“We’re really only at 1% of what is possible, and probably even less than that. […] We should be building great things that don’t exist.” Larry Page, Google I/O 2013 Keynote
With the summer coming to an end, professors everywhere are greeting a new group of students. So, our thoughts turn to the opportunities and challenges that those interested in finance will face over the course of their careers.
Like many important activities, finance is constantly evolving, so the “facts” that students learn in classes today will almost certainly change rapidly. With that in mind, we always strive to find a set of core principles that will endure, so that students can build a career based both on a set of specialized skills and on a broad capacity to imagine where finance and the financial system are heading.
So, what are the big developments that someone entering the field of finance today is likely to face over the next decade or more? We see three fundamental trends: (1) expanding access: (2) advancing technology; and (3) enhancing safety. While each of these is important on its own, they also are intimately related, and sometimes involve trade-offs. Students who understand these trends will have a good chance to cultivate flourishing careers at the same time that they improve the lives of others.
Access. The World Bank reports that in recent years some 700 million adults have gained access to the financial system for the first time. As impressive as that number may seem, it still leaves an estimated two billion adults globally who are “unbanked” and many others who have little more than basic access with limited impact on their lives.
Why is broadening financial access so important? Finance allows people to make payments, to save, to borrow, and to manage risk. These things, in turn, help societies mobilize savings and allocate them to their most productive uses. The result is faster economic growth where it matters most—in regions with widespread poverty.
Recent rapid gains in access reflect a combination of technology and policy. Today, mobile phone companies provide payments and other financial services to millions in the emerging world who have never visited a bank. And, the Mobile Money Deployment Tracker documents that, in 50 countries in Africa, Asia, and Latin America, there are more than 370 current and planned projects to reach the unbanked.
Policymakers increasingly view financial access as win-win: it promotes economic growth and battles poverty. The most ambitious access project is in India. Officials there have created a unique biometric ID and given each of the nearly one billion registrants so far the option to establish a free, no-frills bank account. The Indian government’s ability to transmit benefits through these accounts seems likely to become a powerful incentive to promote their use.
What are the big outstanding issues in promoting access?
First, the services won’t work well unless they lower transactions costs. Just re-locating banks from cities to rural areas or establishing basic bank accounts alone seems unlikely to have much impact on things like people’s willingness to save. The expansion of mobile services suggests that leapfrogging old technologies will be a key ingredient for success.
Second, access varies sharply across geography, ranging from 70% in East Asia to less than 15% in the Middle East. This pattern appears more closely linked to culture and politics than to differences in income or wealth. Learning how to overcome these hurdles is central to expanding access across the globe.
Third, hundreds of millions of newcomers to the world of finance will be obvious targets for unscrupulous fraudsters. If these “newly banked” are to become permanent participants in the financial world, they will require protection so that they trust the system. And, while low-cost payments technologies can have widely shared benefits, limiting their use for money laundering and other criminal activities will be a key challenge for law enforcement.
Technology. As in many other activities, technology is a two-edged sword. Good technologies minimize the costs people face in saving, obtaining credit, making payments, and managing risks. They foster economic growth by lowering the costs of firms seeking funds to implement new projects. In addition to promoting financial markets and making them more efficient, good technologies also can create new avenues for risk sharing and make the financial system as a whole more resilient. But with the good comes the potential to undermine, rather than buttress, markets (think high-frequency trading).
Technology has thoroughly transformed financial services over recent decades. Not long ago, people had to travel to their bank, broker, or insurance agent to conduct business. Even in the largest and most sophisticated financial markets, transactions typically involved extensive intervention by a series of specialized individuals. Today, many people with smartphones have no idea where the nearest branch of their financial service provider is located. And, most transactions—even outside the most sophisticated markets—are implemented electronically without human involvement.
These changes have propelled (and been driven by) a massive expansion of global financial services. The chart below shows the increased role of finance in the U.S. economy: as a share of GDP, value added in finance and insurance rose from less than 3% in 1950 to 7½% prior to the financial crisis of 2007-2009, and has subsequently climbed back above 7%. To put this number into context, current nominal GDP is $18.4 trillion, so the valued added in finance is on the order of $1.3 trillion.
United States: Value Added of Finance and Insurance as a Share of GDP, 1947-2015
Source: BEA.
Yet, despite the technological changes and the related improvements of service, the cost of financial intermediation (measured as the ratio of financial institutions’ income to the quantity of assets they intermediate) is virtually unchanged. Our friend and colleague, Thomas Philippon, estimates that, in the United States, this unit cost has been stuck in the 1½% to 2% range for the past 130 years (see chart)! That is, it still costs nearly 2 cents for the financial industry to create one dollar’s worth of assets. Put differently, intermediaries have not passed on the full benefits of information technology to finance’s end-users: the providers and the users of funds.
United States: Unit cost of financial intermediation (as percent of assets intermediated), 1886-2015
Notes: The data is annual through 1944, and quarterly thereafter. The horizontal axis is expanded from 1945 to make the data more visible. Source: Figure 3 in Thomas Philippon, The FinTech Opportunity, NBER Working Paper 22476, August 2016.
Against this background of stubbornly high unit costs, new technologies have the potential to revolutionize finance yet again. Examples abound. Making payments with fluctuating-value exchange-traded funds could reduce the system’s dependence on runnable short-term liabilities of (shadow) banks. The blockchain—a distributed public ledger of transactions—already has triggered a wave of experimentation. Among other things, it could facilitate tracking and settling mobile payments, providing further incentives for the unbanked and those with limited access to use the financial network.
Naturally, regulation will greatly influence the pace of technical change in finance. For example, in the case of cross-border remittances, it remains to be seen whether the blockchain will allow law enforcement to contain money laundering and other illegal activities. And, as Philippon highlights—and is true in other sectors—the attitude of the regulatory authorities and the power of incumbents will play a role. In an environment that is welcoming of new entrants, start-ups that are neither wedded to obsolete technologies nor reliant on traditional bank-style leverage may be able to disrupt the status quo—think “finance-Uber.”
Safety. In the aftermath of the Global Financial Crisis, in an effort to make the financial system safer, governments introduced a wave of new regulation. While the pace of reform is clearly slowing, the process remains far from complete. The global financial system may be safer than it was a decade ago, but it is still at risk. Consequently, people contemplating careers in finance should expect regulatory efforts aimed at improving resilience of the system to continue for many years to come. Among other things, there will likely be persistently heightened scrutiny of too-big-to-fail behemoths, as well as a sustained focus on financial conflicts of interest that threaten both consumer safety and the integrity of the system as a whole.
On this blog, we have written extensively about measures to make the financial system safe (see, for example, here and here). In the United States, success will require: (1) reducing leverage and reliance on runnable short-term funding; (2) containing regulatory arbitrage (such as shadow banking); (3) strengthening the financial infrastructure (such as the shift to central clearing of derivatives and the remediation of collateral and margin arrangements); and (4) streamlining the obsolete regulatory governance structure.
With respect to promoting consumer safety, behavioral finance has enhanced the case for public intervention. The tools of modern finance often pose complex challenges even for experts. Unsurprisingly, average consumers have difficulty reaping the full benefits from opportunities to save, borrow or manage risks. While improved disclosure and better financial education will remain key elements of the policy response, other tools—ranging from gentle “nudges” to fee caps to outright limits on consumer choice—are likely to gain in importance.
Finally, it remains a tremendous challenge to contain financial conflicts of interest. There is no magic solution. A wave of scandals—including Ponzi schemes, credit ratings failures, the manipulations of LIBOR and the foreign exchange market, and the facilitation of money laundering and tax evasion—have led governments to impose ever-larger fines and secure institutional admission of criminal violations. Yet, the incentives for misconduct remain powerful because the rewards for and costs of detecting wrongdoing are both so high. Even a very small portion of the $1.3 trillion per year of financial-industry income would leave someone wealthy for the rest of their life. While recent developments point to greater efforts to hold individuals (rather than just firms) responsible under the criminal law, the battle is far from over.
Conclusion. What are the takeaways for students arriving on campus? First, we can only discern the broad outlines of how the financial system will develop over the coming decades. So, focus less on specific institutional setups than on the core principles (“risk requires compensation”) that will guide the evolution of the financial industry and its participants. Second, the future of finance will depend on whether governments ensure that participants in the industry have healthy incentives: favoring inclusion, reducing costs, and minimizing systemic risk. The need on occasion to balance these goals, trading off one against another, means that governments will continue to have a central role. Third, and finally, keep your eye on the big picture, and don’t stop thinking about how to build what doesn’t yet exist. You might just create a “self-driving” version of finance, one that is easier for all to use and safer, too.