I would hazard a guess that most people have heard the refrain “greedy bankers” to denigrate the wealthy individuals who work in the financial sector. However, how many are actually aware of what these people do, and what role does investment banking actually play in the economy?
Not ‘just’ greedy
To start with, I want to address the idea that financiers are just greedy bankers. Not that they are not greedy – of course all bankers are greedy, to a certain extent… But so are we all – we all want bigger pay, more comfortable living, more money to spend on material possessions and creature pleasures, such as holidays and haircuts.
The only difference with finance is that bankers tend to earn vastly more than us mere mortals do, and they don’t seem to be producing anything tangible or offer a visible service to Joe Public. Most people can see that rich individuals produce a product or a service: James Dyson created the Dyson vacuum cleaners; Bill Gates produced the Microsoft suite of software products; Mark Zuckerberg gave us the world-famous Facebook social network; and so on and so forth. So it is an understandable misconception that bankers take money from the world without contributing to it. In fact, bankers and financiers provide a very significant contribution to the economy…
Investing in the economy
Financiers are also called ‘investors’. Traditionally, entrepreneurs with a business plan and investors seek out each other, so that investors provide entrepreneurs with the funds to start up a business. This can often be in the form of lending, with the promise of the entrepreneur to pay back the borrowed funds with interest. Alternatively, entrepreneurs sell shares of their business to investors, so that the investor now owns a portion of the new business instead of requiring the entrepreneur pay back the money. As the business develops, investors may gain dividends from being a shareholder, or they may sell their share of the business after its worth has grown. This practice may not be restricted to just one investor – entrepreneurs often float their business on the stock market in the form of IPOs (Initial Public Offerings), where many investors buy a small share of the business, so that all the purchases contribute to the capital fund that the entrepreneur uses to scale up their business.
Thus ‘greedy bankers’, or investors, actually contribute to economic growth by funding the start up of new businesses and funding the growth of existing businesses. In this form of investment, the more bankers there are, the more competitive the rates of investment are. With many investors, demand for objects of investment are high, so entrepreneurs can get competitive rates for their business. The greater the number of investors, the better the rates. The sum effect of all this investment, innovations in technology and provision of services can develop readily, thus the more bankers there are, the quicker an economy can grow.
A certain category of financial institutions, known as fund managers, invest not their own money, but the money they receive from clients. Clients of these funds are people who want their money to create a return on investment (ROI), but are not willing or able to themselves perform the research and the paperwork to carry out these investment activities. Fund managers perform the investment activities on behalf of their clients, so that they either provide an attractive fixed rate of return so that the fund managers bear most of the risk, or they take a cut of the profits that the fund generates, so that their profits are directly linked their performance. Pension funds and hedge funds are examples of these types of funds.
The positive impacts of speculation
There is another form of investment that comes under heavy fire: Speculation on the stock market, which can be investment in the shares of businesses, or in the form of physical commodities such as wheat or oil. There are two ways bankers speculate on the stock market: going long, and going short.
Going short is the somewhat counter-intuitive practice of selling high first, in anticipation of a slump or a crash, and then buying back the stock/share after the prices have dropped. This is obviously a highly speculative practice, and many critics argue that it is highly immoral for bankers to profit from the others’ losses. However, we need to understand the role speculators play in this process. Markets crash or slump when there is a drop in demand for a share/commodity, which can be triggered by worldly events. Crashes tend to be severe because the suddenness of the drop in demand tends to snowball into a sudden loss of confidence in the market. So when bankers buy low, they are in practice increasing demand for that share/commodity, arresting the fall and cushioning the crash. Conversely, when bankers sell high in anticipation of a fall, they are actually increasing the supply, in effect reducing the price prior to the event that triggers the crash. This not only helps to reduce the severity of the crash; it also serves as a signal to the market that prices should be lower. This mechanism is what provides liquidity to the market that helps to level out the fluctuations of the market. Thus bankers do not cause crashes, but they can and do profit from them, and more significantly, the liquidity they provide to the market cushions the impact of crashes, reducing the loss for everybody else.
Going long is the traditional method of buying low with the anticipation of an increase in price and then selling it high later. This is more intuitive to comprehend, but the nature of how this practice contributes liquidity to the economy is identical to the practice of going short, only in the reverse direction. But the speculative nature of this practice becomes more pronounced with the advent of high-frequency trading (HFT), which has been facilitated by the advent of electronic computing. High-frequency trading provides the ultimate in market liquidity, by using computers to facilitate trades between investors and markets at very high frequencies that can only be achieved electronically. It comes under heavy criticism for not seeming to provide value to a business, which has been likened to gambling. However, the liquidity provided by HFT helps both investors and entrepreneurs. Investors who suddenly need to recover their investment at short notice would benefit from this liquidity, in being able to rapidly find other investors who wish to purchase their shares. Businesses alike are able to sell shares rapidly to increase their own liquidity, or to buy back shares or additional stock from their excess liquidity. This form of benefit is not easily measurable in tangible assets, but most businesses who participate clearly benefit from this type of service, with a much lower risk of going into insolvency.
Putting their own money at risk
It is particularly important to note at this point that throughout all this ‘profiteering’, financiers are risking their own money, or the money of their business/clients. Yes, it is a profit-making business, but profit also comes with risk of loss. As all forms of investment are inherently speculative, financiers can and often do experience large losses. But what is significant is that the risk is borne by the investors, not by the general public. When bankers speculate irresponsibly, the loss is not normally passed on to the public – excepting the case of bank bailouts. In case you cannot tell, my position is against the bailing out of the banks during the 2008-2009 financial crisis. The banks should have been left to fall into administration so that the industry can consolidate at their own expense, not at the taxpayers’ expense.
Many members of the public are disgusted by the seemingly obscene amounts bankers appear to receive in bonuses. It is difficult to comprehend how someone’s bonus can be equal to, or even greater than their annual salary. This stems from a misapprehension of bankers’ pay structure and the profits they bring to the business.
Bankers’ bonuses are in effect their performance-related pay. As in most competitive industries, a significant proportion of bankers’ earnings are linked to their performance. A trader in an investment bank might earn a £100,000 base salary, but if they brought in £10million to the bank that year, a bonus of £200,000 is only a meagre 2% of the profits they contributed to the business, even if the bonus is twice as large as their basic salary. If the trader under-performs, they will not receive that kind of bonus.
High-performing investment traders know how much they bring to their employers, so they expect to be paid proportional to what they are able contribute to the business. So when a misguided attempt by the EU to regulate bankers bonuses stopped bankers from receiving a bonus greater than their salary, basic salaries for these bankers went sky high. The sad effect of this misguided attempt to curb bankers’ pay is that it ended up increasing the amount of bankers were paid without actually having to perform.
Running away with your money
It is also a myth that bankers just gamble with your money, run away with the profits, and leave you with a loss. These days, the finance sector is much too tightly regulated for that to happen to the vast majority of investors. It does still happen with personal investors, but these are people who are employed by high net worth individuals (very rich people) to take greater risks with their wealth than is acceptable by regulated industries – they take greater risks for greater reward. Unfortunately for them, the risk also includes unscrupulous investors. Thankfully for the rest of us, regular investments are diversified across a large portfolio of investments from a large score of investors. The risk is spread out very thinly, but that means the returns on investment are also thin. This is commonly understood as the risk-to-reward ratio.
In case you think I write this defence of bankers because I somehow benefit from it, I can assure you that I neither work in the finance sector nor am I paid by anyone who works in that sector. But I can disclaim that I did spend a short spell in fintech (financial technology) and personally know people who do work in the banking industry.
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