Wednesday, February 27, 2013

5 More Graphs on Finance

As a follow-up on the last blog post, I've done a little more research into the financial sector, looking for characteristic and contrary evidence of economic rent. Obviously, there's no precise measure of rent, because we don't have a precise measure of opportunity costs.

Still, there is a lot we can look at. First, average compensation per full-time-equivalent employee in finance relative to all other sectors has soared since 1980. In fact, the graph looks so much like the famous Piketty and Saez graph of the income share of the top 1 percent, it's very possible that we are looking at, in effect, the same graph. The return of financial sector compensation may very well explain their findings.

Next, I looked at the share of GDP and corporate income which the financial industry yields. Note that these are not measures of profits -- which I apparently did wrong in my last post, so see here for an ostensibly accurate graph -- but rather income in two different senses. They come directly from NIPA, so as to avoid trouble. (Finance is defined narrowly here and in all cases as to exclude real estate and, where possible, the central bank.)

Compare this graph with the first graph. What we realize is that the increase in financial-sector compensation is not evenly distributed, but rather incredibly concentrated at the top end of the pay scale.

I think the next two graphs are strong evidence of financial-sector profit being rent. This first one is of the share of noninterest income for commercial banks. The idea is that commercial banks are making more margin off fees, financial services and products, etc. than they once did. Some of this may be financial innovation and change in the commercial-bank business model. But that only raises the question of why they are making so much off everything-but-lending.

I think you need a model where the financial sector became much less competitive to explain the origin of this income and the resulting profits. It seems that a very, very large share of the financial sector's income and profit growth can be explained by "non-core" functions and revenue sources, in general. It's not clear why they should be able to take in so much in fees, for instance, if there was a competitive market in banking.

I think changes in the banking industry itself also goes a long way towards an explanation of the financial sector's profits. In the U.S., at least, we've seen a massive consolidation of what had been a previously (i.e. pre-1980) highly dispersed banking industry.


  1. Evan,

    First, I think when you said "net two graphs" you meant "next two graphs." That tripped me up for a moment :D

    Second, I don't draw the same conclusion that you do with regard to the increasing contribution of noninterest income to total income. I think you're overlooking the possibility that an increase in the total revenue attributable to noninterest bank services can account for the increase in noninterest bank services' contribution to income.

    Shouldn't you really be looking at the profit margins for noninterest bank services to give you a better idea of whether the market for derivatives, insurance, IPOs, mergers, etc. has really gotten less competitive? Given the graphs that you've posted about the dramatic increase in finance salaries, I wonder to what extent the value of those services is retained for bank shareholders vs. extracted by employees.

    Another explanation (which might also account for the increasing consolidation of large firms) is that the profit margins for lending have gone way down as technology and economies of scale have increased competition among banks for depositors. That would leave banks to rely on nonlending income to drive profits.

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  3. Another explanation for the consolidation after 1988 was the final repeal in 1994 of bank branching restrictions following the S&L Crisis. You mention the consolidation after 1980, but that was in response to artificial restrictions. Geographic diversity reduced the idiosyncratic risks inherent in small local banks, but naturally led to larger banks.

  4. I may be biased as someone who works in the financial services industry in NYC, but I would interpret each of these charts differently.

    Chart 1, why did the FTE Comp ratio ever get close to 1. Finance (today anyway) is dominated by employees with bachelors or more. Those jobs should have substantially above average comp ratios to offset the cost and time of the degree. I would not visit a doctor who earned the national median compensation either. I suspect that some of this effect is computer driven processing replacing many lower paid clerical job in finance with fewer highly paid engineer/programmer types as well as outsourcing of those jobs to Asia (I can tell you at our firm the average comp of the outsourced job was much lower than the firm wide average).

    Finance has grown, but it appears by more as a % of GDP (roughly 3 times) than corporate income (roughly 2 times). My comment on your early post highlighted globalization and asset management growth as two important causes of this effect. These charts are consistent with that.

    The NY finance "salary" chart is not accurate. Perhaps its "salary and bonus". I have looked at McLagen comp surveys for NY for many years and you have seen little movement in salary until the financial crisis, as bonuses grew but salaries did not much. Our own firm maintained a maximum $200,000 salary even for the most highly compensated for more than a decade, as did many firms. It was only post-criticism that firms increased salaries to negate the criticism of bonus comp. Nevertheless, comp has increased in like for like jobs, although I expect much of the impact you show is actually the hollowing out of clerical type jobs mentioned above.

    The growth of non-interest income of commercial banks has to be somewhat Glass-Steagall related as investment banks always generated more non-interest income. The other important factor would be asset management in my view. The fact that these have grown is not itself a sign of "rents". You can be critical of asset management in that costs have not declined (I am) but it is a competitive business with lots of non-bank participants.

    The consolidation chart is sort of laughable. First, it does not seem to adjust for inflation is measuring bank size, so we end up with more banks in the large category just from that. More importantly, why would anyone think we need more than 6,000 banks to have a competitive market? Asked another way, how many hardware stores did we have in 1988? Didn't people pretty much decide that they prefer the economies of scale passed through to them by HD and Lowe's? Retail banks, which make up the majority of commercial banks, are processing and service businesses for the most part (I know they get paid by net interest margin). Those are business activities with tremendous economies of scale.

  5. It would be great if you graphs had links to the data sources as well. keep up the great writing.

  6. The share of income coming from non-interest sources is in part a mirror image of net interest margins, which have been declining sharply:

    Even if fees had not risen at all, they would grow as a share of total income as NIM declined. Remember NIM*Total Assets = Interest Income.

    Digging down another level, you can trace part of the growth in fees to growth in credit card fees charged to retailers as a % of every purchase. This is misleading though because a lot of those fees get kicked back to cardholders in the form of rewards. Also in the past banks would make a lot of money on the spread between what they paid on demand deposits (usually zero, or close to zero) and what they would otherwise have to pay in the wholesale markets (the fed funds rate, or thereabouts). Right now in a ZIRP environment, that has gone away, so they are looking to other ways to close the gap.

    Finally, the earlier commenter's point on Glass-Steagal is correct - by law commercial banks couldn't be in the business of advice and capital raising which by definition result in the collection of non-interest income. After passage of G-S most of them got into that game which naturally resulted in more non-interest income.

    I don't see much evidence that there is much in the way of rents in the financial industry. In fact I don't see much evidence that the industry produces much in the way of economic profits, or profits period.

    Over the last ten years, the XLF (a market-cap weighted index of all major publicly traded finance, insurance and real estate companies) has returned 0.5% annually, vs. 8.5% annually for the S&P 500 as a whole:

    There can be other reasons for the low return (maybe financials were really over valued in 2003? maybe they're very undervalued today?) but that is a massive gap over a fairly long time period. Essentially a dollar invested in the US stock market ten years ago would be worth over two dollars today and a dollar invested in the XLF would still be a dollar. Also, the return of the XLF was boosted by its non-banking components (Berkshire Hathaway is almost 9% of the index, and there are some REITs mixed in too). The chief cause of low investor returns has been low profits.

    Commercial banking is one of the most fragmented industries in the US today, if not THE most fragmented. This is in part due to regulation (the 10% deposit cap for example). The domestic airline industry (with about ten major players) is considered very fragmented, and that fragmentation is often cited as the cause for its low returns. Many industries have only 2-4 players that account for most if not all of the profits.