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It’s a standard pattern that as an economy develops, it’s financial sector becomes a larger share of GDP. After, banks and bond and stock markets have less of a presence in low-income countries. But in addition, the shape of the financial services industry changes over time. Robin Greenwood, Robert Ialenti, and David Scharfstein explore these shifts and others in “The Evolution of Financial Services in the United States” (Annual Review of Financial Economics, 2025, 17: 189-206). The abstract says:

This article surveys the literature on the historical growth and transformation of the US financial sector. The sector expanded rapidly between 1980 and 2006, during which its contribution to GDP rose from 4.8% to 7.6%. After the global financial crisis, the size of the sector stabilized at approximately 7% of GDP. After reviewing this literature, we examine recent developments, including the continued growth of high-fee alternative asset management and the shift away from banks to lending by nonbank financial intermediaries. We interpret both the growth and recent evolution of the sector as reflecting a continued transition to a more market-based financial system, with risk migrating away from banks and into markets.

To illustrate, here’s a figure showing the US financial sector as a share of GDP going back to 1950, using a bunch of different measures. NIPA stands for “national income and product accounts,” which is how GDP is calculated. The references to “compensation” are because, for an economist, the output of a sector can be measured by how much compensation is paid to that sector. You can see the long rise leading up the Great Depression, another long rise leading up to the 1990s, and then a levelling out since the Great Recession
 

Much of the paper focuses on how the internal structure of the US financial sector has shifted since about 2006, although the total sector has remained much the same. There are two interrelated changes here. The authors write:

First, the growth of alternative investing (hedge funds, private equity) has continued to drive income in the securities and asset management subsector, with the distribution of fees becoming even more of a barbell—high fees for alternative investing and very low fees for traditional asset management. Second, there has been a notable shift in credit intermediation away from commercial banks. We argue that these two developments are likely connected. On the demand side, continued growth of pension funds has fueled demand for high-fee alternative investments, including private credit funds, as well as securities. On the supply side, post-GFC [global financial crisis] financial regulation has supported the development of the nonbank lending sector.

In short, it’s become easier and cheaper to invest using basic tools like a stock market fund. However, more specialized ways of investing like private equity funds or hedge funds have expanded and are still able to charge high fees. Moreover, banks have faced increasing regulatory restrictions since the Great Recession. Thus, many banks no longer make money by lending for home mortgages and business purposes, and using the interest received to pay expenses and some return to savers. Instead, more banks make money by charging fees, and when they do lend money, they often resell the loan to another financial sector player for collection. But as banks take on less risk, those who want to borrow are turning to alternative nonbank sources of finance. Businesses who want to borrow are more likely to do so through the bond market, or private credit funds and business development companies. Nonbanks owned 40% of home mortgages in 2007, but 65% of home mortgages by 2023.

A big player behind these shifts is large pension funds. The authors explain: “The growth of securities markets and nonbank credit comes alongside the growth of pension funds. And as banks have increased the allocation of their balance sheets to safer assets, pension funds and other investors like insurance companies have stepped in to hold risky credit assets. Thus, both a reduction in the demand for risky credit from banks and an increase in the demand for risky credit by institutional investors can help explain the growth of alternatives, securities, and nonbank credit.”

The broad pattern of the changes is that the investments that most people have in banks or stock market funds are getting easier, cheaper, and probably safer, but investments with a with a higher degree of risk are being sectioned off into hedge funds, private equity funds, corporate bonds, private credit finds, and others. Ultimately, it’s not clear to the authors (or to me) whether the evolving shape of the US financial system is better for supporting US economic growth, or less likely to melt down during a crisis.

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