Markets Insight
July 3, 2012 6:02 pm
Barclays affair shows time to shear banks
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Tipping points in high finance are not always discernible at the time. Yet two events in recent weeks almost certainly qualify for that description. First, we saw Jamie Dimon, high and mightiest of US bankers, stumble badly after JPMorgan Chase incurred potential losses at its chief investment office, to date estimated at about $5bn. The revelation of such fallible risk management irrevocably changed the terms of trade between Wall Street and Washington. Now comes the departure of Bob Diamond from Barclays, which removes one of the more intractable obstacles to a smaller, more manageable financial sector in the UK. So where do we go from here?
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The priorities in this interminable crisis are not difficult to identify. After last week’s eurozone summit the banks’ market ratings have enjoyed a short-term fillip on the basis that policy makers are at last addressing the mutual vulnerabilities of sovereign debtors and banks. That said, prices in equity and debt markets are still passing a pretty damning verdict on the banks, while the cost of insuring against bank defaults through credit default swaps has recently been as high as at the time of the Lehman collapse.
European banks remain undercapitalised relative to the US and overdependent on central bank funding. Banks in the developed world have also, between 2009 and 2011, been overdependent on trading income for growth.
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Above all the sector’s leaders are too big in relation to gross domestic product and too concentrated. There is a need to rebalance away from low quality investment banking income to old fashioned financial intermediation and to shrink in size as far as this can be reconciled with the need to promote the growth of domestic economies.
This raises the tricky question of what constitutes the optimal size for a financial sector. It is not difficult to identify what is far too big – witness the travails of Iceland and Ireland. There is also plentiful literature seeking to identify the point at which debt becomes a drag on the economy. Less well understood is the relationship between financial development, productivity and growth.
The working assumption of most economists is that financial development is a boon because it allocates scarce resources to those who can use them most efficiently, while reducing the volatility of consumption and investment for households, corporations and governments. Yet if the issue of size is looked at in terms of overall employment or output, there is evidence that a point can be reached where financial development and the financial system’s size turn from good to bad.
Stephen Cecchetti, chief economist of the Bank for International Settlements, with fellow economists at the BIS, has identified that point at 3.2 per cent for the employment share of finance and at 6.5 per cent for the value added share of finance. Based on 2008 data on 50 countries, the US, Canada, the UK and Ireland were all beyond the threshold for employment, while the US and Ireland were also beyond the threshold for value added.*
In effect, faster growing financial employment hurts average productivity growth in the economy as does similar growth in value added. More specifically, the BIS economists found that a one percentage point increase in the growth rate in finance’s share of employment cuts average productivity growth by nearly a third of one percentage point per year. That leads to the conclusion that, beyond a certain point, financial development is bad for an economy. Instead of supplying the oxygen that the real economy needs for healthy growth, says Mr Cecchetti, it sucks air out of the system and starts to suffocate it.
.
The notion that more banking and more credit can lower economic growth, though counter-intuitive, is logical because the financial sector competes with the rest of the economy for resources, including scarce talent such as that of rocket scientists. And sure enough, the BIS’s sectoral number crunching shows that credit booms harm the normal engines of growth in sectors such as manufacturing that are research and development-intensive.
.
If we translate that back into the practical world of banking, it would be very helpful if Mr Diamond’s successor were to bring in a strategy for shrinkage. From the shareholders’ point of view it seems questionable whether Barclays’ ambitious targets for return on equity could be achieved by cost cutting alone. There must be a temptation to take on excessive risk.
.
Historically, the returns earned by investment banks have often proved illusory, leaving the boring but stable retail bank to come to the rescue with a handy cross-subsidy when boom turns to bust. Why not retreat from this overrated business?
*S. Cecchetti and E. Kharroubi, “Reassessing the impact of finance on growth”, BIS, January 2012
The writer is an FT columnist
Tipping points in high finance are not always discernible at the time. Yet two events in recent weeks almost certainly qualify for that description. First, we saw Jamie Dimon, high and mightiest of US bankers, stumble badly after JPMorgan Chase incurred potential losses at its chief investment office, to date estimated at about $5bn. The revelation of such fallible risk management irrevocably changed the terms of trade between Wall Street and Washington. Now comes the departure of Bob Diamond from Barclays, which removes one of the more intractable obstacles to a smaller, more manageable financial sector in the UK. So where do we go from here?
.
The priorities in this interminable crisis are not difficult to identify. After last week’s eurozone summit the banks’ market ratings have enjoyed a short-term fillip on the basis that policy makers are at last addressing the mutual vulnerabilities of sovereign debtors and banks. That said, prices in equity and debt markets are still passing a pretty damning verdict on the banks, while the cost of insuring against bank defaults through credit default swaps has recently been as high as at the time of the Lehman collapse.
European banks remain undercapitalised relative to the US and overdependent on central bank funding. Banks in the developed world have also, between 2009 and 2011, been overdependent on trading income for growth.
.
Above all the sector’s leaders are too big in relation to gross domestic product and too concentrated. There is a need to rebalance away from low quality investment banking income to old fashioned financial intermediation and to shrink in size as far as this can be reconciled with the need to promote the growth of domestic economies.
This raises the tricky question of what constitutes the optimal size for a financial sector. It is not difficult to identify what is far too big – witness the travails of Iceland and Ireland. There is also plentiful literature seeking to identify the point at which debt becomes a drag on the economy. Less well understood is the relationship between financial development, productivity and growth.
The working assumption of most economists is that financial development is a boon because it allocates scarce resources to those who can use them most efficiently, while reducing the volatility of consumption and investment for households, corporations and governments. Yet if the issue of size is looked at in terms of overall employment or output, there is evidence that a point can be reached where financial development and the financial system’s size turn from good to bad.
Stephen Cecchetti, chief economist of the Bank for International Settlements, with fellow economists at the BIS, has identified that point at 3.2 per cent for the employment share of finance and at 6.5 per cent for the value added share of finance. Based on 2008 data on 50 countries, the US, Canada, the UK and Ireland were all beyond the threshold for employment, while the US and Ireland were also beyond the threshold for value added.*
In effect, faster growing financial employment hurts average productivity growth in the economy as does similar growth in value added. More specifically, the BIS economists found that a one percentage point increase in the growth rate in finance’s share of employment cuts average productivity growth by nearly a third of one percentage point per year. That leads to the conclusion that, beyond a certain point, financial development is bad for an economy. Instead of supplying the oxygen that the real economy needs for healthy growth, says Mr Cecchetti, it sucks air out of the system and starts to suffocate it.
.
The notion that more banking and more credit can lower economic growth, though counter-intuitive, is logical because the financial sector competes with the rest of the economy for resources, including scarce talent such as that of rocket scientists. And sure enough, the BIS’s sectoral number crunching shows that credit booms harm the normal engines of growth in sectors such as manufacturing that are research and development-intensive.
.
If we translate that back into the practical world of banking, it would be very helpful if Mr Diamond’s successor were to bring in a strategy for shrinkage. From the shareholders’ point of view it seems questionable whether Barclays’ ambitious targets for return on equity could be achieved by cost cutting alone. There must be a temptation to take on excessive risk.
.
Historically, the returns earned by investment banks have often proved illusory, leaving the boring but stable retail bank to come to the rescue with a handy cross-subsidy when boom turns to bust. Why not retreat from this overrated business?
*S. Cecchetti and E. Kharroubi, “Reassessing the impact of finance on growth”, BIS, January 2012
The writer is an FT columnist
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Copyright The Financial Times Limited 2012.
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