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The Growth of Murky Finance
Posted By Guest Author On April 5, 2014 @ 5:00 am In Think Tank | Comments Disabled
The Growth of Murky Finance
Samuel Antill, David Hou, and Asani Sarkar
This post is the fifth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue  of the Economic Policy Review.
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.
How big are shadow banks relative to the more heavily supervised DCIs? Shadow banking’s share of total credit intermediation (by shadow banks and DCIs) tripled in the period from 1975 to just before the crisis in 2007 (see chart below). Indeed, DCI actually shrunk in relative size while shadow banking expanded, fueled mainly by credit intermediation in the securities sector (for example, by investment banks) and asset management (for example, by exchange traded funds). Relatedly, portfolio management (also a part of asset management, but not involved in credit intermediation) has also grown explosively, as noted by Greenwood and Scharfstein . These authors discuss the poor performance and high fees of active managers, while the Office of Financial Research  discusses the vulnerabilities of the asset management sector.
Large and Small Firms
There have been long-standing concerns about too-big-to-fail financial firms whose failure imposes negative externalities on the rest of the economy. We find that large financial firms are a bigger share of all large firms (defined as the top 10 percent of all firms) than small financial firms are of all small firms (defined as the bottom 90 percent of all firms). Although the growth rates of large and small financial firms are similar, small shadow banks have grown faster than large shadow banks, while the reverse is true for DCIs (see chart below). Thus, the shadow banking sector has grown through the emergence of new firms, whereas DCIs have grown through consolidation among existing firms (especially since 1994).
Effect of the Recent Financial Crisis
The recent financial crisis reversed the steady growth of the financial sector in the economy. Shadow banking firms fared particularly poorly in the crisis, as their share in the economy shrank more than 6 percentage points from the pre-crisis peak to the crisis trough quarters. In comparison, financial firms in general shrank about 2 percentage points and large DCIs actually grew in size, especially during periods of government support such as when the FDIC debt guarantee program  was in effect.
Stock Market Valuation of Different Financial Sectors
The financial sector and shadow banks have grown over time, but is the growth expected to continue? Since stock prices incorporate market expectations of future growth, we estimate the ratio of the market value of equity to the book value of equity (market-to-book) of the financial sector, which indicates the market value of $1 of book equity. This ratio is divided by the market-to-book ratio of the business sector in order to obtain the relative valuation of the financial sector.
Financial firms have had a lower valuation relative to business sector firms since the late 1980s, except for a brief period in 2000, and their relative valuation has been steadily declining since around 2003 (see chart below). Within the financial sector, however, shadow banking had a higher valuation than the business sector for the entire sample, and their relative valuation has been increasing since around 2003. The reverse is true for DCIs. These results suggest that the market expects shadow banks to grow faster than DCIs and/or to generate a more stable stream of earnings in the future.
Although the policy response to the growth and vulnerabilities of the financial sector has been to enhance supervision and regulation of large firms and visible financial sectors, our paper documents that, historically, growth has occurred mainly in areas outside the current regulatory ambit. If financial transactions migrate out of regulated sectors, as expected by some , then this trend is likely to persist. We need to improve our knowledge of these opaque financial sectors in order to understand what risks (if any) they pose to the economy.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Asani Sarkar  is an assistant vice president in the Bank’s Research and Statistics Group.
Article printed from The Big Picture: http://www.ritholtz.com/blog
URL to article: http://www.ritholtz.com/blog/2014/04/the-growth-of-murky-finance/
URLs in this post:
 this special issue: http://www.newyorkfed.org/research/epr/index.html
 its role: http://harr123et.files.wordpress.com/2010/07/futureoffinance-chapter11.pdf
 social value of costly financial services: http://pages.stern.nyu.edu/%7Etphilipp/papers/pr_rev15.pdf
 Dodd-Frank Act: http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf
 costs, especially those of large firms: http://www.federalreserve.gov/newsevents/press/bcreg/20131024a.htm
 paper: http://www.newyorkfed.org/research/epr/2014/1403anti.html
 Image: http://libertystreeteconomics.typepad.com/.a/6a01348793456c970c01a3fcda789b970b-popup
 shadow banking sector: http://www.financialstabilityboard.org/publications/r_121118c.pdf
 Pozsar, Adrian, Ashcraft, and Boesky: http://www.newyorkfed.org/research/epr/2013/0713adri.pdf
 Image: http://libertystreeteconomics.typepad.com/.a/6a01348793456c970c01a3fcda78a5970b-popup
 Greenwood and Scharfstein: http://www.people.hbs.edu/dscharfstein/Growth_of_Modern_Finance.pdf
 Office of Financial Research: http://www.treasury.gov/initiatives/ofr/research/Documents/OFR_AMFS_FINAL.pdf
 Image: http://libertystreeteconomics.typepad.com/.a/6a01348793456c970c01a73d955506970d-popup
 Image: http://libertystreeteconomics.typepad.com/.a/6a01348793456c970c01a3fcda78cf970b-popup
 FDIC debt guarantee program: http://www.fdic.gov/regulations/resources/TLGP/index.html
 Image: http://libertystreeteconomics.typepad.com/.a/6a01348793456c970c01a3fcdb875d970b-popup
 as expected by some: http://www.newyorkfed.org/research/staff_reports/sr559.pdf
 Image: http://libertystreeteconomics.typepad.com/.a/6a01348793456c970c01a3fcd1dbe0970b-popup
 Image: http://libertystreeteconomics.typepad.com/.a/6a01348793456c970c01a3fcd1dbd1970b-popup
 Image: http://libertystreeteconomics.typepad.com/.a/6a01348793456c970c01a73d8cf62b970d-popup
 Asani Sarkar: http://www.newyorkfed.org/research/economists/sarkar/index.html
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