Oversized financial sector can increase financial fragility, slow growth

May 4, 2018

Commentary: The financial system plays a critical role in economic development, but can you have too much of a good thing? The evidence is growing that you can.

Banks and financial markets improve economic efficiency by allocating scarce financial capital to the highest value use. A well-functioning financial system is critical for a well-functioning economy. Don’t believe me. Just think back to the 2008 Financial Crisis. I rest my case.

Problems arise when the financial system becomes too large relative to the rest of the economy. An oversized financial system drains talent from other activities without providing significant improvement in financial outcomes. When more Ivy League grads go into finance than into science, you have to ask whether this is the best use of resources.

An example that illustrates this is given by the practice of flash trading. This involves the use of sophisticated patterns of high speed trading to detect large orders, then using this information to make a profit.

Flash trading provides very little benefit to society as a whole. Perhaps the market equilibrium is found a few nanoseconds quicker—an improvement undetectable by human perception with no real implications for financial decision making.

On the other hand, flash trading increaes market instability by introducing the possibility of flash crashes, where competing computer programs, reacting to the same market information, seek to sell the same security simultaneous.

So if the financial system is too small, it has insufficient volume to efficiently allocate capital and the consequence is inefficiency. If the financial system is too large, there is increased economic cost while capital allocation is only slightly improvement if at all. And what gains there are, is offset by increased financial fragility.

The data seems to suggest that when the credit-to-GDP ratio exceeds 90% there is little benefit to expanding the financial system. The global average is 184%. The number for the United States is 242%. Based on this, it appears that the world is over banked.

Of course, as is often said, correlation isn’t causality. It may be that there is reverse causality. Slow growth causes high credit-to-GDP ratios, not the other way around. Or causality could run both directions.

In any case, the expansion of the U.S. financial system is driven in large part, especially prior to the 2008 Financial Crisis, by the implicit guarantees extended to large financial institutions by the Federal Government—the so-called too-big-to-fail doctrine. This was never official policy of the United States government, but when push came to shove, Bear Stearns, Fannie Mae, Freddie Mac, AIG, and Citicorp, among others, all received large bailouts.

Government guarantees allow large banks to expand their balance sheets without fear that increase risk will scare away clients. Thus the large U.S. financial system is not a free market outcome but driven by government policy.

Christopher A. Erickson, Ph.D., is a professor of economics at NMSU. He has taught money and banking since 1984. Chris