Sunday, April 12, 2009

Let's not kill *all* the bankers

Condemnation of Wall Street and banking generally is inevitably overshooting.

Yes, the system was rigged to incentivize greed -- in large part because institutional investors were stupid enough to stampede into hedge funds, notwithstanding their predatory fee structure (2% of assets under management plus 20% of profits was an industry standard), their opacity, and the obvious fact that as thousands more set up shop each year, they couldn't all be run by geniuses. In fact, a recent IBM Global Business Services study suggests that only 10% of hedge funds deliver alpha (outperform an index or equivalent benchmark over a significant period) and that active money management is likely to all but disappear as an industry over the next few years.

Yes, incentives at investment banks were skewed to reward racking up short-term profits by taking undue risks. The distorted compensation structure was exacerbated by competition from hedge funds, where top managers and traders make tens or hundreds of millions or even billions per year. To keep top traders from jumping ship, investment banks put them on proprietary trading desks - internal hedge funds, with similar incentives.

Yes, large swaths of the bloated financial industry turned nonproductive or counterproductive, seeking illusory profits by underrating the risk in poorly underwritten loans. When 40% of corporate profits are in the financial industry, and 59% of the men and 43% of the women in a graduating Harvard class enter the financial industry (as Frank Rich reports today), something is out of whack.

Yet it would be premature to kill all the bankers. We need them - some of them, at least. We even need some talented young people to enter the field, to help remake it on more sustainable terms.

It gets tiresome to keep reading that bankers, traders, institutional investors and other financial professionals "don't produce anything." Duh. They allocate capital. Venture capitalists fund startups. Investment bankers underwrite IPOs and facililate mergers. Institutional investors keep charities, foundations, universities and pension funds solvent and fund corporations through the bond market. Insurance companies ensure that everyday and occasional spectacular disasters won't be disabling. The slow evolution of the financial industry is in large part responsible for the explosion of wealth, first in the west and then in broad swaths of the world, over the last two (or five, or eight, depending on your perspective) centuries.

Of course, financial professionals often "allocate capital" stupidly -- and convince corporations, institutions and individual investors to fund ridiculous startups, ill-conceived mergers, bad debt, and poorly underwritten risks. When the industry grows too powerful, it exercises undue influence over politicians, guts regulation, and thus underwrites its own not-so-creative destruction. It's the worst of all systems for allocating resources - except for all the alternatives.

Which is not to say that Frank Rich is wrong when he writes
In the bubble decade, making money as an end in itself boomed as a calling among students at elite universities like Harvard, siphoning off gifted undergraduates who might otherwise have been scientists, teachers, doctors, entrepreneurs, artists or inventors.
It's true that dysfunction in the health care industry, uncertain prospects in engineering, and perhaps even reduced Federal funding for scientific research, coupled with the outsized pots of money available in hedge funds and investment banks, did draw not only recent grads but practicing physicians, engineers and scientists into the gold rush, and that this outsized pull was counterproductive. (The Times reports today that in the wake of the meltdown, more grads now are entering government, the sciences and "even teaching.")

Even as the percentage of college grads entering finance rose in recent years, however, my guess is that the percentage entering nonprofit, development and service fields was also rising. Anecdotally, in I keep hearing about college-age children of friends who are spending semesters in South Africa or India in education or development internships.

I'm all for public service. But we should not now leap to the conclusion that there is absolute value in inducing as many young people as possible to enter a nonprofit or not-so-lucrative profession, including government service. In an era of fully justifiable backlash, we should not forget that for-profit enterprises generate and will continue to generate most of the world's wealth, that not all the talented young people who prove to have the largest positive impact will do so through nonprofit or helping professions, and that we even need some of them to help remake the financial industry.

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