The Basics: What is the Financial Sector?
We can talk about the financial sector in an intuitive way. We hear about it all the time. But what exactly is it? This simplified graphic from CFI provides a convenient point of departure:
The financial sector is the area of the overall economy devoted to the provision of financial products. Financial services are the companies and people who provide those products to retail and institutional customers. Financial products are what those customers purchase, from a financial asset type to an account to an insurance policy.
The International Monetary Fund defines financial services as “the processes by which consumers or businesses acquire financial goods.” IMF’s explainer provides a useful table that distinguishes insurance from banking by types of services provided; the document is quite clarifying and is available here. Note that, just below the table, the article notes that, in fact, the distinctions among types of service providers are often unclear. (You can see why there would be problems with defining the financial sector as a datapoint.)
The Recognitions project is unlikely to concern itself much with retail banking (banks that serve retail or individual customers, small business and so forth) or payment processor on the order of PayPal. Insurance providers may figure to the extent that they offer (myriad) financial instruments.
A Story. One fairly notorious instance of this was AIG’s selling of credit-default swaps on mortgage-backed securities in the run-up to the 2008 financial crisis. MBS are products that allowed banks to move mortgages off their books; the securities are derivatives in that their price and other characteristics depends on an underlying basket of assets. In the case of an MBS, the underlying was comprised of tranches (slices) of mortgages, distributed by credit rating in order to spread out risk. The idea is that of modern portfolio theory, in which risk (of things not going as planned, of the future not resembling the past within certain boundaries) is hedged (limited by strategy) by diversified holdings the characteristics of which allow the manager assembling the portfolio (and the statistical software package she uses to crunch the numbers) to create a kind of machine that operates by contrary motion, with gains and losses offsetting while guaranteeing smooth returns (that ultimately reflected the manager’s tolerances for risk). So the products were structured to spread out the risk of defaults in the underlying mortgages. In theory, so long as the future resembled the past adequately the balances of the underlying tranches were persuasive to the credit-ratings agencies, who were hired by the MBS issuers to rate their products (an obvious, in-built conflict of interest) as investment grade (AAA). (Investment-grade securities can be purchased by institutional investors like pension funds and endowments). But still there was a risk of default. At the time, before 2008, everyone was all go-go-go so no-one or nearly was looking at the underlying (they weren’t incentivized), relying on the credit ratings as a stand-in for valuation (which was understood something no-one would ever do when the legislation was signed that allow the agencies to assume the role they had in 2008 and still have). AIG helpfully devised a product called a credit-default swap, the purchase of which was like that of an insurance policy that would pay out in the event of defaults in the underlying securities, but which were not regulated like insurance policies. On the assumption that growth was a steady state, AIG sold many times more CDSs than they could possibly have paid out during a crisis. 2008 showed what this could mean.
When you think of “finance” chances are you think Wall Street, of the exchanges (NY Stock Exchange for example) and clearing houses (the institutions that mediates between buyers and sellers on in exchange trading). You might also conjure mental images of old-school open outcry trading, of shouty men with rolled-up sleeves putting orders in on a trading floor. The centrality of the physical exchange was of a piece with the geographical concentration of the financial services industry on Wall St. These days, the address is largely a reflection of history, a metaphor. The physical space of the NY Stock Exchange is largely ceremonial. Most trading is done via computers. Following the logic of concentration of ownership characteristic of our financialized times, the NYSE and clearing houses are owned by the same corporations. (The past decade has seen something of a land rush on stock and commodity exchanges and clearing houses, with ICE at the forefront). Exchanges have been supplemented by privately held high-speed (high-frequency) dark pools the ownership of which is highly concentrated. The location of these pools, circumscribed by the need to maximize speed, have contributed to the transformation of the geography of finance.
The physical spaces occupied by investors and intermediaries like broker-dealers have been basically transformed by computing as well, as have the modes of communication (floor, telephone, messaging) and the infrastructures of trading, including data creation, collection, formatting and provision—yet each successive organization, each successive technology seems to supplant the previous. Bloomberg Terminals provide little sense either that it is the latest in a long series of technologies designed to relay price information, from tickers to Quotron to now, nor to today’s terminals contain much of the succession of designs and technologies since their introduction in 1982.
There is a range of asset types that are traded: we’ll provide a list in a separate document.
While online platforms that allow retail investors to speculate in various asset types are popular on the internet, most retail investments happen via broker-dealers.
Investors can be divided into retail and institutional. Retail investors can be regular people or “high net-worth individuals.” The latter can avail themselves of a host of specialized vehicles and approaches to managing them. US financial regulation exempts those vehicles from regulation not so much because they are private (though they are), but rather because high net-worth individuals are taken to be “sophisticated” and thereby able to take on the risks that attend private markets These include family offices and, more recently “blank-check” shell companies called SPACs.
The space that allows for investment management focused on “sophisticated investors” to operate in private arenas that are largely exempt from disclosure requirements is called the 3c1 exemption to the Investment Advisor Act of 1940. A.W. Jones, who invented the basic strategy that once defined hedge fund in addition to their 2-and-20 basic fee structure, declined to register his hedge fund under 3c1, arguing that the fund was private. The minimum investment threshold meant the fund was oriented toward high net-worth individuals. Disclosure of portfolio holdings would undercut the funds competitive advantages. The arguments succeeded and hedge funds. Private equity was later able to grandfather its way into the 3c1 exemption using the same basic arguments. Problems arose beginning with the 1974 ERISA law that allowed pension funds to function as institutional investors (though they were prohibited from investing in “corporate raiders”—one of the ancestors of private equity that bought up shares in a target company unbeknownst to that company, looking for a “hostile takeover”—but they could invest in leveraged buyout shops that specialized in friendly takeovers that is buyouts that happened with the knowledge and cooperation of the target company.) The problem is that pension funds are not sophisticated high net-worth individuals; they are the pooled pensions of working people. Not long after the publication of David Swensen’s Pioneering Portfolio Management in 2000, university and college endowment money began pouring into these investment management outfits. They have the same problem as pension funds in that, what stands behind the investments is a university or college, its educational and social missions.
Financial assets can be publicly traded or private. Publicly traded assets—primarily stock---sell ownership shares in the company; trade in these assets is tightly regulated by exchanges, states and federal; entities are required to make certain disclosures about their positions and/or financial condition, and these disclosures are available to the public. Private entities are not nearly as tightly regulated nor are they required to make disclosures. In the case of so-called alternative investments (hedge funds, private equity, real-estate investment trusts etc). this opacity creates real problems (unverifiable, unreliable valuations in the instance of PE for example).
Public markets are more transparent and are said to be relatively “efficient” in the sense that share prices approximate the value of the underlying company, a value finance analysts determine via discounted cash-flow analysis. (The practice of buying shares based on prices discrepancies in general is arbitrage). Private assets are then “inefficient.” From a regulatory-facing viewpoint, transparency is desirable—but from an investor viewpoint it may not be. David Swensen once wrote an “efficient market” is where no-one is making any money. Private-equity outfit Bain Capital opined on this in 2019. If you read the report, be alive to their interests as they are worked into the piece and to peculiar dialect of English in which it is written (it is hard to avoid).
Management can be active or passive—an example of passive investment is an index fund like Vanguard. Index funds track a stock index like the S&P 500 or the Dow. They are inexpensive and do quite well, not least because of stock buybacks (companies that issue stock these days frequently issue debt instruments (corporate bonds) in order to raise money to buy back their own shares in order to manipulate the share price---because that prices is taken as a performance indicator and the bonuses built into many executive compensation packages are pegged to it). Active management involves the assembling of a portfolio. There are a host of strategies that can be used; what they have in common is that they are expensive. Active strategies justify themselves when they “beat the market”; that is when they outperform index funds.
The name “Wall Street” also evokes investment banks. JP Morgan Chase, Bank of America are among the bigger names; the hotlink takes you to a list of them. These banks fulfill a host of functions from market-making to helping companies and other entities raise money for expansion to managing a company's initial public offering (IPO) or private placement, to preparing a bond offering. Investment banks are also quite active in underwriting and negotiated mergers & acquisitions. The “What we do” page for Bank of America’s investment banking group lists these services with some further explanations, which you may find useful.
The 2008 financial crisis had devastating consequences on investment banks that opened space for private equity (a type of investment management we will discuss in detail going forward with the Recognitions project) to assume some of their functions What analysts refer to as a “transformation of intermediation” is an important change the overall landscape of finance. Andrew Tuch argues in a recent Harvard Law Review article on the transformations of Wall Street: “private equity firms now mirror investment banks in their mix of activities; ethos of entrepreneurialism, innovation, and risk-taking; role as “shadow banks”; and overall power and influence.” Against critics he argues that PE does not pose a systemic risk by taking over these roles, but the absence of regulation and blurring of boundaries, particular with broker-dealer roles, pose separate and considerable problems. The article is long, but well worth a read.
“Intermediation” is a fairly bloodless word that refers to the central activity undertaken by all financial services providers, source of the fees that are the reason for all of this. Fees can range from modest (investment in an index fund via a mutual fund) to exorbitant (hedge funds or private equity). The fees charged endowments by alts is and likely will remain a problem that will occupy is in the Recognitions project.
Just to emphasize: for all the emphasis on investment, its mechanics and returns and the roles such activities play in “the economy” the financial sector is about fees.
Federal government institutions are extensively involved with finance. At the most basic level, the Treasury Department, working in tandem with the Federal Reserve system (the central bank of the US) oversees (and, by extension, the political authority and “full faith & credit” of the US) that anchors money. The institutions perform different functions, with Treasury broadly responsible for money that flows into or out of the government while the Fed uses its control over money supply (and the setting of interest rates) to keep “the economy” operating.
Aside: There’s surprisingly little consensus on what it is. Geoffrey Ingham’s 2004 book The Nature of Money provides a useful overview of the various schools that have taken shape over the years. He sides with Michel Aglietta and others that money is a political act by a government and does not, as libertarians (and bitcoin people) believe, spring spontaneously from market transactions as worms from cheese. (Here’s a review of the book)
Over the course of its history the Federal Reserve has become the “lender of last resort” that Keynes called for (a genealogy of the category and overview of the state of play with respect to it can be found in this 1999 talk by Stanley Fisher given at IMF).
The remarkable credit line and investment purchase strategies unrolled by the Federal Reserve in response to COVID-19 was admirably described and analyzed by Nathan Tankus in close to real time. The Fed used a “playbook” based on its responses to the 2008 financial crisis. The lineaments of that playbook are assembled in Adam Tooze’s Crashed. The 2008 response leaned on and learned from that undertaken by the Fed to 1929. Barry Eichengreen’s recent Hall of Mirrors: The Great Depression, The Great Recession and the Uses and Abuses of History is a useful comparative piece. Here’s an extended review.
Federal regulators today can be grouped as follows:
Depository (banking) regulators—Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), and Federal Reserve for banks; and National Credit Union Administration (NCUA) for credit unions;
Securities markets regulators—Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC);
Government-sponsored enterprise (GSE) regulators—Federal Housing Finance Agency (FHFA), created by HERA, and Farm Credit Administration (FCA);
Consumer protection regulator—Consumer Financial Protection Bureau (CFPB), created by the Dodd-Frank Act.
Other entities that play a role in financial regulation are interagency bodies, state regulators, and international regulatory fora.
Notably, federal regulators generally play a secondary role in insurance markets.
In his 2020 paper, “Who Regulates Who? An Overview of the U.S. Financial Regulatory Framework” Mark Labonte characterizes US financial regulatory activity in general:
Regulators regulate financial institutions, markets, and products using licensing, registration, rulemaking, supervisory, enforcement, and resolution powers. In practice, regulatory jurisdiction is typically based on charter type, not function. In other words, how and by whom a firm is regulated depends more on the firm’s legal status than the types of activities it is conducting. This means that a similar activity being conducted by two different types of firms can be regulated differently by different regulators. Financial firms may be subject to more than one regulator because they may engage in multiple financial activities. For example, a firm may be overseen by an institution regulator and by an activity regulator when it engages in a regulated activity and by a market regulator when it participates in a regulated market.
Fannie and Freddie underpin the mortgage and mortgage-backed securities markets. This arrangement was the result of a long quest to allow banks to sell mortgages in order to get them off their books, the history of which is detailed in Sarah Quinn’s recent American Bonds: How Credit Markets Shaped a Nation.
The Securities and Exchange Commission (SEC) was created in 1934 to centralize and tighten the regulation of financial activity. While the previous arrangement of state-level (“blue-sky”) laws and exchange rules were not adequate to prevent wide-spread fraud in the run-up the 1929 market crash or to limit its damage, SEC did not eliminate either state authority to regulate or that of exchanges to impose and enforce rules on listed companies. SEC was provided a legal framework; an official diagnosis of the finance-centered causes of the 1929 stock-market crash (and, by extension, The Depression) can be read off the objectives of the laws. The main pieces of legislation are:
Securities Act of 1933
Catalyst: The stock market crash of 1929
Objective: (1) Ensure transparency in financial statements to assist investors in making informed decisions; (2) prohibit deceit, misrepresentation and other fraud in the sale of securities
Securities Exchange Act of 1934
Catalyst: The stock market crash of 1929
Objective: (1) Create the SEC to regulate the securities industry; (2) establish self-regulation; (3) regulate trading of securities
The second of the objectives reflected concerns that, with time, SEC would become overly centralized. To counter this, Congress authorized what became a network of self-regulating organizations (SROs). SROs are overseen by SEC but are independent, industry-group owned and operated. These include:
The Financial Industry Regulatory Authority (FINRA) which governs the professional conduct of financial service providers and oversees and registers bond issuances on their TRACE system except for those issued by municipalities.
Note: Universities and school systems are among the organizations that issue muni bonds--- which makes EMMA an important resource. Take a few minutes to familiarize yourself with how the interface works. Maybe have a look at what your school’s been up to.
Another SRO, the Financial Accounting Standards Board (FASB) is responsible for creating accounting rules.
Auditing is overseen by the Public Company Accounting Oversight Board (PCAOB) which is a government entity overseen by SEC (so not an SRO). It was created by Sarbanes-Oxley in response to the Enron accounting scandal that brought down the auditor Arthur Anderson, making of the Big 5 the Big 4.
The Investment Act of 1940
This Act regulates the organization of companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. The regulation is designed to minimize conflicts of interest that arise in these complex operations. The Act requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis.
Investment Advisors Act of 1940
This law regulates investment advisers. With certain exceptions, this Act requires that firms or sole practitioners compensated for advising others about securities investments must register with the SEC and conform to regulations designed to protect investors. Since the Act was amended in 1996 and 2010, generally only advisers who have at least $100 million of assets under management or advise a registered investment company must register with the Commission.
Note: Hedge funds and private equity outfits are largely exempted from this act under the “3c1 exemption” (though private equity must now register). We’ll have occasion to detail the problems that flow from this.
The graphic that began this document above does not provide a box for financial services like auditing and accounting. Audit is dominated by the Big 4 auditors (EY, PwC, KPMG and Deloitte), for better or worse. We will no doubt have occasion to talk about the myriad problems with auditing in its current form, from conflicts of interest that follow from each of the Big 4 having audit and consulting services (with consulting being the big revenue generators, which provides an interest for auditors to contribute to developing a cozy relationship with their clients who are also potential customers for consulting) to problems of fraud detection (they don’t) and “the expectations gap” (but people think they do). On auditing, the best resource is Francine McKenna’s The Dig. Richard Brook’s Beancounters: The Triumph of the Accountants and How They Broke Capitalism is an important history of the Big 4 that details the centrality in constructing the system of shell companies that comprises the off-shore tax evasion system. In 2014, the UK-based Tax Justice Network compiled data to give a sense of the scale of their achievement that is also well worth a read. A kind of amusing review of Brook’s book appeared recently in The British Accounting Review in which the author, Atul Shah, wonders why it is that one can read reams of academic writing about accounting and never hear about the Big 4 while investigative journalism names name and suggests that—maybe—academic writers can learn something from that.
(We plan to name names.)
Auditing is overseen/regulated by the PCAOB, which was created by Sarbanes-Oxley in 2002.
The graphic also provides no space for legal professionals, who play a host of roles in the world of finance. Alternatives are heavily dependent on their legal representatives and they, in turn, make enormous amounts of money from representing them. Nowhere is this symbiosis more evident than in bankruptcy/distressed debt (a hedge fund strategy.
A sense of how some of these parts fit together can be had by reading Bryan Burroughs and John Helyar’s Barbarians at the Gate (useful as a historical document, not least on the conflict it reproduces between investment bank and junk bond funding strategies for LBOs). A more recent option that focuses on bankruptcy proceedings that set private equity and hedge fund players against each other is Max Frumes and Sujeet Indap’s The Caesar’s Palace Coup: How A Billionaire Brawl Over the Famous Casino Exposed the Power and Greed of Wall Street