. During the early 2000s there were reports of 120% mortgages. That bank regulators permitted this is the key to the tragedy of 2007.
Another change with unfortunate consequences was also unwanted by the industry. Rules were made to end the delays in access to your money when you make bank deposits. i was in favor of it at the time, but this deprived the banks of a stable, low risk source of revenue, which they have made up with riskier activities, and more direct charges to consumers. The less affluent would be much better off with slower access to their money and fewer penalties and fees.
Franklin,
Many thanks for contributing to the dialogue; very instructive. You are more knowledgeable than I about the industry, so I’m not going to try to comment on your various points, except for the one about the industry being inefficient. If you follow the link to the citation, it’s from a blogpost by James Kwak, commenting on research by Thomas Philippon. The relevant quote is:
“The conclusion is that the per-unit cost of financial intermediation has been going up for the past few decades: that is, the financial sector is becoming less efficient rather than more, and that accounts for two percentage points of finance’s share of the economy.”
I have some other opinions, but I’ll generally defer to your point of view on them, since you’re better acquainted than I with the industry.
But my overall question remains: I think it behooves all of us (and especially those in the industry) to answer the question, “Why is the financial services industry objectively ranked the least-trusted industry in the world?” I may not have the complete answers; but the question still stands.
Again, thanks very much for taking the time to join the dialogue.
Charlie, I did begin my reply by saying I largely agree with you. We need finance to be more trustworthy. I think we ought to encourage investment bankers to go private again, and we ought to institute the 1 penny per share trading tax so the high speed traders will do something more socially useful.
That said, I have now read the Kwak blogpost and I don’t buy it. I am not sure whether high frequency trading has a negative impact on the efficiency of the economy as a whole. It may, and that is one way to interpret what Philippon is saying. It does not reduce in the efficiency of the industry. It in fact is a beneficiary or even a consequence of increased efficiency of the industry. High frequency trading is only profitable because it is very efficient. It squeezes large returns on investment out of tiny profits deploying large amounts of capital. The traders aim to capture a fraction of a cent per share on these trades. That is why they need high frequency. The stock markets of 1982 would have collapsed under a fraction of current share turnover.
Franklin: again, thanks. And I note your statement that we’re largely in agreement.
I’ll let you have the last word on this particular issue of efficiency, I think you’re better qualified than me.
Keep commenting, please. It greatly improves the dialogue.