Lorenzo Bini Smaghi: Has the financial sector grown too big?
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Nomura Seminar "The paradigm shift after the financial crisis", Kyoto,
15 April 2010.
* * *
Introduction
I would like to thank Nomura for inviting me at this conference in this historical and
prestigious city of Kyoto. I am particularly happy to be here today for at least two reasons.
First it gives me the opportunity to finally deliver a speech at a Nomura Conference, after my
previously failed attempt, in October 2006 when I was unable to deliver my prepared speech,
because of a knee surgery. In that speech which I ultimately sent to the organisers to be
distributed to the participants (the title was: "Three Questions on Monetary Tightening") I
asked the following three questions related to the process that central banks have to go
through in tightening monetary policy: When to start tightening? At what speed tighten?
When to stop tightening?
Less than four years later, after having gone through a full tightening and loosening cycle
these questions might still look pertinent. I looked back at what I was writing at that time
concerning the answer to the first question, i.e. when to start tightening monetary policy. I
made at that time three recommendations:
1. Don't wait too long, especially if the signs of recovery are apparent and interest
rates are at very low levels. The sooner tightening starts, the less tightening might
be needed later on.
2. To be sure, don't wait to see inflation rising before raising rates. It will be too late.
3. Use a wide set of indicators and arguments to explain to market participants and the
public at large why tightening is needed. Money and credit aggregates, asset prices
and the level of interest rates might be useful indicators of why the time has come to
reduce accommodation.
I leave it to you to judge how valid these recommendations are for the current conjuncture.
The second reason for being pleased to be here today is that I am back in this beautiful city
nearly after ten years. In May 2000 I attended a meeting of the G7 deputies, preparing for the
Okinawa Summit in July that year. Among the participants whom you might know were
Haruhiko Kuroda, from the Japanese Finance Ministry (now President of the Asian
Development Bank), and Tim Geithner, at that time US Finance deputy. I was attending as
Italian Finance deputy.
The discussion in those days was largely focussed on strengthening the financial
architecture after the 1997 Asian crisis. The focus was very much on strengthening the
resilience of Emerging Markets in order to equip them for a possible next crisis. The other
main focus was debt forgiveness for the poorest countries. Looking back to that work
agenda, it seems to me that much has been achieved in these countries. Where we have
been slightly less performing is in our own financial systems. The implementation of the
reform agenda agreed at the Cologne summit, in June 1999, concerning the advanced
economies has been disappointing.
Let me quote parts of the report of the G7 Finance Ministers to the Cologne Summit:
"The past two years have reminded us that investors and creditors often tend to
underestimate risks as they reach for higher yields. In periods of market euphoria, market
participants can make credit and investment decisions that might not otherwise have been
made. In hindsight, the failures on the part of lenders and supervisors in the major countries
include poor risk management practices, inadequate information as well as inadequate
attention to available information, and capital standards that provide unintended incentives to
lend to risky borrowers. Such excessive risk taking, combined with high degrees of leverage,
can magnify the negative effects of any event or series of events."
Doesn't it sound familiar? The risks inherent in financial markets were well known ten years
ago. The problem was in identifying the right remedies. Let me read the part on
recommendations:
"Measures to induce creditors and investors to act with greater discipline (i.e., to analyse and
weigh risks appropriately in their lending and investment decisions), should aim at avoiding
excessive leverage and encouraging more prudent assessment of the risks associated with
lending to .....
emerging markets!"
The main concern ten years ago was that the international financial system would be put
under stress again by emerging markets, not by the core of the system, as if the
underestimation of risks could not happen in advanced economies. We had to learn the hard
way that sophisticated financial markets are also prone to exuberance and contraction
phases which hamper their proper functioning. We thus have to ask ourselves some difficult
questions on how these markets can function better and better serve economic development.
Before getting to the main topic of my speech today, which concerns the size of financial
markets, let me say a few words about some recent events in European financial markets,
which may be of interest to you, also to underline how complex and sometimes irrational
these markets tend to behave.
Last week-end the euro area member states agreed on the procedure, mechanism and
financial amount to support Greece in its fiscal adjustment programme, with a defined burden
sharing mechanism and non-concessional pricing scheme. This will enable Greece to
implement its adjustment programme without loosing market access and ensuring a
sustainable burden of the debt.
This announcement makes it clear what the euro area authorities have said since many
months, i.e. that a scenario of default and exit from the euro area, which some market
participants and observers had toyed with, was simply absurd. The cost of such a doomed
scenario, on which not many have really thought thoroughly, is immensely larger than
implementing the adjustment that the Greek society has to do in any case. This has been
recognized not only by the Greek Government but also by its citizens.
If it was so obvious - one might ask - why wasn't the decision by the euro area countries
and the Greek government taken earlier? It is indeed a good question. The answer has much
to do with the political process and the time that it sometimes takes in our democracies to
take certain decisions. It took months for the Greek Government to realise that, in light of the
new data on the budget deficit, it had to backtrack from its election promises and reverse its
budgetary policy by 180 degrees. It took time for the other euro area governments to realise
that a support package was needed to ensure the credibility of the adjustment in the eyes of
financial markets.
While democracies need time to take decisions, financial markets act quickly, accelerating
their position-taking at any sign of indecision by the policy authorities. Furthermore, the
Lehman Brothers case shows that democracies are not always able to deliver the most
rational and efficient solution. Under certain circumstances it is thus rational for markets to
bet on the irrationality of the democratic decision-making process. It was irrational to let
Lehman Brothers fail, but it happened. Those who bet on that failure earned a substantial
amount of money. So why not bet on a possible irrationality of European decision-making?
European policy makers may have underestimated the self reinforcing nature of market
trends. If a speculative strategy based on a certain hypothesis, such as the default of
Greece, delivers capital gains over time - as has been the case since the fall of 2009 - it is
bound to attract an increasing number of investors. As a result, the market pressure
increases, making the hypothesis more realistic. The action needed to convince market
participants that the hypothesis is unrealistic and to stop the mounting speculative wave has
to be firm. Vague statements that some event, such as a default, will not occur, are not
sufficient to calm the markets. Concrete actions are needed. This was not fully understood
over the last few months.
But there is another element which might have been underestimated and needs to be further
considered in thinking about how our democracies can cope with certain financial market
developments. As an increasing number of investors take positions based on the same
hypothesis, their ability to influence the final outcome increases. The incentive to do all that is
needed to ensure that the outcome coincides with their underlying assumption is enhanced
by the substantial capital gain that these investors would obtain if their strategy is successful
and, conversely, the substantial loss they would suffer if their underlying hypothesis is not
realised. In other words, it is in the interest of those who bet on a sovereign default that
ultimately the country defaults. They have thus the incentive to do what is in their power to
induce the country to default. This applies not only to countries but also to individual
companies or financial institutions.
In a competitive financial market, with many players unrelated to each other, such incentives
do not necessarily create distortions. However, in markets characterised by conflict of
interest, collusive behaviour and lack of transparency, actions by individual agents may lead
to outcomes which do not reflect market efficiency and an optimal allocation of resources.
Just to give concrete examples of what may and has happened recently, we have seen
rating agencies not acting as rating agencies, when they stated that they had to wait for the
reaction of the markets before assessing whether the corrective measures taken by Greece
were sufficient to change their view. Market analysts and observers' views have been widely
publicised without revealing potential conflicts of interest, such as sitting in advisory boards
or acting as consultants for major investment houses or hedge funds. This above is not an
excuse for the slow decision making in the euro area, which is partly constrained by national
processes. But the fact that financial markets may take undue advantage of any sign of
weakness, using all instruments at their disposal to transform uncertainty into profit, has
been underestimated.
The agreement reached over the last week-end is very important and marks a key turning
point in the crisis. But this experience should now be used to create a more efficient decision
making process within the euro area aimed in particular at preventing similar situations from
occurring in the future and eventually at solving them more efficiently.
Let me turn now to the main topic of my speech today, which relates to the size of financial
systems. There is an emerging consensus that while financial markets are generally
conducive to economic growth, in the run-up to the recent crisis they were operating on an
excessive scale. While policy-makers' efforts to prevent a systemic meltdown and mitigate
the negative impact on the real economy after the bubble burst have been largely successful,
the crisis caused the deepest recession since the 1930s, and imposed large fiscal and social
costs on economies throughout the world.
We need to re-examine our all-too-easy assumptions that a large financial sector invariably
benefits the real economy. We have to acknowledge that the financial sector, not to mention
some of its components, may sometimes become "too large". It can end up posing a threat to
both economic and financial stability, so we have to enhance our understanding of where the
optimal threshold lies. We also need to identify the regulatory measures that can address the
problem best: namely, preventing the financial industry from becoming too large and taking
excessive risks, leading to the emergence of bubbles, and to the proliferation of complex and
opaque financial instruments. And we should avoid imposing restrictive measures that will
prevent the financial sector from channelling resources towards productive opportunities. In
doing so, we need to make sure that our measures target non-traditional financial markets as
much as traditional banking, in order not to encourage regulatory arbitrage and a return to
"business as usual" outside the auspices of regulators.
Today my remarks will revolve around four main points. First, I will claim that efficient
financial markets enhance growth. However, if they grow "too large," then they may lead to a
misallocation of resources and cause costly crises. Second, I will present evidence showing
that in the build-up to the crisis, the size of the financial sector outgrew its trend. Third, I
identify some of the main reasons why this occurred and discuss how to avoid that such
imbalances materialise again. To this end, regulation and supervision can play an important
role. Fourth, while ensuring that the financial sector does not grow beyond its optimal size,
the new regulatory framework should not reach the point of financial repression.
1. The optimal size and role of the financial sector
The debate on the relationship between financial markets and the real economy habitually
occupies the intellectual space that exists between Joseph Schumpeter's insights into the
ability of well-developed financial systems to stimulate economic growth, and Joan
Robinson's observation that "where enterprise leads, finance follows".1 The experience of
recent decades from emerging as well as industrialised countries has mostly confirmed the
first claim, namely, that deeper financial markets improve economic efficiency, lead to a
better allocation of productive capital, and increase long-term economic growth. However,
the frequent financial shocks associated with dynamic financial industries, and in particular
the recent economic crisis, also highlight the role large financial markets play in downside
risk. This combined evidence implies that there is a trade-off between a highly vibrant
financial sector and the overall stability of the financial system. In fact, some scholars have
gone as far as to claim that financial instability can only be eliminated by restricting the same
productive forces which are responsible for long-term growth.2
What I will argue in this speech is that one aspect of the financial sector which can give us
key insights into this trade-off is its size. When reasonably large, financial markets promote
economic efficiency by identifying productive opportunities and transforming savings into the
investment necessary to finance those opportunities. However, when they become "too
large", relative to what is implied by economic fundamentals, problems like financial
complexity, poorly understood financial innovation, herding behaviour, and endogenous
risktaking - to name just a few - suddenly outweigh the benefits. The recent financial and
economic crisis is a stark example of that. The pre-crisis period was characterised by the
growing size, complexity and interconnectedness of financial markets, with subsequent
detrimental effects on the global economy. In order to address the problem, regulatory
measures are being taken to impose limits on the propensity of the financial sector to create
downside risk. But a fine balance needs to be reached: these measures must be effective but
not punitive; they need to address the crux of the problem without unduly limiting the ability of
financial markets to sustain economic growth.
In general, the gradual growth of the financial sector is driven by both structural and
conjunctural factors. On the one hand, higher relative productivity, resulting in higher profits
and wages, and the necessity to service ever increasing global savings are fundamental
reasons why the financial industry has gradually expanded. These are structural issues, and
they will hardly go away in the future - it is conceivable that emerging market economies will
keep exhibiting high savings rates, and thus large and efficient financial markets will be
required to service them. On the other hand, there are cyclical deviations from this trend,
driven by risk-taking, excessive leverage, the search for yield as well as the proliferation of
opaque financial instruments, among other things. It is therefore essential to think of the
optimal "threshold" beyond which the financial sector is "too large" - not in absolute terms,
but in terms of deviations from the trend. At such a point, the size of the financial industry
starts to become detached from what economic logic would imply.
Before I go into further detail on this front, it is perhaps useful to explain why we still need a
large and dynamic financial industry. In general, deep and efficient financial markets improve
economic performance both by raising the level of growth3 and by allocating productive
capital4 more efficiently, ultimately generating benefits for the society as a whole. Consider,
for example, the long-standing point in academic and policy discussions on the differences in
average GDP growth between the US and continental Europe. It has been suggested that
deeper financial markets across the Atlantic are to a large extent responsible for the larger
increases in productivity, the faster pace of industrial innovation, and the generally more
dynamic economy of the US compared with that of Europe. For example, deeper credit
markets probably account for the higher rate of business start-ups in the US. The difference
is especially visible when it comes to the financing of innovative ideas, where the much
larger US venture capital industry has been credited over the years with the emergence of
whole new industries and such innovative corporate giants as Microsoft, Cisco Systems,
Google (to name just a few). Out of the world's 500 largest companies, 26 American ones
have been founded since 1975, compared with only 3 European ones, showing a larger
turnover of industry leaders.5 These two aspects of "creative destruction" - new business
creation and innovation - are crucial when we come to think of why deeper financial markets
can benefit economic growth.
The same pattern is seen when we compare European economies. Econometric estimations
suggest that improvements in corporate governance, in the efficiency of legal systems in
resolving conflicts in financial transactions and in some structural features of the less
developed European banking sectors are all factors that are likely to help the financial
system reallocate capital faster from declining sectors to those with good growth potentials.6
In addition, recent ECB research has pointed to the fact that large differences persist among
European countries in terms of new business creation and patenting activity. It has
concluded that much of this difference can be attributed to the existence of more developed
credit markets and risk capital markets.7
All this evidence has led most financial economists to think of the relationship between
finance and growth as one in which "more is better". However, the recent crisis has revealed
that a financial sector which goes beyond a certain threshold (or breaking point) can harm
the economy and society as a whole. In particular, we have seen that an oversized financial
industry tends to exacerbate information asymmetries, moral hazard problems, and the hunt
for yield, leading to excessive risk-taking and over-leveraging of the system. The events of
2007-2008 suggest that when financial sectors are "too large", the allocation of resources
may become inefficient. Examples of such misallocation were abundant during the dot-com
expansion, when many high-tech projects of little value were generously financed. Numerous
examples of misallocation were associated with the credit growth of the early 2000s as well,
of which the expansion of the US sub-prime mortgage market is just the most obvious one.
We can think of examples in Europe too - for instance, growth in Spain relied for years on an
ever-expanding real estate sector fuelled by increasing borrowing.
Looking at specific market segments, there are plenty of examples showing the excesses of
the financial sector, and also illustrating the importance that the "shadow" banking system
has played in this crisis. For example, the growing use of securitisation by banks led to a
distinctly lax screening of loans.8 As a result, mortgage credit growth became disconnected
from both relative and absolute income growth in the sub-prime market.9 The crisis itself
started not as a traditional bank run on deposits, but as a securitized-banking run driven by
the withdrawal of repurchases ("repo") agreements from the balance sheets of investment
banks, which had been funding roughly half of their assets through repo markets.10
During financial bubbles, the search for yield intensifies, risk-taking is everywhere, and
leverage in the system may increase at unsustainable rates. The exponentially rising volume
of financial assets and transactions, especially by highly leveraged and interconnected
institutions, can increase financial instability. Shocks to the system can lead to fire sales and
asset price decreases, resulting in liquidity spirals and widespread bankruptcies.11
On the "real" side, the aftermath of the busts which follow unsustainable booms are
frequently associated with falling housing prices, collapsing equity prices, and lasting
declines in output and employment. Under certain circumstances, the negative impact on
potential output could be long-lasting rather than transitory (see Figure 1). In addition,
financial crises like the recent one tend to worsen the fiscal position of many countries.
Government debt explodes in the wake of banking crises, fuelled not so much by the cost of
recapitalising the banking systems but by collapsing tax revenue.12
As can be seen from this rather sketchy argumentation, the damage caused by "oversized"
financial markets can be quite substantial. But even if we are aware that there are limits to
the "optimal" size of financial markets, we still run into practical problems if we try to establish
the right "threshold", and research in this field has been very limited. Just a handful of
researchers in recent years have studied the non-linearities in the relationship between the
size of financial markets and economic growth using cross-country evidence13, and they
have concluded that at "too high" levels of finance, the effect of finance on growth
substantially weakens. But this line of research needs to be pursued much further,
incorporating the pre-crisis years, looking at various types of financial markets, and better
motivating our analysis in terms of theory.
Establishing an "optimal" threshold above which the size of the financial sector is harmful and
below which it is beneficial for society is much more complicated than identifying multiples
8
Keyes, B., Mukherjee, T., Seru, A., and V. Vig, 2010. Did securitization lead to lax screening? Evidence from
subprime loans. Quarterly Journal of Economics 125, 307-362.
9
Mian, A., and A. Sufi, 2009. The consequences of mortgage credit expansion: Evidence from the U.S.
mortgage default crisis. Quarterly Journal of Economics 124, 1449-1496.
10
Hordahl, P., and M. King, 2008. Developments in repo markets during the financial turmoil. BIS Quarterly
Review (December), 37-53.
11
Adrian, T., and H. Shin, 2010. Liquidity and Leverage. Journal of Financial Intermediation (forthcoming);
Brunermeier, M. and L. Pedersen, 2009. Market liquidity and funding liquidity. Review of Financial Studies 22,
2201-2238.
12
Reinhart, C., and K. Rogoff, 2009. The aftermath of financial crises. American Economic Review 99, 466-472.
13
Deidda, L., and B. Fattouh, 2002. Non-linearity between finance and growth. Economic Letters 74, 339-345;
Rioja, F., and N. Valev, 2004. Does one size fit all? A reexamination of the finance and growth relationship.
Journal of Development Economics 74, 429-447.
BIS Review 50/2010
that deviate from their long-run trends. While some parameters of financial markets - like
total loans outstanding, stock market capitalisation, or foreign financial flows - are relatively
easy to observe and quantify, many are not. The financial system consists of a number of
activities that do not necessarily involve credit expansion. Examples include proprietary
trading, or some of the activities which - especially in the US and the UK - investment
banks, broker dealers, hedge funds and the like have been engaged in.
That "the financial sector is too large" simply cannot be an absolute claim. While it is true
that, for example, financial sector employment as a share of total employment in the US has
doubled in the past 50 years, this may be an efficient development associated, for example,
with the necessity to manage ever increasing savings from booming East Asian countries like
China. Therefore, we can only make the claim that the financial sector is too big relative to a
certain well-defined benchmark. For instance, what is the size of financial markets beyond
which further enlargement leads to lower economic growth because of the emergence of
bubbles? Or to lower innovation because highly skilled labour is drawn away from the
R&D sector? Or to sub-optimal diversification because of herding by uninformed investors?
Recent research at the ECB has shown that while a deep financial sector leads to more
optimal economic diversification, when it becomes "too large", its contribution to
diversification is substantially weakened.14 And in an emerging strand of academic literature,
some authors have looked at such secondary measures of "financial market size" as
excessive profits. They have shown that excessive rents reaped by the financial industry lead
to increased risk-taking which can endogenously generate boom and bust episodes.15
Others have argued that high relative wages in the financial sector can lead to lower rates of
long-term economic growth by attracting "talent" away from the productive sectors of the
economy.16 Continuing work in this direction is critical, not as an abstract intellectual
exercise, but because of the very tangible negative consequences of a "too large" financial
sector, as recent experience has highlighted.
2. Facts
After discussing the negative consequences on financial stability and economic growth that a
"too large" financial sector can generate, in this section I will analyse available evidence to
show that the financial industry as a whole has grown to a sub-optimal size.
While illustrating this point, it is important to keep in mind the difference between a beneficial
long-term trend of gradual deepening of financial markets and the sizeable cyclical deviations
towards "too large" that were at the root of the recent crisis. Let us look first at one
development within the long-term trend. Figure 2 shows the development since WWII of a
very intuitive measure of US financial market "size", namely its share of value added,
compensation and employment. In the past 60 years, its share of GDP has almost
quadrupled, to 8%, and so has financial sector compensation as a share of total
compensation. Based on such shares in value added and total production for the 20 major
industrial countries, some observers have made the point - drafted before the outbreak of
the crisis - that financial instability may nowadays have more severe real effects than in the
past.17 And although the financial sector hasn't grown in terms of employment since the late
1980s, it is still more than twice as big as it was in the 1950s.
If we, however, choose to focus more on compensation, an interesting development can be
seen regarding financial sector wages relative to an economy-wide benchmark which
illustrates the cyclical component of the "too much finance" concept. Figure 3 shows data on
return to equity (ROE) for all domestic US and EU banks between 1994 and 2006. Clearly,
bank profitability has been rising gradually for quite some time. In the US, it has been an
average of 14% since the early 1990s, up from an average of 9% in the 1980s. And in
Europe, with the exception of the dot-com bust in the early 2000s, which was associated with
a fall in profitability, the return on equity increased from 7% in 1994 to almost 19% in 2006,
and in fact it doubled in only 5 years, between 2002 and 2006. Turning to another measure
of financial sector profit - average compensation - Figure 4 demonstrates that while on
average wages in the financial sector have been higher than average US non-farm wages
throughout the twentieth century, they have been higher by 30% only on two occasions
- prior to the Great Depression and during the 2000s. In that second period, financial sector
compensation actually decoupled from benchmark compensation by more than 40%. It is
important to note that this is not due to rising compensation in "traditional" financial sectors
like credit and insurance, but due to the large increase in compensation in non-traditional
financial activities like investment banks, hedge funds and the like (Figure 5). This is another
reason why any changes to the regulatory environment aimed at preventing systemic crises
in the future will have to deal not just with the traditional banking sector, but with the
so-called "shadow" banking sector as well.
Another troublesome parallel with the Great Depression is the level of credit market debt.
Figure 6 shows that during the twentieth century total credit market debt in the US was on
average around 1.5 times GDP, standing at 2.5 times GDP in the 1930s, and at 3.5 times
GDP in 2008. It is important to note the differences in the reason for this expansion: while in
the 1930s debt rose in order to combat the 25% unemployment rate in the US at the time, its
rise in the 1980s, 1990s and 2000s was unrelated to crisis management. Thus the
accumulation of pre-crisis credit market debt stands as a stark example of the downside of
financial market expansion.
Of course, these developments are not confined to the US. Figure 7 shows the evolution of
banking sector assets in the UK during the twentieth century. While they stood at around
50% of GDP until the 1970s, they rose to 300% by 2000, and to 550% by 2007. While part of
this development is a natural consequence of being an international financial centre, it is
difficult to justify such a dramatic expansion merely on the grounds of the rising importance
of finance as a tool to fuel growth. In addition, the explosion in the size of the financial sector
has posed major problems for regulators in the wake of the financial crisis, when they were
faced with addressing the systemic implications of very large, individual banks. For example,
in 2007 the liabilities of Barclays exceeded the UK's GDP, the liabilities of Deutsche Bank
stood at 80% of Germany's GDP, and the liabilities of Fortis were several times larger than
the GDP of its home country, Belgium.18 As some observers rather provocatively remarked,
such financial institutions may not just be "too big to fail", but in fact "too big to exist".19
These observations point to the fact that the expansion of the financial sector in the pre-crisis
years was not an Anglo-American phenomenon. Indeed, as Figure 8 demonstrates, only in
the past 20 years, the broad financial sectors (including real estate and business services) in
France and Germany have expanded by about 25% in terms of share of GDP. These
developments have been very similar in magnitude to the ones in the US and the UK. While
they may simply be part of the process of gradual financial deepening, they bring to mind a
similar financial sector expansion in Japan in the 1980s. As you will surely recall, by 1990 the
world's ten largest banking corporations were headquartered in Japan, and Japanese
branches and subsidiaries accounted for almost 20% of all commercial and industrial loans
to borrowers located in the US.20 This expansion is rivalled in magnitude only by the rapid
decline of Japanese banking overseas during the 1990s.
A crucial question in this respect is: to what degree was this worldwide expansion of finance,
preceding the recent crisis, driven by fundamentals? Part of this process was most certainly
associated with the growing global imbalances, fuelled by fast growth and a rapid
accumulation of savings in emerging markets, like China. As Figure 9 demonstrates, while in
the last 25 years the share of industrialised countries in world trade gradually declined, their
share in cross-border financial positions quickly increased. But growth rate gaps are just one
aspect of the story behind these uneven advances in trade and financial globalisation.
Another, perhaps more important, one was the fact that developed countries engaged in
rapid innovation in the