How Much Finance Is Too Much: Stability, Growth & Emerging Markets

IMF Blog, May 4, 2015

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Canonical URL: How Much Finance Is Too Much: Stability, Growth & Emerging Markets

Study authors: Ratna Sahay, Martin Čihák, Papa N’Diaye.
Publication date: May 4, 2015.
Addresses policy questions for emerging markets using a comprehensive index of financial development for over 170 countries.
Motivation: global financial crisis that began in the United States in 2008 highlighted dangers from rapid expansion of financial systems beyond traditional banks.

Financial development measured as a combination of three elements:
- Depth – the size and liquidity of financial institutions and markets;
- Access – the ability of individuals to access financial services;
- Efficiency – the ability of institutions to provide financial services at low cost and with sustainable revenues, and the level of activity of capital markets.

Evidence of “too much finance”: 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.
The “too much finance” effect primarily reflects impact on total factor productivity growth:
- High financial development does not impede capital accumulation.
- High financial development leads to a loss of efficiency in investment, implying declining quality of finance and poorer allocation of financial resources toward productive activities.
The weakening effect on growth at higher levels of financial development stems from financial deepening, not from access or efficiency.
Most developing and emerging economies are still in relatively safe territory; examples where further financial development is clearly growth-enhancing include Gambia, Ecuador, and Morocco.
Warning: risks to financial stability are present even at low levels of financial development; capital and liquidity reserves are necessary to mitigate crisis effects.

Benefits from developing financial institutions are large when countries have low income levels and decline as country income increases.
Benefits from developing markets increase as country income rises.
Policy implication: sequence reforms to emphasize developing institutions in early stages, then increasingly develop markets as per capita income rises.
Raising access to finance and improving financial sector efficiency is beneficial for growth at any level of financial development.

Faster pace of financial deepening is associated with greater risks of crisis and economic instability.
Positive relationship between the speed at which financial institutions grow and financial instability, because rapid growth often involves taking on too much risk and leverage—especially under weak regulation and supervision.

Strong institutions and sound regulatory and supervisory environments improve tradeoffs: they increase benefits from financial development while reducing risks.
Better protection of property rights, creditor rights and information, higher regulatory quality, and rule of law are positively associated with financial development.

Empirical evidence: 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 critical principles capture regulators’ ability to act by setting and demanding adjustments to:
- capital,
- loan loss provisioning,
- employee compensation.
They also include requirements for transparent financial reporting and disclosures.
Policy implication: better—not necessarily more—regulation promotes both financial stability and financial development.

Source: IMF blog post “How Much Finance Is Too Much: Stability, Growth & Emerging Markets” (May 4, 2015).

Staff Discussion Note
- Staff Discussion Note (Markdown version)
- Staff Discussion Note (PDF)