Archive for September 2016
On this day six years ago, Helanya said ‘yes’. It was in Riverside park, New York, on a bench with the inscription ‘…forever…when the wind whispers…’. (A tip for future proposal-hopefuls: I asked her to marry me on that spot because I couldn’t find the place where Kathleen Kelly meets Joe Fox in You’ve Got Mail, although we found it immediately afterwards, of course. It worked out well, though, that place was pretty crowded.) Much of that day is a blur. I remember that as we were walking home to our illegally-rented room-stay apartment on the East Side (those were the days before Airbnb), we got absolutely soaked in an unexpected autumn rain storm. We hid out in a Central Park cabin until the worst had subsided. But I was happy, she seemed happy, and that made me even more happy.
Today is another day for celebration. Tonight, Helanya will become an alumna of Utrecht University. She graduates with a Masters in Economics and Law. I am told she did pretty well. #proudhusband
Now to figure out how this thing called a dishwasher works…
(Also: a shout-out to my brother who got engaged last week! Advice: buy a dishwasher with only one button.)
Although few would dispute that a strong financial industry is necessary for a thriving economy, the growth in finance over the last three decades, as a 2015 paper by Thomas Philippon in the American Economic Review shows, has not contributed to more efficient capital allocation. The cost of financial services – or more technically: the unit cost of financial intermediation – has remained roughly around 2% for the past 130 years in the US. This is not much different for other countries. Financial innovation has not benefited consumers in terms of lower costs as innovations in other industries have done.
Why this happens is not a theoretical puzzle. Innovation in finance is often geared towards rent-seeking and business stealing by incumbents rather than radical disruptions from new entrants. The problem is that such innovation does not improve the overall efficiency of the system; it results in private returns to incumbents but with low or no social returns. Although this is true for most industries, the ease of entry and competition in most industries make this less of a concern.
Finance, though, is characterised by high barriers to entry. The trend, at least since the 1990s, has been to consolidate further. The number of US banks and banking organisations fell, for example, by almost 30% between 1988 and 1997.
The South African banking sector followed roughly the same trajectory, with one exception: Capitec. Using improvements in information technology, Capitec has managed to reduce fees which have reshaped the South African banking landscape. But much of finance still remains expensive. Despite the new entrant, South African banks, like their US counterparts, generate large spreads on deposits. As Philippon argues in a recent NBER working paper, ‘finance could and should be much cheaper. In that respect, the puzzle is not that FinTech is happening now. The puzzle is why it did not happen earlier.’
That is why FinTech, or financial technology, is all the rage. The hope is that financial technology – including cryptocurrencies and the blockchain, new digital advisory and trading systems, artificial intelligence and machine learning, peer-to-peer lending, equity crowdfunding and mobile payment systems, to name a few – will result in innovation where the social returns surpass private returns. In other words, FinTech must disrupt to be effective. This sentiment is echoed in a wonderful new book, Money Changes Everything: How Finance Made Civilization Possible by William Goetzmann: ‘While finance can solve great problems, it also can threaten the status quo. It changes who turns to whom in an emergency. It reallocates wealth; it creates the potential for social mobility and social disruption.’
In July, Ronald Khan of BlackRock investment management firm gave the biennial Thys Visser Memorial Lecture at Stellenbosch University. Over three nights he delved into the details of investment history, theory and its future outlook. He explained how his firm is already using textual analysis and machine learning techniques – Big Data analysis – to improve their returns on global stock markets, and the impact this will have on the active management industry. I was surprised that not once did he mention that these innovations will lead to lower costs for consumers, but that the main purpose was to maintain the high returns (and cost structure) of investment firms.
This type of FinTech will not disrupt the industry, and thus won’t have the large social returns that creative destruction promises. It will most likely only reinforce the position of the incumbent. What is necessary, then, is to encourage start-ups to enter and compete with technologies that can disrupt. Here, according to Philippon, financial regulation can help. He emphasises three challenges that regulation can help address.
First, regulation can help FinTech firms enter a more level playing field. This is complex, however, as some parts of the financial system, like custody and securities settlement, are inherently concentrated. For example, blockchain technology can improve the efficiency of the market, but it could also restrict entry which will see the incumbent firm increase its rents.
Second, regulation must be forward looking. Regulators must identify the basic features or principles of what the FinTech industry must look like within a decade or two, and implement the appropriate regulations when the industry is still small. It will be difficult to regulate once the industry is already established.
Third, FinTech will require additional regulations to protect consumers. One example which Philippon use is the use of robot advisers for portfolio management. The legal challenge here is that no robot will provide fail-safe ‘advice’, but it is highly likely that these robots will be better than their human equivalents.
Just how FinTech will disrupt the South African finance industry is anyone’s guess. But as long as the incumbents develop their own products (or continue to buy young start-ups), don’t expect consumers to benefit soon. If consumers are to benefit, regulators must find a way to make entry and competition a reality in an increasingly complex and technologically advanced industry.
*An edited version of this first appeared in Finweek magazine of 25 August.
We know them well, those people who make things happen. Leaders, entrepreneurs, creators, builders, movers and shakers. Those who see opportunities where others might not, or take risks when others won’t. Some have built – or are building – global empires. Think Elon Musk or Jeff Bezos. Others make things happen at a smaller scale, perhaps in less glamorous industries or with a preference to avoid the limelight. But they are active: building a business, a political movement or fighting for a social cause.
Economists have been slow to understand what makes successful movers and shakers. Our theories generally assume that where profitable opportunities exist, a competitive market will allow entrepreneurs to fill the void. We care little about explaining the characteristics of those entrepreneurs who see the gap in the market first, and then manage to beat the competition. That is, until now.
A forthcoming paper in the Quarterly Journal of Economics attempts to do just that. The authors, Robert Akerlof (son of Federal Reserve Chair Janet Yellen and Nobel Prize winner George Akerlof) and Richard Holden, construct a mathematical model that has two types of agents: managers (or entrepreneurs – the ‘mover and shaker’) and investors. The managers form social connections with investors and then bid to buy control of an investment project. The winning bidder then has to make other investors aware of the project, and these investors then have to decide whether to invest in the project or not.
The model shows that of the many managers that start, there is only one ‘mover and shaker’ that emerges victorious, and that this manager earns a high payoff for doing so. The noteworthy contribution is that the success of this ‘mover and shaker’ depends on their network: “the most connected manager ends controlling the projects”. Other qualities, like a manager’s skill at running the project, their talent in communicating with investors, and the amount of capital they have personally, will also influence the outcome. But, most importantly, a larger network of connections may often compensate for a deficiency in one of these other dimensions.
The authors use William Zeckendorf, a well-known US property developer in the 1950s and 1960s, as a case in point. Zeckendorf was responsible for many ambitious building projects in the US and Canada, and his autobiography attributes his success to his social connections: “the greater the number of … groups … one could interconnect … the greater the profit”.
Akerlof and Holden’s model provide theoretical support for the increasing body of empirical evidence which shows that social networks matter, now and in the past. My PhD student, Christie Swanepoel, have found, for example, that those settler farmers in South Africa’s eighteenth-century Cape Colony that were well-off also had extensive networks of debt and credit.
What is clear, though, is that it is not necessarily the number of connections that matter, but the quality of those connections. In a recent summary of the literature on social networks, Matthew Jackson, Brian Rodgers and Yves Zenou argue that the network structure of a society can have large implications for how innovation and new ideas spread through it. “Not only does the average number of relationships per capita in a society matter, but also higher variance in connectivity matters since highly connected individuals can serve as hubs that facilitate diffusion and contagion.”
Understanding the network structure of a society is, therefore, essential for businesses and policy-makers. At the most basic level, marketers may find that a customer’s decision to buy is heavily influenced not only by the price or quality of the product, but who their customers are shopping with. (My grocery basket looks remarkably different when I do the groceries with or without my wife.) At a more macro level, policy-makers should realise that networks can have a significant impact on the success of policies ranging from education, public health, segregation, finance, and even policing. Let’s take the latter as an example. Movers and shakers operate, of course, not only within the bounds of the legal economy. The mafia is a classic example of the success of an interlinked network. Using Swedish criminal records, two researchers at Stockholm University have shown that if the police target ‘key players’ – i.e. the mafia bosses – in the criminal network, they can reduce crime much more than if they had just focused on tracking the most active criminals or, worse, just tracked any criminal without considering their position in the network. Using network analysis in their crime fighting strategy, they suggest, the police can reduce crime by 37%.
From criminal networks to political networks to business networks, identifying movers and shakers, and the reasons for their success, can be a very useful strategy in fighting crime, securing votes or boosting profits. But networks vary across many dimensions, and so too its applications; size, clearly, isn’t everything. Understanding network structures in a diversity of social settings will be a fruitful avenue for future interdisciplinary research, fertile ground for the next academic ‘mover and shaker’.
*An edited version of this first appeared in Finweek magazine of 11 August.