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Is our financial sector too big?

Most economists would agree that a growing economy requires a well-functioning financial system that is able to move capital between its owners and those who need it.

The larger the financial sector, the argument goes, the more likely it is that capital will be efficiently allocated, and the better for the economy.

Of course, the same is true for other intermediate services, from law and consulting to auditing and marketing, which perform intermediate services that help firms to specialise, and flourish.

But a new working paper by economists Stephen Cecchetti and Enisse Kharroubi at the Bank for International Settlements questions this logic. They argue instead that a too-large intermediate sector (they specifically refer to finance) can actually hurt growth, and find that there is a threshold beyond which growth of the finance industry actually reduces total factor productivity growth.

All developed economies are already beyond this threshold, they find, and provide evidence of a clear negative correlation between financial sector growth and R&D-intensive industries.

One mechanism through which this happens is that finance consumes resources that could have been utilised more productively in other sectors.

A complex financial system needs highly qualified engineers, for example, clever people that could have been employed in research industries that would have had a bigger impact on society.

This is worrying for a country like South Africa where financial and other intermediate services are, like the US, a large part of the economy.

The more finance and other intermediate service firms employ our smartest students (a precious resource), the fewer there are of them to start their own businesses producing goods that we can export, or doing research that can invent new things.

I’ve seen this myself: the largest consulting firms pilfer our best graduates (promising the incomes and status that come with these jobs) at the expense of far less appealing jobs in industries that our economy desperately needs. Who wants to work in a factory anyway?

In their book Concrete Economics, Brad Delong and Stephen Cohen explain why the finance industry grew so rapidly, from roughly 3% in 1950 to almost 9% of US GDP today. It happened as a result of the deregulation that already began in the 1970s but intensified in the 1990s.

Some of this was good, like the innovation of low-cost brokerages and low-cost investment funds, just like the regulators had hoped. Unfortunately, these were the exceptions rather than the rule.

Financial intermediaries soon realised that it is much easier to promise clients that “they could beat the market and become rich” than provide value to their clients by “soberly matching risks to risk-bearing capacity”.

And so, instead of charging lower fees, which would benefit investors, a freer market made financial intermediaries move into fancy office blocks, recruiting the smartest minds, and charge higher fees as a signal that their portfolios are the ones with the best returns.

In South Africa, I would venture that this also happened in other intermediate sectors, like auditing and consulting. Between 1981 and 2006, our service sector increased by 42%.

Finance may have benefitted from deregulation, but the tightening of accounting standards and other types of well-intentioned regulation to safeguard businesses from fraudulent practices meant that these highly concentrated industries had a captured market for their services. High prices – and Sandton office towers – followed.

Our large intermediate services sector means that we have fewer innovative firms that can produce products and services to sell to a global audience.

Our best minds should be developing new genetically modified crops or mobile apps, not more complex financial instruments.

How we fix this is a more difficult question. It is unlikely that change will come from within these firms; in fact, expect lobbying for more rules and higher standards which require bigger teams of experts selling better advice. Why kill the goose that lays the golden eggs?

A concerted effort by government is instead necessary to reduce the demand for and market power of these intermediate services firms. Reducing excessive bureaucratic red tape can help with the former. Competition policy can help with the latter.

Perhaps the emphasis should instead be on growing other sectors, specifically manufacturing. But what regulators should realise is that bigger is not always better when it comes to finance and other intermediate service industries.

This article originally appeared in the 5 May 2016 edition of finweek. Buy and download the magazine here

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