The Social Value of Financial Expertise
What’s Up in Economics
By Joe Maginnis
This month’s article from the American Economic Review is titled, “The Social Value of Financial Expertise.” In it, author Pablo Kurlat analyzes the social and private returns from investment in financial expertise with a focus on junk bonds. Kurlat is harsh on the financial sector – perhaps reasonably so – accusing it of rent-seeking behavior and questioning whether it is too large at 8% of GDP. To help answer this question, he measures the ratio of marginal social value to marginal private value of expertise in asset underwriting: the process of assessing the risk of an asset for the purpose of setting fair terms. The author makes the assumption that financial firms make profits by leveraging expertise to trade in markets with asymmetric information. He then assumes a market that is composed of good and bad assets where there is only one price per unit for the asset – whether it is good or bad. If there are no banks with sufficient expertise to identify good assets from bad ones, good assets will trade at a steep discount to their fair prices due to the possibility that they are actually bad assets. It follows that expertise in asset underwriting is accretive to private banks by increasing the returns to their portfolios and also accretive to society by creating differentiated markets based on asset quality and increasing earnings potential for owners of good assets.
DEFINITION
Rent-Seeking is an individual’s or entity’s use of company, organizational or individual resources to obtain economic gain without reciprocating any benefits to society through wealth creation.
The author’s goal is to measure the welfare gained by asset owners relative to the welfare gained by private banks from investing in underwriting expertise. Kurlat derives a formula for the ratio of social gain to private gain, r, that depends on the elasticity of the volume of good assets traded with respect to capital inflows, the proportion of bad assets that are traded among the asset pool, and the average return to a bank’s portfolio. For the junk bond market, Kurlat finds a ratio of 0.16 – implying for the last dollar earned by private banks from investing in junk bonds, $0.16 is offset by social welfare gain and $0.84 is rent captured by financial intermediaries. A ratio of less than 1 suggests overinvestment in expertise in asset underwriting from a social surplus perspective. The findings taken in isolation would imply that – yes, finance is too big at 8% of GDP and we would be better off as a society investing resources in gaining expertise across different domains. However, the author acknowledges that the model fails to capture important considerations: like the fact that evaluating trades in environments with asymmetric information is just one of the many things that financial firms do. Pablo Kurlat’s research hardly provides justification for major overhaul, but it does add a small amount of evidence to the case against a big financial sector.
