'Financialisation' and the growth of the financial sector
In the 1980s and 1990s western governments deregulated the financial system, and removed obstacles to the cross-border movement of capital. One of the results was a significant expansion in the size and profitability of the financial sector relative to the rest of the economy.
As restrictions on banks and other financial institutions were lifted, and the global economy grew, lending increased. Private debt - owed by businesses and households - rose rapidly in the period up to the financial crash of 2008, which revealed the increasingly risky nature of credit practices and the greater financial instability to which it led. Public debt increased after the crash as governments were forced to bail out the financial sector and respond to the recession. In 2021 total global debt had risen to over three and half times the value of global GDP.
The same period saw many financial companies focus on essentially short-term financial activities - trading and speculating in shares, bonds, currencies and other assets - rather than providing investment capital for new and growing businesses.
These processes of financial sector growth - and the increasing use of financial metrics in other parts of the economy - are often described as the 'financialisation' of the economy.
In the UK the City of London and the wider financial sector employ over a million people and make a major contribution to the UK's trade balance. However some analysts argue that the financial sector has now become too large, acting as a drain on the rest of the economy rather than as a net asset. Critics of financialisation argue that the financial sector is now too much focused on extracting value from the economy and not enough on helping create it.
Finance for business investment
Prior to the pandemic, UK banks lent a smaller proportion of their total lending portfolio to businesses than did banks in other European countries, with a higher proportion going to housing and real estate mortgages. This has helped fuel the growth of house prices while doing little to develop the UK's productive base.
Although bank lending to small and medium sized enterprises (SMEs) has risen sharply during the Covid-19 crisis, it is widely believed that the underlying problem - the difficulty many businesses have in accessing affordable loans from banks - may return once the crisis is over.
A widespread criticism of the UK's financial system is that there is insufficient provision of 'patient capital' - long-term finance for innovation and business development - with too many financial institutions seeking short-term returns.
Reform proposals range from stronger credit guidance policies, to steer lending towards productive sectors, to the development of publicly-owned and other 'stakeholder' banks focused on financing innovation and business development.
Financial system reform
Since the financial crash of 2008 national and international authorities have implemented a range of reforms aimed at reducing the risks which individual financial firms can take, and the systemic risks which the financial system as a whole poses to the rest of the economy.
But critics of the structure and behaviour of the financial system argue that these reforms do not go far enough. They note that the incentives faced by financial companies and the herd-like behaviour of financial markets tend to drive asset bubbles in an upswing and exacerbate recessionary forces when the economy experiences a downturn. Closer regulation of the shadow banking sector and stronger counter-cyclical measures are required if financial instability is to be reduced.
The financial crises of 2008-12 showed that, while shareholders gain the benefit of financial firm profitability, major losses will be borne by debtors, and by society and taxpayers. A number of reform proposals therefore focus on ensuring that financial firms share the liability for failure.
The financial system connects savers and investors. But recent decades have seen the growth of 'agency capitalism', in which a wide range of financial intermediaries manage investment funds. Reformers seek to ensure that such companies have stronger fiduciary duties to act in the interests of savers.
Deeper financial reform proposals centre on the goal of creating a 'purpose-driven' financial system, designed to serve the rest of the economy rather than itself, and in particular which supports efforts to build a more environmentally sustainable and inclusive economy.
Achieving an environmentally sustainable and net zero economy requires a significant increase in investment in green technologies and sectors. This in turn will require much larger financial flows into these investments. At the same time, investment in high-carbon and polluting activities needs to diminish.
Over recent years the Bank of England other central banks have begun to pay attention to the risks to financial stability posed by climate change and climate change policy. They have sought in particular to ensure that financial institutions disclose their exposure to climate risk.
Some reformers are now calling for financial regulation to be tightened for financial firms with significant exposure to assets - for example investments in fossil fuels - which could become devalued or 'stranded' as a result of future climate change policy.
Various proposals are now being made to incentivise financial investment in green technologies and sectors. The European Commission has set out a taxonomy of sustainable economic activity to underpin its 'Green Deal' strategy.