LONDON – For at least a quarter-century, the financial sector has grown far more rapidly than the economy as a whole, both in developed and in most developing countries. The ratio of total financial assets (stocks, bonds, and bank deposits) to GDP in the United Kingdom was about 100% in 1980, while by 2006 it had risen to around 440%. In China, financial assets went from being virtually non-existent to well over 300% of GDP during this period.
As the size of the financial industry grew, so, too, did its profitability. The share of total profits of companies in the United States represented by financial firms rocketed from 10% in 1980 to 40% in 2006. Against that background, it is not surprising that pay in the financial sector soared. The City of London, lower Manhattan, and a few other centers became money machines that made investment bankers, hedge-fund managers, and private equity folk immoderately wealthy. University leaders like me spent much of our time persuading them to recycle a portion of their gains to their old schools.
For the last two years, things have been different. Many financial firms have shrunk their balance sheets dramatically, and of course some have gone out of business altogether. Leverage is down sharply. Investment banks with leverage of more than 30 times their capital in early 2007 are now down to little more than ten times. Trading volumes are down, as is bank lending, and there have been major layoffs in financial centers around the globe.
Is this a short-term phenomenon, and will we see an early return to rapid financial-sector growth as soon as the world economy recovers? Already the market is full of rumors that guaranteed bonuses are returning, that hedge funds are making double-digit returns, and that activity is reviving in the private equity market. Are these harbingers of a robust recovery for the financial sector, or just urban myths?