Building upon previous posts in this series that discussed individual banks, we examine the historical growth of the entire financial sector, relative to the rest of the economy. This sector’s historically large share of the economy today (see chart below) and its role in disrupting the functioning of the real economy during the recent financial crisis have led to questions about the social value of costly financial services.
While new regulations such as the Dodd-Frank Act impose restrictions on financial activities and increase their costs, especially those of large firms, our paper suggests that there may be limits to what regulation can achieve. In particular, we show that financial growth has occurred in the more opaque and harder to regulate sectors: private firms, shadow banks, and small nonbank financial firms. Moreover, we find that the stock market values these opaque areas of finance more, suggesting that they may expand even faster in the future.
Rise of Finance and Shadow Banks
We measure the relative size of the financial sector by the value of its assets (the market value of equity plus the book value of debt), relative to the value of assets in the business sector (that is, the financial and nonfinancial sectors). This measure,Tsize–qmv (in the chart below), includes only publicly listed firms, and is estimated at the firm level. A second measure, Fsize (also in the chart below), is the total liabilities (generated by all transactions, not just those of publicly listed firms) of the financial sector, relative to the total liabilities of the business sector, and is estimated at the sectoral level.
By either measure, the financial sector has been a growing part of the economy. It has mostly increased in relative size over the past four decades, interrupted in a major way only by the recent financial crisis (see chart below). On average, the financial sector has accounted for about 50 percent of the asset values of publicly listed firms, but roughly 70 percent of total business sector liabilities. Hence, one reason to worry about the size of this sector is its high representation among private firms that have virtually no transparency.
