Financialization Explained

Financialization is an economic paradigm where the conversion of real economic value into financial instruments and their exchange within the financial system comes to dominate economic institutions, activity and value creation.  Through financialization, the financial industry converts any work product, physical asset or service to an exchangeable financial instrument, that can be traded, speculated upon and ultimately managed through the financial system. As Professor Geta Krippner has stated it, financialization is the “Pattern of accumulation in which profit making occurs increasingly through financial channels rather than through trade and commodity production.” Financialization can be thought of as the virtualization of our real economies. Through information technology and lots of financial analysts, we perform what is called securitization. Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security that can be traded. As this process has grown in scale the importance of financial markets and institutions in the operation of the global economy and its governing institutions has also risen to unprecedented levels. This has raised concerns from many, while at the same time society’s perspective on finance has changed significantly.

Since the liberalization of capital markets in the 1980s, the number and quantity of financial instruments have grown rapidly. Today the financial system dominates over the real economy. In this time financial leverage has tended to override capital equity, and financial markets have tended to dominate over traditional industrial economic activity. Traditionally, prior to the 1980s, the primary occupation of banks was in taking deposits and lending them out to businesses, thus making them strongly integrated with real economic activity. However, recent research has shown that only approximately 15% of the financial flows coming out of the largest financial institutions in the US are now going to business investments. This is a profound shift in what the financial system does and is, that departs significantly from our traditional economic models for the role of finance within the overall economy. Much of the money that has been diverted from real economic activity has gone into the development of the global derivatives market. A key feature of financialization as it has evolved over the past decades has been the proliferation of derivatives of all form. In the year 2006 derivatives trading reached a level of 1,200 trillion dollars, dwarfing the output of the real global economy that was approximate 50 trillion dollars at that time.

On a broader level, financialization can be seen to mark a transition from a traditional form of Industrial Age capitalism, that was based on the physical means of production as the primary source of capital, power and value creation, to a new form of information and services based financial capitalism. In this transition, the financial system has ceased to simply play the role of assisting in the running and operation of the real economy of goods and services but rather has come to dominate, even displace, real economic activity.  This broader transformation has fed through to the strong effect the financial system has had in shaping the evolving nature of the corporation within advanced economies, as financial rationale and practices have re-shaped performance metrics within the corporation. As the remuneration going to top management has become increasingly aligned with the interests of the financial system, shareholder equity has increasingly come to replace other metrics for success. Equally, the rise of finance has gone hand in hand with privatization enabling it to affect almost all sectors of the economy including the public sector and utilities. The net result of financialization and globalization is the formation of one of the first truly global complex systems that we are far from understanding, and this lack of understanding creates major vulnerabilities. The critical role that finance plays within a modern economy places the real global economy in a very precarious and unstable situation. Adair Turner – the head of Britain’s Financial Services Authority – directly named financialization as the primary cause of the 2007 financial crisis.