table of contents
Purpose of the paper 3
1. Definition of production in the 1993 System of National Accounts (SNA93) 4
1.1 General definition 4
1.2 Definition of financial intermediation 4
2. Definition of the financial corporations sector 5
3. Analysis of the activity of financial intermediaries 56
3.1 General analysis 56
3.2 Special points 6
4. Consequences of the current prescriptions 8
5. Avenues for further thought 9
1. What form do services take in a post-industrial society? 9
2. What in fact is meant by «a purely natural process outside human control or intervention» , which is not counted as production in national accounts? 11
3. Should special treatment be given to financial «market makers»? 12
6. Conclusion 13
BRIEF BIBLIOGRAPHY 14
WHAT SERVICES FOR WHAT SOCIETY?
How should the services provided by financial intermediaries in a modern society be measured?
Purpose of the paper
This paper looks at the consequences of moving from an industrial society to a service society. It focuses in particular on the changes of the characteristics of service activities and more specifically asks what should be measured in such a society.
Using financial corporations as an example, it shows why the current definition of services deserves discussion or even revision if the changes in the conditions prevailing in financial markets are to be taken into account.
The aim of a paper such as the present one is not to call the fundamental principles of national accounts into question, to increase GDP out of hand or to alter production boundary. Rather the intent is to launch an in-depth discussion on how to define services in particular rapidly developing segments of a post-industrial society.
In recent years, businesses have raised extensive bond loans and large share issues in order to finance their operations, while bank loans, the traditional source of funding, have declined in importance. As a result, countries that were formerly economies with debt systems based on bank loans have turned into economies with debt systems based on financial markets through the issue of bonds and shares. This fundamental change involves transfer of the credit risk; whereas banks used to be the sole bearer of the risk of debtor default when granting a loan, that risk has now been passed on to the individual holders of securities.
In addition, this structural change has opened up national markets and led to the standardisation of securities, thus encouraging the emergence of financial firms that operate in the international arena. Such firms are paid commissions in return for advice on the issue, placement and negotiation of securities. They also manage large portfolios both for their customers and on their own account. The globalisation of markets and businesses and the magnitude of capital flows have radically altered the way banks work.
As a statistical synthesis and as a tool for economic analysis, national accounts are expected to reproduce economic realities in all their complexity. The structural changes that have affected financial businesses in recent years have in many ways made it difficult to collect data and carry out measurement. Globalisation, for example, makes it hard to apply the criterion of territoriality so dear to the hearts of macro-economists. Banks working on an international scale take advantage of standardised securities and the close linkages of financial markets in order to monitor the movements in the securities in their various portfolios. Since an operation may be brought to completion in any international financial centre, the time zone is often the determining factor in finalising it. A European unit floating an offer might well leave the operation to be terminated by its American partner. In such cases, it is difficult to assign all of the value added to one unit or the other. The banks themselves employ sophisticated monitoring procedures to ensure that the various players are remunerated in accordance with their actual contribution. Without detailed information, national accounts find it hard to apply the criterion of territoriality in a rigorous way.
In a more fundamental way, the very core activity of banks has changed. Their traditional function of taking in money in order to reinvest it is giving way to the management of financial assets. For a country like Switzerland, the amounts involved are enormous. The securities deposited in its banks came to 3285 billion Swiss francs in December 1999, while Switzerland’s GDP was 388 billion Swiss francs in 1999.
The point is that the management of financial property generates holding gains and losses. For conceptual reasons, national accountants exclude these from the production boundary. This paper examines the reasons for this treatment. It considers the implications of the present approach and the problems it involves for interpretation. It indicates a number of approaches that may help in thinking about the issue. The aim is not to integrate holding gains and losses in the production boundary but rather to focus the reflections on how to define services, using financial intermediaries as an example. This sector has been chosen because the practices mentioned above are growing in importance. Furthermore, it involves a restricted number of global players. These major banks engage in a number of tasks that benefit all economic players (maintaining market liquidity, guaranteeing the security of transactions, disseminating information, etc.) The point under consideration is how this service is remunerated. To start with, the best approach is to look more closely at the kind of «service» offered by these businesses and then seek ways to quantify it.
1. Definition of production in the 1993 System of National Accounts (SNA93)
1.1 General definition
SNA93 defines production as an activity carried out under the control and responsibility of an institutional unit. An institutional unit owns goods produced as outputs or is entitled to be paid, or otherwise compensated, for the services provided. A purely natural process without any human involvement or direction is not production in an economic sense. (SNA93,§6.15)
Apart from this general definition, SNA93 provides detailed indicators for measuring production in given branches of activity, such as wholesale trading, financial leasing or research and development. Financial intermediation itself is defined in the section dealing with institutional sectors and units (Chapter IV) and not the one dealing with production (Chapter VI). Those not party to the discussions preparing the SNA93 might be surprised by this provision. Indeed it means that financial intermediation is narrowed down to the description of characteristics of activities performed by financial intermediaries. It only enables them to be distinguished from other businesses. This approach makes assignation to sectors easier but causes some problems in measuring production.
1.2 Definition of financial intermediation
According to SNA93, financial intermediation is «a productive activity in which an institutional unit incurs liabilities in its own account for the purpose of acquiring financial assets by engaging in financial transactions on the market. The role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them. They collect funds from lenders and transform or repackage them in ways which suit the requirements of borrowers. A financial intermediary does not simply act as an agent for other institutional units but places itself at risk by incurring liabilities on its own account». (SNA93, §4.78)
SNA93 distinguishes two types of output of financial intermediaries. The first comprises services that are billed directly such as currency exchange and investment advice. This output is valued like other services on the basis of fees or commissions. The second type of output comprises services which are not charged explicitly. In such cases financial intermediaries pay and charge different rates of interest to lenders and borrowers. Such income, termed financial intermediation services indirectly measured (FISIM), is measured as the total property income receivable by financial intermediaries minus their total interest payable (SNA93, §6.125).
2. Definition of the financial corporations sector
This sector includes:
• All resident corporations or quasi-corporations principally engaged in financial intermediation. These units generally assume risk themselves by incurring liabilities on their own account. They thus meet the principal criterion for financial intermediation as defined above.
• All resident corporations or quasi-corporations engaged in auxiliary financial activities which are closely related to financial intermediation. Provision of such auxiliary services can be a secondary activity of financial intermediaries or be provided by specialised agencies or brokers. These units unlike those in the preceding category, do not acquire financial assets and put themselves at risk by incurring liabilities on their own account. However, the services they provide do nevertheless facilitate financial intermediation as such.
The inclusion of financial auxiliaries in this sector gives rise to the following comment in SNA93:
«(…) It is becoming (…) increasingly difficult to draw a clear distinction between true intermediation and certain other financial activities. The boundary (…) has become rather blurred as a result of continuous evolution and innovation in financial markets. (…) However, this is not the only reason for classifying financial auxiliaries in the System (...) . Corporations whose principal function is financial intermediation also tend to provide a wide range of auxiliary services themselves as secondary activities. As a corporation as a whole has to be allocated to a sector, the auxiliary activities of financial corporations would fall within the financial corporate sector of the System anyway, even if financial auxiliaries themselves were to be excluded» (SNA93, §4.80 and §4.81).
3. Analysis of the activity of financial intermediaries
3.1 General analysis
The activity of financial intermediaries:
• Enables the preferences of units with different redemption periods or risk profiles to be equated, which leads to a change in the nature of the funds collected and loaned.
• Implies a special kind of balance sheet. In manufacturing, the production process physically changes goods purchased from third parties into finished or semi-finished products. The inputs are generally radically altered. In the case of financial corporations, liabilities are an outcome of the production process and continue to exist as such in conjunction with the assets that are created once the production process is complete.
• Is defined in relation to a limited number of financial assets and liabilities. The liabilities are mainly deposits, or close substitutes while the assets are chiefly advances or loans and the purchase of bills, bonds or other securities (SNA93, §4.78).
3.2 Special points
The following points may be noted:
1. The principle whereby the creation of financial instruments as such does not generate value added lies at the heart of this review. To take a simple example, consider a bank which takes in deposits of amount X from households and then makes this sum available to businesses. The bank’s liabilities are increased by the same amount as its assets. Creation of financial assets such as "Transferable deposits" and "Loans" therefore creates no value added.
On the other hand, the remuneration earned by these positions is different, with the interest paid by the bank on household deposits being lower than the interest charged on loans. The advisability of including this interest differential in the accounts of financial corporations was once the subject of much debate. Economic theory considers interest flows by their nature to be property flows, since they remunerate the act of making funds available. In that context, they come under the heading of allocation of added value. If interests were to be considered as generating added value, all sectors would become producers of services. National accountants solved this problem by putting forward the special nature of financial intermediation: the intermediary itself assumes a risk by using funds it has collected to make liabilities on own account. It thereby provides a service, that is the adjustment of preferences, and that service is remunerated in the form of an interest differential The accomodation of differences in preferences in terms of redemption periods and risk profiles is thus the factor generating the value added. The interest differential is thus no more than an indirect means of measuring the service provided by the financial intermediary.
This review may be extended to other cases but the end result is exactly the same. Hence when funds on deposits are used to acquire a non-quoted bond, the bank again receives a higher rate of interest than that paid out to depositors. At redemption, reimbursement of the capital permits recovery of the initial investment. With bonds quoted on the stock market, the only change is in financial balance sheet, where the relevant positions must be evaluated at market price. Changes in the stock-market quotation during the year are reflected in the revaluation account, which balances the opening and closing positions in financial balance sheets. If the bond is sold, the intermediary receives the stock-market price. The total of the financial balance sheet remains the same, since the security already appears there at its market value. The only change is in its composition (replacement of «Securities other than shares» by «Currency and deposits»). On the other hand FISIMs are not affected by changes in the value of the security so that the value added of financial intermediaries remains unchanged.
Under SNA93 therefore, the creation of securities generates no added value. This can also be shown by the following example: consider a firm instructing a financial intermediary to float some of its share capital on the stock market. For various reasons (a fall in the stock market for instance), the operation fails and no securities are issued. The firm nevertheless pays commissions, which are reported as output in the financial intermediary’s production accounts. These commissions do not therefore represent remuneration for the creation of securities associated with flotation on the stock exchange. They pay for the preparatory work (scrutiny of legal aspects, preparation of paperwork, publicity, etc.) as well as the bank’s expertise and access to the financial intermediary’s distribution network.
2. Conversely, holding securities does not belong to the production process, which is defined as an activity conducted under the control and responsibility of an institutional unit. Price or quotation changes arise from the overall interplay of supply and demand. There is therefore no control or responsibility exercised by any individual unit. The SNA therefore considers that the holding gains resulting from price changes cannot effect the output of the unit holding the assets. They only affect the financial balance sheet.