Arnold Kling  

Valuing Financial Services

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Christina Wang writes,


Making conservative assumptions, we show that the current official method overestimates the service output of the commercial banking industry by at least 21% (amounting to $116.8 billion in 2007:Q4 for example) and GDP by 0.3% ($52.9 billion in 2007:Q4 for example) between 1997 and 2007. The overstatement to GDP is mitigated because when the customer is another company, the official method simply re-assigns the firm's value added to its bank, leaving GDP unchanged...the overstatement comes from counting term and credit risk premium earned by banks as part of their value added.

Pointer from Mark Thoma.

Tyler Cowen has been harping about the problem of measuring value added in financial services. He suggests that the economy is stagnating more than we think because we over-value financial services. The above paragraph says that, yes, on the one hand, we overstate the value of financial services, but on the other hand we under-estimate the value added in other sectors.

Quite apart from statistics, there is the issue of whether resources devoted to financial services produce commensurate increases in well-being, or whether instead they earn rents by writing out-of-the-money options. In the latter case, the managers who write the options may be able to get out before those options have to pay out. Or the institution can be bailed out altogether. Either way, you could get too many out-of-the-money options written, to much rent earned by managers who write them, and too few resources going to more productive uses.


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COMMENTS (2 to date)
TA writes:

Let's say you, Arnold, own a corporate bond. The interest on that bond shows up as a piece of GDP, the way GDP accounting is now done. If I understand the Wang article, to be consistent with her prescription for banks, none of that interest over the risk-free overnight rate should count. Extending this, it is hard to see how most asset income should count, including corporate profits.

What am I missing here?

Mike Rulle writes:

My take is similar, but the angle I focus on are public companies in general. The rent seeking of Wall Street is in part supported by the rent seeking activities of public companies.

My premise is that public companies in general are run by managements who really have adversarial relationships with shareholders. The most egregious example of this was demonstrated by both Tech and Financial companies during the "options as compensation" scandels. There were some years when all "free cash flow" was laundered thru the stock market to pay employees.

For example, Microsoft or Goldman engages in stock repurchase programs, thus "paying shareholders". Then, employees exercise options at below market values, and resell shares back into the market---thus getting back what was paid to shareholders. So rather than paying cash directly to employees (equal in many years to more than income and free cash flow), they are paid thru this method, thus fraudently overstating income, although not according to GAAP.

These same companies "strategically" use Wall Street to engage in M@A, Buyouts, resales, biased research, etc.--moving "deck chairs" kind of stuff. But they also raise new capital. Wall Street does provide liquidity in general and that is an undervalued function. Even as their direct intermediation function has declined their indirect liquidity function has increased.

But I really wish all companies were permitted to be structured as MLPs. This way at least shareholders would have the option to force payouts of earnings pre-tax and eliminate the muddle we call earnings when it is not paid in cash. GAAP earnings are strangely flexible. I prefer the extra cost of firms having to continue come to the market to raise capital for new projects.

I am perplexed that there is no equivalent to a "Tea Party" style revolt among shareholders.

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