What is the right size and purpose of the U.S. financial system?

The U.S. financial services industry weathered plenty of criticism in the wake of the 2007 financial crisis, a natural reaction considering the roles played by different financial institutions in inflating a housing bubble and triggering the worst recession since the Great Depression. Of course, more prudential financial regulations are now in place, courtesy of the Dodd-Frank Act of 2010, yet it’s still worthwhile to take a step back and consider the large role of the financial system in the U.S. economy today.

A first and important observation is that the finance sector as a whole has actually become less efficient since the 1980s, according to research by New York University economist Thomas Phillippon. But Noah Smith, a professor at Stony Brook University, points out in a column for Bloomberg View that what we think of as “finance” encompasses a variety of different services. Hedge funds are different from venture capital funds, which are different from community banks. But Smith notes that they all have one thing in common: They take savings and turn them into investments, which is an incredibly important function in a complex capitalist economy.

But how big and dominant does finance writ large need to be within the U.S. economy to perform this important function? Smith argues that the best way to figure this out is to evaluate the value of each specific part of the finance sector. The questions then become, for example, what’s the value of high-frequency trading or debt-driven private equity investing.  His answer is that these are subsectors that probably are “too big on the margin.”

Then there’s the question of purpose. The U.S. financial system turns savings into investment, but are the kinds of investments chosen the most effective? Take, for example, the transformation of the commercial banking sector over the course of the 20th century. Most people think commercial banks are focused on funding business investments, yet the reality is that they increasingly focus on channeling savings into home mortgages while sub-financial sectors such as the bond markets and the leveraged loan markets serve the needs of businesses. Perhaps given these facts, we might want to consider restructuring the commercial banking sector to match its most prominent purpose.

Or consider the role of activist investors who deploy savings to drive the movement of investments toward increased dividends and share buybacks. These kinds of financial firms are setting the standards by which investments are judged. But are these payouts an accurate sign of the long-run stability of firms? If not, then that could have consequences for the broader economy. That’s certainly a question of purpose, not size.

So size might not be the only relevant question when it comes to the financial sector. The structure and the purpose of the financial system and its constituent parts are important to consider as well. If finance acts like an irrigation system for the broader economy, we need to question not only how big specific pipes are but also where those pipes eventually lead.

April 20, 2015


Monetary Policy

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