Why finance matters for inclusive growth

Most people would agree that a successful modern economy, particularly one which promotes inclusive growth, requires an effective financial system.  But few stop to ask how we might measure efficacy. Indeed you will search, almost in vain, amongst the writings of economists to find a single one who begins by defining the purpose of the financial system, leave alone trying to measure how well it serves that purpose. As a result, our debate about what the finance system looks like often ends up either in platitudes, “it should have a good culture”, or in the micro detail which only the practitioners themselves understand.

There may be a better approach, which can create a proper debate about this most vital industry.  We should start by defining the purpose of the finance industry. If we did we might note that it should be able to keep our money safe; to help facilitate transactions; to allow us to share risk. And above all to intermediate, that is “to take money from point A where it is, to point B where it is needed”. That is perhaps the most important role of the finance industry and a vital one if we are to promote growth.

So how well does the finance industry perform this function?  One study in the US, has looked at how much it has cost, over 130 years, to take $1 of savings and invest it in the real world. You might expect it would have fallen, after all we have invented phones, computers and the internet. But you would be wrong. Thomas Philippon, the academic who wrote the report, concluded there had been no improvement in productivity measured this way. Yes, there were many more transactions between financial institutions but these had not shown benefit in the outside world. The industry that financed the railroads was as efficient as the one financing the internet! One response to that is to reflect on how dismal this performance is. But another is to note the vast opportunity for improvement.  It is to that that we should be turning their attention.

Our paper on this topic, The Purpose of Finance, launched earlier this year, sets out some initial thinking for the industry as a whole. It takes as an example the private pension system. Pensions savings are there to allow people to secure a regular income in retirement. Yet today we have a system that fails to deliver on that purpose; instead in the private sector we simply give retirees a cheque and tell them to fend for themselves. Were we to establish a collective system, most studies, including those of the government actuary, suggest that we could provide more predictable pensions which were 30%+ higher than those which British retirees will manage if they fend for themselves.

We can also apply the same logic for other each part of the finance industry, including banks, stock exchanges, regulators and so on. This is surely the only safe foundation for designing the institutional checks and balances and the regulatory framework that would sustain a purposeful industry over the long-term.

In the 10 years since the banking crisis, no-one has approached reform from this perspective. Few have seriously noted the concerning view of the former head of the Financial Services Authority that what goes on in the industry may be “socially useless”. Indeed we know that such practices exist. Worse still we fail to promote those activities that are of vital importance. Demanding that we think about these issues is not an attack on the finance industry, any more than it is an attack on the medical industry to ask whether treatments are curing patients. Quite the reverse. As professional financiers, it behooves us continually to be addressing these questions.

That is the discussion we will be sponsoring over the coming two years. We hope that, whether you are a policy maker, a practitioner or a user of financial services, you will become involved. We don’t have all the answers yet but here are a few indications of the sort of conclusions that might emerge.

First, finance is a vital industry. Its functions are central to a modern economy.

Second, regulation is not the (only) answer. Indeed we should be very careful of over regulation

For example, in 1990 there were 3,000 pages of regulation covering pensions. Today there are 166,000. Yet you would be hard pressed to find anyone who would argue that the pension system we have today is adequate.

Finally, the prize from reform could be huge. Just by creating a well-designed and regulated pension system to emerge in the UK, we could add the equivalent of more than two per cent to GDP. This is a huge sum, roughly equivalent to the contribution that North Sea oil makes to our economy. Think of the benefit if the same were true for the rest of the finance industry.

This is a big prize. Let’s not wait for a crisis before we try and win it.

David Pitt-Watson is a leading thinker and practitioner in the field of responsible investment and business practice. He is currently Executive Fellow of Finance at London Business School. Until the end of 2012, he was Chair of Hermes Focus Funds and a former board member of Hermes Fund Managers. As co-founder and former Chief Executive Officer of the Focus Funds and Equity Ownership Service, he built and led the largest responsible investment group of any institutional fund manager in the world.

David’s paper The Purpose of Finance is co-authored with Dr Hari Mann, Professor of Strategy and Innovation at Ashridge Business School, for the Pension Insurance Corporation.