Aurora Borealis
1 November 2013 CFA Institute Journal Review

An International Look at the Growth of Modern Finance (Digest Summary)

  1. Marc L. Ross, CFA

The long-run evolution of modern financial services in the United States can be evaluated alongside other economies with similar levels of development. The authors investigate whether conclusions regarding the development of the profession within the United States hold for the other economies in their study.

What’s Inside?

The authors discuss the determinants of the growth of finance in a number of developed economies. Adjusting for country-specific differences, they conclude that the financial sector’s share of national income has grown over time, compensation in the financial field has increased relative to that in the overall economy, and the practitioner skill set has become more specialized—a fact attributable both to trends in deregulation and investment in information technology.

How Is This Research Useful to Practitioners?

Finance as a share of output in developed economies has risen gradually and steadily over time, but the growth varies by country. The authors examine and reject—or at least question—several hypotheses put forth in the literature, including neoclassical models, globalization, and increased specialization.

The recent experience of the US financial sector demonstrates the lack of uniformity in the growth of financial services in developed economies. The role of finance in the economy has been as large (as shown by the proliferation of consumer and business credit) as the increase in compensation and skill level (as exemplified by top traders’ salaries and bonuses).

The authors examine the role of deregulation in the overall growth trends in finance on a cross-country basis. They find relatively heterogeneous levels of regulation across the sample but observe a common trend toward deregulation over time. Greater skill intensity is a function of innovation that stems from greater latitude for creativity provided by deregulation. Less clear is the impact of deregulation on relative wages.

Another factor in the growth of finance is technology, which enables quicker and more efficient work. Technological progress and innovation have affected finance significantly.

Policymakers and economists will find this research interesting not only for its conclusions but also for the questions that it raises. The authors’ conclusion of modern finance’s ascendancy in developed economies leaves open the qualitative appraisal of the proliferation of such services.

How Did the Authors Conduct This Research?

The authors meld their robust study of relevant research with data from their own metrics and investigative techniques.

For their observations of the historical income share of the financial sector from 1850 to 2007, the authors draw on various historical sources as well as on the Structural Analysis Database (STAN) and the EU KLEMS database for more recent time periods. These sources reveal an increase in the income share in the early, but not middle, stages of development. Overall, the share has increased over time.

The authors use bank loans to nonfinancial entities as a proxy for output to examine the ratio of output to GDP. Bank data are used because they provide a consistent historical time series. Output is then regressed against income (GDP). There is a much greater change in output relative to income in the period after 1980, when banks loans were understated because of the advent of securitization.

By using data from the EU KLEMS dataset, the authors measure the income share of the finance industry relative to total GDP in three-year moving averages in a number of EU countries as well as Japan, Canada, and the United States. Although some countries exhibit a clearly increasing trend, others display somewhat mixed results. But the overall trend is upward. The authors provide a similar analysis of the wages in finance in relation to the overall economy. The trend is mainly positive when adjusted for country-specific differences. Underpinning finance’s share of the overall economy is the rigor of the skill set of financial workers, which also exhibits a strong upward trend. Such a trend makes sense given the high remuneration of the profession relative to others.

Finally, the authors consider the effects of regulation and technology on the share of finance relative to GDP in the same developed economies by using a regression analysis that considers skill intensity, relative wages in finance, and relative wages of skilled financial professionals. They conclude that deregulation, by providing more freedom for professionals to innovate, has led to greater skill intensity and that technology has provided greater speed and sophistication. To what extent deregulation has affected financial professionals’ relative wages is less clear.

Abstractor’s Viewpoint

The size of the financial industry has, for the most part, steadily grown over time in developed economies. The authors explore this trend in a robust fashion. Deregulation and the increased use of information technology have played a major role in this development by enabling skilled practitioners to parse, understand, and exploit phenomena of increasingly complex markets.

It would be interesting to explore the qualitative aspects of these trends further. How could finance better address those corners of the financial marketplace where opacity seems to be the norm rather than the exception? The rapid growth and complexity of credit derivatives spring to mind. The authors leave aside the discussion of whether a surfeit of finance exists. The Great Recession, which was not just a US occurrence, would seem to beg the question.

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