The role and limits of finance

The essentials

Finance carries out missions of general interest

Finance brings together all the institutions responsible for creating money and/or channelling savings (mainly from households and businesses) towards economic agents in need of financing.

These financial entities can be grouped into five main categories:

• BANKS ;
• insurance companies, some of which are bank-owned;
• pension and retirement funds;
• collective management organizations ;
• and investment funds, some of which are speculative.

As the following diagram shows, each of these financial entities has different activities and functions.

By determining which players can access financing to bring their projects to fruition, and under what conditions, financial players play an essential role in the smooth running of the economy. Their activity is at the service of all other economic sectors and, in this respect, concerns the general interest. We would like to emphasize the following points:

Banks create money and analyze credit risks

Money is created by banks

Banks are special financial institutions: they play a specific and important role in the economy.

On the one hand, by managing deposits and means of payment, they are at the heart of the payment system, the major infrastructure of any market economy. The sudden closure of banks would paralyze the economy, as the vast majority of exchanges would no longer be able to take place in the absence of the tools needed to carry out the related financial transactions.

On the other hand, banks, mainly through their lending activity, create money and thus additional purchasing power, enabling projects to be carried out that would otherwise not have been possible(see the module on money). By deciding whether or not to grant credit, banks decide how and to whom the new purchasing power is directed, and which projects are or are not financed and can be carried out. In this, they have an important responsibility. If too much money is created, or allocated to the wrong projects, it can have harmful effects on society and the economy(see the module on money and Essentiel 4 below).

Risk analysis

Banks therefore also play an important role in analyzing credit quality. It’s a question of making a loan that’s well advised (i.e. that has a reasonable chance of being repaid by the borrower) without being overly cautious (which would also ruin the lender’s business, who needs to know how to take “reasoned” risks). Although the proverb says that you only lend to the rich, the reality is more nuanced, and we have to acknowledge that some banks have real expertise in this field: they are capable of analyzing a credit risk and proposing interest rate and collateral conditions adapted to the lender on the basis of this analysis.

Financial players channel existing savings into new economic projects

In addition to bank money creation, financial players collect existing savings, i.e. the portion of income (mainly household income) that is not spent on current consumption, and use it to meet the financing needs of companies, households or public authorities.

In this respect, they play an important economic role, since they enable more (financial) resources to be used in the economy than would be the case if each saver were to invest directly: it is more difficult for an individual to identify and select projects or companies; financial players offer individuals the possibility of recovering, under certain conditions, the capital invested, thus reassuring savers.

Difference between primary and secondary markets :

The primary market is the “new market” on which an issuer (government, company) introduces financial securities (shares, debt securities) for the first time.

These securities can then be traded on the secondary market, a “second-hand market”. The value of the secondary market lies in the fact that it ensures the liquidity of financial securities, i.e. the possibility of converting them more or less rapidly into money. It thus facilitates the mobilization of capital to finance investments in the productive economy. Without this possibility, far fewer savers would consider allocating their financial assets to finance long-term projects that do not directly concern them.

The existence of secondary markets is not without perverse effects

The primary market is the only way to finance the productive economy. Savings channeled into the secondary market certainly ensure the liquidity of securities (and thus facilitate the issuance of these securities on the primary market), but it also has the effect of driving up their price (since they are in greater demand) and, if savings are in excess, creating destabilizing financial bubbles.

Moreover, the liquidity of financial securities at a given moment does not guarantee that this will always be the case. It gives the dangerous illusion of unconditional reversibility of financial decisions. In the event of a financial crisis, markets become illiquid: nobody wants to buy securities any more, everyone wants to sell, and prices plummet (see our fact sheet on liquidity ).

Finance helps manage risk

The development of financial techniques goes back a long way. European merchants would doubtless have been less adventurous in the Middle Ages had it not been for the inventiveness of financiers offering them insurance or “paper” instruments (such as promissory bills) that would have saved them the trouble of carrying gold coins. ³ .

The mission of finance and insurance is to manage the risks associated with economic activity. These are difficult professions, requiring experience and methods that can legitimately be sophisticated (because the activities of the real economy can be complex). It would therefore be counter-productive to deny all interest in financial innovation and to prohibit all new financial products on principle.

More precisely, finance manages risk from a specific perspective: the trade-off between return and risk. The idea is simple: every economic player takes a risk with every transaction (see box). When they don’t bear the risk directly (particularly in the credit business), financial players offer services that either delegate the management of this risk-taking, or hedge it partially or totally (via derivatives ). In exchange, they expect a return (which may take the form of an interest rate, dividends, etc.). The higher the risk, the higher the expected return.

If there aren’t many truths in the financial world, there’s one we can remember: it’s an illusion to believe that you can earn money over the long term by investing it risk-free. The financiers in charge of investing household money, insurers, asset managers and pension funds all know this, and use a formula which, in this case, has a precise and very accurate meaning: ” there is no free lunch “. ⁴ . This is the idea that there is no such thing as a financial strategy that, for zero initial cost, will enable you to acquire definite wealth. Even more technically, there are no arbitrage opportunities on the financial markets. Financial advisors who offer “martingales”, who promise “magic” returns, are swindlers or liars (at least by omission). They deliberately or inadvertently forget to mention the risk they are passing on to those who follow their advice. This idea is sometimes confused with that of market efficiency, which is, on the contrary, a dogma without any foundation or precise definition (see Misconception 1).

The banking and financial sphere has grown by leaps and bounds in recent decades.

In the vocabulary of finance, financialization refers to the increased reliance of all economic agents on external financing, and in particular debt, compared with previous periods. Over the past 50 years, the world economy has clearly become increasingly financialized, with finance playing a growing role in the global economy. This financialization is the result of economic and political evolutions that have affected most advanced economies since the 1970s (see Essentiel 3).

Numerous indicators show the growth of the financial sphere relative to the productive economy:

• the growth in the relative weight of the banking and financial sector in GDP, the growth in the income of individuals working in the financial sector and their growing share of the highest incomes;
• the relative weight of goods that are the subject of a financial market (oil, gas, coal, metals, foodstuffs such as wheat, soya, etc.);
• growth in the volume of “derivatives”;
• the growing dependence of governments on financial markets for their financing.
• the weight of finance in corporate shareholding (compared with that of individuals and non-financial companies) – see Essentiel 5.

Disconnecting the financial sphere from the productive economy

According to the Financial Stability Board (FSB) ⁵ global financial assets have risen from around $128,000 billion in 2002, or 370% of GDP, to over 400,000 billion euros in 2019, or 460% of GDP. As can be seen from the following graph, the crisis of 2007-2008 only slightly slowed the continued growth of the financial sphere.

As economists Gunther Capelle-Blancard and Jézabel Couppey Soubeyran point out in the article Une régulation à la traîne de la finance globale (2018), the lack of strict proportionality between flows in the financial sphere and those in the productive sphere is not surprising in itself. For example, it’s understandable that in order to finance international trade activities and hedge the associated risks (currency and interest-rate risk in particular), several flows are required on the foreign exchange and derivatives markets ⁶ . “However, when 70 times the value of international trade is exchanged on the foreign exchange market in a single year, there is every reason to believe that the financial sector is no longer serving the real economy, and is now primarily serving itself.

The excesses of finance

In the same article, the authors highlight “some measures of excess” in finance:

“There are many measures that can be used to account for the explosion of finance. In the OECD countries, credit to the private sector rose from an average of around 50% of GDP in the 1970s to over 100% of GDP at the time of the financial crisis, and has remained at this level ever since. ⁷ . Bank balance sheets grew at an exponential rate at the turn of the 1990s-2000s, particularly in Europe, where they now represent the equivalent of 3.5 times GDP, compared with 1.8 times in Japan and 1.2 times in the U.S. ⁸ . The financial crisis of 2007-2008 slowed this trend, but did not reverse it. Globally, assets managed by banks practically tripled during the 2000s, rising from just over $50,000 billion at the end of 2003 to $133,000 billion at the end of 2015 [ed. note: $155,000 billion in 2019]. ⁹ .

Transaction volumes on the stock, foreign exchange and derivatives markets also illustrate this disproportionate growth. These financial quantities are now out of all proportion to those of the real world. Remember that in 2008, merchandise trade between the G7 countries was worth $3,000 billion (before declining with the crisis), and global GDP was worth $75,500 billion in 2016. And yet, despite the crisis and the slowdown it may have brought about, financial transactions amount to hundreds of thousands of billions of dollars. The Bank for International Settlements (BIS) estimated the notional amount of derivatives outstanding at $483,000 billion at the end of December 2016 [ndr $558,500 billion in 2019].

As far as the foreign exchange market is concerned, the BIS triennial survey published in 2016 suggested a slight contraction, but still estimated the daily volume of foreign exchange transactions at over 5,000 billion (equivalent to more than 2.5 times the GDP of a country like France in a single day) [ndr $6600 billion at the end of 2019].

And last but not least, equity market transactions today amount to more than $100,000 billion every year, equivalent to almost 150% of global GDP, compared with just 5% in 1975. ¹⁰ . This increase is essentially driven by the boom inhigh-frequency trading (HFT), which now accounts for between half and two-thirds of trading volumes, with transactions carried out at microsecond intervals.”

Financialization took off in the 1970s as a result of neo-liberal political decisions.

The decades following the Second World War were marked by strict regulation of the financial sector, sometimes referred to as “financial repression”. ¹¹ A fixed, controlled exchange rate based on the convertibility of the dollar into gold ¹² set up following the Bretton Woods agreements; control of transnational capital movements; supervision of credit activities; segmentation of the banking and financial industry. States financed themselves by mobilizing domestic savings, obtaining preferential loans from captive national publics (such as pension funds or national banks) or from their central bank.

Generally speaking, central banks were in a position of relative subordination to governments: monetary policy was used in conjunction with fiscal policy to pursue economic policies aimed at sustaining activity, or curbing it in periods of overheating. It was also at this time that the welfare state, a system of mutualized social insurance at national level, developed in many countries.

This period of strong state intervention in the economy gradually came to an end in the 1970s. Against a backdrop of greater instability, marked in particular by the end of the Bretton Woods exchange rate system, oil shocks and the emergence of stagflation (concomitant inflation and mass unemployment), neoliberal theses, which had hitherto gone unheeded, gained ground in political circles on both the right and left in advanced countries. The aim is to promote the market economy and the “open society” on a global scale, and to limit public intervention in the economy to ensuring social stability and the smooth functioning of markets.

In financial terms, this is reflected in a vast movement towards liberalization and globalization, sometimes referred to as the 3D movement. ¹³ movement” (deregulation, decompartmentalization, disintermediation). Without claiming to be exhaustive, let’s highlight just a few of the major developments in this movement.

The end of the Bretton Woods Agreement and the introduction of a floating exchange rate system

In August 1971, faced with the melting of the country’s gold reserves, US President Nixon decided to suspend the convertibility of the dollar. The new system of floating exchange rates was ratified by the Jamaica Agreements in 1976. Henceforth, the price of currencies on the foreign exchange market would evolve according to supply and demand. This opened the door to currency speculation. Currency crises multiply around the world ¹⁴ with major consequences for the economies concerned, given the importance of the exchange rate on the price of exports and imports. (See Essentials 11 and 12 in the currency module). Moreover, the introduction of floating exchange rates, by creating a new risk (currency risk) in international trade, will provide the impetus for the growth of derivatives.

Free movement of capital

The end of the Bretton Woods system was accompanied by the gradual lifting of controls on transnational capital movements. From the 1980s onwards, advanced countries, led by the United States, gradually opened up their public debt markets to foreign investors. Financial players were then given the opportunity not only to invest wherever they wished on the planet, but also to set up in other countries to compete with local financial players. These policies were also promoted and even imposed on developing countries following the adoption of the Washington Consensus doctrine by the IMF and the World Bank. ¹⁵ . The opening of borders to capital movements has several negative consequences for the global economy: it contributes to the emergence of mega-banks, encourages the development of international speculative movements that destabilize national economies, and facilitates tax evasion and money laundering in tax havens.

The deregulation of lending activities and the development of prudential regulation of banks

From the 1970s onwards, most advanced economies deregulated the credit sector, gradually removing some of the limits on banks. All rules aimed at directly limiting (via quotas, for example) the quantity of credit granted by banks, as well as the orientation of credit according to economic sectors, came to an end. This period also saw the end of bank specialization by type of activity (retail banking, investment banking, banks specializing in local credit, etc.), or by geographical area (in the United States, for example, banks were not allowed to expand beyond a single state). Many governments allow banks to engage in non-banking activities, such as insurance or asset management. Some countries are also lifting constraints on borrowers.

These different trends are reflected in the concentration of the sector, leading to the emergence of international mega-banks, some of which are “universal” in the sense that they are active in all areas of finance.

At the same time, following the resurgence of banking crises virtually unheard of in the previous period, prudential regulation of banks developed with the establishment of the Basel Committee. Banks were required to hold a minimum level of capital to guarantee their ability to absorb losses arising from borrower defaults. However, these rules have not prevented a proliferation of banking crises, nor the outbreak of the systemic crisis of 2008 (see our fact sheet on prudential regulation). On the contrary, they had the perverse effect of leading some banks to securitize loans so as not to keep them on their balance sheet, thereby reducing their incentives to analyze credit risk properly. This perverse mechanism was at the heart of the 2008 crisis.

Disarming public authorities

This period of financial liberalization was also marked by the placing of public debt on the market. The various mechanisms that had previously enabled public deficits to be financed at low cost were abolished. Expensive governments had to submit to the “healthy” discipline of the market(see the module on money). The “debt order” is gradually established. ¹⁶ as intense bond-issuing activity developed, generating fees for banks and “safe” assets (government bonds) for financial investors.

Lastly, this period coincided with an evolution in doctrine concerning the governance and missions of central banks, as well as the role of monetary policy. On the one hand, the role of central banks was now confined to monetary stability (the fight against inflation). It wasn’t until their decisive intervention during the 2008 crisis that the objective of financial stability returned to the heart of their missions. On the other hand, the model of independent central banks became widespread, on the grounds that governments’ inflation targets were insufficiently credible, as they were marked by time inconsistencies (linked in particular to their desire to win re-election).

Financial activity is at the root of cycles and crises that are harmful to society and the environment.

Hyman Minsky clearly demonstrated the intrinsic instability of liberalized finance. ¹⁷ . After a period of growth, investors begin to take greater and greater risks, while lenders become less and less cautious. This triggers a phase in which rising asset prices and rapid credit expansion reinforce each other, jeopardizing the stability of the system (see below). The point at which over-indebted investors are forced to sell their assets en masse to meet their debts is sometimes referred to as the “Minsky moment”, triggering a self-sustaining downward spiral in asset prices and a drying-up of liquidity. Far from impacting only the financial sector, financial crises can be transmitted to the economy as a whole, particularly through overindebtedness and the drying-up of credit.

This has dramatic social consequences, with rising poverty, unemployment and inequality. They also result in a further delay in addressing the ecological emergency, as decisions in favor of transition are postponed or watered down. How can we raise taxes on energy when precariousness is on the rise and public money is lacking to compensate for its effects? How, in such a context, can economic players (local authorities, businesses and households) decide on long-term investments?

Private debt is at the heart of this financial instability

The following graphs show how debt (public and private) has risen inexorably since the 1970s. Worldwide, it rose from 114% to 227% of GDP in 2018.

This trend is even stronger in the so-called advanced countries ¹⁸ total debt reached 267% of GDP in 2018, compared with 125% in 1970.

While debate focuses on public debt, private debt (that of households and non-financial companies) is far more significant. In the years leading up to the 2007-2008 financial crisis, both globally and in the advanced economies, private debt was more than double public debt. The gap has since narrowed, not least because governments have assumed a large share of the consequences of the crisis, whether by supporting the financial sector or bearing the social costs.

The importance of private debt is of great concern, as the root cause of both the Great Depression of the 1930s and the crisis of 2007-2008 was the bursting of a debt-financed speculative bubble. Rising debt and speculative bubbles go hand in hand. One of the main reasons for this is that loans are granted with “collateral” that is in fact speculative (real estate or financial securities). The supply of and demand for debt are both increasing functions of expectations of rising asset prices. In this mechanism, there is no restoring force. Credit providers feel protected by the rising financial value of collateral (speculative asset). Credit seekers, always on the lookout for added value, increase their demand for debt as speculative bubbles develop.

A strong correlation between the banking crisis and financial liberalization

From a factual point of view, there is a strong correlation between the number of banking and financial crises and periods of financial liberalization, as shown in the following graph:

Financialization has many negative consequences for the economy

As we saw in Essentiel 4, the intrinsically unstable nature of finance is a source of crises that reverberate throughout the economy, with dramatic social consequences. On the ecological front, financial and economic crises have most often resulted in a delay in the necessary transition to a low-carbon economy. At a time of mass unemployment and massive indebtedness, the investments needed for the transition and environmental regulations are being postponed (or even scaled back in the case of regulations) on the grounds that priority should be given to employment, recovery and growth.

As we shall see, beyond this periodic destabilization of the economy, financialization also has other negative impacts.

Companies’ shorter time horizons

The financialization of the economy has been accompanied by the widespread adoption of a management model for listed companies aimed atmaximizing shareholder value. According to this doctrine, the interests of shareholders, seen as the owners of the company, take precedence over those of all other stakeholders (employees, suppliers, customers, etc.). Executives and managers, whose interests are aligned with those of shareholders via various mechanisms (bonuses, stock options), must first and foremost pursue the objective of maximizing return on equity (ROE). To achieve this, they adopt a variety of practices aimed at increasing dividend payouts and boosting share prices: focusing on cost reduction, limiting investment (tangible or intangible _R&D), increasing debt leverage, share buy-backs.

This form of corporate governance diverts profit from productive investment, while increasing the company’s financial fragility through growing indebtedness. It also leads to a decline in the share of wages in value added, due to the focus on cost reduction and the weakening of employees’ collective bargaining power. According to the OECD, over the period from 1990 to 2009, the share of labor compensation in national income fell in 26 of the 30 advanced countries for which data were available ¹⁹ . The median labor share of national income in all these countries fell considerably, from 66.1% to 61.7%.

Thus, the financialization of corporate management, with the shift in the 80s to a mode of governance based on maximizing shareholder value coupled with the rise of financial institutions ²⁰ focused on generating short-term profits for shareholders, managers generally neglect measures and investments aimed at the company’s long-term profitability and even viability.

Needless to say, this also applies to ecological and climate transition strategies, which require projections into the future and substantial investments to decarbonize or even reorient the company’s activities. This short-termist logic is not limited to listed companies: because of the market power of multinationals, it spreads to the rest of the economy via the chain of suppliers and subcontractors.

Finally, it should be noted that this model of the financialized company is also partly responsible for the increase in private debt. Companies take on debt to support their shareholders’ financial returns, or to buy back their own shares, even if this means jeopardizing their very survival; households take on debt to support their consumption in a context of stagnating purchasing power, partly created by the dogma of shareholder value; the financial sector itself and speculators take on debt to take advantage of the speculative opportunities offered by a hypertrophied, globalized financial system.

Rising income inequality

The increase in income inequality over recent decades is well documented. A number of factors have contributed to this: less progressive tax policies, globalization which has exerted downward pressure on incomes in advanced countries (due to competition from low-wage countries), the pursuit of automation and the start of robotization… Financialization has played its part through various channels:

-Income from financial activities is on average higher than in other sectors, sometimes reaching astronomical levels, as in the case of traders. This point no longer needs to be made, as studies on the subject abound. ²¹ .

-Another source of financial inequality is unequal access to credit and financial services: high-income earners have easy access to credit, enabling them to take advantage of the investment opportunities they spot; financial and real-estate bubbles contribute, for as long as they last, to increasing income from wealth (rents, dividends, capital gains on asset disposals, interest income); wealthier households have the means to call in experts to “optimize” their taxes, or even to evade the taxman, which in turn reduces revenue and therefore the redistributive capacity of governments. At the other end of the income distribution scale, debt can be a factor in poverty traps. Unlike high-income households, poor households do not take out credit in order to exploit investment opportunities and thus enrich themselves. These households have seen their incomes stagnate or fall, notably due to the advent of shareholder value as a corporate management principle (see previous point) and the rise in housing costs (a consequence of real estate bubbles). Credit to these households enables producers to sell their products. In the short term, it enables households to “cope”, but in the long term, the burden of interest penalizes them even more.

-Finally, financialization is increasing poverty and inequality, due to the impact of financial crises on the economy (with rising unemployment and, more generally, underemployment) and on public finances. Household income inequality in OECD countries (before taxes and transfers) measured by the GINI index rose by 1.4% over the 2007-2010 period. ²² . The actions taken by governments to rescue the financial system and the consequences of the crisis on public finances (lower tax revenues, higher social spending) have resulted in a considerable increase in public debt. In fiscally constrained countries such as those of the European Union, the level of debt very quickly justified the implementation of austerity policies with disastrous social consequences, such as a reduction in the quality of public services (or even the disengagement of the State), primarily affecting the most disadvantaged populations. It should be noted that this austerity has proved counterproductive in terms of its primary objective: debt reduction (see our fact sheet on the budget multiplier ).

The detour of financial activity from the real economy

As noted in Essentials 1, the banking and financial sector is expected to provide services to all other sectors of the economy. Economics textbooks generally describe banks as lending to support activity and finance new investment.

However, the financialization of the economy is changing all this. Adair Turner, former head of the UK’s Financial Supervision Authority, points out that in today’s banking systems, most loans do not finance real new investments, but the purchase of existing assets, whether real estate or financial securities (on the “secondary market”, see Essentiel 1). ²³ . Credit excesses do not therefore reflect over-financing of productive activity, but rather fuel bubbles.

Credit can also fuel over-investment in certain sectors. In the heart of Europe, Ireland and Spain suffered cruelly from such over-investment in real estate in the pre-crisis period, leaving the countries bereft, socially damaged by the bankruptcies of builders and developers and the resulting unemployment, banks gorged with bad debts, and a territory blighted by ghost-buildings that can’t find buyers and have often been halted before completion.

Bad loans are therefore those that do not finance useful investments. Adair Turner points out that in Great Britain, in 2012, of the 1,600 billion in outstanding bank loans to non-financial players, only 14% went towards productive business investment. The rest went to office property (14%), residential property (65%) and household consumption (7%). This is the general trend in advanced economies (see the Money module).

Savings are also massively channelled into the purchase of existing assets on secondary markets. In so doing, they contribute to the liquidity of securities and thus to the success of primary market issues, but do not provide new financing for the real economy. This is all the more true when savings or credit are used to speculate on derivatives. Finally, as we saw above, the financialization of the economy has been accompanied by the spread of the shareholder value management standard, which subjects companies to an arbitrary standard of financial return to satisfy shareholders, sometimes to the detriment of their long-term viability.

Volatile financial markets prevent the “price signal” from reflecting changes in the scarcity of raw materials

For a number of products, “derivatives” have been progressively invented which “complete” the market, thus contributing, from the doxa’s point of view, to improving the functioning of said market. It is possible to buy a barrel of oil futures, a call (or put) option on that barrel, and then a host of “derivatives”, the imagination being limitless in this area.

Contrary to the initial idea of stabilization, price volatility on these financialized markets has, on average, increased. The risks of banking, monetary and financial crises have increased. This is clearly not in the interests of manufacturers and farmers, who are seeking to protect themselves from this volatility.

As a result, the price signal observed on these markets has become blurred and, contrary to popular belief, no longer provides information on quantities. Take oil, for example. Its price peaked in 2008 at $140, only to fall back to less than $60 a few months later. Clearly, during this period, neither proven oil reserves nor global production capacity changed substantially. The price per barrel therefore provides no information on the physical realities of the market. It does, however, provide information on the instantaneous mood of the markets?

That’s why mathematician Nicolas Bouleau describes markets as “smoke and mirrors “. As he shows, it is also possible that, for purely mathematical reasons, the price of a raw material could collapse even though its resources are close to exhaustion.

So, if we want to guard against the risk of exhaustion, it’s up to public authorities to build up and communicate quality information on the physical realities of strategic markets.

Rising commodity price volatility and large-scale social crises in developing countries

As early as the end of the ^19th century, specialized markets (mostly located in London and Chicago) were established. Cereals, rice, soybeans, cocoa, copper, nickel, rare earths and precious metals… are traded on financial markets where financial and non-financial players negotiate not only physical products (the underlyings), but increasingly contracts and ” derivatives “. While some players might have hoped for price control, or at least a degree of stability and reduced volatility, the opposite is true. The consequences are unfortunately very real, and harmful to the most disadvantaged. Take, for example, the “bread riots” in Egypt, following the doubling of wheat prices between April 2007 and April 2008, from 5 to 10 dollars a bushel, a doubling that was not justified by any shortage. At the same time, we witnessed a 20-fold increase in futures contracts held between 2003 and 2008, from $13 billion to $260. While this is not absolute proof of causality (of the effect of financialization on price rises, or at least of their greater volatility), it is, on the contrary, clear evidence of the absence of a stabilizing effect.

As Ivar Ekeland and Jean-Charles Rochet note in their book, the U.S. Congress tried, unsuccessfully, to remedy this situation in 2010 ²⁴ .

“The Dodd-Franck Act calls on the Commodities futures Trading Commission (CFTC) to impose limits on speculative positions in commodities (also including metals oil and gas) when it deems speculation in these markets “excessive”. The rule was adopted on October 18, 2011, despite intensive lobbying by the financial industry. It was immediately attacked by two trade associations (ISDA and SIFMA), who argued that the CFTC had failed to conduct a prior cost-benefit analysis showing that its new rule would be beneficial. On September 28, 2012, a federal judge sided with the financial industry and struck down the new rule adopted by the CFTC on the grounds that it had presented no quantitative or empirical analysis showing that the new regulation would benefit the market! ²⁵ Triumph of finance: the judge no longer takes the citizen’s point of view, but the market’s!”

The risk of a new systemic financial crisis still exists

In the aftermath of the 2008 crisis, the firmness of public statements ²⁶ made it possible to envisage a real return to financial control. A decade later, after intense negotiations with the banking industry in all the world’s major countries, measures have certainly been adopted to reduce the risks taken by financial players. But, as the many studies published to mark the tenth anniversary of the crisis underline ²⁷ these measures are far from sufficient to protect the economy from another banking and financial crisis.

The 2008 financial crisis put systemic risk back at the center of public authorities’ attention.

This expression refers to the fact that a particular event causes a chain reaction of negative effects on the entire financial system, culminating in its collapse. It is all the more serious because the impact is not limited to the financial sphere, but spreads to the rest of the economy.

The 2008 crisis highlights the two dimensions of systemic risk.

The transversal dimension is linked to the interdependence between financial institutions. Not all economic sectors are subject to the risk of contagion: for example, if a major car manufacturer like Renault goes bankrupt, there’s no reason why its competitor Peugeot should, quite the contrary. The situation is different for banks (and financial players in general). They are unique in that they lend to each other on a massive scale. As a result, the failure of a very large bank can have a knock-on effect on other financial institutions, since the latter will have to bear losses on assets that were not considered risky in the first place (and for which they had therefore not set aside sufficient capital). This is how the real estate crisis in the United States, triggered by subprime defaults, which could have remained local, was transmitted to the entire global financial system via the collapse of a very large bank, Lehman Brothers.

The temporal dimension is linked to the procyclical nature of players’ behavior: as the financial cycle rises, risk increases as agents take on debt and invest, following a bubble-forming logic in which rising asset prices and debt are self-perpetuating (see l’Essentiel 4 and our fact sheet on Minsky and Fisher ); conversely, in the downturn of the financial cycle, rational behavior at the microeconomic level (stopping lending to other potentially insolvent players, selling supposedly risky assets or to free up financial resources or before prices fall too far) deepens the crisis at the global level (collapse of asset prices, liquidity crisis).

Despite public regulation, the face of the global financial system has not fundamentally changed

Without going into the details of post-crisis financial regulations, we will simply highlight a few figures which show that the financial sector does not seem to have turned any significant corner.

The financial system has continued to grow and still represents around 500% of GDP. It remains as concentrated and interconnected as ever (see Essentiel 8). The shadow banking “remains as important as ever, and is no longer regulated. There are still 30 systemic banks, and even if they are better capitalized than before the financial crisis, this does not guarantee that they could cope with a new global crisis without help from the public authorities.

In short, systemic risk is present in its cross-functional dimension.

As for the time dimension, you only have to look at the levels reached by the equity and real estate markets to realize the financial euphoria underway.

Stock market valuations are reaching record levels, as shown by the following chart tracing the long history of the Dow Jones index (see also here for the S&P500, here for the Nasdaq, here for the Stock Europe 600).

In many countries, real estate has caught up with or even exceeded its 2007 level. This is the case, for example, in the United States, France, the United Kingdom and Germany.

It is impossible to predict when a crisis will erupt, or how deep it will go, how long it will last, or what its economic consequences will be. All we can say is that the financial system is still a long way from a state where any risk of crisis is eliminated or becomes highly unlikely.

However, there is a fundamental difference between the current period and the pre-2008 period: banks and financial markets are on a drip-feed of liquidity from central banks. The financial system is kept weightless, and continues to boom despite the economic crisis linked to the measures taken to deal with the COVID 19 pandemic. It is no longer just the indebtedness of private players (households and companies) and financial players that is fuelling the bubbles, but the monetary policy pursued by central banks.

One final point: the COVID-19 crisis has highlighted a new reality at the start of the 21st century: the sources of destabilization in the financial system can come from our natural environment. This realization is not entirely new: back in 2015, the systemic risks posed by climate disruption to financial activity were identified by Mark Carney in his now-famous “tragedy of the horizons” speech(see next point).

Climate is a source of proven systemic risks

In September 2015, in a speech delivered at Lloyd’s headquarters, Mark Carney, Governor of the Bank of England and Chairman of the Financial Stability Board ⁵ stated that global warming poses risks with potentially systemic financial consequences.

He introduces the concept of the “tragedy of horizons”. The gap between the short-term horizons of financial players and the long-term horizons of climate impacts means that financial players are unable to identify the risks they run as a result of global warming. It also draws up a typology of these risks.

Following this seminal speech, central banks around the world took up the subject. As a result, the Network of Central Banks and Supervisors for the Greening of Finance was created at the end of 2017. It aims to develop and promote methodologies to better identify and measure the financial sector’s exposure to climate risk, to draw up climate stress tests, but also to promote financing for the transition to a low-carbon economy. To date, however, supervisors’ attention has focused much more on risk measurement than on adapting monetary and prudential policies to combat global warming(see the module on money).

Physical risks: insurance and investor exposure to the physical consequences of global warming

Global warming generates “extreme” meteorological events (cyclones, heatwaves, intense rainfall events, etc.), i.e. those that statistically significantly exceed historically observed reference levels. It also manifests itself in profound changes to the natural environment, such as rising sea levels or the melting of continental glaciers (which feed the planet’s major rivers). Physical risks concern the destruction of asset stocks (due to forest fires, floods, cyclones, rising oceans, etc.), the reduced profitability of exposed companies and/or the deterioration of income streams (impact on tourism, fishing, harvests or the incomes of workers in the areas concerned, disruption of production chains, etc.). This physical damage can directly affect the longevity of capital and accelerate its depreciation. The direct impact on financial stability comes via the often cumulative and highly correlated losses of insurers and reinsurers, but also via other transmission belts that are sometimes just as direct, such as lending channels or bank investments. These physical risks will generate feedback and contagion effects between sectors and regions that are very difficult to quantify.

Transition risks: the economic and financial consequences of reducing greenhouse gas emissions

Reductions in greenhouse gas (GHG) emissions can result from the implementation or mere announcement of low-carbon policies (carbon tax, banning certain polluting vehicles from city centers, ambitious trajectory to increase the share of renewable energies in the energy mix, etc.), from a technological breakthrough making a rapid transition possible, or from a shift in individual preferences and social norms. In all cases, economic activities are affected more or less strongly and rapidly. In financial terms, the most feared transition risk is that of a sudden adjustment in asset prices.

The polarization of market expectations in response to such changes in climate policy, technology or behavior can lead to a sharp depreciation of assets backed by high-carbon activities (e.g. fossil fuel exploitation), with chain effects that are difficult to assess. These assets are known as stranded assets, in the sense that they are backed by investments that have lost all or part of their value before the end of their economic life, due to unforeseen regulatory or technological developments.

The following table is taken from an article published in 2019 ³¹ in which the authors carried out a systemic empirical analysis for a number of European countries of the stocks of productive capital exposed to the risk of stranding, in particular via cascade effects due to sectoral interdependencies. As can be seen, losses can represent very substantial portions of the sectors analyzed.

The link between public climate policies and the direct realization of transition risk considerably complicates public decision-making. Indeed, a public climate policy leading to a massive and widespread depreciation of carbon assets would manifest itself in the short term as a systemic financial crisis, whereas the effects on the climate would only be felt over several decades. ³² . This is one of the manifestations of the tragedy of horizons.

This is also a challenge for central banks. In the event of a climate-related financial crisis affecting the solvency of banks and insurance companies, central banks will be under massive pressure to buy assets impaired by physical and transitional risks. They will then be, against their will, climate loss absorbers of last resort rather than mere lenders of last resort.

Liability risks

These risks concern legal action taken by victims of natural disasters attributable to climate change to seek compensation from those they hold responsible. Such proceedings can hit carbon-based industries and their insurers hard. These lawsuits can damage the reputation and solvency of the companies concerned, and even bankrupt them (see box).

The banking and financial system is too concentrated

The free movement of capital and the decompartmentalization of banking and financial activities have led to financial globalization: financial activities and players have taken on a cross-border or even international dimension, giving rise to financial multinationals with dominant positions in virtually every segment of the banking and financial services market.

This is particularly evident in the banking sector. Since 2011, the Financial Stability Board ⁵ has maintained a list of so-called systemic banks, known as G-SIBs (Global Systemically Important Banks). Since 2016, there have been 30 of these banks, whose failure would be likely to cause a contagious collapse of the international financial system as a whole. According to the Global Capital Index of the Federal Deposit Insurance Corporation (one of the US regulatory bodies), these 30 systemic banking groups weighed in at over $53,000 billion at the end of 2017 (aggregate balance sheet size), or almost 53% of global banking assets (which , according to the Financial Stability Board, totalled over $141,000 billion in 2017).

According to François Morin , four of these groups (Deutsche Bank, Citigroup, Barclays, UBS) accounted for 50% of foreign exchange market transactions in 2015 (with ten accounting for 80%). Fourteen of them belonged to the eighteen groups making up the Libor (London Interbank Offered Rate) panel, putting them in a position to influence the main market benchmark for determining the price of money in the very short term. These groups are also dominant on the public debt market, acting as intermediaries between issuing governments and investors purchasing public securities.

This concentration is not immutable: it is the fruit of history, as can be seen by looking at the evolution of the concentration of banking assets in the United States over a long period, as a function of group size.

As Jézabel Couppey Soubeyran and Gunther Capelle-Blancard note, “The size of institutions and the market concentration that goes with it result, at least in part, from a logic that is very specific to the banking sector. Larger size generally enables a company to benefit from economies of scale and offer a wider range of services. ” Size also facilitates the gathering of information that plays a crucial role in the markets. The bulk of financial flows pass through these groups (see above on the share of volumes on the foreign exchange market), who naturally exploit this dominant position. This information is not public, which clearly creates an asymmetry between players. “In addition to these traditional arguments, however, banks have every interest in increasing the size of their balance sheets as much as possible, in order to benefit implicitly from government guarantees in the event of financial difficulties: this is the famous moral hazard problem of the too-big-to-fail principle, which the bank resolution mechanisms set up under the Banking Union in Europe and the Dodd-Frank Act in the United States are trying to remedy. Let’s also recognize that governments, particularly in Europe, have never really sought to limit the size of banks, and have instead encouraged mergers to create “national champions” in a context of competition between financial centers.

Beyond the banking sector itself, recent decades have also seen the development of collective savings management. Individuals are managing their financial assets less and less directly, entrusting them to professional institutional investors (notably pension funds, insurance companies and sovereign wealth funds). These players have grown considerably in importance since the 1980s, in line with the financialization of the economy. For example, the assets managed by insurance companies, which amounted to some $519 billion in 1980, will reach $34,000 billion in 2019. For pension funds, the figure has risen over the same period from $860 billion to $39,000 billion. Beyond this explosion in assets under management, these sectors are also highly concentrated, as demonstrated, for example, by the fact that the FSB is also developing indicators to identify systemic insurers (even if this is being done with a delay compared to the work of a similar nature done for the banking sector).

Finally, the asset management sector is emblematic of this concentration in the financial sector. Assets under management have almost doubled in less than 10 years, reaching $104.4 trillion at the end of 2019.

This sector is characterized by hyper-concentration at the top: Black Rock, the largest, managed $7,800 billion in assets in 2020. The top 20 asset managers account for 43% of funds under management.

As economist Olivier Passet points out: “Between them, BlackRock, Vanguard and State Street control 25% of the voting rights of the 500 largest US-listed groups and manage 10% of the world’s market capitalization. Shareholder governance is under the tutelage of global behemoths that the crisis has propelled even higher. ”

Tax havens are an unacceptable source of tax losses for governments

Tax havens are countries or territories in which certain taxes are very low or non-existent and which are characterized by a high degree of opacity. ³⁶ . Their importance has grown with financial globalization. The free movement of capital has reduced controls and facilitated the movement of capital, including for tax evasion purposes (and, of course, money laundering). Financial institutions and law firms established in these countries offer their services to wealthy individuals and multinationals from all over the world. You only have to try to understand offshore schemes to see just how sophisticated the financial techniques used are.

Tax evasion (see box) has become better known and understood since the proliferation of cases, investigations and revelations that followed the 2008 crisis. ³⁷ . These led to the mobilization of several countries and international bodies to collect data on a phenomenon that had previously been largely opaque ³⁸ .

A huge loss of revenue for governments

In their research Missing Profits, published in 2022, economists Thomas Tørsløv, Ludvig Wier and Gabriel Zucman estimate that, on a global scale, “almost 40% of multinationals’ profits (nearly $1,000 billion in 2019) are hidden in tax havens every year”. For France, this represents a loss of tax revenue of over $13 billion.

Gabriel Zucman also estimates that the wealth of individuals hidden in tax havens “costs” governments $155 billion a year. “Almost half of the wealth relocated to tax havens belongs to the wealthiest 0.01% of the population in wealthy countries. In the UK, Spain and France, around 30% to 40% of the wealth of these households is domiciled abroad.”

In this respect, the European Union is in a difficult position: on the one hand, increased competition between countries since the 1980s has led to a radical drop in corporate tax rates, from an average of 49% to 24% in 2018. On the other hand, and above all, since its creation, it has been home to tax havens such as Luxembourg and Ireland, without wishing to acknowledge it.

Banks are at the heart of the process, not only by facilitating their customers’ tax avoidance practices, but also by locating their own profits in tax havens. A study shows that in 2015, tax havens accounted for 18% of the foreign sales and 29% of the foreign profits of the 36 biggest banks, compared with just 9% of the workforce they employ abroad ³⁹ . These figures clearly show that a significant proportion of their business and profits are artificially transferred there.

Tax evasion is a major factor in increasing inequality

Clearly, it’s the wealthiest individuals who benefit the most, whether directly by avoiding taxes, or indirectly through the higher profits of the companies whose shares they own. On the other hand, the loss of tax revenue has to be compensated either by raising taxes on the middle classes, or by cutting public spending (and therefore public services accessible to all citizens). Scandals and revelations are therefore also a source of growing social protest: when governments want to cut public spending or raise taxes, in the name of budgetary rigor, tax evasion comes as an even greater shock. Finally, tax havens lead us to underestimate the level and growth of global inequality. Wealth invested in tax havens disappears from the statistical radar, and in particular from national accounts and tax returns.

Markets won’t finance the ecological transition on their own

Facing up to the ecological and social challenges of the 21st century implies a profound transformation of our development model in order to distribute resources more equitably, drastically reduce greenhouse gas emissions, save natural resources, depollute water and rehabilitate soil.

To achieve this, we need to invest massively in new infrastructures where they are lacking, and in bringing existing ones into line with ecological standards. Transport, energy and water infrastructures, fleets of vehicles, aircraft and ships, fleets of buildings, stocks of machinery: it’s our entire stock of physical capital, our entire economic heritage, that needs to be renovated, restructured and sometimes even destroyed to limit the exploitation of natural resources and GHG emissions. We also need to invest in education, training and R&D, in order to support the professional transition of those working today in activities such as the fossil fuel industries, which will not be able to continue if the transition takes place.

As a result, the financial requirements are extremely substantial, amounting to trillions of dollars worldwide. Many are betting on green finance, i.e. on the fact that investors will make their investments according to ecological criteria, notably due to regulatory developments such as the obligation to disclose the environmental impact of financing.

A number of factors cast doubt on the ability of the financial markets alone to finance the ecological transition.

Financial markets are driven by the search for short-term returns

Firstly, given the current state of the capital markets, it is highly unlikely that public interest considerations will take precedence over the short-term return objectives of financial players. As noted in Essentiel 4, the vast majority of the financial system is ⁴⁰ less focused on financing new investments than on buying existing assets (i.e. on the secondary market) with a view to generating capital gains through rising asset prices.

These are the words of the experts of the High Level Expert Group on Sustainable Finance (HLEG), mandated by the European Commission to make proposals for the implementation of a Europe-wide sustainable finance strategy. “Strategic frameworks and market behaviors continue to favor a focus on liquid assets, short-term financial instruments and returns, and low-profitability debt in a low-interest-rate environment. On the other hand, investments in infrastructure, small-cap indices, SMEs, tritrisation, private equity and real assets are more limited. Yet these assets are often critical to the transition to sustainable development. ⁴¹ .

Changing these short-termist practices would require far more far-reaching regulatory and tax changes than have been implemented to date. For example, measures would need to be taken to reduce purely speculative investments and leverage.

Moreover, it’s not just a question of putting the financial world back at the service of the productive economy, it’s also necessary to specifically target investments conducive to a low-carbon economy that consumes fewer natural resources. This would mean going far beyond current measures, which focus on extra-financial reporting by companies and financial institutions, in line with the received wisdom that well-informed markets will correctly orient financial capital (see Received wisdom 1). A much more consistent mobilization of monetary and prudential policies to integrate environmental criteria would appear to be a prerequisite for any real reorientation of financial flows. ⁴² .

Financial markets are not suited to financing many transition projects

Even assuming that the above obstacles have been overcome, two additional characteristics of transition projects cast doubt on the wisdom of relying on capital markets alone to finance the ecological transition.

First of all, many ecological transition projects are too unprofitable or even unprofitable under current economic conditions, which do not properly value the ecological and social impacts (e.g. soil decontamination activities, developments to create ecological continuities, wetland restoration). Furthermore, some projects are profitable in the long term, but the populations concerned do not have the means to invest. This is the case, for example, of energy-efficient building renovation, which is profitable in the long term thanks to the savings made on energy bills, but whose owners or occupants are low-income households. These investments require a combination of public funding (often in the form of subsidies) and regulatory obligations. Markets are of little help.

Finally, it should be noted that a large proportion of transition project sponsors do not have access to market finance. This is the case for households who want to renovate their homes, farmers who need to radically change their practices, or non-innovative SMEs who need to renew their production tools. It’s also the case for small local authorities: the renovation of their public buildings is on the order of a few million euros, an insufficient size to reach the financial markets, which handle transactions worth at least tens of millions of euros.