How does the financial work for the rest of the world?

Share of financial sector in gross domestic pr...

Share of financial sector in gross domestic product 1860 to 2006 (Photo credit: Wikipedia)

“The U.S. financial sector’s share of GDP grew from less than 5% in 1980 to more than 8% in 2007—the largest share in any advanced economy except Switzerland. With this growth came big increases in financial sector employment and compensation. The industry was transformed from a sleepy old boys’ club to a dynamic business that attracts the best and the brightest.

It is tempting, then, to declare the industry a roaring success. But the financial sector exists to serve the needs of U.S. households and firms, and by this standard its performance has been mixed. The sector’s growth has been beneficial for some, particularly U.S. corporations, which enjoy ready access to the deepest capital markets in the world. At the same time, the industry has evolved in several unhealthy ways, which have had negative consequences for the U.S. economy.

There are three main problems

First, the financial system is less stable than it was 30 years ago. The recent crisis was in part the consequence of a shift from traditional deposit-based banking to a market-based system, without adequate regulatory adjustments.

Second, the financial sector—in combination with generous government subsidies—has steered trillions of dollars into residential real estate and away from other, more productive investments.

Third, the cost of professional investment management, which has been growing as a share of GDP, is simply too high. Excessive investment fees have important implications not only for household savings but also for the allocation of the country’s talent: Finance will continue to attract the best and the brightest as long as the rewards are so high.

Successes

The key functions of a financial system are to facilitate household and corporate saving, to allocate those funds to their most productive use, to manage and distribute risk, and to facilitate payments. The financial sector is working well when it performs those functions at a low cost and makes the rest of the economy better off. Recent research has shown that economies with well-developed financial systems grow reliably faster than those in which finance plays a smaller role. In general, finance does serve a crucial economic purpose.

In the United States, the system appears to be working well for corporations, which enjoy easy access to debt and equity markets. The development in recent decades of institutional venture capital and private equity, along with the growth of professional money management, has helped improve the allocation of capital. Venture capital, in particular, has fostered a vibrant entrepreneurial sector that has transformed industries such as information technology and communications and has helped create new ones, such as online retailing and biotechnology. Venture-capital-backed entrepreneurs have also put pressure on existing firms to adapt their business models and to innovate.

Venture capital could not have thrived without stock market investors willing to purchase the shares of risky young firms. Their investments were made possible, in part, by the rise of professional money managers, who are in a better position than individual investors to assess the prospects of these newcomers. Ironically, 30 years ago a major concern was whether the increased emphasis on shareholder value would lead to an excessive focus on short-term profits. But the development of U.S. capital markets since then suggests the opposite: The percentage of firms that go public with negative earnings has jumped dramatically, demonstrating the willingness of the U.S. capital markets to bet on new ideas. This willingness is reflected in the growing amount of money the private sector has poured into R&D—an indication that the financial sector is steering capital toward long-run investments.

None of this is to say that venture capital and public equity markets have functioned perfectly. Venture capital has on average failed to deliver acceptable risk-adjusted returns for investors, and public equity markets seem to go through periods of euphoria and fear. But the same markets that overfunded internet and telecom start-ups during the late 1990s also identified and nurtured Google.

Private equity and hedge funds have at times played an important role in helping to unlock value trapped in large, underperforming conglomerates. They can work to align management and shareholder interests, fostering an environment in which well-run firms get capital and poorly run firms are shut down or acquired. This is healthy. However, private equity is not without problems. Like venture capital, it is subject to boom-and-bust cycles that undermine its value; transactions can often be motivated by tax considerations rather than true economic value creation; and the average returns to private equity investors have generally not been enough to compensate them for the risk they bear.”
This article presented by Robin Greenwood and David S. Scharfstein in the Harvard Business Review give a fairly description of the role and the need of an healthy financial industry.
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