Remuneration in financial sector
and its impact on the investment perspective
Introductory remarks
International Meeting, Observatoire de la Finance
Finance and Common Good
Geneva,
March 30, 2001
by Charles Goldfinger
Remuneration of financial operators – the ways and means handlers of money make money - is a sensitive even emotional topic. It is difficult to discuss it purely in terms of economic rationality or business justification. Immediately, far-reaching questions of morality and ethics spring out. These questions are rooted in fundamental values and deeply held spiritual or religious beliefs. A striking example of the close links between religion and money is the Islamic prohibition of riba, payment of interest. Without going this far, a view that earning money on money is at best suspect and most likely immoral has been widely held throughout the history. “Usury” is one of the oldest sins, which has become a crime since the Middle Ages. Suspicion of moneymen and their trade has been shared by an extremely diverse group of thought leaders, from Aristotle, through Shakespeare to Keynes. Moneylenders are seen as parasites, who do not produce anything and take advantage of their privileged position to extract a rent from those who need money to produce or transact.
This deep suspicion of money triggers a vicious cycle: money handlers are reluctant to disclose their remuneration and their reluctance in turn aggravates the suspicion. The upshot of this vicious cycle is the opacity surrounding financial remuneration. In theory, the conceptual bases of interest rates set-up have been well defined and are widely disseminated. In practice, while the interest on money lent is the most visible form of financial remunerations, it is not necessarily the only one or the most lucrative. For instance, financial institutions that benefit from a broad deposit base often use it to generate additional revenues from short-term lending and placement. These revenues supplement the spread between interest paid on money held and interest earned on money lent. As depositors become better informed, reduce their free deposits and/or obtain higher interest rates, both deposit taking and lending activity become less interesting, thus inciting financial institutions to seek other forms of revenues, in particular commission revenues. The shift from interest-based revenues to commission-based ones has been the governing trend of financial remuneration for the last thirty years
This broad trend covers a variety of situations. There are commissions for the use of the financial infrastructure of payment systems and services. An example here is the fee paid for the use of a credit or debit card. Other large category of commissions is for intermediation services, bringing together buyers and sellers of various financial assets. Within this category, financial institutions can act as pure brokers, who simply bring together interested parties and facilitate establishment of a common price. They can also act as broker-dealers, acting as a counterparty to either buyer or seller and thus using their own capital to facilitate their transactions. In some instances, such as Initial Public Offering of an equity stock, they can go as far as to underwrite the transaction for its entire amount. For intermediation activities, the key variable is the degree of risk involved. Clearly, activities that require the use of the capital of a financial institution are more risky than those that do not and therefore should command higher remuneration. It is interesting to note that as financial institutions moved from an interest–based revenue model (which is inherently risky) to the commission-based one, their initial preference was for broking activities, which require little if any capital and entailed. However, many of them discovered that, in the world where the costs of information search are decreasing, pure brokerage is perceived as a low value-added service. Little capital means low barriers to entry and thus a more intense competition. The result of these two trends was a dramatic fall of brokerage commissions to the point where these were no longer linked to the value of underlying transactions but were defined on a fixed basis per transaction. In securities markets for instance, trading brokerage fees are based on the number of shares to be traded or on a given amount per trade. Internet, which enhances information transparency, accentuates this trend.
Activities requiring use of the intermediary firm’s capital may be more risky but are less susceptible to commoditisation. They allow both greater leverage in determining the price and greater competitive differentiation. Leading financial institutions today rely increasingly on risk-based commissions, derived in part from commitment of their capital. This in turn creates a situation where they compete with their customers, as they seek to optimise their use of capital. Thus, in a number of large investment banks, proprietary trading or other revenues generated from investing their own capital constitute an important, sometimes the most important, profit center.
The shift from interest-based remuneration to commission-based remuneration, from lending to market has made financial market prices more ubiquitous, more transparent but also more volatile. The price of financial assets is no longer determined by interactions between a limited number of commercial banks and very few central banks but by constant trading between many heterogeneous actors.
This trend has been accentuated by the development of financial theory, which created tools for pricing of financial assets, in particular the option theory. This theory provides a more accurate and fine-grained methodology to evaluate risk for specific asset or asset class than the standard interest rate theory. Its development has allowed a proliferation of instruments to model a wide variety of risks, going well beyond the well-known credit and market price risks. Derivates markets, futures, options, swaps, etc. have dramatically expanded the notions of tradeability and risk management. More recently, derivatives have been created to handle catastrophic risks, weather or pollution risks.
Certain financial institutions have acquired highly sophisticated skills, allowing them to create customized instruments and proprietary markets to trade those instruments.
Predictably, as financial markets become the dominant matrix of price formation, they are becoming more controversial. Today, leading social thinkers are more likely to denounce market-makers rather than moneylenders, tyranny of the markets rather than the greed of the banks. In particular, they are concerned that the increased power and influence of financial markets leads to short-termism, an excessive focus on short-term financial performance.
Another major grief is the volatility, widespread, persistent and contagious. Financial markets oscillate between “irrational exuberation” and excessive doom.
Criticism of financial markets needs to be taken seriously. Clearly, their evolution has worrisome aspects. Their rapid development accentuates the lag between the speed of the evolution of economic systems and that of political and social structures, creating strong tensions and accentuating development disparities. At the same time, predictive and corrective power of modern financial markets has to be acknowledged. Thus in the celebrated case of pound sterling devaluation in 1992, markets were right and the UK government was wrong: the strong pound was strangling the British economy and the devaluation has had a positive impact on growth and employment, without creating undue inflationary pressures.
Securities markets, despite crashes and aberrations, do send useful signals about relative performance of companies and economic sectors. These markets have played a critical role in the development of technologies, whose impact has been far reaching and long-lasting: personal computers, new media, biotechnology and Internet. One can apply to financial markets the Churchilian definition of democracy: it is the worst solution, except for all the others.