Getting Real with Financial Intermediation

Real assets in the economy – created by entrepreneurs and operating companies are fundamentally what drive long term growth. Real assets include tangibles ones such as manufacturing capacity and intangibles ones such as patents. Financial assets – claims on the real assets - are a mechanism to divide and distribute real asset value to diverse capital providers. The transactions in financial assets – such as venture capital intermediation and investment banking are activities that allow capital to flow into real assets.

In a well functioning market, intermediation should have very low premium. In the presence of current technologies, such as the Internet, that have the capability to efficiently connect real asset owners to capital providers, all premium in intermediation should tend toward zero. Why, then, are certain investment banks and venture capital intermediaries earn very high premium for their services – in some cases an order of magnitude higher than the real asset owners themselves? This is due to market failures.

In investment banking, one form of market failure is monopoly power. Before the financial crisis, regulators identified “special firms,” and gave them exceptions to lever up 3 times more than other commonplace firms. Armed with the leverage, they have been able to effectively dictate the terms of the design of financial instruments – in some cases almost disconnected from the underlying real assets. Some were so smart as to create value from thin air – by creating derivatives without an appropriate underlying asset. Such smartness, however, was short lived and needed a taxpayer bailout. After the crisis, the surviving firms in this category now wield monopoly power much higher than what existed before. There is no reason to believe they will change any of their past behavior. This is a clear market failure.

In venture capital intermediation, the intermediaries have created many information and entry barriers for new entrants, perpetuating the market failure. They have also been able to establish “conventions,” that block new entrants from securing capital to sufficient scale. Financial meltdown has scared many capital providers as they flock to “experts,” with long track records, regardless of performance. So, the financial crisis has reinforced the existing market failures in private equity and venture capital.

Financial intermediation is an activity that siphons away significant parts of the value of the real assets to the intermediaries. This destroys societal value and dampens innovation and overall growth in the economy. Growth in financial intermediation is not a “good thing” for the economy as proposed by policy makers and the intermediaries themselves. Good policies should attempt to drive the premium in highly inefficient financial intermediation to zero by removing market failures and imposing a tax commensurate to the loss to society while relieving marginal taxes for the owners and creators of real assets. This will grow the economy faster and increase overall societal utility.