This is an interesting explanation of one of the curiosities of the modern economy: Why the US financial sector is so large?. In voxeo.org you can find more detail and some hard numbers about this phenomenon. Empirically, Greenwood and Scharfstein (2013) find that, in the US, financial services, which accounted for 2.8% of GDP in 1950, made up 8.3% of GDP in 2006. This huge amount could be the accumulated GDP of several countries.
In Biais et al. (2014), a formal analysis explains why finance markets have become so large. In a model developed, the growth of the financial sector is driven by innovation. The analysis is applicable to a wide range of innovations – such as collateralized debt obligations (CDOs) or credit default swaps (CDSs), to asset classes such as junk bonds or exchange-traded funds (ETFs) – and management styles.
The model considers two types of market participants: investors who own the assets, and managers who operate the innovation. The analysis is conducted under the assumption of symmetric information (investors evaluate the ability of managers), and asymmetric information, when investors are uncertain of managers’ competence or diligence.
Based on observed performance, market participants learn about the strength of the innovation. They rationally interpret good performance and the absence of shocks as a sign of robustness. Thus, when no shock occurs, confidence increases and the innovation grows, attracting funds and managers. As the innovation flourishes, managers’ earnings increase and exceed the norm of the other sectors, consistent with the empirical findings of Philippon and Resheff (2008).
In the symmetric information version of the model the innovation has remained at a size that is socially optimal. Investors know what they are getting and are paying a competitive price for it. Then the asymmetric assumption is introduced to the model, when opacity and complexity of the innovative sector prevent investors from perfectly monitoring the risk-control systems and efforts of managers. Negligent managers earn excess profits (‘informational rents’). The influx of relatively inefficient managers attracted by rich rewards for little effort spurs faster growth than under symmetric information. This takes the scale of the innovation beyond its social optimum and also increases the vulnerability of the sector. Consequently, the model suggests that information asymmetry implies more severe crises in a much larger system.
This conclusion should provoke discussions about the transparency and regulation of the financial sector in US, which market information imperfections and oversize will bring more severe crisis with global reach.
Biais, B, J C Rochet, and P Woolley (2014), “The dynamics of innovation and risk”, Forthcoming in Review of Financial Studies.
Greenwood, R and D Scharfstein (2013), “The growth of finance”, Journal of Economic Perspectives, 2: 3–28.
Philippon, T and A Resheff (2008), “Wages and Human Capital in the U.S. Financial Industry: 1909–2006”, Working Paper, New York University.