Wednesday, September 16, 2009

Conflict between Short vs Long Term profits?

Speaking at a conference in Hong Kong, outgoing chief of HK Monetary Authority said: "... large banking profits and staff bonuses led to lower financial efficiency and contributed to the financial crisis...

He said there was a conflict between the private, short term interest of financial groups to maximise profits and the public interest of effective financial intermediation that provided support to the economy. “This conflict has not been talked about much, if at all, even in central banking forums...”

Questions: 1) how does one distinguish between short versus long term profits in an investment bank that derives its income mainly through services and trading profits? 2) how does it lead to lower financial efficiency exactly; and 3) how does one differentiate between private and public interest in terms of what banks do?

Answer to:

1) It is impossible to different between short and long term profits for an investment bank whose principal activities by their nature are trading oriented.

2) Maximizing profits is what private firms do whether they are financial or manufacturing. Making a profit only leads to financial inefficiency if information is "asymmetrical" meaning the firm withholds information from its clients who buy financial products from it and if regulatory authorities do not enforce properly and if there are insufficient regulations on the book to ensure proprietary information is kept to an absolute minimum.

3) The differential between public and private interests can only be defined if prices do in fact reflect complete symmetry of information. In other words if one party knows more than the other, then prices are not optimally determined creating inefficiency in the economy. If a tire company keeps making faulty tires, it can only fool its customers some of the time, but not all. However, it is important that this tire company is not the only game in town.

What is worrisome is Wall Street is now in fewer and fewer hands. So even if someone got burned by Goldman Sachs, say, as long as it remains the dominant player on Wall Street, customers, old or new, are likely to return to its fold thinking it possesses "insider" information that it could share with its clients.

Know what? That's exactly what happened. Favored clients did and continue to receive favorable treatment by getting more information sooner than the average client. It pays to be a big client. And that's the main problem Yam did not at all raise.

Mr Yam was nowhere near what are the central issues are.


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