What is wrong with Western banking?

I said in an earlier post that the banking sector needed to shrink. And I promised an explanation of this. Well here it is.

According to the BEA's figures, in 1987, the contribution of the banking and insurance industries to national GDP was 5.79%. In 1997 it was 7.17%. In 2007 it was 8%. The financial sector is becoming a larger and larger part of the US economy.

This shouldn't be the case. The wider economic value of the banking sector (yes there is one!) is in the efficiency it creates in the allocation of capital. A working financial system channels money to those parts of the economy where it provides the greatest return on capital. Banking does this by facilitating direct investment; insurance does it by turning small, catastrophic risks into more likely but less impacting ones, making returns more predictable and thereby encouraging investment.

But the point is that finance doesn't produce capital; It allows it to be employed more efficiently. So if the financial sector were improving - rather than simply growing - you would expect it to become a smaller part of the economy over time rather than a larger one as it became a more efficient mechanism for deploying capital. Even in good times you would expect, if not absolute contraction, then certainly to see finance becoming a smaller and smaller proportion of overall GDP.

How has Western finance escaped this reckoning?

The first ploy is simply by leveraging 'beta'. The economy has been growing. By borrowing and investing you can make money as long as things keep going up. Things go up, you go up faster. The flipside is of course that you go down faster too. The simplicity of this ploy has largely been disguised by developing increasingly complex and opaque derivatives.

As an aside, contrary to reports in the press, derivatives are not intrinsically ruinous. They are by definition a zero sum game. If one counterparty loses money, it is only because someone else has made it. But by and large, they are a not much more than a punt on the markets. As such, they don't (intrinsically) really help to realise the macroeconomic efficiencies in capital allocation I mentioned before. And the more exotic and complex they are, the more opaque and illiquid they become, and arguably the less efficiently they allocate capital. And banks have devoted a lot of resources to developing, trading and hedging these things. This represents an abandonment of the core purpose of finance and a failure to create a macroeconomic return in capital efficiency.

Derivatives can, I believe, create liquidity and enhance capital allocation, but to do so they must be simple, transparent and not generate long-term counterparty risk. Creating ever more complex, bespoke, over-the-counter products rather than moving derivative markets onto exchanges represented a move in the wrong direction for the financial sector.

To return to the main thread: The other, more significant, engine for the imploded growth of the financial sector was charging what were effectively brokerage fees for the supply of credit to the consumerist West. It hardly needs to be said, but consumption on credit is a really bad idea. It is fundamental misallocation of capital. It produces no return at all. The mechanism is opaque but by now well studied. I won't bore you with yet another essay on the bursting of the property bubble.

But a consideration of how banking went wrong wil be vital once the dust has settled. It is clear that the cost of their catastrophic failure is society's loss confidence in Big Finance to manage the economy. It was of course always suspect to imagine that a regime run for the self-interest of employees and shareholders would, in the long run, prove more competent than a political establishment accountable to population at large. But in future, the banks will be subject to a lot more government regulation - and rightly so. What is vital is that government regulation is well thought out and intended to realise the value of a well functioning financial sector as well as just curbing the excesses. That means it needs to be about realising efficiencies, promoting transparency and liquidity, formed around principle rather than bureaucracy. This will be a difficult thing to accomplish.