During the last 30 years, the financial services sector has grown enormously. An analysis of how the financial sector has changed reveals both social benefits and costs of financial sector growth.
Much of the growth in the financial sector is associated with two activities: asset management and the provision of household credit. The benefits of the professionalization of asset management include an increase in financial market participation and diversification, which likely decreases the cost of capital to corporations, but costs have been high in terms of fees and generating economic rents that could draw more resources to the industry than is socially desirable. Greater access to credit has improved the ability of households to smooth consumption but at the cost of consuming in excess of sustainable levels.
How Is This Research Useful to Practitioners?
The authors suggest that little is known about what activities contributed to the rapid growth of the financial sector; thus, this research is useful in quantifying and clarifying the nature of the growth. After describing what drove the growth of these industries over the 1980–2007 period, they draw several conclusions. The direct cost of professional asset management, at 1.3% of assets, is high. The present value of this fee paid over 30 years adds up to approximately one-third of the assets initially invested—a large amount to pay a manager who does not outperform passive benchmarks. Most of the potential benefits (and some of the costs) of professional asset management do not accrue directly to investors. In addition, many investors have trouble assessing the quality and cost of professional asset management services or are influenced by agency considerations in choosing and compensating asset managers.
Much of professional asset management is not explicitly directed at participation and diversification but rather at beating the market. Most studies document that active investment managers underperform, especially after taking fees into account. The pursuit of excess returns is shown to have the social benefit of more accurate and efficient securities prices, which enable firms to raise new capital at prices that better reflect their fundamental value.
Information produced by active managers is questionable because there is evidence that it caters to the preferences of unsophisticated investors, and both individuals and institutions overpay for active management. When investors overpay for active management, rents created in the sector lure talented individuals away from potentially more productive sectors. In fixed income, “shadow banking” and increasing household indebtedness beyond sustainable levels may have adverse consequences for macroeconomic stability.
How Did the Authors Conduct This Research?
The growth of the securities industry accounted for almost half of the overall growth of the financial sector relative to GDP from 1980 to 2007, and the growth of credit intermediation accounted for roughly one-quarter of the growth. There are no published data on the input costs at the activity level needed to calculate the added value; thus, the authors use data on the output of the various activities of the securities industry (i.e., the revenues of each of the activities of the industry).
Fees earned from traditional asset management along with administration costs of pension funds are the largest component of output for the securities industry. Fees collected by alternative asset managers—hedge funds, private equity funds, and venture capital funds—also rose substantially over the study period. The growth in fees was driven by increases in the total outstanding amount of financial assets and increases in the share of these assets that was professionally managed. In equities, much of the growth came from an increase in valuation ratios. In fixed income, much of the growth came from securitization. Securitization is intricately linked with the growth of shadow banking, in which key functions of traditional banking are provided by a host of nonbank entities. Shadow banking has increased the number of interconnected steps in the credit intermediation process; combined with short-term leverage, this new approach to banking may have increased the fragility of the financial system.
The authors assume that outperforming passive benchmarks is the main added value in charging an investment management fee and do not consider other services provided by investment professionals, such as helping households with budgeting, access to research, financial planning, and other activities, resources, and advice included in the fees charged. Data may not be available to quantify these additional services, but the interpersonal aspect of asset management is an important component in assessing added value. Also, as the authors state, households do not take macroeconomic externalities into account when choosing how much to borrow; thus, the relationship between professionals and individuals is paramount to macroeconomic stability. In other words, advice on prudent financial management mitigates the macroeconomic instability resulting from increased household debt.