ADAM SMITH'S HIDDEN HAND IS VANISHING
PHILIP AUGAR
Tuesday, March 20, 2007
It is ironic that, at the time when Adam Smith's head is featuring on the Bank of England's £20 notes, the financial services industry appears exempt from the market forces he described. Smith was the 18th century economist who said the invisible hand of competition would reduce excess profits in business to normal levels. Yet financial institutions seem to be defying conventional theory. Commercial banks are reporting record results, the $50m bonus has arrived for top investment bankers and hedge and buy-out fund managers are being paid off the scale.
It is tempting to write this off as just another cyclical peak. But there is a powerful underlying trend. Smoothing results through mini-cycles reveals rising levels of profitability for a quarter of a century. Profits and compensation levels have parted company with those in other industries. In contrast to what we might expect from Smith's teaching, financial services industry returns have been remarkably resilient to pressure from customers and competitors.
One reason for this is that capital markets products have become so complicated that market forces seem not to apply. Whereas in traditional securities businesses, commissions and fees have been under pressure in a way that Smith would recognise, the opposite is true in structured derivatives trades. It is difficult for clients to understand the make-up of these trades and still harder to challenge prices since they are often protected by confidentiality agreements.
A second reason is that the industry has moved from being an agency to a principal business, but a principal business with a twist. Capital commitment has been rising ever since the deregulation of Wall Street in 1975, when investment banks began to move away from old-style agency business, in which they provided a service for clients in return for a fee, into new principal businesses involving capital commitment. This really stepped up a gear in 2003 after the Wall Street settlement of the initial public offering scandals gave implicit approval to such activities.
While there has been much discussion of the heavy regulation imposed by the Sarbanes-Oxley Act of 2002, the investment banks' settlement with the Securities and Exchange Commission a year later was much more generous and even more significant. Whereas, given the mood of the time, the authorities might have demanded a separation of customer advice and proprietary trading, they actually sanctioned an integrated business model.
This put financial institutions that were able to combine proprietary and customer business into a strong position. As a result of knowing what their customers were doing, they had an information advantage that provided a vital edge over other market users. The 2003 settlement gave them the message that the integration of customer and proprietary business was acceptable so long as it was policed properly. They strengthened their compliance departments, tightened internal controls and stepped up their capital commitment.
The twist is co-investing with clients. The idea came from buy-out and hedge funds. In return for managing buy-out funds and sharing in the risk, private equity managers traditionally got a management fee and a share in the fund's performance. As hedge funds grew up, they seized on this concept and “two and 20” – a management fee of 2 per cent of committed capital and 20 per cent of profits over an agreed benchmark – became the norm.
Once the authorities had approved integration, investment and commercial banks piled into the hedge fund and buy-out sectors, seeding funds with their own capital and buying into established operations. The result is that a notable proportion of the financial services industry co-invests with clients and gets paid through carried interest. While there is some slight evidence of “two and 20” easing towards “one and 10”, the concept of alignment of interest between service provider and client offers powerful resistance to conventional market forces.
The new business model means future profitability will be even more closely linked to the market's cycles and less to the invisible hand. Paradoxically, we could eventually see a situation where wholesale banks give advice for free in return for getting a flow of customers. While this might be seen as the ultimate victory for the invisible hand, a quick look at the returns made on the principal side of the business should serve as a reminder that someone, somewhere, is still paying a price.
The writer led Schroders' global securities business before becoming a writer. His latest book is The Greed Merchants: how the investment banks played the free market game (Penguin)
