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Possible Trade-off Between Growth, Safety in Financial Sector

Banks and other financial institutions also are adapting how they do business (photo:Tetra Images/Corbis)

GLOBAL FINANCIAL STABILITY REPORT

Possible Trade-off Between Growth, Safety in Financial Sector

IMF Survey online

September 25, 2012

  • First look at how financial structures are associated with economic growth and stability
  • No financial structure model fits all circumstances
  • Well-managed, regulated, and supervised banks with strong financial buffers deliver better results

With policymakers aiming for safer financial systems, the International Monetary Fund (IMF) examines in a new study the extent to which safer financial structures are tied to good economic growth outcomes.

Responding to the global financial crisis, policymakers around the world have adopted ways to deal with the crisis, which have in turn started to change the structure of their financial systems. Banks and other financial institutions also are adapting how they do business.

The new analysis from the IMF looks at whether such changes are associated with countries’ financial stability and growth. The preliminary findings shed some light on the impact of the global crisis and other factors on the relationship between a country’s financial structure and the economic results it produces.

Variety of models

The analysis in a chapter of the IMF’s Global Financial Stability Report says that no one financial structure is best under all circumstances. What is good for China may not be good for Germany, and what works in Japan may not work in the United States.

“Our analysis reinforces the lesson from the crisis that high quality regulation and supervision should be at the forefront of reform efforts,” said Laura Kodres, chief of global stability analysis in the IMF’s Monetary and Capital Markets Department, at a Washington press conference to launch the study.

The IMF’s preliminary findings examined data from 58 economies between 1998 and 2010.

The IMF’s researchers focused on the financial system’s structural features such as the extent of financial buffers, the dependence on nontraditional intermediation by banks and use of other financial institutions in intermediation, as well as the connections among banks, both at the national level and globally.

Too much of a good thing

They found that higher ratios of capital to assets within banks are associated with better results for the economy. Many emerging market economies had these large buffers in place before the crisis, and as a result, their banking systems weathered the financial turmoil far better than many of their counterparts in advanced economies.

However, beyond a certain point, a large storage of capital may actually start to be a drag on growth.

“A system that is too safe may limit the funds available for lending, and hinder growth,” said Kodres.

Also, cross border connections through foreign banks are beneficial most of the time, but during a crisis may be associated with instability. The financial connections between banks in different countries can mean that what begins as a problem in the United States is quickly transmitted around the world. Instead of a route for risk-sharing, such connections become a conduit for contagion.

The IMF said the research provides some new information as new policies and regulations are put in place to make the financial system safer and prevent a replay of the crisis that spread around the world after the collapse of U.S. investment bank Lehman Brothers in the fall of 2008.

Not too hot, not too coldjust right

The IMF says that better regulation and more intrusive supervision is needed to adapt to changing circumstances.

The institution’s suggestions for regulatory reform and other financial policies that deliver better economic results include:

• Sufficient amounts and quality of capital and levels of liquid assets, but not so high that they inhibit banks’ lending role to help economic growth

• Effective management and supervision of foreign banks to support healthy financial activity across borders

• Strong frameworks to deal with failed banks that lend across borders to ensure that financial flows between countries are less volatile.

In a related study released on the same day, the IMF said while progress has been made, there are still some important elements of the reform agenda left to finish to ensure a safer global financial system.