Unbridled financial sector hurting Eurozone; lessons India must learn

A study released this month by Berlin-based non-profit think tank Finanzwende on the Eurozone, makes devastating disclosures. It says the size of Eurozone’s financial sector, relative to GDP, has outgrown the economy and society and is hurting both. It has three key conclusions:

• The financial sector size in Eurozone doubled relative to GDP in the last 20 years.

• The financial sector is fulfilling less of its original function of lending to firms and households. Instead, 70% of banking activities take place within the sector – not producing goods and services and not benefiting the real economy.

• To be inclusive again, the financial sector must shrink.

Self-serving nature

Not all finance is bad. The study says beyond a limit, growth of the financial sector harms the economy and society and is in line with US and UK studies over the past years.

The International Monetary Fund in its 2020 study says beyond a point, growth of the financial sector causes high inequality and leads to financial crisis. During 2007-’09, it said “too much credit, including to lower-income households” in the US contributed to the crisis. Its earlier study proposed tighter regulations and “speed limits” for financial sector growth after studying growth in 100 countries over 33 years.

The Finanzwende study explains it is the “self-serving nature” of the sector which is responsible for the ill-effects. Bad financial activities are large-scale financial dealings with finance itself, like lending to little-regulated shadow banks—called NBFCs in India, high-frequency share and derivative trading in stock markets –credit default swaps (CDSs)—for example, that caused the US housing bubble and plunged the global economy into recession in 2007-‘09.

The study found, a large share of financial activities “is not focused on useful financial services, but extracts wealth from the real economy” and stock market activities are a zero-sum game in any case.

It points out that European banks bypass regulations and evade tax through subsidiaries in tax havens like the British Virgin Islands, Cayman Islands and Bermuda. Between 2014-20, 36 European banks reported Euro 20 billion or 14% of profits in tax havens each year. European banks have also “financed the climate crisis”, pointing out that “between 2015 and 2020, the 24 largest European banks have poured almost one trillion dollars into fossil companies and projects”.

It alerts about the havoc private equity (PEs) firms have caused with care homes (for elderly, disabled and children) in Europe (Germany, the UK and France). PE funds have bought up care homes, loaded them up with debt, captured their real estate, paid workers less and use tax haven routes “to extract high profits”. In many cases in the UK, care homes have been bailed out with public money. Economist Prof Mariana Mazzucato and tax expert Nicholas Shaxson have given detailed accounts of the harm caused by PEs and venture capital (VCs) funds to the economy and care services in their books, The Value of Everything and The Finance Curse, respectively.

The role of the financial sector in creating all major economic crises in the world—from the Great Recession of 1929 to the one in 2007-‘09 and those in-between is well known. These lead to massive job losses, increase inequality and redistribute wealth from the bottom to the top of society. Many private financial entities were bailed out by the US with public money, describing some as “too big to fail”.

The excessive growth of the financial sector began during the liberalisation and deregulation that followed the end of the Bretton-Woods system in the 1970s, which put tight regulations on banks and other financial institutions following the 1929 Depression. The 1970s saw another development that helped: inclusion of finance in the calculation for GDP; until then finance was an “intermediate input” and “a distributor, not a creator of wealth”, as Mazzucato explained in her book.

Growth of financial sector in India

These findings are relevant to India. The country has been witnessing stock markets and billionaires’ wealth zooming amidst all-around economic ruin – massive loss of lives, jobs and businesses caused by the pandemic. Fortune India’s analysis of soaring profits of 500 top listed companies in FY21 showed it is the financial sector, banks, which topped the list with over 20% of total profits.

In October 2020, two leading multinational financial entities, Swiss bank UBS and PwC highlighted the relationship between zooming stock markets and billionaires’ wealth with finance while the world economy was sinking. Their report “Riding the Storm” said “the V-shaped equity market recovery from April-July 2020 propelled billionaire wealth to a new high” – from $8 trillion at the beginning of April 2020 to $10.2 trillion by end-July. It explained, “billionaire wealth is loosely correlated with equity markets, due to holdings in listed companies” and “governments’ huge fiscal and quantitative easing packages drove a recovery in financial markets”.

India too relied on liquidity infusion (cheap credit) to fight the slowdown and saw a boom in stock markets and billionaires’ wealth in 2020. The trend continues in 2021. There is, however, no study in India to map the expansion of the financial sector. It can be gleaned from information available. Here are a few of those:

• The RBI’s July 2020 report on “Sectoral classification of financial stocks and flows” of the economy, shows that in FY19, the share of ‘financial corporations’ in total financial assets of the economy was 44% –far higher than four sectors of ‘non-financial corporations’ (17%), ‘general government’ (6%), ‘household’ (25%) and ‘rest of the world’, which accounts for foreign borrowings (8%).

Assets of financial corporations have grown from 222.7% of net national income in FY12 to 233% in FY19 and 239% in FY20 (preliminary estimates), while assets of other sectors fell. The same trend is seen in ‘financial net worth’ too.

Besides, assets under mutual funds have risen from 6.7% of GDP in FY12 to 15.9% in FY21. The market capitalisation of BSE went up from 71% to 103.5% during the same period, while for NSE it jumped from 69.8% to 102.8% of GDP during the period.

Assets of SCBs (minus regional rural banks) fell from 95% to 88.5% in FY20 (data for FY21 is not available) but, assets of NBFCs jumped from 12% to 16.7% of GDP during the period. The credit outflow from NBFCs increased from 8.6% of GDP in FY13 to 11.6% FY20.

The NPA crisis propelled banks to increasingly finance NBFCs in FY18 and FY19, which in turn led to further risks and instabilities. Several of them—IL&FS, HDIL and DHFL—collapsed beginning 2018 and massive financial frauds were detected in their dealings.