To Fix the Financial System, We Have to Stop Throwing Rocks at Windows

I’m writing this because I too often hear my friends who work at startups say terrible things about bankers, or those in finance, without holding the slightest clue about how the financial system actually works.

The world of finance is rife with issues, especially now, and the system is broken. But it’s more complicated than most might assume. It also doesn’t mean that everyone in finance is evil.

Statements I hear too often:

“Bankers just push money around”

“The world of finance is evil”

“People just work in finance to make money”

“I don’t want to do banking cause I want to do something meaningful with my life”

First, Let me Explain Banking

In a traditional investment bank such as JP Morgan there are a few types of people:

(1) Investment bankers—these guys help large companies raise major amounts of capital, go public, or restructure if distressed or facing bankruptcy. Example, if you are in a tech coverage or tech M&A group your job may be to help former tech startups raise a series D round, execute an acquisition or go public.

(2) Research analysts—These guys look at both macro and micro trends to try and predict where the world is going. They generate reports that help the rest of the bank determine valuations on companies, trading ideas, etc.

(3) S&T folks—The people on trading desks who watch public equity markets (basically the stock market) bond markets etc. and execute trades on behalf of the bank, or on behalf of clients such as hedge funds or other major institutions.

(4) The Risk team—these bankers spend their day watching the world operate and trying to predict where potential risk, exposure and danger may occur.

Investment banks are considered to be on the “sell side.” This means that they are pitching companies, trade ideas or companies to purchase to institutions on “the buy side.” For example, a private company like Survey Monkey might ask JP Morgan to go help them sell $400mm worth of shares. JP Morgan will run around to private equity firms, hedge funds or other major players and sell those shares on behalf of the Survey Monkey team, so that the CEO of the company can focus on operations without getting distracted.

This “selling of shares” is an example of why banks are on the “sell side.”

The “Buy Side”

This includes the following types of institutions:

Private Equity Firms: Kinda like venture capital firms except they commonly buy a majority % in companies at much later stages. Often they buy other types of assets as well, such as real estate.

Hedge funds: these things are weird. Hedge funds are firms that claim to buy a variety of assets that all hedge each other, guaranteeing gains. Hedge funds differ heavily from one another—some try to do high frequency trading to expose arbitrage, while others even have VC arms as well as buy commodities.

Endowments: big pools of money universities have that they invest in various asset classes so that they don’t constantly hold a bunch of cash in the bank (getting no return).

Pension Funds: Where your retirement money is. You might not even want to know about some of the kind of stuff your money might be invested in without you knowing it (guns, porn etc.)

This Stuff is Important, and Hard:

Your friends in finance may be taking companies you’ve heard of, public. They may have been saving American Airlines this year, pitching Twitter stock to institutional investors or investing in Detroit housing.

So Where do Things Go Wrong?

A lot of it comes down to incentives. More examples:

Investment banks make more money, the higher they price a stock at an IPO event: This means they’ll do their best to oversell a company if they can get away with it. Their reports are biased… much like your pitch deck would be biased while raising venture capital. The difference is your $5mm series A round is too small to put a huge dent in the universe yet.

Short time horizons: imagine a hedge fund raises $10B from investors, but has to return they money in 7 years. 2 years into the fund they purchase stock in Barnes N Nobles. Such a purchase is a long-term play. It will take Barnes N Nobles a long time to redefine itself—the problem is that the hedge fund only has 5 years to see a material return, so will rush the process and act in the best favor of its investors, not in the welfare of operations.

Traders on sales desks often execute multiple trades per day, and they have even shorter time horizons: Much like voters in political elections, they often react too strongly to sound bites than to actual logic.

Managers of these firms are under immense pressure to exhibit positive returns. Otherwise they won’t be able to raise more money. This means that too often numbers get manipulated by a few really bad people, and this reflects poorly on everybody else.

The people in finance often have tons of money, and use this money to “donate” to election campaigns: This forces political figures to listen when their major constituents have needs that directly benefit their companies, but may present negative repercussions on the general economy.

Firms are often “over-leveraged:” This means they can invest $1B and borrow $39B to buy something for $40B. If the $40B purchase returns a 10% increase than the fund returns $4B on a $1B purchase enabled by leverage. But if things go wrong, a firm may owe billions it doesn’t even have.

And many more issues… these are just the tip of the iceberg.

Conclusion

Banks are important, and some of my best friends work in them. The same goes for private equity, hedge funds etc. While there are many issues with the current financial system, throwing rocks at the windows and making blanket statements isn’t helping.

I encourage everyone to learn more, and present specific solutions to specific cases. Only then will the system improve, and will we be able to have an intelligent dialogue.