LONDON - For at least a quarter-century, the financial sector has grown far more rapidly than the economy as a whole, both in developed and in most developing countries. The ratio of total financial assets (stocks, bonds, and bank deposits) to GDP in the United Kingdom was about 100% in 1980, while by 2006 it had risen to around 440%. In China, financial assets went from being virtually non-existent to well over 300% of GDP during this period.
As the size of the financial industry grew, so, too, did its profitability. The share of total profits of companies in the United States represented by financial firms rocketed from 10% in 1980 to 40% in 2006. Against that background, it is not surprising that pay in the financial sector soared. The City of London, lower Manhattan, and a few other centers became money machines that made investment bankers, hedge-fund managers, and private equity folk immoderately wealthy. University leaders like me spent much of our time persuading them to recycle a portion of their gains to their old schools.
For the last two years, things have been different. Many financial firms have shrunk their balance sheets dramatically, and of course some have gone out of business altogether. Leverage is down sharply. Investment banks with leverage of more than 30 times their capital in early 2007 are now down to little more than ten times. Trading volumes are down, as is bank lending, and there have been major layoffs in financial centers around the globe.
Is this a short-term phenomenon, and will we see an early return to rapid financial-sector growth as soon as the world economy recovers? Already the market is full of rumors that guaranteed bonuses are returning, that hedge funds are making double-digit returns, and that activity is reviving in the private equity market. Are these harbingers of a robust recovery for the financial sector, or just urban myths?
There is no certain answer to that question, but perhaps economic history can offer some clues. A recent analysis by Andy Haldane of the Bank of England of long-term returns on UK financial sector equities suggests that the last 25 years have been very unusual.
Suppose you had placed a long-term bet on financial equities in 1900, along with a short bet on general equities - in effect a gamble on whether the UK financial sector would outperform the market. For the first 85 years, this would have been a very uninteresting gamble, generating an average return of only around 2% a year.
But the period from 1986 to 2006 was radically different. During those two decades, your annual average return would have been more than 16%. As Haldane puts it, "banking became the goose laying the golden eggs." Indeed, there is no period in recent UK financial history that bears any comparison to those jamboree decades.
If you had unwound your bet three years ago, you would now be sitting pretty - as long as you had gone into cash, of course - because the period since 2006 has undone most of these gains. So if you had held your bank stocks up to the end of last year, over 110 years your investment would have yielded an annual average return of less than 3%, still broadly a break-even strategy.
Why was this 20-year experience so unusual, with returns so much higher than at any time in the last century?
The most straightforward answer seems to be leverage. Banks geared up dramatically, in a competitive race to generate higher returns. Haldane describes this as resorting to the roulette wheel.
Perhaps that analogy is rather insulting to those who play roulette. Indeed, the phrase "casino banking" tends to ignore the fact that casinos have a rather good handle on their returns. They are typically very astute at risk management, unlike many of the banks that dramatically increased their leverage - and thus their risks - during the last 20 years.
The conclusions that we might draw for the future depend heavily on how central banks and regulators react to the crisis. At present, financial firms are learning the lessons for themselves, reducing leverage and hoarding capital and cash, whereas the authorities are trying to persuade banks to expand lending - precisely the strategy that led to the current crisis.
Of course, we know that a different approach will be needed in the longer run. In effect, the authorities are following the approach first outlined by St. Augustine. They would like banks to be "chaste," but not yet.
But when growth does return, leverage will be far more tightly constrained than it was before. Regulators are already talking about imposing leverage ratios, as well as limits on risk-weighted assets. If they follow through, as I expect, there will be no return to the strategies of the last two decades.
In that case, finance will no longer be an industry that systematically outpaces the rest of the economy. There will be winners and losers, of course, but systematic sectoral out-performance looks unlikely. What that will mean for financial-sector pay is a slightly more complex question, to which I will return.
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