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Financial service inefficiency

Despite technological advances, the finance industry can’t show consumers it has become more efficient over the past century, says David Pitt-Watson, Visiting Professor at Cambridge Judge.

The finance industry has grown hugely in the past century. But despite all the new technologies made available to it, it cannot demonstrate that it serves the outside world more efficiently than it did 100 years ago. We need to ask how that unfortunate situation has come about, says David Pitt-Watson, Pembroke Visiting Professor at Cambridge Judge Business School.

Those who use the finance industry (perhaps to save for a pension or borrow for a mortgage) and those who study the finance system in business schools should ask why its huge growth has not been accompanied by efficiency gains, he told an audience of 800 people at this year’s Hay Festival.

While costs in such sectors as food, pharmaceuticals and automobiles have gone down as those industries have grown in scale, in its most important function the finance industry seem to have shown no efficiency improvement for more than a century.

“The financial system has got more complex, but what evidence we have suggests that it has not got any more efficient in taking our savings and investing them in the real world. We are simply not seeing any improvement in the cost of getting money from savers to borrowers.”

In the US the finance industry as a proportion of the total economy has grown from two per cent in 1880 to eight per cent now, but the cost of performing basic intermediary functions has remained around two per cent for the past 130 years.

David has recently commissioned work into the European industry which similarly shows limited productivity improvement. “One researcher concluded that the finance industry which funds the internet is no more efficient than the one which funded the railroads.”

The Hay Festival presentation on 26 May was moderated by the well-known comedian Marcus Brigstocke. The Hay Festival is held every year in the town of Hay-on-Wye on the England-Wales border.

David said that the financial system performs many incredibly important and useful functions: safely holding people’s money, allowing transactions, facilitating risk-sharing, and investing our savings in projects that need financing. Yet when asked, the public associates banking with such words as “corrupt”, “dangerous” and “rigged”.

“We have on the one hand this sense of a ‘corrupt’ industry, yet it is an industry which provides invaluable services. This is a dangerous situation. The financial industry, whose very existence depends on trust, is seen to be corrupt. Unless we start to ask the right questions of the finance industry, unless we build it to do the right thing in the first place, it will continue to use our money in ways that are ‘not socially useful’.

“Rather than addressing the fundamental question of the purpose of finance, policymakers have waited for something to go wrong and then pass another set of rules, in a game of regulatory whack-a-mole. In 1990 we had 3,000 pages of pension regulations for the UK; today it is 166,000. All this regulation adds costs. Yet I still can’t explain to my children how they can save for a reliable income from the time they retire until the time they die.”

As an example of how simple things can go wrong, David noted that investment managers don’t tell their customers the full costs they are being charged. When they do, the language can be misleading. The “total expense ratio”, for example, doesn’t include many costs necessary to manage your investments, including the cost of trading shares.

An animation that accompanied David’s presentation focused on the proliferation of financial specialists, each of whose skills seem to be justified, but whose costs can mean “savings are slowly bleeding under the weight of an increasingly complex and expensive chain”.

Another example is the way we can be fooled by compound interest calculations. Fees that appear to be relatively small actually result in people paying a large share of their eventual pension to fund managers, he added.

If someone retains a fund manager at age 25 to handle their pension until retirement at age 65, and draws that pension over the next 20 years, annual fees of 0.5 per cent would result in the saver keeping 85 per cent of the possible pension, while an annual fee of three per cent would leave the saver with just 35 per cent.

“If people think there isn’t a difference between paying half a percent and paying three per cent, they’ve made a huge mistake because it more than halves their pension, because the fee is paid every year,” David said. “It isn’t that there’s anyone doing anything hugely wrong here, it’s that people don’t notice the issue. As a result of simple issues like this, a pension system can fail.”

Pembroke Visiting Scholars have been welcomed at Cambridge Judge since 2012 to allow senior faculty active in finance to visit the business school for periods up to six months. Holders of the post are admitted to Pembroke College, one of the Colleges of the University of Cambridge, where they join in meals and other events at the College, and have use of a room for the period of their residence.