Refocus Finance on its Purpose

This essay is included in the new book from the Parliamentary Network on the World Bank and IMF: The Future of Work for the People we Serve. To sign up for the launch of the book as well as a conference on the future of work and inequality, click here!

Rt Hon Liam Byrne MP, House of Commons, and Prof David Pitt-Watson, University of Cambridge, UK

Governments and bankers have always had a love hate relationship. When one has a crisis only the other can sort it out. Sometimes it ends well. And sometimes it doesn’t.

Outside the House of Commons stands Carlo Marochetti’s great bronze statue of Richard the Lion-heart, a king kidnapped on his way back from the Third Crusade and only saved when Italian bankers stumped up a loan to pay the ransom. They were richly rewarded – only to be smashed when Edward III defaulted on his huge war loans.

Six hundred years later countries do not leave lenders high and dry. Banks, however, have proved perfectly capable of manufacturing problems of their own. When big banks go wrong, only governments – and tax-payers – can bail them out. Now, ten years after the crash, taxpayers are debating whether they got their monies worth, when they spent so much rescuing so many financial institutions. In particular many debate whether banks are really playing the role they should in mobilising the finance needed to modernise economies around the world.

Before and after the crisis, banks lent less. So the newest entrepreneurs – those without a long track record of borrowing – went to the back of the queue for finance. So many now ask: how do we ensure financial services do more to foster the creation of good jobs in the years to come? And how do we make sure that regulation actually helps?

We argue the key is to refocus on the purpose of the finance industry.

The actual purpose of finance is a question that is rarely debated, and still more rarely answered. Yet we cannot create a growing, inclusive economy, without an effective finance industry.

For most industries, it is not difficult to define their purpose. Food is there to keep us alive and to please our palates. Cars are there to get us from A to B, quickly, conveniently safely and in comfort. Pharmaceuticals cure and ameliorate illnesses.

But finance is more complicated. And those who study it have preferred to ignore the question of purpose. Rather they assume that if financial markets are competitive, they must ipso facto be purposeful.

But that can be a dangerous assumption.

In the past many medical treatments were open to competition, but not all of them cured patients. For that reason, new pharmaceuticals need to demonstrate efficacy; they need to fulfil their purpose.

We believe finance has four critical elements.

The first is simply (i) to keep our money safe. That was why the first banks were established. The second is (ii) to facilitate transactions. Because once your gold is in the bank vault, you don’t need to take it out in order to buy goods from someone who also has an account at the bank. You simply ask that gold be transferred from your account to theirs. Or you can just give them a bank-note, which promises to pay the bearer a certain sum on demand.

The third is to allow (iii) a sharing of risk. That is what insurance companies do. It is what a good fund manager will do when they ensure that they don’t put all of a saver’s money in one basket.

The fourth, and most critical function is (iv) intermediation; that is taking money from point A, were it is, to point B where it is needed.

These functions are profoundly important. The history of finance demonstrates that early financial pioneers often saw themselves as social reformers. Henry Duncan in Scotland who opened one of the first savings banks, or Friedrich Raiffeisen in Germany who created the first agricultural credit union, saw their activities as having social purpose, in much the same way as Nobel Peace prize winner Mohamed Yunus does today in Bangladesh. Their activities are critical to the improvement of the lives of poor people, and critical to creating inclusive growth.

So if these are the four functions of the finance, how well are they executed by today’s industry?

The truth is: we don’t know. We do know that over the past 70 years, the finance industry has grown enormously. But remarkably without the sort of productivity savings that we would expect as an industry matures. Thomas Philippon’s study in the USA, and Guillaume Bazot’s work, commissioned for “The Purpose of Finance” project, looks at Europe. Both show there has been no improvement in the cost of intermediation over 70 years. Unlike almost every other industry, the finance industry is no better at fulfilling its purpose today, than it was in 1950.

This then raises two questions.

First how is is possible for this to happen? In the boxed example, we summarise a study commissioned by the Purpose of Finance project, investigating asset management, which illustrates how that industry may be doing costly things which are nor purposeful, while failing to do things which are.

But the second question, and the one which is central to our work is to ask how we can create a finance industry which better fulfils its purpose.

That must begin with a debate about what a purposeful industry would look like. That is not simply a question for experts. It is one for all of us, and particularly for those who seek to guide public policy. The debate must begin, we believe by defining the hallmarks of a successful, inclusive, financial system, and then measuring whether or not we are realising that goal. In the UK, we are now bringing together the finance industry, politicians and policymakers for precisely this debate. WE know that we will not agree on everything. But unless we find the overlapping consensus and regulate to deliver these outcomes, we will consign a critical section of our economy to ever greater costs, lose the progress towards a more inclusive economy that we need, and profoundly damage our ability to mobilise investment towards creating the jobs of the future. The jobs that could reconnect the people we serve to a fair share of the prosperity our economics are capable of delivering.