Whether the growth of the financial sector has been beneficial to society depends in large part on the social benefits of active asset management, the increase in household credit, and the growth of shadow banking. In our view, professional asset management was beneficial in that it facilitated an increase in financial market participation and diversification. This likely decreased required rates of return for investors and thereby lowered the cost of capital to corporations. But, there is likely too much high-cost, active asset management, which creates rents for the financial sector and distorts the allocation of talent away from more productive sectors. We also raise concerns about whether the potential benefits of households’ increased access to credit — the main output of the shadow banking system – are outweighed by the risks associated with shadow banking system.
Our overall assessment comes in two parts. First, a large part of the growth of finance is in asset management, which has brought many benefits including, most notably, increased diversification and household participation in the stock market. This has likely lowered required rates of return on risky securities, increased valuations, and lowered the cost of capital to corporations. The biggest beneficiaries were likely young firm, which stand to gain the most when discount rates fall. On the other hand, the enormous growth of asset management after 1997 was driven by high fee alternative investments, with little direct evidence of much social benefit, and potentially large distortions in the allocation of talent. On net, society is likely better off because of active asset management but, on the margin, society would be better off if the cost of asset management could be reduced.
Second, changes in the process of credit delivery facilitated the expansion of household credit, mainly in residential mortgage credit. This led to higher fee income to the financial sector. While there may be benefits of expanding access to mortgage credit and lowering its cost, we point out that the U.S. tax code already biases households to overinvest in residential real estate. Moreover, the shadow banking system that facilitated this expansion made the financial system more fragile.