Nov 23 2011

Just what is the economic contribution of banks?

Posted by: Nick Shaxson in: Thoughts

From the FT:

Bankers’ efforts to water down tougher new regulations by claiming they will harm economic growth are “intellectually dishonest and potentially damaging” and could inspire an even more robust crackdown, a leading UK regulator has warned. “A profession which should stand for integrity and prudence now supports a lobbying strategy that exploits misunderstanding and fear,” said Robert Jenkins, who was named in July to the 11-member Financial Policy Committee, a new body charged with protecting financial stability.

Intellectually dishonest – don’t we just know it! And that’s interesting enough that someone in his position should say it.

But there’s another article just out co-authored by the one and only Andrew Haldane, of the Bank of England, which is a must-read for anyone wanting to understand the economic contribution of the financial sector. Crucially, the article does not seek to assess the damage from the financial crisis, but looks at the financial sector’s contribution in normal times. The headline quote is this:

As currently measured . . . it seems likely that the value of financial intermediation services is significantly overstated in the national accounts.

Conventionally measured, the financial sector’s contribution in the U.S. has risen fourfold to 8% of GDP since the Second World War, compared to 10% in the UK. In addition, returns on equity capital were extremely high.

What lies behind the financial sector’s contribution to GDP?

High pre-crisis returns to banking . . . . reflected simply increased risk-taking across the sector. . . . a traverse up the high-wire of risk and return.

And then the question:

In what sense is increased risk-taking by banks a value-added service for the economy at large? In short, it is not. . . .bearing risk is not, by itself, a productive activity.”

Duh, well, yeah. As he explains, managing risk can be a valuable productive activity – banks using labour and capital to screen borrowers, assess their creditworthiness and monitor them, and so on. But taking on risk into the bank’s balance sheet is not productive. And here lies a measurement problem:

The current framework for measuring the contribution of financial intermediaries captures few of these subtleties. Crucially, it blurs the distinction between risk-bearing and risk management. Revenues that banks earn as compensation for risk-bearing . . .  are accounted for as output by the banking sector.

But it isn’t, of course, real output. It is merely increased returns entirely offset by the increased risks (often borne by taxpayers or others elsewhere.) The upshot, they continue, is a potentially significant over-estimation of the valued-added of the financial sector.

The size of this effect is potentially very large.

He cites studies suggesting just how large – 25-40%, one study has it. But it may be worse.

Indeed, a banking system that does not accurately assess and price risk could even be thought to subtract value from the economy.

And there’s that other thing, which we all know about. The taxpayer subsidy to banks, helping them take risks, which he has estimated elsewhere. And this is a humdinger, of course:

Elsewhere, we have sought to estimate those implicit subsidies to banking arising from its too big-to-fail status. For the largest 25 or so global banks, the average annual subsidy between 2007-2010 was hundreds of billions of dollars; on some estimates it was over $1 trillion (Haldane 2011). This compares with average annual profitability of the largest global banks of about $170 billion per annum in the five years ahead of the crisis.


I spent the year from about 1992-2007 researching the phenomenon of the Resource Curse in oil-rich countries in West Africa, where hundreds of billions of dollars in financial inflows didn’t seem to have done these countries any damn good at all. In fact, it was not hard to construct an argument saying that many if not most of them were even worse off than if they hadn’t discovered any of the black stuff. The Resource Curse is firmly established in academic circles; it is considered indisputable in fact (although there is some disagreement as to its degree, in the case of different countries.)

Now we all need finance – to get money out of our ATMs, or to finance business start-ups, or whatever. But we only need finance up to a point. I would argue that we have gone way, way, past that point. My experience shows me beyond and doubt that most (although not all) of the factors that drive the Resource Curse seem to apply in the case of finance-dependent economies. The time is coming to to start talking about the Finance Curse. More on this soon.

3 comments so far

Jonah 11rd November, 2011 4.37 pm

“Finance Curse” is very apt, looking forward to reading how you expand on it. Are there any studies on the set of resource rich developing countries that look for correlations between degree of resource curse and degree of off-shore capture? Are there any clear cases of resource cursed countries where no or almost no off-shore shenanigans occur?

[…] Zombie Economics – a term popularised by John Quiggin and by Paul Krugman to describe economic theories that have been thoroughly discredited by experience in the real world, yet refuse to die. “The strange triumph of failed ideas. Free-market fundamentalists have been wrong about everything — yet they now dominate the political scene more thoroughly than ever.” (Nowhere are the lies thicker than in banking.) […]

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