IEA releases report on financial services and the benefits they bring to all

The much-maligned financial services industry is a crucial part of everyday life. Contrary to popular misconceptions, its greatest benefits are felt by the less-well-off and middle classes. The economic function of the financial services industry is to reduce transaction costs for saving, for protecting against major risks, providing for an income in old age, acquiring capital to start a business and for making every day transactions. The costs of these things for most people would be prohibitive without the modern financial services industry.

A new report from the Institute of Economic Affairs debunks the commonly held idea that financial services are “socially useless”, and demonstrates that, despite having intangible outputs, the sector is vital to consumers regardless of income. Moreover, the oft-proposed remedy – increased statutory regulation – may heighten rather than mitigate the exposure of taxpayers and households to recessions and speculative bubbles.

The financial services industry is one of the UK’s most productive and the increased regulation of the sector has contributed to the decline in productivity. Half of the UK’s financial services output is exported, thus helping to finance the import of (mainly) manufactured goods.

Key benefits of financial services:

• The financial sector is a pro-poor industry, making possible everyday activities that in the past were only possible for the wealthiest. Financial institutions exist to reduce the cost to businesses of raising capital and the costs to individuals of saving and protecting against risk. Thanks to the existence of financial markets, households can spread risk across a range of institutions and a range of potential borrowers. Reducing the transaction costs of financial activity enables people to spend their time more productively.
• The sector embraces innovation. Financial institutions are continually evolving. For example, peer-to-peer lending networks now enable households to diversify their risk while omitting the intermediary partly or entirely.
• The UK has a huge trade surplus in the financial sector, equivalent to 3 per cent of national income. Even if the financial services output of the economy was socially useless, the fact that much is exported – providing the income to buy other goods and services – significantly reduces the power of that argument.

Debunking criticisms of the sector:

• Inequality. The much-cited literature linking financial growth and adverse economic outcomes is simply too crude to warrant drawing clear policy conclusions. Studies linking financialisation with inequality are similarly ambiguous: the top ten countries for their share of finance in GDP are a mixture of high-, medium- and low-inequality countries. Three of the OECD’s eight most equal countries are in the top ten of countries with the largest financial sector as a proportion of national income.
• High salaries. Compensation in the financial sector, at 6.9 per cent of all compensation, is in line with the sector’s contribution to the economy (7.2 per cent of gross added value).
• Short termism could be tackled by removing the regulations that encourage rapid turnover of shares and short-term metrics in management reporting. Corporate governance codes are overly focused on information provision which may encourage managers to pursue short-term objectives contrary to the interests of shareholders.
• Duping consumers. It is often argued that consumers are harmed through mis-selling, which is the justification behind a large amount of consumer finance regulation. Yet we cannot know in advance whether regulation will improve a market. The perfectly informed regulator is as much of a fiction as the perfectly informed consumer. The FCA’S recent cap on payday loans costs shrank the market by between three and five times more than the regulator expected. Markets are not perfect, but regulation is often a very poor substitute.

Commenting on the report, Professor Philip Booth, Senior Academic Fellow at the Institute of Economic Affairs, said:

“Animosity towards the business of finance is ancient and persistent, but just because its outputs are intangible should not take away from its inherent value. Over-regulation can increase risk in the financial sector as well as reduce competition.

“The Government itself should recognise the unintended consequences of legislation and take a more patient approach. A more stable policy framework would help long-term investment and reduce short-termism.”

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