Too Cold, Too Hot, Or Just Right? Assessing Financial Sector Development Across the Globe

Too Cold, Too Hot, Or Just Right? Assessing Financial Sector Development Across the Globe. By A Barajas et alii.
IMF Working Paper No. 13/81
March 28, 2013
http://www.imf.org/external/pubs/cat/longres.aspx?sk=40441.0

Summary: This paper introduces the concept of the financial possibility frontier as a constrained optimum level of financial development to gauge the relative performance of financial systems across the globe. This frontier takes into account structural country characteristics, institutional, and macroeconomic factors that impact financial system deepening. We operationalize this framework using a benchmarking exercise, which relates the difference between the actual level of financial development and the level predicted by structural characteristics, to an array of policy variables. We also show that an overshooting of the financial system significantly beyond levels predicted by its structural fundamentals is associated with credit booms and busts.


Excerpts:

Ample empirical evidence has shown a positive, albeit non-linear, relationship between financial system depth, economic growth, and macroeconomic volatility. At the same time, rapid expansion in credit has been associated with higher bank fragility and the likelihood of a systemic banking crisis.1 This seemingly conflicting evidence is actually consistent with theory. The same mechanisms through which finance helps growth also makes it susceptible to shocks and, ultimately, fragility. Specifically, the maturity and liquidity transformation from short-term savings and deposit facilities into long-term investments is at the core of the positive impact finance on the real economy, but it can also render the system susceptible to shocks. The information asymmetries and ensuing agency problems between savers and entrepreneurs that banks help to alleviate can also turn into a source of fragility given agency conflicts between depositors/creditors and banks.

The importance of the financial sector for the overall economy raises the question of the “optimal” or “Goldilocks” level of financial depth and the requisite policies to reach this optimum. Given the dual-faced nature of financial deepening, contributing to growth while often resulting in boom-bust cycles, and the identification of non-linear relationships between growth, volatility, and financial depth, it is apparent that additional deepening is not always desirable. Further, there is increasing evidence for a critical role of the financial system in defining policy space and the transmission of fiscal, monetary and exchange rate policies (IMF, 2012). Both shallow as well as over-extended financial systems can severely reduce the available policy space and hamper transmission channels.

The conceptual and empirical frameworks offered in this paper are relevant for the academic and policy debate on financial sector deepening, particularly in developing countries. We introduce the concept of a financial possibility frontier as a constrained optimum level of financial development to gauge the relative performance of financial systems around the globe. Specifically, this concept allows us to assess the performance of countries’ financial systems over time relative to structural country characteristics and other state variables (e.g., macroeconomic and institutional variables). Depending on the position of country’s financial system relative to the frontier, policy options can be prioritized to address deficiencies.

Three different sets of policies can be delineated depending on a country’s standing relative to the frontier. Market-developing policies, related to macroeconomic stability, long-term institution building, and other measures to overcome constraints imposed by a small size or volatile economic structure, can help push out the frontier. Market-enabling policies, which address deficiencies such as regulatory barriers and lack of competition, can help a financial system move toward the frontier. Finally, market-harnessing policies help prevent a financial system from moving beyond the frontier (the long-term sustainable equilibrium), and include regulatory oversight and short-term macroeconomic management.

We also operationalize this conceptual framework by presenting a benchmark model that predicts countries’ level of financial development based on structural characteristics (e.g., income, size, and demographic characteristics) and other fundamental factors. The most straightforward approach for assessing a country’s progress in financial deepening is to benchmark its financial system against peers or regional averages. Such comparisons, while useful, do not allow for a systematic unbundling of structural and policy factors that have a bearing on financial deepening. Using regression analysis, we relate gaps between predicted and actual levels of financial development to an array of macroeconomic, regulatory, and institutional variables. We also provide preliminary evidence that overshooting the predicted level of financial development is associated with credit boom-bust episodes, underlining the importance of optimizing rather than maximizing financial development.

This paper is related to several literatures. First, it is directly related to an earlier exercise to derive an access possibilities frontier as a conceptual tool to assess the optimal level of sustainable outreach of the financial system (Beck, and de la Torre, 2007). While Beck, and de la Torre (2007) focus on the microeconomics of access to and use of financial services, this paper provides a macroeconomic perspective on financial sector development. Second, our paper is related to the empirical literature on benchmarking. Based on Beck et al. (2008) and Al Hussainy et al. (2011), we derive a benchmarking model that relates a country’s level of financial development over time to a statistical benchmark, obtained from a large panel regression.

In a broader sense, the paper is also related to the literature on the finance-growth nexus, financial crises, and studies identifying policies needed for sound and effective financial systems. The finance and growth literature, as surveyed by Levine (2005), among others, has found a positive relationship between financial deepening and growth. More recent work, however, has uncovered non-linearities in this relationship. There is evidence that the effect of financial development is strongest among middle-income countries (Barajas et al., 2012), whereas other work finds a declining effect of finance on growth as countries grow richer.2 More recently, Arcand et al. (2012) find that the finance-growth relationship becomes negative as private credit reaches 110 percent of GDP, while Dabla-Norris and Srivisal (2013) document a positive relationship between financial depth and macroeconomic volatility at very high levels.

Our paper is also related to a growing literature exploring the anatomy of financial crises. This literature has pointed to the role of macroeconomic, bank-level and regulatory factors in driving and exacerbating financial fragility. Finally, our paper is related to a diverse literature exploring macroeconomic and institutional determinants of sound and efficient financial deepening.