The Past Speaks

I’m writing this blog post in response to a recent report that was published by the Conference Board of Canada. The report,  “An Engine for Growth 2015 Report Card on Canada and Toronto’s Financial Services Sector” appears to have been produced with the cooperation of the Toronto Financial Services Alliance (TFSA), a lobby group that clearly wants to expand the size of Toronto’s financial services sector. (Details about whether the TFSA paid the Conference Board to write this report are not yet available, but if you have them, please email me).  The report isn’t arguing in favour of any specific policy. Instead, it is designed to soften readers up for concrete policy proposals by convincing people that financialization is good. My guess is that it is targeted at policymakers in Canada’s new government, including the new Minister of Finance, who himself worked in finance but has, on occasion, criticized proposed retirement policies that would have increased the degree of financialization in Canada.

The report reminded me a little bit of PR documents produced by similar lobbying groups in the City of London prior to the 2007-9 financial crisis, during the period of Finance-Led Growth in the UK. (Actually the financial sector still talks about the City of London being an “engine of growth”-– old metaphors never die).  It is similar to the earlier British reports in the sense that is designed the convince the reader that the financial services sector makes a massive and net positive contribution to the local and national economies and that it therefore needs the support and encouragement of policymakers. The tactic used by the report is to say: “Hey, look at the thousands of people who are employed in the financial services sector. Their wages stimulate the local economy, etc. Finance is a big share of GDP, pays lots of taxes for hospitals and schools, etc. Our financial institutions are very profitable and stable so it would be good for everyone if the government could help Toronto to become a world-class financial centre. Blab, blah, blah.”

I disagree with the basic thrust of the Conference Board’s report.  Don’t get me wrong: I’m not some sort of moron leftist who hates banks and wants to reduce financial services to 0% of GDP. I don’t want to go back to barter and I think that African countries could definitely benefit from a good dose of Victorian-style financialization. I recognize that financial institutions are very important public utilities. No country I would want to live in has a financial sector that is less than 10% of GDP.  However, I think that it is not at all clear that government policies designed to nurture the perpetual growth of financial sector as a share of GDP  would actually benefit the real economy of a city or country, although through certain accounting tricks it might be able to increase (measured) GDP.

The people who wrote the “Engine for Growth” report appear to think that more financialization would be good for the economy of Canada and, in particular, Toronto.  They think that Canada and Toronto would be better off if Toronto could essentially become another London or Wall Street.  I disagree with this view. Maybe Toronto and its immediate environment might benefit, but not Canada as a whole, at least not in the long-run.

I have come round to the view that the UK experienced excessive “financialization” in the years leading up the crisis. The percentage of the UK’s GDP and the workforce involved in finance, which rose above the levels seen in similar economies (e.g., Germany) was at an unnaturally elevated level. People joked that everyone in London either worked in finance or sold services to the people who did (e.g., the waiters at restaurants in the financial district). This was an exaggeration, but the joke contained an element of truth. Lots of paper profits were made in this period between 2002 and 2008, when London displaced New York as the world’s top financial centre. Some of that money filtered down to the real economy when it was spent by bankers in restaurants, strip clubs, etc. However, it is not at all clear that this financial activity truly increased actual prosperity in any meaningful sense. As Diane Coyle, an economist at Manchester Business School, has pointed out, the rules that govern how nations calculate GDP mean that unnatural bank profits and even bank losses can actual boost GDP, and thus apparent living standards, even if the real economy doesn’t grow at all.  John Kay, an Oxford economist, Financial Times columnist, and former bank board member, has said that much of the additional activity that took place in the UK financial services sector after deregulation in 1986 was totally parasitical on the real economy: some people in London got great jobs in finance and the sector appeared to be a net asset to the UK economy, but now taxpayers throughout the UK are paying for the party.

We are paying for the pre-2008 party through a massive increase in the national debt that took place when we bailed out the Too Big to Fail Banks and the rest of an artificially large financial services sector. Financial services grew too large, in his view, because the banks enjoyed an implicit subsidy because they were TBTF and investors knew about this subsidy. The last chief executive of the UK’s now defunct Financial Services Authority, Lord Turner, has concluded that much of the money-making activity in the financial services sector prior to 2008 is socially parasitical (“socially useless”). Turner isn’t some leftist sociologist but a onetime Conservative Party member who  was Vice-Chairman of Merrill Lynch Europe between 2000 and 2006.

Let me quote some of the relevant sentences from the Conference Board report:

Financial services have been a major source of growth for Canada over the past decade, with the sector’s employment, financial results, and international trade and investment performance outpacing the average for all sectors.

Just because a given sector (e.g., finance or the arts or paying men to dig holes and fill them back in again) is growing fast, doesn’t mean it is actually increasing GDP or doing some useful.  Given that banking enjoys an implicit subsidy that operates through a weird mechanism, I would want to see some hard evidence of social usefulness here. It may be that Canada’s financial sector is much larger than it would be under a regime of free market capitalism.

Financial institutions account for one-quarter of the profits generated by Canada’s private sector and have high profit margins.

A critic might say that’s because they are artificially profitable since they enjoy an implicit subsidy due to their TBTF status that other firms (say Tim Hortons) doesn’t have.

Compared with their international peers, Canadian deposit-taking institutions have healthy levels of capital adequacy and liquidity, with high rates of return and low levels of non-performing loans. Broadly speaking, Canadian deposit-taking institutions perform well on measures of capital adequacy. For example, the Tier 1 to RWA ratio in Canada was 11.9 per cent at the end of 2014. This is similar to the ratio in peer countries and well above the current guidelines set out by both the Basel III (6 per cent) and Office of the Superintendent of Financial Institutions (OSFI) (8.5 per cent). (See Chart 9.) Similarly, the total regulatory capital to RWA ratio in Canada, at 14.2 per cent, is well above Basel III (8 per cent) and OSFI (10.5 per cent) guidance

Measuring how much capital a TBTF bank requires under Basel III is notoriously difficult, since the question of how we risk-weight assets is very complex and a bit subjective. However, even if we accept the claim that the Canadian deposit-taking institutions have higher capital levels than their peers in other nations, they are still below the levels that  Anat Admati and Martin Hellwig regard as necessary to ensure that bankers do not again take undue risks. They think that the capital ratios should be in the range of 20-30%, which is what they were in most countries before the advent of Deposit Insurance and the implicit government subsidy that comes with that. Only capital ratios above 20% will eliminate the type of moral hazard in evidence before the crisis.

“Canada’s financial services sector is innovative; 73.6 per cent of financial services firms had undertaken some form of innovation in the previous year versus 63.5 per cent for all sectors.”

Yeah right. Can you measure innovation in a more meaningful way?  Simply asking people whether they have introduce one or more innovations, however, defined, is a very poor metric. Looking at home many patents in financial technology are filed by Canadian banks would be a somewhat better metric.  Even then, patent counts are a crude metric of how innovative a company or sector is. An even better measure would be whether Canada is a net importer or net exporter of financial technologies. Has a Canadian bank ever created a new financial technology (e.g., a new type of contactless payment card) that it then patented and licensed out to foreign banks? If so, that would show up in Canada’s export data as an export of Intellectual Property.   Now maybe Canadian banks have originated the odd innovation in socially useful retail banking technology or in socially useless trading technology (e.g., the supercomputers that do socially useless High-Frequency Trading) but I haven’t heard of it.  We certainly don’t hear about it in this report. Judging by the report, Canadian banks and other companies don’t appear to be doing much fintech innovation of either the socially useful or the socially useless variety. That’s a bit sad, actually, either way. They can’t even be Flash Boys.

I should mention that the UK government has now targeted “fintech” technology as a growth area. The current government here is concerned that while British firms were world leaders in financial technology in the past (the ATM was basically invented by Barclays in London in the 1960s), the UK is now falling behind in fintech and is becoming a net importer of fintech that was invented in US financial institutions and by US non-financial companies (Apple recently got into fintech with its new payment systems, which it has licensed out to Barclays here in the UK).

My impression is that Canadians aren’t even thinking about how the country can become a leader in fintech. Canadian banks do seem to be pretty quick at adopting fintech invented elsewhere but the country isn’t a net exporter of fintech.

Ok. The report boast that:

Canadian employment in 2014 (at 780,000 jobs) and for 6.8 per cent of Canadian GDP. the sector’s role goes well beyond the jobs it supports and the GDP it generates. A well-functioning financial services sector is a critical ingredient in a successful economy, as it links the economy together in a unique way. Financial services are a necessary input for every single business across the country and are used by essentially every adult individual. Only a handful of other sectors, such as telecommunications or transportation, have the same impact on the day-to-day functioning of the economy.

It’s certainly true that financial services are very important public utilities. Payment systems run by banks are the pipes in the economy of any advanced society. The banks’ role in routing monthly salary payments and in processing cheques and electronic transactions is very important, perhaps as important as the sewer system that shunts excrement all around town. However, I’m not aware that the Canadian financial system is incompetent at performing these basic functions. In fact, I believe that cheque clearing in Canada is much more efficient than in the United States. So why would it be necessary to increase the number of people or the share of GDP involved in providing this utility?

In fact, Canadian ROE for deposit-taking institutions is among the highest for countries that contain one or more major global financial centres. At the same time, non-performing loans as a share of all loans in Canada are among the lowest for the same group of countries. Canadian insurance firms also report above-average ROE, compared with their international peers, despite the challenges of limited premium growth and the impact of low interest rates on investment returns.

Hmmm—it’s dangerous when banks rely on ROE as a metric of their performance, since that metric incentivizes managers to economize on capital by funding expansion by issuing debt instead of through equity. As a taxpayer in a country with TBTF banks, I would prefer if people in finance started focusing on return on capital employed (ROCE) instead of Return on Equity.

Let me close by talking about what isn’t any report—any hint that the authors are aware of the possibility that there will be a wave of disruptive innovations that will do to banking what Uber had done to traditional taxi companies and what Netflix did to Blockbuster video. The absence of any discussion of the possibility that new technologies and business models such as P2P lending and blockchain might cause financial disintermediation is astonishing to me. In fact, I couldn’t even find the word “disintermediation” in this hilarious document!

I strongly suggest that the readers of this report look at the literature on the issue of fintech and financial disintermediation. They would do well to read The End of Banking, which give a good introduction to both the problems with banking as it currently exists and the potential of new technologies to replace banking with something more efficient and socially productive.