By Karen Petrou
After crafting the initial features of the post-crisis bank-regulatory framework, global and U.S. policy-makers were dumbfounded to discover that costly new rules changed the competitive financial-market balance. Mirabile dictu, when costs rose for banks, banks changed their business model to cling to as much investor return as possible instead of, as regulators apparently expected, taking it on the chin to ensure ongoing financial-service delivery at whatever pittance of a profit remained. As markets rapidly and in some cases radically redefined themselves, global regulators dubbed the beneficiaries of this new competitive landscape “shadow banks.” At the most recent meeting of the FSB Plenary, they changed shadow banks to the less stealthy moniker of “non-bank financial intermediaries.” A new BIS working paper shortens the scope of shadow banking to “market-based finance,” going on to assess a fundamental question: does the transformation of financial intermediation from banks to non-banks alter the income and equality landscape? The answer: It’s complicated.
What the BIS Found
The new paper looks at 97 nations in 1989 and 2012 to assess the extent to which a financial system premised on banks is more or less equalizing than one dependent on market-based channels (e.g., the bond market, non-bank lenders). The sheer scope of the study – i.e., the huge differences among nations in terms of financial-system development, financial-market structure, and applicable rules – combines with the selected timeframe – before most post-crisis rules kicked in with a vengeance – to make this study’s results interesting, but nonetheless of uncertain value.
In broad terms, the paper concludes that financial intermediation from whomever however is good for equality, but only up to a point. The more advanced the economy and the greater the dependence on market-based finance, the higher the income inequality. Importantly, advanced economies dependent on banks do not see an inequality effect as what might be called financialization increases.
Unfortunately, the BIS paper breaks down its results only in broad categories (e.g., advanced economies versus emerging ones). It’s thus impossible to review individual nations in terms of the measures deployed (e.g., a financial-development scale) and how this jibes with one measure of income inequality (the Gini coefficient). The paper does provide a useful overview of why some nations are bank-centric and some not, going into detail on how differences in development and reliance on common versus civil law determine financial-market structure. But why might market-based finance do damage to income equality unseen in the data when banks dominate financial intermediation?
The BIS Hypothesis
This paper readily admits that it’s not sure why it finds what it found when it comes to market-based finance. Its conclusions about the overall benefits of financial development are straightforward – i.e., poor people given access to financial products can more rationally allocate their own resources, safeguard savings, and reduce borrowing costs. After some point, though, it’s posited that market-based financial services are particularly prone to rent-seeking – that is, to exploit information asymmetries or otherwise increase the cost of financial products above optimal levels presumably more likely to be found where finance is housed in regulated banks.
To test this hypothesis, the paper reviews recent rent-seeking literature to suggest that advanced economies permit far greater remuneration that in turn raises income inequality by concentrating still more money at the top of the income distribution. However, data on rent-seeking CEOs are not clearly differentiated to isolate the financial industry from other posh CEOs. Further, how all this rent-seeking determines bank-vs.-market finance inequality is not made clear other than by an offhand suggestion that market-based entities can pay their CEOs still less equitably than allowed at banks. This is fashionable reasoning, but not well developed in the paper or persuasive as we read not only its analysis, but also the data it presents.
A More Plausible Inequality Rationale
Were we constructing this analysis, our first-order question after gathering the empirical data – very interesting, if opaque – would have been to ask if the extent to which inequality differs between regulated and less-regulated entities might be due to regulation. Although the full force of post-crisis rules did not kick in until well after 2012, many were at least on the books in rough form and, even before the crisis, banks in most countries were subject to rules that generally did not apply to market-based competitors. It’s axiomatic that costs drive pricing and product offerings so it could well be that regulatory costs push banks out of certain financial activities that, once a sector is dominated by non-banks, interact very differently with critical equality incentives.
For example, see several of our previous posts. Each of these prior blog posts assesses the changes in U.S. mortgage finance attributable in large part to post-crisis regulation, showing how loan characteristics change, credit availability drops, and wealth equality suffers.
Changing rules have also sharply altered bank small-business activity, with market-based finance generally not filling a gap dependent on the type of relationship lending only banks do. P2P lending and fintech are stepping into the business outside the regulatory perimeter, with inequality effects already clearly evident despite the early stage of most fintech commercial-lending ventures.
So, is it true that unregulated finance could be adverse to income inequality in advanced economies that are no longer bank-centric? Intuitively, this seems obvious and the new data presented in this paper suggest strongly that intuition may well be right. More work is, though, clearly needed to parse these hypotheses and data by national financial structure under the full thrust of post-crisis rules. With these data, we can move on to the pressing business of defining financial-sector regulatory perimeters in advance markets to ensure that incentives align with equality whether by rule or – far better – for profit.