By Stephany Griffith-Jones
A guest post by the Financial Markets Director at the Initiative for Policy Dialogue Columbia University
The financial sector should have two main functions.
Firstly it should serve the needs of the real economy. Secondly, it should help manage and mitigate risk.
In the last three decades the private financial sector has done neither. It has not provided sufficient sustained finance for key sectors like the green economy, SMEs and infrastructure.Furthermore, instead of mitigating and managing risk, it has created risk.
In recent decades numerous crises happened after financial markets were liberalised and many regulations stripped away. This was seen with the 1980s debt crisis in Latin America, which led to its lost decade of development. These crises continued in East Asia in 1997/8 as well as in numerous other countries. Since 2007 there has been a major crisis in the North Atlantic region.
Financial crises has become the new normal
This is not inevitable. When the financial sector has been well regulated and controlled - and when well-run public banks have played an important role in this - the financial sector has played a positive role to support and not undermine the real economy. Examples of this include post-World War II USA and Europe.
Currently a lot of the focus of the financial sector is still on making exorbitant profits and salaries for its employees. Instead countries need a far smaller, simpler, transparent and accountable financial sector focussed on lending to the real economy. If this transformation does not happen it will make it very difficult to finance sustained and equitable growth. A weakened and crisis-prone real economy will continue to serve the interests of the financial sector and not the reverse as it needs to be!
So what should be done?
Firstly, the financial sector needs to be regulated in a way which would have prevented the current crisis - and future ones - from occurring. This includes comprehensive equivalent regulation of the entire financial sector, including the shadow unregulated banking sector, which in the US and Europe is larger than the existing regulated banking sector.
Secondly, regulation of capital adequacy, leverage and liquidity must be rigorous and counter-cyclical. It must be counter-cyclical to compensate for the natural boom-bust pattern of financial markets and banks, which has been damaging to the real economy
Thirdly, speculative activity should be limited - and ideally eliminated - where the risks created outweigh any possible benefits to the real economy. Banks should also be divided. The more important part of banking, so called utility banking, should be separated completely from more risky activity, as was done in the 1930s with the Glass Steagall Act
Lastly, remunerations for bankers should be reformed to significantly reduce their level of income. Bonuses could be eliminated - or be linked to long-term performance - instead of rewarding short-term gains. If the profits and remunerations in the financial sector were reduced this would also limit the unhealthy power and influence that the financial sector has over regulators and politicians.
As a complement to regulating tightly and comprehensively the private financial system, the time has come for a significant expansion of efficient public banks. They can finance investment in sectors poorly served by the private financial sector, such as SMEs and the green economy. Where markets fail, governments need to act effectively. There are also many positive examples of public banks around the world, such as Brazilian Development Bank (BNDES).
Where banks have been nationalised due to the crisis, often at high cost to the taxpayer, they should be used to serve the public interest. Where public banks do not exist, they need to be created.
Stephany Griffith-Jones is giving the Sussex Development Lecture "Rethinking finance for development in the light of the global financial crisis", on Wednesday 10th April 2013. Follow Professor Griffith-Jones on Twitter.