Thursday, April 24, 2014
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Is Finance Too Competitive?

NEW DELHI – Many economists are advocating for regulation that would make banking “boring” and uncompetitive once again. After a crisis, it is not uncommon to hear calls to limit competition. During the Great Depression, the head of the United States National Recovery Administration argued that employers were being forced to lay off workers as a result of “the murderous doctrine of savage and wolfish competition, [of] dog-eat-dog and devil take the hindmost.” He appealed for a more collusive business environment, with the profits made from consumers to be shared between employers and workers.

Concerns about the deleterious effects of competition have always existed, even among those who are not persuaded that government diktat can replace markets, or that intrinsic human goodness is a more powerful motivator than monetary reward and punishment. Where the debate has been most heated, however, concerns the effects of competition on incentives to innovate.

The great Austrian economist Joseph Schumpeter believed that innovation was a much more powerful force for human betterment than was ordinary price competition between firms. As a young man, Schumpeter seemed to believe that monopolies deaden the incentive to innovate – especially to innovate radically. Simply put, a monopolist does not like to lose his existing monopoly profits by undertaking innovation that would cannibalize his existing business.

By contrast, if the industry were open to new players, potential entrants, with everything to gain and little to lose, would have a strong incentive to unleash the waves of “creative destruction” that Schumpeter thought so essential to human progress. In a competitive industry, only paranoid incumbents – those constantly striving for betterment – have any hope of surviving.

As an older man, Schumpeter qualified his views to argue that some degree of monopoly might be preferable to competition in creating stronger incentives for companies to innovate. The rationale is simple: If patent protection were limited, or if it were easy for competitors to innovate around intellectual property, a firm in a competitive market would have very little incentive to invest in pathbreaking research and development. After all, the firm would gain only a temporary advantage at best. If, instead, it withheld spending, and simply copied or worked around others’ R&D, it could survive perfectly well – and might be better off. Knowing this, no one would innovate.

But if the firm enjoyed a monopoly, it would have the incentive to undertake innovations that improved its profitability (so called “process” innovations), because it would be able to capture the resulting profits, rather than see them be competed away. A “boring” bank, shielded from competition and knowing that it “owns” its customers, would want to go the extra mile to help them, because it would get its pound of flesh from their future business. Customers can be happy even when faced by a monopoly, though they would grumble far more if they knew how much they were paying for good service!

An analogy may be useful. A monopoly is like running on firm ground. Nothing compels you to move, but if you do, you move forward. The faster you run, the more scenery you see – so you have some incentive to run fast.

Competition is like a treadmill. If you stand still, you get swept off. But when you run, you can never really get ahead of the treadmill and cover new terrain – so you never run faster than the speed that is set.

So which industrial structure is better for encouraging you to run? As economists are prone to say, it depends.

Perhaps one can have the best of both worlds if one starts on a treadmill, but can jump off if one runs particularly fast – the system is competitive, but those who are particularly innovative secure some monopoly rents for a while. This is what a strong system of patent protection does.

But patents are ineffective in some industries, like finance. The overwhelming evidence, though, is that financial competition promotes innovation. Much of the innovation in finance in the US and Europe came after it was deregulated in the 1980’s – that is, after it stopped being boring.

The critics of finance, however, believe that innovation has been the problem. Instead of Schumpeter’s “creative destruction,” bankers have engaged in destructive creation in order to gouge customers at every opportunity while shielding themselves behind a veil of complexity from the prying eyes of regulators (and even top management). Former US Federal Reserve Board Chairman Paul Volcker has argued, somewhat tongue-in-cheek, that the only useful financial innovation in recent years has been the ATM. Hence, the critics are calling for limits on competition to discourage innovation.

Of course, the critics are right to argue that not all innovations in finance have been useful, and that some have been downright destructive. By and large, however, innovations such as interest-rate swaps and junk bonds have been immensely beneficial, allowing a variety of firms to emerge and obtain finance in a way that simply was not possible before.

Even mortgage-backed securities, which were at the center of the financial crisis that erupted in 2008, have important uses in spreading home and auto ownership. The problem was not with the innovation, but with how it was used – that is, with financiers’ incentives.

And competition does play a role here. Competition makes it harder to make money, and thus depletes the future rents (and stock prices) of the incompetent. In an ordinary industry, incompetent firms (and their employees) would be forced to exit. In the financial sector, the incompetent take on more risk, hoping to hit the jackpot, even while the regulator protects them by deeming them too systemically important to fail.

Instead of abandoning competition and giving banks protected monopolies once again, the public would be better served by making it easier to close banks when they get into trouble. Instead of making banking boring, let us make it a normal industry, susceptible to destruction in the face of creativity.

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  1. CommentedCharles Villette

    The problem with banks is that the imperative for each to be well capitalized is inversely correlated with the imperative of the system as a whole to be robust, i.e. for banks to be well connected with each other: the more banks are connected with each other, via the payment system or risk swapping deals, the less they need equity and the less they have equity (as % of assets).
    Banking is monopolistic by nature, both of its traditional activities (payment system) and its newer ones (for ex. market making, in the broadest sense). Since it is a natural monopoly, the State naturally controls it, via the central bank and state-chartered clearing houses. The State's de facto control of the banking industry is an aspect that should not be revealed, or else the public would naturally seek to end the political "independence" of central banks whenever it perceives that their control is insufficient.

  2. CommentedMichael Lupsor

    I find the arguments in favor of a ‘reasonable’ level of monopolistic power as spurious, going against the decades, if not centuries, of solid experience.
    This is an argument still preached in North Korea and still very popular in France. The best/worst example is the French Minitel, a visionary product, a testimony of French creative spirit – a product that anticipated interned by several decades- only to see the French government giving full control of its production, distribution and operation to the state-owned France Telecom. As expected, the product did not change - ever, and provided France Telecom and the government with billions in revenue, only to be wiped away by the internet, few decades later after its creation. The morale – why bother innovate if you have full control of a monopolistic product, the market and captive consumers for it?
    As to the innovation in the banking sector, the recent Libor saga should reasonably put an end to the naïve belief of the ‘innovation’ coming out of that industry. The morale – why bother to innovate and compete when you can collude, rig the markets and enjoy handsome rent? The myth still promoted by the finance textbooks that the financial sector plays a significant (positive) economic role as the intermediary between savers – individuals, companies and governments – and those in need for capital, should be severely qualified, as the shifting of banks’ activities to more ‘lucrative’ activities left the original activity as a marginal one. The free market model never worked in the banking world, because it was never adopted and implemented. Even though the financial crisis is still fresh in our memory - and very much so in many European countries – the pressure to reform the financial system – in a responsible, free market and competition spirit, is receding with every passing day. The highly institutionalized lobby is making its job very effectively, that is until the next crisis, which is – make no mistake – in the making and will bring back the questions we are not able – or willing - to address now.

  3. CommentedSami Al-Suwailem

    The author does not answer the simple question: Why finance is not, and has not been, like ordinary industries?
    Simply put, because finance is a means, as J. Stiglitz repeatedly emphasized. Once finance diverges from being a means for trade and production, it becomes a casino living-off the economy. That is why finance is more dangerous than any of the real-sectors, as recent research by IMF and BIS shows.

  4. CommentedKaleem Alam

    RR, I can see the use of “dog eat dog” and “cannibalism” with picture of a ‘piggy’, isn’t all that referring to problem of ‘interest’. The problem with interest is that it eats away the profits. The Europe and the world including America are suffering from it. The other issue with interest is everyone with money in pocket can become a ‘financer’, as it carries least risk or no risk. But, the problem with present day banking system and financing mechanism is, it is ‘others’ money which is being lent out on interest for meager interest to the depositor. Hence the industry cannot be treated as any other industry, as it would affect the innocent the most, especially those who are just ordinary depositors.

    The ‘Regulation’ can also mean a sense of direction, defining the prohibited areas and perhaps the new regulation can demand the bankers/financers to get linked with real economic activities (with the borrower). Can this direction work for innovative brains of the industry? If it does, the world would be a different place, indeed, and we would see less of frightening financial crisis.

    Kaleem Alam

  5. CommentedSuhan Gurer

    The problem lies in money. Letting banks go bankrupt is directly related to the savings of millions of people and these losses mean direct votes. Unfortunately votes are the most expensive commodity in the world. Therefore that is why we see only a couple of scapegoat banks going bankrupt and the rest being rescued with the cost levied on the general public, not a certain amount of savers who were relying on reckless companies.

    As long as you cannot free politics from finance, you are bound to have monopolies, "saved by the bell style" aids.

  6. CommentedArvind Gupta

    Generally, in a normal industry destruction in the face of creativity causes losses, relatively speaking to a limited number of investors and lenders and losses are small.

    In the case of a highly leveraged financial institution the losses are bigger and more widespread across, investors, lenders and depositors; thus leading to very strong political pressure for bailout and therefore insufficient opportunity for creative destruction to work its magic.

    Should financial institutions move towards lower leverage via regulation or via market forces? If a few large institutions were to shut down for lack of creativity then is it possible that going forward investors, lenders and depositors would become more prudent and thus leverage would automatically decline and banking would show balance sheet characteristics like any other normal industry?

  7. CommentedKaren Williams

    One has to wonder how much banking history Mr. Rajan knows.

    When banking was a free market industry, before government deposit insurance, it was subject to frequent runs. These were extremely unpleasant both for the banks in question (which went out of business whether they were insolvent or merely, as all banks are, illiquid) and for the depositors who lost their money. Borrowers were sometimes also hurt, as desperate banks called in their loans early.

    I see no need to revisit an option we already know was very unpleasant. The "boring" banking we all got used to under FDIC and Glass-Steagall was far better, and we should go back to that.

  8. Commentedde Lafayette

    RR: Many economists are advocating for regulation that would make banking “boring” and uncompetitive once again. After a crisis, it is not uncommon to hear calls to limit competition

    There are two key components of banking - Commercial and Investment. The former is risk-averse and the latter is risk-prone.

    We must keep these important qualifiers in mind at all time. Because, if there was an economic catastrophe that was provoked by the Toxic Waste mess it was because we forgot the nature of those qualifiers and confused them.

    Clinton was confused by his advisors in the matter (who will remain nameless, but we know well who they are) and allowed the demise of the Glass-Steagall Act - which was the firewall established between both types of banking subsequent to the Stock Market Crash of 1929. That Act effectively set up a barrier between both types of banking businesses that lasted from 1933 to 1995. The demise was officiated by the FRB at the time, which had already enacted certain rules that allowed the division between the two entities to be breached.

    The Finance Industry was heading for Bigger Is Better consolidation, meaning, of course, that for as long a business went well, everything was fine. But nobody, apparently, counted on the Toxic Waste to upset Finance's apple-carts. Banks were now able to use customer commercial deposits as reserves to borrow money with which to purchase increasingly more speculative debt-instruments based upon Toxic Waste. Which would be their ultimate downfall.

    For many, therefore, the fault is not only the repeal of the Glass-Steagall Act but also the previous de facto neutering of it by the FRB before its official demise. According to Wikipedia, "Shortly after approving the merger of Citicorp and Travelers, the Federal Reserve Board announced its intention to eliminate the 28 ‘firewalls’ that required separation of Section 20 affiliates from their affiliated bank and to replace them with “operating standards” based on 8 of the firewalls" - which happened before the Gramm–Leach–Bliley Act was passed in 1999.

    It is difficult to imagine that the pell-mell rush of Banking towards consolidation of Financial Monoliths was beneficial because of its “competitiveness”. Quite the contrary. The lack of separation between commercial reserves and speculative debt-instruments was calamitous in 2008.

    Many think that Banks are Too Big To Fail. I agree. Which is why the US must get a handle on the greed-factor that pushes financiers towards ruinous gaming-schemes in order to earn enormous personal profits. Individual Compensation and Capital-Gains income taxation is so low that it stimulates the sort of greed that produced the Credit Mechanism Seizure in the fall of 2008 and the Great Recession of 2009.

    And until America raises tax levels on megabuck earnings, there is no way to prevent what happened from recurring. That incentive is in the very nature of the beast.

  9. CommentedDominic Albino

    This idea of closing banks more easily is fine, so long as it can be done in a manner that protects customers' assets--which is essentially the goal of those who propose to back to a monopolistic market structure. In any bankruptcy process, customers' accounts must be the most senior debt and made whole before other creditors' and equity holders' interests are addressed.

  10. CommentedVenu Madhav

    Financial innovation is a key ingredient for supporting Entrepreneurship and Business Start-ups. However, there is a need for a globally co-ordinated oversight framework to curb bubbles at the right time and place to preclude any infectious shortsighted irrational exuberance. The 2008 financial crash was partly caused by the "rating agencies", which are supposed to be working with highest rigor and integrity, and since they failed there was hardly any recourse for the rest of the world. Thus to ensure mistakes are not repeated there is a need for a bit of regulation to ensure banks' are held accountable for their actions, while there is no compromise on financial innovation.

  11. Commentedcaptainjohann Samuhanand

    The author is advocating the big Pharma MNCs case for monopoly. Why is it that these pharma majors having monopoly of 20 years still want to continue their monopoly using the clever method of "Ever Greening" of molecules in the guise of new use?Reasonable return of capital invested instead of Monopoly of 20 years etc should be the solution.

  12. CommentedProcyon Mukherjee

    The least that one would expect from competition is that the market clearing mechanism would ensure that buyers and sellers are poised to benefit or lose depending on the stances taken by each; in a financial market we see the preponderance of one side gaining at the cost of the other. Therefore the question of competitiveness must be reviewed in the context of the regulatory environment.

    This leads us to the subject of regulatory capture. That regulatory capture is pervasive and comprehensive, there is enough evidence both in the run up to the crisis as well as after it had mellowed and even in periods of tranquil. The financial markets helped by central bank advances have amassed assets that have compounded annual growth rate of 9% (even after the painful adjustments), whereas the world economy has not even grown by 3%. This apparent dysfunctional arrangement had raised the doubt that financial markets instead of propounding systemic stability, consumer protection and risk mitigation practices to benefit large sections of people may have actually not served the lofty goals of bringing financial service access to greater majority of people, who go through the pains of adjustment more than the larger institutions; in providing the balance between serving those sections who have less knowledge of the products on offer that could advance credit and could be actually used judiciously through a mode of smoothening consumption (not excessive leverage), the larger focus had shifted to misallocation of resources to housing and consumer credit at an alarming rate which is not sustainable. People who need to keep their financial savings in safe custody actually succumbed in this process with large scale erosion of their net worth. But more importantly the competitive efficiency of the global financial markets whose benefits should have flown unequivocally to the larger sections of the society actually petered to an excessive financialization that made some of the sovereign back-stops insufficient. The question of sovereign insolvency, which was never in doubt, has become a very common word and the moral hazard has multiplied in recent times.

    Procyon Mukherjee

  13. CommentedCarol Maczinsky

    Don't mix competitiveness (power) and competition (access), they mean exactly the opposite and you should know that.

    As long as there are structures "too big to fail" downsizing is advisable unless we could internalise the risk in a market. That is a pretty ordoliberal view. What else to do after society was burdened with the US financial crisis and regulatory failure. Market resilience is critical and dinosaurs tend to be less resilient, regardless how impressive they appear at first sight.

    You should also avoid to abuse Schumpeter to advocate for the patent system. Economists like Schumpeter know that the patent system has no real base in our science.

  14. CommentedFrank O'Callaghan

    The essential fact of "deregulation" was that the individuals in high positions within financial institutions rewarded themselves to such an extent that it became necessary to artificially inflate their institutions' performance. This resulted in a retrospective transfer of public and private funds to fill this "black hole".

    The issue is not about competition but theft.

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