Financialisation is one of those catch-all terms for the rise of financial capitalism since the 1980s where loans, stocks, derivatives, leveraging, share buy-backs and other financial products have become enmeshed within the very fabric of businesses, not just in Canary Wharf but also affecting SMEs and local businesses. For the scope of this post I looked at FIRE (the US Labour Bureau categories of Finance, Insurance and Real Estate) as well as the newer FinTech sector. Before we get into trashing finance and people working in the industry for being leeches remember, originally finance and money-lending came into being because people and businesses found it useful to borrow against future earnings or revenue. I did a deeper dive into the different aspects of finance and here’s a not-so-quick take on whether finance in the broader economy helps or hinders.
For example, you’re a budding entrepreneur and you want to get your business off the ground. But you need money. Between getting a lease on an office or shop, hiring one or two people, buying inventory and office supplies and paying for any software, hardware or machinery you need for your… say, printing shop or software company, you could be several tens of thousands of pounds out of pocket. But these days, there’s options from local banks and building societies, angel investors and venture capitalists all the way to institutional investors keen to get ahead with the next big thing.
For most people ‘in the real world’, finance has a dirty ring to it. Apart from banking, credit cards, car loans and maybe the mortgage on the biggest asset people own, there’s little interaction with the kind of finance occurring in boardrooms, trading floors and glass offices in Canary Wharf or Wall Street.
And there’s a good reason for that – as a person there’s only a few things expensive enough to warrant leveraging so the realm of personal and residential mortgage only has so much room for product innovation. By that I mean using your down-payment much the same way as a pulley – you apply far less force on one side but the combination of angles amplifies that force through mechanical advantage. But leveraging and by definition debt is taken against future potential earnings. This is why a bank will look at both your record on earning and paying bills but also future prospects to assess credit-worthiness. With a person there’s a degree of predictability, especially with salaried employees whose earnings are likely going to be more or less where they are now in a year’s time.
But if you’re a company, your revenue depends on a hundred different factors: the success of expansion plans, raw materials, supplier reliability, the workforce, competition, changing customer tastes, currency fluctuations if you sell abroad and these days a dozen technology platforms from CRMs, and HRMs to your Azure, G-Suite or AMS cloud applications. Breakdowns and changes in any of those could affect a company’s revenue from year to year. Business planning and contingency planning helps, but just how nobody predicted the current health crisis back in 2019, there are smaller shocks battering the average company from every direction every year.
As the quote by the Prussian general Helmut Moltke the Elder goes, “No battle plan survives contact with the enemy.”
Some companies have big enough margins from profits to build a war-chest (Apple’s was estimated at around $210bn in July 2019). But if you’re a supermarket (the original aggregators selling other companies’ stuff with a margin on top), you make less than 2% in some cases. So you sell volume, you cut costs all the time, reduce the stock you keep to only a handful of options (discount shops like Aldi and Lidl popularised this strategy). But shocks still come and in a pinch you borrow against future earnings. If you weather the storm, you recover and keep operating. But between the interest eating away at what little margins you might have and other shocks the next quarter, the next year and industries changing in all the wrong ways, companies rarely if ever finish paying loans. Besides, spreading one big cost like a new factory or piece of equipment over many months or even years is an attractive option.
Insurance and real estate as finance
FIRE (Finance, Insurance and Real Estate) is a US definition for the highly-financialised sectors of the service economy. Real Estate stands out as more ‘real’ (har har har) or tangible than the other two, but between the size of the mortgage industry and what happens to those mortgages after they get underwritten makes this a very financialised sector too.
Insurance I found the most interesting out of the three and also the most difficult to determine whether it has a net positive or negative impact on society at large. The concept’s pretty simple – nasty stuff happens all the time so you take out a policy to protect in case it does happen.
The negative is that insurance policies are geared towards protecting insurers from having to cash out unless very specific conditions are met. Your house may have burned down but if it started because of a cigarette lit by your neighbour (who hasn’t smoked in 20 years and only lit one to feel something, anything after a long and tedious marriage with two thankless children) might not apply to the policy conditions.
There’s another layer to it called re-insuring (see Munich Re, Swiss Re and Lloyd’s). This is insurance for the insurers – if some rare event affects multiple customers either across a country or even internationally and the insurer has to pay out more than they have available, they cash in their re-insurance policy.
Somewhat surreally, someone designed a re-insurance policy for a global health crisis like a pandemic back in 2018. But between the launch in mid-2018 and December 2019 when the reality of coronavirus hit business leaders outside of China for the first time, that insurance policy had no takers. The scientist working with Munich Re on creating this specific insurance policy said: “As far as I know, nobody bought the policy,”
As humans, we are bad at forecasting risks, even more so when the risks are so rare we don’t keep them front of mind. A good way to think of insurance and many financial products is preparation for the future in a world with humans. Smoothing out risk helps businesses and individuals. There is value in having the finance industry.
The complicated, nitty-gritty of finance
Going back to real estate, banks underwrite mortgages. But there’s a massive investment industry ready and willing to buy financial products so MBS (mortgage backed securities) were created. They’re pools of mortgages designed to spread the risk of default. But this only works if the quality of most mortgages included was solid (i.e. high repayment rates, stress-tested forecasts, high FICO scores in the US/ agency-specific credit ratings in the UK and reliable auditing by independent evaluators). You can tell there’s a lot of places for it to go wrong – a change in measuring methodology, perverse incentives on behalf of the auditor – and take down the whole show with them. *cough 2008 *cough
Part of the issue is the quantitative easing (QE) going on right now. QE is the central bank (independent of the government, aims to keep inflation in check) buying assets to stimulate the economy. This works mainly in two ways – buying corporate bonds in effect finances large companies over long periods of time and buying government bonds helps keep interest rates down, as well as finance government spending.
Interest rates have been at an all time low for nearly 10 years. To the point that economists agree (assuming no change in economic theory to allow for negative rates) there’s no room to stimulate the economy that way. So the central banks of the US, UK, EU and Japan chiefly set out to purchase financial instruments to push money into the economy at large. But a breakdown of where that money goes shows us that trying to get banks to lend more by giving them money is (according to the New Economic Foundation) ineffective.
QE also purchases other assets but by and large it pumps money into the financial sector through bond-buying.
The size of finance
It’s a bit ironic, all the talk of diversification from financial advisers when so many service economies are made up of larger and larger financial sectors. Banks are getting bigger, the ring-fence separating investment from commercial banks is unlikely to prevent another crash and worst of all, the rise of algorithmic and high-frequency financial instrument trading means a productive company’s stocks don’t react like they used to.
That’s a lot of links, not because I’ve decided to become Wikipedia, but because it’s such a complicated topic. Besides, determining the size of the finance sector is much easier than determining its exact impact or the best size of it. The heart of the ‘too big’ side’s argument is that finance is invariably connected to the rest of the economy multiple times over.
If we take the purpose of the finance industry as ‘providing capital to businesses’, I’d argue it’s a matter of allocation (isn’t everything?), not lack of capital. Venture capital is awash with money and start-ups are often overloaded and overvalued, in the case of unicorns (valuation>$1bn) by as much as 50%. The venture capital money is chasing the unicorn rewards, when there are plenty of SMEs and local businesses who still rely on mainstream banks.
By this measure, it’s misaligned incentives that makes finance not deliver on its purpose for existing. This is why I, like many others, believe the tech sector (but most platforms and venture-capital backed companies) are at risk of the bubble bursting, sending waves through the economy. Less ripples, more tsunamis. 2008 is obviously the inspiration here.
While 2008 was all about misaligned incentive structures that rewarded risky mortgage underwriting, let’s assume for the sake of the argument anything similar that happened again won’t be malicious. I’m of the opinion that the bigger a system or network is, the higher the chance that miscommunication compounds. Promotions and bonuses based on results often lead to inter-department feuds. Cost-cutting drives remove bits of a company that work perfectly fine, even if the impact isn’t immediately obvious.
Neo-liberalism and free-market economics (and social darwinism, survival of the fittest that features as part of this school of thought) posits that for an industry to be so successful, it must have delivered value so that individuals and companies kept buying their insurance policies, financial instruments that smoothed out risk and welcomed finance into their company structures.
To further evaluate this point, commercial retail banks often operate on above-average margins of 24% vs 8% for the market average (If you don’t like Investopedia – here’s a table). This means they make more profit than the average company for a fixed amount of ‘sales’ or ‘product’. For retail banking that’d be loans, mortgages and associated services they offer. But those margins are deceptive – we have been at an all-time-low in interest rates for years and we don’t know if they would survive another trial by fire as in 2008.
What can we do?
But those profit margins indicate also that there’s an effective model, basic business studies classes suggest a lot of that money must be reinvested in the business. Otherwise, businesses that don’t would quickly be outmatched by those that do.
Interestingly, banking as an industry lags in terms of R&D. I would argue it’s the productive economy’s dependence on finance that’s the issue, coupled with mature markets (retail banking anyway). If finance goes down, so does the steel mill, the car dealership and the corner shop. Not that the businesses are blameless for overextending themselves and having excessive debt service coverage ratios.
The New Economic Foundation report I mentioned earlier argues that the purpose of a loan matters more than the amount of it – that we could reduce lending and the amount of money while increasing the proportion of it for investment and productive use. A national industrial strategy as proposed by Mariana Mazzucato could sideline the finance sector and provide finance directly from the government to the sectors of the economy deemed nationally strategic. Naturally, any government involvement is deeply political and private sector efficiency has long been held in high regard. This is one of the more heavy-handed solutions. One which, like government regulation, is often steered by lobbying from the exact companies it seeks to regulate.
Another solution is re-evaluating the ring-fence between commercial and investment arms of banks to protect retail savers and debtors from risks inherent to the big deals of investment banking.
Going back to QE – there’s nothing new about the open market operation, other than the scale and time on which it is happening. The only change I would bring up is refocusing the asset-buying programme to companies directly rather than having over 50% of QE buy financial instruments held by finance sector companies. Even then, there’s an inequality built into buying assets, since asset-less citizens have benefited least. This article outlines that. The Bank of England, on the other hand, argues QE has helped increase incomes for the average Brit by £8000 by 2018 over what it would’ve been without.
This is a massive topic. Some parts get really technical, like MBS, securities and QE. To the average person they seem useless or worse, fraud disguised in legal-finance mumbo-jumbo. I stand by my assumption that in most cases where it fails to deliver its purpose it’s misaligned incentives, rather than corporate malice. Then there’s other parts of finance, like arbitrage in stocks and commodities, that I chose to skip entirely to keep this post to reasonable size (it’s still on the longer side of what I’d like to put out).
It has also proven difficult to outline more solutions (although the NEF report I linked twice seemed to go furthest with that), especially when it comes to QE (it’s only been running for 10 years so we’re only now seeing reports and studies about the effects of the 2010-11 round of QE). One clear conclusion I can draw is there is too much money and not enough of it is going to the productive economy (share buy-backs in some cases). QE helps somewhat with that, by buying corporate and government bonds. But to shift that money to the productive (not necessarily just tangible goods) economy would require more government involvement than ever. Perhaps the recession following the lockdown in 2020 spurs that on. Perhaps the government steps back after spending so much money during the lockdown itself, on furlough and the CBILS.
At a personal level, it’s more important than ever to support public and private initiatives that help the productive economy. This involves voting, keeping yourself (especially as a business owner) informed about industry alliances and government partnerships. I am a big supporter of the national industrial strategy ideas M. Mazzucato puts forward, in the same way that the space race in the 1950s and 60s created entire industries out of thin air (pun quota fulfilled) and the military research of the Cold War developed the GPS, the Internet and smartphone prototypes. But as we stand at the crossroads of environmental and health crises, it is up to politicians and business leaders to decide whether the finance industry fulfils its purpose.