'Financialisation' and the growth of the financial sector
In the 1980s and 1990s western governments deregulated the financial system, and removed obstacles to the cross-border movement of capital. One of the results was a significant expansion in the size and profitability of the financial sector relative to the rest of the economy.
As restrictions on banks and other financial institutions were lifted, and the global economy grew, lending increased. Private debt - owed by businesses and households - rose rapidly in the period up to the financial crash of 2008, which revealed the increasingly risky nature of credit practices and the greater financial instability to which it led. Public debt increased after the crash as governments were forced to bail out the financial sector and respond to the recession. In 2021 total global debt had risen to over three and half times the value of global GDP.
The same period saw many financial companies focus on essentially short-term financial activities - trading and speculating in shares, bonds, currencies and other assets - rather than providing investment capital for new and growing businesses.
These processes of financial sector growth - and the increasing use of financial metrics in other parts of the economy - are often described as the 'financialisation' of the economy.
In the UK the City of London and the wider financial sector employ over a million people and make a major contribution to the UK's trade balance. However some analysts argue that the financial sector has now become too large, acting as a drain on the rest of the economy rather than as a net asset. Critics of financialisation argue that the financial sector is now too much focused on extracting value from the economy and not enough on helping create it.
The Transnational Institute explains the concept and history of financialisation and explores its impacts in the economy and society.
In a report for the IPPR Commission on Economic Justice, Grace Blakeley analyses the impact of financialisation on the UK economy. Arguing that the City of London's role in the global financial system has damaged UK manufacturing and exporting sectors by pushing up the value of sterling, contributed to a model of economic growth overly dependent on house price inflation, and fuelled inequality, she proposes a range of reforms.
A report from the Sheffield Political Economy Research Institute argues that the UK's financial sector is now too large. Arguing that the UK economy suffers from a ‘finance curse’ through which the finance sector skews the development of the economy as a whole, the authors seek to estimate the scale of the economic damage caused.
Economist William Lazonick shows how the growth of 'share buybacks' (where companies buy their own shares) reveals the financialisation of modern corporations, and the extent to which they and the financial sector have become value extractors rather than value creators.
Economist Daniela Gabor explains the growth of 'shadow banking', the network of financial institutions which act like banks but are not regulated or supervised in the same way, and examines their impact on overall financial stability.
Economists Brian Bell and John van Reenen examine the significant increase in financial sector pay and bonuses over the last three decades and show how this has contributed to extreme wage inequality in the UK.
Finance for business investment
Prior to the pandemic, UK banks lent a smaller proportion of their total lending portfolio to businesses than did banks in other European countries, with a higher proportion going to housing and real estate mortgages. This has helped fuel the growth of house prices while doing little to develop the UK's productive base.
Although bank lending to small and medium sized enterprises (SMEs) has risen sharply during the Covid-19 crisis, it is widely believed that the underlying problem - the difficulty many businesses have in accessing affordable loans from banks - may return once the crisis is over.
A widespread criticism of the UK's financial system is that there is insufficient provision of 'patient capital' - long-term finance for innovation and business development - with too many financial institutions seeking short-term returns.
Reform proposals range from stronger credit guidance policies, to steer lending towards productive sectors, to the development of publicly-owned and other 'stakeholder' banks focused on financing innovation and business development.
UCL’s Institute for Innovation and Public Purpose argues that governments should experiment with credit guidance policies to support business development. Such policies could limit the proportion of bank lending which goes to housing and real estate and require higher proportions of lending to go to non-financial sector businesses.
UCL's Institute for Innovation and Public Purpose has examined the role which publicly-owned investment banks have played in a variety of countries to provide patient finance for innovation and business development, and proposed the creation of a UK National Investment Bank. The centre-right think tank Onward has also called for the establishment of a national investment bank, arguing that this could unlock £16 billion in capital for investment in small and medium sized businesses, municipal infrastructure and project finance to level up lagging regions. The Scottish Government established the Scottish National Investment Bank in 2020.
Business academic Colin Mayer explains why the UK’s big four clearing banks are ill-suited to funding the long-term growth of small and medium sized enterprises and calls for a new state-backed venture capital fund.
Financial system reform
Since the financial crash of 2008 national and international authorities have implemented a range of reforms aimed at reducing the risks which individual financial firms can take, and the systemic risks which the financial system as a whole poses to the rest of the economy.
But critics of the structure and behaviour of the financial system argue that these reforms do not go far enough. They note that the incentives faced by financial companies and the herd-like behaviour of financial markets tend to drive asset bubbles in an upswing and exacerbate recessionary forces when the economy experiences a downturn. Closer regulation of the shadow banking sector and stronger counter-cyclical measures are required if financial instability is to be reduced.
The financial crises of 2008-12 showed that, while shareholders gain the benefit of financial firm profitability, major losses will be borne by debtors, and by society and taxpayers. A number of reform proposals therefore focus on ensuring that financial firms share the liability for failure.
The financial system connects savers and investors. But recent decades have seen the growth of 'agency capitalism', in which a wide range of financial intermediaries manage investment funds. Reformers seek to ensure that such companies have stronger fiduciary duties to act in the interests of savers.
Deeper financial reform proposals centre on the goal of creating a 'purpose-driven' financial system, designed to serve the rest of the economy rather than itself, and in particular which supports efforts to build a more environmentally sustainable and inclusive economy.
The NGO Finance Watch sets out why deeper financial system reform is needed, and the principles on which it should be based.
The Finance Innovation Lab explains the concept of 'purpose-driven' financial regulation, exploring how current regulatory assumptions hinder financial firms focussed on social and environmental impact. It argues that regulators need to be given new mandates on the purpose of finance; a different mindset, embracing purpose-centred business models; and new metrics that assess how well the financial system and financial firms are fulfilling their ultimate purposes.
The Finance Innovation Lab explains the different ownership structures and business models of purpose-driven and non-shareholder-based financial institutions, including building societies, credit unions, mutual and ethical banks, and community development finance institutions (CDFIs). It discusses the barriers to a further scaling-up of these models and how they can be overcome.
In a policy briefing for Economists for Inclusive Prosperity, Atif Mian examines the economic impact of the growth of credit and debt. Among his policy proposals to reduce financial volatility is the use of ‘state-contingent contracting’ which allows a more equitable sharing of risk between creditor and debtor in the event of a wider economic downturn.
In a SPERI blog, economist Johnna Montgomerie proposes a 'modern debt jubilee', in which targeted debts of low-income households would be written off. Such a measure, she argues, would bring macroeconomic renewal by freeing up household cash-flow in the same way as a tax cut, and help relieve poverty. It would signal an end to debt-dependent growth.
Financial taxes
Green finance
Achieving an environmentally sustainable and net zero economy requires a significant increase in investment in green technologies and sectors. This in turn will require much larger financial flows into these investments. At the same time, investment in high-carbon and polluting activities needs to diminish.
Over recent years the Bank of England other central banks have begun to pay attention to the risks to financial stability posed by climate change and climate change policy. They have sought in particular to ensure that financial institutions disclose their exposure to climate risk.
Some reformers are now calling for financial regulation to be tightened for financial firms with significant exposure to assets - for example investments in fossil fuels - which could become devalued or 'stranded' as a result of future climate change policy.
Various proposals are now being made to incentivise financial investment in green technologies and sectors. The European Commission has set out a taxonomy of sustainable economic activity to underpin its 'Green Deal' strategy.
A paper for the Climate Change Committee sets out a series of recommendations to enable the UK to build a "net zero financial system". It argues that both sector-specific strategies and system-wide instruments are required to enable market innovation and increase demand for climate-aligned financial products. It proposes that the Bank of England should fully integrate climate risk and net-zero into financial regulation and monetary policy, and net-zero targets should be made mandatory for financial institutions.
UCL’s Institute for Innovation and Public Purpose and the EIC-Climate KIC set out a comprehensive framework for green financial reform, including the stress-testing of UK financial institutions for how resilient they are to climate change.
Finance Watch calls on regulators to break the "climate finance doom loop", in which financing of fossil fuels causes climate change, and climate change threatens financial stability. It argues that higher capital requirements should be required for banks exposed to stranded assets. By the same token, Breugel propose that central banks offer a lower cost of capital to low carbon firms.
Columbia University historian Adam Tooze argues that central banks need to move from managing the financial risk posed by climate change to altering the direction of economic growth so as to minimise those risks arising in the first place