Too much money is bad for you

Finance and inclusive growthBefore the recent crisis, the biggest failure of a commercial bank in the UK was the City of Glasgow Bank in 1878. The CGB collapse was due to mismanagement and fraud, and the authorities set up a commission of inquiry that recommended a number of measures to improve corporate governance. No they didn’t. They arrested the bank’s directors and sent them to prison, and corporate governance improved remarkably. As this Bank of England paper argues, the CGB collapse had a lasting impact on the financial system, requiring banks to be externally audited, and prompting a move away from unlimited liability banking (too late for William Love, whose newly worthless £200 shareholding exposed him to £5500 liability). The crisis also led to a wave of mergers and the emergence of the banking structure dominated by big banks we know today, as well as a change in risk management, with banks increasing the share of more liquid, lower-risk assets on their balance sheets.

The Bank of England paper discusses the lessons for today from the CGB crisis, and how the financial sector should change. The Bank’s Governor, Mark Carney, came back to the question in a speech last week about “Building real markets for the good of the people”. Carney argues that in the City, “Unethical behaviour went unchecked, proliferated and eventually became the norm. Too many participants neither felt responsible for the system nor recognised the full impact of their actions.” He feels “let down” by this, and explains how it contributed to “ethical drift”. I strongly advise you to use this lovely concept in court next time you’re caught stealing.

Why did they start drifting? It wasn’t to feed their starving children if the data in a new OECD Economic Policy Paper are right. Finance and inclusive growth shows that the finance sector pays better than other sectors, even for workers with similar profiles, and the gap with people doing similar jobs widens as you scale the corporate ladder. The paper doesn’t say whether this is because traders and the like are paid more than they’re worth or because the rest of us are paid less than we deserve. (What do you think, readers?) And in more news, “male financial sector workers earn a substantial wage premium over female financial sector workers, especially at the top”.

Another finding reminds me of a scene in a film with Roberto Benigni when he goes to the bank to borrow money because he’s broke. The banker refuses, explaining that you need collateral. Furious and incredulous, Benigni protests that when he goes to get tomatoes, the greengrocer doesn’t expect him to have aubergines in the house before he’ll serve him. That translates as “The distribution of credit can be an additional source of income dispersion if it implies that low income people cannot finance the opportunities they identify to the same extent as their better-off counterparts”.

These then are the findings most of us would have guessed or noticed anyway. The real surprise in the paper is the argument that there can be too much finance in the economy. The authors show that the extravagant salaries paid to the ethical drifters are only one of the negative consequences of the way the sector has developed. The analysis uses two direct measures of financial activity: the volume of credit provided by financial intermediaries such as banks to the non-financial private sector, and stock market capitalisation.

Over the past half-century credit by banks and other financial institutions to households and businesses in OECD countries has grown three times as fast as economic activity. Stock market capitalisation has tripled relative to GDP over the past 40 years, but today the value of stock markets still only equals 65% of GDP, just over half that of financial sector credit.

The OECD economists looked at how this growth in the financial sector affects growth in the rest of the economy. Initially, an expanding financial sector is beneficial, but it eventually reaches its ideal weight, and apart from contributing to inequality, “further increases in its size usually slow long-term growth”. This conclusion holds even when you consider a range of other factors including country specificities, the business cycle, and even financial crises. In general, more credit to the private sector slows growth in most OECD countries, while more stock market financing boosts growth. Bank loans slow economic growth more than bonds. Credit is a stronger drag on growth when it goes to households rather than businesses.

The long-term increase in credit is linked to slowing growth through five channels, including bank lending increasing more than bond financing, and a disproportionate increase in household credit compared with business credit. The first channel the OECD identifies may however amuse those of you with good memories (or long-held grudges) – excessive financial deregulation. Compare and contrast that with this, from 2008: “Observing the changes that have taken place in the past 25 years, a consensus has emerged that a deregulated financial sector operating in a competitive, open environment with market-based supervision grounded in international norms, is optimal contribution for economic development.”

Still, we admit our mistakes and are trying to learn from them, and even have a whole programme called New Approaches to Economic Challenges (NAEC) that calls for “a serious reflection to revisit policy approaches” in the wake of the crisis. Can the financial sector and the policymakers who influence it do the same? The OECD strategy to reform the financial sector to stop it slowing growth and making inequality worse has three broad components.

First, use macro-prudential instruments (measures that address risks to the whole system rather than individual institutions) to prevent credit overexpansion, and make sure banks maintain sufficient capital buffers. Second, reduce subsidies to too-big-to-fail financial institutions through break-ups, structural separation, capital surcharges or credible resolution plans. Reduce the tax bias against equity financing and make value added tax neutral between lending to households and businesses.

We could also remind the financiers what The Spectator said in arguing against a national subscription to help William Love and the others: “The notion that a grand failure is a pure misfortune, and one for which the partners are irresponsible, is one far too widely diffused already, and one which it is wrong as well as inexpedient to make deeper.”

Useful links

Too Much Bank Lending Can Slow Economic Growth: OECD Chief Economist Catherine Mann talks about the impact of bank lending on finance practices and economic growth on Bloomberg Television’s “Market Makers.”

Macro-prudential policy, bank systemic risk and capital controls by Adrian Blundell-Wignall and Caroline Roulet in OECD Journal Financial market Trends 2014

Patrick Love

5 comments to “Too much money is bad for you”

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  1. Charles Kovacs - 17/06/2015 Reply

    I was puzzled to see the failure of the City of Glasgow Bank in 1878 mentioned as an introduction to the financial issues of our day. By 1878, the UK experienced several major banking crises; for example in 1825, six London banks and 60 country banks failed due to bad lending decisions, greed, etc. This combination has been the cause of any number of bank failures through history even without external variables such as wars, crop failures and so on. Not much new to this day.

    However, there were two major and new developments since World War II:

    1. After World War II, banks discovered the consumer market segment, previously present only as depositors, This led to a massive increase, inter alia, in checking accounts (before World War II only the wealthy had these), real estate loans, credit cards (which are unsecured personal loans). This fueled the rapid post-war increase in economies and the standard of living of most people in the First World,

    2. For a variety of reasons, from the 1960’s onwards there has been a rapid disintermediation of banks, starting in the United States and then spreading to Europe. This affected the banks in both their deposit taking and lending activities: many other non-bank institutions became successful sectoral competitors. The banks lost entire segments of borrowers, the importance of retail deposits declined, and the banks started to enter into markets which they previously avoided or were forbidden to enter.

    The above developments eventually led to the status quo of 2008. By then, arguably, neither the bankers nor the regulators understood the complex financial markets of the day, and when the markets froze, the reactions bordered on panic, abetted by hysteria in the media fed by writers and commentators even less informed than the financial executives and the regulators. All the same, disaster was averted, political scores were settled, and more laws regulations were passed, ostensibly to avoid a repetition of the latest crisis.

    Meanwhile, however, the dynamics and the structure of the financial markets have remained unchanged. The new rules and regulations have impacted on the actions of the financial institutions, for one, they have made the banks more risk averse in lending, but this has little do with ethics or morality. What remains to be seen is how the financial sector will perform within the confines of the new regulatory environment and whether the regulators will try to use bank credit to advance a political and social agenda.

  2. James Greyson - 18/06/2015 Reply

    May I offer input to your New Approaches to Economic Challenges programme? The currently proposed macro-prudential instruments seem to be considering only tools already in use. This neglects the biggest systemic risk that policymakers continue to overlook the scale of the problem and the out-of-the-box thinking that would be required to really learn from our mistakes. The missing tool is the policy option of switching new money creation from the banking system to transparent accountable public bodies. Could this be the switch that finally ends the casino mindset of banking and the global debt tsunami?

    If it’s not – could someone from OECD or IMF please explain to me why not? Thanks!

  3. Tom Schuller - 19/06/2015 Reply

    Patrick, a brilliant post – see my general compliments at “Pay gaps, at both ends of the scale. And OECD on an overblown finance sector”.

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