## _sdn1508

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### Key findings (Executive summary)
- Using a new, broad, measure of financial development (the FD index), many benefits in terms of growth and stability can still be reaped from further financial development in most emerging markets (EMs).
- The effect of financial development on economic growth is bell-shaped: it weakens at higher levels of financial development. This weakening stems from financial deepening, rather than from greater access or higher efficiency, and primarily reflects impacts on total factor productivity (TFP) growth rather than on capital accumulation.
- The pace of financial development matters: when it proceeds too fast, deepening financial institutions can lead to economic and financial instability by encouraging greater risk-taking and high leverage if poorly regulated and supervised. There are speed limits to safe financial deepening.
- Among a large number of regulatory principles, a small subset is critical for both financial development and financial stability. There is very little or no conflict between promoting financial stability and financial development; better regulation promotes both.
- There is no “one-size-fits-all” sequencing of developing financial institutions versus markets. As economies evolve, the relative benefits from institutions decline and those from markets increase.

### Quantitative context and stylized facts
- At end-2013: outstanding private credit accounted for close to 50 percent of GDP in the average EM.
- Stock markets in EMs have grown by 10–15 percent of GDP and have averaged about 40 percent of GDP since 2000.
- By contrast, in advanced economies (AEs): private credit averages more than 130 percent of GDP and stock market capitalization is about 70 percent of GDP.
- The FD index measures financial development across three dimensions: depth, access, and efficiency, and across Financial Institutions (FI) and Financial Markets (FM).

### Measurement and methodology (FD index construction)
- Data coverage: 176 countries (25 AEs, 85 EMs, 66 LIDCs) for 1980–2013; main country-sample figures use 128 countries for some analyses (1980–2013).
- FD index structure:
  - Two main components: Financial Institutions (FI) and Financial Markets (FM).
  - Three dimensions within each: Depth (D), Access (A), Efficiency (E) — yielding six sub-indices: FID, FIA, FIE, FMD, FMA, FME.
  - Indicators normalized between 0 and 1; data winsorized at the 5th and 95th percentiles.
  - Sub-indices formed as weighted averages where weights are squared factor loadings from principal component analysis.
  - Example: banking system credit to the private sector has a weight of 0.25 within the depth subcomponent of FI; FI in turn has a weight of less than 0.40 in the FI subcomponent.
- Missing-data treatments include exclusion, treating as zero, and splicing/backfilling using growth rates; the approach uses informed judgment to fill or treat gaps to maximize coverage.

### Empirical findings: bell-shaped FD–growth relationship
- Main empirical result:
  - A significant bell-shaped (inverted-U) relationship between the FD index and economic growth: finance increases growth up to a point and then the effect weakens and can become negative.
  - Estimation sample: 128 countries, 1980–2013, controlling for endogeneity, crisis episodes, initial income per capita, education, trade openness, FDI flows, inflation, and government consumption.
- Estimated turning points and magnitudes:
  - The level of financial development above which positive effects on growth begin to decline lies between 0.4 and 0.7 on the FD index.
  - With a confidence level of 95 percent, the point at which the marginal impact of finance on growth becomes significantly negative is around 0.7.
  - Broadly, an FD index between 0.45 and 0.7 (with 95 percent likelihood) could generate the largest cumulative growth returns (moving from 0 to the growth-maximizing point) in the range of 4–5½ percentage points, holding other determinants constant.
- Cross-country heterogeneity:
  - No evidence of EM-specific effects; relationship is general across AEs, EMs, and LIDCs.
  - Wide band around the turning point—location and shape differ by country fundamentals, institutions, and regulatory/supervisory quality.

### Channels: why very high finance can harm growth
- Primary mechanisms discussed:
  - Increased frequency of booms and busts, lowering long-run real GDP growth.
  - Diversion of talent/human capital from the real sector into finance.
  - Moral hazard and rent extraction leading to resource misallocation.
- Decomposition:
  - The “too much finance” effect reflects primarily impacts on TFP growth rather than on capital accumulation.
  - High FD reduces investment efficiency, implying impaired allocation of financial resources and human capital.
  - Core functions such as mobilizing savings and transaction facilitation may remain intact at high FD, while functions like efficient capital allocation and corporate control may break down.

### Sub-index results and policy implications
- Sub-index relationships with growth:
  - The inverted-U relationship applies only to depth components (FID and FMD).
  - Access (FIA and FMA) has a positive linear relationship with growth.
  - Efficiency (FIE and FME) on its own does not show a robust positive association with long-term growth.
- Policy implications:
  - Countries at or beyond growth-maximizing depth should emphasize improving access to financial services.
  - Strengthening regulatory and supervisory quality can shift the optimal FD level rightward, allowing larger financial sectors to remain growth-enhancing.
  - Monitor allocation-related functions of finance (allocation efficiency, corporate governance) to mitigate adverse effects of very large financial sectors.
  - Avoid excessively rapid financial development that outpaces institutional and regulatory capacity.

### Benefits and risks across stages of financial development (Regions I–III)
- Three-region framework as FD increases:
  - Region I (“benevolent”): further FD enhances growth and stability; most EMs are in Region I.
  - Region II (tradeoff): further FD increases economic volatility while growth effects remain positive; buffers decline.
  - Region III (“too much finance”): FD leads to both lower growth and increased volatility.
- Social optimal FD (FD*):
  - FD* lies in Region II where marginal social benefits equal marginal social costs; location depends on policymakers’ tradeoff between growth and stability.
- Numerical frontiers (illustrative):
  - Frontier between Regions II and III set at FD = 0.7 (marginal growth impact statistically < 0 at 95 percent).
  - Frontier between Regions I and II illustratively set at FD = 0.4 (reflecting marginal costs of inflation volatility becoming positive at ~0.4 and output volatility at ~0.5).
- Dynamic potential:
  - Regulatory and institutional improvements can shift marginal benefit and cost curves rightward (e.g., from SO* to SO**), expanding Regions I and II and shrinking Region III.
  - At very high FD, private-sector incentives to reduce finance may diverge from social welfare; regulatory measures may be needed.

### Creating an enabling environment: institutions and regulation
- Institutions:
  - Strong property rights, creditor rights, information availability, regulatory quality, and rule of law are positively associated with greater financial development (overall and for institutions and markets).
  - Improvements in creditor rights and information mainly affect the institutions component.
- Regulatory quality and critical principles:
  - Strong positive correlation between financial development and regulatory quality (approximated by compliance with Basel Core Principles (BCP), Insurance Core Principles (ICP), and IOSCO Principles).
  - Empirical overlap: many principles that lower banking-crisis probability also promote financial development.
  - Summary counts:
    - 25 of the 93 regulatory principles (BCP, ICP, IOSCO) were found critical for financial stability.
    - 23 of these 25 were also found critical for financial development.
    - Total regulatory principles considered: 93.
  - Key principle areas:
    - Regulators’ ability to set and demand adjustments to capital, loan loss provisioning, and employee compensation.
    - Regulatory definitions (capital, nonperforming loans, loan losses).
    - Financial reporting and disclosures.
  - Specific principles identified (of the 25 critical for financial stability in IMF (2014d)):
    - BCP principles: 2, 3, 5, 12, 13, 15, 17, 19, 22, 25, 27, and 28.
    - ICP principles: 5, 8, 16, 17, 19, and 25.
    - IOSCO objectives/principles: 1, 5, 14, 15, 16, 18, and 19.
    - Of these 25, only BCP 15 (operational risk) and IOSCO 15 (assistance to foreign regulators) were not critical for financial development.
- Policy implication:
  - Little tradeoff between financial development and financial stability across many regulatory principles; effective implementation can promote both and shift FD frontiers rightward.
  - Empirical testing of interactions between regulatory quality and growth turning points is constrained by limited time variation in regulatory variables.

### Chile case (Box 1) — selected facts
- Reform chronology: rapid liberalization starting 1974; crisis in 1982–84; subsequent reforms expanded capital markets and created a large pool of long-term institutional investors.
- Market structure and size:
  - Total bank credit to the private sector currently stands at 75 percent of GDP.
  - Domestic bond market (excluding government securities) represents almost 40 percent of GDP; market dominated by long-term and inflation-linked bonds and is not very liquid.
  - Market value of listed companies is about 90 percent of GDP; equity market relatively illiquid with low and declining turnover.
- Institutional investors:
  - Pension funds, insurance companies, and asset managers account for nearly half of financial sector assets.
  - Stable institutional investors provide some protection against global financial shocks but may reduce market liquidity.
- Financial inclusion:
  - Only 45 percent of adults in Chile have a formal bank account.

### Summary statistics of the FD index (Table A2 — preserved values)
- All Countries (Observations = 5,984)
  - FID: Observations 5,984; Mean 0.20; Median 0.11; Standard Deviation 0.23; Minimum 0.00; Maximum 1.00
  - FIA: Observations 5,984; Mean 0.15; Median 0.00; Standard Deviation 0.24; Minimum 0.00; Maximum 1.00
  - FIE: Observations 5,984; Mean 0.49; Median 0.55; Standard Deviation 0.27; Minimum 0.00; Maximum 1.00
  - FMD: Observations 5,984; Mean 0.14; Median 0.02; Standard Deviation 0.23; Minimum 0.00; Maximum 1.00
  - FMA: Observations 5,984; Mean 0.12; Median 0.00; Standard Deviation 0.23; Minimum 0.00; Maximum 1.00
  - FME: Observations 5,984; Mean 0.16; Median 0.00; Standard Deviation 0.28; Minimum 0.00; Maximum 1.00
  - FI: Observations 5,984; Mean 0.32; Median 0.31; Standard Deviation 0.22; Minimum 0.00; Maximum 1.00
  - FM: Observations 5,984; Mean 0.14; Median 0.01; Standard Deviation 0.22; Minimum 0.00; Maximum 1.00
  - FD: Observations 5,984; Mean 0.23; Median 0.17; Standard Deviation 0.21; Minimum 0.00; Maximum 1.00

- Emerging Markets (Observations = 2,890)
  - FID: Observations 2,890; Mean 0.19; Median 0.14; Standard Deviation 0.19; Minimum 0.00; Maximum 1.00
  - FIA: Observations 2,890; Mean 0.15; Median 0.00; Standard Deviation 0.24; Minimum 0.00; Maximum 1.00
  - FIE: Observations 2,890; Mean 0.47; Median 0.56; Standard Deviation 0.29; Minimum 0.00; Maximum 0.98
  - FMD: Observations 2,890; Mean 0.13; Median 0.04; Standard Deviation 0.19; Minimum 0.00; Maximum 0.90
  - FMA: Observations 2,890; Mean 0.12; Median 0.00; Standard Deviation 0.23; Minimum 0.00; Maximum 1.00
  - FME: Observations 2,890; Mean 0.16; Median 0.03; Standard Deviation 0.27; Minimum 0.00; Maximum 1.00
  - FI: Observations 2,890; Mean 0.31; Median 0.33; Standard Deviation 0.20; Minimum 0.00; Maximum 0.86
  - FM: Observations 2,890; Mean 0.14; Median 0.04; Standard Deviation 0.20; Minimum 0.00; Maximum 0.91
  - FD: Observations 2,890; Mean 0.23; Median 0.19; Standard Deviation 0.18; Minimum 0.00; Maximum 0.85

- Advanced Economies (Observations = 850)
  - FID: Observations 850; Mean 0.58; Median 0.61; Standard Deviation 0.23; Minimum 0.08; Maximum 1.00
  - FIA: Observations 850; Mean 0.30; Median 0.21; Standard Deviation 0.29; Minimum 0.00; Maximum 1.00
  - FIE: Observations 850; Mean 0.70; Median 0.75; Standard Deviation 0.17; Minimum 0.01; Maximum 0.98
  - FMD: Observations 850; Mean 0.46; Median 0.42; Standard Deviation 0.30; Minimum 0.00; Maximum 1.00
  - FMA: Observations 850; Mean 0.42; Median 0.45; Standard Deviation 0.29; Minimum 0.00; Maximum 1.00
  - FME: Observations 850; Mean 0.48; Median 0.42; Standard Deviation 0.34; Minimum 0.00; Maximum 1.00
  - FI: Observations 850; Mean 0.62; Median 0.62; Standard Deviation 0.19; Minimum 0.04; Maximum 1.00
  - FM: Observations 850; Mean 0.46; Median 0.44; Standard Deviation 0.27; Minimum 0.00; Maximum 1.00
  - FD: Observations 850; Mean 0.55; Median 0.55; Standard Deviation 0.21; Minimum 0.04; Maximum 1.00

- Low-Income and Developing Countries (Observations = 2,244)
  - FID: Observations 2,244; Mean 0.08; Median 0.05; Standard Deviation 0.08; Minimum 0.00; Maximum 0.50
  - FIA: Observations 2,244; Mean 0.08; Median 0.00; Standard Deviation 0.18; Minimum 0.00; Maximum 1.00
  - FIE: Observations 2,244; Mean 0.42; Median 0.47; Standard Deviation 0.25; Minimum 0.01; Maximum 1.00
  - FMD: Observations 2,244; Mean 0.02; Median 0.00; Standard Deviation 0.05; Minimum 0.00; Maximum 0.50
  - FMA: Observations 2,244; Mean 0.00; Median 0.00; Standard Deviation 0.01; Minimum 0.00; Maximum 0.16
  - FME: Observations 2,244; Mean 0.02; Median 0.00; Standard Deviation 0.12; Minimum 0.00; Maximum 1.00
  - FI: Observations 2,244; Mean 0.22; Median 0.23; Standard Deviation 0.14; Minimum 0.00; Maximum 0.76
  - FM: Observations 2,244; Mean 0.01; Median 0.00; Standard Deviation 0.05; Minimum 0.00; Maximum 0.43
  - FD: Observations 2,244; Mean 0.12; Median 0.12; Standard Deviation 0.08; Minimum 0.00; Maximum 0.43

### Conclusion and policy lessons (summary)
- Most EMs remain in the relatively safe and growth-enhancing Region I and have scope to develop further.
- There is evidence of “too much finance”: beyond a certain FD level, growth benefits decline and economic/financial volatility rises.
- Policy priorities for EMs:
  - Measure financial development comprehensively across depth, access, and efficiency.
  - Promote financial development by building a strong business, regulatory, and supervisory environment—better regulation, not necessarily more regulation, fosters both stability and development.
  - Focus on implementing the critical regulatory principles that support both financial stability and development.
  - Raise access and efficiency at any level of FD to secure benefits; manage and avoid excessively rapid deepening.
  - Tailor sequencing to country context, shifting emphasis from institutions toward markets as economies develop.
- Final outlook:
  - Complete implementation of global regulatory reforms would be favorable for growth and stability prospects across countries; deleveraging observed in advanced countries post-crisis implicitly confirms that there had been “too much finance.”

*Source: IMF staff (Rethinking Financial Deepening), content unit: _sdn1508.*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 5

### EXECUTIVE SUMMARY

### Key findings
- First: Using a new, broad, measure of financial development (the FD index), many benefits in terms of growth and stability can still be reaped from further financial development in most emerging markets (EMs).
- Second: The effect of financial development on economic growth is bell-shaped: it weakens at higher levels of financial development. This weakening effect stems from financial deepening, rather than from greater access or higher efficiency. Empirical evidence suggests this weakening primarily reflects the impact of financial deepening on total factor productivity growth, rather than on capital accumulation.
- Third: The pace of financial development matters. When it proceeds too fast, deepening financial institutions can lead to economic and financial instability by encouraging greater risk-taking and high leverage if poorly regulated and supervised. There are speed limits to safe financial deepening.
- Fourth: Among a large number of regulatory principles, a small subset is critical for both financial development and financial stability. There is very little or no conflict between promoting financial stability and financial development; better regulation promotes both.
- Fifth: There is no “one-size-fits-all” sequencing of developing financial institutions versus markets. As economies evolve, the relative benefits from institutions decline and those from markets increase.

### Quantitative context and stylized facts
- At end-2013: outstanding private credit accounted for close to 50 percent of GDP in the average EM.
- Stock markets in EMs have grown by 10–15 percent of GDP and have averaged about 40 percent of GDP since 2000.
- By contrast, in advanced economies (AEs): private credit averages more than 130 percent of GDP and stock market capitalization is about 70 percent of GDP.
- The FD index measures financial development across three dimensions: depth (size and liquidity of markets), access (ability of individuals to access financial services), and efficiency (ability of institutions to provide financial services at low cost and with sustainable revenues, and the level of activity of capital markets).

### Motivation and research questions
- The 2008 global financial crisis, originating in large and complex AE financial systems, prompted questions:
  - Are there limits to financial development for growth and stability?
  - Is there a right pace of development?
  - Are there tradeoffs between growth and stability?
  - What role do institutions, regulation, and supervision play in ensuring a safe financial system?
- The paper reassesses whether EMs have reached limits where additional financial development could be counterproductive.

### Measurement and methodology
- Contribution: development of a broad-based FD index encompassing banking and nonbanking institutions as well as markets, and covering depth, access, and efficiency.
- Empirical approach follows dynamic panel data techniques used in recent literature, using lagged values of financial variables as instruments and controlling for other determinants of growth to identify causality from finance to growth.
- The paper also examines non-linearities (bell-shaped relationships) and the role of pace of deepening, regulatory frameworks, and sequencing between institutions and markets.

### Synthesis of empirical findings and mechanisms
- Financial development generally increases resilience and boosts economic growth by mobilizing savings, promoting information sharing, improving resource allocation, facilitating diversification and risk management, and enhancing countries’ ability to absorb shocks.
- However, at high levels of financial development there can be “too much finance” where costs outweigh benefits. Proposed mechanisms include:
  - Adverse effects on allocative efficiency and crowding out of human capital from the real sector into finance.
  - Financial innovation increasing fragility in the presence of neglected tail risk.
  - Rapid expansion encouraging risk-taking and high leverage when regulation and supervision are weak.
- The weakening of the finance-growth nexus at higher levels of financial depth is driven primarily by financial deepening (quantity/size), not access or efficiency, and appears to operate mainly through effects on total factor productivity rather than capital accumulation.

### Policy implications and priorities for EMs
- Most EMs remain in a favorable region where further financial development promotes both higher growth and greater stability, implying scope for further development.
- Managing the pace of financial deepening is crucial: policymakers should avoid excessively rapid deepening that outpaces institutional and regulatory capacity.
- Strengthening a targeted subset of regulatory and supervisory principles can simultaneously promote financial development and financial stability—there is minimal inherent tradeoff between the two when regulation is effective.
- Sequencing should be country-specific; as economies develop, the relative emphasis should shift gradually from institutions toward markets.

*Source: EXECUTIVE SUMMARY from the IMF paper "Rethinking Financial Deepening" (content unit: _sdn1508 - EXECUTIVE SUMMARY).*

### 14.      With the passage of time, financial sectors have evolved across the globe and modern

### _sdn1508 - 14.      With the passage of time, financial sectors have evolved across the globe and modern

### Evolution and role of financial systems
- Financial systems have become multifaceted: banks remain typically largest and most important, but investment banks, insurance companies, mutual funds, pension funds, venture capital firms, and many other nonbank financial institutions now play substantive roles.
- Financial markets (stocks, bonds, foreign exchange) and the constellation of institutions facilitate diversification of savings and firm financing.
- The efficiency of and access to financial services shape the level and rate of increase in economic prosperity.
- Empirical illustration: data for 128 countries from 1980 to 2013 show that, relative to bank deposits, domestic private bond markets and stock markets increase with GDP per capita; mutual funds and pension funds grow rapidly at higher income; public bond markets’ relative size tends to fall.

### Measuring financial development: the FD index
- Motivation:
  - Single, bank-centered measures (e.g., bank credit to private sector) can be misleading; nonbank assets can change substantially even when bank credit to GDP is stable.
  - Example contrasts: Korea vs. Vietnam—similar private credit to GDP near 100 percent, but banking account usage differs (Korea virtually universal; Vietnam one-quarter of adults have a bank account).
- Data coverage and sample:
  - Data collected for 176 countries: 25 AEs, 85 EMs, and 66 low-income developing countries (LIDCs), for 1980–2013.
  - Main country-sample figure references use 128 countries for some analyses (1980–2013).
- Structure of the FD index:
  - Two main components: Financial Institutions (FI) and Financial Markets (FM).
  - Within FI and FM, three dimensions measured: Depth (D), Access (A), Efficiency (E) — producing six sub-indices: FID, FIA, FIE, FMD, FMA, FME.
  - Aggregation procedure:
    - Indicators normalized between 0 and 1 (highest value = 1, lowest = 0).
    - Data winsorized with the 5th and 95th percentiles as cutoffs.
    - Sub-indices formed as weighted averages where weights are from principal component analysis.
    - Sub-indices aggregated similarly up to the overall FD index.
  - Example weight note: banking system credit to the private sector has a weight of 0.25 within the depth subcomponent of FI; FI in turn has a weight of less than 0.40 in the FI subcomponent (i.e., bank credit is important but not the sole driver).
- Data and construct challenges:
  - Broad measures capture functions of finance only partially (risk management, corporate control, pooling savings).
  - Missing data handled to balance comprehensiveness and coverage; some earlier missing values were “filled in backwards” using growth rates of other indicators.
  - Lack of extensive country/time data for some institutions/activities (e.g., shadow banks) and for payment instrument forms (credit transfers, direct debits, mobile banking).
  - IMF staff will continue to improve the index as data coverage widens.

### Landscape of financial development in Emerging Markets and across groups
- Time pattern (1980–2013):
  - Financial development progressed noticeably in both AEs and EMs, less so in LIDCs.
  - Gap between AEs and EMs widened between mid-1990s and early 2000s (the “Greenspan Era”), reflecting rapid growth in AEs’ financial systems; gap declined after the global financial crisis due to deleveraging in AEs.
- Cross-group comparisons (peer group averages):
  - EMs are closer to AEs on financial institutions than on financial markets.
  - Despite lower depth, the efficiency of EM and LIDC financial institutions is relatively high.
  - Access is low on average across all income groups.
- Within-group heterogeneity:
  - Some large EMs (Brazil, China) have higher FD than certain AEs (Greece, Portugal).
  - Some EMs (Armenia, Ecuador, Tunisia) have lower FD than some LIDCs.
- Policy-relevant observation:
  - Countries that have reached high depth may still earn growth benefits from improvements in access.

### Financial development and growth: the bell-shaped relationship
- Main empirical finding:
  - There is a significant, bell-shaped relationship between financial development (FD index) and economic growth: financial development increases growth up to a point, after which further financial development weakens growth and can become negative.
  - Estimation sample: 128 countries over 1980–2013; regressions control for endogeneity, crisis episodes, initial income per capita, education, trade openness, foreign direct investment flows, inflation, government consumption.
- Estimated turning points and magnitudes:
  - The level of financial development above which positive effects on growth begin to decline lies between 0.4 and 0.7 on the FD index.
  - With a confidence level of 95 percent, the point at which marginal impact of finance on growth becomes significantly negative is around 0.7.
  - Broadly, an FD index between 0.45 and 0.7 (with 95 percent likelihood) could generate the largest cumulative growth returns (moving from 0 to the growth-maximizing point) in the range of 4–5½ percentage points, holding other determinants constant.
- Cross-country heterogeneity:
  - No evidence of EM-specific effects; the estimated relationship is general across AEs, EMs, and LIDCs.
  - Wide band around the turning point—location and shape of bell differ by country fundamentals, institutions, and regulatory/supervisory quality.

### Channels: why very high finance can harm growth
- Primary channels discussed:
  - Increased frequency of booms and busts, leaving lower long-run real GDP growth.
  - Diversion of talent/human capital from productive sectors into the financial sector.
  - Moral hazard and rent extraction leading to resource misallocation.
- Decomposition of growth effects:
  - The “too much finance” effect reflects primarily impacts on total factor productivity (TFP) growth rather than on capital accumulation.
  - High levels of financial development do not impede capital accumulation but reduce investment efficiency, suggesting impaired allocation of financial resources and human capital.
  - Many finance functions (mobilizing savings, transaction facilitation) may remain intact at high FD, while functions like efficient capital allocation and corporate control may break down.
  - No evidence of EM-specific effects in this decomposition.

### Sub-index findings and policy implications
- Sub-index relationships with growth:
  - The bell-shaped (inverted-U) relationship pertains only to the depth components (both institutions and markets).
  - Access has a positive linear relationship with growth.
  - Efficiency on its own does not have a robust positive association with long-term growth.
- Implications for policy and reform priorities:
  - Countries that have reached or exceeded growth-maximizing depth levels should prioritize improving access to financial services (to still gain growth benefits).
  - Strengthening regulatory and supervisory quality can shift the optimal level of financial development rightward, allowing larger financial sectors to be growth-enhancing.
  - Monitor functions of finance beyond depth—particularly allocation efficiency and corporate governance—to mitigate potential adverse effects of very large financial sectors.

*Source: IMF staff estimates and analysis in the chapter text.*

### Box 1. Financial Development in Chile

### Box 1. Financial Development in Chile

### Background and reform chronology
- Financial development accelerated in 1974 with rapid financial liberalization that ended decades of financial repression.
- Between 1974 and 1976, the government removed most banking-sector regulations, including interest rate and credit controls, and privatized state-owned banks.
- Subsequent reforms included equity market reforms, insurance market liberalization, the creation of a fully funded pension system, and measures to facilitate bond issuances.
- The 1982–84 banking crisis interrupted the process, triggering massive government intervention in the banking sector and the reinstatement of financial controls; reforms resumed shortly after the crisis and led to an expansion of the capital market and the creation of a large pool of long-term institutional investors.

### Drivers of market development
- The creation of a fully funded pension system contributed to the early development of a domestic institutional investor base.
- The 1982–84 banking crisis likely accelerated growth of the equity and corporate bond markets.
- Early establishment of a sovereign bond market facilitated development of other markets.
- Improvements in contract enforcement, institutions reducing information asymmetries, and increased availability of collateral helped deepen markets.

### Market structure, size, and liquidity
- Total bank credit to the private sector currently stands at 75 percent of GDP.
- The efficiency of Chile’s banks, measured by the lending-deposit rate spread, is close to the OECD average.
- The domestic bond market (excluding government securities) represents almost 40 percent of GDP; the market is not very liquid and is dominated by long-term and inflation-linked bonds.
- The low liquidity, long maturities, and indexation to inflation are driven by high demand from institutional investors, especially life insurance companies with inflation-linked, long-term liabilities.
- The market value of listed companies is about 90 percent of GDP, indicating a relatively large equity market, but the equity market is relatively illiquid with a low and declining turnover.

### Role of institutional investors
- Pension funds, insurance companies, and asset managers (investment funds) account for nearly half of the financial sector assets.
- The presence of these investors contributed to the strong development of the local capital market, but may have limited liquidity because of the buy-and-hold strategies they typically employ.
- There is evidence that the presence of stable investors such as pension funds and insurance companies offers some protection to domestic financial systems against global financial shocks.

### Financial inclusion and market access challenges
- Only 45 percent of adults in Chile have a formal bank account (about half of the OECD average).
- The relatively low liquidity of equities and corporate bond markets limits the ability of smaller firms to raise capital outside the banking system.

*Prepared by Nicolás Arregui and Luis Brandao-Marques, drawing in part on Gallego and Loayza (2000), de la Torre, Ize, and Schmuckler (2012), IMF (2014b), and World Bank (2014).*

### 36.      Combining the various pieces of empirical evidence, a picture of benefits and risks

### Combining the various pieces of empirical evidence, a picture of benefits and risks emerges as financial development moves from low to high

### Benefits–Risks across stages of Financial Development (FD)
- Empirical evidence identifies three regions as financial development increases:
  - Region I: a “benevolent” stage — in early stages, growth and macroeconomic stability are both enhanced by further financial development; banking becomes more active, capital buffers begin to decline, and earnings volatility increases. Overall, risks remain contained and benefits are large. Most EMs are currently situated in Region I.
  - Region II: a tradeoff region — beyond a certain level, further financial development increases economic volatility while growth effects remain positive and buffers continue to decline. Some EMs and AEs are found in Region II.
  - Region III: “too much finance” — beyond a point, financial development leads to both lower growth and increased volatility.
- The analysis frames a “social optimal” level of FD (FD*) as the point where marginal social benefits equal marginal social costs; FD* lies somewhere in Region II and depends on policymakers’ normative preferences between growth and macroeconomic/financial stability.

### Marginal Social Benefits and Costs of Financial Development (Box 4)
- Definitions and interpretation:
  - Marginal social benefit of finance (MBF): the marginal effect on growth; initially positive but declining, eventually turning negative.
  - Marginal social cost of finance (MCF): aggregates marginal impacts on output volatility, inflation volatility, and financial stability; shown as initially negative (net stabilizing effects) but increasing with FD and eventually positive.
- Regions characterized by MBF and MCF:
  - Region I: MBF positive, MCF negative — unambiguous net benefits to further financial development.
  - Region II: MCF becomes positive; net social benefit continues until FD* where MBF = MCF (social optimum SO*).
  - Region III: MBF negative, MCF positive — unambiguous social costs; society would benefit from contraction in finance.
- Numerical frontiers (illustrative estimates from the estimation results):
  - Frontier between Regions II and III established at a level of FD of 0.7, where the marginal growth impact of FD becomes statistically less than zero at a 95 percent level.
  - Frontier between Regions I and II is illustrative and set at a level of FD of 0.4. This choice reflects normative weighing because:
    - Marginal costs of inflation volatility become positive at about 0.4.
    - Marginal costs of output volatility become positive at about 0.5.
    - Financial stability costs are positive at all levels of FD.
- Dynamic considerations:
  - Selected actions in the enabling environment—especially regulatory and institutional improvements—can shift MBF and MCF curves to the right (e.g., from SO* to SO**), potentially expanding Regions I and II and shrinking Region III.
  - At very high levels of finance, private benefits of reducing financial development may diverge from social benefits; regulatory actions may be needed to induce private sector contraction toward socially optimal FD.

### Creating an enabling environment: institutions and regulation
- Role of institutions:
  - Stronger institutions—better protection of property rights, creditor rights and information, higher regulatory quality and rule of law—are positively associated with greater financial development in the overall FD index and in institutions and markets measures.
  - Improvements in creditor rights and information tend to have measurable effects mainly on the institutions component.
- Role of regulatory quality:
  - There is a strong positive correlation between financial development and the quality of the regulatory framework, approximated by country compliance grades with Basel Core Principles (BCP), Insurance Core Principles (ICP), and IOSCO Principles.
- Overlap between principles supporting stability and development:
  - Empirical analysis (following IMF 2014d methodology) identified principles significantly associated with a lower probability of a banking crisis; these largely coincide with principles positively associated with financial development.
  - Summary counts:
    - 25 of the 93 regulatory principles (BCP, ICP, and IOSCO) were found critical for financial stability.
    - 23 of these 25 were also found critical for financial development.
    - Total regulatory principles considered: 93.
  - The key principles capture:
    - (1) Regulators’ ability to set and demand adjustments to capital, loan loss provisioning, and employee compensation.
    - (2) Regulatory definitions, such as definitions of capital, nonperforming loans, and loan losses.
    - (3) Financial reporting and disclosures.
- Specific principles identified (of the 25 critical for financial stability in IMF (2014d)):
  - BCP principles: 2, 3, 5, 12, 13, 15, 17, 19, 22, 25, 27, and 28.
  - ICP principles: 5, 8, 16, 17, 19, and 25.
  - IOSCO objectives/principles: 1, 5, 14, 15, 16, 18, and 19.
  - Of these 25, only BCP 15 (operational risk) and IOSCO 15 (assistance to foreign regulators) were not critical for financial development.
- Policy implication from regulation analysis:
  - There is very little tradeoff between financial development and financial stability across many regulatory principles; effective implementation of key regulatory principles can promote both simultaneously.
  - Strengthening regulatory implementation could shift the frontiers of Regions I–III rightward, allowing higher FD without additional costs of lower growth or higher volatility.
  - Empirical testing of interactions between regulatory quality and growth turning points is constrained by limited time variation in regulatory variables.

### Conclusion and policy lessons
- Main findings:
  - Most emerging markets are still in the relatively safe and growth-enhancing Region I and have scope to develop further.
  - There is evidence of “too much finance”: beyond a certain FD level, growth benefits decline and economic/financial volatility rises.
  - Following the 2008 global financial crisis, substantial regulatory reforms have been proposed and implemented; these reforms aim to make financial systems safer and can potentially expand Regions I and II.
- Policy recommendations and lessons for emerging markets:
  - Financial development is multi-faceted and should be measured across many indicators.
  - Promote financial development by building a strong business, regulatory, and supervisory environment—better regulation, not necessarily more regulation, fosters both stability and development.
  - The critical regulatory principles for financial development and financial stability are essentially the same.
  - Since the weakening effect on growth at higher FD stems from financial deepening per se, raising access or efficiency at any level of FD is beneficial.
  - Avoid excessively rapid financial development to mitigate economic and financial stability risks and to reduce the likelihood of crisis.
  - There is no “one-size-fits-all” sequencing for financial system development; over time, the relative benefits from institutions decline while those from markets increase.
- Final outlook:
  - Complete implementation of global regulatory reforms would be favorable for growth and stability prospects across countries; deleveraging observed in advanced countries post-crisis implicitly confirms that there had been “too much finance.”

*Source: IMF staff (Rethinking Financial Deepening), content unit: _sdn1508 - 36. Combining the various pieces of empirical evidence, a picture of benefits and risks.*

### ANNEX I. CONSTRUCTION OF THE INDEX

### ANNEX I. CONSTRUCTION OF THE INDEX

### Approach
- Introduces a comprehensive index of financial development using indicators of financial depth, access, and efficiency for financial institutions and markets.
- The broad approach follows the matrix of financial system characteristics developed by Čihák and others (2012).

### Data
- Annual data between 1980 and 2013 for 176 advanced, emerging, and low-income economies.
- Data sources: World Bank Global Financial Development Database and World Bank FinStats, IMF’s Financial Access Survey, Dealogic corporate debt database, and Bank for International Settlement (BIS) debt securities database.
- Selected variables follow Čihák and others (2012) and aim to cover a wide range of countries and years.
- Notes on availability and proxies:
  - Global Findex user-side data available only for 2011 and 2014 and thus not used for full series coverage.
  - A “production frontier” efficiency measure exists for a small set of AEs but not for most EMs and LIDCs; proxy variables chosen instead to preserve broad coverage.
  - Robustness checks performed for inclusion of individual variables such as return on assets and return on equity.

- Table A1. Construction of the Financial Development Index (variables listed by category)
  - FINANCIAL INSTITUTIONS — DEPTH
    1. Private-sector credit (% of  GDP)
    2. Pension fund assets (% of GDP)
    3. Mutual fund assets (% of GDP)
    4. Insurance premiums, life and non-life (% of GDP)
  - FINANCIAL MARKETS — DEPTH
    1. Stock market capitalization to GDP
    2. Stocks traded to GDP
    3. International debt securities government (% of GDP)
    4. Total debt securities of nonfinancial corporations (% of GDP)
    5. Total debt securities of financial corporations (% of GDP)
  - FINANCIAL INSTITUTIONS — ACCESS
    1. Branches (commercial banks) per 100,000 adults
    2. ATMs per 100,000 adults
  - FINANCIAL MARKETS — ACCESS
    1. Percent of market capitalization outside of top 10 largest companies
    2. Total number of issuers of debt (domestic and external, nonfinancial corporations, and financial corporations)
  - FINANCIAL INSTITUTIONS — EFFICIENCY
    1. Net interest margin
    2. Lending-deposits spread
    3. Non-interest income to total income
    4. Overhead costs to total assets
    5. Return on assets
    6. Return on equity
  - FINANCIAL MARKETS — EFFICIENCY
    1. Stock market turnover ratio (stocks traded/capitalization)

### Missing data
- Three main treatments for missing data:
  1. Excluding the series from the final index average (line "missing" in Figure A1, right panel).
  2. Treating as zero (line "zero" in Figure A1, right panel).
  3. Splicing (line "non-zero" in Figure A1, right panel).
- Splicing method: cross-country levels of financial development determined from the most recently available data by taking a weighted average across performance on various indicators; index expanded backward using average growth rates in the available series when earlier-year data unavailable.
- Paper’s chosen approach:
  - Use as much available data as possible.
  - Make an informed judgment whether missing data indicate market exists but unreported (fill retrospectively) or non-existent market.
  - When relevant market existed in previous years but data missing, fill missing data retrospectively starting from the first available observation and applying the average growth rate of other indicators with available previous-year data.
  - If data are missing for the most recent years, set values equal to latest available observations.

### Compiling the index
- Apply missing-data treatment to actual data series before creating ratings.
- Winsorize data at the 5th and the 95th percentiles to avoid extreme observations driving best and worst scores.
- Normalize each indicator in a subcategory between 0 and 1 using a global min-max procedure (relates country performance to global min and max across all countries and years).
- For some series where higher value indicates worse efficiency (net interest margin, lending-deposits spread, non-interest income to total income, overhead costs to total assets), ratings are rescaled so that higher value indicates greater financial development using the alternate formula described in the source.

### Weighting
- Sub-indices constructed as weighted averages of underlying series.
- Weights are squared factor loadings (sum to 1) from principal component analysis of the underlying series (Figure A2).
- Series contributing more to common variation receive higher weight.
- Sub-indices combined into higher indices using principal component analysis with weights shown in Figure A2.

### Final index
- Produces a relative ranking of countries on:
  - Depth, access, and efficiency of financial institutions and financial markets.
  - Development of financial institutions and markets.
  - Overall level of financial development (Table A2).

### Table A2. Summary Statistics of the Financial Development Index — Key statistics (preserved exactly)
- Note: FD = financial development; FI = financial institutions; FIA = financial institutions access; FID = financial institutions depth; FIE = financial institutions efficiency; FM = financial markets; FMA = financial markets access; FMD = financial markets; FME = financial markets efficiency.

- All Countries (Observations = 5,984)
  - FID: Observations 5,984; Mean 0.20; Median 0.11; Standard Deviation 0.23; Minimum 0.00; Maximum 1.00
  - FIA: Observations 5,984; Mean 0.15; Median 0.00; Standard Deviation 0.24; Minimum 0.00; Maximum 1.00
  - FIE: Observations 5,984; Mean 0.49; Median 0.55; Standard Deviation 0.27; Minimum 0.00; Maximum 1.00
  - FMD: Observations 5,984; Mean 0.14; Median 0.02; Standard Deviation 0.23; Minimum 0.00; Maximum 1.00
  - FMA: Observations 5,984; Mean 0.12; Median 0.00; Standard Deviation 0.23; Minimum 0.00; Maximum 1.00
  - FME: Observations 5,984; Mean 0.16; Median 0.00; Standard Deviation 0.28; Minimum 0.00; Maximum 1.00
  - FI: Observations 5,984; Mean 0.32; Median 0.31; Standard Deviation 0.22; Minimum 0.00; Maximum 1.00
  - FM: Observations 5,984; Mean 0.14; Median 0.01; Standard Deviation 0.22; Minimum 0.00; Maximum 1.00
  - FD: Observations 5,984; Mean 0.23; Median 0.17; Standard Deviation 0.21; Minimum 0.00; Maximum 1.00

- Emerging Markets (Observations = 2,890)
  - FID: Observations 2,890; Mean 0.19; Median 0.14; Standard Deviation 0.19; Minimum 0.00; Maximum 1.00
  - FIA: Observations 2,890; Mean 0.15; Median 0.00; Standard Deviation 0.24; Minimum 0.00; Maximum 1.00
  - FIE: Observations 2,890; Mean 0.47; Median 0.56; Standard Deviation 0.29; Minimum 0.00; Maximum 0.98
  - FMD: Observations 2,890; Mean 0.13; Median 0.04; Standard Deviation 0.19; Minimum 0.00; Maximum 0.90
  - FMA: Observations 2,890; Mean 0.12; Median 0.00; Standard Deviation 0.23; Minimum 0.00; Maximum 1.00
  - FME: Observations 2,890; Mean 0.16; Median 0.03; Standard Deviation 0.27; Minimum 0.00; Maximum 1.00
  - FI: Observations 2,890; Mean 0.31; Median 0.33; Standard Deviation 0.20; Minimum 0.00; Maximum 0.86
  - FM: Observations 2,890; Mean 0.14; Median 0.04; Standard Deviation 0.20; Minimum 0.00; Maximum 0.91
  - FD: Observations 2,890; Mean 0.23; Median 0.19; Standard Deviation 0.18; Minimum 0.00; Maximum 0.85

- Advanced Economies (Observations = 850)
  - FID: Observations 850; Mean 0.58; Median 0.61; Standard Deviation 0.23; Minimum 0.08; Maximum 1.00
  - FIA: Observations 850; Mean 0.30; Median 0.21; Standard Deviation 0.29; Minimum 0.00; Maximum 1.00
  - FIE: Observations 850; Mean 0.70; Median 0.75; Standard Deviation 0.17; Minimum 0.01; Maximum 0.98
  - FMD: Observations 850; Mean 0.46; Median 0.42; Standard Deviation 0.30; Minimum 0.00; Maximum 1.00
  - FMA: Observations 850; Mean 0.42; Median 0.45; Standard Deviation 0.29; Minimum 0.00; Maximum 1.00
  - FME: Observations 850; Mean 0.48; Median 0.42; Standard Deviation 0.34; Minimum 0.00; Maximum 1.00
  - FI: Observations 850; Mean 0.62; Median 0.62; Standard Deviation 0.19; Minimum 0.04; Maximum 1.00
  - FM: Observations 850; Mean 0.46; Median 0.44; Standard Deviation 0.27; Minimum 0.00; Maximum 1.00
  - FD: Observations 850; Mean 0.55; Median 0.55; Standard Deviation 0.21; Minimum 0.04; Maximum 1.00

- Low-Income and Developing Countries (Observations = 2,244)
  - FID: Observations 2,244; Mean 0.08; Median 0.05; Standard Deviation 0.08; Minimum 0.00; Maximum 0.50
  - FIA: Observations 2,244; Mean 0.08; Median 0.00; Standard Deviation 0.18; Minimum 0.00; Maximum 1.00
  - FIE: Observations 2,244; Mean 0.42; Median 0.47; Standard Deviation 0.25; Minimum 0.01; Maximum 1.00
  - FMD: Observations 2,244; Mean 0.02; Median 0.00; Standard Deviation 0.05; Minimum 0.00; Maximum 0.50
  - FMA: Observations 2,244; Mean 0.00; Median 0.00; Standard Deviation 0.01; Minimum 0.00; Maximum 0.16
  - FME: Observations 2,244; Mean 0.02; Median 0.00; Standard Deviation 0.12; Minimum 0.00; Maximum 1.00
  - FI: Observations 2,244; Mean 0.22; Median 0.23; Standard Deviation 0.14; Minimum 0.00; Maximum 0.76
  - FM: Observations 2,244; Mean 0.01; Median 0.00; Standard Deviation 0.05; Minimum 0.00; Maximum 0.43
  - FD: Observations 2,244; Mean 0.12; Median 0.12; Standard Deviation 0.08; Minimum 0.00; Maximum 0.43

*Source: IMF staff calculations.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2015/_sdn1508.pdf_