Sifting the rubble left by the financial crisis has turned up some revealing clues about the causes of the catastrophe. At the same time, this forensic examination has given us an opportunity to do some fundamental thinking about to what extent sheer size of the financial industry contributes to the growth and success of economies, or whether size does more harm than good. There has been much discussion about moral hazard and the "too big to fail" phenomenon; but could it also be true that beyond a certain threshold, the size of the financial sector actually becomes a drag on economic growth rather than an engine? Erkii Liikanen, Governor of the Bank of Finland and Chairman of the Highlevel Expert Group on the Structure of the EU Banking Sector, recently gave
remarks in Helsinki raising some interesting points about the direction not only of financial regulatory reform, but the size and utility of the financial sector itself. According to Liikanen, "it is not only the size of the financial sector and banks that is important, but also what the sector does."
Mr. Liikanen believes, and evidence bears out, that a well developed financial system helps to allocate productive resources more efficiently, both by channelling funds to growth sectors and pulling resources from declining ones. However,
BIS research suggests that after a certain point, the size of the financial sector stops being a channel for efficient capital formation, and merely becomes an indicator that high risk-taking is occurring, resulting in over-investment and dangerous levels of leverage concentrated in particular sectors, like real estate.
This kind of risk-taking can be caused by misapplied incentives, like focusing on executive compensation rather than responsible growth, as well as failures of financial institutions to "internalize systemic risks that stem from growth of leverage and ballooning balance sheets to rent-extraction in opaque OTC markets." Of course, the most obvious reason banks might take on excessive risks in exchange for growth and greater returns to scale is the too-big-to-fail phenomenon. Implicit guarantees of bank bailouts tend to reduce funding costs for the largest institutions, and low funding costs drive growth. Common sense,
backed up by research, tells us now that the social cost of too-big-to-fail banks appears to be significantly higher than the benefits the global economy derives from the economies of scale.
According to Liikanen, the goal of financial regulatory reform is to make sure that the sector continues to serve as an engine for growth in the real sector, not merely as an engine of growth of banks and financial institutions.
The challenge at hand is to reform the financial sector and banks towards a more healthy size and structure in order to redirect banking activities to support the society and the real sector in the best way possible.
Liikanen believes that by making sure that the proper economic incentives and motivations are enforced among banking executives and stakeholders, we can ensure that the banking system continues to make markets efficient and act as engines of growth in the real economy. This in turn, according to Liikanen, will engender an equilibrium with regard to the size of the financial sector itself, because there is such a thing as, "too big to succeed."
No one knows what the right size of the financial sector is, but what we can do is remove any perverse incentives which could lead to an excessive growth of the sector. For example, the safety nets needed to protect depositors must not lead to the kind of moral hazard which would undermine the stability of the financial system and entire economies.