Do Financial Services Create Value?
The short answer? Not really...
January 23, 2012
Thus Occupy Wall Street protestors decried banks that had been bailed out, yet still handed out lavish bonuses to their own employees. This, for them, was evidence of neo-liberalism and financialisation, which guts the truly productive economy in favour of speculation.
More latterly, the Tea Party has warmed up to the theme: private equity makes money by firing workers. At least that’s what one might assume from a recent political video disparaging Republican candidate Mitt Romney, once a prominent leveraged buyout specialist, now the Snidely Whiplash-like King of Bain.
Which leads to an obvious question: do financial services create value? Certainly the academic wisdom has come under fire. In the two decades leading to the Great Recession, academics had mostly converged on Schumpeter’s view that well-developed financial systems play a crucial role in stimulating economic growth. … In fact, the body of empirical evidence linking causally and positively the depth of financial markets to growth was growing so rapidly that in 2003, in a discussion of a survey on the subject, one author was prompted to conclude that “…In 1993 many people doubted that there was a relation between finance and growth; now very few do.”
That’s from a paper, “On the tradeoff between growth and stability: The role of financial markets,” written for the VoxEu website by Alexander Popov and Frank Smets at the European Central Bank. It’s one of a series of papers VoxEu has published.
The absence of financial intermediation certainly has an impact and is, perhaps, key in the prolongation of the slump.
“At this stage of a normal recession, output would be about 5% above its pre-crisis level. Today, in the UK, it remains about 3.5% below. So this much is clear: Starved of the services of the financial sector, the real economy cannot recuperate quickly,” note Andrew G. Haldane and Vasileios Madouros at the Bank of England.
“But that does not answer the question of what positive contribution finance makes in normal, non-recessionary states. This is an altogether murkier picture. Even in concept, there is little clarity about the services that banks provide to customers, much less whether statisticians are correctly measuring those services.2 As currently measured, however, it seems likely that the value of financial intermediation services is significantly overstated in the national accounts …”
Explains Christina Wang, an economist at the Federal Reserve Bank of Boston: “In particular, how much of the income received by financial institutions is compensation for actual services provided to their customers and how much is merely for taking on risk, such as funding risky loans with short-term borrowing?”
The former is valuable; the latter a passive activity whose profits stem from leverage. But, she says, it is hard to separate the two activities.
“This is primarily because they often do not charge explicitly for services. Instead, they earn a spread between the interest rates received and the rates paid, as well as fees for writing derivatives contracts such as options and swaps. But earning interest is not in and of itself a productive activity that contributes to GDP. This is obviously sensible in the case of passive investors who buy market securities and then merely receive interest or dividends without producing new goods or services.”
Instead, she argues that ‘[t]he basic logic of the method for inferring the value added of bank services is intuitive. First, consider cases where a bank performs a transaction that earns it interest or fees, such as making a loan or underwriting a derivatives contract. We can ascertain what the bank would have to pay (in terms of either interest or fees) to purchase in the market a financial instrument of the same risk characteristics. Subtracting the value of, or interest on, the comparable market security from total income allows one to infer the implicit revenue the bank earns for services above and beyond investing passively in market securities. An analogous adjustment applies for transactions on which banks pay rather than receive interest or fees, such as those related to depositors.”
As a result she concludes that, “[m]aking conservative assumptions, we show that the current official method overestimates the service output of the commercial banking industry by at least 21% (amounting to $116.8 billion in 2007:Q4 for example) and GDP by 0.3% ($52.9 billion in 2007:Q4 for example) between 1997 and 2007.”
Outside the U.S., Haldane and Madouros come to a similar conclusion.
“The headline national accounts numbers point to a significant contribution of the financial sector to the economy. For the US, the value-added of financial intermediaries was about $1.2 trillion in 2010 – equivalent to 8% of total GDP. In the UK, the value-added of finance was around 10% of GDP in 2009. The trends over time are even more striking. For example, they suggest that the contribution of the financial sector to GDP in the US has increased almost fourfold since the Second World War. At face value, these trends would be consistent with large productivity gains in finance.”
In fact, however, the productivity gains seem illusory.
“But crisis experience has challenged this narrative. High pre-crisis returns in the financial sector proved temporary. The return on tangible equity in UK banking fell from levels of 25%+ in 2006 to – 29% in 2008. Many financial institutions around the world found themselves calling on the authorities, in enormous size, to help manage their solvency and liquidity risk. That fall from grace, and the resulting ballooning of risk, sits uneasily with a pre-crisis story of a shift in the technological frontier of banks’ risk management.
“In fact, high pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector. This was not an outward shift in the portfolio possibility set of finance.”
More intriguingly, adds Thomas Phillippon, a professor at the Stern School of Business in New York:
“The cost of intermediation in the US is between 1.3% and 2.3% over 130 years. However, the finance cost index has been trending upward, especially since the 1970s. This is counter-intuitive. If anything, the technological development of the past 40 years – in IT in particular – should have disproportionately increased efficiency in the finance industry. How is it possible for today’s finance industry not to be significantly more efficient than the finance industry of John Pierpont Morgan?”
His answer: excessive trading, as a result of which “the finance industry’s share of GDP is about 2 percentage points higher than it needs to be and this would represent an annual misallocation of resources of about $280 billion for the US alone. “