Creative Destruction in the Financial Sector

There’s a matching set of links from Clusterstock that deserve to be read together. Andy Xie, formerly of Morgan Stanley, points out the obvious—that the financial sector has overflowed its banks and is threatening to drown the rest of the economy:

Why do large service organizations exist? The main reason is precisely that one cannot price its product instantly. The quality of the product may take years to prove. A large organization provides the confidence to buyers through the reputation effect. If its previous customers are happy, it has incentives to protect its reputation. Hence, new customers also should buy from it with confidence.

A hospital, for example, fits this description well. A reputable hospital can charge a premium for its services, using revenues to purchase good equipment and hire good doctors. This sustains its reputation. A hospital with a reputation for bad quality, however, faces the opposite issue. Thus, unless one is willing to invest a lot to build a good reputation, it’s stuck in a vicious cycle.

Every city has this good hospital-bad hospital phenomenon. But even good hospitals experience the 20-80 phenomenon. This same, inherent inefficiency can be found throughout large, white-collar service organizations.

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Financial services providers are intermediaries by definition. They match buyers and sellers of stocks, bonds, commodities and other financial products. They fit perfectly the definition of information broker. They can still make a living by brokering among institutional investors who are, by definition, few.

But institutional investors are intermediaries, too. Why should savers give them money to manage? Not for superior performance: More than 90 percent of institutional investors underperform market indexes. The main justification is that they bring down costs of information acquisition and processing, as well as transactions. This justification looks shakier by the day. Any individual can have access to as much information as a fund manager at virtually no cost. I’m afraid the financial services industry is likely to decline structurally.

As financial services industry loses value-added to customers and the real economy, it is increasingly dependent on gaming the system and profiting from customer ignorance. This makes the industry and financial market more volatile and bubble-prone. In the last financial crisis, the financial sector survived by holding the real economy hostage.

There’s lots more there. And, as if on cue, former Oppenheimer & Co. analyst Meredith Whitney predicts a dramatic downsizing among Wall Street firms:

Securities firms around the world will cut as many as 80,000 jobs in the next 18 months as revenue growth begins to slow, said Meredith Whitney, the former Oppenheimer & Co. analyst who now runs her own firm.

The reductions, about 10 percent of current levels, will come after 2010 compensation payments, Whitney, 40, said in a report dated Aug. 31 and obtained by Bloomberg News today. The industry’s payouts will be “down dramatically,” said Whitney, who started New York-based Meredith Whitney Group after correctly predicting Citigroup Inc.’s dividend cut in 2007.

Here is a vital point:

“The key product drivers of Wall Street’s revenues and profits over the past decade have been in a structural decline over the past three years,” Whitney said in the report. “2010 marks the first year in many in which Wall Street-centric firms will go through structural changes.”

I think I’d go farther than that. As Mr. Xie correctly points out Wall Street’s revenues have been under pressure due to technological change for the better part of the last couple of decades. When you add that pressure to a certainty born of experience that, not only will they not be subjected to market discipline if they fail, they will not be allowed to fail, together with incomprehensibly large prospective financial rewards it creates a perfect Petrie dish for increasingly risky, er, innovations.