The financial industry
is beginning to face the humble reality that it is neither too big to fail nor too large to manage.
After several decades of astronomic growth, the financial industry
is now on a more stable trajectory back to earth: hopefully returning to the model of adding value rather than extracting equity.
The most recent company to recognize and accept the new reality is General Electric. After a strong push into finance the early 1980s, GE has decided to throw in the towel and wind down its financial arm, GE Capital. This process will take several years, but it recently began this journey by selling $26.5 billion worth of real estate assets.
Entering this line of business had little downside risk at the time: low levels of long-term investment in land, plant and equipment; taxpayer-subsidized financing in the form of modest capital requirements; and the ability to offset U.S. industrial profits with interest payments on U.S. loans that were then invested abroad and generated foreign profits not taxed by the U.S.
GE Capital has helped trim GE's total effective tax rate by 5 to 10 percentage points since 2009. That year, it shaved off 33.4 percentage points, resulting in a rate of negative 11.6 percent — meaning the taxpayers owed GE a lot of money.
However, revenue generated by GE Capital fell from 42 percent of the total in 2008 to 28 percent in 2014.
The current climate that requires these financial entities to take more responsibility for potential losses in the form of additional capital and liquidity has rendered this activity futile to an industrial firm like GE.
GE has deemed it more prudent to divest from finance even though it means a doubling of their effective tax rate, from roughly 10 percent today to 20 percent or more in the future, and repatriating $36 billion in overseas profit from GE Capital, generating a tax liability approaching $6 billion.
also remains under attack. Much of this extremely short-term arbitrage trading extracts equity instead of creating value by rewarding speed at the expense of competitive price discovery. High-frequency trading reached a peak of 61 percent of the total equity trading market in 2009, and by 2013 it fell to 49 percent, according to the Tabb Group, a financial markets research and advisory firm.
The current continuous time-series order processing can be replaced with less frequent and discrete-interval batch auctions. This would ameliorate deficiencies of communication latency, clock synchronization and feed discrepancies, thereby promoting a more healthy competition based on price, increasing liquidity and lowering unproductive wealth transfers, according to Eric Budish of the University of Chicago Booth School of Business, Peter Cramton of the University of Maryland and John Shim of the Booth School of Business. They estimate the duration of arbitrage opportunities in the Chicago Mercantile Exchange and the New York Stock Exchange fell from a median of 97 milliseconds in 2005 to 7 milliseconds in 2011.
In report by John McPartland, senior policy advisor of financial markets at the Chicago Federal Reserve, he goes further suggesting the auction time intervals be random to further enhance price competitiveness and value creation.
Compounding the short-term focus is the drive to reward shareholders with stock buybacks and dividends. In 2014, this figure for those companies in the S&P 500 Index was estimated at $914 billion by Bloomberg and S&P Dow Jones Indices.
Laurence Fink, CEO of BlackRock, with $4.7 trillion in assets under management, suggests long-term capital gains tax rates should be applied to investments of longer than three years — not one year — with a possible rate of zero for those held longer than 10 years. This model would create greater long-term incentives for investment in innovation, high-skilled labor and productive capital expenditures and lower the demand for short-term arbitrage opportunities that extract equity and contribute little to society.
In his recent New York Times piece, Harvard economics professor Sendhil Mullainathan claims that in 2014 nearly 20 percent of students at Harvard who found work went into finance. Astonishingly, this figure was closer to 50 percent for economics majors.
He went on to say: "So how should I feel about my students going into finance? I hope they realize that they have the potential to do great good and not simply make money. It may not be how the industry is structured now, but idealism and inventiveness are two of the best traits of youth, and finance especially could use them."
We seem to be on the right road to recovery. However, sustainable progress may still be a decade or more away.
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