Two scenarios for future of big finance

28 February 2013


No one with any common sense would welcome a return to the mania of the mid-2000s. Too much finance can be dangerous to economic health. But too little finance hurts, too. Promising investments are starved. Consumers can't borrow for homes or education. Growth is slower.

Bankers complain that the plethora of post-crisis regulation and the persistence of low interest rates make lending unattractive. Analysts and policy makers seared by memories of the panic worry that the foolish risk-taking is returning to some corners of the market.

As a share of the world economy, the global stock of debt, both private and public, and equity peaked in 2007, plunged and has now recovered to 2000 levels, according to a McKinsey Global Institute database of 183 countries.

By this gauge, finance grew at nearly an 8% annual rate in the 1990s and early 2000s. A big chunk of the increase - more than a third - came from big finance leveraging itself to make bigger bets.

By 2007, financial institutions' borrowing had grown to five times the bonds issued by other corporations and was even bigger than the market for government bonds, McKinsey estimates in a snapshot of global finance to be released today.

The social value of finance isn't to fuel Wall Street's casinos or make traders and hedge fund partners rich. It is, rather, to deploy the world's savings in investments that pay off in the future.

But only about one quarter of the increase in global finance between 1995 and 2007 went to households and non-financial corporations. The rest went to big financial firms or government, some of which did go to infrastructure, education and other investments.

Then came the crisis. Since then, the supply of global finance has climbed at less than 2% a year, and much of that increase is the result of governments borrowing to shield the world economy from the aftereffects of the bust.

Rich country banks have pulled back. European banks increasingly are reluctant to lend across borders; jitters about the durability of the euro and the stability of national governments have reversed a decade of financial integration. In emerging markets, the growth in stock and bond markets - which had been a welcome sign of economic maturity - has largely stalled.

At the same time, there are signs that big finance is no longer in retreat. Among them, the return of enormous, debt-financed corporate takeovers - some of them with such pre-crisis warts as interest paid in IOUs instead of cash - and the surging demand for junk bonds.

So now what?

As you would expect from a consulting firm, McKinsey offers two scenarios.

In the first, recent trends will persist and total financial assets as a share of the world economy remain stable or even decline a bit. We get less of the bad stuff, but less of the good stuff, too. The resolve of governments to complete the refashioning of the financial regulatory scaffolding weakens, and banks are overwhelmed by inconsistent and redundant national rules. Cross-border flows of capital remain below pre-crisis levels. Emerging markets with shallow, undeveloped capital markets are stuck there.

A repeat of the 2008 financial crisis is less likely. But a credit crunch starves businesses that need financing to expand as well as investments in infrastructure, research and education that would pay off in the future; the world economy continues to grow very slowly.

In the second scenario, we get more good finance but less bad. Global governments finish regulatory scaffolding to avoid the worst excesses of the recent past: They make sure banks are well capitalised, but not discouraged from taking sound risks. They figure how to close, rather than bail out, big border-crossing banks that run into trouble. They let banks get big enough to serve multinational corporations, but not so big that they put the whole system at risk. They protect national economies without building barriers to competition or the healthy flow of capital among countries.

The innovative energy of financial engineers is diverted to creating new, better ways to direct credit to small and medium-size companies and emerging market consumers. Outside the US, bond markets grow, reducing the share of financing that runs through big banks. Anachronistic barriers that block pension funds and other institutional investors from investing abroad are dismantled. Foreign direct investment flourishes, spreading the innovations that help improve lives.

This is an age of ambivalence about finance - and for good reason. It nearly destroyed us. But we can't prosper without it.

It's like the joke that Woody Allen tells at the end of "Annie Hall."

"A guy walks into a psychiatrist's office and says, "Hey doc, my brother's crazy! He thinks he's a chicken." Then the doc says, "Why don't you turn him in?" Then the guy says, "I would, but I need the eggs.'"

  • By David Wessel

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