Why do we need a financial sector?

November 22, 2011 1:51 AM

Economics blog VoxEU debates Why do we need a financial sector? Serious, important and very dull articles discuss the trade-offs and myths of innovation, and whether the sector is overrated, critical or a contributor to the wider economy.
posted by TheophileEscargot (35 comments total)

The latest XKCD illustrates how mind-numbingly huge the financial sector is. All those trillions of derivatives on the market dwarfing the entire global GDP, the world's total liquid assets, all of Earth's known oil reserves -- you name it.
posted by DaShiv at 2:40 AM on November 22, 2011 [5 favorites]

Metafilter: Serious, important and very dull articles
posted by twoleftfeet at 3:41 AM on November 22, 2011 [3 favorites]

DaShiv: I mostly found that the latest XKCD illustrates how mind-numbingly huge the latest XKCD is. It's so large as to be completely unreadable - if you zoom in enough that you can read it then you can't see enough of the context to make sense of it.
posted by DRMacIver at 3:44 AM on November 22, 2011 [3 favorites]

It's so large as to be completely unreadable -

It is also so large at this moment as to be difficult to regulate even if the will for regulation existed. Like Washington said of fire, the financial sector is "a useful servant, but a terrible master" and this is what happens when you leave it unattended for too long.
posted by three blind mice at 4:10 AM on November 22, 2011 [7 favorites]

Wish I could find the reference now (it could be in Andrew Sullivan or in Boing Boing) but somewhere recently there was a quote along the lines of 'due to all the recent "financial innovations", 90% of all transactions of equity bearing instruments (I might have that bit wrong) are now entirely unreported and unregulated.' I really wish I had the exact quote handy as I found it to be entirely shocking. Basically it's a feature, rather than a side effect, that all these innovative financial products are unregulated.
posted by newdaddy at 4:11 AM on November 22, 2011

[I'll just point out that we actually have a thread on the XKCD money infographic, so comments that are mostly about that should probably go over there.]
posted by taz at 4:34 AM on November 22, 2011 [1 favorite]

Everyday people get the same benefit from the international finance industry that turkeys get from Thanksgiving.
posted by absalom at 4:43 AM on November 22, 2011 [3 favorites]

Why do we need a financial sector?

Why do we assume that it's for us?
posted by DU at 4:49 AM on November 22, 2011 [2 favorites]

All those trillions of derivatives on the market dwarfing the entire global GDP, the world's total liquid assets, all of Earth's known oil reserves -- you name it.

The derivatives market is big, but figures sizing it as astronomically large are highly misleading: Saying there's $668 trillion in derivatives floating out there is like saying every lottery ticket sold is worth the full value of the jackpot. If the jackpot is $100 million and lottery organizers sell 2 million tickets, "that's $200 trillion worth of lottery wealth that's circulating!" jokes Figlewski. "When you say it that way, everybody knows that's a complete nonsense number."
posted by shivohum at 5:13 AM on November 22, 2011 [4 favorites]

Serious, important and very dull articles

You're not selling it to me.
posted by londonmark at 5:20 AM on November 22, 2011 [1 favorite]

Saying there's $668 trillion in derivatives floating out there is like saying every lottery ticket sold is worth the full value of the jackpot.

Well, it is if we insist on bailing out each ticket holder for the whole jackpot when they lose.
posted by KingEdRa at 5:22 AM on November 22, 2011 [13 favorites]

Well, it is if we insist on bailing out each ticket holder for the whole jackpot when they lose.

Good thing we don't do that then.
posted by shivohum at 5:46 AM on November 22, 2011 [5 favorites]

The latest XKCD illustrates how mind-numbingly huge the financial sector is. All those trillions of derivatives on the market dwarfing the entire global GDP, the world's total liquid assets, all of Earth's known oil reserves -- you name it.

Yeah the 'nominal value' of all those derivatives kind of a meaningless number. I'm sure some of those can't be realized at the same time -- for example a put option and a call option on a stock, if the price of the stock goes up the call option becomes valuable and the put option becomes worthless.

I don't know how all of that is calculated either. Would something like a $10 million insurance policy be counted as $10 million? Would the nominal value of a 'lottery ticket' be the jackpot value or the jackpot value times the probability of winning?

A lot of the derivatives value is never expected to be realized. A credit default swap, for example is never expected to paid in full, people buy and sell because the incredibly low probabilities go up and down over time.

Think about it like a lottery tickets that don't expire, if the numbers on your card don't get called up you can still win if they come up the next time, or any time after that.

The tickets would have a value and you would be able to buy and sell them based on the current probabilities and jackpots. People would buy the cards if they thought the odds would improve, even if they never expect to actually win
posted by delmoi at 5:54 AM on November 22, 2011

As I understand options, they are zero-sum anyways. I think it would make more sense to should the value of the fees paid to the clearing house that created the options since that is the only part that isn't zero-sum.
posted by VTX at 6:57 AM on November 22, 2011

I think it would make more sense to should the value of the fees paid to the clearing house that created the options since that is the only part that isn't zero-sum.

This would downplay the leverage and counterparty risk.

The notional value of derivatives is absurdly large but it's probably better to overstate the risks instead of understating them.
posted by mullacc at 7:09 AM on November 22, 2011 [1 favorite]

One may as well as "Why do we need a legal profession?" No one likes lawyers much either.

The answer is "Because we couldn't function as a society, much less a modern one, without out it." Just like the only way we moved past mob lynchings and fiat legislation was by the introduction of a robust legal sector, the only way we moved past subsistence farming and centuries with multiple famines was by the introduction of a robust financial sector. If nothing else, the financial sector exists to help individuals and businesses deal with and allocate risk.

Yes, the financial system does include all those evil, evil investment bankers and derivatives traders, but it also includes your local insurance agent and credit union. Let's not throw out the baby with the bathwater.

The real question is "Do we really need or even want the financial sector to do all the things that it's currently doing?"

That answer is "Of course not." But that's both 1) blindingly obvious, and 2) less rhetorically dramatic. So it's less likely to generate a lot of link traffic.
posted by valkyryn at 7:09 AM on November 22, 2011 [8 favorites]

A lottery ticket is a stupid analogy.

It's more like a bet on a horse race if anything. A race that never finishes running and you sell your betting ticket to the race if you feel like cashing out.
posted by Talez at 7:15 AM on November 22, 2011 [1 favorite]

I'd definitely never thought of VoxEU as a "rhetorically dramatic" generator of "link traffic" before.
posted by TheophileEscargot at 7:27 AM on November 22, 2011

As an example, Bank of America's purchased credit default swap notional balance was about $2.1 trillion as of September 30.

In theory, if every company that issued the bonds that underlay the CDS went bankrupt, then the parties that sold the CDS to BOA would owe BOA $2.1 trillion. There are likely hundreds or even thousands of distinct issuers so the probability of each defaulting is very small, but not necessarily zero.

In the event each CDS contract were to suddenly be in the money (every bond issuer defaulted), the CDS sellers are not going to be out $2.1 trillion. They still own the underlying bonds, which will mostly have a value greater than zero. The standard assumed recovery rate for a bond on which CDS has been written is 40%.

Finally, each time a CDS was sold to BOA, the seller also purchased a CDS to hedge their exposure to BOA. In other words, if the CDS seller is forced to pay BOA, they also will be receiving the same amount from a different counter party.
posted by otto42 at 7:36 AM on November 22, 2011

A lottery ticket is a stupid analogy.

It's more like a bet on a horse race if anything. A race that never finishes running and you sell your betting ticket to the race if you feel like cashing out.
posted by Talez at 7:15 AM on November 22 [1 favorite +] [!]

It is more like the horse owner betting on every other horse in the race in case the horse you own doesn't win.
posted by otto42 at 7:44 AM on November 22, 2011 [1 favorite]

Why do we need a financial center? Well we need to put all the assholes.
posted by X-Himy at 7:54 AM on November 22, 2011

*somewhere

Bloody smartphone.
posted by X-Himy at 7:55 AM on November 22, 2011

I haven't had my coffee yet, but weren't CDSs the big problem behind the AIG blowup, and aren't CDSs a pretty big contributing factor to the MF Global problems (as a trigger, not the money mixing bits)?
posted by ryoshu at 7:58 AM on November 22, 2011 [1 favorite]

The New Republic's John Judis (who I believe is a pretty staunch liberal/progressive) recently wrote this serious, important, and dull article:

Stop Blaming Wall Street.
It isn't the reason our economy is in shambles.

posted by John Cohen at 8:01 AM on November 22, 2011

The answer is "Because we couldn't function as a society, much less a modern one, without out it." Just like the only way we moved past mob lynchings and fiat legislation was by the introduction of a robust legal sector, the only way we moved past subsistence farming and centuries with multiple famines was by the introduction of a robust financial sector. If nothing else, the financial sector exists to help individuals and businesses deal with and allocate risk.

The question is whether or not we need one today. I would imagine most of the important stuff that wallstreet does for society in general could be done by computer these days.

For example, one of the major activities of the finance industry is selling corporate bonds. Ford needs to sell some bonds, they go to Goldman Sachs to issue bonds and sell them to investors. Investors find out about the bonds and buy them. But why not just buy bonds directly from ford?

Someone at Ford could just run some software to create the bonds, and post them on their website. Users could use software that collates all the available bonds and the investor could invest in them.
posted by delmoi at 8:21 AM on November 22, 2011

Someone at Ford could just run some software to create the bonds, and post them on their website. Users could use software that collates all the available bonds and the investor could invest in them.

The US Treasury does this via Treasury Direct. But even the US government still relies on investment banks to make a market.
posted by mullacc at 9:16 AM on November 22, 2011

The question is whether or not we need one today. I would imagine most of the important stuff that wallstreet does for society in general could be done by computer these days.

You've conceded my point. Someone needs to do at least some of the things that the financial sector does. We may not need Goldman Sachs as such to do it, and we may not actually need to pay them a hojillion dollars for doing so, but we do need someone to perform the services necessary to create, evaluate, market, and sell things like corporate bonds.

And for all the crap ratings agencies get, they do actually permit bonds to be sold for a price investors are willing to pay. Without the information the ratings agencies provide, no one would be willing to pay reasonable rates of interest for anything, because they'd have to assume there was a real risk of default in every case. Which means we need someone to sit down and evaluate the financials of every company that wants to issue bonds. There's your financial sector right there.
posted by valkyryn at 9:28 AM on November 22, 2011

"Someone at Ford could just run some software to create the bonds, and post them on their website. Users could use software that collates all the available bonds and the investor could invest in them."

Putting aside the numerous regulations that prevent this from happening, Ford does not issue bonds often enough to justify keeping their underwriting efforts in house, and I'm guessing Ford is probably one of the more active issuers compared to all of the other companies out there.

White Shoe Investment Bank performs some of the functions that it would be impossible for Ford to do on its own.

If Ford really needs to issue $500 million next week, and not doing so would cause some serious issues, (bankruptcy, missed production, missed tax payment, etc.) White Shoe will guarantee Ford gets it's $500 million. White Shoe essentially buys the entire issue ($500 million) and incurs the risk of not being able to sell it off to its customers. In short, Ford is assured it will have $500 million in the bank on a certain day, White Shoe is not.

Other related functions for White Shoe that are not necessarily impossible for Ford, but costly:

-Determining the cheapest price of the bond based on market demand. ie

What coupon rate is the market demanding for a bond that matures in November 2017?
What if the maturity is 2016 or 2018?
What if the bonds are callable?
What if the bonds are putable?
What price do similarly rated bonds trade at?
etc., etc.
posted by otto42 at 10:03 AM on November 22, 2011 [1 favorite]

maybe i am a simple wood-headed cube moron. but that tnr article seems to say that the US's problem is that allowing production offshore (which i thought american firms did because it was cheaper than hiring cranky and expensive US labor with its need for living wage etc) somehow crippled our economy and (???) is going to fix it

also usually progressives don't drop in weird little jabs at "liberals" early in their articles but maybe thats just me
posted by beefetish at 10:41 AM on November 22, 2011

The latest XKCD illustrates how mind-numbingly huge the financial sector is.

What it illustrates is how influential the financial sector is. We have given Goldman et. al. permission to invent bizarre new financial instruments. They have used that permission to leverage the money entrusted to them to such a degree that they can buy anyone or anything, including all of earth's known oil reserves.

They may write on a piece of paper that their transactions dwarf the world's GDP but that is a fantasy, a fiction that they and we have created together. All ways of organizing people and economies are ultimately daydreams to which we give our consent. What we have now is a nightmare.
posted by justsomebodythatyouusedtoknow at 1:42 PM on November 22, 2011 [1 favorite]

As a follow up which addresses many of the comments above, see What is the contribution of the financial sector? in today's VoxEU. And unless I missed it, no one above has mentioned liquidity risk when ratings on collateral on CDSs drop and the seller has to pony up more money.
posted by carping demon at 5:42 PM on November 22, 2011

If Ford really needs to issue $500 million next week, and not doing so would cause some serious issues, (bankruptcy, missed production, missed tax payment, etc.) White Shoe will guarantee Ford gets it's $500 million. White Shoe essentially buys the entire issue ($500 million) and incurs the risk of not being able to sell it off to its customers. In short, Ford is assured it will have $500 million in the bank on a certain day, White Shoe is not.

At the same time it sounds like Ford would be leaving a lot on the table by doing this, then since the bank obvious expects to make a profit.

-Determining the cheapest price of the bond based on market demand. ie

What coupon rate is the market demanding for a bond that matures in November 2017?
What if the maturity is 2016 or 2018?
What if the bonds are callable?
What if the bonds are putable?
What price do similarly rated bonds trade at?
etc., etc.

Why can't those questions be answered by computer program? Seems like it's just math.
posted by delmoi at 6:54 PM on November 23, 2011

Why can't those questions be answered by computer program? Seems like it's just math.

It's just math but the inputs are subjective. That's why pricing is done in the market. Ford could set up an electronic auction and invite investors to participate, but a passive approach wouldn't work very well. Instead Ford would need to actively market its bonds--e.g., go on the road to visit investors and convince them of the merits of Ford's bonds. At some point it just becomes more efficient to outsource this work.

At the same time it sounds like Ford would be leaving a lot on the table by doing this, then since the bank obvious expects to make a profit.

The initial underwriting is only part of the equation. I'd argue that the more important role is making a secondary market. Corporate bonds are less liquid than you probably imagine. Nowhere near as liquid as stocks. Investors value liquidity, obviously, and it would be difficult for Ford to promise that there will be a market for its bonds if it snubs Wall Street and issues directly.
posted by mullacc at 8:11 AM on November 25, 2011

Instead Ford would need to actively market its bonds--e.g., go on the road to visit investors and convince them of the merits of Ford's bonds. At some point it just becomes more efficient to outsource this work.

Well, investment banks could bid on the bonds directly themselves.
posted by delmoi at 12:18 AM on November 27, 2011

That kinda is what happens now.
posted by mullacc at 1:46 PM on November 28, 2011