José Manuel González-Páramo: Financial systems, new technologies
and productivity growth
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the Summer School of the University of Málaga, Ronda,
11 July 2008.
* * *
1. Introduction1
Ladies and Gentlemen,
It is a great pleasure for me to be here in Ronda and participate in the Summer School of the
University of Málaga. I would like to thank the organisers, particularly Professors Amparo
Ruiz Sepúlveda and David Bueno Vallejo, for giving me the opportunity to share with you
some views on the relationship between financial systems, new technologies and productivity
growth.
The notion that financial and economic activities are closely interrelated is not new. Indeed, it
has a long tradition in economic theory. For instance, Clément Juglar - the French economist
who was among the first to investigate the nature of business cycles - argued back in 1860
that economic fluctuations originate in the credit system.
Financial development can have a significant impact on the economic performance of our
economies. Indeed, developments in the financial system can directly influence productivity
growth in the euro economy, since the financial sector accounts for a significant and growing
share of output and employment in our economies. More generally, developments in the
financial sector have an impact on economic performance well above their relative
importance in employment or output. This is because financial services represent key
intermediate inputs into other sectors of the economy, and thereby provide a very important
contribution to productivity, innovation and economic growth in the long term. In fact, a
wellfunctioning financial system enables an economy to exploit its full potential for output and
employment growth.
2. Productivity growth in the financial system
Developments in the financial system can directly influence the performance of our
economies, since the financial sector accounts for a significant and growing share of output
and employment in the euro area.2
More generally, the increase in the relative importance of services in developed economies
has been singled out as one of the potential explanations for the substantial decline in
macroeconomic volatility over the last two decades (the so-called "Great Moderation"). In
particular, the share of euro area total value added and employment accounted for by the
services sector has significantly risen since the 1980s. As a result, the structure of the euro
area economy has increasingly shifted away from traditional manufacturing industries
towards services.
Within the services sector, over the last few decades there has been a slight increase in the
importance of financial intermediation relative to other services sub-sectors. Data show that
in 2005 financial and business services represented the sub-sector accounting for the largest
share of value added. Their relative importance for employment is more limited, as a result of
their relatively high productivity compared to other services sub-sectors.
Indeed, in contrast to other sub-sectors, financial services are substantially more exposed to
international competition and the use of Information and Communication Technologies (ICT).
Besides, the liberalisation of this sector started in the EU earlier than regulatory reforms in
other services. As a result, the financial sector has been subjected to the combined of
pressure of: (1) increased competition from capital markets and foreign financial institutions,
and (2) earlier deregulation. The combination of technological progress and market structural
changes should have spurred productivity growth in the euro area financial industry.
Nevertheless, data from the EU KLEMS Growth and Productivity Accounts spanning the
1996-2005 period show that labour productivity growth in financial services was rather
disappointing over this period, especially if compared with their corresponding performance
in the US. Indeed, labour productivity growth of the financial sector was slightly negative in
the euro area over this decade, while it outperformed the economy as a whole in the US.
Thus, in the euro area the financial services sector seems to have to some extent contributed
to two important developments in labour productivity over this period: (1) the sharp slowdown
in labour productivity growth in the euro compared to the period 1980-1995; (2) the
emergence of a significant labour productivity growth gap between the euro area and the US.
Weak productivity developments in the financial services are also evident if we look at total
factor productivity growth, a factor generally believed to have played a key role in
determining the emergence of a significant output growth gap between the US and the euro
area over 1996-2005. Indeed, over this period the financial services sector provided a
significant negative contribution to euro area output growth, compared with a marginal
positive contribution in the US. It should be noted that, while the negative rate of growth of
TFP for this sector deteriorated in the euro area compared with the level observed over the
period 1980-1995, over the same period the financial sector recorded a significant
turnaround in the US. Developments across individual euro area countries were fairly mixed,
but in the majority of cases TFP growth either improved at best only marginally or
deteriorated significantly.
Overall, the deterioration in the productivity performance of the euro area financial services
industry - and, more generally, the evidence of disappointing productivity performance also
in other market-services sub-sectors making relatively intensive use of ICT - reflects
insufficient technological and innovation spillovers as well as the negative impact of labour
and market rigidities. From the policy point of view, these findings point to the need to
continue implementing structural reforms, introducing measures aimed at increasing market
competition and investing in education and human capital formation in order to achieve the
objectives of the Lisbon strategy.
3. Financial sector and growth
Developments in the financial sector have an impact on economic performance well above
their share in total employment or value added.3 This is because the financial sector provides
an important contribution to the efficient functioning of the entire economy, by ensuring that
the most valuable real investment opportunities receive the necessary financing at a
reasonable cost. In particular, a well-functioning financial system fosters saving and capital
accumulation, allows for a more efficient spatial and inter-temporal allocation of resources,
enhances risk-sharing and improves the diversification of risk. It can reduce the cost of
capital as well as that of financial intermediation and improve competitiveness, thereby
lowering prices and stimulating economic growth, job creation and welfare. Insofar as
financial services are important for the economy as a whole and enable other economic
transactions to run smoothly, they are associated with strong externalities affecting the rest
of the economy.
The efficiency of a financial system typically depends on several key factors, including its
degree of integration, market competition, level of development and innovation capacity. In
particular, many studies have found evidence of a correlation between the level of financial
development and the economic growth.4 Indeed, there is a significant amount of empirical
evidence derived from cross-country data showing that countries in which more credit to the
private sector is extended typically experience stronger economic growth.
In standard neoclassical models, financial development fosters growth mainly by supporting
a higher level of investment activity. Other models suggest that the positive influence of
financial development may work through the accumulation of human capital (by supporting
investment in education by individuals). However, recent studies have found evidence that in
developed economies a more relevant channel through which financial intermediation affects
economic growth may work through increases in total factor productivity.5
There is increasing interest in understanding the specific channels through which financial
development affects productivity. Some studies have found out that this may be related to
the superior ability of countries with more developed financial systems to finance investment
for technological-related reasons or to enable firms to adopt new technologies more quickly.
In addition, it has also been argued that finance fosters growth by stimulating "creative
destruction", in the words of Joseph Schumpeter, the famous Austrian economist who
argued that fluctuations in investment and economic activity are determined by
creditfinanced innovation waves.
According to this argument, developed financial markets help to channel scarce capital from
declining sectors to firms that are expected to grow faster and also make it easier for firm to
enter industries facing good growth prospects. Hartmann et al. (2007) test this hypothesis for
a group of 22 OECD countries and indeed find that in countries with more developed
financial markets, industries with better growth prospects tend to benefit from more
investment activity.6
How developed are the financial markets in the euro area? In order to answer this question,
ECB staff members have developed aggregate measures of the size of stock, bond and
loans markets that can be used as proxies for the degree of development of capital markets
as a whole.7 Based on these indicators, one can conclude that on average, capital markets in
euro area countries tend to be smaller than those of the UK and US, and roughly comparable
in size to those of Japan. It has been suggested that differences in the degree of
development and, more generally, efficiency of capital markets may have played a role in
explaining the better economic performance of the US relative to the euro area in the second
half of the 1990s.8 It should be noted though that there are significant differences across
euro area countries, with the relative size of capital markets in some countries comparable or
even bigger than in the Anglo-Saxon countries.
Of course, one important difference between the capital markets of the euro area and other
developed economies regards the relative importance of their market segments. In general,
the euro area still has a much more "bank-based" system compared with the rather
"marketbased" system in the US. However, the euro area financial landscape is changing, as a result
of a number of structural developments, including the introduction of the euro, increasing
financial integration, securitisation and other forms of financial innovation, the impact of
longrun demographic trends, etc.
4. Financial innovation
I have mentioned securitisation as one of the factors changing the euro area financial
landscape. This is an important issue since securitisation is an example of a relatively mature
form of financial innovation, a factor that plays an important role in determining the degree of
efficiency of a financial system. Indeed, financial innovation can render financial markets
more efficient by rendering them more complete, thereby allowing firms, households and
governments to interact in the market place facing lower transaction costs, enhanced risk
sharing instruments and contracting possibilities. I will concentrate on two specific examples
of financial innovation: securitisation and the development of venture capital financing.
Securitisation
Securitisation - the practice of transforming formerly illiquid assets into portfolios of assets
that can be sold widely - is particularly common in the banking sector. In fact, asset
securitisation was introduced in the 1970s in the US precisely for the purpose to allow
depository institutions to sell their pools of mortgage loans before maturity, thereby providing
an additional source of funding. Banks subsequently extended the securitisation model to
other forms of credit, such as consumer credit and student loans, that were historically
regarded as highly illiquid.
Increasing securitisation of lending-related assets, together with relentless financial
innovation in credit markets, have led to the diffusion of a new business model - the
"originate to distribute" model - among banks, particularly those of large size. Under this new
model, banks originate loans but sell them to structured investment vehicles (often set up by
themselves) to be repackaged and subsequently sold as asset-backed securities (ABSs).
In principle, this business model is attractive for banks since it provides them with a new
source of financing to expand lending (thereby mitigating their funding liquidity risks), while
also allowing them to economise on costly capital requirements. From the point of view of the
economy as a whole, the "originate to distribute" model could be viewed as having many
advantages. First, capital requirements are costly, thus the ability to sustain a given level of
credit supply with a lower volume of capital enables the banking sector to reduce the costs of
financing for borrowers. Moreover, it may be seen as representing a step towards more
complete credit markets, thereby contributing to enhancing the efficiency of the economic
system. In addition, the securitisation of loans in principle could reduce a secular source of
vulnerability of the economies, by taking risk concentrations associated with loan portfolios
away from the banking sector and spreading them more broadly across other sectors. As a
result, the "originate to distribute" model may potentially diminish the likelihood of the credit
busts and banking crises that have historically been a major source of macroeconomic and
financial instability in many economies. I will come back to this point later on when talking
about the implications of financial developments for financial stability.
Following a relatively slow start compared to the US, the European market for structured
finance products has grown rapidly during the last 5-10 years, often at double-digit rates.
This development has been even more pronounced in the euro area compared with other
regions due to a variety of factors, including the introduction of the single currency, further
financial market integration through the use of credit derivatives and related financial
instruments, and an innovative financial industry.9 Growth in structured finance products has
also been fuelled by high demand from investors stemming from the search for yield, in an
environment of relatively low yields, and diversification opportunities. Securitisation has also
been positively affected by the general move towards a more market-based financial system.
Nevertheless, the volume of issuance of ABSs relatively to the size of the economy for the
euro area as a whole remains lower than in the UK and the US, probably reflecting regulatory
and legal barriers to financial integration.10 Within the euro area, the countries in which the
issuance of ABSs is more frequent are Spain, Ireland, Luxembourg, the Netherlands and
Portugal.
Venture capital financing
Venture capital is a type of private equity investment provided by specialised investors as
start-up money to finance new high-risk firms with large scope for growth (e.g. those involved
in new technologies), in return for an equity position in the firm.11 It represents an alternative
source of capital financing, especially for those categories of firms (start-ups and small
innovative firms) for which informational asymmetries are particularly pronounced, as it has
been documented by the credit channel literature. Indeed, even bank financing may be
difficult to obtain for such firms, as they are usually involved in high-risk businesses, but have
little collateral to offer. Under a venture capital agreement, the investor acquires a significant
equity stake in the firm, which provides him/her with the right incentive to monitor and control
the firm and overcomes the potential asymmetric information problems. Venture capitalists
also serve their portfolio firms by providing coaching and guidance, as well as networking for
strategic alliances and further funding. Finally, venture capital financing is provided on a
piecemeal basis over several stages, which reduces the entrepreneur's incentive to skimp on
effort during the early life of the firm.
It should be noted that providing financing to small and medium-sized enterprises is very
important in the euro area because these categories of firms represent a significant
component of the economies of many of its members. Thus, the financing of small- and
medium-sized firms is crucial for fostering entrepreneurship, competition, innovation and
growth in Europe. In addition, venture capital financing plays an important role in supporting
the diffusion of new technologies in existing sectors and in fostering the developments of
new industries. In that sense, venture capital is a type of finance which is ideally suited for
the purpose of transforming scientific knowledge into commercial output. For instance, a
recent study of the European biotech industry by ECB Staff has shown that venture capital
financing increases the number of patent applications per unit of industrial R&D, suggesting
that the involvement of venture capital investors makes R&D investment more efficient.12
Despite having grown substantially over the past ten years, venture capital financing in most
euro area countries remains a fraction of venture capital financing in the UK or, especially, in
the US. While average euro area venture capital financing in the late 1990s was larger than
in the UK, this is no longer the case. Within the euro area, only Finland has levels of venture
capital financing that can rival those of the United States. A second-tier group of countries
(Belgium, Germany, France, Ireland and the Netherlands) have similar amounts of venture
capital financing. Finally, early-stage venture capital financing remains limited in Austria,
Greece, Italy and Spain.
It is not clear whether the apparent weakness of the European venture capital sector is
caused by (1) a lack of capital supplied, perhaps reflecting lack of liquidity in still somewhat
nationally segmented venture capital markets, (2) legal, regulatory and tax barriers, or (3) a
shortage of viable exit options for venture capitalists through liquid specialised equity
markets.
5. Implications for central banks
From the point of view of central banks, developments in the financial sector have a special
role that distinguishes them from other services. In so far as financial developments influence
the long term output and employment growth, they can affect the wide range of indicators
and tools that central banks use to monitor and model the behaviour of the economy. More
specifically, changes in the banking sector may affect the monetary transmission
mechanism. A more developed and efficient financial system is likely to contribute to a more
effective, harmonised and smooth transmission of the single monetary policy. In addition, the
stability of the financial system is also a crucial concern for central banks and for the
economy as a whole. In principle, deeper and more complete financial system should provide
a number of social benefits, including better risk hedging and risk diversification that render
economies less vulnerable to disturbances. However, there have long been concerns that
some financial developments may lead to increased speculative behaviour, market volatility
and, ultimately cause or exacerbate financial crises.
Securitisation provides an interesting illustration of how financial developments may
influence the traditional monetary transmission mechanism and raise questions about
financial stability.
As noted above, securitisation provides banks with a new source of financing and capital
regulatory relief. Therefore, under normal macroeconomic conditions, one of the anticipated
consequences of securitisation should be an overall increase in the aggregate supply of
loans.13 By affecting the ability and incentives of banks to grant credit, changes in
securitisation activity are also likely to affect the way monetary policy is transmitted through
credit markets. For instance, according to the "bank lending channel" theory, banks'
conditions can significantly affect how their supply of credit responds to monetary policy
changes. In this respect, after a monetary tightening, the drop in the supply of credit is
expected to be larger for small, less liquid and poorly capitalised banks. However,
securitisation may weaken the effects of these factors on the transmission mechanism since
(1) it may enable banks to provide additional lending without increasing the size of their
balance sheets, (2) it allows them to obtain additional liquidity independently of their
securities holdings, and (3) by removing loans from their balance sheet through
securitisation, banks can improve their capital position on account of the transfer of credit
risk. There is some evidence that the increase in securitisation may have reduced the impact
of monetary policy changes through the "bank lending channel", although this effect seems to
be dependent on the economic cycle and other factors, such as bank risk.14 However, this
does not necessarily mean that the banking sector or the credit markets have become less
relevant since they transmit monetary policy impulses through several other channels
(notably, balance sheets).15 Besides, securitisation affects banks in many different ways that
may render them more sensitive to changes in monetary policy (e.g. by tightening the
relationship between banks' funding ability and conditions in wholesale capital markets).
An additional issue that has become rather topical over the past year is the potential impact
of securitisation and the "originate-to-distribute" model on financial stability. As mentioned
earlier, in principle the ability to securitise loans should enhance the banking sector and
reduce the likelihood of the credit busts and banking crises that have historically posed a
major threat to financial stability in many economies. However, even before the outbreak of
the current financial market turmoil, some commentators have argued that, while
securitisation certainly spreads existing risks, it may in fact encourage the creation of further
risks, particularly by relaxing the incentives for banks to screen and monitor borrowers in
order to alleviate the informational asymmetries associated with credit contracts.16
In
addition, it has been argued that the markets for securitised loans and credit derivatives may
have failed to spread risks as effectively as expected and, by contrast, may have
exacerbated information asymmetries, probably as a result of their opacity and the
complexity of the underlying contracts. More generally, the recent turmoil has highlighted a
number of weaknesses in the credit markets, namely in the areas of transparency, valuation,
risk management practices, the current prudential framework and market functioning.
However, a number of recommendations have been put forward by a wide range of fora and
organisations (e.g. the Financial Stability forum) that should be fully implemented in order to
restore the public's confidence in the ability of securitisation to contribute to social welfare.
To sum up, financial systems provide an important contribution to productivity, innovation
and non-inflationary economic growth in the long term. Central banks have a keen interest in
ensuring their orderly and efficient functioning since this is essential for the smooth conduct
of monetary policy and for the safeguarding of financial stability.