How the Financial System Fails Us, and How to Fix It (Yale University Press, 2016)

By Stephen Davis, Jon Lukomnik, and David Pitt-Watson 

Capitalism is no longer working for the capitalists. That, in essence, is the premise of ‘What They Do With Your Money’, a sceptical take on how the financial services industry has developed. 

The book’s three authors set out to describe fundamental conflicts of interest that permeate the modern financial industry, how they came to pass, and how to combat them. It makes for an interesting read, albeit one that seems to focus on a number of pet peeves (high frequency trading and derivatives are particular bugbears). 

When they refer to capitalists, the authors are referring to us, the people providing capital to banks, fund managers or insurers. They contend the purpose of much of the world’s financial services industry is to siphon off capital to pay itself. “We, the providers of capital, have an interest in growing our savings for the long haul. But the agents hunt rapid profits because that is what they are paid to do.”

A compelling early point is that financial service providers’ mutual back-scratching enriches only themselves. The authors refer to a study by Thomas Philippon, professor of finance at New York University. He tracked borrowing and lending in the US finance industry back to the 1880s, and concluded that the finance industry charges about 2% per ‘intermediated dollar’ (i.e. any money that passes through a financial services company)…and has done ever since the industry began, despite huge gains in efficiency. “No matter how you cut the data…there has been no trend towards cheaper or better service,” the authors state. Ouch. 

This inefficiency is due to the number of financial service players now involved in trading and investing, each siphoning off a portion of money. This labyrinthine network has grown in large part because investors are focused on making quick gains rather than long-term value, a la renowned investor Warren Buffet. The authors note that average fund portfolio turnover has soared since World War II; to the extent the average fund completely overturns its portfolio in just over a year.  

What is to be done? The authors argue investors (particularly those owned by shareholders) should be required to hold themselves to fiduciary standards that clearly prioritise us, the end investors. Actions we as investors can take include using more low-cost index funds and pressurising our fund managers to sign up to the United Nations Principles for Responsible Investment – both areas AsianInvestor agrees hold merit. It’s also vital that investors and regulators force full transparency on where, why and how fees are charged. Sunshine is the best disinfectant. 

Ultimately, the authors contend that investors should better appreciate long-term asset ownership and force companies to think for the long haul too. It’s a lesson more asset owners and fund managers could do with taking on board.