Is taking risk a useful economic activity?

Andrew G Haldane of BoE has been criticising financial sector and its too big to fail burden.

In this article with Vasileios Madouros he explains some key ideas behind his thought. He says before the crisis everyone believed finance added huge value but this has crashed post-crisis. Why? He says the value of finance was overvalued to begin with.

There is no doubting the financial sector has a significant impact on the real economy. Financial crisis experience makes this only too clear.1 Financial recessions are both deeper and longer-lasting than normal recessions. At this stage of a normal recession, output would be about 5% above its pre-crisis level. Today, in the UK, it remains about 3.5% below. So this much is clear: Starved of the services of the financial sector, the real economy cannot recuperate quickly.

But that does not answer the question of what positive contribution finance makes in normal, non-recessionary states. This is an altogether murkier picture. Even in concept, there is little clarity about the services that banks provide to customers, much less whether statisticians are correctly measuring those services.2 As currently measured, however, it seems likely that the value of financial intermediation services is significantly overstated in the national accounts, for reasons we now explain.

He says previously we took risk taking as value added activity.  But risk taking is just transfer of risk. What matters more is risk management where banks/financial sector allocates credit/finance after screening the needy and worthy:

In what sense is increased risk-taking by banks a value-added service for the economy at large? In short, it is not.

The financial system provides a number of services to the wider economy, including payment and transaction services to depositors and borrowers; intermediation services by transforming deposits into funding for households, companies or governments; and risk transfer and insurance services. In doing so, financial intermediaries take on risk. For example, when they finance long-term loans to companies using short-term deposits from households, banks assume liquidity risk. And when they extend mortgages to households, they take on credit risk.

But bearing risk is not, by itself, a productive activity. The act of investing capital in a risky asset is a fundamental feature of capital markets. For example, a retail investor that purchases bonds issued by a company is bearing risk, but not contributing so much as a cent to measured economic activity. Similarly, a household that decides to use all of its liquid deposits to purchase a house, instead of borrowing some money from the bank and keeping some of its deposits with the bank, is bearing liquidity risk.

Neither of these acts could be said to boost overall economic activity or productivity in the economy. They re-allocate risk in the system but do not fundamentally change its size or shape. For that reason, statisticians do not count these activities in capital markets as contributing to activity or welfare. Rightly so.

What is a demonstrably productive economic activity is the management of risk. Banks use labour and capital to screen borrowers, assess their creditworthiness and monitor them. And they spend resources to assess their vulnerability to liquidity shocks arising from the maturity mismatches on their balance sheets. Customers, in turn, remunerate banks for these productive services.

The next problem is National accounts do not differentiate between risk taking and mgt. As a result, value of finance is both overhyped in boom and in bust:

these productive services.

The current framework for measuring the contribution of financial intermediaries captures few of these subtleties. Crucially, it blurs the distinction between risk-bearing and risk management. Revenues that banks earn as compensation for risk-bearing – the spread between loan and deposit rates on their loan book – are accounted for as output by the banking sector. So bank balance-sheet expansion, as occurred ahead of the crisis, counts as increased value-added. But this confuses risk-bearing with risk management, especially when the risk itself may be mis-priced or mis-managed.

The upshot is a potentially significant over-estimation of the valued-added of the financial sector. The size of this effect is potentially very large. For example, Colangelo and Inklaar (2010) suggest that, for the Eurozone as a whole, adjusting for risk-taking would reduce the estimated output of the financial sector by about 25-40 % relative to the current methodology. If the same factor were applied in the UK, the measured contribution of the financial sector would suddenly drop to about 6-7.5% of GDP. That’s a measurement error of about £35-£55 billion based on 2009 data. The impact of this on overall GDP is likely to be smaller because half of the output of the financial sector is consumed by other businesses – so, while the measured value added of finance would drop, that of other sectors would increase.

Hence the challenge is to adjust this hyped value:

If risk-making were a value-adding activity, Russian roulette players would contribute disproportionately to global welfare. And if government subsidies were the route to improved well-being, today’s growth problems could be solved at a stroke. Typically, this is not the way societies keep score. But it was those very misconceptions which caused the measured contribution of the financial sector to be over-estimated ahead of the crisis.

Risk-management is a legitimately value-added activity. It lies at the heart of the services banks provide. Today’s debate around banking and bankers has usefully rediscovered that key fact, amid the rubble of broken balance sheets and wasted financial and human capital. Investors, regulators and statisticians now need to adjust their measuring rods to ensure they are not blind to risk when next evaluating the return to banking.

This is going to be a task. How does one put a value and measure  risk management activity? It was far easier to understand this measurement of financial activity  as difference between interest rate spreads (credit rate- deposit rate). Moreover, we have always understood these spreads as rewards for risk management/bearing by financial system. This requires a complete rethink on what we mean by risk and how do we put a value to it.

Basics of finance need a rethink..

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One Response to “Is taking risk a useful economic activity?”

  1. Wall Street jobs and bonus cuts to hurt growth?? « Mostly Economics Says:

    […] then there is a nice e-book from voxeu titled -Why do we need a financial sector? I did point to a Haldane piece in the same book questioning the high value add of finance […]

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