Putting Finance to Work for the Real Economy: The Next Reform
Finance is a service industry, but in the past three decades it seems to have gone its own way.
The functions of the finance sector are to protect property rights for the real sector, improve resource allocation, reduce transaction costs, help manage risks and help discipline borrowers. Financial intermediaries are agents of the real sector. Bankers were traditionally among the most trusted members of the community because they looked after other people’s money.
The divide between bankers and their customers (the real sector) is epitomised by a recent report that the mantra of a large British bank is about “increasing share of wallet of existing customers” . It recalls Woody Allen’s joke that the job of his stockbroker was to manage his money until it was all gone. And despite what bankers say, a lot more would have gone between 2007 and 2009 (I) without massive bailouts from the public purse.
The heart of the problem is the principal-agent relationship, where trust is everything. The real sector (“the principal”) trusts the finance sector to manage its savings and the banks, as agents, have a fiduciary duty to their customers. Agency business is a big public utility because the intermediary does not take risks, which are those of his customers. All this changed when the drive for short-term profits pushed banks more and more into proprietary trading for their own profits. All this was in the name of capital efficiency, a misnomer for increasing leverage.
In the past 30 years, with growth in technology and financial innovation, finance morphed from being a service agent to a self-serving principal that is larger than the real sector itself. The total size of financial assets (stock market capitalisation, debt market outstanding and bank assets, excluding derivatives) has grown dramatically from 108 per cent of global GDP in 1980 to over 400 per cent by 2009 (II) . If the notional value of all derivative contracts were included, finance would be roughly 16 times the size of the global real sector, as measured by GDP. The agent now dwarfs the real sector in economic and, some say, political power.
Can finance be a perpetual profit machine that makes more money than the real sector? In the US, finance’s share of total corporate profits grew from 10 per cent in the early 1980s to 40 per cent in 2006 (III) . Since wages and bonuses make up between 30 to 70 per cent of financial sector costs, there are tremendous incentives to generate short-term profits at higher risk, particularly through leverage.
The key thrusts of the post-crisis reforms in the financial sector are: caps on leverage, strengthened capital and liquidity, more transparency in linking remuneration with risks, and a macro-prudential and counter-cyclical approach to systemic risks. What the current reforms have not addressed is the increasing concentration of the finance industry at the global level and increasing political power that may sow the seeds for another Too Big To Fail (TBTF) failure in the next crisis.
In 2008, the 25 largest banks in the world accounted for US$44.7 trillion in assets(IV) – equivalent to 73 per cent of global GDP and 42.7 per cent of total global banking assets . In 1990, none of the top 25 banks had total assets larger than their “‘home”’ GDP. By 2008, there were seven (V) , with more than half of the 25 banks having assets larger than 50 per cent of their “home” GDP. Post-crisis, the concentration level has increased as there were mergers with failed institutions. With this rate of growth and concentration, the largest global financial institutions simply outgrew the ability of their host nations and the global regulatory structure to underwrite and supervise them. Such concentration of wealth and power is a political issue, not a regulatory one.
Finance is not independent of the real sector, but interdependent upon the real sector. It is a pivotal amplifier of the underlying weaknesses in the real sector that led to the financial crisis – over-consumption, over-leverage and bad governance. In the past 30 years, the finance sector has helped print money, encouraging its customers and itself (particularly through shadow banking) to take on more leverage in the search for yield. Instead of exercising discipline over borrowers and investors, it did not exercise discipline over its own leverage and risks. Unfortunately, there was also supervisory failure. To bail out the financial sector from its own mistakes, advanced countries, already burdened by rising welfare expenses, have doubled their fiscal deficits to over 100 per cent of GDP.
In spite of these trends, we should not demonise finance or blame the regulators, but examine the real structural and systemic issues facing the world and how should finance respond.
The greatest opportunity for finance is the rise of the emerging markets. An additional one billion in the working population and middle class over the next two-to-three decades will have more to spend and more to invest. At the same time, the world needs to address the massive stress on natural resources arising from new consumption, which is likely to be three times current levels. Ecologically, financially and politically, the present model of overconsumption funded by over-concentrated leverage is unsustainable. Indeed, to replicate the existing unsustainable financial model in the emerging markets may invite a bigger global crisis. Sustainable finance hinges on sustainable business and on a more inclusive, greener, sustainable environment. Financial leaders need to address a world where consumption and investment will fundamentally change.
To arrive at a greener and more inclusive, sustainable world, there will be profound changes in lifestyles, with greener products, supply chains and distribution channels. Social networking is changing consumer and investor feedback so that industry, including finance, will become more networked and more attuned to demographic and demand changes. As community leaders, finance should lead that drive for a more inclusive, sustainable future.
The greatest transformation of the financial sector is less likely to be driven by regulation than by the enlightened self-interest of the financial community. Only when trust is restored, when finance cannot thrive independently of the real sector, will we have sustainable finance.
The incentive issues are very clear. If financial engineers are paid far more than green engineers, will a green economy emerge first or asset bubbles?
I. Patrick Jenkins and Sahrlene Goff, “Relief as Lloyds releases upbeat review”, The Financial Times, June 30, 2011.
II. Estimates based on McKinsey Global Institute, “Global Capital Markets: Entering a New Era” (2009) and International Monetary Fund, “Global Financial Stability Report” (April 2010)
III. The Economist, “What Went Wrong”, March 19, 2008
IV. International Monetary Fund (op cit)
V. JPMorgan, “Global Banks – Too Big to Fail”, February 17, 2010