Bloated financial sectors weigh on economies: study

July 18, 2012 | Last updated on July 18, 2012
2 min read

Modern economics says a healthy financial sector is good for economic growth—the economy needs a certain number of advisors and planners to help borrowers and lenders invest and spend wisely.

Read: Informed investors create better markets and Informed investors make better clients

But, financial industry growth and development can also weigh on productivity growth and “is good only up to a point, after which it becomes a drag on [the economy],” says a new paper published Tuesday by two economists with the Bank for International Settlements (BIS).

“A more developed financial system is supposed to reduce transaction costs, raise investment directly, and improve the distribution of capital and risk across the economy,” says the paper.

Read: Economies are shifting

The study finds, however, a fast-growing financial sector can not only adopt a too-big-to-fail mentality, but also overshadow other economic sectors. When it represents more than 3.5% of total employment, further increases in its size tend to be detrimental to growth of the overall economy.

The researchers list two reasons for their findings:

  • “At low levels, a larger financial system goes hand in hand with higher productivity growth. But, there comes a point where more banking and more credit are associated with lower growth”
  • The industry often competes for resources with the rest of the economy

Mainly, the financial sector requires not only physical capital, but highly skilled workers as well. As it grows, people who might have become scientists or labourers instead pursue financial careers, becoming hedge fund managers and bankers, the paper claims.

Take the boom in the 1990s: a plethora of financial companies were formed, with a surplus of capital invested and many skilled workers employed.

Some of these resources should have gone elsewhere to help boost the economy and weakening sectors, says the paper. But they were hoarded.

And following the dotcom bust, computers were scrapped, office buildings vacated and highly trained people laid off.

Read: Talent shortage threatens financial services (2007), for more on how a shortage of workers in the industry can also have a negative effect

Additionally, in countries where the financial sector’s share in total employment is stable, a typical financial boom—employment growth of 1.6% per year—reduces growth in combined GDP per worker by about half a percentage.

If the financial sector were to shrink, the paper found the potential gain in GDP-per-worker is estimated at 1.3% for Canada, 0.7% for Switzerland, and 0.2% for Ireland.

For more, access the report.