Financial Innovation

Financial Innovation

As the Thanksgiving holiday is here, you'll have plenty of time to read a fascinating article published in The New Yorker entitled "What Good is Wall Street." It's a long, well-written article that is eye opening in many ways.

The basic point of the article is that much of what passes for banking in the large financial institutions such as Citigroup, Morgan Stanley, and JP Morgan Chase, does nothing to further the economy or the social good of the US. Rather, it serves only to increase the profits of the banks and profit their shareholders.

Of course, at Rich Dad, we've been saying this for years.

What surprises me is not the news that banks are selfish and will find any way to increase their profits but that people still think that banks ever had a desire—or even a responsibility—to exist for the social good. But that's another blog for another day.

According to the article's author, John Cassidy, "In effect, many of the big banks have turned themselves from businesses whose profit rose and fell with the capital-raising needs of their clients into immense trading houses whose fortunes depend on their ability to exploit day-to-day movements in the markets. Because trading has become so central to their business, the big banks are forever trying to invent new financial products that they can sell but that their competitors, at least for the moment, cannot."

The argument is that traditional banking was the financing of clients for new businesses and investment deals. This financing was good for society and thus "good banking" because it helped grease the wheels of an economy that produced tangible goods like computers, cars, houses, and more.

All this changed with the repeal of the Glass-Steagall act in 1999, which allowed traditional banks to own investment banks and blurred the lines between investment banking and traditional banking. This is something I wrote extensively about in my book, Conspiracy of the Rich: The 8 New Rules of Money.

Essentially, the repeal of Glass-Steagall paved the way for financial firms like Citigroup and set the foundations for the economic crisis by allowing such firms to undertake incredibly risky trading programs that ballooned their bottom line while making the institutions too-big-to-fail and shifting the risks of their trading activities to shareholders and the US taxpayer.

A major consequence of the unholy marriage between traditional banks and investment banks was the invention of "sophisticated" financial trading tools such as CDO's and other derivatives, which Warren Buffet has called financial bombs of mass destruction. These new financial products, created for the purpose of trading, are what are collectively referred to as financial innovation, meaning banks are creatively thinking up new ways to exploit markets for huge profits, often creating nothing tangibly good for society but reaping huge profits for their bottom line and for shareholders.

Ben Bernanke has commented on this financial innovation, saying that it "isn't always a good thing" and that they are often used "to take unfair advantage rather than create a more efficient market."

The use of the phrase "unfair advantage" by Ben Bernanke is apt since it's the title of my upcoming book, Unfair Advantage: The Power of a Financial Education. While I thank Mr. Bernanke for his unintended endorsement of my book, I laugh at the fact that somehow he would speak out against financial innovation since the Fed exists for the sole benefit of the banking industry. Let it be clear that the Fed is only concerned about market efficiency so long as it ensures huge profits for the banking industry and Wall Street. The Federal Reserve Bank, which is neither a government institution nor a bank but rather a banking cartel, doesn't care about social good—they care about a rich banking system.

So, while Mr. Bernanke gives lip service to the dangers of banks profiting greatly from trading, the Fed and the big banks' actions speak louder than his words. For instance, sixty-three percent of Goldman Sachs' revenue between July and September of this year came from trading, and Citigroup's investment arm accounts two-thirds of its net profits. This despite government efforts to curb the big banks' trading activities.

Why is trading so dangerous?

Trading causes banks to follow trends and capitalize on bubbles, making them worse, and moving money into industries ready to pop and crash rather than financing true innovation.

Financial innovation while bad for the economy is great for the banks and the ultra-rich. Because they know how money works, they're able to profit greatly while the average investor gets decimated. They are able to utilize their unfair advantage to get rich even in times of crisis. Often times, big banks and the ultra-rich reap huge profits leaving behind a devastating wake of economic destruction behind them. And if they make a mistake? The government bails them out. To this day, the US taxpayer is the single largest shareholder of Citigroup.

The only way banks make these huge profits is by taking on huge amounts of risk. Thankfully for the too-big-to-fail financial institutions, they can take on these huge amounts of risk and pass that risk onto the taxpayer in the form of bailouts when they fail while reaping huge profits when they succeed.

Today, big banks and financial institutions, the very core of the financial crisis, are flush with cash and ramping up their trading activities again while throwing up the smoke screen of a return to "responsible banking", if there ever was such a thing. In many cases, big banks are finding ways around rules that are meant to stop them from trading in ways that don't directly benefit the economy.

Nothing New

At the end of the day, none of this is news. As the old proverb goes, "There is nothing new under the sun." The history of humanity is one those with knowledge and power working to exploit those who are ignorant and powerless.

Big banks and the ultra-rich will not stop trying to use their unfair advantage, their financial education, to capitalize on the financially ignorant. No amount of regulation will stop their activities. Why? Because they can and will always be financially innovative. They understand how money works and how to make money work for them.

This week, as you celebrate the Thanksgiving holiday, be thankful of this: you can create your own unfair advantage.

You don't have to be a victim of the financially intelligent. You can be financially intelligent as well. We live in a country that gives unlimited access and opportunity to those who are willing to put in the hard work and effort.

Today, take advantage of the freedom you have to increase your financial education and apply it to create your own unfair advantage. It will be the best investment you've ever made—and your family will thank you for generations to come.

Happy Thanksgiving.


Original publish date: November 30, 2010