The death of derivatives?

Amid the gloom on the Eurozone, sluggish growth in the US and worries over a real estate collapse in China, some students ask me if there’s any future for the financial system? Understandably their main concern is jobs. I can give a moderately glass half full answer as follows.

All economies need some sort of financial system. Unless your economic wealth depends mainly on natural resources (a mixed blessing in most cases) you also need a basic banking system to move money from savers to investors. If you have a mass of reasonably high income people (a “middle class”, neither too poor to have no savings nor so rich that they transact offshore) then you also need a proper savings system, including pensions, insurance and mortgages. Companies with international business (the majority) also need some sort of foreign exchange services. Larger companies want advice on mergers and acquisitions. And any fairly sophisticated economy needs a stock market and a bond market, plus the services to raise equity and debt capital.

So unless we see a return to bronze age economics, the outlook for global growth of financial services is very good. There are hundreds of millions of people without bank accounts who will sooner or later need one. There is a huge unmet demand for savings products in China. As the middle class grows in other high growth economies there will be a big expansion of what we call financial institutions, the providers of pensions, insurance and savings products. All of this will in turn stimulate the growth of stock and bond markets and the need for investment banking services to provide them, though mostly outside the mature economies of the US, western Europe and Japan.

But there is one category of products which is not so sure to grow and that is, unfortunately for the bankers, one of the more profitable: risk management services. The financial derivatives business is the main creation of modern finance theory, starting with relatively simple products in the early 1970s and growing into a vast and complex machine today. These are products which allow clients to hedge (protect) against movements in interest rates, currencies, commodity prices and the values of financial assets. They can also be used for speculation, a fact which explained why most were illegal under anti-gambling laws in the US until a change of Illinois state law in the 1970s.

Banks make a lot of money and employ a lot of well paid people providing these services. But, as former Federal Reserve Chairman Paul Volker pointed out a few years ago, where is the evidence that they have helped the growth of the rest of the economy? The golden era of growth in the world economy was from the mid-1940s to the early 1970s, admittedly helped by post-war reconstruction in Germany and Japan. There were no derivatives to speak of then, apart from for commodities, where products to fix the price of agricultural produce go back to ancient times.

The need for risk management was less in the era of fixed exchange rates, which ended in the early 1970s. But it is far from clear that the explosion of derivatives products since then has actually benefited anyone much, other than investment bankers. A lot of risk management costs are wasted, so far as shareholders concerned, since they can diversify their risks quite effectively by holding a wide portfolio of companies. The use of derivatives is often more for the benefit of company management.

If there is another major banking crisis it’s quite likely that even more stringent regulation and capital requirements will push many derivatives products out of existence. This is bad luck for those hoping to work in those businesses. But probably not a problem for what we economists call the “real” economy.