Average starting salaries for an entry-level investment banker are £72,000, rising to £329,000 in ten years. Those pay packets push up rents and house prices in finance-focused cities beyond what ordinary people can afford.
Now this would be money would be well-spent if bankers actually created value. But it seems that the opposite is true. Financial workers manipulated LIBOR, mis-sold payment protection insurance, and allegedly caused the 2008 financial crisis.
Indeed, France or Germany seem to be getting by just fine, even though their financial sectors are one third the size of the UK’s. A study claimed that the UK economy would be worth £4.5 trillion more if its financial sector wasn’t so outsized. As a result, many people viewed the warning that Brexit would harm UK finance as a reason to leave, not remain.
But in my column, I’ve tried to emphasise two themes. The first is whether evidence is reliable. Many people accepted the above headline uncritically because it confirmed what they’d like to be true. But the study hasn’t been published in any peer-reviewed journal, likely due to basic errors. For example, its measure of the financial sector only considers private credit. It thus ignores pension funds and mutual funds, which allow ordinary people to save for the future and benefit from rising stock markets.
The second is the distinction between pie-growing and pie-splitting. Even if the financial sector is large, this need not be at the expense of the rest of other industries (taking slices from them) but as a by-product of growing the pie, benefiting other industries as well.
So does finance grow the pie? It’s pretty clear that primary financial markets do. This is where new money is lent to companies. Without bank loans or venture capital, new businesses could never be launched. Indeed, improving access to finance is a key component of the government’s Industrial Strategy.
But the vast majority of activity occurs in secondary financial markets, where no new funds are being raised. When investors trade, they’re exchanging second-hand stocks and bonds that have already been issued. No new money flows to firms to fund new investment. Instead, secondary trading appears to be a pie-splitting activity. If one investor gains from a trade, another investor has to lose.
Surprisingly, even secondary financial markets can grow the pie, through two channels The first is incentives. Managers’ shares and reputation depend on the stock price. So their incentives to take decisions hinge on whether those decisions will be reflected in the stock price. If the financial market is inefficient, because unsophisticated traders value a firm based on short-term profit rather than long-term value, then the stock price will reflect short-term profit, and so managers will focus on it. However, an active financial sector, where investors are critically analysing a firm’s purpose, strategy, and stakeholder relationships, will ensure that prices reflect long-term value – in turn encouraging the manager to think long-term.
The second is learning. Many key drivers of long-term value, such as a firm’s strategic positioning, are difficult to measure objectively. Like an efficient polling system, the stock price aggregates the information of millions of investors into a single number, which can be used by anyone for free. For example, a bank deciding whether to lend, or a worker choosing which company to join, can use the stock price to guide them.
Most importantly, it can be used by the company’s management itself. For example, Carly Fiorina, former CEO of Hewlett Packard, dropped a bid for the consulting arm of PwC because investors indicated by falls in the stock price that they did not think the acquisition was a good idea. More broadly, evidence shows that CEOs invest more when their stock price is high, as this signals favourable growth opportunities – and the effect is stronger where the price is more informative.
Of course, a larger financial sector is not necessarily a more efficient financial sector, and not all trading is good. Stock prices may be manipulated, reducing rather than enhancing the amount of information in prices. But, the benefits of an efficient financial sector for the real economy are clear. The challenge for policymakers is to harness the financial sector’s vast resources to make prices more informative. One channel is to encourage investors to take large stakes, so that they have incentives to gather intangible information, rather than relying on freely-available earnings figures. When stock prices reflect long-term value, not short-term numbers, managers’ decisions will too.
Alex Edmans is a professor at London Business School and Gresham College