# Chapter 10 National Wealth

What are balance sheets and why do they matter in understanding financial stability?

What are the ways to measure balance sheets?

How can the recording of financial flows and stocks help in understanding financial crises?

What are the measurement challenges to recording financial transactions?

## 10.1 Introduction

global financial crisis
The global financial crisis (GFC) of 2007 and 2008 refers to a period of extreme stress in global financial markets and banking systems, in which the US subprime mortgage crisis was a catalyst for a financial crisis that spread from the United States to the rest of the world through linkages in the global financial system. The interconnectedness of global finance meant that the UK financial system was exposed to the fallout from the US subprime mortgage market. This led to some of the largest global financial institutions facing major financial difficulties and the failure of the financial intermediation system.

In 2008, the UK and global economy experienced the largest financial crisis for around a hundred years. On 5 November that year, the Queen visited the London School of Economics to open a new building. The global financial crisis was awful, she agreed, and famously asked the professors of economics, “Why did no one see it coming?”

Great Moderation
The Great Moderation was a period of sustained macroeconomic stability that occurred across advanced economics. For the UK, this refers to the period 1993 to 2007, which was characterised by lower levels of output and inflation volatility, following the economic boom and bust cycles of the late 1980s and early 1990s.

At the time, the largest fall in output seen since the Great Depression seemed to come out of nowhere. It followed 15 years or more of sustained and steady growth – what some commentators called the Great Moderation.

balance sheets
These record the value of financial assets and liabilities held at the start and end of a reference period. Start- and end-period stock levels are linked by a flow-stock relationship involving transactions, revaluation effects (for example, fluctuations in exchange rates or equity markets) and other flows (such as debt write-offs).

Later it became clear that the policymakers and commentators had perhaps not been paying enough attention to the balance sheets of the sectors of our economies, and how these connect. The global financial crisis highlighted the integrated nature of modern financial systems, and how this can transmit financial shocks through domestic and global economies.

One of the lessons of the global financial crisis was therefore that the financial accounts data that existed at the time were insufficient to measure accurately the risks that were piling up in the balance sheets of the financial sectors in different countries. This was particularly relevant for the UK, which has a large global financial hub and so is more exposed to the interconnectedness of global finance. Given that the accounts and other statistics relating to the financial sector were not always of the quality needed for proper monitoring of developments, in 2013 the G20 – the group of 20 leading developed economies – asked the IMF and the Financial Stability Board to set up the Data Gaps initiative to improve the quality and coverage of the statistics where this was necessary.

The Data Gaps Initiative (DGI) was introduced following the 2008/09 financial crisis. It was launched in order to improve the availability and comparability of economic and financial statistics, as the global financial crisis highlighted the need of broader datasets for policymakers and supervisors to enable an assessment of the evolution of the economy and the monitoring of financial and non-financial risks. The recommendations cover:

• monitoring risk in the financial sector
• international network connections
• sectoral and other financial and economic datasets
• communication in official statistics.

The latest IMF update highlights the benefits for participating members in the DGI from improved data collection in response to the Covid-19 pandemic. The pandemic raised policymakers’ demand for timely and granular data, and policymakers have been able to gain better access to key information to monitor risks in the financial and non-financial sectors, as well as to analyse interconnectedness and cross-border spillovers.

The Financial Stability Board and the IMF publish regular updates and reports on the Data Gaps Initiative.

#### ONS Resource

The ONS Enhanced Financial Accounts provide policymakers with far richer insights into whether financial vulnerabilities might be building in the UK and global economy.

In the UK, this has led to the development of the ONS Enhanced Financial Accounts to provide a complete picture of bilateral financial relationships between sectors, in an effort to begin to repair these deficiencies. For example, these accounts would show the stock of loans that households owe to building societies – a liability for households but a counterparty asset for building societies. Alternatively, they might show how much households own in pension funds – an asset for households and a counterparty liability for pension funds.

## 10.2 The composition of balance sheets

### 10.2.1 Saving, lending and borrowing

financial assets and liabilities
Financial transactions capture the change of ownership in financial assets and liabilities. Examples include deposits, investments in equity, shares and bonds. A change of ownership leads to an income that is received on that asset and an income that is paid on the equivalent liability, such as interest or dividends. Financial assets are entities over which ownership rights are enforced by institutional units, individually or collectively, and from which economic benefits may be derived by their owners by holding them or using them over a period of time. There is a counterpart liability on the part of another institutional unit. The financial accounts show how net borrowing is funded or net lending is invested by recording changes in the net acquisition of financial assets and net incurrence of financial liabilities. Transactions are recorded for assets and liabilities on a gross basis, allowing for the full scale of financial activity to be captured.

The link between GDP and financial assets and liabilities is not obvious. So far in this book we have discussed GDP as being about economic activity and economic output. This assumes assets are physical – for example, investment in a new factory. But where do financial assets and liabilities fit in?

To understand the link between GDP and financial assets and liabilities, we can start from the headline measure of GDP and then break it down into various components of income. That income is then distributed between households, firms, government and the rest of the world. The difference between the income available (or “resources”) and the expenditure (or “uses”) shows whether a sector is running a surplus or a deficit. Is it saving, lending (when income is greater than consumption) or borrowing (when income is less than consumption)?

It is this saving or lending/borrowing that gives rise to financial assets and liabilities. Where a sector is lending, it acquires a financial asset, say ownership of a bank deposit or of shares issued by companies. If the sector is borrowing, it incurs financial liabilities such as a bank loan or some other form of credit. These liabilities will also be the corresponding financial assets of the sector that is lending.

So we can trace the financial assets and liabilities all the way back through the sector accounts to the key concepts that underpin GDP. This is one of the strengths of the National Accounts framework, in that all these concepts need to reconcile.

The National Accounts can also yield information about the implications for net saving or borrowing by each of the main sectors of the economy. These show how the financial economy is evolving, capturing the extent to which there might be material imbalances in the domestic economy and how expenditure is being financed by households, firms and government. This can then be reconciled to produce estimates of balance sheet positions.

### 10.2.2 A reminder about stocks and flows

In economics, wealth and income are related but clearly distinct:

• Wealth is a stock. How much do I possess at this point?
• Income is a flow. How much more will I get in this period of time? Flows of income that are not consumed are savings. Our savings make us more wealthy, they do not increase our income.

If I save, I can either use my wealth to acquire new non-financial assets, or I can lend out the money. And the opposite also holds – if I am dis-saving, I can either sell my non-financial assets or I can borrow money to cover the difference.

While we think of wealth typically in terms of individuals, these same concepts can be applied to a country or – our particular interest in this chapter – to the specific sectors within it.

net worth
Net worth is the value of all the non-financial and financial assets owned by an institutional unit or sector, less the value of all its outstanding liabilities. It is a measure of the wealth of a unit or sector at a point in time.

Confusingly, National Accounts do not refer to wealth, but rather, worth. When you discuss the net worth of the economy as a whole, or different sectors within the economy, always use this term.

For each sector, we can identify:

net lending/borrowing
Net lending is the net amount a unit or a sector has available to finance, directly or indirectly, other units or other sectors. Net lending can be derived as savings plus net receipts of capital transfers minus net purchases of non-financial assets (i.e. the balance of the capital account), or it can be measured as the difference between net acquisition of financial assets and net incurrence of liabilities (i.e. the balance of the financial account). The income and expenditure of the different sectors of the economy imply a path for each sector’s net lending to, or borrowing from, the others.
• Non-financial transactions: transactions that relate to production, income, consumption and capital investment, which shows whether income exceeds expenditure that culminate in net lending or net borrowing.
• Financial transactions: transactions that capture the change of ownership in financial claims that culminate in net lending or net borrowing.

So, if a sector has a net lending position in any period, then it can equivalently be said to have a financial surplus. It can use that surplus either to buy new financial assets or, if it has any, to repay existing liabilities. A household, for example, with a financial surplus might use it to buy assets such as increasing its bank balance or buying non-cash assets such as shares. Alternatively, it might pay to reduce an existing mortgage or consumer credit.

Similarly, if the sector has a net borrowing position – a financial deficit – it could finance this either by selling some financial assets or increasing its borrowing.

When a sector borrows or lends, the process involves the creation of financial assets or, more precisely, changes in the stocks of those assets.

Notice that so far, we have focused only on flows. We may know that a particular sector has increased or decreased its net financial assets in one particular period. But if we are to have a full understanding of the sector’s circumstances, we also need to know about the stock position, and that is known as its balance sheet.

## 10.3 Sectoral and national balance sheets

These stock positions record the value of assets and liabilities owned at the start and end of a reference period, which provides insight into how sustainable the financial position is by indicating what the value is of the financial assets that a sector owns, and how this compares with the value of the liabilities to which that sector is indebted.

net financial assets
This is a stock concept; it is the total assets – total liabilities. This is also the same as net worth.
non-financial assets
Non-financial assets held by households include produced and non-produced non-financial assets. Produced non-financial assets are those that have come into existence as outputs from the production processes, whereas non-produced assets are those that come into existence other than through processes of production. These non-financial assets include dwellings, other buildings and structures and land improvements; machinery and equipment; intellectual property products and land.

The UK’s balance sheet comprises its non-financial assets, which include land, housing, machinery and infrastructure, plus its net financial assets (its financial assets less its liabilities). Many of one domestic sector’s financial assets and liabilities will correspond to liabilities or assets of another domestic sector. These will net out, but what we are left with are the UK’s net financial claims on the rest of the world, its total net worth. Figure 10.1 shows the UK’s total net balance sheet position. The main features are clear: a rapid rise in net worth to 2007, followed by a fall around the time of the global financial crisis, then an increase from 2013.

### 10.3.1 Decomposing net worth

This overview of elements of the balance sheet obscures some key developments and it is necessary to dig deeper to detect these.

One important feature that we need to examine more closely is the composition of the UK’s worth. Figure 10.2 splits total wealth that people hold as land (which is taken to include their houses) and other wealth.

This information provides a significant new element to the story: land and housing play a far more prominent role in overall UK wealth than in any other comparable developed country. Figure 10.2 shows that much of the growth before 2007 and after 2012 reflects rapidly rising land and housing prices. In contrast, if you look at the net worth position that excludes land, it is clear that other UK worth has grown much less rapidly. This is not an argument for excluding land and housing from the wealth estimates, they represent real assets. But it does show how important land and housing wealth is in the UK, and the potential impact on the UK’s net worth of a fall in house prices, for example.

### 10.3.2 Calculating changes in financial asset stock

If we also know how many additional financial assets or liabilities are being acquired in a current period, we are well on the way to knowing what the stock position would look like at the end of the period. But this is not quite the whole story because many financial assets and, to some extent, financial liabilities, are subject to revaluations. Shares, for example, have a market price, which can go down as well as up. So I might start the year with shares in a firm that provide me with wealth, buy some more shares in that firm during the year, and still end up with a less valuable asset if the price of each share has gone down. Or, I can sell some shares, but still have a more valuable stockholding if the share price rises during the period.

So the accounting identity is:

\begin{align} \text{End period value of } &= \text{Beginning period value net financial assets} \\ &+ \text{Net acquisitions of net financial assets} \\ &+ \text{Revaluations} \end{align}

### 10.3.3 Calculating changes in physical asset stock

We can do something similar on the physical capital side – housing, say, or value of land or machinery. A sector starts off with a certain value of physical assets and then adds to this by way of new investment in such assets over the period. As with financial assets, the end period position may be affected by revaluations. House prices, for example, show both rises and falls at particular times. So the value of physical assets held as housing will clearly reflect this.

depreciation
The amount of capital resources used up in the process of production in any period. It is not an identifiable set of transactions but an imputed transaction, which can only be measured by a system of conventions.

There is one other factor that has to be taken into account with physical capital, that is not really relevant in the case of financial assets. This is depreciation, which reflects that physical assets are subject to factors such as wear and tear, becoming less efficient as they age over time, or just technical obsolescence. All of these influences may reduce the value of the physical capital and need to be taken into account. Chapter 3 discusses ways to estimate the extent of depreciation at some length.

The accounting identity that then connects physical capital stocks and flows is:

\begin{align} \text{End period value of physical assets } &= \text{Beginning period value of physical assets} \\ &+ \text{Gross capital formation} \\ &+ \text{Revaluations}\\ &- \text{Depreciation} \end{align}

Notice that the logic of deriving these two accounting identities can apply at any level of disaggregation. It would apply, for example, to an individual household or company acquiring or disinvesting in financial or physical assets. It also applies at aggregate level to the whole household or company sector and, for that matter, to any subsector.

### 10.3.4 The “unidentified” line in the accounts

In reality, there is only one value for the assets and liabilities in the balance sheets. But bear in mind that National Accounts are estimates, not precisely exact measures.

We have two ways of estimating how large assets and liabilities are:

• Use the accounting identities as described above. Period by period, we could generate afresh new stock figures for all the assets and all the liabilities that concerned us. But our estimates of each sector’s net acquisition of financial assets may not be precisely right. Similarly, the National Accounts estimates of gross capital formation cannot be expected to be perfectly accurate.
• Estimate the value of each of the assets and liabilities directly. We can observe, for example, that value of money held in bank accounts at the end of each period. We know how many equities are outstanding (or, at least, from various sources, we can make a reasonable estimate of this) and we can observe equity prices or at least the great majority of them that are traded on the stock exchange. But there will inevitably be approximations or just gaps in the data available to make estimates.

This means the two measures will differ. We therefore add an “unidentified” item to them, in recognition of these measurement challenges. So we have:

\begin{align} \text{End period value of } &= \text{Beginning period value net financial assets directly estimated} \\ &+ \text{Net acquisitions of net financial assets directly estimated} \\ &+ \text{Revaluations}\\ &+ \text{Unidentified change in financial assets} \end{align}

and

\begin{alignat*}{2} \text{End period value of}\\ \text{physical assets directly estimated} &=\ &&\text{Beginning period value of} \\ &\ &&\text{physical assets directly estimated} \\ &+\ &&\text{Gross capital formation} \\ &+\ &&\text{Revaluations}\\ &-\ &&\text{Depreciation}\\ &+\ &&\text{Unidentified physical asset formation} \end{alignat*}

Note that these unidentified items can be calculated for each sector and can be either positive or negative depending upon which of the two methodologies gives the greater estimate for each period.

They are important not just as an arithmetic way of preserving the identities but as giving implicit information about the quality of the estimates. The smaller the unidentified item, the closer are the estimates coming from the two methodologies, and the more confidence we can have in the stock estimates for financial assets and liabilities or for physical assets. They also provide some information about the quality of the National Accounts overall. Small unidentified items, for example, might suggest that the errors and omissions in the National Accounts estimates themselves are relatively minor.

## 10.4 What the sectoral balance sheets show

It would be wrong to think that it is just the balance between assets and liabilities that is important. The movements in the assets and liabilities themselves may be important, too.

Let us take the example of a homeowner who owns a £250,000 house backed with a £225,000 mortgage, so on the balance sheet, her or his net worth is £25,000. If house prices fall by 20%, the house is now only worth £200,000, meaning that the net worth is now a negative £25,000. In this case, it is the size and sensitivity of the liabilities that caused a large swing in the overall balance. So we should also pay attention to the size of the balance sheet relative to measures of income or output.

We need to recognise that looking at the balance sheets for the UK can hide imbalances at a lower level, as the distribution of assets and liabilities will often be uneven. More insights are provided by digging down into the asset and liability picture for the various sectors that make up the UK aggregate, which can provide more insights into financial vulnerabilities and how exposed the UK might be to shocks.

### 10.4.1 Government

fiscal sustainability
Fiscal sustainability refers to the long-term projections for the public finances and sustainability of debt, which is typically considered a requirement for macroeconomic stability. An important feature is the debt dynamics, which capture the difference between non-interest spending and receipts as well as the difference between the effective interest rate paid on government debt and nominal GDP growth.
public sector net debt (PSND)
Public sector net debt excluding public sector banks (PSND ex) represents the amount of money the public sector owes to private sector organisations including overseas institutions, largely as a result of issuing gilts and Treasury Bills, minus the amount of cash and other short-term assets it holds.

One such insight is provided by looking at the sectoral estimates for government. Fiscal sustainability refers to the ability of any government to maintain public finances at a credible and serviceable position over the long term. This is why the range of government assets and liabilities has to be taken into consideration, which covers those that are financial and non-financial, to have a more complete picture of fiscal sustainability. Unlike the more traditional concept of public sector net debt (PSND), this includes a fuller range of the government financial position. It includes financial assets such as student loans, fixed assets such as social housing, as well as non-debt liabilities such as public sector pensions.

Figure 10.3 shows the assets and liabilities of central and local government, both their financial assets and their physical ones, as well as the net position shown by the continuous line.

fiscal consolidation
Fiscal consolidation refers to concrete policies aimed at reducing government deficits and debt accumulation, which are aimed at looking to restore sustainable finances. This is typically referred to as reducing the structural deficit of the government.

From 1995 up to 2007, general government enjoyed a small and fairly stable positive net asset position. But after 2007, the position deteriorated so that by 2016, it had negative net wealth amounting to £763 billion, equivalent to nearly 39% of GDP. There was a substantial reduction in this negative position in 2017, but negative net worth of general government still amounted to the equivalent of over 33% of GDP. This is the background to the programme of fiscal consolidation of recent years, known as “austerity”.

### 10.4.2 The external balance sheet

current account deficit
The balance of payments records a country’s transactions with the rest of the world. The current account records international trade and cross-border income flows associated with the international ownership of financial assets, as well as current transfers (for example, foreign aid or remittances). If a country is running a current account deficit, it is said to be a net borrower from the rest of the world. Likewise, a country is a net lender to the rest of the world if it is running a current account surplus.

A further important dimension is provided by the UK’s balance with the rest of the world. The UK has historically run a current account deficit – the UK has been a net borrower from the rest of the world. The reliance on foreign capital inflows in recent years to finance its net borrowing has made the UK economy more vulnerable to a reduction in foreign investor appetite for UK assets.

Policymakers are particularly interested in whether the UK is able to rely on record high levels of external financing to help fund its domestic expenditure – the reliance on the “kindness of strangers” – as sudden stops in this financing could lead to an abrupt hit to the economy.

Mark Carney’s 2017 speech, A fine balance, deals with the kindness of strangers.

net international investment position (NIIP)
The NIIP measures the difference between the UK’s external stock of assets (that is, UK-owned claims on non-residents) and liabilities (that is, foreign-owned claims on UK residents). It is an important barometer of the financial creditworthiness of a country: too high a net liability position may imply unsustainable national borrowing, while a small net liability or asset position helps a country accommodate net financial inflows from increasing external liabilities to the rest of the world and/or from disinvesting previously owned external assets.

The external balance sheet can offer insights into how sustainable it is for a country to finance its current account deficit. The net international investment position (NIIP) is the excess of the stock of UK residents’ claims on the rest of the world (UK assets) over the rest of the world’s claims on the UK (UK liabilities). By convention, a positive NIIP means that the UK’s assets overseas exceed its liabilities to the rest of the world, while a negative NIIP represents the opposite. Too high a net liability position may imply unsustainable national borrowing, while a small net liability or asset position helps a country accommodate net financial inflows.

#### ONS Resource

Concerns have been raised as to whether the historically high levels of borrowing from the rest of the world can be sustained into the future. The size and composition of the UK’s net international investment position can provide further insight on how sustainable a country’s external position is. (See Understanding the UK’s net international investment position.)

These financial assets and liabilities include:

• Direct investments. This is direct ownership of all or a substantial part of an overseas concern by a UK one. The exact form of the ownership can vary, but may involve either debt or equity as part of the arrangement.
• Portfolio investment. This is investment in overseas assets by UK investors as part of their portfolio. This could involve, for example, investment in overseas equities or debt either by people or companies directly or indirectly through, for example, pension funds or unit/investment trusts.
• Holdings of financial derivatives. These include relatively new forms of financial instruments such as options and interest or currency swaps, and have grown rapidly as such markets have developed.
• Other investments. These are predominantly holdings of bank deposits and loans.
• Official reserves. These are holdings by the government of foreign currency reserves for market management purposes. Still a significant item, though proportionately far smaller than was the case in earlier decades.

One important reason for looking at the NIIP is the information it can give about the sustainability of the UK’s external position. Essentially, it is the stock counterpart of the UK’s current account balance, as the flow measure of the UK’s position with the rest of the world. When the UK is spending more on goods and services from, and other transfers to, the rest of the world, than it is receiving in corresponding income from the rest of the world, then that deficit has to be financed. This can be financed either by selling overseas assets or by increasing overseas liabilities, which helps to explain why the stock position is informative on how sustainable its external position is. (If the UK was enjoying a current account surplus, the reverse would be true.)

This would not be problematic for a time, but if the selling of assets and/or increasing of liabilities went on at length and at sufficient volume, eventually the position would become unsustainable. The rest of the world may not be prepared to go on increasing its net lending to the UK. In fact, the UK generally has been running a current account deficit over the last couple of decades, which have tended to become larger over time. Note, however, that this would not necessarily imply a worsening NIIP because of the other terms involved in the identity linking the stock and the flow.

In particular, there is the influence of revaluations to be considered. These are typically distinguished between exchange rate and market price changes.

• Currency effects. Assets and liabilities can be denominated in different currencies, but are recorded in the domestic currency of a country’s international investment position. So, when exchange rate movements of the domestic currency in relation to a foreign currency take place, this has the effect of revaluing foreign currency-denominated positions in domestic currency terms. For example, if there is a depreciation in the British pound, the British pound value of foreign currency-denominated positions increases.
• Price effects. Changes in the market values of external assets and liabilities arise from movements in the market prices of financial assets, such as equity and debt traded on international stock markets. The impact of these price changes on the NIIP will reflect the size and portfolio mix of investments and the extent to which UK and global equity and debt markets move with one another. A positive price impact on the UK’s NIIP is more likely to occur if global equity and debt markets perform better than domestic equity and debt markets, and vice versa.

So the overall effect, and which of the various influences predominate, can only be determined by looking at the behaviour of the NIIP empirically. Figures 10.5a and 10.5b show the course of UK assets, liabilities and the NIIP, as the difference between the two.

Figure 10.4 Top graph: Gross stocks position of foreign assets and liabilities, UK, 1997 to 2018. Bottom graph: Net international investment position, UK, 1997 to 2018

Top graph: Gross stocks position of foreign assets and liabilities, UK, 1997 to 2018. Bottom graph: Net international investment position, UK, 1997 to 2018

In recent years, the UK current account deficit has been large by historical and international standards. That said, we still seem a long way from the point where investors are unwilling to lend to or invest further in the UK. The negative NIIP is narrower than recent financial transactions would imply, as exchange rate movements and equity price changes have had a positive impact on the UK’s net international investment position. This explains why the NIIP has been improving in recent years, notwithstanding the substantial current account deficits over this period.

### 10.4.3 Households

One common hypothesis about the run-up to the global financial crisis is that households had saved less out of incomes and financed their expenditures by borrowing.

Although it seems obvious now, before the GFC, few economists were warning about the risks of widespread household indebtedness, preferring to focus on how innovation had made it possible for the financial sector to lend more without increasing systemic risk. One who did sound the alarm was Raghuram Rajan, the chief economist of the International Monetary Fund at the time. His 2006 working paper ‘Has financial development made the world riskier?’ warned that:

“The increase in the risk bearing capacity of economies, as well as in actual risk taking, has led to a range of financial transactions that hitherto were not possible, and has created much greater access to finance for firms and households … As a result, under some conditions, economies may be more exposed to financial-sector-induced turmoil than in the past.”

When Rajan presented his paper, Lawrence Summers, a former chief economist of the World Bank and a holder of many public offices in the US, responded that the “slightly luddite premise” of his paper was “largely misguided”.1 2

The same sustainability issues that we have been discussing above are relevant here. The balance sheet position of households helps policymakers unpick the extent to which an adverse shock to the economy could lead households to rebuild their financial position. For example, when households are already in debt, and someone loses a job or has their hours cut, they often have no choice but to cut their spending. This might also mean they decide or are forced to cut or default on loan or credit card payments. In return, lenders either don’t give loans, or cut credit limits.

So, there are two questions here:

1. Did households reach a point at which their borrowing was so great that they were no longer able to support it?
2. Was the financial system at a point where it was no longer willing or able to advance further loans to households?

Household balance sheets can throw light on these issues, though the story needs a little untangling.

Figure 10.5 Household financial balance sheet, UK, 1987 to 2018

Household financial balance sheet, UK, 1987 to 2018

There is therefore at least a suggestion that borrowing in the household sector had by the time of the financial crisis reached levels that were difficult to sustain. Certainly, since the financial crisis, liabilities have shown much less rapid growth and the ratio to household income has fallen back significantly. That might reflect less willingness on the part of households to incur borrowing, or less willingness on the part of financial institutions to lend to them. Indeed, it might be the result of a combination of the two.

But households own non-financial assets as well as financial ones. These are mainly physical assets such as housing so it could be, for example, that while households appeared to be over-stretching themselves by acquiring excessive mortgage debt or other forms of consumer credit, in reality this was matched by rising values of housing. So we should look at financial and net financial wealth together.

In Figure 10.6, households’ net financial wealth is the same as in Figure 10.5. But it also now shows the evolution of housing and other forms of non-financial wealth.

We can see that this ratio rose from a level of 315% in 1995 to a peak of 457% in 2007. Thereafter, there was some fall as the financial crisis and the recession made their impact on both financial assets and house prices. The ratio fell to just 400% in 2008. Thereafter, there was a sluggish and not wholly smooth recovery as the economy itself recovered from the recession, to new peak levels in 2016 and 2017. In the last year for which data currently exists, 2018, the ratio fell back – perhaps under the influence of Brexit uncertainties.

This chart highlights:

• Land and housing wealth constitute the bulk of households’ non-financial wealth. It makes sense to consider the two together because in practice it is hard to separate the value of houses themselves from the value of the land that they are built on. Households do own other physical assets, such as the capital equipment and inventories that unincorporated businesses own to carry out their work. These approached a value in 2017 of nearly £200 billion. Nevertheless, this is small in relation to households’ other assets.
• Rising house prices have been reflected in land and housing wealth increasing even more quickly than net financial wealth. Between 1995 and 2018, net financial assets increased by 208%. But, over the same period, land and housing increased in value by 403%.

The overall conclusion is that UK households have become increasingly wealthy, under the influence of both rising financial wealth and of increasing housing and land values. However, it is important to bear in mind that these are aggregate figures relevant to households as a whole. They say nothing about the distribution of this increased wealth – whether the increases are generally enjoyed or whether a relatively small group of households have enjoyed very large rises in wealth, with those of other households more modest. It seems likely, for example, that homeowners have fared better than those not yet on the housing ladder. Chapter 7 discusses the measurement of distributional issues and inequalities.

### 10.4.4 International bank balance sheets

One of the key developments that preceded the financial crisis in 2008 was a rapid expansion in the size of the banking system relative to the economies in which they were based. While economies were growing smoothly, this had not seemed to matter. But when the economies started to falter, banking systems with large assets and liabilities relative to the size of their economies created an explosive mixture. Nowhere was this more clearly seen than in the case of Iceland.

Figure 10.7 shows how Icelandic banks assets and liabilities grew as a percentage of GDP.

In 2003, Iceland’s banking system’s assets/liabilities were a bit less than twice the country’s GDP. Four years later, it had grown by leaps and bounds to around nine times GDP. Liabilities to non-Icelandic residents rose from the equivalent of 43% of GDP in 2002 to over 700% in 2008. When the first signs of downturn became apparent, confidence in the banks quickly deteriorated, with depositors wanting to repatriate their assets as quickly as possible. This meant a raft of emergency economic and financial support had to be enacted. In the process, the Icelandic economy suffered severely, with GDP falling by some 10% by the middle of 2010.

One other warning sign, to which, in hindsight, more attention might have been paid, was the emerging imbalances in other parts of Iceland’s economy. Household and business debt increased from 200% of GDP in 2003 to 350% in 2007.

Since 2010, the Icelandic economy has recovered and the excesses in the banking system steadily resolved. At the end of 2017, the banking system’s assets/liabilities represented only 130% of GDP – lower in fact than in 2002. But it had been a slow and painful process. After a decade or so, real wages were only marginally higher than before the crisis.

Note that Iceland was far from the only country whose banking system represented a high multiple of the size of its economy. The Swiss banking system was only a little smaller relative to GDP than in Iceland, and a range of quite small countries – Malta, Belgium, Luxembourg, Cyprus – had ratios not much lower.

On the other hand, a low relative size of the banking sector is not necessarily a guard against banking problems. The US banking system was less than half the size of its GDP, but that was not sufficient to prevent the collapse of Lehman Brothers. Other factors were at play there.

## 10.5 Methods for compiling more comprehensive financial information

### 10.5.1 From whom, to whom?

We have explained how finance plays an important role in any economy, but can also lead to the buildup of imbalances that pose a challenge for policymakers. The 2008 financial crisis showed how the integrated nature of financial systems can transmit shocks through the world economy. But financial connections can be complicated by second or third round interlinkages, especially as financial flows have become increasingly international in nature. This is why financial information can provide early warning indications of a rise in financial instability, which helps explain why the examination of the balance sheets can yield important economic insights on understanding potential financial vulnerabilities and transmission mechanisms. And yet in the UK, compiling comprehensive estimates on the financial activities of an economy have traditionally been given a lower profile than those on the real economy.

Balance sheets are an integral part of the system of national accounts. However, historically in the UK, we have not provided a complete picture of “from-whom-to-whom” transactions, that is, a framework that shows which sectors are lending to and borrowing from other sectors. The absence of so-called “from-whom-to-whom” information makes it more difficult to analyse and detect the build-up of risk in parts of the economy, for example, the extent to which savers are investing heavily in particular financial sectors or instruments, rendering them vulnerable should problems or weakness occur in that area.

Flow of Funds Accounts
Financial accounts provide the flow and stock positions of financial assets and liabilities for households, corporations, government and the rest of the world. The Flow of Funds Accounts enhance the information provided on these financial positions by showing the bilateral debtor/creditor relationships of these transactions. These can be referred to as “from-whom-to-whom” accounts, as they provide a breakdown of the assets and liabilities by specific financial instruments that are owned, including counterparty information. That is, they provide information on who owns the financial asset and who owns the financial liability.

The experience of the financial crisis highlighted the importance of compiling comprehensive financial information. This “from-whom-to-whom” information is provided in the Flow of Funds Accounts of the Enhanced Financial Accounts. These accounts provide the counterparty information of the financial assets and liabilities for each sector.

### 10.5.2 Surveys

Traditionally, the source for UK financial statistics has been very heavily in the form of surveys, for example, those sent to financial institutions such as banks to complete. But this requires the surveys themselves to keep up with the range of activities and transactions taking place in the real world. Furthermore, it relies upon the ability of those charged with completing the surveys to be able to do so accurately and comprehensively. Given the complexity of many financial transactions, and the speed at which the industry has evolved, this is unlikely always to be the case.

### 10.5.3 Alternative data sources

New information sources have become available to complement or replace these traditional surveys, including:

• the detailed financial information that banks and other financial institutions make to the Financial Conduct Authority of other regulators
• information from credit card and other credit providers on the transactions being made by these means
• data provided to and compiled by market makers such as the Stock Exchange
• information assembled, often at very detailed levels, by commercial credit reference agencies.

One particularly interesting possibility is the development of so-called Securities Holdings databases. Within the Eurozone, the European Central Bank, starting in 2011, has been developing a database recording the issuance and ownership over time of every euro-denominated security in existence. The power of this, and of the other micro-level information listed above, is that it can be used to assemble statistics at almost any level of aggregation of interest. Steps are being taken towards a similar database for the UK. But it is a major undertaking and realistically it would be years rather than months before it came to full fruition.

Compared to traditional surveys, using any or all of the above as sources for financial statistics requires much greater computing power to process the large amounts of information concerned. Given advances in data and technology, however, the hope is that this will be less of a constraint. More fundamental is the need to guarantee the personal or commercial confidentiality of the information that is being used. This is an issue that statistical institutes, including ONS, will always need to have at the forefront of their thinking.

### 10.5.4 Micro-data

Data collected at the micro-level, then reconciled with information that is recorded at the macro-level, has the potential to increase our understanding of the evolving dynamics in the real and financial economy, particularly if a bottom-up view of the economy can be built that might provide further insights into where vulnerabilities may be building.

The financial crisis highlighted the problems that can arise if there are specific parts of the economy that are under pressure, for example, subprime mortgages in the United States. It is possible that the availability of improved micro-level information, such as the positions of individual financial institutions, would have highlighted the exposures of the UK economy to those developments through 2007 and 2008.

Portugal, Austria and France all have “data warehouses” that now form the basis for compilation of their respective financial statistics. In each case, a variety of data inputs go into the warehouse, which are then used to compile statistics to meet each need in a consistent way. Great care is taken with regard to the availability of the outputs from the warehouse. Some macroeconomic and financial information is published, but other information, such as prudential information about an individual or financial institution, are strictly controlled. Such information would be given only to the competent financial supervisor to preserve proper commercial confidentiality.

### 10.5.5 The UK Enhanced Financial Accounts

In November 2019, the ONS published its first experimental estimates of the UK Enhanced Financial Accounts, which is an enhancement of the basic National Accounts framework. The overall aim is to provide a more complete picture of financial relationships, in particular, including more information on who is involved in these transactions, and publishing more granularity of the types of financial assets and liabilities. More information on understanding the nature of these financial relationships would have provided more insight into how exposed the UK economy was to the US subprime mortgage market in the years leading up to the financial crisis, which might have helped policymakers see it coming.

The Enhanced Financial Accounts have provided new insights on the size and composition of financial assets and liabilities, but also information about who owns these assets and who has the counterparty liabilities. The new work has gone a long way to filling this need for “from-whom-to whom” information. Traditionally, such information is displayed by means of a matrix. The columns represent the various sectors of the economy and the various assets in which they invest or the liabilities that they incur as a result of investment by some other sector. Such matrices often contain a lot of cells, which make them not always easy to interpret. A rapid and summary impression can be obtained from Sankey diagrams such as that shown in Figure 10.8.

Figure 10.8 The UK Enhanced Financial Accounts: a from-whom-to-whom matrix, 2019

The UK Enhanced Financial Accounts: a from-whom-to-whom matrix, 2019

Each sector’s total financial liabilities are represented on the left-hand side, where the bars relate to the relative level of total financial liabilities that are held by each sector. So the banks (technically, in the jargon, known as Monetary Financial Institutions) have more financial liabilities than, say, households or central government.

On the right-hand side, the size of the bars – again one for each sector – reflect the size of the financial assets. This feature of the Enhanced Financial Accounts captures the counterparty relationships, showing the lending/borrowing relationship. The threads between the two indicate the size of the asset/ liability relationship between the respective sectors.

The wider the thread, the more important the relationship. So, for example, households have large assets with insurance and pension companies, who have the corresponding liability to households. So the thread is wide. On the other hand, private companies have few or no assets with central government. So the thread is vanishingly small.

Looking at a Sankey diagram for a single year gives a snapshot of the financial dependencies between various sectors of the economy. This can be supplemented by looking at a run of diagrams for successive years. Comparing how the relative sizes of the threads are expanding or contracting then indicates areas where financial dependencies are either increasing or becoming less strong. Easily accessible information of this kind is invaluable in anticipating and pre-empting shocks to the economy.

## 10.6 Summary

In 2008, the UK experienced the largest financial crisis for around a hundred years. In helping understand how the crisis unfolded, we have highlighted the role that finance played in transmitting a shock from the US subprime mortgage market through the global economy. This reinforces the importance of compiling comprehensive financial information to understand where vulnerabilities might be building, as well as how sustainable the financial positions of households, businesses, the government and the rest of the world are. More attention to these accounts in the years leading up to the financial crisis in 2008 would have helped pre-empt the Queen’s question, “Why did no one see it coming?”

The wealth and financial accounts are integral parts of the system of National Accounts and are designed to join fully with the flows in the accounts which add up to GDP, and with the sectoral accounts.

This framework can be particularly relevant for the purpose of looking at financial stability, offering insights these statistics can provide which would not be available from other parts of the National Accounts. Understanding the financial system and its links to borrowers and savers in the real economy is important in considering a wide range of policy questions. These tell interesting stories both at national level and in terms of some of the key sectors within the economy.

But these parts of the National Accounts remain relatively unused. They rarely figure as a central part of public debate. That may be in part because of perceived issues with the quality and reliability of the information that is published. ONS has recognised such concerns by developing the Enhanced Financial Accounts to help address such issues. Helping to provide policy insights is particularly relevant for the UK, and understanding the financial system and its links to borrowers and savers in the real economy is important in considering a wide range of policy questions. There is a long way to go, but progress to date is promising.

One especially interesting feature of this work is that it is heavily focused on use of “new” data sources – big data and administrative data. As such, it exemplifies the same possibilities and has to confront the same challenges as does the transformation agenda more generally with UK economic statistics. This work may therefore hold useful lessons.