In an article in the Financial Times (April 27, 2006), Andrew Glyn, who teaches economics at Oxford University, estimated that "US financial companies earned 10-15 per cent of total US corporate profits in the 1950s and 1960s, but now account for 30-40 per cent of the total".
He went on to argue that even this figure did not include the profits earned by financial divisions of industrial and commercial companies - say, the finance subsidiaries of vehicle manufacturers, and other industrial companies like GE and, indeed, Microsoft. If these are included, profits from finance "could soon account for a majority of US corporate profits".
One does not know whether Prof. Glyn has included the profits of private equity and hedge funds in the numbers he is using - perhaps not, because such funds are not really part of the corporate sector and, in general, do not publish their earnings.
Yet, given the galloping size of both private equity and hedge funds and the kind of moneys many of them have made, the aggregate earnings of financial activities probably exceed those made in the real economy.
One of the reasons why financial services are prospering is mathematical finance, or the structuring of ever more complex financial instruments using statistical methods and powerful computing systems.
When I did my post-graduate in statistics, back in the 1950s, I never imagined that it would invade the field of finance and banking as powerfully as it has done in the last quarter century. To be sure, the original contribution and models for measurement of risk got developed as part of the modern portfolio theory, back in the 1950s.
The huge increase in the profits of financial activities thus has three pillars: private equity and hedge funds; structured finance; and complex derivatives. And, the way more traditional investors like university endowments, pension funds, etc. are getting attracted to these newer investment classes, the size of profit from finance probably will keep growing.
If I find the growth of mathematical finance gratifying from a professional perspective, I also feel somewhat concerned about how finance and profits from financial activities are overshadowing the real economy.
Is it in societal interest that finance should attract the brightest minds, the most brilliant engineers, through huge compensations ($100 mn plus for many hedge fund managers and investment bankers); to produce money from money; to design more complex structures which do not have any apparent economic purpose (other than filling the pockets of the makers of the structures, of course!) or fulfil any felt needs; to divert huge creative resources, human and monetary, from manufacturing better widgets to structuring complex financial products aimed at hiding margins?
While I am not a religious person, are most major religions, not just Islam, right in frowning on making money from money? Ironically, the largest growth in making money from money is coming in the United States, a country much more religious than Europe or, indeed, any other major region of the world.
In some ways, this increasing dominance of the financial over the real economy has also been the driving force behind too many corporate scandals, Enron being the most publicised. This is manifest in the way several company managements manipulated data on earnings "to meet Wall Street expectations". Some were also motivated by the fact that their compensations were based on financial targets and the temptation to juggle the figures became very strong.
In his autobiography, Jack Welch, the former and much-admired chief executive of General Electric, narrates an interesting incident. Divisional heads were discussing the impact of a $350 mn write-off in GE's bond trading activity, on the quarterly profits.
Even as all the other divisional managers were considering how they can increase their reported profits to plug the big hole, the investment bankers were only complaining about how their bonuses were going to be affected by the fraudulent act of a few! While Mr Welch contrasts the greediness of his own investment bankers, with the team sprit displayed by the manufacturing divisions, the incident also evidences how even mighty GE was slave to fulfilling stock market expectations - indeed, Mr Welch became the darling of the investors by fulfilling bottom line expectations quarter-after-quarter-after-quarter.
And, it seems the culture of doing anything to meet the targeted returns and personal bonuses seems to be invading the Indian market as well. The other day I happened to be talking informally with a young banker about the highly complex structure of a loan transaction in foreign currency.
My question to him was whether he was not adding to his own risk as a lender, through the complexity. His answer was that the only way he can meet the target for return on equity on the loan book is through complex structures, embedding derivatives in the loan pricing.
We are also seeing other parallels to what is happening internationally, in the Indian market. Graduate school toppers are being recruited mostly by the financial services sector, both domestic and foreign, at fancy compensation packages. (When I used to teach at IIMA, perhaps 70 per cent of the students in the post-graduate program used to be engineering graduates, with none of them wanting even to touch a screwdriver in their working lives).
Another manifestation is the increasing involvement of private equity in the Indian corporate world. Given the spectacular profits some of them have made, surely more will be attracted. Yet another manifestation is the kind of complex derivatives being marketed in India, carrying huge profit margins because too many Indian banks and corporate houses do not know how to analyse and price them.
Indeed, I sometimes wonder whether the situation in the complex derivatives market in India is not running a close parallel to what was happening in the capital market in 1992.
There were strong rumours then about how the Big Bull was manipulating the stock market, through access to apparently limitless resources.
It took a report in the media by Sucheta Dalal for the regulator to initiate action in the securities scam. One hopes that the regulator would step in on the subject of complex derivatives before it is too late.
