IMF Working Paper
Research Department
Too Much Finance?*
Prepared by Jean-Louis Arcand, Enrico Berkes and Ugo Panizza
Authorized for distribution by Andrew Berg
June 2012
Abstract
This paper examines whether there is a threshold above which financial development no
longer has a positive effect on economic growth. We use different empirical approaches to
show that there can indeed be ?too much? finance. In particular, our results suggest that
finance starts having a negative effect on output growth when credit to the private sector
reaches 100% of GDP. We show that our results are consistent with the "vanishing effect"
of financial development and that they are not driven by output volatility, banking crises,
low institutional quality, or by differences in bank regulation and supervision.
p 23.
V. CONCLUSIONS
In the summer of 2011, former FED chairman Alan Greenspan wrote an Op Ed that
criticized regulatory reforms aimed at tightening capital standards in the US financial
sector. He stated that such reforms may lead to the accumulation of "excess of buffers at
the expense of our standards of living" (Greenspan, 2011).
The view that policies that lead to a reduction in total lending may have a negative effect
on standards of living seems to be based on the assumption that larger financial sectors are
always good for economic growth. This paper questions this assumption and shows that in
countries with very large financial sectors there is no positive correlation between
financial depth and economic growth. In particular, we find that there is a positive and
robust correlation between financial depth and economic growth in countries with small
and intermediate financial sectors, but we also show that there is a threshold (which we
estimate to be at around 80-100% of GDP) above which finance starts having a negative
effect on economic growth. We show that our results are robust to using different types of
data and estimators. We also showed that our results are consistent with the "vanishing
effect" of finance reported by various authors using recent data: when a specification
which omits the quadratic term is mis-specified, and the "true" relationship is indeed
quadratic, the downward bias in the linear term will increase as more and more
observations correspond to countries with particularly large financial sectors.
We believe that our results have potentially important implications for financial regulation.
Using arguments similar to those in Mr. Greenspan?s Op Ed, the financial industry lobbied
against Basel III capital requirements by suggesting that tighter capital regulation will
have a negative effect on bank profits and lead to a contraction of lending with large
negative consequences on future GDP growth (Institute for International Finance, 2010).
While it is far from certain that higher capital ratios will reduce profitability (Admati et
al., 2010), our analysis suggests that there are several countries for which smaller financial
sectors would actually be desirable.
There are two possible reasons why large financial systems may have a negative effect on
economic growth. The first has to do with economic volatility and the increased
probability of large economic crashes (Minsky, 1974, and Kindleberger, 1978) and the
second relates to the potential misallocation of resources, even in good times (Tobin,
1984).
Rajan (2005) and de la Torre et al. (2011) provide numerous insights on the dangers of
excessive financial development, but they mostly focus on the finance-crisis nexus. The
discussion of the "Dark Side" of financial development by de la Torre et al. (2011) is
particularly illuminating (pun intended). They point out that the "Too much finance" result
may be consistent with positive but decreasing returns of financial depth which, at some
point, become smaller than the cost of instability brought about by the dark side. While
this may be true, it is important to note that our results are robust to restricting the analysis
to tranquil periods. This suggests that volatility and banking crises are only part of the
story. Of course, it would be possible that in the presence of decreasing returns to
financial development the marginal cost of maintaining financial stability becomes higher
than the marginal return of financial development (de la Torre et al., 2011, make this
point). In this case, however, the explanation for our "Too Much Finance" result would not
be one of financial crises and volatility (which do not necessarily happen in equilibrium)
but one of misallocation of resources.
Another possible explanation for our result has to do with the fact that the relationship
between financial depth and economic growth could depend upon the manner through
which finance is provided. In the discussions that followed the recent crisis it has been
argued that derivative instruments and the "originate and distribute" model, which by
providing hedging opportunities and allocating risk to those better equipped to take it
were meant to increase the resilience of the banking system, actually reduced credit
quality and increased financial fragility (UNCTAD, 2008). Perhaps a test that separates
traditional bank lending from non-bank lending could reveal whether these types of
financial flows have differing effects on economic growth.
It is also plausible that the relationship between financial depth and economic growth
depends on whether lending is used to finance investment in productive assets or to feed
speculative bubbles. Using data that for 45 countries for the period 1994-2005, Beck et al.
(2009) show that enterprise credit is positively associated with economic growth but that
there is no correlation between growth and household credit. It is possible that a dataset
that includes more countries and time periods would show that it is the rapid expansion of
household credit that leads to the negative effect of financial development that we
document in this paper.
http://www.imf.org/external/pubs/ft/wp/2012/wp12161.pdf
Research Department
Too Much Finance?*
Prepared by Jean-Louis Arcand, Enrico Berkes and Ugo Panizza
Authorized for distribution by Andrew Berg
June 2012
Abstract
This paper examines whether there is a threshold above which financial development no
longer has a positive effect on economic growth. We use different empirical approaches to
show that there can indeed be ?too much? finance. In particular, our results suggest that
finance starts having a negative effect on output growth when credit to the private sector
reaches 100% of GDP. We show that our results are consistent with the "vanishing effect"
of financial development and that they are not driven by output volatility, banking crises,
low institutional quality, or by differences in bank regulation and supervision.
p 23.
V. CONCLUSIONS
In the summer of 2011, former FED chairman Alan Greenspan wrote an Op Ed that
criticized regulatory reforms aimed at tightening capital standards in the US financial
sector. He stated that such reforms may lead to the accumulation of "excess of buffers at
the expense of our standards of living" (Greenspan, 2011).
The view that policies that lead to a reduction in total lending may have a negative effect
on standards of living seems to be based on the assumption that larger financial sectors are
always good for economic growth. This paper questions this assumption and shows that in
countries with very large financial sectors there is no positive correlation between
financial depth and economic growth. In particular, we find that there is a positive and
robust correlation between financial depth and economic growth in countries with small
and intermediate financial sectors, but we also show that there is a threshold (which we
estimate to be at around 80-100% of GDP) above which finance starts having a negative
effect on economic growth. We show that our results are robust to using different types of
data and estimators. We also showed that our results are consistent with the "vanishing
effect" of finance reported by various authors using recent data: when a specification
which omits the quadratic term is mis-specified, and the "true" relationship is indeed
quadratic, the downward bias in the linear term will increase as more and more
observations correspond to countries with particularly large financial sectors.
We believe that our results have potentially important implications for financial regulation.
Using arguments similar to those in Mr. Greenspan?s Op Ed, the financial industry lobbied
against Basel III capital requirements by suggesting that tighter capital regulation will
have a negative effect on bank profits and lead to a contraction of lending with large
negative consequences on future GDP growth (Institute for International Finance, 2010).
While it is far from certain that higher capital ratios will reduce profitability (Admati et
al., 2010), our analysis suggests that there are several countries for which smaller financial
sectors would actually be desirable.
There are two possible reasons why large financial systems may have a negative effect on
economic growth. The first has to do with economic volatility and the increased
probability of large economic crashes (Minsky, 1974, and Kindleberger, 1978) and the
second relates to the potential misallocation of resources, even in good times (Tobin,
1984).
Rajan (2005) and de la Torre et al. (2011) provide numerous insights on the dangers of
excessive financial development, but they mostly focus on the finance-crisis nexus. The
discussion of the "Dark Side" of financial development by de la Torre et al. (2011) is
particularly illuminating (pun intended). They point out that the "Too much finance" result
may be consistent with positive but decreasing returns of financial depth which, at some
point, become smaller than the cost of instability brought about by the dark side. While
this may be true, it is important to note that our results are robust to restricting the analysis
to tranquil periods. This suggests that volatility and banking crises are only part of the
story. Of course, it would be possible that in the presence of decreasing returns to
financial development the marginal cost of maintaining financial stability becomes higher
than the marginal return of financial development (de la Torre et al., 2011, make this
point). In this case, however, the explanation for our "Too Much Finance" result would not
be one of financial crises and volatility (which do not necessarily happen in equilibrium)
but one of misallocation of resources.
Another possible explanation for our result has to do with the fact that the relationship
between financial depth and economic growth could depend upon the manner through
which finance is provided. In the discussions that followed the recent crisis it has been
argued that derivative instruments and the "originate and distribute" model, which by
providing hedging opportunities and allocating risk to those better equipped to take it
were meant to increase the resilience of the banking system, actually reduced credit
quality and increased financial fragility (UNCTAD, 2008). Perhaps a test that separates
traditional bank lending from non-bank lending could reveal whether these types of
financial flows have differing effects on economic growth.
It is also plausible that the relationship between financial depth and economic growth
depends on whether lending is used to finance investment in productive assets or to feed
speculative bubbles. Using data that for 45 countries for the period 1994-2005, Beck et al.
(2009) show that enterprise credit is positively associated with economic growth but that
there is no correlation between growth and household credit. It is possible that a dataset
that includes more countries and time periods would show that it is the rapid expansion of
household credit that leads to the negative effect of financial development that we
document in this paper.
http://www.imf.org/external/pubs/ft/wp/2012/wp12161.pdf