The world still lives in the shadow of the global financial crisis that began in the United States in 2008. The U.S. experience shone a spotlight on the dangers of financial systems that have grown exponentially and beyond traditional banks. It triggered a rethinking of the extent and speed of the expansion of a country’s financial sector, and raised questions about which policies promote a safe financial system.
In our new study, we emphasize that the most commonly used indicator—bank credit—is not sufficient to measure the size and scope of a country’s financial development. We create a comprehensive index for over 170 countries to answer several policy questions from the perspective of emerging markets.
We show that financial development entails tradeoffs. Our analysis uncovers evidence of “too much finance” in the sense that beyond a certain level of financial development, the positive effect on economic growth begins to decline, while costs in terms of economic and financial volatility begin to rise (see figure below). The analysis shows that these tradeoffs can be improved by strong institutions and a sound regulatory and supervisory environment. In other words, regulatory reforms can increase the benefits from financial development while reducing the risks.
We find that the gains for growth as well as for economic and financial stability from further financial development remain large for most emerging markets. But there are speed limits on financial deepening: when financial sectors deepen too fast, it often leads to crises and instability.
Moreover, we find it is better for countries to develop financial institutions first, and then markets. Strengthening regulations also matters. In fact, there is little trade-off between growth and stability when it comes to deciding on which regulatory principles to focus on—they are key for both.
What we mean by “too much finance”
We measure financial development by a combination of three elements:
- Depth – the size and liquidity of financial institutions and markets;
- Access – the ability of individuals to access financial services; and
- Efficiency – the ability of institutions to provide financial services at low cost and with sustainable revenues, and the level of activity of capital markets.
The “too much finance” effect reflects primarily the impact of a country’s financial development on total factor productivity growth. High financial development does not impede capital accumulation. However, it leads to a loss of efficiency in investment. This suggests that the quality of finance—for instance, allocation of financial resources toward productive activities—begins to decline.
Emerging markets still benefit from financial development
Most developing and emerging economies are still in relatively safe territory when it comes to financial development. In countries such as Gambia, Ecuador, and Morocco, further financial development is clearly growth-enhancing. That is, they can achieve higher growth and financial stability, and reduce economic volatility by developing their financial systems further. One health warning: risks to financial stability are present even at low levels of financial development. Therefore, policymakers need to ensure that capital and liquidity reserves are in place to mitigate the effects of financial crisis.
The benefits from developing financial institutions are large when countries have low income levels, and they decline as country income level increases, whereas the opposite is true for markets. Thus, when it comes to financial development, an appropriate sequencing would emphasize developing institutions in the early stages, with increasing attention to developing markets as per capita income rises.
Interestingly, we find that raising access to finance and financial sector efficiency is beneficial for growth at any level of financial development. In other words, the weakening effect on growth at higher levels of financial development stems from financial deepening, not access or efficiency.
A faster pace of financial deepening means greater risks of crisis and economic instability, other things being equal. There is a clear positive relationship between the speed at which financial institutions grow and financial instability. This is because when financial institutions grow fast, they often do so by taking on too much risk and leverage, particularly when the system is poorly regulated and supervised.
Building strong institutions and regulations helps increase a country’s benefits from financial development while reducing the risks. Better protection of property rights, creditor rights and information, higher regulatory quality and rule of law are positively associated with financial development.
Better regulation promotes both financial development and stability
There have been fears that sweeping changes to global regulatory frameworks would curtail credit, hamper financial development, and stifle growth.
Indeed, one effect of global regulatory reforms has been that banks in advanced economies have increased their capital and in some cases also reduced their assets to unwind some of the pre-crisis excesses. The empirical evidence in our study shows that of the 93 regulatory principles contained in international standards for regulation and supervision of banks, insurance companies, and securities markets, the critical principles that matter for financial development and stability are essentially the same. These principles capture regulators’ ability to act by setting and demanding adjustments to capital, loan loss provisioning, and employee compensation. They also include transparent financial reporting and disclosures. This means that better—not necessarily more—regulation is what promotes financial stability and development.