Why Finance Should Be Boring

This article first appeared in the Summer 2016 issue of Understanding Investments.

screen-shot-2016-12-02-at-2-55-05-pmEvery industry relies on jargon to conduct business. Internally, work is done efficiently when everyone speaks the same technical language. But no industry is an island and when your main function is as an intermediary, relying on highly specialized language has consequences. The use of complicated language may seem the best way to demonstrate your superior ability or knowledge. Too often, however, the speaker just seems condescending. Meaning, which should be clear, is obscured.

The financial industry is one of the worst culprits. For a sector whose primary objective is to act on behalf of others (and whose communication output is staggering), the industry is too internally focused. As a result, it only seems to speak to itself, patting itself on the back for facilitating ever larger markets and for having a unique place in the business world. Yet there is a serious disconnect between the work of banks, too big to fail, and individuals and businesses, who bear the brunt of the consequences when they do. U.S. society may have moved on from the Great Recession, but Europe is still grappling with the aftershocks. So it is worth exploring the fundamentals underpinning the finance industry’s existence. As informed citizens, we can recognize what services we truly need, when we are provided them, and when we are being spoken over.

A healthy financial system is valuable. It facilitates an efficient deployment of capital, from those who have no current need for that capital to those who do. As a whole, society benefits from projects that would not have started without taking on debt. Savers benefit from the interest generated by providing their capital upfront. The current financial system has four main functions:

  1. Payments System: A payment system allows businesses to transfer money to its employees, other businesses and vice versa. We need some sort of structure that facilitates our various needs to trade cash for goods and services.
  2. Capital Allocation: The financial industry also matches lenders with borrowers. At its fundamental level, banks provide savers with the ability to profit from their unused capital and for other entities to begin economic activity sooner. Some debt is healthy, if it is put to productive projects.
  3. Personal Finance: As a corollary to capital allocation, the industry manages personal finances across an individual’s life and the generations to come.
  4. Risk Management: A person or a business buys insurance to protect themselves from the risk of catastrophic, random events that occur in everyday life and economic activity.

These are the pillars of our financial system. They are simple in theory. When it works, our lives are easier: our employer sends a direct deposit to our checking account on a regular basis, allowing us to plan our lives with one less worry. But if we don’t understand what we need from a healthy financial industry, we have a hard time identifying the symptoms of an ailing one. When the industry expends greater effort talking and trading with each other than with their customers, the system complicates, as it did when banks created and started trading credit default swaps (see John Kay’s Other People’s Money

[2015] for an insightful review of the effects of ever greater financialization). And when we are offered financial products whose details are laid out in pages of complicated techno-speak, we should recognize that the person offering it is contributing to an ever convoluted financial system that is not, ultimately, in our best interest. It isn’t wrong to question them about it and ask for a simple explanation.

Simple isn’t stupid. We should strive for a system that is clean, efficient and elegant.