Are banks doing more harm than good?

Welcome to Finance and Fury. Recent issues with banks has once again highlighted the fragility with the financial sector and the impact this can have on financial markets, the economy and daily lives – these failures have come from the smaller bank sectors and their failure to account for higher interest rates and having concentrated risks – First Republic is almost the same as Silicon Valley banks collapse – rather than focusing on this – Want to go deeper and ask the question – is the financial sector destroying real economic growth – and with it, your potential for greater prosperity?

1. a strong financial sector can be important for economic growth – but is it always true that the stronger, or larger the better?
   1. This is where there is plenty of evidence that this is not the case – there is a tipping point
2. as a country’s financial sector grows it can help the local economy, but only up to an optimal point, after which it turns bad – important for us – as Most advanced countries passed the optimal point long ago – and it is only getting worse the more monopolised the financial sector becomes – with legislation reinforcing this – such as what has been seen over the past few months around the world – with larger banks gobbling up other banks under the governments directive

First – why is having a financial sector – i.e. banks, important

1. We all use the modern financial system and banks – use transaction accounts or credit cards/loans to pay our bills
   1. But financial institutions provide the ability to also save for retirement or borrow to purchase a home, or start a business
   2. This function can be a massive benefit to an economy – in the past, the way the banking sector worked was allowing deposits, i.e. our savings to be redirected to lend out – often to businesses so they can invest and create additional supply
      1. Allows speculators to make new investment opportunities in our economy – such as R&D – boosting economic growth – but with changes to capital adequacy requirements as banks grew in size – less is now going to business and more to households – just since 2001 – it has flipped, where business used to account for around 50% of lending, to around 30% today, whereas housing went from around 40% to just under 65% – so more is going to what is considered unproductive lending – or even counter productive lending – as higher lending on housing can lead to lower GPD growth, as we will go through – but having less being lent to business also means that the potential for additional supply and consumption in an economy starts to diminish
   3. Each country/economy has stages with a financial system
      1. If there isn’t one present – i.e. zero banking or financial lending – little more than subsistence farming is possible –
         1. If you want to start a business (which has the potential to add real economic growth/GDP) – need to borrow for seed capital, but can’t, then you have no business
      2. As finance develops – it helps an economy become more sophisticated, channelling savings to productive investments and providing other useful services, and helping to create wealth
         1. We need a banking system and the ability to borrow funds – but this tells us nothing about how big our financial centre should be or what roles it should serve
      3. But then it reaches an optimal size – this point maximises the equilibrium between productivity and finance availability – whilst not coming at the cost to the consumer
      4. But beyond this optimal point – the financial system starts to inflict damage on the economy that it once helped to foster
         1. When a financial system moves away from providing a service for a profit – i.e. lending – to one that is focused on profitability at any cost – it can start to extract wealth from other parts of the economy begin to overpower traditional financial activities that support the creation of wealth
            1. Recent example of this – packaging loans with high default risks in MBS – saw how that ended in GFC
            2. Or using derivative contracts on assets – multiplying the leverage on a position – this introduced real risk all for the sake of profit for a bank – without providing the functional service of being a place to deposit funds and then lend these out
         2. A growing body of economic research confirms that once a financial sector grows above an optimal size and beyond its useful role, it begins to harm the country that hosts it
            1. The finance curse – What is the tipping point above which financial development no longer has a positive effect on economic growth –
               1. This is the same for any organisation within an economy – governments can grow too large and become a detriment to the economy, but small governments can be a benefit, small companies can be a benefit, but large monopolistic companies can be a detriment – the same exact market dynamics plays out for banks
            2. Beyond the academic – think about it from a practical point of view – two scenarios – diminishing marginal returns and servicing costs
               1. The more that is spent on projects, the lower the marginal returns can be – think about taking out a loan to buy a car – if you need this to get to work, it can be worth the costs to service the interest payments – you cant do a job without the car, so you can earn an income, but does have a cost – but the aim is to generate the income – but now say you take out a loan to purchase a second car, that just sits there, that loan is no longer creating economic growth – diminishing the returns
               2. Borrowing comes at a cost – the interest and principal repayments – typically government bonds only pay principal back at maturity – to do this if they don’t have the money at hand, they can just reissue more bonds, but the coupon payments, or interest costs on the debt don’t go away. In your own lives, the more debt, the higher the interest expense – less income then to use on other areas – such as wealth creation – some level of debt can be good – but beyond a point, the level of interest can put you behind, where much of your income is just going to service a debt

Another problem to an economy comes in the form of financial crises – the larger the financial sector, when it falls apart, can create economic problems, but is this really the main problem?

5. But the problem is in fact older, and bigger – oversized financial sector began turning away from supporting the creation of wealth, and towards extracting it from other parts of the economy
   1. To achieve this, it shapes laws, rules, thinktanks and even our culture so that they support it.
   2. What damage does this do – There is the observable (like GDP growth) and also the unseen/unmeasurable

The measurable – be a link to the database on all of the papers and research that has been done on this

1. Finance becomes a net drag on GDP growth and productivity –
   1. Paper called too much finance – it shows that countries with very large financial sectors have no positive correlation between financial depth (i.e. the size of the economic sector) and economic growth
      1. They found that there is a very strong correlation between financial depth and economic growth in countries with small and intermediate financial sectors – but the threshold to which the debt to GDP for the financial sector, once they reach 80-100% of GDP starts having a negative effect on economic growth – two reasons why
         1. Increases risk to the economy – in a paper that seemed controversial at the time – Rajan (2005) discussed the dangers of financial development suggesting that the presence of a large and complicated financial system had increased the probability of a “catastrophic meltdown.” – Leading to the GFC
         2. Misallocation of resources – when there is an unlimited level of funds that can be borrowed at low cost, funds can be sent to non-productive investments
      2. Negative relationship between the rate of growth of the financial sector and the rate of growth of productivity
         1. Banks incentives to lend changes the more the financial sector grows and is regulated – focuses more on high collateral/low productivity projects – so the financial sector grows more quickly at the expense of the real economy
      3. Cheap finance and availability lowers hurdle rate to invest in projects – Profits and the cost of capital
         3. Borrow costs of 3% – for a 3.5% return versus borrowing cost
         4. credit booms harm what we normally think of as the engines for growth – those that are more R&D intensive
      4. Too much household debt works at first – then also becomes a drag (IMF study)
         1. short term – increase in the ratio of household debt is likely to boost economic growth and employment
         2. But in three to five years, those effects are reversed; growth is slower than it would have been otherwise
            1. Plus the odds of a financial crisis increase
            2. effects are stronger at the higher levels of debt typical of advanced economies-compared to emerging ones
         3. What’s the reason for the trade off? At first, households take on more debt to buy things like new homes and cars
            1. gives the economy a short-term boost – e.g. builders hire more workers
            2. later – highly indebted households may need to cut back on spending to repay their loans = drag on growth (spending)

• enter a sudden economic shock –e.g. decline in home prices–trigger a spiral of credit defaults that shakes the foundations of the financial system

1. IMF study – 5% increase in the ratio of household debt to GDP – in three-year =1.25% decline in inflation-adjusted growth
   1. higher debt is associated with significantly higher unemployment up to four years ahead
   2. a 1% increase in debt raises the odds of a future banking crisis by about 1% point
   3. significant increase – normal probability of a crisis is 3.5% without any increase in debt
   4. Aus – 1993 – 45% to 2008 at 110% = 65% difference, or 144% increase in probability – today at 120% – been there for 3 years

 Other Real life examples – One comes from Brittan –the City of London corporation – if you haven’t heard about this entity – I did an episode around 4 years ago – but a simple google search can show you that the this entity is above the law of the UK – and does have its benefits

1. 360,000 banking jobs, £31bn in direct tax revenues last year and a £60bn financial services trade surplus to boot
2. Research papers – an oversized City of London has inflicted a cumulative £4.5tn hit on the British economy from 1995-2015. That is worth around two-and-a-half years’ economic output, or £170,000 per British household – net loss
   1. first £1.8tn in lost economic output caused by the global financial crisis since 2007
   2. second, £2.7tn in “misallocation costs” – what happens when a powerful finance sector is diverted away from useful roles (such as converting our savings into business investment) toward activities that distort the rest of the economy and siphon wealth from it.
   3. expect the growth in financial sector to provide increased investment for other sectors in our economy, but the exact opposite has happened
      1. 100 years ago – 80% of bank lending went to businesses for genuine investment
         1. Which was mostly manufacturing
      2. Today – 4% goes to manufacturing –

• financial institutions are lending mostly to each other, and into housing and commercial real estate.

USA

1. misallocation costs, or the price of diverting resources away from non-financial activities;
2. crisis costs, meaning the cost of the 2008 financial crisis.
   22. Together – estimate – excess cost of as much as $22.7 trillionbetween 1990 and 2023 – making finance a net drag on the American economy

Australia –

1. shown that the marginal contribution of financial depth to economic growth becomes negative when credit to the private sector surpasses 100 percent of GDP – private debt not household debt – includes business debt
   1. Where is Australia – 1996 (120%) – 2006 (190%) – 2016 (210%) – 2022 at 200% – most Comes from the housing market – but this has declined from about 120% in 2021 to 114% in 2022
   2. Issues – when interest rates low – lower inventive to save – higher incentive to borrow

• statistically significant correlation between economic growth and credit to enterprise, there is no significant correlation between economic growth and credit to households.

The unmeasurable

3. finance curse inflicts damage in many other areas which have no system of unmeasurable
   1. such as damage to democracy and to the rule of law – this is rather complex but in essence relies on political rhetoric
   2. IMF literature looks at – multiple political, economic, cultural, democratic and social effects that oversized finance can have on a country
   3. The outcomes include lower economic growth, distorted markets, deeper corruption, the hollowing-out of alternative economic sectors
4. One is also information drain – misallocation of human capital – where the best and brightest go into a field that limits economic growth – rather than other areas like engineering that can go to development

Can use this knowledge to our own use – applying the same rules – of having too much debt – especially non-productive debt can hurt your own personal economy

Summary – That is it for todays episode – looking at how without finance we would be doomed, but with too much we are as well – almost like the goldilocks ratio – not too hot, but not too cold

1. In the financial sector – Resources are being misallocated as finance has become an end in itself: unmoored, disconnected from the real economy and from the people and real businesses it ought to serve – profits by any means is the new goal

https://financecurse.net/research/academic-papers-too-much-finance/

https://www.imf.org/external/pubs/ft/wp/2012/wp12161.pdf

https://taxjustice.net/topics/the-finance-curse/