Is the financial sector too large?

A question asked by Greg Mankiw over at his blog. He points us to two possible answers.

This first of these is The Growth of Modern Finance by Robin Greenwood and David Scharfstein. Their abstract reads:

The U.S. financial services industry grew from 4.9% of GDP in 1980 to 7.9% of GDP in 2007. A sizeable portion of the growth can be explained by rising asset management fees, which in turn were driven by increases in the valuation of tradable assets, particularly equity. Another important factor was growth in fees associated with an expansion in household credit, particularly fees associated with residential mortgages. This expansion was itself fueled by the development of non-bank credit intermediation (or “shadow banking”). We offer a preliminary assessment of whether the growth of active asset management, household credit, and shadow banking – the main areas of growth in the financial sector – has been socially beneficial.

They conclude,

Our objective in this paper has been to understand the activities that contributed to the growth of finance between 1980 and 2007, and to provide a preliminary assessment of whether and in what ways society benefited from this growth.

Our overall assessment comes in two parts. First, a large part of the growth of finance is in asset management, which has brought many benefits including, most notably, increased diversification and household participation in the stock market. This has likely lowered required rates of return on risky securities, increased valuations, and lowered the cost of capital to corporations. The biggest beneficiaries were likely young firm, which stand to gain the most when discount rates fall. On the other hand, the enormous growth of asset management after 1997 was driven by high fee alternative investments, with little direct evidence of much social benefit, and potentially large distortions in the allocation of talent. On net, society is likely better off because of active asset management but, on the margin, society would be better off if the cost of asset management could be reduced.

Second, changes in the process of credit delivery facilitated the expansion of household credit, mainly in residential mortgage credit. This led to higher fee income to the financial sector. While there may be benefits of expanding access to mortgage credit and lowering its cost, we point out that the U.S. tax code already biases households to overinvest in residential real estate. Moreover, the shadow banking system that facilitated this expansion made the financial system more fragile.

The second is Is Finance Too Big? by John H. Cochrane. He concludes,

Greenwood and Scharfstein’s big picture is illuminating. The size of finance increased, at least through 2007, because fee income for refinancing, issuing, and securitizing mortgages rose; and because people moved assets to professional management; asset values increased, leading to greater fee income to those businesses. Compensation to employees in short supply – managers – increased, though compensation to others – janitors, secretaries – did not. Fee schedules themselves declined a bit.

To an economist, these facts scream “demand shifted out.” Some of the reasons for that demand shift are clearly government policy to promote the housing boom. Some of it is “government failure,” financial engineering to avoid ill-conceived regulations. Some of it – the part related to high valuation multiplied by percentage fees – is temporary. Another part – the part related to the creation of private money-substitutes – was a social waste, has declined in the zero-interest rate era, and does not need to come back. The latter can give us a less fragile financial system, which is arguably an order of magnitude larger social problem than its size.

The persistence of very active management, and very high fees, paid by sophisticated institutional investors, such as nonprofit endowments, sovereign wealth funds, high-wealth individuals, family offices, and many pension funds, remains a puzzle. To some extent, as I have outlined, this pattern may reflect the dynamic and multidimensional character of asset-market risk and risk premiums. To some extent, this puzzle also goes hand in hand with the puzzle why price discovery seems to require so much active trading. It is possible that there are far too few resources devoted to price discovery and market stabilization, i.e. pools of cash held out to pounce when there are fire sales. It is possible that there are too few resources devoted to matching the risk-bearing capacities of sophisticated investors with important outside income or liability streams to the multidimensional time-varying bazaar of risks offered in today’s financial markets.

Surveying our understanding of these issues, it is clearly far too early to make pronouncements such as “There is likely too much high-cost, active asset management,” or “society would be better off if the cost of this management could be reduced,“ with the not-so-subtle implication ( “Could be?” By whom I wonder?) that resources devoted to greater regulation (by no less naïve people with much larger agency problems and institutional constraints) will improve matters.