From the June 2009 issue of Research Magazine • Subscribe!

Demonizing the Financial Sector is Folly

The explosive growth of the financial services industry and its revolutionary creativity are not only an integral part of today's economy but the very foundation on which the prosperity of recent years was based.

The information technology revolution of the 1980s and 1990s is justly considered one of the highest American achievements in the 20th century. Its positive impacts on the world economy, quality of life and opportunities to learn, connect and advance given to individuals around the world are universally acknowledged.

We have been far more ambivalent about another major revolution of the past quarter century, the financial revolution. Not only has it not been celebrated but, on the contrary, since the implosion of the housing bubble in the United States and the advent of the global credit crunch, it has been blamed for all our ills. Its achievements and benefits to society -- which included, among other things, making the technological revolution possible -- have been completely disregarded. Tighter regulation and greater restrictions on the financial services industry are looming, threatening to push it back to where it was in the 1970s.

This may end up throwing the baby out along with the bathwater. It is, in fact, very much like declaring that the use of personal computers, cell phones and the Internet should be severely restricted on the grounds that they have eliminated millions of excellent jobs for secretaries, typists and telephone operators.

Demanding Action

It is ironic that the current financial and economic crisis is being blamed on lack of regulation and the hollowing out of U.S. regulatory structures. The truth is that resources available to the SEC were beefed up substantially at the start of this decade, following corporate malfeasance scandals involving Enron, WorldCom and other infamous cases. The U.S. regulatory environment was tightened and quite a few finance professionals complained that unnecessarily onerous restrictions cost companies millions for compliance while preventing foreign firms from listing their shares on Wall Street.

It is equally ironic that the call for new international financial regulations is being spearheaded by Gordon Brown, currently the British prime minister but over the previous decade chancellor of the exchequer. Brown oversaw the explosive growth of the City of London that took impetus from Britain's lax, hands-off regulatory environment. The City prospered in large measure by attracting companies and financial institutions from Russia, the Middle East and other less transparent locales.

The consensus seems to be that the wrong thing was being regulated. Regulators should have kept an eye not so much on individual companies and their accounting practices but on the banking sector as a whole, making sure institutions were not taking on excessive risk, engaging in too much speculation or getting over their heads into derivatives, structured instruments, etc. Curiously, all those machinations in the banking sector are now widely seen as something that was going on outside the "real economy," a kind of sideshow that got out of hand and scuttled our well-earned prosperity.

The reality, of course, was quite different. The explosive growth of the financial services industry and its revolutionary creativity are not only an integral part of today's economy but the very foundation on which the prosperity of recent years was based. Many fewer of us would have had our own homes and well-paid jobs had it not been for the ingenuity of all those maligned, overpaid financial engineers.

From 1990 to 2006, the broadly defined financial services sector increased from 23 percent of U.S. GDP to 31 percent. That is a massive change, surpassing even the rise in health care expenditures over the same time period, which went from 12 percent of GDP to around 16 percent. Overall, the financial sector's contribution to GDP increased by over $3 trillion during the past quarter of a century and accounted for one third of all growth in the U.S. economy. This has given rise to criticism that the U.S. has become mainly a manufacturer of financial derivatives and other fanciful financial products, essentially building a huge castle in the sand.

Yet, the banking sector, whose function is financial intermediation -- making sure that savings are profitably invested in the form of loans so that they can earn an attractive rate of return for depositors -- also grew dramatically, from around 4 percent of GDP to 8 percent. It was an era of extremely high investment and dramatic expansion of productive capacity, much of it accomplished directly or not by American companies with the assistance of U.S.-based financial institutions.

While it is true that the U.S. consumer has become overleveraged in this decade, it is also true that the rate of homeownership in the country increased, the standard of living has gone up and -- perhaps most important of all -- entrepreneurs, inventors and small businesses had unprecedented access to start-up capital from a variety of sources.

Utility and Casino

Critics see the U.S. banking sector as a public utility, responsible for a vital public service of providing consumer and business credit -- attached to a casino, meaning the kinds of practices that created trillions of dollars worth of toxic assets. They declare that a concerted international effort is needed to rein in the casino by shutting down offshore banking centers, regulating hedge funds and other non-banking players who make up the shadow banking system and, in the case of the U.S., rolling back the banking deregulation of the 1980s and 1990s.

In this view, commercial banking functions should once more be separated from investment banking, returning the financial system to its New Deal roots. In addition, the idea pressed by Treasury Secretary Hank Paulson's last year, to create a super-regulator responsible for finance as a whole, has the support of his successor Timothy Geithner.

The merits of these suggestions are questionable, to say the least. Like any other industry, financial services thrive on innovation. Mortgage-backed securities, which allowed banks to get 30-year mortgages off their balance sheets and free up bank capital for new lending -- while also spreading the risk associated with mortgage lending to a much broader universe of bondholders -- was what created the $20 trillion housing market in the U.S. The same is true of collateralized debt obligations (CDOs), which had tranches of different levels of risk and which paid a risk-based rate of return.

The problem was not the instruments but how they were priced.

The current financial crisis is largely the result of gross mispricing of risk in the U.S. housing market. Consider that the financial industry itself, in the scheme of things, is fairly new. Until the 19th century its core concept of charging interest was considered morally suspect in Western culture, and it is not yet accepted in the Muslim world. The risk models used to price financial products have thus relied on data spanning less than 150 years and only a handful of economic cycles.

These models incorporated two historical assumptions, namely, that house prices never go down and that homeowners don't walk away from their homes. Both proved incorrect, but no one could have predicted this outcome with any degree of certainty because there had been, indeed, no historical precedent.

Now that a precedent has been set, it will be priced into risk management models in the future. Financial institutions are unlikely to misprice this particular risk again -- which means mortgages will be costlier and harder to get going forward.

The financial industry is still going through a long-term learning curve. It is like a child who has to catch all the common colds for his immune system to develop immunity. The government has a choice of allowing the industry to keep maturing while protecting it by tightening law enforcement and combating fraud and abuse. Alternatively, it can put in place severe regulatory restrictions and stifle financial innovation.

A banking system that takes deposits paying a fixed interest rate and lends money at a slightly higher rate is likely to be quite safe. But if we choose such a course, we shouldn't complain if we soon return to the stagnant economic landscape of the 1970s.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past six years, 2004-2009.

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