The Bank of England’s executive director of financial stability has a refreshingly straight-forward answer to his self-imposed question “The Contribution of the Financial Sector: Miracle or Mirage?”
His response:
. . . Banking has undergone, at least arithmetically, a “productivity miracle” over the past few decades . . . Risk illusion, rather than a productivity miracle, appears to have driven high returns to finance. The recent history of banking appears to be as much mirage as miracle.
In a speech that will be presented at Wednesday’s Future of Finance conference in London, Andrew Haldane uses some impressive maths to shore up his claim. It’s a pity the accompanying and often-referenced charts and tables aren’t included. The speech is based on a chapter from a co-authored book called ‘The Future of Finance: The LSE Report,’ which is due to be published today.
Here’s the relevant bit on banking’s contribution:
Over the past 160 years, growth in financial intermediation has outstripped whole economy growth by over 2 percentage points per year. Or put differently, growth in financial sector value added has been more than double that of the economy as a whole since 1850. This is unsurprising in some respects. It reflects a trend towards financial deepening which is evident across most developed and developing economies over the past century. This structural trend in finance has been shown to have contributed positively to growth in the whole-economy . . .
The period from the early 1970s up until 2007 marked . . . [a] watershed. Financial liberalisation took hold in successive waves. Since then, finance has comfortably outpaced growth in the non-financial economy, by around 1.5 percentage points per year. If anything, this trend accelerated from the early 1980s onwards. Measured real value added of the financial intermediation sector more than trebled between 1980 and 2008, while whole economy output doubled over the same period.
In 2007, financial intermediation accounted for more than 8% of total [gross-value added], compared with 5% in 1970. The gross operating surpluses of financial intermediaries show an even more dramatic trend. Between 1948 and 1978, intermediation accounted on average for around 1.5% of whole economy profits. By 2008, that ratio had risen tenfold to about 15% (Chart 2).
What to make of such a rapid rise? Haldane has some ideas.
He figures — per that mirage memo above — that most of the increase in apparent productivity was down to unusually high returns. Until about 1970, return on equity (ROE) in banking was around 7 per cent — roughly equivalent to returns in the broader economy. But since then, it’s shot up to 20 per cent.
As for that burst in ROE — Haldane blames increased leverage (off-balance sheet vehicles), plus more assets held at fair value (search for yield), plus a preference for writing deep out-of-the-money options (insuring for tail risk — think AIG). As he puts it:
What each of these strategies had in common was that they generated a rise in balance sheet risk, as well as return. As importantly, this increase in risk was to some extent hidden by the opacity of accounting disclosures or the complexity of the products involved. This resulted in a divergence between reported and risk-adjusted returns. In other words, while reported ROEs rose, risk-adjusted ROEs did not . . .
His depressing — but very well-grounded — conclusion:
. . . because banks are in the risk business it should be no surprise that the run-up to crisis was hallmarked by imaginative ways of manufacturing this commodity, with a view to boosting returns to labour and capital. Risk illusion is no accident; it is there by design. It is in bank managers’ interest to make mirages seem like miracles. Regulatory measures are being put in place to block off last time’s risk strategies, including through re-calibrated leverage and capital ratios. But risk migrates to where regulation is weakest, so there are natural limits to what regulatory strategies can reasonably achieve. At the height of a boom, both regulators and the regulated are prone to believe in miracles. That is why the debate about potential structural reform of finance is important – to lessen the burden on regulation and reverse its descent into ever-greater intrusiveness and complexity. At the same time, regulators need also to be mindful of risk migrating outside the perimeter of regulation, where it will almost certainly not be measured.
Regulators, you have your work cut out for you.
And on a related note — and since we have no charts to go with this paper — we’re gonna throw this one in. From Bloomberg back in April — an updated version of Deutsche Bank strategist Jim Reid’s controversial “Trillion Dollar Mean Reversion” chart:
Related links:
Déjà vu all over again: Financial sector profit soars - Trader’s Narrative
The tale of the Shadow Banks – FT Alphaville
The bank problem in a single chart – FT Alphaville
Reforming risky banks the old-fashioned way – FT Alphaville