Cream skimming in financial markets∗

We propose a model where investors may choose to acquire costly information that identifies good assets and purchase these assets in opaque (OTC) markets. Uninformed investors access an asset pool that has been cream-skimmed by informed investors. When the quality composition of assets for sale is fixed there is too much information acquisition and the financial industry extracts excessive rents. In the presence of moral hazard in origination, the social value of information varies inversely with information acquisition. Low quality origination is associated with large rents in the financial sector. Equilibrium acquisition of information is generically inefficient. ∗This article was previously circulated under the title “Is the Financial Sector too Big?” We thank seminar participants at the Bank of Spain, Cambridge University, CEMFI, EHESS, HEC-Paris, HKUST, INSEAD, London Business School, London School of Economics, MIT-Sloan, Rochester, Rutgers Business School, Studienzentrum Gerzensee, Toulouse School of Economics, University of Virginia-McIntire, Washington University-Olin Business School, Wharton, and the 6th Banco de Portugal Conference on Monetary Economics for their feedback and suggestions. We also thank Guido Lorenzoni and Marzena Rostek for detailed comments and Rishab Guha and Linan Qiu for research assistance. This paper was awarded the IV Jaime Fernández Araoz Prize. What does the financial industry add to the real economy? What is the optimal organization of financial markets, and how much talent is required in the financial industry? We revisit these fundamental questions in light of recent events and criticisms of the financial industry. The core issue underlying these questions is whether the financial industry extracts excessively high rents from the provision of financial services and whether these rents attract too much talent.1 Figure V Panel B from (Philippon and Reshef, 2012, p. 1569) plots the evolution of US wages (relative to average non-farm wages) for three subsegments of the finance services industry: credit, insurance and ‘other finance.’ ‘Credit’ refers to banks, S&Ls, and other similar institutions, ‘insurance’ to life and P&C insurers, and ‘other finance’ to the financial investment industry and investment banks. The most remarkable finding is that the bulk of the growth in remuneration in the financial industry took place in the ‘other finance’ sector. In this paper we attempt to explain the outsize remuneration in this latter sector by modeling a financial industry that is composed of two sectors: an organized, regulated, standardized, and transparent market where most retail (‘plain vanilla’) transactions take place, and an informal, opaque sector, where informed professional investors trade and ‘bespoke’ services are offered to clients. We refer to the transparent, standardized, markets as organized exchanges and call the opaque sector the over-the-counter (OTC) sector even though in practice not all OTC markets are opaque (e.g. markets for foreign exchange are quite transparent). A central idea we develop is that although OTC markets provide special valuation services to sellers of securities, their opacity also allows informed dealers to extract informational rents. What is more, OTC markets cannibalize organized exchanges by ‘cream-skimming ’ the juiciest deals away from retail investors.2 What is worse, informed investors don’t just get access to the best assets but they also benefit from the cream-skimming activities of other informed dealers which help them extract better terms from the asset sellers. The reason is that cream skimming worsens the quality of the pool of assets flowing into the exchange, thereby lowering the price a seller of a good asset can obtain in the exchange as an outside option. This is how informed dealers are able to extract outsize terms from the sellers of good assets. Cream-skimming and outsize remuneration are two sides of the same coin. Moreover, the outsize informational rents in OTC markets attract talent to the financial industry, thereby enhancing the cream-skimming externality and further increasing the information rents extracted by informed dealers. In this way, growth in OTC markets does not lead to the dissipation of these