HOW TO MAKE FINANCE WORK

- Robin Greenwood and David S. Scharfstein

Y.V.S.KALYAN PGDM-BIFAAS 1/22 B616

 Robin Greenwood is the George Gund Professor of Finance and Banking. He is a Faculty Research Associate at the National Bureau of Economic Research and an associate editor at the Review of Financial Studies.

David S. Scharfstein is the Edmund Cogswell Converse Professor of Finance and Banking at Harvard Business School. Scharfstein is a Research Associate of the National Bureau of Economic Research.

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 The U.S. financial sectors share of GDP grew from less than 5% in 1980 to more than 8% in 2007the largest share in any advanced economy The industry was transformed from a sleepy old boys club to a dynamic business that attracts the best and the brightest. The financial sector exists to serve the needs of U.S. households and firms The sectors performance has been beneficial to some, in particular the US Corporations. Simultaneously the Industry resulted in unhealthy ways which had a negative impact on US economy.
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There are 3 main problems:

1)
2)

The financial system is less stable than was 30 years ago

The financial sector has steered trillions of dollars into real estate, away from more productive investments The cost of professional investment management is simply too high.
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3)

Successes
The key functions of a financial system is to facilitate household and corporate saving, to allocate those funds to most productive use, manage and distribute risk. Recent research has shown that economies with well developed financial systems grow reliably faster than those in which finance plays a smaller role. In US corporations got easy access to debt and equity markets. Venture-capital-backed entrepreneurs have also put pressure on existing firms to adapt their business models and to innovate.
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With the development of U.S. capital markets suggests that

The percentage of firms that go public with negative earnings has jumped dramatically, demonstrating the willingness of the U.S. capital markets to bet on new ideas. Example: Financing R&D
Forty years ago, the U.S. government and private industry made roughly equal contributions to R&D. Now private industry funds approximately four times as much R&D as the governmentan indication that the financial sector is steering capital toward new ideas. 6/22

FINANCIAL FAILURES

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Failuresand How to Address Them

Despite the successes outlined above, the U.S. financial system has had difficulties in Managing and distributing risk Allocating capital Facilitating low-cost savings

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FINANCIAL INSTABILITY

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Financial instability
What changes made the financial system so vulnerable?

Growth of securitization
This was fueled by significant flaws in the credit ratings process, which resulted in a breakdown in the quality of securitized loans. The critical functions of banking were provided by players other than traditional deposit-taking banks. The growth of nonbank financial firms and investment vehicles from Wall Street broker-dealers to Fannie Mae, Freddie Mac, insurance companies, hedge funds, and money market mutual fundscreated a shadow banking system.
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The financial crisis revealed at least three significant weaknesses of shadow banking and the broader financial system. 1. The amount of capital that regulators required the shadow banking system to hold against securitized credit risk was lower than the amount banks were required to hold. 2. The entities involved in shadow banking were tightly connected to one another and to the traditional banking sector. Those links created considerable risks that were poorly understood before the crisis. 3. The shadow banking system turned out to be vulnerable to the same kind of bank runs that plagued traditional banks prior to the 11/22 establishment of deposit insurance.

 Increasing capital requirements, which regulators have agreed to do, would go a long way in stabilizing the Financial Status. Limiting the extent to which financial firms can fund long-term assets with short-term liabilities. Placing stronger safeguards on the largest financial institutions would be an important measure to promote stability.

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HOUSING FINANCE

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Housing finance
The United States has been an outlier in its support of homeownership through both government policy and private-sector activities Fannie Mae, Freddie Mac, and the Federal Housing Administration implicitly or explicitly guaranteed more than half of all outstanding home mortgages in the years before the financial crisis. The excess allocation of capital toward housing diverted resources from potentially more productive uses. When home values appreciated, households borrowed against their equity to finance consumption.
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 Rising house prices put a damper on homeownership rates, reduced household savings rates, and left households vulnerable to economic adversity The leading proposals for housing finance reformsupported by a coalition of the financial services industry, the real estate industry, and consumer advocatesfocus on keeping mortgage credit cheap and available and call for government to play a critical role in achieving that goal.

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How to address this problem?

The long term goal of Housing finance reform should be to promote financial stability and proper allocation of capital. The industry should focus on designing securities that deliver the fundamental promise of securitizationenhanced liquidity and diversification of riskand not on those that arbitrage gaps in regulation. Once the government steps back from guaranteeing most new mortgage credit, private securitization of mortgage credit can and should return. The details of how to regulate housing finance are to be worked out.
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INVESTMENT COSTS

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Investment costs
The asset management and securities industry grew from 0.4% of GDP in 1980 to 1.9% in 2006. This reflects growth in financial assets and in the share of those assets that are managed professionally. It also reflects the industrys high fees. Fees are assessed on the basis of a funds overall performance rather than on relative risk-adjusted performance.

High investment fees affect U.S. competitiveness chiefly by distorting the allocation of talent. Among employed 2008 graduates of Harvard College, 28% went into financial services, compared with about 6% from 1969 to 1973.
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 According to a study by Thomas Philippon of New York University and Ariell Reshef of the University of Virginia, in 1980 a financial services employee typically earned about the same wages as his counterpart in other industries; by 2006 he was earning 70% more. But if investment fees is too high, then finance is inefficiently draining talent from other industries, hampering overall productivity growth Institutional investors, corporations, and financial firms pay high costs to trade in many over-the-counter markets for corporate bonds and derivatives, where prices are quoted by individual brokers and getting information can be expensive. This gives brokers a degree of pricing power, allowing them to command higher spreads from trading.
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 Investment costs are unlikely to fall overnight

Nevertheless, they can be reduced by making fees more visible so that financial firms can better compete on them.
For most households, asset management should be a utilitylow cost and reliable. The broad principle underlying both proposals is that asset managers should compete on the true value of the services they provide.

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 Aspects of the financial sector have distorted the allocation of talent and capital and have left the economy vulnerable to crisis. Since Financial Sectors contribution to the GDP plays a significant part, utmost care has to be taken in order to see that Financial Sector is performing well without any loopholes. In the end, the financial sector should be judged not on its profitability and size but on how well it promotes a healthy, more competitive economy over the long term.

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Thank You

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