Problem 12: When a Few Financial Institutions Control Everything
Author: John Coates
Columbia Global Report2023
In the modern economy, industrial concentration has long been a focus of academics and policymakers, ultimately spurring vigorous conceptual and public policy debates about the structure, behavior, and performance of market-driven systems as a whole. Over the years, evidence has shown that it is beneficial to side with markets across the entire spectrum of public policy objectives. It is therefore equally important to understand market dynamics and how markets themselves are structured to contribute to economic growth through resource allocative efficiency and factors of production, factor productivity, and technological change. And what positive and negative externalities are created in the process?
In this short book, John Coates, a Harvard Law School professor and former adviser to financial firms and public service agencies, casts a skeptical eye on the concentration of the American financial industry, focusing primarily on two specific sectors: index funds and private equity. As the title suggests, he argues that the degree of concentration that has evolved in each of these sectors contains flaws that offset some of the core advantages of American market capitalism. Importantly, it includes a frank discussion of the relationships between dominant financial intermediaries and their clients, and between each other.
What this short book largely fails to address is the competitive design of many financial firms themselves. In particular, those that describe themselves as “universal” can apply economies of scale and scope across activities, customer targets, and geographic areas, and effectively deal with the inevitable conflicts of interest and regulatory complexities that arise. As the author argues, when financial concentration is a problem, who is doing the concentrating matters. The zoo has so far been home to a wide range of animals, from JP Morgan to KKR, which should help to allay some concerns about where things are headed. It would have been helpful to include a Herfindahl-Hirshman analysis of what has happened to market share here. within A 12-company group. Despite the increasing concentration of the 12 companies, the market share within the 12 companies is more evenly distributed, which may alleviate some of the concerns about concentration.
Most of the anecdotes presented in this book are well known, but they are woven into the fabric of a story of concentration that will be credible to readers who have been in the field for a long time. Advocates of free-market capitalism wonder whether their belief in vigorous competition can be reconciled with the increasing concentration (and often cooperation) described in the narrative, sometimes pushing the boundaries of acceptable behavior, regulatory constraints, and laws, and backed by powerful lobbying efforts, creating a federal tax environment that no one else can afford.
Moving away from the industry hub-and-spoke narrative focused primarily on index funds and private equity, the story delves into “spokes” of “dark” business practices outside of public markets and information dissemination, and into key economic and political issues involving the distribution of income and wealth in the United States.
Some readers will be struck by the anecdotal evidence of income and wealth attributed to many of the leaders of the twelve financial firms the author focuses on. Americans have generally been generous in their large income and wealth gaps, believing that they are largely the result of market forces and that the process has many positive spillover effects for the rest of society. But his lenience can change on issues such as wealth taxes, which in turn threaten the positive functioning of the financial sector. When fraudsters emerge, the public expects strong prosecutions to ensure that corruption undermines the very foundations of the system and that the baby does not die out with the bathwater. Of course, the super-rich die out sooner or later and their financial fortunes eventually disappear. Moreover, they donate huge sums to worthy causes that elsewhere in the world depend entirely on taxpayers, whether they are opera-goers or not.
This book is a delightful read for those who were around when the systemic changes in finance and investment took place in the 1980s and 1990s, and will appreciate the well-integrated sketches used to highlight key points or explain how the basic competitive concentration hypothesis played out in the real world. Those too young to have observed these events and who are seeking exposure in the sterile classroom environment (mostly from academics with little direct industry experience, unlike the author) will find the core competitive structure of the argument easy to grasp and learn from its applications, once they understand the basic drivers, key market players, and specialized terminology. For someone as close to action as the author, it took some courage to write this book. Some in the industry will no doubt be offended by the core argument and some of the supporting evidence. But many industry leaders simply don’t have much time to read anyway, and will leave it to their subordinates to get excited when it comes to asserting systemic flaws and proposing reforms that challenge the “problem of 12.”
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