The Problem with the Profit Motive in Finance

Why you’re very welcome, Financial Services Roundtable! You see, almost all of the positive indicators above were enabled by or forced on banks by people working for us the taxpayers (by which I mean Congress, the Federal Reserve, and financial regulators). Most of them — increased capital, executive compensation changes, higher credit quality, fortress balance sheets — would have been fought tooth and nail by the Financial Services Roundtable before the financial crisis. (Because Jamie Dimon always gets bent out of shape when people tar all bankers with the same brush, it should be noted that JP Morgan Chase and a few other institutions were improving credit quality and building up capital before 2007. But the industry as a whole was not. If it had been, there wouldn’t have been a financial crisis.)

There’s a lesson here. If you let the financial services industry do exactly what it wants, the financial services industry will eventually get itself — and by extension the economy — into staggering amounts of trouble. If you force it to behave, it might just thrive.

The question is who that “you” ought to be. Relying on regulators or central bankers doesn’t always work because during good times they have a habit of getting caught up in the same idiocy as the financiers do. And so historically, attempts at controlling the industry’s bad habits have also involved restricting what different institutions can do, and how they are organized. Sometimes these have been imposed by government — the Glass-Steagall division between commercial banks and investment banks, for example — but often they have arisen organically. Investment banks used to all be partnerships. Savings and insurance institutions were usually organized as mutuals.

In recent decades, though, the trend has been to allow old barriers to fall and encourage the creation of the for-profit, shareholder-owned, boundary crossing financial juggernauts that make up the membership of the Financial Services Roundtable. Which hasn’t worked out super well.

I thought about this while listening Tuesday to David Swensen, the legendary manager of Yale University’s endowment, arguing that acting as a fiduciary for other people’s money and maximizing profits are incompatible activities. “A fiduciary would offer low-volatility funds and encourage investors to stay the course,” he said. “But the for-profit mutual fund industry benefits by offering high-volatility funds.”

Swensen said this at a Bloomberg Link conference held in honor of that great fiduciary, Vanguard founder Jack Bogle. It was an event packed with prominent people who work (or worked) in finance, but seem to come from a different, more genteel world than the bulk of modern Wall Street: Bogle, Swensen, former Fed chairman Paul Volcker, former TIAA-CREF CEO John Biggs. One distinguishing characteristic: All of these guys are wealthy. None of them are, by modern Wall Street standards, rich.

For Bogle, that’s because the company where he spent his peak earning years was structured as a mutual — owned by its customers and operated on their behalf. All mutual funds are legally organized along these lines. But all the major mutual fund families except Vanguard are now dominated by a for-profit investment “adviser.” Some of these for-profit advisers (Capital Group and T. Rowe Price spring to mind) have built a reputation for looking out for investors’s interests. But, to follow Swensen’s reasoning, the incentives are all wrong.

A lot of investors seem to get this — which helps explain why Vanguard has grown to account for 17% of mutual fund assets in the U.S., leaving long-time archrival Fidelity in the dust. But Vanguard only became a mutual because of a strange confluence of events in the 1970s, when Bogle was kicked out of the presidency of the for-profit Wellington Management Company, and organized a rebellion among the directors of Wellington’s funds. The organization that had created the mutual fund industry, Massachusetts Investors Trust, had switched from a mutual into for-profit Massachusetts Financial Services a few years before. No firm since has followed in Vanguard’s footsteps.

“Why not?” somebody asked Tuesday. “The profit motive,” replied Burton Malkiel — the Princeton economist, Vanguard board member, and author of A Random Walk Down Wall Street. Or as Bogle told me once: If he hadn’t been forced out of his Wellington job, he probably wouldn’t have done anything to shake up the mutual fund industry, and would have retired “rich as Croesus.”

The profit motive is generally a good thing. It drives hard work, innovation, and the success of the capitalist system. But in financial markets, it’s problematic. That’s partly because of the zero-sum nature of most financial intermediation: Every penny in fees is that much less in investor returns. It’s also the fact that most investors are incapable of judging whether their money manager or broker is doing right by them. And then there’s the issue of risk, as illustrated by the recent financial crisis. You can make a lot of money in finance doing things that are bound blow up in someone’s face a few years down the road. There’s a good chance you’ll have changed employers by then, after all. Plus, if your bank is so big that its failure might bring financial panic, taxpayers will bail it out.

The untempered pursuit of profit, then, is almost never good for the customers of the financial sector. Over the long run, it may not be good for the financial sector, either. So I’m hoping that this new white paper is an indication that the Financial Services Roundtable finally realizes all this, and is about to start lobbying for tougher regulation, a return to true mutual status for the mutual fund industry, a return to partnerships for investment banks, and a breakup of big, complicated financial institutions. That is the plan, right?

By Justin Fox, from:

Justin Fox is editorial director of the Harvard Business Review Group and author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.