One thing we’ve discussed repeatedly is that the activities of large banks, as presently constituted, are purely extractive. The reason is that they impose large costs on society as a whole in the form of periodic crises. Andrew Haldane of the Bank of England, using a simple back-of-the-envelope analysis, concluded that there was no way for banks to even remotely pay for all the damage they produce in terms of lost output. A mere 1/20th of a reasonable levy exceeded the entire market capitalization of all the major international banks. That sort of disparity between their worth as enterprises versus the losses they create means any intervention is justified to reduce the damage, including our preferred solution, regulating them as utilities.
Nevertheless, the banks have been quite successful in perpetuating the myth that they are particularly, indeed, uniquely valuable. So it’s important to look at that claim: pray tell what to they contribute?
One oft-cited measure is their contribution to GDP. It’s worth remembering that that’s a statistical construction as opposed to directly measured. And should anyone be surprised that the official approach makes banking look bigger, and hence more valuable, than it really is? As Nick Dunbar explains (hat tip Richard Smith):
Diane Coyle’s excellent new book on GDP…dissects the way the finance sector contributes to national accounts.
Consider the UK’s GDP figures for the fourth quarter of 2008, when the UK financial sector showed record growth, outstripping the contribution of manufacturing to the economy. This as at the same time as the sector required massive government bailouts, putting the UK economy into a tailspin. As Coyle points out, this absurdity means that something must be wrong.
The problem comes from the way financial services output is measured. While fee-based services (such as debt underwriting) are straightforward, most banking services are not explicitly charged to customers. For example, price of deposit taking and lending are embedded in the interest rates that banks set for these services.
As Coyle relates, the economists’ solution to this conundrum was an ugly acronym called FISIM, or ‘financial services intermediation indirectly measured’. This is calculated as the difference between the interest rate banks earn on loans or pay on deposits and a benchmark risk-free rate, multiplied by the outstanding loan balance. FISIM is recognised as the international standard for measuring bank contributions to GDP (See note 1).
The trouble with FISIM is that it doesn’t account for risk. Before the 2008 crisis, banks’ increased risk-taking and leverage was counted as ‘growth’ in GDP. Since then studies have shown that adjusting for risk-taking would reduce financial sector contributions to GDP by 25-40%. If the financial sector contribution to GDP is largely a statistical mirage, then why isn’t the methodology changed?
The depressing answer is that by boosting the importance of financial services in national accounts, FISIM became a self-fulfilling prophecy: policymakers became captured by financial services because the numbers said it was important. Why else, two years after the Bank of England published papers criticising the methodology, did incoming governor Mark Carney deliver a speech in October praising finance as contributing 10% of UK GDP?…
Note 1) As well as fees and FISIM there is also net spread earnings (NSE) from trading on behalf of clients. Since no-one actually buys a product called FISIM, government statisticians create an imaginary customer that buys it as an intermediate input and adjust overall GDP statistics accordingly.
So here we can add another reason to the burgeoning list of why it’s so hard to rein in Big Finance: government officials and analysts believe it contributes more to the economy (if you can correctly call its activities contribution) than it actually does.