It's official: too much banking is bad for you

When the newish boss of the International Monetary Fund, Bulgarian economist Kristalina Georgieva, contemplates the challenges of the new decade, she thinks of many things: increasing uncertainty, climate change and increasing inequality – particularly the role the financial sector in making it worse.

Georgieva foresees increasing uncertainty over geopolitical tensions, uncertainty that the trade truce between the US and China will last, and uncertainty that governments can fix the frustrations and growing populist unrest in many countries. "We know this uncertainty harms business confidence, investment and growth," she said in a recent speech.

On climate change, after observing that the "brush fires" blazing across Australia are a reminder of the toll on life that climate change exacts, she avoids saying that we are possibly the most vulnerable among the rich countries (something that might have surprised the she’ll-be-right Scott Morrison).

But she did note that it’s often the poorest and most vulnerable countries that bear the brunt of "this unfolding existential challenge". "The World Bank estimates that unless we alter the current climate path an additional 100 million people may be living in extreme poverty by 2030," she says.

The previous decade saw the rich world’s economists become much more conscious of the economic importance of inequality, with the IMF’s economists at the forefront of this realisation. "We know that excessive inequality hinders growth and hollows out a country’s foundations. It erodes trust within society and institutions. It can fuel populism and political upheaval," she says.

Many people think of using the budget to reduce inequality, which they should, "but too often we overlook the role of the financial sector, which can also have a profound and long-lasting positive or negative effect on inequality," she says.

"Our new staff research shows how a well-functioning financial sector can create new opportunities for all in the decade ahead. But it also shows how a poorly managed financial sector can amplify inequality."

"Financial deepening" refers to the size of a country’s financial services sector relative to its entire economy. Georgieva notes that, on one hand, developing countries benefit from the growth of their undeveloped financial sectors as small businesses and ordinary households gain access to credit and saving and insurance products.

The sustained growth in the financial sectors of China and India during the 1990s, for instance, paved the way for enormous economic gains in the 2000s. This, in turn, helped in lifting a billion people out of poverty.

On the other hand, the IMF’s latest research shows there’s a point at which financial deepening is associated with exacerbated inequality and less inclusive growth. Many factors contribute to inequality, but the connection between excessive financial deepening holds across countries, she says.

Why is too much "financialisation" of an economy a bad thing? "Our thinking is that while poorer individuals benefit in the early stages of deepening, over time the growing size and complexity of the financial sector end up primarily helping the wealthy.

"The negative impact is especially visible where financial sectors are already very deep. Here, complicated financial instruments, influential lobbyists, and excessive compensation in the banking industry lead to a system that serves itself as much as it serves others."

The US has one of the most diversified economies in the world (it has a lot of everything). And yet, in 2006, financial services firms comprised nearly a quarter of the S&P500 share index and generated almost 40 per cent of all profits. (Read that again if it doesn’t amaze you). Obviously, this made the financial sector the single biggest and most profitable part of the whole sharemarket.

Does that strike you as out of whack? What happened next – the global financial crisis and the Great Recession – tells us that excessive financial sectors increase the risk of financial instability and collapse.

The painfully slow recovery from that episode of financial crisis was the defining issue of the past decade. Research shows that, on average, a country’s financial crisis leads to a permanent loss of output (gross domestic product) of 10 per cent. This can cause a lasting change in the country’s direction and leave many people behind (as the Americans, with their opioid and middle-aged male suicide crises, know only too well).

The IMF’s latest research shows that inequality tends to increase before a financial crisis, suggesting a strong link between inequality and financial instability. But also, of course, the subsequent recession usually leads to a long-term worsening in inequality.

Much effort has been made since the global financial crisis to make the banks more stable and better regulated. But no one imagines this guarantees there couldn’t be another major crisis.

Georgieva says financial stability will remain a challenge in the decade ahead – for all the usual reasons, but also for "climate-related shocks". "Think of how stranded assets [such as now-unviable coal-fired power stations or coal mines] can trigger unexpected loss," she says. "Some estimates suggest the potential costs of devaluing these assets range from $US4 trillion to $US20 trillion."

The private sector and the banking industry, not just governments, have a critical role to play in making the financial system more stable, she says. That’s certainly the case when it comes to the climate’s effect on financial stability.

"The financial sector can play a critical role in moving the world to net zero carbon emissions and reaching the targets of the Paris agreement. To get there, firms will need to better price climate change impacts in their loans.

"Last year, climate change claimed its first bankruptcy of an S&P500 company. It is clear investors are looking for ways to adapt. If the price of a loan for an at-risk project increases, companies may simply decide the money for the project could be better spent elsewhere."

What has stopping climate change got to do with inequality? If we don’t, the consequences will fall hardest on the world’s poor (and Australians).

Ross Gittins is the Sydney Morning Herald’s economics editor.

Twitter: @1RossGittins