The Role of the Financial Sector Making Money or Serving the Real Economy

The former British Prime Minister William Gladstone expressed the importance of finance for the economy in 1858 as follows: "Finance is, as it were, the stomach of the country, from which all the other organs take their tone."

In a Perfect World The optimal financial system, in combination with a well-developed legal system, should incorporate elements of both direct, market and indirect, bank-based finance. Companies of all sizes and at all stages of development should be able to avail of said financial system.

The Current Model Most financial intuitions are public companies. Rewards are based on quarterly earnings and share value. Plenty of other issues (regulatory) such as interest rate caps, direct lending, and high reserve requirements generally discourage banks from taking risks on micro and meso enterprises.

Financial institutions and information Unbanked transactions are the driving force behind micro-enterprises. Micro-enterprise owners have in general never had a checking or saving account, taken a bank loan, or entered into legal contracts. Difficult for financial institutions to determine risk levels.

The Markets Stock and Bond markets have a high cost of entry Bonds have a minimum issue size of million USD Private placement bonds may be as little as 50 million USD but carry a much larger interest charge Not Ideal for Startups

The Markets – Especially for SMEs Nevertheless, the lack of a well-developed stock and bond market would be a particularly serious disadvantage for any economy. Equity is essential for the emergence and growth of innovative firms. As to debt through bonds, it is important to insure – not diluting the value of existing shareholding; unlike issuing additional shares – enabling more cash to be retained in the business - because the redemption date for bonds is several years after the issue date

The Gap – Indirect Finance New breed of micro financing institutions has emerged to some degree around the world. Meso financing, however, still has a long way to go. So while micro-enterprises are slowly being better served, a gap exists for SMEs and SME startups in the indirect arena. The gap in financing is for 50,000, to 1 million range, an amount that would enable small and startup business to grow to levels where they could begin to take advantage of economies of scale which in turn would lead to the creation of a significant number of jobs.

The Gap – Direct Finance Small Stock exchange with very limited liquidity (USD 1 million a day is a very good day). Limited understanding of the value of growth (chasing the dividend yield). Limited understanding of SMEs of how to access international debt markets. And obviously, even if improved, not a solution for startups.

The Gap - Startups Venture Capital… Improving but… – Limited especially compared to Israel (170 USD per capita), USA (75 USD per capita), and Norway (50 USD per capita). – Why the lack of incentive? » Taxes! Or the lack thereof!

Why do we care? The Business of Business is Business Business activity creates job, cultivates relationships, enables tech transfer, and contributed in developing human capital as well as infrastructure. This is in addition to offering a variety of products and services to consumers as well as other businesses. This translates into various contributors to the economy that create a multiplier effect on development. In developing countries, this multiplier effect is usually hampered by market failures and/or governance gaps

Why do we care? We have addressed part of the externalities that have affected this multiplier effect on our economy through the introduction of a body that aims to drive forward the business of business (Tamkeen). Governance is a continuous and never ending effort. But what have we done about aligning the goals of finance with that of National Development?

Why do we care? Until recently, the financial services sector was the largest in the world in terms of earnings and contribution to economic development. Recently overtaken by technology sector (Apple alone is larger than all of the European banks put together). But even Apple wouldn’t exist without the Finance Sector. The importance of the financial sector cannot be undermined. It has driven plenty of growth in developed nations though its role in the developing world without the right tools to incentivize it has been limited in such economizes primarily to organizations that sit on the top tier of a national pyramid.

And they aren’t the ones who drive Innovation and Growth What drives an organisation to innovate? Top tier organisations seldom innovate as innovation changes the status quo and thus is destructive of current profit centres. Innovation, while in some exceptions does originate from larger organisations, is predominantly the domain of the startup and the smaller more nimble and hungry organisations.

What we need The Bahrain Development Bank is looking at establishing a Venture Capital fund for startups. Well done. Can we have twenty more funds please? Tamkeen continues to improve its schemes to target high potential enterprises and is considering removing the distinction between existing businesses and startups and simply focus on potential. Well done. But can we stop relying on Tamkeen and BDB for a minute?

What we need The World Bank published a report estimating the private wealth in GCC nations, of which Bahrain is one. – Where is the private sector’s role in investment? – How many of the existing venture capital funds are driven by local money? What about the role of the central bank in incentivizing financial institutions?

Its not about making money OR serving the real economy. Its about making money. But lets be honest, if you don’t serve your economy, you wont make money for long. The finance sector isn’t the banks in a nation, the finance sector is the money in the nation, be it FDI, banking, markets, or the people of that nation.