Banks' contribution to the economy may be hugely overstated, underscoring anger about the scale of taxpayer rescues and resultant government cutbacks, but a sharp retreat of banking worldwide looks painful for all and needs calibrating.

As sovereign debts and austerity bite across the West, spurring popular protest over rising inequality and malfunctioning capitalism, governments have been under pressure to act tough on the outsized and risky banking that was deemed too big to fail.

With everyone now on the hook for shoring up those banks and severe economic hardship being felt across the North Atlantic countries, the debate about "socially useless" aspects of banking has been intense.

Since 2007, the regulatory backlash has included forcing banks to build higher capital buffers; separating retail banking

from global investment finance; curbing excessive pay; and taxing transactions and speculative activity.

But one eye-catching angle on the reassessment came from Bank of England economists this month.

In a paper for the VoxEU think tank, the Bank's executive director for Financial Stability, Andrew Haldane, and economist Vasileios Madouros claimed British and U.S. national accounts have significantly overestimated the "value added" provided by financial services firms before and since the crisis began.

The essence of their argument is that in calculating gross domestic product, government statisticians give far too much weight to banking activity that merely involves creating and bearing risk in lending and asset holdings.

Under the current system, the paper points out that the value added ascribed to U.S. financial intermediaries was as much as $1.2 trillion last year -- some 8 percent of GDP and a fourfold increase in its share of GDP since World War Two. In Britain the equivalent in 2009 was even higher at 10 percent.

To justify those huge gains, the economists argue that the productivity of bank capital and staff would need to have soared too -- in part justifying the huge rises in pay and bonuses. But the precipitous collapse of many of these banks in 2007 and 2008 questions whether the scale of those efficiency gains was anything more but smoke and mirrors.

"High pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector," Haldane and Madouros wrote, insisting that risk taking such as credit expansion to complex products leveraged by short-term borrowings does not amount to value added.

But national accounts blur the distinction between this unproductive "risk bearing" and productive "risk management," where banks provide valuable services of broking, credit screening or intermediation that helps firms and households grow, save and invest.

As a result, the gigantic balance sheet expansion of global banks in the decade prior the credit crisis was wrongly accounted for as increased value added. Households investing in a bond or taking out a mortgage, for example, also bear credit and liquidity risk but this is not seen as value added in GDP.

"If risk-making were a value-adding activity, Russian roulette players would contribute disproportionately to global welfare," Haldane and Madoura concluded.

The paper cites studies that showed adjusting accounts for this error would reduce the estimated economic output of euro zone banks by up to 40 percent. And applying that to UK banks would have cut their 2009 contribution to GDP from 10 percent to as low as six percent -- or an error of some 55 billion pounds.

A bigger distortion is that the hundreds of billions of dollars of public subsidies or bailouts to ailing banks meant many of these firms didn't even have to bear the very risks incorrectly flattering their output, productivity and pay.

"Instead it has been borne by society. That is why GDP today lies below its pre-crisis level. And it is why government balance sheets, relative to GDP, are set to double as a result of the crisis in many countries," Haldane and Madouros said.

ROLLING BACK BANKS

The calculations go some way to quantifying how far out of kilter banking was from the real economy. But it also shows that resolving the "too big to fail" dilemma that forced the bailouts will also involve some reversal of the balance sheet explosion.

The problem right now is that banking retreat is unleashing a double-whammy on an already austerity-squeezed global economy.

Uncertainty about the future shape of banking and another world downturn mean new capital for banks is scarce, forcing them to cut lending to meet more stringent capital ratios, such as the 9 percent base required of euro zone banks by mid-2012.

European banks alone are expected to ditch up to 3 trillion euros of loans next year to meet new capital rules.

U.S. investment banking giants too are cutting back assets and activities and openly talking about a secular downsizing of the industry [ID:nN1E7AE1WW]. And the world's ten largest banks involved in capital markets are estimated to have have lost about $250 billion of market capitalization since March.

Though wary of being deflected by banking lobbies into abandoning reforms, policymakers are recognizing that too much, too soon could dangerous.

Bank of England governor Mervyn King said on Monday euro bank deleveraging was already showing signs of a credit crunch.

"These are enormous challenges and it will not be easy to get through this," he said. "There will I think need to be a significant amount of rationalization of debts and credits in the world before we are finally to emerge from the end of this."

Finding a way to let the air out of the balloon slowly may be the big challenge of 2012 and beyond.

(Editing by Ruth Pitchford)

Retail Gdp Bank of england United kingdom