growth, edited by aghion & steven durlauf. king & levine ( 1993 ), finance and growth, schumpeter might be right, quarterly journal of economics 108 ; king & levine ( 1993 ), finance, entrepreneurship and growth, journal of monetary economics 32. anderson and joeveer ( 2012 ), bankers and bank investors : reconsidering the economies of scale in banking, cepr discussion paper 9146. bis central bankers ’ speeches the events of the financial crisis have led to also consider the malign diagnosis of the massive size of the financial sector and of the single financial institutions that dominate the banking sector. some recent research at the bis suggests that finance does contribute to economic growth but only up to a point. 4 too large a financial sector may imply too high risk - taking, which results from over - investment and too much leverage in some sectors of the economy, typically the real estate related sector. this increases the frequency of crises which involve heavy output losses. too large and a very well paid financial sector may also deprive other sectors of some of the most productive human resources. what makes the financial sector grow too big? researchers have suggested reasons ranging from banks ’ failure to internalize systemic risks that stem from growth in leverage and ballooning balance sheets to rent - extraction in opaque otc markets. 5 however, the most natural explanation may be the explicit and implicit public guarantees which have led to lower funding costs to the largest institutions which the markets expect to be “ too - big - to - fail ”. pursuing such a status in the eyes of the market, and the ensuing cheaper funding, can give a strong incentive to grow. given the size of the largest banks ’ balance sheets, even a relatively small advantage in the funding spread means a big hidden flow of subsidy from the taxpayers to those banks. 6 recent research at the bank of england suggests that the increasing returns to scale in banking, beyond a certain size range, may largely result from the cheaper funding costs of the presumed too - big - to - fail banks. 7 an interesting aspect of the research is also that the social cost of too - big - to - fail banks, due to increased systemic risk, appears to be significantly higher than the benefits from the economies of scale. 8 however, not only the size of the financial sector and that of the banks is important, but also what the sector actually does. in the run - up to the crisis there was a trend among the biggest

banks to strengthen their focus on investment banking, including trading operations. [ slide 3 : shifts in focus of operations as illustrated by shifts in assets structures ] part of this trend was driven by the growing demand by corporate customers for risk management services. to a significant extent, however, the growth in investment banking activities was driven by the banks themselves in search for new revenue streams and higher profitability. in many banks the proportion of trading assets in the balance sheet increased substantially as securities and derivatives trading provided a relatively fast and flexible way to grow. 9 cecchetti and kharoubi ( 2012 ), reassessing the impact of finance on growth, bis working paper 381. stein ( 2012 ) and bolton, santos, and scheinkman ( 2012 ), respectively. noss and sowerbutts ( 2012 ), bank of england fs papers series, fs paper no 15. davies and tracey ( 2012 ), too big to be efficient? the impact of implicit funding subsidies on scale economies in banking. bank of england mimeo. boyd and heitz ( 2012 ), the social costs and benefits of too - big - to - fail banks : a “ bounding ” exercise, university of minnesota working paper, february. boot and ratnovski ( 2012 ), banking and trading, imf working paper 12 / 238. bis central bankers ’ speeches the relative importance of customer loans fell over time and the importance of interbank lending grew. moreover the customer loan business transformed as many banks particularly in the us moved away from the “ originate and hold until maturity ” model to the “ originate and distribute ” model where granted loans are pooled, then securitized and sold to investors, including european banks. securitization was motivated by the desire to economize on capital buffers, but it turned out later that the assumed benefits of diversification were vastly outweighed by the increasing propensity to contagion. big risks followed, also at the systemic level, as balance sheet growth was often matched with dramatic changes in the liability side of banks ’ balance sheet. firstly, banks became increasingly leveraged as the solvency rules allowed this to happen without a proportionate addition of fresh capital. the loss absorption capacity weakened. second, banks relied increasingly on short - term wholesale funding, typically from the repo market, which made them more vulnerable to market disruptions. thirdly, the rapid balance sheet growth also required more interbank financing,