It could be said the benefits of efficiency have been pocketed by financial services executives, instead of being passed to consumers
It is hard not to be disappointed by technology in financial services. Surrounded by gadgets and gizmos which amuse and distract us to the point of madness, workplace technology will always seem pedestrian.
The complaints I hear from advisers rarely change: overpromised, overpriced and underdelivered are the three most commonly used adjectives. Is this fair or are expectations set too high? And what are the implications for investors?
The financial services industry has a poor track record as far as consumer costs are concerned. Philippon’s study of the US finance industry from 1870 to 2010 showed the total cost of financial intermediation increased over this time, especially in the last 40 years from 1970 to 2010.
This is despite all the advances – especially in technology – that occurred in these decades. To quote Philippon: “The finance industry that sustained the expansion of railroads, steel and chemical industries, and the electricity and automobile revolutions was more efficient than the current finance industry.”
Philippon’s definition of financial intermediation is a tight one. It does not include advice, drawing more from banking and corporate finance activity, but it is easy to apply consistently over such a long time period. It is also based on US data.
However, in 2013, Bazot recreated similar results in Europe from 1950 to 2007, during which time the cost of intermediation rose from 1.3 per cent of assets to 1.8 per cent in the UK, and increased or remained static in most other European countries.
Where have the advantages of technology gone? The simple answer is that it has mostly been used to create secondary markets for trading. Is this a good thing? Possibly. Certainly, the unit costs of trading have come down over the years.
However, Philippon highlights two things you would expect to see if increased costs from technological developments had improved the financial system. Firstly, greater information on stock prices should be more predictive of future income streams, leading to better capital allocation.
Secondly, better risk sharing and risk management. He finds no evidence for either, highlighting the fact aggregate trading costs now are three times higher than any time in history while individual trading costs have decreased.
The financial services industry may be culpable but not guilty. There are other issues which should be picked out, aside from the inevitable methodological limitations of the research.
Firstly, the speed of modern information exchange has removed the clear information advantages many relied on in previous decades. Now, use of inside information is a market abuse with criminal sanctions of up to seven years imprisonment. Not so long ago, the very reason you paid a broker was because they would have some inside information. Finding an advantage to exploit which nobody else knows about is tough and getting tougher.
Secondly, interest rate hikes in the 1970s and 1980s also had an upwards effect on cost. Thirdly, as both the finance and technology sectors have become more and more competitive and lucrative, remuneration in both has shot up, and this is included in the costs quoted. In a similar way, efficient manufacturing has put more cars on the road, caused congestion and slowed average speeds in many cities. Their actions have caused the regression, although I am not sure they are to blame.
Pocketing the benefits
These studies are broad and do not focus specifically on the costs associated with advice, although Philippon has also drawn conclusions and commented on the costs of active fund management in the US.
His work has been used by critics of the current system to show the benefits of efficiency have been pocketed by financial services workers and executives.
In the mid-20th century, US finance workers were paid about the same as those in other sectors with similar levels of education but, by the end of the century, it was 50 per cent higher than elsewhere, while executives took home two and a half times what their counterparts earned in other sectors.
This is a compelling but simplistic view. Financial intermediation has become more complex, more competitive and more demanding of mathematical skill.
With all the talk of fintech and global technology giants entering financial services (which we have been hearing for years), it is worth remembering these lessons in among the workshops on client journeys and experiences.
The cost of intermediation did come down a little in the mid noughties, although only to the same level as the mid-1880s. When you look at the newly disclosed transaction costs for some funds, and the anticipated re-platforming costs of some platforms, you have to return to Philippon’s quote: “The finance industry that sustained the expansion of railroads, steel and chemical industries, and the electricity and automobile revolutions was more efficient than the current finance industry.”
All this cost is a drag on the real economy. Are we really in the midst of the fourth industrial revolution?
Phil Young is managing director of Zero Support