strategy

but also for the allocation of the country’s talent: Fi-nance will continue to attract the best and the bright-est as long as the rewards are so high.

successesThe key functions of a financial system are to fa-cilitate household and corporate saving, to allocate those funds to their most productive use, to manage and distribute risk, and to facilitate payments. The financial sector is working well when it performs those functions at a low cost and makes the rest of the economy better off . Recent research has shown that economies with well-developed fi nancial sys-tems grow reliably faster than those in which fi nance plays a smaller role. In general, fi nance does serve a crucial economic purpose.

In the United States, the system appears to be working well for corporations, which enjoy easy ac-cess to debt and equity markets. The development in recent decades of institutional venture capital and private equity, along with the growth of professional money management, has helped improve the allo-cation of capital. Venture capital, in particular, has fostered a vibrant entrepreneurial sector that has transformed industries such as information tech-nology and communications and has helped create new ones, such as online retailing and biotechnology. Venture-capital-backed entrepreneurs have also put pressure on existing firms to adapt their business models and to innovate.

Venture capital could not have thrived with-out stock market investors willing to purchase the shares of risky young fi rms. Their investments were made possible, in part, by the rise of professional money managers, who are in a better position than individual investors to assess the prospects of these newcomers. Ironically, 30 years ago a major concern was whether the increased emphasis on shareholder

the u.s. Financial sector’s share of GDP grew from less than 5% in 1980 to more than 8% in 2007—the largest share in any advanced economy

except Switzerland. With this growth came big increases in financial sector employment and compensation. The industry was transformed from a sleepy old boys’ club to a dynamic business that attracts the best and the brightest.

It is tempting, then, to declare the industry a roaring success. But the fi-nancial sector exists to serve the needs of U.S. households and firms, and by this standard its performance has been mixed. The sector’s growth has been beneficial for some, particularly U.S. corporations, which enjoy ready access to the deepest capital markets in the world. At the same time, the industry

has evolved in several unhealthy ways, which have had negative consequences for the U.S. economy.

There are three main problems. First, the fi nan-cial system is less stable than it was 30 years ago. The recent crisis was in part the consequence of a shift from traditional deposit-based banking to a market-based system, without adequate regulatory adjustments. Second, the fi nancial sector—in com-bination with generous government subsidies—has steered trillions of dollars into residential real estate and away from other, more productive investments. Third, the cost of professional investment manage-ment, which has been growing as a share of GDP, is simply too high. Excessive investment fees have im-portant implications not only for household savings

104  harvard Business review March 2012

How toHow tomakeFinancework

PhotoGraPh Fpg/getty images: u.s. Bureau of engraving and printing, 1929

tHe u.s. Financial sector Has boomed, but tHat Hasn’t always been good news For tHe rest oF tHe economy.by robin greenwood and david s. scHarFstein

private equity is not without problems. Like ven-ture capital, it is subject to boom-and-bust cycles that undermine its value; transactions can often be motivated by tax considerations rather than true economic value creation; and the average returns to private equity investors have generally not been enough to compensate them for the risk they bear.

Failures— and How to address tHemDespite the successes outlined above, the U.S. finan-cial system has had difficulties managing and distrib-uting risk, allocating capital, and facilitating low-cost savings. It has been prone to crisis, has diverted too much capital toward housing, and has been beset by what appear to be excessive investing costs.

Financial instability. Until the recent crisis, the period after the Great Depression was one of un-precedented stability in the U.S. financial system— achieved in large part by regulatory oversight, deposit insurance, and the Federal Reserve’s “lender of last resort” capabilities. However, beginning in the 1980s, fundamental changes in the architecture of the financial system put it at risk. With lax over-sight and a regulatory regime that was ill-suited to the new architecture, the system eventually came crashing down. Without extraordinary support from the U.S. government and the Federal Reserve, the financial crisis would have been even worse. Three years later, economic growth is anemic and unem-ployment remains high.

What changes made the financial system so vul-nerable? As is now well known, part of the answer is the 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. But securitization was part of a more funda-mental transformation in which the critical func-tions of banking were provided by players other than traditional deposit-taking banks.

The growth of nonbank financial firms and in-vestment vehicles—from Wall Street broker-dealers to Fannie Mae, Freddie Mac, insurance companies, hedge funds, and money market mutual funds—cre-ated a “shadow” banking system, so called because it serves the same basic functions as the traditional deposit-taking system. Like banks, financial or-ganizations in this system collectively transform short-term savings into long-term loans to house-holds and firms—what economists call maturity transformation.

value would lead to an excessive focus on short-term profits. But the development of U.S. capital markets since then suggests the opposite: 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. This willingness is reflected in the growing amount of money the private sector has poured into R&D—an indication that the financial sector is steering capital toward long-run investments.

None of this is to say that venture capital and public equity markets have functioned perfectly. Venture capital has on average failed to deliver ac-ceptable risk-adjusted returns for investors, and public equity markets seem to go through periods of euphoria and fear. But the same markets that over-funded internet and telecom start-ups during the late 1990s also identified and nurtured Google.

Private equity and hedge funds have at times played an important role in helping to unlock value trapped in large, underperforming conglomerates. They can work to align management and share-holder interests, fostering an environment in which well-run firms get capital and poorly run firms are shut down or acquired. This is healthy. However,

Federal and private Funding oF research and development as a % oF gdp

1953 2008Source national science Foundation

0.0%

0.4%

1.6%

1.2%

0.8%

a success story: Financing r&dForty 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 government—an indication tHat tHe Financial sector is steering capital toward new ideas.

Federal FUnding

Private indUstry FUnding

106  harvard Business review March 2012

restoring u.s. competitiveness strategy

A compelling economic logic underlies shadow banking: Risks can be shared across the system in-stead of concentrated in individual banks. But the financial crisis revealed at least three significant weaknesses of shadow banking and the broader fi-nancial system.

First, the amount of capital that regulators re-quired the shadow banking system to hold against securitized credit risk was lower than the amount banks were required to hold. As a result, financial ac-tivity shifted from banks to shadow banks in a form of regulatory arbitrage. And when low-quality secu-ritized loans began to go bad, there was insufficient capital to absorb the losses.

Second, the entities involved in shadow banking were tightly connected to one another and to the traditional banking sector. Those links created con-siderable risks that were poorly understood before the crisis.

Third, the shadow banking system turned out to be vulnerable to the same kind of bank runs that plagued traditional banks prior to the estab-lishment of deposit insurance. Creditors could run on a moment’s notice by, for example, refusing to roll over short-term loans. Without the supports offered to the traditional banking sector, even rela-tively small losses could bring shadow banking to a standstill.

We face many challenges in stabilizing the finan-cial system. Significantly increasing capital require-ments, which regulators have agreed to do, would go a long way in that regard. Limiting the extent to which financial firms can fund long-term assets with short-term liabilities—thereby decreasing the risk of bank runs—would also help protect the system. And placing stronger safeguards on the largest financial institutions would be an important measure to pro-mote stability. Whatever is done, regulatory treat-ment should be consistent across the traditional banking and shadow banking sectors. Making this

work will require approaches beyond those in the standard regulatory tool kit.

Top executives of financial services firms often say that nobody could have predicted the magnitude of the crisis and that nobody will be able to predict the source of the next one. It’s impossible to know if that is true, but it strengthens the case for increased capital and liquidity requirements.

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 (and the percent-age has only gone up since). The government also subsidizes homeownership through the mortgage-interest deduction—a benefit extended by only a handful of countries. And the private sector was an eager and increasingly careless mortgage lender. The subsequent crisis was the culmination of decades of rising mortgage-credit availability.

The excess allocation of capital toward housing diverted resources from potentially more productive

idea in brieFalong the way, it has seen big gains in employment and compensation. But the finan-cial sector exists to serve the needs of u.s. households and firms, and by this standard its performance has been mixed.

the sector’s growth has been beneficial to u.s. cor-porations, which enjoy ready access to the deepest capital markets in the world, but there are also problems. First, the financial system is less stable than it was 30 years ago. second, the financial sector has steered

trillions of dollars into resi-dential real estate and away from other, more productive investments. third, the cost of professional investment management is simply too high. Fixing these flaws will require changes in regulation but also private-sector disci-pline and innovation.

a compelling logic underlies sHadow banking: risks can be sHared across tHe system instead oF concentrated in individual banks.

over tHe past tHree decades, tHe u.s. Financial sector Has grown mucH Faster tHan tHe overall economy.

How to make Finance work hBr.org

March 2012 harvard Business review 107

uses. Moreover, subsidies and easy credit drove up the demand for residential real estate, most likely increasing prices in coastal cities with limited hous-ing supply and leading to overbuilding in other areas. When home values appreciated, households bor-rowed against their equity to finance consumption. Rising house prices put a damper on homeowner-ship rates, reduced household savings rates, and left households vulnerable to economic adversity. The current debt burden on underwater homeowners is stifling U.S. economic recovery.

The leading proposals for housing finance re-form—supported by a coalition of the financial services industry, the real estate industry, and consumer advocates—focus on keeping mortgage credit cheap and available and call for government to play a critical role in achieving that goal. We think this focus is misplaced. The long-term goal of housing finance reform should be to promote finan-cial stability and the proper allocation of capital. In their book This Time Is Different, Carmen Reinhart of the Peterson Institute for International Econom-ics and Kenneth Rogoff of Harvard University show that real-estate-related crises, which often have their roots in an excess supply of credit, are com-mon and do lasting damage to the banking sec-tor and economic growth. Housing policy should therefore seek to reduce volatility in the credit sup-ply and protect the financial system from shocks to the housing sector.

How can this goal be achieved while weaning the housing market off government subsidies? The industry should focus on designing securities that deliver the fundamental promise of securitization—enhanced liquidity and diversification of risk—and not on those that arbitrage gaps in regulation. Once the government steps back from guaranteeing most new mortgage credit, private securitization of mort-gage credit can and should return. As we discussed above, regulations must recognize that securitized mortgage credit performs some of the same func-tions as deposit-based banking and is prone to some of the same risks. The details of how to regulate housing finance remain to be worked out, but reori-enting the discussion to ensuring financial stability will go a long way toward better serving U.S. house-holds and economic competitiveness.

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 as-sets and in the share of those assets that are man-aged professionally. It also reflects the industry’s high fees.

The sector’s ability to maintain those fees despite fierce competition to manage assets is partly due to consumers’ lack of financial sophistication. Fees are assessed on the basis of a fund’s overall performance rather than on relative risk-adjusted performance. This means that if the market as a whole rises, equity managers garner higher fees—even if a passive index fund would have done just as well. Decades of stud-ies have produced little evidence that equity fund

tHe explosive growtH oF tHe Finance industry Has led to large increases in compensation and in tHe cost oF investing.

tHe rise oF Finance

insurance

Finance’s share oF u.s. GdP

securities and Fund ManaGeMent

credit interMediation

1929 2009

8.0%

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

Source Bureau oF economic analysis

108  harvard Business review March 2012

hBr.orgrestoring u.s. competitiveness strategy

28%

70%

managers outperform market indexes with similar risk, even before fees.

Mutual fund fees have been falling over time, but high-fee vehicles such as hedge funds have been gaining market share. As a result, the total fee for equity management as a percentage of market capi-talization has remained approximately constant, at 0.8% of assets under management, according to Dartmouth’s Kenneth French. In their efforts to beat the market, money managers make decisions and dig up information that leads to more accurate pricing of stocks. Is 0.8% a reasonable rate for soci-ety to pay for that service? It seems high in light of the technological progress of the past several years: Despite increasing computer speed and advances in information technology, the financial sector is about as productive, per unit of managed funds, as it was 30 years ago.

Equity management firms and their employees have profited handsomely from the run-up in stock values since 1980. In fact, we estimate that a big part of the increase in the financial sector’s share of GDP can be explained simply by the increase in stock prices from 1980 to 2006. There is no reason to be-lieve that high-priced stocks are more costly to man-age. Many investors do not appreciate how quickly fees add up: Owing to compounding, overpayments of 80 basis points per year for 30 years equals about 21% of current wealth.

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. The industry’s attraction is not difficult to understand: According to a study by Thomas Philippon of New York University and Ariell Reshef of the University of Virginia, in 1980 a finan-cial services employee typically earned about the same wages as his counterpart in other industries; by 2006 he was earning 70% more. The channeling of talent to finance can be justified if the high wages and profits reflect value added to the rest of the economy. But if investment fees are too high, then finance is inefficiently draining talent from other industries, hampering overall productivity growth. Imagine if Bill Gates or Steve Jobs had left college to start a hedge fund.

One area in which costs have come down is trad-ing in equity markets, where commissions and bid-ask spreads are much lower than they were 30 years ago. But institutional investors, corporations, and

financial firms pay high costs to trade in many over-the-counter markets for corporate bonds and deriva-tives, 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. The problem is transparency. Studies of the corporate and munic-ipal bond markets have shown that market opacity increases trading costs. Price reporting systems for corporate bonds and exchanges and clearinghouses for derivatives should therefore lower costs.

Investment costs are unlikely to fall overnight. Nevertheless, they can be reduced by making fees more visible so that financial firms can better com-pete on them. For most households, asset manage-ment should be a utility—low cost and reliable. But in retirement accounts, for example, management fees are sometimes hard to identify. We should also demand accountability and transparency from com-panies that select retirement funds for their employ-ees. It should not be acceptable, for instance, to of-fer employees an index fund with annual fees of 1% when an identical product is available at one-fifth of the cost. The broad principle underlying both pro-posals is that asset managers should compete on the true value of the services they provide.

Pension funds and endowments can be an impor-tant voice in this discussion. These investors pay low fees for the active management of public equities but very high ones for private equity, venture capital, and hedge funds. The evidence suggests that those vehicles have, on the whole, delivered only modest risk-adjusted returns to investors. Active investing is difficult, and talented managers should be paid for their performance. But investors should be paid for skill, not luck.

in a recent competitiveness survey of HBS alumni, respondents listed the capital markets as an endur-ing strength of the U.S. economy. Yet aspects of the financial sector have distorted the allocation of tal-ent and capital and have left the economy vulner-able to crisis. 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 econ-omy over the long term. hBr reprint r1203h

robin Greenwood is an associate professor of busi-ness administration and david s. scharfstein is the

edmund cogswell converse professor of Finance and Bank-ing at harvard Business school.

aMonG eMPloyed 2008 Graduates oF harvard colleGe, 28% went into Financial services, coMPared with aBout 6% FroM 1969 to 1973.

6%

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.

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hBr.orgrestoring u.s. competitiveness strategy

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